Bank Regulation, Supervision and Liquidity Creation

Abstract

The exposures of the banking system during the global financial crisis of 2007-2009 alerted regulators who strengthened their supervision of banks to prevent future problems. Yet, banks need to perform one of their main functions in the economy, which is creating liquidity. This raises the question: does greater regulation and supervision of banks enhance or impede bank liquidity creation? We use the 2019 Bank Regulation and Supervision Survey published by the World Bank to update five regulation indexes and examine the relationship between regulation and liquidity creation. Our results show that liquidity creation is associated with the five regulatory indexes, although in different ways. More specifically, we find that banks create more liquidity in countries with greater official supervisory power and more actions taken to curtail moral hazard associated with deposit insurance, while they create less liquidity in countries with tighter capital regulations, more activity restrictions and stronger private monitoring.