Chapter 10 - Do Better Capitalized Banks Create More or Less Liquidity?

Abstract

The theories on the effects of bank capital on liquidity creation are split: some suggest that capital may impede liquidity creation, while others argue it improves liquidity creation. This chapter reviews these theories and summarizes the empirical evidence. The US evidence shows that the results differ by bank size: based on the preferred “cat fat” measure, the effect is positive for large banks (most of the banking sector assets), and negative for small banks (most of the banks). Based on the less-desired “cat nonfat” measure, which excludes off-balance sheet activities, the effect is not significant for large banks but remains significantly negative for small banks. Evidence from the rest of the world, while limited, is generally consistent, except that the large bank results are generally insignificant, possibly because off-balance sheet activities are less important outside the United States. The key takeaway is that bank capital may on net have a positive or a negative effect on liquidity creation, with different effects dominating for banks in different size classes and countries, depending in part on off-balance sheet activities.