How does competition influence liquidity creation? Exploring credit risk, foreign banks, and crisis

Abstract

Contributing to the past literature related on how bank competition affects the creation of liquidity, this research explores a comprehensive dataset of 43 European countries for a total of 13,487 individual banks spanning the period 2005–2020. We evaluate the influences of credit risk, foreign banks, and crisis in the liquidity creation and competition nexus, presenting results that greater competition lowers fragile banks’ incentives and/or risk absorption capacity and increases unprofitable liquidity creation, thus supporting the fragility channel hypothesis. Nevertheless, there is an opposite competition causality for commercial banks and financial holding companies. Commercials banks as well as holding companies are generally larger in terms of assets than other financial institutions and hence may have more market power and capacity to lend more, supporting the price channel hypothesis. Credit risk, foreign banks, and crisis exhibit concrete roles in the liquidity creation and competition nexus. Lastly, we discuss policy implications.