New evidence on liquidity creation and bank capital: The roles of liquidity and political risk

Abstract

This research intends to investigate whether the “bank capital channel” does exist, by examining the relationship between bank capital and liquidity creation through 35 Asian countries over the period 2001–2018 and contributes to the literature in several respects. First, this study confirms the existence of the “bank capital channel” and solves the puzzle between the “risk absorption” hypothesis and the “financial fragility-crowding out” hypothesis. Our results reveal that strongly-capitalized banks retain more liquid assets, but do not lend more. Second, we explore the role of liquidity on the effects of bank capital and lending. Third, this study investigates whether the effect of bank capital on lending differs depending upon the role of political risk. Higher political risk leads to a higher level of uncertainty and results in a decrease of liquidity creation; only properly-capitalized banks are able to increase their liquidity creation. Our robustness tests also reveal that the “risk absorption” effect remains for commercial banks and large banks. However, cooperative banks have a greater positive effect on the banking capital channel probably due to differences in capital requirements. We also consider the effects of concentration and a financial crisis and find that liquidity creation drops under higher competition and during a crisis period. Lastly, we discuss policy implications.