The Interrelationship between Liquidity Creation and Capital in Vietnamese Banking

Abstract

We examine the interrelationship between liquidity creation and capital in Vietnamese banking where mainly includes small banks between 2007 and 2015 by using the three-stage least squares in a simultaneous equation framework. This appears that a strong expansion in liquidity creation was mainly contributed by large banks. Furthermore, we find that an increase in non-performing loans is associated with greater liquidity creation, supporting a moral hazard hypothesis. Finally, our findings indicate the two-way negative relationships between liquidity creation and capital. This suggests that Basel III could reduce liquidity creation but also that greater liquidity creation could increase banks’ insolvency. Therefore, this trade-off between the benefits of financial stability induced by tightening capital requirements and those of enhanced liquidity creation has important implications for Vietnamese authorities in strengthening the banking system.