The role of investor sentiment in bank liquidity creation

Abstract

Using a comprehensive, forward-looking estimate of investor sentiment based on equity, option, and fixed income markets, we find that investor sentiment is positively related to bank liquidity creation, LC. As investors become more optimistic, both asset-based and off-balance sheet LC rise while liability-based LC decreases, which results in a net increase in LC. The effect is seen in large banks’ LC, while the impact on small banks’ LC is weaker. A channel analysis finds increases in sentiment and bank LC coincide with greater lending that is financed by liquidating cash and securities, as well as by relying on non-depository sources.