Bank Liquidity Creation

Abstract

Although the modern theory of financial intermediation portrays liquidity creation as an essential service provided by banks, comprehensive measures of bank liquidity creation do not exist. We therefore have little understanding of how much liquidity banks create, how this liquidity creation changes over time, and the key factors that affect it. In this paper, we construct four comprehensive measures of bank liquidity creation and apply them to data on U.S. banks from 1993-2003. Based on our preferred measure, the amount of liquidity created by the banking sector has grown from less than $1.0 trillion in 1993 to over $1.5 trillion in 2003 in real dollars. Existing theories also provide specific predictions regarding the effect of bank capital on liquidity creation that have not been tested. We test the net effect of bank capital on liquidity creation to examine the circumstances under which the different theories empirically dominate. We find very different results for large and small banks. For large banks, capital has a weak positive effect on liquidity creation and for small banks, the effect is strongly negative. These results are robust to using alternative methods of measuring liquidity creation; using different measures of capital; and corrections to address a potential endogeneity problem associated with bank capital.