A Theory of Bank Capital

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.     

Bank liquidity creation,monetary policy,and financial crises

This paper examines the interplay among bank liquidity creation (which incorporates all bank on- and off-balance sheet activities), monetary policy, and financial crises. We find that: (1) high liquidity creation (relative to trend) – particularly off-balance sheet liquidity creation – helps predict crises, controlling for other factors; (2) monetary policy has statistically significant, but economically minor effects on liquidity creation by small banks during normal times, and these effects are even weaker during financial crises; (3) monetary policy has very little effects on medium and large bank liquidity creation during both normal times and crises. These findings suggest that authorities may wish to monitor bank liquidity creation closely in order to predict and perhaps lessen the likelihood of financial crises. They might also consider other tools to control bank liquidity creation, such as capital and liquidity requirements.     

Liquidity creation and bank capital structure in China

This paper investigates the relationship between liquidity creation and bank capital structure in China. We test the so-called “financial fragility-crowding out” hypothesis and the “risk absorption” hypothesis on Chinese banks and find that bank capital is negatively related to liquidity creation, which supports the financial fragility-crowding out hypothesis. In contrast, we find that foreign banks in China have a weaker relationship between liquidity creation and bank capital, which is consistent with the risk absorption hypothesis and findings in prior studies.     

Do stress tests affect bank liquidity creation?

We examine the impact of Federal Reserve stress tests from 2009 to 2016 on U.S. bank liquidity creation. Empirical results show that regulatory stress tests have a negative effect on both on-and off-balance sheet bank liquidity creation and asset-side liquidity creation. As banks enter the stress tests, they reduce their liquidity creation to avoid failing the stress tests. These results are consistent with the hypothesis that banks manage their risk exposures to meet higher capital requirements. The negative effect of stress testing on liquidity creation continues to persist in the quarters after the stress tests. Finally, stress test banks appear to increase liability-side liquidity creation. These findings highlight that the enhanced financial stability from greater regulatory scrutiny may be achieved at the expense of financial intermediation.     

CARE/CEASA Roundtable on: Liquidity and Capital Management

Five distinguished banking and accounting scholars explore the role of liquidity at not only the “macro” level of the economy, but also at the level of individual companies. The first of the four main speakers, who is the author of the preceding article, restates his argument that the stability of financial systems can be increased by directing bank regulators and executives to find the optimal combination of liquidity and capital requirements. The second of the four speakers shifts the focus to liquidity management by non‐financial companies, with particular emphasis on their use of lines of credit and their role in helping companies weather the financial crisis. The third speaker places liquidity in the context of capital markets, and presents suggestive evidence that improvements in corporate disclosure and transparency have beneficial effects on both the level and volatility of liquidity in those markets. The panel is rounded out by a discussion of liquidity in corporate bond markets and the proposal of a new way to measure such liquidity.     

Limited liability and bank safety net procedures ∗

A model is presented of bank behaviour which identifies the factors determining a bank's optimal capital/asset ratio, its optimal liquidity ratio, the expected value of non-performing loans and the probability of bank failure. We propose that this last variable can act as an index of bank credit-worthiness. The main factors determining this index are (i) the risk associated with bank asset returns, (ii) the variability of bank deposits, (iii) the costs associated with bank failure and (iv) the implicit or explicit government subsidy involved in depositor protection schemes. The principal general conclusion of the paper is that regulations governing capital requirements, liquidity requirements and depositor protection should be (a) risk related and (b) integrated. Depositor protection can be improved through relatively high capital requirements. However, the optimal strategy is for all bank safety net procedures and incentive mechanisms to be related to the riskiness of individual bank portfolios.     

银行监管和股东属性对银行风险的影响——基于新兴经济体的监管数据分析

银行监管按世界银行的标准划分为总体监管和12类分项监管;银行大股东属性包括政府类、金融企业类、外资类等.总体监管可以有效地降低银行风险;大股东为工业类、金融类企业的银行能够更好地控制风险,而家族类银行的风险程度较高;通过对分项监管进行研究可以发现,加强对所有权、资本要求、经营活动限制、外部审计要求、流动性、存款保险制度、退出及监管效率八个方面的监管可降低银行总体风险,而加强准入、内部管理、资产分类配置、信息披露这四类监管反而会增加银行总体风险.     

The effect of bank capital on lending: Does liquidity matter?

This paper uses a sample of quarterly observations of insured US commercial banks to examine whether the effect of bank capital on lending differs depending upon the level of bank liquidity. We find that the effect of an increase in bank capital on credit growth, defined as growth rate of net loans and unused commitments, is positively associated with the level of bank liquidity only for large banks and that this positive relationship has been more substantial during the recent financial crisis period. This result suggests that bank capital exerts a significantly positive effect on lending only after large banks retain sufficient liquid assets.     

International Banking and Liquidity Allocation

This paper explores the comparative advantage of multinational banking over cross-border financial services in terms of capitalizing on a global access to funding sources. We argue that this advantage depends on the benefit and the cost of multinational banks’ intimacy with local markets. The benefit is that it allows multinational banks to create more liquidity. The cost is that it causes inefficiencies in internal capital markets, on which a bank relies to allocate liquidity across countries. We analyze the conditions under which multinational banking is then likely to arise and show that capital requirements have an effect as they influence the degree of inefficiency in internal capital markets for alternative organization structures differently.     

Funding liquidity and bank risk taking

This study examines the relationship between funding liquidity and bank risk taking. Using quarterly data for U.S. bank holding companies from 1986 to 2014, we find evidence that banks having lower funding liquidity risk as proxied by higher deposit ratios, take more risk. A reduction in banks’ funding liquidity risk increases bank risk as evidenced by higher risk-weighted assets, greater liquidity creation and lower Z-scores. However, our results show that bank size and capital buffers usually limit banks from taking more risk when they have lower funding liquidity risk. Moreover, during the Global Financial Crisis banks with lower funding liquidity risk took less risk. The findings of this study have implications for bank regulators advocating greater liquidity and capital requirements for banks under Basel III.     

Bank regulatory capital and liquidity: Evidence from US and European publicly traded banks

The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital and bank liquidity measured from on-balance sheet positions for European and US publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks decrease their regulatory capital ratios when they face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009). However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, our findings also shed light on the need to further clarify how to define and measure illiquidity and also on how to regulate large banking institutions, which behave differently than smaller ones.     

Getting the Right Mix of Capital and Cash Requirements in Prudential Bank Regulation*

Cash reserve requirements are useful as a broadly conceived prudential tool, not just as a narrowly focused means of limiting the risks associated with illiquidity. Indeed, illiquidity risk is neither a necessary nor a sufficient condition for establishing bank liquidity requirements. The primary means of mitigating the systemic costs of bank illiquidity risk is the creation of an effective lender of last resort (LOLR). But instead of focusing narrowly on bank funding risks when designing liquidity requirements, regulators should consider tradeoffs among capital requirements, liquidity requirements, and LOLR policies for achieving the broader prudential goal of limiting bank default risk. When considering the optimal tradeoff between capital ratios and cash ratios as prudential requirements, five “frictions” are identified that favor the use of one or the other: (1) the adverse‐selection costs of raising equity (which favors the use of cash); (2) the opportunity cost of forgone abnormal profits (or “quasi rents”) from lending (which favors the use of capital); (3) the limited verifiability of loan outcomes (which favors the use of cash); (4) the moral hazard that results from costly or postponed loss recognition, given the incentive for risk shifting in bad states (which favors the use of cash); and (5) the prospect of changes in the risk environment (which favors cash since it creates greater option value for maintaining targeted default risk with lower adjustment costs in the face of changing loan risk or illiquidity risk). When viewed from the perspective of achieving the main prudential goal of controlling default risk at a minimum social cost, capital requirements have some limitations that favor liquidity requirements, and vice versa. And thus the optimal regulatory policy will combine liquidity and capital requirements.     

Corporate social responsibility and bank liquidity creation

Under the stakeholder theory hypothesis, reputable corporate social responsibility (CSR) banks are expected to attract more loans and deposits, which in turn strengthens their ability to create liquidity. Our findings support this view. Further analyses reveal that the positive effect of CSR on liquidity creation differs depending on bank size, bank capital, and type of financial crisis. In addition, deposit growth, loan growth, lending rate, and funding rate are potential channels through which CSR influences bank liquidity creation. The findings are not driven by an endogeneity issue.     

Does bank capital reduce liquidity creation?

This paper investigates the relationship between bank capital and liquidity creation against the backdrop of the 2007–2008 financial crisis. Analyzing an unbalanced panel of 11,617 U.S. commercial banks from 1996 to 2016, we find a negative association between regulatory capital and on-balance-sheet liquidity creation, but positive associations for small banks and after the financial crisis. Further, we observe lower liquidity creation among banks that participated in the Troubled Asset Relief Program (TARP). The results are largely robust to several alternate variable proxies and model specifications. Our findings suggest that “one-size-fits-all” policy may have some unintended consequences for banks.     

Efficiency in Islamic vs. conventional banking: The role of capital and liquidity

We show that higher capital and liquidity ratios increase the efficiency of conventional and Islamic banks. Using conditional quantile regressions, we further show that the effect is stronger for highly efficient, small, highly liquid, and highly capitalized conventional banks. We also find that more capitalized and liquid banks were efficient during the 2008/2009 financial crisis and the Arab Spring. Our findings support the view that the constraints imposed by Shari'a law may widen the efficiency gap between the two bank types, at the expense of Islamic banks. Furthermore, our findings suggest that the efficiency of conventional banks not only depends on bank capital and liquidity, but also on the level of bank efficiency while the relationship is inconclusive for Islamic banks. These findings provide insight into how capital and liquidity can shape bank efficiency. They suggest that higher capital and liquidity buffers serve a constraint on policymakers and may function very differently depending on the level of bank efficiency.     

Bank funding structures and risk: Evidence from the global financial crisis

This paper analyzes the evolution of bank funding structures in the run up to the global financial crisis and studies the implications for financial stability, exploiting a bank-level dataset that covers about 11,000 banks in the U.S. and Europe during 2001–09. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with pre-crisis bank risk-taking. In the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border (Global) banks were more vulnerable to solvency risk due to excessive leverage. In fact, a 3.5 percentage point increase in the pre-crisis capital buffers of Global banks would have caused a 48 percentage point in their probability of failure during the crisis. The results support the proposed Basel III regulations on structural liquidity and leverage, but suggest that emphasis should be placed on the latter, particularly for the systemically-important institutions. Macroeconomic and monetary conditions are also shown to be related with the likelihood of bank failure, providing a case for the introduction of a macro-prudential approach to banking regulation.     

Banking Market Size Structure and Financial Stability: Evidence from Eight Asian Countries

Using commercial bank data from eight major Asian countries, we examine the relationship between the banking market size structure and the stability of financial institutions. We also analyze the effect of bank upsizing on the financial stability. Our results show that a rise in large banks’ market power, accompanying an increase in their market shares, lowers the capital adequacy of small banks. Small banks’ nonperforming loans and the possibility of their bankruptcy also increase as large banks’ market shares rise. We further show that larger banks tend to have lower capital adequacy ratios, liquidity ratios, and distance-to-default ratios. Our study suggests that large banks’ greater market shares are associated with small banks’ financial instability. Overall, these findings are consistent with the notion of the recent banking literature that has important antitrust policy implications.     

Large EU banks’ capital and liquidity: Relationship and impact on credit default swap spreads

This paper explores the interrelations between bank capital and liquidity and their impact on the market probability of default. We employ an unbalanced panel of large European banks with listed credit default swap (CDS) contracts during the period 2005–2015, which allow us to consider the impact of the recent financial crisis. Our evidence suggests that bank capital and funding liquidity risk as defined in Basel III have an economically meaningful bidirectional relationship. However, the effect on CDS spread is ambiguous. While capital appears to have a relatively large impact on CDS spread changes, liquidity risk is priced only when it falls below the regulatory threshold.     

Bank Capital and Liquidity Creation: Granger-Causality Evidence

We examine the relation between capital and liquidity creation. This issue is interesting because of the potential impact on liquidity creation from tighter capital requirements such as those in Basel III. We perform Granger-causality tests in a dynamic GMM panel estimator framework on an exhaustive data set of Czech banks, which mainly includes small banks from 2000 to 2010. We observe a strong expansion in liquidity creation until the financial crisis that was mainly driven by large banks. We show that capital negatively Granger-causes liquidity creation in this industry, where majority of banks are small. But we also observe that liquidity creation Granger-causes a reduction in capital. These findings support the view that Basel III can reduce liquidity creation, but also that greater liquidity creation can reduce banks’ solvency. Thus, we show that this reverse causality generates a trade-off between the benefits of financial stability induced by stronger capital requirements and the benefits of increased liquidity creation.     

Why do banks choose to finance with equity?

A majority of U.S. banks between 1973 and 2012 held equity capital significantly beyond the required minimum. We study the risk-return tradeoff in connection with a bank’s capital structure, and identify several new significant market factors that drive the level of equity capital in banks. During normal growth periods, bank leverage is negatively related to a level of competition and loan portfolio diversification, while high bank leverage is associated with low past liquidity. During recessions and expansions, the roles of those factors change following distortions in risk-return tradeoff. In distress, when banks approach regulatory capital requirements, market determinants of book leverage lose their significance; however, leverage does not decrease until a bank is within 1% of the minimal capital threshold.