Bank Liquidity Creation and Risk‐Taking: Does Managerial Ability Matter?

• Author: Peter Robejsek,Panayiotis C. Andreou,Dennis Philip
• Published date: 01 January 2016
• Date: 01 January 2016
• DOI: http://doi.org/10.1111/jbfa.12169

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(1) & (2), 226–259, January/February 2016, 0306-686X

doi: 10.1111/jbfa.12169

Bank Liquidity Creation and Risk-Taking:

Does Managerial Ability Matter?

PANAYIOTIS C. ANDREOU,DENNIS PHILIP AND PETER ROBEJSEK∗

Abstract: This study investigates the impact of managerial ability on banks’ liquidity creation

and risk-taking behavior. We find that higher ability managers create more liquidity and take

more risk. During times of financial crisis, however, higher ability bank managers reduce

liquidity creation as a way to de-leverage their balance sheets. Our findings inform recent

theoretical and empirical studies that investigate determinants of liquidity creation and risk

by introducing managerial ability as a prominent antecedent of the banks’ intermediation and

risk-transforming service. Moreover, this study has policy-related implications, since managerial

ability can be quantified as a key performance indicator for prudential supervision of banks and

could help regulators to target intervention efforts more purposefully during times of crisis.

Keywords: financial institutions, managerial ability, liquidity creation, risk-taking, financial crisis

1. INTRODUCTION

Bank intermediation, as facilitated by liquidity creation, is one of the central services

banks provide for the economy. Surprisingly, this core function of banks has only

recently received attention in the empirical literature (see, for example, Berger and

Bouwman, 2009). Similarly, the impact of managerial ability on a firm’s outcome has

long been ignored, under the assumption that managers are largely homogeneous

entities that follow identical goals. Only recently has this view been challenged by a

growing body of literature that recognizes the impact that managers have on firm

performance (see, for example, Bamber et al., 2010; Bertrand and Schoar, 2003;

Demerjian et al., 2012). Understanding the link between managerial ability and bank

intermediation is important, especially for policy-makers and regulators. This study

is the first to contribute to this discussion by investigating the impact of managerial

ability on bank liquidity creation. Since risk transformation may coincide with liquidity

creation, this paper also makes assertions regarding the impact of managerial ability

on bank risk-taking behavior.

∗The first author is from Cyprus University of Technology, Department of Commerce, Finance and Shipping,

Lemesos, Cyprus and Durham University Business School, Department of Economics and Finance, Durham,

United Kingdom. The second author is from Durham University Business School, Department of Economics

and Finance, Durham, United Kingdom. The third author is from PwC Strategy & (Germany) GmbH,

Frankfurt, Germany. (Paper received February 2015, revised version accepted November 2015).

Address for correspondence: Dennis Philip, Durham University Business School, Department of Economics

and Finance, Durham, United Kingdom.

e-mail: dennis.philip@durham.ac.uk

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The main goals of this study are twofold. Firstly, we investigate whether managerial

ability has a positive impact on bank liquidity creation. More ably managed banks have,

for example, been found to report higher quality earnings (see, for example, Cantrell,

2013). Higher ability managers are also found to decisively influence corporate

outcomes (Bertrand and Schoar, 2003; Choi et al., 2015; Dejong and Ling, 2013)

and to positively affect firm performance (see, for example, Demerjian et al., 2012)

in industrial firms. Liquidity creation is a key feature of a bank’s outcome and has

been shown to be positively related to bank performance (Berger and Bouwman,

2009). Hence it is reasonable to assume that more able managers will leverage their

bank’s assets to create greater liquidity,aiming for higher per formance. Therefore, we

hypothesize that more able managers create more liquidity. In addition, we postulate

that, because of their superior ability, more able bank managers can better manage,

and in fact do take, more risk. This is a natural corollary to the above argumentation

since, as shown in Berger and Bouwman (2009), banks’ risk-taking is linked to liquidity

creation, as for example when banks issue riskless liquidity deposits to finance risky

illiquid loans.

Secondly, we investigate the link between managerial ability and liquidity expansion

or contraction caused by adverse economic shocks, such as the ones evidenced during

the recent financial crisis. On the managerial ability ambit, Andreou et al. (2015)

find that higher ability managers invest more during the recent financial crisis period

compared to their less able peers, because they reduce the information asymmetry gap

with the markets and have greater capacity to access financing resources; this evidence

lends support to the notion that managerial ability effectiveness is heightened during

such periods. On the bank intermediation ambit, Bebchuk and Goldstein (2011)

develop a theory to support the hypothesis that it may be individually optimal for banks

to curtail their intermediation activity in the face of negative shocks to the economy.

In this respect, Ivashina and Scharfstein (2010) report that loans extended by banks to

large borrowers were significantly reduced during the recent financial crisis. However,

Berger and Bouwman (2014) (see also discussions in Berger and Bouwman, 2009,

2013) present empirical evidence to the contrary. Their collective findings indicate

that some banks may even increase liquidity creation during crises and that such

an increase improves these banks’ value creation and competitiveness. This suggests

that during crises managers under certain conditions may have incentives to expand

the intermediation activity. Banks led by more able managers should therefore be

in a much better position to either contract or expand liquidity in crises, if it is

indeed optimal for them to do so. In this paper, we develop arguments that lead

to testable hypotheses that take into account the divergent views in the literature.

As previously, it is again reasonable to consider a corollary risk-taking hypothesis

that emerges from the banks’ liquidity creation behavior; hence we hypothesize as

to whether higher ability bank managers take more or less risk during the financial

crisis.

Our empirical tests utilize data from virtually every US bank from 1994 to 2010,

comprising 100,976 bank-year observations. Berger and Bouwman (2009) show that

liquidity creation differs considerably among large banks (those with gross total assets

(GTA) exceeding $3 billion), medium banks (those with GTA of $1 billion to $3

billion), and small banks (those with GTA up to $1 billion). Therefore, since size

differences among banks are substantial in terms of liquidity creation, our empirical

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228 ANDREOU, PHILIP AND ROBEJSEK

mediation also takes into account these three size groups separately. With respect

to bank liquidity creation, we rely on the main measure as operationalized in the

seminal work of Berger and Bouwman (2009), which accounts for a bank’s liquidity

creation due to on- and off-balance-sheet activities. To quantify managerial ability,

we elaborate on the methodological ideas in Demerjian et al. (2012), adjusted,

however, to the banking environment confronted in our study. In particular, we

employ stochastic frontier analysis to compare bank managers’ efficiency relative to

their industry peers regarding the transformation of corporate resources to profits, a

process that is in line with the important tenet of a profit-maximizing firm. Managerial

ability is then estimated out of the efficiency scores after taking into account a large

array of bank-specific characteristics that cannot be attributed to the management

team.

For our empirical analysis, we regress bank liquidity creation and risk measures on

the lagged managerial ability while controlling for other bank-related characteristics

that may affect those dependent variables. We use the dollar amount of bank liquidity

divided by GTA as our measure of bank liquidity creation, since, as explained in

Berger and Bouwman (2009), it is necessary to make the liquidity measure meaningful

and comparable across banks, while avoiding giving undue weight to the largest

institutions. Regarding risk measures, we rely on the widely applied risk proxies that

capture a bank’s fragility such as: (i) the tier 1 ratio calculated as tier 1 capital divided

by risk weighted assets using Basel II rules, (ii) risk-weighted assets divided by GTA,

and (iii) Z-Score, which captures distance from default.

To avoid omitted variables, we include (depending on the regression specifica-

tion) a large array of control variables, such as risk, size, bank holding company

membership, merger and acquisition history, local market competition, economic

environment, and bank cost efficiency score. In the empirical investigations of our

hypotheses, for all of the variables relating to managerial ability and other bank

characteristics, we use lagged values rather than contemporaneous values to mitigate

endogeneity concerns that may arise from reverse causality.

Consistent with our hypotheses, the results show that managerial ability is signifi-

cantly positively related to liquidity creation for small and medium-sized banks as well

as for the overall sample. We also find that, for the case of medium and large banks,

higher managerial ability contributes significantly to the riskiness of the bank. For

small banks, this relation is reversed; yet, this can be rationalized as small banks are

confronted with very different incentives, funding constraints and regulatory scrutiny,

which may force higher managerial ability bank managers to handle risk differently

from their peers who lead larger-sized banks. Regarding the effects of managerial

ability on liquidity creation and risk-taking during the financial crisis, findings reveal

that more able managers significantly reduce both their banks’ liquidity and risk

during this period. A large set of robustness checks regarding the definition of the

liquidity creation measure, alternative construction methods for the managerial ability

measure, and various treatments for endogeneity concerns reveal that our results

remain unchanged and provide qualitatively similar conclusions.

The results in this paper contribute to the understanding of the banking industry

in several important ways. This is the first study to investigate the impact of managerial

ability on the liquidity creation of banks. It is also the first study that links bank risk-

taking to the ability of managers. These findings offer a nexus of vital information to

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