Bank Liquidity Creation, Regulations, and Credit Risk

• Published date: 01 June 2020
• Date: 01 June 2020
• Author: Meng‐Fen Hsieh,Chien‐Chiang Lee
• DOI: http://doi.org/10.1111/ajfs.12295

Bank Liquidity Creation, Regulations, and

Credit Risk*

Meng-Fen Hsieh**

Department of Finance, National Taichung University of Science and Technology, Taiwan (ROC)

Chien-Chiang Lee***

Research Center of the Central China for Economic and Social Development, Nanchang University, China

and School of Economics and Management, Nanchang University, China

Received 29 November 2018; Received in current form (2

nd

revision) 25 December 2019; Accepted 19

February 2020

Abstract

This study employs bank-level data covering 3007 individual banks (commercial, savings, and

others) in 27 Asian countries to investigate the determinants of bank liquidity creation, con-

sidering four conditional factors over the period 1999–2013: credit risk, deposit insurance,

financial market regulations, and bank reforms. Bank liquidity creation is shown to be statis-

tically and economically significantly positively related to real economic output, as well as

illiquid assets and core deposits. Larger banks increase their liquid assets ratio, but decrease

their credit commitment. Countries implementing an explicit deposit insurance scheme may

lead to moral hazard and excessive bank risk taking. If supervisory authorities can force a

bank to change its internal organizational structure, or have more power to take legal action

against external auditors for negligence, or increase capital requirements, then banks generally

reduce their lending activities. Nevertheless, larger banks are able to increase liquid assets and

lending to those countries with stricter financial regulations.

Keywords Bank liquidity creation; Capital regulation; Credit risk; Basel III; Financial crisis;

Deposit insurance

JEL Classification: G21, G28, C23

*We would like to thank the editor and referees for their highly constructive comments. The

usual disclaimer applies, and the views are the sole responsibility of the authors. Meng-Fen

Hsieh is grateful to the Ministry of Science and Technology of Taiwan (MOST 107-2410-H-

110-005-MY2 and MOST 106-2410-H-025-003).

**These authors contributed equally to this study and share equal authorship.

***Corresponding author: Distinguished Professor, School of Economics and Management,

Nanchang University, Nanchang, Jiangxi, China. Tel: +86-791-8396-9463, email:

cclee6101@gmail.com.

Asia-Pacific Journal of Financial Studies (2020) 49, 368–409 doi:10.1111/ajfs.12295

368 ©2020 Korean Securities Association

1. Introduction

The 2007–2008 global financial crisis exposed various shortcomings in the manage-

ment of market liquidity. Despite having adequate capital levels, many banks still

experienced difficulties, with significant consequences for system-wide financial sta-

bility. In response to the severity of the financial crisis, the Basel Committee issued

a new international regulatory framework for banks, known as Basel III, w hich pro-

posed both enhanced capital standards and introduced liquidity regulation. Accord-

ing to the new framework, banks are required to meet two quantitative liquidity

ratios: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

1

Most banks in the Asia region, however, emerged from this global financial cri-

sis relatively unscathed versus their peers in Europe and North America, due to the

lessons that governments and companies learned from the 1997 Asia crisis (Lee

et al., 2016). In Asia, the learning curve for banks is steeper in some countries, such

as the Philippines, which will implement Basel III in 2019 in one step according to

the Central Bank of the Philippines. In Singapore, the capital conservation buffer

was phased in between 1 January 2016 and 1 January 2019 (Basel Committee on

Banking Supervision (BCBS), 2016). Specific rules also vary from country to coun-

try. Banks with different classifications in the same country will have various imple-

mentation phases. Thus, banks in different countries, of different types, and with

various credit exposures may behave differently in terms of liquidity.

Our study employs bank-level data covering 3007 individual banks in 27 Asian

countries to investigate the determinants of bank liquidity creation. We contribute

to the existing literature on bank liquidity creation channel by examining the role

that the framework for bank reform plays in explaining the variation across banks

and over time, as well as in the correlation between bank-specific variables and liq-

uidity creation behavior.

As King (2013) presents, given their lack of experience with liquidity regulation,

banks may engage in riskier activities or may reduce traditional activities such as

liquidity creation or market making. Several sophisticated studies on liquidity cre-

ation focus on banks in the United States, in which regulations are not considered

(such as Berger and Bouwman, 2009; Ivashina and Scharfstein, 2010; Cornett et al.,

2011; Acharya and Mora, 2015 etc.). Only a few studies exist on the effects of

changes in capital requirements on one element of liquidity creation, lending (e.g.,

Berger and Udell, 1994; Peek and Rosengren, 1995), as well as studies of changes in

supervisory toughness on lending (Berger et al., 2001). Recently, Jiang et al., (2019)

1

See Basel Committee on Banking Supervision (BCBS) (2010b), Basel Committee on Banking

Supervision (BCBS) (2013), Basel Committee on Banking Supervision (BCBS) (2014) for

more details on the changes to capital requirements and the definitions of the liquidity ratios

as well as the implementation timetable. Thanks for the referee’s suggestion and following

Ashraf et al. (2016) and L’Huillier et al. (2018), this study also adopt NSFR as the proxy of

liquidity.

Bank Liquidity, Regulations and Credit Risk

©2020 Korean Securities Association 369

found that regulatory-induced competition reduces liquidity creation based on

commercial banks in the United States from 1984 to 2006.

There are some studies considering the possible impact of newly introduced reg-

ulatory measures, such as the net stable funding ratio (NSFR). These studies include

the relationship between capital stability and bank liquidity for United States and

European publicly traded banks (Distinguin et al., 2013), risk-taking behavior (Ash-

raf et al., 2016; L’Huillier et al., 2018; Casu et al., 2019), cost efficient strategies for

15 countries (King, 2013), and cost–benefit analysis (Dietrich et al., 2014).

2

More specifically, exploring 136 Islamic banks for over 2000 and 2013, Ashraf

et al. (2016) exam the impact of NSFR on stability and confirm the positive rela-

tionship. Similarly, L’Huillier et al. (2018) echo the positive NSFR–stability relation-

ship by using data from 647 banks located in 47 countries (excluding those in

Europe and North America) from 2003 to 2013. Moreover, focusing on 17 Euro -

zone countries, Casu et al. (2019) evaluate the relationship between capital and liq-

uidity creation following the implementation of the Basel III rules. Casu et al.

(2019) find a bi-causal negative relationship, which suggests that banks may reduce

liquidity creation as capital increases; and when liquidity creation increases, banks

reduce capital ratios.

Liquidity risk in modern banks stems more from exposure to undrawn loan

commitments, the withdrawal of funds from wholesale deposits, and losses of other

sources of short-term financing than from the loss of demand deposits (e.g., Dia-

mond and Dybvig, 1983). With both explicit and implicit government backing,

deposits are unlikely to leave the banking system during crises. Studies have shown

that banks experience funding inflows when liquidity dries up (Saidenberg and Stra-

han, 1999; Gatev and Strahan, 2006).

Pennacchi (2006) shows that governments tend to subsidize deposit insurance

premiums and require too little bank capital during times of tight market liquidity,

even under risk-based capital standards such as Basel II. More recently, Fung

a

cov

a

et al. (2017) examine how the introduction of deposit insurance influences the rela-

tionship between bank capital and liquidity creation in Russia. They find that the

introduction of the deposit insurance scheme has different effects on the relationship

between capital and bank liquidity creation across different types of banks, the banks

characterized by relatively high household deposit ratios being the most affected. For

these banks, deposit insurance reduces the impact of capital on liquidity creation.

Therefore, bank liquidity creation behavior should not just depend on bank

characteristics, but should also vary according to host countries’ financial competi-

tion and regulatory environment. Our paper contributes to the existing lite rature

on the liquidity creation channel by examining the role of the framework for bank

reforms in explaining the variation across banks and over time in the correlation

between bank-specific variables and liquidity creation behavior.

2

Please refer to L’Huillier et al. (2018) for more details.

M.-F. Hsieh and C.-C. Lee

370 ©2020 Korean Securities Association