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. JEL Classification: G21, G28Keywords: Bank capital, Liquidity creation, Basel III 2 Nontechnical SummaryThis paper examines the relation between capital and liquidity creation, which is a comprehensive measure of a bank's overall ability to finance relatively illiquid assets with relatively liquid liabilities and thereby serve as a financial intermediary. We test the relation between bank capital and liquidity creation by using an exhaustive dataset of Czech banks from the Czech National Bank from 2000 to 2010. This way we propose a broad perspective on the interactions between capital and liquidity creation in the banking industry. In doing so, we are able to provide evidence on capital requirements limiting liquidity creation, which is highly relevant for appraising the economic implications of the capital requirements in the Basel III reforms.We show, especially for small banks, that capital is found to negatively Granger-cause liquidity creation. However, we also observe that liquidity creation Granger-causes capital reduction. We thus support the view that there is a negative, bi-causal relation between capital and liquidity creation, which corroborates the importance of examining this causality.Our findings have two policy implications for small banks. First, they suggest that the Basel III Accords might lead to reduced bank liquidity creation by introducing tighter capital requirements. Second, our findings support the view that greater liquidity creation may hamper bank solvency.Overall, our primary conclusion is that there is a trade-off between the benefits of financial stability induced by stronger capital requirements and the benefits of greater liquidity creation. Therefore, any action in favor of one objective would deteriorate the other.A possible caveat is that our findings might be dependent on our sample and might not be easily generalizable. However, the Basel III rules are planned to be implemented for a vast array of countries, including that examined here an...

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The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.