Bank Capital, Liquidity Creation and Deposit Insurance

Abstract

This paper examines how the introduction of deposit insurance influences the relationship between bank capital and liquidity creation. As discussed by Berger and Bouwman (2009), there are two competing hypotheses on this relationship which can be influenced by the presence of deposit insurance. The introduction of a deposit insurance scheme in an emerging market, Russia, provides a natural experiment to investigate this issue. We study three alternative measures of bank liquidity creation and perform estimations on a large set of Russian banks. Our findings suggest that the introduction of the deposit insurance scheme exerts a limited impact on the relationship between bank capital and liquidity creation and does not change the negative sign of the relationship. The implication is that better capitalized banks tend to create less liquidity, which supports the "financial fragility/crowding-out" hypothesis. This conclusion has important policy implications for emerging countries as it suggests that bank capital requirements implemented to support financial stability may harm liquidity creation.

A Financial Analysis of the Liquidity Creation and the Capital Holdings of Turkish Banks

“…Specifically, while more capital leads to more liquidity creation for small Turkish banks, it results in reduced liquidity creation for large banks. As indicated by Fungáčová et al (2017), a decrease in liquidity creation is very important to consider because it could lead to other problems in the economy such as a decrease the amount of financing and a slowdown in economic growth. Therefore, according to our findings, there exists a tradeoff between financial stability and liquidity creation for the case of large banks in emerging markets.…”

“…To consider the impact of reverse causality and endogeneity, following Berger and Bouwman (2009) and Fungáčová et al (2017), we use lagged independent variables in the model. Since we have a limited number of quarters and observations, following Fungáčová et al (2017), we only use a lag of one quarter for limiting the decrease in observations. We regress the liquidity creation measure on the independent variables that capture the bankspecific and macroeconomic factors that may potentially affect the relationship.…”

“…On the other hand, the "financial fragility-crowding out" hypothesis holds for small banks where higher levels of capital let small banks to create more liquidity. Fungáčová et al (2017) explore the link between bank capital, deposit insurance and liquidity creation using a dataset on an emerging market, Russia. Their findings indicate that there exists a negative relationship between the level of bank capital and liquidity creation, supporting "financial fragility-crowding out" hypothesis, which also holds under deposit insurance mechanism.…”

Cyclicality of bank liquidity creation

“…Existing empirical literature in the emerging research area of bank liquidity creation focuses on determinants of bank liquidity creation. Several studies suggest, for example, that while bank capital tends to be negatively related to liquidity creation, it may depend on bank size and presence of deposit insurance system (Lei and Song, 2013;Fungáčová, Weill, and Zhou, 2017).…”

“…Several works build on this approach in examining the determinants of liquidity creation (e.g. Berger, Bouwman, Kick, and Schaeck, 2016;Fungáčová, Weill, and Zhou, 2017), as well as the consequences of liquidity creation for financial stability (Berger and Bouwman, 2012;Fungáčová, Turk, and Weill, 2015).…”