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

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.

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“…They find that firms with higher relative peer quality tend to earn higher risk-adjusted stock returns and to have higher profitability growth than firms with lower values. Using managerial profit efficiency, Andreou et al (2016) find that banks managed by executives with higher abilities create more liquidity and take on more risk. Our hypothesis is consequently that executive directors with higher values of managerial efficiency help the bank more in turning around poor performance than those with lower values of managerial efficiency.…”

“…It is often estimated with stochastic frontier analysis because an important drawback of nonparametric frontier approaches like data envelopment analysis, used to investigate firm efficiency (Demerjian et al, 2012), rest on the assumption of no random errors (Berger and Humphrey, 1997). Thus, the stochastic frontier analysis is better equipped to accommodate noise in the measurement of input, output, and price variables (Andreou et al, 2016). Instead of estimating cost efficiency (e.g.…”

“…Andreou et al, 2016), we estimate risk-return efficiency, hereafter RRE, because Koetter (2008) and Hughes et al (1996) argue that efficiency estimates control insufficiently for bank risk and may be misleading especially when risk preferences differ. We follow banking efficiency studies (i.e., Hughes et al, 1996;Hughes, Mester, and Moon, 2001;Koetter, 2008;Andreou et al, 2016), and choose the stochastic frontier analysis (SFA) to estimate the RRE frontier. Then, we use the intuition by Demerjian et al (2012) to parse out managerial ability from full efficiency.…”

“…Many studies have used cost efficiency (Demerjian et al, 2012;Francis et al, 2016) or profit efficiency (Andreou et al, 2016) to obtain information on managerial ability. However, an important drawback of using them for banks is that risk is not sufficiently controlled for (Koetter, 2008).…”

“…Many recent studies have distilled managerial ability from cost efficiency (e.g. Demerjian et al, 2012;Francis, Hasan, Mani, and Ye, 2016) and profit efficiency (Andreou, Philip, and Robejsek, 2016) by separating full efficiency into a part caused by firm or bank characteristics and another part which is attributed to managerial ability. We use their approach of separating full efficiency, but we do not rely on cost or profit efficiency.…”