Creation and Regulation of Bank Liquidity

Abstract

Liquidity creation is a core function of banks and an important economic service to the economy. This chapter discusses two distinct notions of bank liquidity creation developed in the theoretical literature—funding liquidity creation and improved risk sharing for risk-averse depositors. It also examines the empirical literature on bank liquidity creation. The focus is on the economics of bank liquidity creation, both in the traditional relationship banking context and in the shadow-banking context. This chapter discusses related prudential regulation issues, pertaining mainly to capital requirements and liquidity requirements, as well. It provides a historical overview, starting in the early 1800s and ending with Basel III and the Dodd–Frank Act. It identifies open research questions regarding both capital requirements and liquidity requirements.

Liquidity regulation and bank lending

“…During the global financial crisis of 2007-2009, regulators intervened extensively to provide short-term liquidity support to banks that were unable to meet short-term obligations. Since then, bank liquidity has attracted the attention of academics (Calomiris, Heider, and Hoerova 2015;De Nicolò 2016;Chiaramonte, 2018;Bouwman 2019) as policymakers have introduced rules requiring banks to hold more higher quality liquid assets. 2 Proponents of these new regulations contend that by holding a greater proportion of liquid-to-total assets, banks are more resilient to sudden balance sheet shocks, and as a consequence can continue lending even during stressed periods (Schmaltz et al 2014;Boissay and Collard 2016;Bressan 2018;Hoerova et al 2018).…”

“… Goddard, Molyneux and Wilson (2010, 2015, 2019 provide detailed overviews of the banking systems of EU member states before, during and after the global financial crisis.…”

Bank regulation, supervision and liquidity creation

“…This is however contrasting with the finding by Jiang et al ( 2019) that regulatory-induced competition (reducing activity restrictions) has a negative effect on liquidity creation. 8 Also, creating less liquidity under more stringent capital regimes would be consistent with the financial fragility effect argued by Berger and Bouwman (2009), which suggests that banks create more liquidity when their capital structure is fragile as greater fragility motivates banks to monitor their borrowers and commit to creating loans and thus liquidity.…”

“…Literature suggests that the level of regulation stringency may affect positively banks' capability of liquidity creation as a tighter regulatory environment is likely to reduce banks' exposure to excessive risk. When banks create liquidity in the market, they are exposed to liquidity risk (Bouwman, 2019). Banks with higher levels of risk-bearing capacity are therefore able to create more liquidity.…”

Banks and the real economy: An assessment of the research

“…Moreover, banks create liquidity for the nonbank public by transforming relatively illiquid assets such as loans to informationally opaque businesses into relatively liquid liabilities such as transactions deposits that allow almost instantaneous access to funds. Banks also create significant liquidity by issuing offbalance sheet guarantees like loan commitments that allow customers to draw funds under predetermined conditions Bouwman, 2009, 2016;Bouwman, 2020). Banks also manage credit, solvency, interest rate, foreign exchange rate, liquidity, and other risks via diversification, derivatives, and other on-and off-balance sheet activities.…”