Strategic Liquidity Mismatch and Financial Sector Stability

Abstract

This paper examines whether banks strategically incorporate their competitors’ liquidity mismatch policies when determining their own and the impact of these collective decisions on financial stability. Using a novel identification strategy exploiting the presence of partially overlapping peer groups, I show that banks’ liquidity transformation activity is driven by that of their peers. These correlated decisions are concentrated on the asset side of riskier banks and are asymmetric, with mimicking occurring only when competitors take more risk. Accordingly, this strategic behavior increases banks’ default risk and overall systemic risk, highlighting the importance of regulating liquidity risk from a macroprudential perspective. ReceivedMay 4, 2016; editorial decision January 1, 2019 by Editor Philip Strahan. Author has furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Liquidity creation, investment, and growth

“…Our classification is largely consistent withSilva (2019), who calculates on-balance sheet liquidity creation for 1, 584 commercial banks operating in 34 OECD countries from 1999 to 2014. Our study further considers off-balance sheet liquidity creation since banks create a significant part of their liquidity off the balance sheet (with potentially important effects on economic activity).…”

“…We discard data after 2014 because they have undergone important changes resulting from the termination of contract between BvD and Fitch. This choice is in line with recent studies using Bankscope data (Silva, 2019). Also following Silva (2019), we rely on information at the most disaggregated level and avoid double-counting within the same bank by discarding consolidated entries if banks report unconsolidated data.…”

“…This choice is in line with recent studies using Bankscope data (Silva, 2019). Also following Silva (2019), we rely on information at the most disaggregated level and avoid double-counting within the same bank by discarding consolidated entries if banks report unconsolidated data. 5 We then build on the work of Berger and Bouwman (2009) in creating our measures of liquidity creation, which incorporate the contributions of all bank assets, liabilities, equity, and off-balance sheet activities.…”