Ebook Bank Liquidity Creation, Monetary Policy, and Financial Crises
Over the past quarter century, the U.S. has experienced a number of financial crises. At the heart of these financial crises are often issues surrounding liquidity provision by the banking sector (e.g., Acharya, Shin, and Yorulmazer 2009). For example, in the current subprime lending crisis, liquidity seemed to have dried up for an extended time period.
The practical importance of liquidity during financial crises is buttressed by financial intermediation theory, which indicates that the creation of liquidity is an important reason why banks exist. Early contributions argue that banks create liquidity by financing relatively illiquid assets such as business loans with relatively liquid liabilities such as transactions deposits (e.g., Bryant 1980, Diamond and Dybvig 1983). More recent contributions suggest that banks also create liquidity off the balance sheet through loan commitments and similar claims to liquid funds (e.g., Holmstrom and Tirole 1998, Kashyap, Rajan, and Stein 2002). The creation of liquidity makes banks fragile and susceptible to runs (e.g., Diamond and Dybvig 1983, Chari and Jagannathan 1988), and such runs can lead to financial crises via contagion effects. Such crises can affect the real economy if they rupture the creation of liquidity (e.g., Dell’Ariccia, Detragiache, and Rajan 2008).
Because of the importance of liquidity provision by banks to the real economy, the central bank’s monetary policy seeks to counter the effects of negative liquidity shocks. According to the bank lending channel literature, monetary policy may affect bank lending and deposits (for survey papers on this, see Bernanke and Gertler 1995, Kashyap and Stein 1997). Moreover, it may also affect off-balance sheet activities like loan commitments (e.g., Woodford 1996, Morgan 1998).
It is plausible that the conduct of monetary policy varies across normal and financial crisis periods and that monetary policy affects and possibly interacts with aggregate liquidity creation by banks. Yet, we know little about the relationship between monetary policy and bank liquidity creation, and particularly about how this relationship changes during and around financial crises. This paper seeks to fill this void in the literature. Since monetary policy potentially influences both sides of the bank’s balance sheet as well as off-balance sheet activities, we use a comprehensive measure of bank liquidity creation that includes all on and off-balance-sheet activities.
Specifically, we address four broad questions. First, what has been the magnitude of liquidity creation (and some key components) by US banks of different size classes and how has this changed over time? Second, what has been the effect of monetary policy on aggregate bank liquidity creation, and does this effect differ in financial crises from normal times? Third, how have bank liquidity creation and monetary policy behaved during financial crises and in the periods immediately preceding and following those crises? Fourth, from the perspective of bank liquidity creation, how is the current subprime lending crisis different from other financial crises?
To address these questions, our analyses use data on virtually all banks in the U.S. from 1984:Q1 -2008:Q4. The sample period includes five financial crises: the 1987 stock market crash, the credit crunch of the early 1990s, the Russian debt crisis plus the Long-Term Capital Management meltdown in 1998, the bursting of the dot.com bubble plus the September 11 terrorist attack of the early 2000s, and the subprime lending crisis of 2007 – ?
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