Over the past quarter century, the U.S. has experienced a number of financial crises. At the heart of these crises are often issues surrounding liquidity provision by the banking sector and financial markets (e.g., Acharya, Shin, and Yorulmazer 2007). For example, in the current subprime lending crisis, liquidity seems to have dried up as banks seem less willing to lend to individuals, firms, other banks, and capital market participants, and loan securitization appears to be significantly depressed. This behavior of banks is summarized by the Economist: “Although bankers are always stingier in a downturn, […] lots of banks said they had also cut back lending because of a slide in their current or expected capital and liquidity.”
The practical importance of liquidity during 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).3 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 crises via contagion effects. Bank liquidity creation can also have real effects, in particular if a financial crisis ruptures the creation of liquidity (e.g., Dell’Ariccia, Detragiache, and Rajan 2008). Exploring the relationship between financial crises and bank liquidity creation can thus yield potentially interesting economic insights and may have important policy implications.
The goals of this paper are twofold. The first is to examine the aggregate liquidity creation of banks around five financial crises in the U.S. over the past quarter century.5 The crises include two banking crises (the credit crunch of the early 1990s and the subprime lending crisis of 2007 – ?) and three crises that can be viewed as primarily market-related (the 1987 stock market crash, the Russian debt crisis plus the Long-Term Capital Management meltdown in 1998, and the bursting of the dot.com bubble plus the September 11 terrorist attack of the early 2000s). This examination is intended to shed light on whether there are any connections between financial crises and aggregate liquidity creation, and whether these vary based on the nature of the crisis (i.e., banking versus market-related crisis). A good understanding of the behavior of bank liquidity creation around financial crises is also important to shed light on whether banks create “too little” or “too much” liquidity, and whether bank behavior exacerbates or ameliorates the effects of crises. We document the empirical regularities related to these issues, so as to raise additional interesting questions for further empirical and theoretical examinations.
The second goal is to study the effect of pre-crisis equity capital ratios on the competitive positions and profitability of individual banks around each crisis. Since bank capital affects liquidity creation (e.g., Diamond and Rajan 2000, 2001, Berger and Bouwman forthcoming), it is likely that banks with different capital ratios behave differently during crises in terms of their liquidity creation responses. Specifically, we ask: are high-capital banks able to gain market share in terms of liquidity creation at the expense of low-capital banks during a crisis, and does such enhanced market share translate into higher profitability? If so, are the high-capital banks able to sustain their improved competitive positions after the financial crisis is over? The recent acquisitions of Countrywide, Bear Stearns, and Washington Mutual provide interesting case studies in this regard. All three firms ran low on capital and had to be bailed out by banks with stronger capital positions. Bank of America (Countrywide’s acquirer) and J.P. Morgan Chase (acquirer of Bear-Stearns and Washington Mutual’s banking operations) had capital ratios high enough to enable them to buy their rivals at a small fraction of what they were worth a year before, thereby gaining a potential competitive advantage. The recent experience of IndyMac Bank provides another interesting example. The FDIC seized IndyMac Bank after it suffered substantive losses and depositors had started to run on the bank. The FDIC intends to sell the bank, preferably as a single entity but if that does not work, the bank will be sold off in pieces. Given the way the regulatory approval process for bank acquisitions works, it is likely that the acquirer(s) will have a strong capital base.
A financial crisis is a natural event to examine how capital affects the competitive positions of banks. During “normal” times, capital has many effects on the bank, some of which counteract each other, making it difficult to learn much. For example, capital helps the bank cope more effectively with risk,8 but it also reduces the value of the deposit insurance put option (Merton 1977). During a crisis, risks become elevated and the risk-absorption capacity of capital becomes paramount. Banks with high capital, which are better buffered against the shocks of the crisis, may thus gain a potential advantage.
To examine the behavior of bank liquidity creation around financial crises, we calculate the amount of liquidity created by the banking sector using Berger and Bouwman’s (forthcoming) preferred liquidity creation measure. This measure takes into account the fact that banks create liquidity both on and off the balance sheet and is constructed using a three-step procedure. In the first step, all bank assets, liabilities, equity, and off-balance sheet activities are classified as liquid, semi-liquid, or illiquid. This is done based on the ease, cost, and time for customers to obtain liquid funds from the bank, and the ease, cost, and time for banks to dispose of their obligations in order to meet these liquidity demands. This classification process uses information on both product category and maturity for all activities other than loans; due to data limitations, loans are classified based solely on category (“cat”). Thus, residential mortgages are classified as more liquid than business loans regardless of maturity because it is generally easier to securitize and sell such mortgages than business loans. In the second step, weights are assigned to these activities. The weights are consistent with the theory in that maximum liquidity is created when illiquid assets (e.g., business loans) are transformed into liquid liabilities (e.g., transactions deposits) and maximum liquidity is destroyed when liquid assets (e.g., treasuries) are transformed into illiquid liabilities (e.g., subordinated debt) or equity. In the third step, a “cat fat” liquidity creation measure is constructed, where “fat” refers to the inclusion of off-balance sheet activities. Although Berger and Bouwman construct four different liquidity creation measures, they indicate that “cat fat” is the preferred measure. They argue that to assess the amount of liquidity creation, the ability to securitize or sell a particular loan category is more important than the maturity of those loans, and the inclusion of off-balance sheet activities is critical.9 We apply the “cat fat” liquidity creation measure to quarterly data on virtually all U.S. commercial and credit card banks from 1984:Q1 to 2008:Q1.
Our measurement of aggregate liquidity creation by banks allows us to examine the behavior of liquidity created prior to, during, and after each crisis. The popular press has provided anecdotal accounts of liquidity drying up during some financial crises as well as excessive liquidity provision at other times that led to credit expansion bubbles (e.g., the subprime lending crisis). We attempt to give empirical content to these notions of “too little” and “too much” liquidity created by banks. Liquidity creation has quadrupled in real terms over the sample period and appears to have seasonal components (as documented below). Since no theories exist that explain the intertemporal behavior of liquidity creation, we take an essentially empirical approach to the problem and focus on how far liquidity creation lies above or below a time trend and seasonal factors. That is, we focus on “abnormal” liquidity creation. The use of this measure rests on the supposition that some “normal” amount of liquidity creation exists, acknowledging that at any point in time, liquidity creation may be “too much” or “too little” in dollar terms.
Our main results regarding the behavior of liquidity creation around financial crises are as follows. First, prior to financial crises, there seems to have been a significant build-up or drop-off of “abnormal” liquidity creation. Second, banking and market-related crises differ in two respects. The banking crises (the credit crunch of 1990-1992 and the current subprime lending crisis) were preceded by abnormal positive liquidity creation by banks, whereas the market-related crises were generally preceded by abnormal negative liquidity creation. In addition, the banking crises themselves seemed to change the trajectory of aggregate liquidity creation, while the market related crises did not appear to do so. Third, liquidity creation has both decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation likely both exacerbated and ameliorated the effects of crises. Fourth, off-balance sheet illiquid guarantees (primarily loan commitments) moved more than semi-liquid assets (primarily mortgages) and illiquid assets (primarily business loans) during banking crises. Fifth, the current subprime lending crisis was preceded by an unusually high positive abnormal amount of aggregate liquidity creation, possibly caused by lax lending standards that led banks to extend increasing amounts of credit and off-balance sheet guarantees. This suggests a possible dark side of bank liquidity creation. While financial fragility may be needed to induce banks to create liquidity (e.g., Diamond and Rajan 2000, 2001), our analysis raises the intriguing possibility that the causality may also be reversed in the sense that too much liquidity creation may lead to financial fragility.
We then turn to the second goal of the paper – examining whether banks’ pre-crisis capital ratios affect their competitive positions and profitability around financial crises. To examine the effect on a bank’s competitive position, we regress the change in its market share of liquidity creation measured as the average market share of aggregate liquidity creation during the crisis (or over the eight quarters after the crisis) minus the average market share over the eight quarters before the crisis, expressed as a proportion of the bank’s average pre-crisis market share – on its average pre-crisis capital ratio and a set of control variables. Since the analyses in the first half of the paper reveal a great deal of heterogeneity in crises, we run these regressions on a per-crisis basis, rather than pooling the data across crises. The control variables include bank size, bank risk, bank holding company membership, local market competition, and proxies for the economic circumstances in the local markets in which the bank operates. Moreover, we examine large and small banks as two separate groups since the results in Berger and Bouwman (forthcoming) indicate that the effect of capital on liquidity creation differs across large and small banks.
One potential concern is that differences in bank capital ratios may simply reflect differences in bank risk. Banks that hold higher capital ratios because their investment portfolios are riskier may not improve their competitive positions around financial crises. Our empirical design takes this into account. The inclusion of bank risk as a control variable is critical and ensures that the measured effect of capital on a bank’s market share is net of the effect of risk.
We find evidence that high-capital large banks improved their market share of liquidity creation during the two banking crises, but not during the market related crises. After the credit crunch of the early 1990s, high-capital large banks held on to their improved competitive positions. Since the current subprime lending crisis was not over at the end of the sample period, we cannot yet tell whether highcapital large banks will also hold on to their improved competitive positions after this crisis. In contrast to the large banks, high-capital small banks seemed to enhance their competitive positions during all crises and held on to their improved competitive positions after the crises as well.
Next, we focus on the effect of pre-crisis bank capital on the profitability of the bank around each crisis. We run regressions that are similar to the ones described above with the change in return on equity (ROE) as the dependent variable. We find that high-capital large banks improved their ROE in those cases in which they enhanced their liquidity creation market share – the two banking crises – and were able to hold on to their improved profitability after the credit crunch. They also increased their profitability after the market-related crises. In contrast, for high-capital small banks, profitability improved during two crises, and subsequent to virtually every crisis.
As an additional analysis, we examine whether the improved competitive positions and profitability of high-capital banks translated into better stock return performance. To perform this analysis, we focus on listed banks and bank holding companies (BHCs). If multiple banks are part of the same listed BHC, their financial statements are added together to create pro-forma financial statements of the BHC. The results confirm the earlier change in performance findings of large banks: listed banks with high capital ratios enjoyed significantly larger abnormal returns than banks with low capital ratios during banking crises, but not during market-related crises. Our results are based on a five-factor asset pricing model that includes the three Fama-French (1993) factors, momentum, and a proxy for the slope of the yield curve.
We also check whether high capital provided similar advantages outside crisis periods, i.e., during “normal” times. We find that large banks with high capital ratios did not enjoy either market share or profitability gains over the other large banks, whereas for small banks, results are similar to the small bank findings discussed above. Moreover, outside banking crises, high capital was not associated with high stock returns.
Combined, the results suggest that high capital ratios serve large banks well, particularly around banking crises. In contrast, high capital ratios appear to help small banks around banking crises, marketrelated crises, and normal times a like.
The remainder of this paper is organized as follows. Section 2 discusses the related literature. Section 3 explains the liquidity creation measures and our sample based on data of U.S. banks from 1984:Q1 to 2008:Q1. Section 4 describes the behavior of aggregate bank liquidity creation around five financial crises and draws some general conclusions. Section 5 discusses the tests of the effects of precrisis capital ratios on banks’ competitive positions and profitability around financial crises and “normal” times. This section also examines the stock returns of high- and low-capital listed banking organizations during each crisis and during “normal” times. Section 6 concludes.
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