According to the modern theory of financial intermediation, an important role of banks in the economy is to create liquidity by funding illiquid loans with liquid demand deposits (e.g. Diamond 1984, Ramakrishnan and Thakor 1984). More generally, banks create liquidity on the balance sheet by transforming less liquid assets into more liquid liabilities. Kashyap, Rajan, and Stein (2002) suggest that banks may also create significant liquidity off the balance sheet through loan commitments and similar claims to liquid funds.
Despite the importance of bank liquidity creation, we are not aware of any comprehensive empirical measurement of liquidity creation by the banking industry. There are no measures to our knowledge that incorporate all the on- and off-balance sheet activities of banks. Moreover, studies of research and policy issues in banking typically focus only on some components of liquidity creation, such as bank loans, which may yield incomplete results.
The first goal of this paper is therefore to develop comprehensive measures of bank liquidity creation and apply these measures to data on U.S. banks. We use annual data on virtually all U.S. banks over 1993-2003, a total of 84,080 bank-year observations. We compare and contrast four alternative measures of liquidity creation, examine the relative importance of different components assets, liabilities, equity capital, off-balance sheet guarantees, and derivatives and trace the growth in liquidity creation over time. We also compare liquidity creation between large and small banks.
Our second goal is to use the liquidity creation measures to analyze the effect of bank capital on liquidity creation, an issue of significant research and policy relevance. As discussed below, the theoretical literature produces diametrically opposing predictions, with some suggesting that capital has a negative effect on liquidity creation and others suggesting a positive impact. There are surprisingly few empirical studies of these theoretical predictions, and the ones that do focus only on limited components of liquidity creation.
We use a three-step procedure to construct our liquidity creation measures. In Step 1, we classify all bank assets, liabilities, equity, and off-balance sheet activities as liquid, semi-liquid, and illiquid. We do this 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. Our use of just three liquidity classifications (liquid, semi-liquid, and illiquid) is a necessary simplification any finer distinctions would have to be arbitrarily made. In Step 2, we assign weights to the activities classified in Step 1.
The weights are consistent with the theory maximum (i.e., dollar-for-dollar) liquidity is created when illiquid assets are transformed into liquid liabilities and maximum liquidity is destroyed when liquid assets are transformed into illiquid liabilities or equity. In Step 3, we construct four liquidity creation measures by combining the activities as classified in Step 1 and as weighted in Step 2 in different ways. The measures classify all activities other than loans by both product category and maturity but due to data limitations classify loans based either on category (“cat”) or on maturity (“mat”). We also alternatively include off-balance sheet activities (“fat”) or exclude them (“nonfat”). We thus construct liquidity creation measures based on the four combinations, “cat fat,” “mat fat,” “cat nonfat,” and “mat nonfat.” As explained below, “cat fat” is our preferred measure.
Our calculations suggest that banks created over $1.5 trillion in liquidity in 2003 using our preferred “cat fat” measure. This is approximately equal to 22% of bank gross total assets or GTA (total assets plus allowance for loan and lease losses and the allocated transfer risk reserve) and about two and a half times the overall level of bank equity capital. Thus, by our estimates, the industry creates approximately $2.5 of liquidity per $1 of capital. Although liquidity creation using this measure declined slightly after 2000, overall bank liquidity creation grew by approximately two-thirds in real terms between 1993 and 2003. Our results are fairly similar when we calculate liquidity creation using our “mat fat” measure that classifies loans based on maturity instead of category. When we use our “nonfat” measures instead which exclude off-balance sheet activities the patterns of liquidity creation over time are similar, but the dollar amounts of liquidity creation are much lower. These findings highlight the importance of liquidity created off the balance sheet.
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