Recent theory papers by Diamond and Rajan (2000, 2001) and others suggest that banks with higher capital ratios may create less liquidity because capital diminishes financial fragility and/or “crowds out” deposits. Other contributions suggest the opposite outcome: banks with higher capital ratios may create more liquidity because capital gives them greater capacity to absorb the risks associated with liquidity creation. We construct liquidity creation measures for U.S. banks from 1993-2003 and test these opposing theoretical predictions. Our calculations suggest that the industry created over $1.5 trillion in liquidity as of year-end 2003, and this amount has grown over time. For large banks, which account for most of the industry’s assets, we find a statistically significant positive relationship between capital and liquidity creation. For small banks, which comprise the vast majority of the observations, the relationship is significantly negative. Simulation of 1 percentage point higher lagged capital ratios for all banks yields a predicted greater aggregate liquidity creation of 2.0% ($30.6 billion), as the positive effect for large banks overwhelms the negative effect for small banks. However, the positive effect at the industry level may be eliminated under alternative assumptions.
Published in Conference on Bank Structure and Competition (2005 : 41th) ; The art of the loan in the 21st century : producing, pricing, and regulating credit Number 997 223 pages long228
