BANK LIQUIDITY CREATION,
FINANCIAL CRISES, AND POLICY ACTIONS
Allen N. Berger
University of South Carolina
Wharton Financial Institutions Center
CentER, Tilburg University
Presentation at the
Southern Finance Association Meetings
Key West, November 2011
WHAT IS BANK LIQUIDITY CREATION?
• Consider a world without banks. An untraded steel
company needs $10 million to build a new mill.
• To finance this, the public must hold an illiquid long-term $10
million security or the firm goes unfunded.
• Enter banks: A bank makes the loan and finances it
with transactions deposits.
• The bank has created liquidity. It has taken something illiquid
away from the public (long-term illiquid loan) and given the
public something liquid (short-term transactions deposits).
• This is one of the primary functions of banks – creating
liquidity by transforming illiquid assets into liquid liabilities.
• Banks also create liquidity off the balance sheet.
• Under a loan commitment, a customer can get cash almost as
easily as with a transactions deposit.
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WHY IS BANK LIQUIDITY CREATION A
CRUCIAL CONCEPT?
• Beyond banking, liquidity creation is very important to
the macroeconomy as a whole.
• Lending, loan commitments, and liquid deposits are all key to
greasing the wheels of commerce, without which we would
have very little economic activity.
• Changes in bank liquidity creation are a potentially important
tool of monetary policy.
• Bank liquidity creation helps keep financial crises from
getting out of control.
• When financial markets freeze up during a crisis, participants
often draw down their loan commitments, which keeps illiquid
firms from becoming insolvent.
• In the recent crisis, all of the big investment banks faced
liquidity problems and either failed, were merged with banks,
or became bank holding companies to gain access to liquidity.
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MOST RESEARCH ON BANK LIQUIDITY
CREATION IS THEORETICAL
• …until Berger and Bouwman (“Bank Liquidity
Creation,” RFS 2009) introduced a comprehensive
measure of bank liquidity creation.
• Value-added of our measure:
• For macroeconomic research: It quantifies an
important function of banks in the economy and a
tool of monetary policy.
• For research on financial crises: Too much bank
liquidity creation may cause financial crises and too
little bank liquidity creation may exacerbate them.
• For banking research: Liquidity creation is a more
complete measure of bank output than the usual
measure of total assets. It includes assets,
liabilities, and off-balance sheet activities.
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GOALS OF THE REST OF THE TALK
• Explain the liquidity creation measure.
• Give some examples of research using the measure.
• Make the measure available to you for your research.
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STEP 1: Classify all bank activities as either liquid, semiliquid, or illiquid.
ASSETS
Liquid Assets
e.g., securities
Semi-liquid Assets
e.g., home mortgages
Illiquid Assets
e.g., business loans
LIABILITIES + EQUITY
Liquid Liabilities
e.g., transactions deposits
Semi-liquid Liabilities
e.g., time deposits
Illiquid Liabilities + Equity
OFF-BALANCE SHEET
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
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STEP 2: Assign weights.
Weight
ASSETS
- 0.5
Liquid Assets
e.g., securities
0
Semi-liquid Assets
e.g., home mortgages
+ 0.5
Illiquid Assets
e.g., business loans
LIABILITIES + EQUITY Weight
Liquid Liabilities
+ 0.5
e.g., transactions deposits
Semi-liquid Liabilities
e.g., time deposits
0
Illiquid Liabilities + Equity
- 0.5
OFF-BALANCE SHEET
+ 0.5
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
- 0.5
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STEP 3: Combine Step 1 and Step 2:
$ liquidity creation = Σ (weight * $ activity)
Weight
ASSETS
- 0.5
Liquid Assets
e.g., securities
0
Semi-liquid Assets
e.g., home mortgages
+ 0.5
Illiquid Assets
e.g., business loans
LIABILITIES + EQUITY Weight
Liquid Liabilities
+ 0.5
e.g., transactions deposits
Semi-liquid Liabilities
e.g., time deposits
0
Illiquid Liabilities + Equity
- 0.5
OFF-BALANCE SHEET
+ 0.5
Illiquid Guarantees
e.g., loan commitments
Liquid Derivatives
(gross fair values)
- 0.5
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Liquidity creation in U.S. (1984-2008)
in $billions
6,000
5,000
4,000
Off-balance
sheet
Total Bank
Liquidity
creation
3,000
2,000
On-balance
sheet
1,000
2008:Q1
2006:Q1
2004:Q1
2002:Q1
2000:Q1
1998:Q1
1996:Q1
1994:Q1
1992:Q1
1990:Q1
1988:Q1
1986:Q1
1984:Q1
0
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RESEARCH ON BANK CAPITAL AND
LIQUIDITY CREATION
• The theoretical literature is ambiguous regarding the
relationship between bank capital and liquidity creation.
• Some theories predict a positive relationship, other
theories predict a negative relationship.
• Using the liquidity creation measure, Berger and
Bouwman (2009) show that capital and liquidity creation
are:
– positively related for large banks
– negatively related for small banks
supporting different theories for different-sized banks.
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IS THERE SUCH A THING AS TOO MUCH
BANK LIQUIDITY CREATION?
• Too much liquidity during a boom may be associated
with lower lending standards, which may create asset
bubbles that burst and cause financial crises.
• Berger and Bouwman (working paper 2011) find that
high aggregate liquidity creation relative to trend is
associated with a significantly increased probability of
a financial crisis striking.
• The liquidity creation measure helps predict financial
crises even after controlling for other macroeconomic
factors.
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HOW DOES POLICY AFFECT BANK
LIQUIDITY CREATION?
1. Monetary policy
• Berger and Bouwman (same paper) find that
loosening US monetary policy does little to
increase bank liquidity creation during normal
times except at small banks.
• These effects are even weaker during financial
crises.
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HOW DOES POLICY AFFECT BANK
LIQUIDITY CREATION?
2. Regulatory interventions (restrictions on lending or
dividend payouts, dismissal of managers, etc.)
• Goal is to reduce risk taking, but may have the
unintended consequence of reducing liquidity
creation.
• Berger, Bouwman, Kick, and Schaeck (working
paper 2011) find that regulatory interventions in
Germany reduce liquidity creation significantly in
both normal times and financial crises.
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HOW DOES POLICY AFFECT BANK
LIQUIDITY CREATION?
3. Capital support (injecting capital into distressed
banks)
• Goal is to reduce risk, but the effect on liquidity
creation may go either way theoretically.
• Berger, Bouwman, Kick, and Schaeck (same
paper) find that capital support at German banks
reduces liquidity creation during normal times,
but not during financial crises.
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OTHER RESEARCH ISSUES
• Countless interesting research and policy questions that
could be addressed using this measure:
• How does bank liquidity creation differ across bank
types, bank- versus market-based systems, and legal
frameworks around the world?
• How do M&As and competition affect bank liquidity
creation?
• How did TARP affect bank liquidity creation?
• How will Basel III capital rules affect bank liquidity
creation?
• How will Basel III liquidity rules affect bank liquidity
creation?
• Any question for which a comprehensive measure of
bank output is called.
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GO FORTH AND USE
THE BANK LIQUIDITY CREATION MEASURE
• I encourage you to be creative in addressing the
previous and other research questions.
• The data for all US banks quarterly from 1984:Q1 to
2010:Q4 is available for free and waiting for you to use it
at Christa Bouwman’s website:
• http://faculty.weatherhead.case.edu/bouwman/data.html
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