Creating liquidity is one of the crucial functions of bank, and this function is linked with bank traditional lending business. But the increasing non-traditional business leads to the decrease of traditional business recently. We wonder if the traditional business is negligible and introduce the measurement of liquidity creation to examine the relationship of liquidity creation on both risk-unadjusted and risk-adjusted performance. This study researches on relationship among liquidity creation and bank performance for 11 advanced countries across 14 years from 1995 to 2008. Since the liquidity creation cannot be determined exogenously, we apply panel two stage least square (2SLS) method.
We found that the liquidity creation is positively related to ROA and risk-adjusted ROA and negative to ROA volatility. The results shows that banks can improve both performance and risk-adjusted performance by creating liquidity, and liquidity creation can also reduce bank risk. Furthermore, the results also present that scale economies exist so that larger banks link with a higher performance and a lower risk level. But additional capital would rather increase performance and risk, this result does not support the risk absorption theory.
In the subsample analysis, since bank-based and market-based systems are very different, then we would divide our sample by financial systems. Evidence shows that the results from financial systems are unsurprisingly different; liquidity creation could improve bank performance in market-based system but harm in bank-based system, and consider to the risk-adjusted ROA, liquidity creation only works in market-based system. But the stabilization ability on ROA both exists in bank-based and market-based systems, this point out the importance of stabilization of liquidity
creation.
Though liquidity creation cannot carry profits for a part of banks, but the effectiveness of lowering risk is doubtless. This study measures the bank traditional lending business and finds that the traditional business can lower the risk effectively and heighten the risk-adjusted return. This implies that even the non-traditional business is profitable, but never overlooks the risk hidden behind and the traditional business can help reduce bank risk thus obtain a better risk-adjusted return. For a firm which pursues high profit and low risk at the meanwhile, it should not abandon the traditional business since its risk-downing nature.
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Table 1 Liquidity classification (sorted in Bankscope categories)
This table is modified from the categories of Berger and Bouwman (2009) since the categories are different from these in Bankscope database.
Assets
Illiquid (weight=1/2) Semi-liquid (weight=0) Liquid (weight=-1/2) HP / Lease Mortgages Deposits with Banks
Other Loans Loans to Banks Cash and Due from Banks Loans to Group Companies / Associates Loans to Municipalities / Government Due from Other Banks
Loans to Other Corporate Due from Other Credit Institutions
Overdue Loans Total Securities
Restructured Loans Treasury Bills
Other non-performing Loans Other Bills
Trust Account Lending Bonds
Other Lending CDs
Intangible Assets Equity Investments
Other Non Earning Assets Other Investments Land and Buildings
Total Fixed Assets
Table 1 Liquidity classification (cont’d) Liabilities plus Equity:
liquid (weight=1/2) Semi-liquid (weight=0) Illiquid (weight=-1/2) Deposits - Demand Time Deposit Subordinated Debt
Deposits – Savings Commercial Paper Other Liabilities Banks Deposits Other Funding Total Equity Municipalities / Government Deposits Other Securities Other Bonds
Commercial Deposits Debt Securities Mortgage Bonds Other Deposits Securities Loaned Convertible Bonds
Off-balance sheet activities:
Illiquid (weight=1/2) Semi-liquid (weight=0)
Acceptances Documentary Credits
Documentary Credits Guarantees
Other
Table 2 Variable definition
This table summarize all variable used and the expected sign denotes the expected results of specific variable for regression on avroa.
Variable Symbol Expected Sign Definition
Performance
avroa -- 3 year average of return on average asset from year t-2 to t sigavroa -- 3 year standard deviation corresponding to AVROA sharproa -- Sharpe ratio of ROA = AVROA/sigavroa
Liquidity creation lnlc + Ln(liquidity creation)
Size size ? Ln(total asset) Capital teta + total equity/total asset Macroeconomic gdpc + annual change(%) in GDP
gdpct_1 + lagged GDP change
Regulation
osp ? index for official supervisory power pmi ? private monitoring index bar ? bank activity regulatory
Liquidity l_ta -- gross loan/ total asset Financial
Structure d_fs -- dummy for financial structure, 0 = Market-based, 1 = Bank-based
Table 3 Financial system classifications
This table shows the corresponding financial systems of the countries in our sample criteria and the data source is originated from Demirgüç-Kunt & Levine (1999)
Financial System Country
Bank-based Belgium France
Germany Italy Japan
Market-based Canada Netherland
Sweden Switzerland United Kingdom
United States of America
Table 4 Correlation coefficients
avroa sigavroa sharproa lnlc size teta gdpc gdpct_1 gdpcxosp gdpcxpmi gdpcxbar
avroa 1.0000
sigavroa 0.2153 1.0000
sharproa 0.1038 -0.3485 1.0000 lnlc -0.1477 -0.1588 0.0502 1.0000
size -0.0385 -0.0284 -0.0284 0.3161 1.0000
teta 0.4645 0.3274 -0.0591 -0.4069 -0.2349 1.0000 gdpc 0.3983 0.0674 0.0588 -0.1232 -0.0524 0.2503 1.0000
gdpct_1 0.3869 0.0717 0.0547 -0.1184 -0.0346 0.2476 0.8408 1.0000
gdpcxosp 0.4183 0.0544 0.1035 -0.0930 -0.0010 0.2107 0.9147 0.7559 1.0000
gdpcxpmi 0.4444 0.0821 0.0749 -0.1233 -0.0239 0.2615 0.9795 0.8458 0.9527 1.0000
gdpcxbar 0.4552 0.0738 0.0700 -0.0913 -0.0450 0.2585 0.9485 0.8482 0.8933 0.9596 1.0000
Table 5 Descriptive statistics
This table shows the descriptive statistics of all time-variant variables.
Table 6 Unit root test results
Fisher Pλ test is proposed by Maddala and Wu (1999) and test for the null hypothesis that the specific variable is nonstationary, and we test for all time varying variables include dependent and independent variables.
Variable df. Chi2 Prob > chi2
avroa 10384 1.76e+04 0.0000
sigavroa 10372 2.08e+04 0.0000
sharproa 10334 2.81e+04 0.0000
lnlc 12848 1.96e+04 0.0000
teta 12838 2.32e+04 0.0000
size 12848 1.41e+04 0.0000
l_ta 12782 2.17e+04 0.0000
Variable Obs Mean Std. Dev. Min Max avroa 46050 0.558549 0.663699 -1.38333 5.036667 sigavroa 45692 0.25529 0.426366 0.005774 3.810372 sharproa 45234 7.689502 9.675609 -1.0505 59.17843 lnlc 63107 11.43905 5.94134 -20.7909 20.88027
teta 63083 8.999253 10.04948 0 100
size 63112 13.61435 1.820165 6.471707 21.82674 l_ta 62775 58.1515 20.47498 -0.23 99.99 gdpc 63112 1.176872 1.307741 -1.810955 5.22 gdpct_1 63112 1.220063 1.317528 -1.810955 5.22 gdpcxosp 63112 11.40942 14.0274 -23.5424 45.74921 gdpcxpmi 63112 7.404327 9.223923 -14.4876 31.32 gdpcxbar 63112 2.311303 3.486737 -5.97615 13.01324
Table 7 Endogenous regression result
This model use fixed-effect model to test for the relationship of endogenous variable (LnLC) and instrument variables.
gdpct_1 0.059*** 0.016658 3.53 0
l_ta 0.112*** 0.001482 75.59 0
Rsq=0.4306
Note: ***, ** and * denote significance at the 1%, 5% and 10% levels respectively.
Table 8 IV Regression results for full sample
In this table we estimate the effects of dependent variables on performance by two stage least square (2SLS), and from panel A to C shows the result for unweighted 3 year average (AVROA), 3 year sigma of ROA (sigavroa) and Sharpe Ratio of ROA (sharproa).
Panel A: Regress for AVROA (N=46045)
_cons 0.110* 0.060 0.108 0.132**
lnlc 0.011*** -0.001 0.011*** 0.012***
size 0.013** 0.029*** 0.013** 0.011**
teta 0.020*** 0.017*** 0.020*** 0.020***
gdpc 0.001 0.019* -0.016 0.032***
gdpct_1 -0.032*** -0.033*** -0.033*** -0.031***
gdpcxosp -0.002*
gdpcxpmi 0.003
gdpcxbar -0.017***
R-sq 0.1156 0.1063 0.1284 0.0683
Hausman Chi2 2,924.770*** 3,473.860*** 2,575.310*** 2,517.570***
Davidson-MacKinnon F 39.053*** 38.396*** 38.036*** 43.233***
Panel B: Regress for sigavroa (N=45685)
_cons 0.591*** 0.609*** 0.594*** 0.608***
lnlc -0.015*** -0.015*** -0.015*** -0.015***
size -0.016*** -0.018*** -0.017*** -0.018***
teta 0.006*** 0.006*** 0.006*** 0.006***
gdpc 0.009*** -0.016 0.038*** 0.034***
gdpct_1 0.009*** 0.009*** 0.010*** 0.010***
gdpcxosp 0.002***
gdpcxpmi -0.005**
gdpcxbar -0.014***
R-sq 0.0729 0.0713 0.0706 0.0706
Hausman Chi2 415.650*** 434.560*** 441.330*** 449.720***
Davidson-MacKinnon F 54.500*** 53.738*** 52.365*** 51.322***
Panel C: Regress for sharpROA (N=45685)
_cons 14.945*** 13.736*** 14.874*** 14.602***
lnlc 0.098* 0.092* 0.090* 0.090*
size -0.538*** -0.455*** -0.526*** -0.508***
teta -0.025* -0.022 -0.026* -0.024*
gdpc -0.419*** 1.328*** -1.312*** -0.974***
gdpct_1 -0.254*** -0.262*** -0.277*** -0.273***
gdpcxosp -0.169***
gdpcxpmi 0.146***
gdpcxbar 0.298***
R-sq 0.0002 0.0042 0.0016 0.0015
Hausman Chi2 37.090*** 535.380*** 916.700*** 1,310.790***
Davidson-MacKinnon F 3.789* 3.085* 3.173* 3.127*
Note: *, ** and *** denote significance at the 10%, 5% and 1% levels respectively. The Hausman Chi2 and Davidson-MacKinon F is using to compare the IV versus OLS regression and fixed-effect versus random-effect, and only the fitting one would be shown in table.
Table 9 IV regression results split by financial structure
Same as table 7, this model is estimated by two stage least square (2SLS) both in bank-based and market-based countries, and from panel A to C shows the result for unweighted 3 year average (AVROA), 3 year sigma of ROA (sigavroa) and Sharpe Ratio of ROA (sharproa) respectively.
Panel A: Results for unweighted 3 year average ROA
avroa Market-Based(N=12738) Bank-Based(N=33185)
_cons 0.733*** 0.721*** 0.715*** 0.703*** -0.099 -0.100 -0.120* -0.093 lnlc 0.031*** 0.031*** 0.031*** 0.031*** -0.001* -0.001* -0.001* -0.001*
size -0.010 -0.009 -0.009 -0.007 0.025*** 0.025*** 0.027*** 0.024***
teta 0.015*** 0.015*** 0.015*** 0.015*** 0.024*** 0.024*** 0.025*** 0.024***
gdpc 0.031*** 0.053** 0.101 0.138*** -0.006** -0.005 -0.058*** -0.002 gdpct_1 -0.089*** -0.088*** -0.088*** -0.089*** -0.018*** -0.018*** -0.019*** -0.018***
gdpcxosp -0.002 0.000
gdpcxpmi -0.009 0.009***
gdpcxbar -0.050*** -0.002
R-sq 0.0601 0.0581 0.059 0.0294 0.1648 0.1653 0.1857 0.1597 Hausman Chi2 273.400*** 302.910*** 277.340*** 490.460*** 1098.81*** 1039.04*** 926.19*** 968.47***
Davidson-MacKinnon F 78.635*** 78.569*** 78.673*** 81.546*** 2.546 2.627 3.758* 2.492
Note: *, ** and *** denote significance at the 10%, 5% and 1% levels respectively. The Hausman Chi2 and Davidson-MacKinon F is using to compare the IV versus OLS regression and fixed-effect versus random-effect, and only the fitting one would be shown in table.
Panel B: Results for 3 year sigma ROA
sigavroa Market-Based(N=12853) Bank-Based(N=32694)
_cons 0.489*** 0.451*** 0.431*** 0.490*** 0.636*** 0.680*** 0.662*** 0.701***
lnlc -0.023*** -0.023*** -0.023*** -0.023*** -0.011*** -0.010*** -0.010*** -0.010***
size -0.001 0.003 0.004 -0.001 -0.026*** -0.029*** -0.029*** -0.032***
teta 0.004*** 0.004*** 0.004*** 0.004*** 0.008*** 0.008*** 0.008*** 0.008***
gdpc -0.001 0.059*** 0.217*** -0.005 0.009*** -0.049*** 0.074*** 0.051***
gdpct_1 0.046*** 0.048*** 0.048*** 0.046*** -0.002 0.000 0.000 0.000
gdpcxosp -0.005*** 0.006***
gdpcxpmi -0.029*** -0.011***
gdpcxbar 0.002 -0.024***
R-sq 0.0735 0.0766 0.0779 0.0736 0.0478 0.0325 0.0512 0.0488 Hausman Chi2 252.480*** 252.350*** 251.350*** 252.700*** 148.910*** 511.360*** 10.860* 340.400***
Davidson-MacKinnon F 44.008*** 44.198*** 44.031*** 44.117*** 15.758*** 13.257*** 13.130*** 12.301***
Note: *, ** and *** denote significance at the 10%, 5% and 1% levels respectively. The Hausman Chi2 and Davidson-MacKinon F is using to compare the IV versus OLS regression and fixed-effect versus random-effect, and only the fitting one would be shown in table.
Panel C: Regress for sharpROA
sharproa Market-Based(N=12754) Bank-Based(N=32297)
_cons 19.957*** 19.707*** 19.965*** 19.635*** 12.720*** 10.945*** 11.763*** 11.339***
lnlc 0.197*** 0.197*** 0.197*** 0.200*** -0.001 0.004 0.001 0.049***
size -0.781*** -0.757*** -0.782*** -0.742*** -0.360** -0.279* -0.278* -0.305***
teta -0.029 -0.028 -0.029 -0.025 -0.013 -0.008 -0.005 -0.054***
gdpc -0.194 0.267 -0.228 0.912** -0.449*** 2.044*** -3.012*** -1.347***
gdpct_1 -0.876*** -0.860*** -0.876*** -0.875*** -0.080 -0.138* -0.121* 0.044
gdpcxosp -0.041 -0.250***
gdpcxpmi 0.005 0.455***
gdpcxbar -0.521*** 0.659***
R-sq 0.031 0.0272 0.031 0.0232 0.0012 0.0204 0.0039 0.0003 Hausman Chi2 62.540*** 299.540*** 189.320*** 72.660*** 170.03*** 498.84*** 149.35*** 189.28***
Davidson-MacKinnon F 7.039*** 7.023*** 7.039*** 7.385*** 0.333 0.002 0.012 0.005
Note: *, ** and *** denote significance at the 10%, 5% and 1% levels respectively. The Hausman Chi2 and Davidson-MacKinon F is using to compare the IV versus OLS regression and fixed-effect versus random-effect, and only the fitting one would be shown in table.
Appendix: Survey Questions of Bank Regulation and Supervision
I. Based on Barth, Caprio, and Levine (2004), the survey questions used to construct the official supervisory power:
1. Does the supervisory agency have the right to meet with external auditors to discuss their report without the approval of the bank? Yes/No
2. Are auditors required by law to communicate directly to the supervisory agency any presumed involvement of bank directors or senior managers in explicit activities, fraud, or insider abuse? Yes/No
3. Can supervisors take legal action against external auditors for negligence?
Yes/No
4. Can the supervisory authority force a bank to change its internal organizational structure? Yes/No
5. Are off-balance sheet items disclosed to supervisors? Yes/No
6. Can the supervisory agency order the bank’s directors or management to constitute provisions to cover actual or potential losses? Yes/No
7. Can the supervisory agency suspend the directors’ decision to distribute dividends? Yes/No
8. Can the supervisory agency suspend the directors’ decision to distribute bonuses?
Yes/No
9. Can the supervisory agency suspend the directors’ decision to distribute management fees? Yes/No
10. Can the supervisory agency legally declare—such that this declaration supersedes the rights of bank shareholders—that a bank is insolvent? Yes/No 11. Does the Banking Law give authority to the supervisory agency to
intervene—that is, suspend some or all ownership rights—a problem bank?
Yes/No
12. Regarding bank restructuring and reorganization, can the supervisory agency or any other government agency do the following? Yes/No
13. Supersede shareholder rights? Yes/No 14. Remove and replace management? Yes/No 15. Remove and replace directors? Yes/No
II. Based on Barth, Caprio, and Levine (2004), the survey questions used to construct the private monitoring index:
1. Whether bank directors and officials are legally liable for the accuracy of information disclosed to the public? Yes/No
2. Whether banks must publish consolidated accounts? Yes/No
3. Do banks must be audited by certified international auditors? Yes/No
4. Whether 100% of the largest 10 banks are rated by international rating agencies?
Yes/No
5. Are off-balance sheet items are disclosed to the public? Yes/No
6. Whether banks must disclose their risk management procedures to the public?
Yes/No
7. Whether accrued, though unpaid interest/principal enter the income statement while the loan is still non-performing? Yes/No
8. Is subordinated debt is allowable as part of capital? Yes/No
9. Whether there is no explicit deposit insurance system and no insurance was paid the last time a bank failed? Yes/No
III. Based on Barth, Caprio, and Levine (2004), the survey questions used to construct overall bank activities and ownership restrictiveness:
Bank activities restrictiveness:
1. What is the level of regulatory restrictiveness for bank participation in securities activities (the ability of banks to engage in the business of securities underwriting, brokering, dealing, and all aspects of the mutual fund industry)?
2. What is the level of regulatory restrictiveness for bank participation in insurance activities (the ability of banks to engage in insurance underwriting and selling)?
3. What is the level of regulatory restrictiveness for bank participation in real estate activities (the ability of banks to engage in real estate investment, development, and management)?
Unrestricted = 1: full range of activities can be conducted directly in the bank.
Permitted = 2: full range of activities can be conducted, but some or all must be conducted in subsidiaries.
Restricted = 3: less than full range of activities can be conducted in the bank or subsidiaries.
Prohibited = 4: the activity cannot be conducted in either the bank or subsidiaries.
Ownership restrictiveness:
1. What is the level of regulatory restrictiveness for bank ownership of nonfinancial firms?
Unrestricted = 1: a bank may own 100 percent of the equity in any nonfinancial firm
Permitted = 2: a bank may own 100 percent of the equity of a nonfinancial firm, but ownership is limited based on a bank’s equity capital
Restricted = 3: a bank can only acquire less than 100 percent of the equity in a nonfinancial firm
Prohibited = 4: a bank may not acquire any equity investment in a nonfinancial firm.
Source: World Bank guide questions, which is available from World Bank research (Bank Regulation and Supervision) or Barth, Caprio, and Levine (2004).