Liquidity Creation

The liquidity creation is the function that bank creates liquidity to financial market through accepting liquid assets and making illiquid loans. This procedure of liquidity creation is not just restricted to bank activities, former research considered it as a behavior that transforms the assets into liabilities, so the liquidity creation may be accomplished at the firm level without the necessity for bank intermediation (Gorton

& Pennacchi, 1990). Firms can just simply split the cash flows of their asset portfolios

by issuing both equity and debt in a stock or equity market. In this study we mainly focus on the bank activities and performance, therefore we don’t take this view into account. Since the definition of liquidity creation is not so clear, we thus discuss its original senses by introducing the origin of liquidity in the first section.

2.2.1 The Origin of Liquidity Creation

It is necessary to distinguish the liquidity versus liquidity creation. Though they are highly correlated, they are not all the same. Initially, the analyses of Patinkin (1965), Tobin (1965), and Niehans (1978) provided insights into characterizing the liquidity of assets, and inspired Diamond & Dybvig (1983) to discover the importance of liquidity, therefore the definition of liquidity had been broadly discussed for a long time. Thadden (1999) concluded three prominent views as follows: we view an asset as a liquid asset if it can be bought or sold quickly at low transaction costs and a reasonable price (Biais et al, 1997); the liquidity also refers to the availability of instruments that can be used to transfer wealth across periods (Bryant, 1980;

Holmström & Tirole, 1998), that means we can get money by liquidating assets over periods; Diamond & Dybvig (1983) also defined an asset is liquidity if it allows agents to consume intertemporally as they would like to, it describes the function best that banks prepare liquidity for being withdrawn anytime. Even though the opinions are widely divided, but in generally we refer to the ability that how fast and how good an asset converts into cash when mentioning the word “liquidity”.

Compare to the definitions of liquidity, the liquidity creation is essentially the process that bank provides liquidity for any natural or legal person for drawing anytime, and make the illiquid loans so that agents can ensure that bank won’t call back its money anytime. In short, the liquidity creation is that bank accepting

short-term, liquid deposits and make long-term, illiquid loans (Deep & Schaefer, 2004). Consider the category rather than the maturity, Berger & Bouwman (2005, 2009) extended the definition and thought liquidity creation as the procedure that bank transforms its illiquid assets into liquid liabilities. In fact it’s more like extension from the view of Diamond & Dybvig (1983); bank creates liquidity for customers to be used. Through this process, or this function, bank injects liquidity into the financial market and stimulates the economic activities.

2.2.2 Measurement of Liquidity Creation

Though the function of creating liquidity had been brought up since 1965, there was no measurement for quantifying it until the liquidity creation by Berger &

Bouwman (2009). Allen (1981) indicated that the pure liquidity creation takes place when the banking system guarantees the client that he will be able to borrow money whenever he likes. However, they did not offer a comprehensive method to measure the liquidity creation; it just represents the loan-deposit matching relationship. Even if Diamond & Dybvig (1983) provided an insight of the process of liquidity creation, they only take this idea into account but didn’t develop the measurements.

The liquidity creation measurement was originated from liquidity transformation by Deep & Schaefer (2004). They constructed the liquidity transformation gap (LT gap) to calculate the magnitude of liquidity transformation, and defined it as the difference between liquid liabilities and assets held by a bank, scaled by its total assets, and the liquid reffered to the maturity that below one year.

LT Liquid Liabilities Liquid Assets

gap Total Assets

 

(1) The intuition is that a bank financed in large part by liquid deposits and that

holds mostly illiquid loans (and thus a small proportion of liquid assets) performs a significant amount of liquidity transformation and would have a high LT gap value.

Berger & Bouwman further constructed liquidity creation and wider the criteria because they thought the domain of liquidity transformation which Deep & Schaefer discussed was too narrow. On one hand they argued that the catagory should be the most important determinant of liquidating velocity rather than the maturity since assets such as residential mortgage may have a long maturity but easily be sold if one can securitize it. On the other hand Deep and Schaefer exclude the off-balance sheet activities because they don’t involve in the transformation process and occupied a relatively small part in bank assets, but Berger & Bouwman found that the off-balance sheet activities exactly have influence on the liquidity creation indeed and included this part. Hence they extended the liquidity creation measurement to two dimensions:

category/maturity (cat/mat) and on/off-balance sheet (nonfat/fat), and chose the catagory-off-balance sheet (cat-fat) combination rather than the maturity/on-balance sheet (mat-nonfat) one.

Here we follow the definition and measurement of liquidity creation by Berger &

Bouwman (2005) to examine our study. They evaluate the assets on the basis of ease, cost, and time, and categorize them into several groups. They calssfied all bank activities as six categories: liquid assets, semi-liquid assets, illiquid assets, liquid liabilities, semi-liquid liabilities, and illiquid liabilities. Then the liquid creation is computed by using these data. We will discuss it in later chapter.

2.2.3 Determinants of Liquidity Creation

Though there are not so many studies about the liquidity creation, some scholars still devoted to discover the determinants of liquidity creation. Berger & Bouwman

(2005, 2009) found some interesting conclusions. On one hand, for large banks a higher level of bank capital may enhance the ability to create liquidity according to the risk absorption theory. This theory is based on two stands that liquidity creation exposes bank to the liquidity risk (Allen & Gale, 2004; Allen & Santomero, 1998;

Diamond & Dybvig 1983) but the bank capital expands bank’s risk-bearing capacity (Bhattacharya & Thakor, 1993; Repullo, 2004; von Thadden, 1999). On the other hand, higher bank capital may impede the financial fragility-crowding out effect, and then reduce the liquidity creation for small banks. A fragile capital structure encourages the bank to commit to monitoring its borrowers, and hence allows it to extend loans. Additional equity capital makes it harder for the less-fragile bank to commit to monitoring, which in turn hampers the bank’s ability to create liquidity.

Capital may also reduce liquidity creation because it “crowds out” deposits (Gorton and Winton, 2000). We can infer that the bank size and bank capital may be important factors in determining liquidity creation.

Besides, the liquidity intuitionally represents the potentials that bank operates a liquidity creation just like the chips for the gambler; that is, if bank holds more liquidity, the possibility or the ability that create/destruct more liquidity. Berger &

Bouwman (2009) also indicate that the macroeconomic changes would affect the liquidity creation so they add it as control variables. To conclude, liquidity creation could be mainly interpreted by these items, hence we use these terms to construct our endogenous model in later chapter.