2.1 Liquidity Definitions
It is difficult to offer a definition of Liquidity. Thadden (1999) concludes three prominent views: Biais et al (1997) described that an asset is liquid if it can be bought or sold quickly at low transaction costs and a reasonable price‘. Other views show that the liquidity refers to the availability of instruments that can be used to transfer wealth across periods (HolmstrÖ m and Tirole, 1998a, p.2). But Diamond and Dybvig (1983) mentioned that an asset is liquidity if it allows agents to consume inter-temporally at anytime.
In Addition, Brunnemeier and Pederson (2007) contrast ‗funding liquidity‘ with
‗market liquidity‘. The funding liquidity means that traders‘ ability to raise cash with securities as collateral, and the market liquidity describes the cost of selling assets.
For these literature, the definition focus on the liquidity risk, the capability which can transfer to money.
According to liquidity creation theory (Berger et al；2005, 2008, 2009), the liquidity creation represent that banks create liquidity on the balance sheet when they transform liquid liabilities into assets illiquid.
In this paper, we use the definition and measurement of liquidity creation theory to examine our study.
2.2 Measurement of Bank Liquidity Creation
During 1980 to 2000, there are some papers discussing about that banks‘ role and how does bank create the liquidity. For example, William (1981) indicated that ―pure
liquidity creation‖ takes place when the banking system guarantees the client that he will be able to borrow money whenever he likes. However, the liquidity creation does not use a complete method to measurement, it just show the loans matched by deposits.
Diamond and Dybvig (1983) analyzed about bank runs by the effect of liquidity, but in this research, they focused on the banks‘ role and suggested that how to prevent bank runs. It has been lack of the literature of measurement of liquidity creation until 2000s.
Deep and Schaefer (2004) analyzed the degree of liquidity transformation by the US commercial banks. They constructed ―LT Gap‖ to calculate the amount of banking liquidity creation. LT Gap (Liquidity Transformation Gap) is the difference between liquidity liabilities and liquidity assets as percentage of total assets. The higher the gap, the greater is the transformation effect.
Berger and Bouwman(2009) may be the only one that measure bank liquidity creation. The purpose is to discuss the relationship between capital size and liquidity.
Although Deep and Schaefer define the ―LT gap‖, the method only considered maturity loans, and exclude loans commitments and other off-balance sheet activities.
According this, in Berger and Bouwman‘s study, they construct a new method based on LT gap. They classified loans by category rather than by maturity, and joint off-balance sheet to discuss. When banks transform $1 of illiquid assets into $1 of liquid liabilities, that $1 of liquidity is created, and the formula could simple present 1/2 * $1 illiquid assets + 1/2 * $1 liquid liabilities = $1 liquid creation.
2.3 Relationship between Liquidity Creation, and Economic Growth
Early theories can be traced back to Diamond and Dybvig (1983). They noted
that when bank run occurs, the bank may be forced to liquidate all assets for preventing the liquidity. The phenomenon caused banks call back the loans and terminate some investments, and then make economy problem.
In recent years, several researches have concerned with the causality between economic growth and financial development (e.g., Shan et al.;2001, Shan;2005, Dritsakis and Adamopoulos;2004),but the contribution of this studies only focus on macro analysis , not bank sector.
The different financial systems may affect the bank‘s ability, Allen, Chui and Maddaloni (2004) suggest that the financial structure matter the efficiency, which means the ability of allocate resource. Besides, King and Levine (1993) point out that finance development is connection to economy growth. Allen and Gale (1999) indicated bank-based system and market-based also have different comparative advantage.
Berger, Bouwman and Hasan (2005) use a new method to calculate liquidity creation and examine the relationship between economic growth and liquidity creation.
The study suggested that the liquidity creation has different effects between bank-based market system and market-based system country, and liquidity creation really affects the economic growth. Besides, they also identified the important primary factor of liquidity creation in different financial system.
Financial crises may be influenced by liquidity creation. After subprime lending crisis, Berger and Bouwman (2008) calculated the liquidity creation of around past financial crises in US from 1987 stock market to 2007 subprime lending crisis. Their study is intended to whether there are any relationship between crises and liquidity creation, and the change degree. The result shows that there has been a significant abnormal positive liquidity creation may cause banking crises, whereas the abnormal negative liquidity creation make market-related crisis. For example, the subprime
lending crisis was possibly caused by lax standards make banks to enlarge amount of credit and other guarantees.
Why a financial system problem spill over into the world? Holmstrom and Tirole (1998) suggested that when the firm wants to overcome liquidity shock problem to avoid bankruptcy, they may hold liquid securities that can cell in that time. If the private supply is insufficient, the government may be forced to issue debt to improve welfare. Allen and Carletti (2008) point out the role of liquidity is important in subprime lending crisis, and there are some phenomena as the drying up of interbank markets exacerbated the effect of this crisis.
Strahan (2008) observed the trends of liquidity production over past 20 years, he found out that the form of production has changed by development of financial technology and strengthen of securities markets. And he argued that the liquidity production has always been, and continues to be, and it is one of the most important functions of banks.
In particular, banks hoard liquidity during periods of economic downturn, when lending opportunities may not be as good. Aspachs, Nier and Tiesset (2005) show that banks would build up liquidity buffers in periods of weak economic growth and run down in strong.
Because little attention has also been paid to the causality between liquidity creation and economic growth, this paper tests the lead lag relationship between these variables.