Bank capital and liquidity creation: evidence of relation from India
| Published date | 02 May 2017 |
| Date | 02 May 2017 |
| Pages | 152-166 |
| DOI | https://doi.org/10.1108/JABS-12-2015-0208 |
| Author | Muhammad Umar,Gang Sun,Muhammad Ansar Majeed |
| Subject Matter | Strategy,International business |
Bank capital and liquidity creation:
evidence of relation from India
Muhammad Umar, Gang Sun and Muhammad Ansar Majeed
Muhammad Umar is
based at AIR University
School of Management,
Islamabad, Pakistan.
Gang Sun is Professor at
the School of Finance,
Dongbei University of
Finance and Economics,
Dalian, China.
Muhammad Ansar Majeed
is based at the Dongbei
University of Finance and
Economics, Dalian,
China.
Abstract
Purpose –This study analyzes the impact of changes in bank capital on liquidity creation. More
specifically, it tests “financial fragility – crowding out” and “risk absorption” hypotheses for Indian banks.
Design/methodology/approach –It uses the data of 136 listed and unlisted banks, ranging from the
year 2000 to 2014. The analysis is based on panel data techniques.
Findings –There is negative relationship between narrow measure of bank liquidity creation and
capital. Therefore, in the case of India, “financial fragility – crowding out” hypothesis holds for “cat
nonfat” measure of liquidity creation. However, there is no relationship between “cat fat” measure of
liquidity creation and capital, except for listed banks, and the banks in the pre-crisis period. In these two
cases, “risk absorption” hypothesis holds. Furthermore, none of the hypotheses holds in the post-crisis
period.
Practical implications –The higher capital requirements posed by the Basel III will result in lower
on-balance-sheet liquidity creation, which may result in lower profitability for the banks. However,
increase in capital does not affect off-balance-sheet liquidity creation, rather enhances it in case of
listed banks. So, the managers may use risky off-balance-sheet liquidity creation to improve profitability.
Therefore, the regulators must be vigilant to the off-balance-sheet activities of banks to avoid banking
turmoil.
Originality/value –To the best of authors’ knowledge, this is the first study to explore which hypothesis
regarding the relationship between bank capital and liquidity creation holds for Indian banks. It
contributes to the existing literature by providing the empirical evidence that “financial fragility –
crowding out” hypothesis holds for on-balance-sheet liquidity creation and “risk absorption” hypothesis
holds for listed banks. It also points to the new direction that neither of the hypotheses holds in the
post-crisis period in India.
Keywords India, Liquidity creation, Bank capital
Paper type Research paper
1. Introduction
Banks are very important financial intermediaries. They play an important role of providing
liquidity by funding long-term illiquid assets with short-term liquid liabilities, i.e. they create
liquidity by holding illiquid assets, and providing cash to the rest of the economy.
According to all the measures proposed by Berger and Bouwman (2009), a bank creates
$1 of liquidity when it converts $1 illiquid assets into $1 liquid liabilities. Similarly, a bank
destroys $1 of liquidity by transforming $1 of liquid assets into $1 illiquid liabilities. A bank
does not create or destroy liquidity when it converts $1 of liquid assets into $1 of liquid
liabilities or $1 of illiquid assets into $1 of illiquid liabilities or equity. Therefore, an
imbalance in their assets and liabilities management may result in their demise, affecting
the whole financial system as proved by the recent financial crisis (BIS, 2009). Basel
Committee on Banking Supervision believes that bank risk-taking could be curtailed by
requiring them to maintain minimum capital adequacy ratio (CAR) at 8 per cent. CAR is
calculated as the ratio of capital to risk weighted assets. As a result, this study focuses on
Received 19 December 2015
Revised 16 March 2016
Accepted 14 April 2016
PAGE 152 JOURNAL OF ASIA BUSINESS STUDIES VOL. 11 NO. 2, 2017, pp. 152-166, © Emerald Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-12-2015-0208
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