Determinants, persistence and value implications of liquidity creation: an evidence from Indian banks
| DOI | https://doi.org/10.1108/JABS-06-2019-0192 |
| Published date | 11 February 2021 |
| Date | 11 February 2021 |
| Pages | 384-400 |
| Subject Matter | Strategy,International business |
| Author | Naina Grover,Pankaj Sinha |
Determinants, persistence and value
implications of liquidity creation: an
evidence from Indian banks
Naina Grover and Pankaj Sinha
Abstract
Purpose –The purposeof this paper is to explore the micro and macro factors affectingliquidity creation
by scheduledcommercial banks (excluding RegionalRural Bank) in India from 2005 to 2018.
Design/methodology/approach –Two measures of liquiditycreation, the broad and narrow measures,
are constructed usingRBI data available on Indian banks. System generalizedmethod of moments has
been appliedto explore the factors affecting liquidity creation.
Findings –This study finds high levelof persistence in liquidity creation in banks. Variationin the broad
measure is explained by equity ratio,market share, GDP, gross savings and lending rate, whereas the
narrow measure is explained by equityratio, market share, size and lending rate. The Global Financial
Crisis had a negative effect on liquidity creation as per both the measures, and the impact was more
severefor the broad measure as compared to thenarrow measure.
Research limitations/implications –This study finds a positive correlation between bank value and
liquidity creation whichsuggests that the investors favourably evaluatebanks that create more liquidity.
This studyis confined to India only.
Practical implications –There is a negative influence of capital on liquidity created by banks, which
implies a trade-off that exists between financial stability and liquidity creation. Basel III norms impose
highercapital and liquidity standards which will have negativeimplications for liquidity creation.
Originality/value –To the best of authors’ knowledge, this is the first study in the Indian context that
focusses on factors affecting liquidity creationin a dynamic framework and determines the relationship
betweenliquidity creation and market value of a bank.
Keywords India, GMM, Crisis, Persistence, Scheduled commercial banks, Liquidity creation
Paper type Research paper
1. Introduction
Liquidity creation is one of the fundamental functions performed by a bank which stimulates
the economy. Liquidity is said to be created when illiquid assets are financed with liquid
liabilities. Off-balance activities also contribute to liquidity creation (Holmstro
¨m and Tirole,
1998;Kashyap et al., 2002). For instance, activities such as loan commitments are
analogous to illiquid loans from the banks’ perspective and savings/current deposits from
the customers’ perspective. They provide a liquid claim to the customers and help them in
planning their expenditures as they know banks will provide funds as per the requirements.
It has been confirmed empirically that liquidity creation has positive effects on the economy
(Berger and Sedunov, 2017). However, liquidity creation is a risky process. Banks may
suffer from default risk if there are unexpected withdrawals by the depositors. The Global
financial crisis is a stark reminder of how excessive liquidity creation can affect
macroeconomic stability. Illiquidity was crystallized owing to be mismanagement in assets
and liabilities (Basel Committee, 2009). Further, the study of Berger and Bouwman (2017)
Naina Grover and
Pankaj Sinha are based at
the Faculty of Management
Studies, University of Delhi,
New Delhi, India.
Received 21 June 2019
Revised 25 November 2019
19 May 2020
Accepted 2 October 2020
Authors would like to thank the
anonymous reviewers for their
insightful suggestions and
comments.
PAGE 384 jJOURNAL OF ASIA BUSINESS STUDIES jVOL. 15 NO. 2 2021, pp. 384-405, ©EmeraldPublishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-06-2019-0192
corroborated that there was high liquidity creation (in comparison to trend) before the
financial crisis which suggests that liquidity creation plays a significant role in indicating an
impending crisis. Fung
a
cov
aet al. (2013) also assert that the possibility of a bank failure is
intensified when there is an extreme amountof liquidity creation.
Considering liquidity creation is such an important activity and has repercussions for the
economy, what is the total amount of liquidity creation and what are the significant factors
affecting it? These questions are still unanswered in the Indian context. There has been
emerging research on contributing factors towards liquidity creation. Factors like capital,
size, competition, NPA, GDP, monetary policy, corporate governance has been used to
explore the determinants, but they have been confined to countries like USA, Russia, China
or European countries (Berger et al.,2017;Berger and Bouwman, 2009;Fung
a
cov
a and
Weill, 2012;Horvath et al.,2016;Lei and Song, 2013).The motivation for this research is
derived from the fact that there is no empirical study in the Indian context that explores the
factors affecting liquiditycreation in a dynamic framework. There has been only one study in
the Indian context undertaken by Umar et al. (2017) for 2000–2014, which focuses on
determining the relationship between capital and liquidity creation. They deployed fixed
and random effects techniques that ignore the problem of endogeneity arising because of
the bi-directional relationship between the two. This study examines factors affecting
liquidity creation during 2005–2018.Using the unique data set provided by Reserve Bank of
India and following the methodology of Berger and Bouwman (2009), this study has
developed two measures of liquidity creation, i.e. Catfat and Catnonfat which are also
called broad and narrow measures respectively.
This study differs in terms of the construct used to measure liquidity creation, which is more
applicable to developing countries like India. It also highlights the differences in the broad
and narrow measures of liquidity creation and how the relationship between liquidity
creation and factors affecting liquidity creation varies with the measures used. Moreover, it
is also essential to know how investors perceive liquidity creationby the bank. If it generates
a surplus between the bank and its participants, liquidity creation and market value of the
bank will be positively related.
We find a high degree of persistence in liquidity creation as per both the measures of
liquidity creation. We determine that there are variations in the magnitude of the impact on
broad and the narrow measure of liquidity creation. For example, we find a negative impact
of the crisis on both the measures ofliquidity creation, but the impact is more severe for the
broad measure as compared to the narrow measure. Similarly, a positive relationship is
found between the interest rate and liquidity creation, but the magnitude is high in broad
measure as compared to the narrow measure. Other than these, variation in the narrow
measure is explained by GDP and gross savings, while size explains thebroad measure. A
negative relationship between liquidity creation and equity is found as per both the
measures, which suggests the “Financial Fragility-Crowding out” out hypothesis holds for
Indian banks. Policymakers should be mindful of Basel III implementation as it has liquidity
destroying effects on the on-balance sheet as well as off-balance sheetactivities. A positive
relationship is observed between market share and liquidity creation as per both the
measures of liquidity creation. This study finds a positive correlation between liquidity
creation and market value of a bank which helps in understanding the value implications of
liquidity creation.
This study adds to the literature in the following ways; firstly, it creates an index to quantify
liquidity creation by banks for developing countries like India. It also highlights how the two
measures of liquidity creation differ fromeach other. Secondly, it explores micro and macro,
affecting liquidity creation and emphasizes how the liquidity creation in the past impacts the
current liquidity creation. Thirdly, it is shown that banks which create more liquidity
are valued positively by the investors.The flow of this study is as follows: Section 2 gives the
introduction about the Indian banking industry. Section 3 presents the review of the
VOL. 15 NO. 2 2021 jJOURNAL OF ASIA BUSINESS STUDIES jPAGE 385
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