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Capital constraint relief and liquidity creation in small and medium-sized banks: Evidence from a quasi-natural experiment in China

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  • Yu, Weifeng
  • Wu, Huiqi
  • Song, Zhihui

Abstract

Using the policy change of allowing local governments to issue special bonds to replenish capital for small and medium-sized banks (SMBs) in 2020 as a quasi-natural experiment, this paper investigates the effects of capital constraint alleviation on liquidity creation among these banks. With an unbalanced panel dataset comprising 205 SMBs in China from 2018 to 2023, we find that capital constraint relief reduces liquidity creation through two channels: by reducing banks' regulatory incentives and by “crowding out” deposits in such banks. The reduction is more pronounced for smaller SMBs, unlisted SMBs, and those in regions with lower level of financial development. Further research indicates that due to different regulatory intensity on the on- and off-balance sheet activities, capital constraint relief results in a notable reduction in the level of on-balance sheet liquidity creation, while off-balance sheet liquidity creation is unaffected. Our results have relevant implications for the government policy aimed at replenishing capital for SMBs.

Suggested Citation

  • Yu, Weifeng & Wu, Huiqi & Song, Zhihui, 2025. "Capital constraint relief and liquidity creation in small and medium-sized banks: Evidence from a quasi-natural experiment in China," International Review of Economics & Finance, Elsevier, vol. 103(C).
    • Handle: RePEc:eee:reveco:v:103:y:2025:i:c:s1059056025005684
    DOI: 10.1016/j.iref.2025.104405
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