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Effect of shadow banking on the relation between capital and liquidity creation

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  • Chen, Ting-Hsuan
  • Shen, Chung-Hua
  • Wu, Meng-Wen
  • Huang, Kuo-Jui

Abstract

This research investigates the effects of shadow banking on the relation between capital and liquidity creation in China's banking industry. We consider three trust beneficiary rights as the proxies for shadow bank activities, which transform risky corporate loans into interbank loans inside the banking system. Findings present that these activities tend to exaggerate the regulatory capital ratios and liquidity creation measures and then distort the relationship between capital and liquidity creation ratios. The result shows that before removing the influence of shadow banking, banks with a lower capital ratio would engage in more liquidity creation, thus supporting the financial risk-taking hypothesis. By contrast, the risk-absorption hypothesis exists whereby banks would engage in more liquidity creation when they have a higher capital ratio if we consider the effect of shadow banking. Our study also contributes to policymaking by indicating that a failure to use correct information for the assessments of capital and liquidity creation can lead to false conclusion that China's banks are safe, which further mislead any regulatory policy.

Suggested Citation

  • Chen, Ting-Hsuan & Shen, Chung-Hua & Wu, Meng-Wen & Huang, Kuo-Jui, 2021. "Effect of shadow banking on the relation between capital and liquidity creation," International Review of Economics & Finance, Elsevier, vol. 76(C), pages 166-184.
    • Handle: RePEc:eee:reveco:v:76:y:2021:i:c:p:166-184
    DOI: 10.1016/j.iref.2021.05.006
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    2. Chen, Ting-Hsuan & Lee, Chien-Chiang & Shen, Chung-Hua, 2022. "Liquidity indicators, early warning signals in banks, and financial crises," The North American Journal of Economics and Finance, Elsevier, vol. 62(C).

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    More about this item

    Keywords

    Shadow banking; Capital adequacy ratio; Liquidity risk; Risk-taking hypothesis; Risk-absorption hypothesis; Trust beneficial rights;
    All these keywords.

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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