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Causal Nexus Between Liquidity Creation and Bank Capital Ratio: Evidence from India

Author

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  • Seba Mohanty

    (Seba Mohanty (corresponding author) is an Assistant Professor of Economics, Birla School of Humanities and Social Sciences, Birla Global University, Bhubaneswar, Odisha, India.)

  • Jitendra Mahakud

    (Jitendra Mahakud is a Professor of Economics and Finance, Department of Humanities and Social Sciences, Indian Institute of Technology, Kharagpur, West Bengal, India. E-mail: jmahakud@hss.iitkgp.ac.in)

Abstract

This study investigates the interrelationship between bank capital and liquidity creation in the Indian banking sector. The sample considers 68 commercial banks (public, private and foreign banks) operating in India during the period from 1996–1997 to 2013–2014. We employ the generalised method of moments technique in a Granger causality framework and find a bidirectional relationship between bank capital and liquidity creation for the entire sample. Our results support the financial fragility–crowding-out hypothesis, which suggests that Indian banks follow a fragile financial structure to maximise liquidity creation and increase their capital ratio by crowding out deposits to limit liquidity creation. Our results also support the liquidity substitution hypothesis, which suggests that stable liabilities can be substituted for bank capital, while facing more risk. We find similar results with the whole sample regardless of ownership, size, capitalisation and periods. These findings have implications for bank managers and policymakers on formulating appropriate policy for capital and liquidity creation of commercial banks in India. JEL Codes: G20, G21, G33

Suggested Citation

  • Seba Mohanty & Jitendra Mahakud, 2021. "Causal Nexus Between Liquidity Creation and Bank Capital Ratio: Evidence from India," Margin: The Journal of Applied Economic Research, National Council of Applied Economic Research, vol. 15(2), pages 205-237, May.
    • Handle: RePEc:sae:mareco:v:15:y:2021:i:2:p:205-237
    DOI: 10.1177/0973801021990399
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    More about this item

    Keywords

    Bank capital; Liquidity creation; Financial fragility hypothesis; Granger causality; Generalised method of moments; Indian banks;
    All these keywords.

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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