On the nonlinear relationship between bank liquidity creation and financial stability: the moderating role of institutional quality in African economies

We investigate the nonlinear relationship between bank liquidity creation and financial stability across the African continent. Given the weak institutional environment of most African countries, we also examine how institutional quality moderates the relationship. We use a quasi-maximum likelihood estimator on a sample of 485 commercial banks from 51 African countries between 2011 and 2020 and find an inverted U-shaped relationship between liquidity creation and financial stability. Initially, liquidity creation enhances financial stability by enabling banks to fund viable, high-yield projects, but only up to a threshold of 52.32%. Beyond this point, liquidity creation leads to financial distress. Institutional quality—captured by political stability, control of corruption, and the rule of law—plays a significant moderating role. We find that strong institutional quality shifts the threshold at which liquidity creation becomes detrimental, allowing banks to sustain liquidity creation while maintaining stability. Conversely, in weaker institutional environments, the relationship is U-shaped, with increasing financial fragility even at lower levels of liquidity creation. These findings suggest that African policymakers should promote balanced liquidity creation while strengthening institutional frameworks to enhance financial stability in the banking sector.