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Banks' Capital and Liquidity Creation: Granger Causality Evidence

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  • Roman Horvath
  • Jakub Seidler
  • Laurent Weill

Abstract

This paper examines the relation between banks' capital and liquidity creation. This issue is of interest to determine the potential impact of higher capital requirements for banks on their liquidity creation, which may have particular importance with new Basel III reform demanding from banks higher capital. We perform Granger-causality tests in a dynamic GMM panel estimator framework on an exhaustive dataset of Czech banks from 2000 to 2010. We observe a strong expansion of liquidity creation during the full period, which was slowed by the financial crisis, and was mainly driven by large banks. We show that capital is found to negatively Granger-cause liquidity creation but also observe that liquidity creation Granger-causes capital reduction. These findings support the view that Basel III reforms demanding higher capital can reduce liquidity creation, but also that greater liquidity creation can have a detrimental impact by reducing bank solvency. We thus show that there might be a trade-off between the benefits of financial stability induced by stronger capital requirements and those of increased liquidity creation of banking sector.

Suggested Citation

  • Roman Horvath & Jakub Seidler & Laurent Weill, 2012. "Banks' Capital and Liquidity Creation: Granger Causality Evidence," Working Papers 2012/05, Czech National Bank.
  • Handle: RePEc:cnb:wpaper:2012/05
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    References listed on IDEAS

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    More about this item

    Keywords

    Bank capital; liquidity creation.;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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