BANK LIQUIDITY CREATION, FINANCIAL CRISES, AND POLICY ACTIONS

1. BANK LIQUIDITY CREATION, FINANCIAL CRISES, AND POLICY ACTIONS Allen N. BergerUniversity of South Carolina Wharton Financial Institutions Center CentER, Tilburg University Presentation at the Southern Finance Association Meetings Key West, November 2011

2. WHAT IS BANK LIQUIDITY CREATION? Consider a world without banks. An untraded steel company needs $10 million to build a new mill. To finance this, the public must hold an illiquid long-term $10 million security or the firm goes unfunded. Enter banks: A bank makes the loan and finances it with transactions deposits. The bank has created liquidity. It has taken something illiquid away from the public (long-term illiquid loan) and given the public something liquid (short-term transactions deposits). This is one of the primary functions of banks – creating liquidity by transforming illiquid assets into liquid liabilities. Banks also create liquidity off the balance sheet. Under a loan commitment, a customer can get cash almost as easily as with a transactions deposit.

3. WHY IS BANK LIQUIDITY CREATION A CRUCIAL CONCEPT? Beyond banking, liquidity creation is very important to the macroeconomy as a whole. Lending, loan commitments, and liquid deposits are all key to greasing the wheels of commerce, without which we would have very little economic activity. Changes in bank liquidity creation are a potentially important tool of monetary policy. Bank liquidity creation helps keep financial crises from getting out of control. When financial markets freeze up during a crisis, participants often draw down their loan commitments, which keeps illiquid firms from becoming insolvent. In the recent crisis, all of the big investment banks faced liquidity problems and either failed, were merged with banks, or became bank holding companies to gain access to liquidity.

4. MOST RESEARCH ON BANK LIQUIDITY CREATION IS THEORETICAL …until Berger and Bouwman (“Bank Liquidity Creation,” RFS 2009) introduced a comprehensive measure of bank liquidity creation. Value-added of our measure: For macroeconomic research: It quantifies an important function of banks in the economy and a tool of monetary policy. For research on financial crises: Too much bank liquidity creation may cause financial crises and too little bank liquidity creation may exacerbate them. For banking research: Liquidity creation is a more complete measure of bank output than the usual measure of total assets. It includes assets, liabilities, and off-balance sheet activities.

5. GOALS OF THE REST OF THE TALK Explain the liquidity creation measure. Give some examples of research using the measure. Make the measure available to you for your research.

6. ASSETS LIABILITIES + EQUITY STEP 1: Classify all bank activities as either liquid, semi-liquid, or illiquid. Liquid Assets e.g., securities Liquid Liabilities e.g., transactions deposits Semi-liquid Assets e.g., home mortgages Semi-liquid Liabilities e.g., time deposits Illiquid Assets e.g., business loans Illiquid Liabilities + Equity OFF-BALANCE SHEET Illiquid Guarantees e.g., loan commitments Liquid Derivatives (gross fair values)

7. Weight ASSETS LIABILITIES + EQUITY Weight STEP 2: Assign weights. Liquid Assets e.g., securities Liquid Liabilities e.g., transactions deposits - 0.5 + 0.5 Semi-liquid Assets e.g., home mortgages 0 Semi-liquid Liabilities e.g., time deposits 0 Illiquid Assets e.g., business loans + 0.5 Illiquid Liabilities + Equity - 0.5 OFF-BALANCE SHEET Illiquid Guarantees e.g., loan commitments Liquid Derivatives (gross fair values) - 0.5 + 0.5

8. $ liquidity creation = Σ(weight * $ activity) Weight ASSETS LIABILITIES + EQUITY Weight STEP 3: Combine Step 1 and Step 2: Liquid Assets e.g., securities Liquid Liabilities e.g., transactions deposits - 0.5 + 0.5 Semi-liquid Assets e.g., home mortgages 0 Semi-liquid Liabilities e.g., time deposits 0 Illiquid Assets e.g., business loans + 0.5 Illiquid Liabilities + Equity - 0.5 OFF-BALANCE SHEET Illiquid Guarantees e.g., loan commitments Liquid Derivatives (gross fair values) - 0.5 + 0.5

9. Liquidity creation in U.S. (1984-2008)in $billions Off-balance sheet Total Bank Liquidity creation On-balance sheet

10. RESEARCH ON BANK CAPITAL AND LIQUIDITY CREATION The theoretical literature is ambiguous regarding the relationship between bank capital and liquidity creation. Some theories predict a positive relationship, other theories predict a negative relationship. Using the liquidity creation measure, Berger and Bouwman (2009) show that capital and liquidity creation are: positively related for large banks negatively related for small banks supporting different theories for different-sized banks.

11. IS THERE SUCH A THING AS TOO MUCH BANK LIQUIDITY CREATION? Too much liquidity during a boom may be associated with lower lending standards, which may create asset bubbles that burst and cause financial crises. Berger and Bouwman (working paper 2011) find that high aggregate liquidity creation relative to trend is associated with a significantly increased probability of a financial crisis striking. The liquidity creation measure helps predict financial crises even after controlling for other macroeconomic factors.

12. HOW DOES POLICY AFFECT BANK LIQUIDITY CREATION? Monetary policy Berger and Bouwman (same paper) find that loosening US monetary policy does little to increase bank liquidity creation during normal times except at small banks. These effects are even weaker during financial crises.

13. HOW DOES POLICY AFFECT BANK LIQUIDITY CREATION? Regulatory interventions (restrictions on lending or dividend payouts, dismissal of managers, etc.) Goal is to reduce risk taking, but may have the unintended consequence of reducing liquidity creation. Berger, Bouwman, Kick, and Schaeck (working paper 2011) find that regulatory interventions in Germany reduce liquidity creation significantly in both normal times and financial crises.

14. HOW DOES POLICY AFFECT BANK LIQUIDITY CREATION? Capital support (injecting capital into distressed banks) Goal is to reduce risk, but the effect on liquidity creation may go either way theoretically. Berger, Bouwman, Kick, and Schaeck (same paper) find that capital support at German banks reduces liquidity creation during normal times, but not during financial crises.

15. OTHER RESEARCH ISSUES Countless interesting research and policy questions that could be addressed using this measure: How does bank liquidity creation differ across bank types, bank- versus market-based systems, and legal frameworks around the world? How do M&As and competition affect bank liquidity creation? How did TARP affect bank liquidity creation? How will Basel III capital rules affect bank liquidity creation? How will Basel III liquidity rules affect bank liquidity creation? Any question for which a comprehensive measure of bank output is called.

16. GO FORTH AND USE THE BANK LIQUIDITY CREATION MEASURE I encourage you to be creative in addressing the previous and other research questions. The data for all US banks quarterly from 1984:Q1 to 2010:Q4 is available for free and waiting for you to use it at Christa Bouwman’s website: http://faculty.weatherhead.case.edu/bouwman/data.html