Liquidity creation is a vital service that banks provide to the economy. Banks create liquidity by using relatively liquid liabilities, such as demand deposits, to fund relatively illiquid assets, such as business loans. This simultaneously satisfies the demand for liquidity by savers and the demand for longer-term financing commitments by firms (Diamond and Dybvig 1983, Gatev and Strahan 2006). Banks also create liquidity off the balance sheet by providing loan commitments and standby letters of credit that allow firms to develop and modify long-run investment strategies efficiently (Boot et al 1993, Kashyap et al. 2002). By creating liquidity, theory suggests that banks improve the allocation of capital and accelerate economic growth (Bencivenga and Smith 1991, Levine 1991). Empirically, Berger and Sedunov (2016) find that the positive impact of liquidity creation on economic growth is larger than the growth effects of other services provided by banks.
Given the importance of liquidity creation, there is surprisingly little empirical work on its determinants. Indeed, it is only recently that Berger and Bouwman (2009) created the first comprehensive measures of liquidity creation for US banks over the period from 1993 to 2003. With these data, they examine the connection between capital regulations and liquidity creation. Cornett et al. (2011), Berger et al. (2015), and Peydro et al. (2016) examine how liquidity creation changes when banks are under financial duress.
In a new paper, we evaluate conflicting theoretical perspectives on whether competition among banks increases, decreases, or has no effect on liquidity creation (Jiang et al. 2016a). Some models suggest that competition reduces liquidity creation by lowering the risk absorption capacity of banks. There are two building blocks to this view. First, by squeezing profit margins and depleting buffers against losses, competition can induce banks to reduce risk-taking (Boyd and De Nicolo 2005, Peydro et al. 2016). Second, liquidity creation is risky, i.e. banks tend to suffer losses if they must quickly dispose of illiquid assets to meet the demands of those holding liquid liabilities. Thus, competition can decrease the risk-absorption capacity of banks, inducing banks to lower risk by reducing liquidity creation. A second set of models also predicts that competition will reduce liquidity creation but highlights a different mechanism. First, competition can make it easier for firms to change banks, which makes it harder for banks to recoup the costs of building long-run relationships with firms (Petersen and Rajan 1995, Cetorelli and Strahan 2006). Second, long-run bank-firm relationships can facilitate banks’ acquisition of ‘soft’ information about the liquidation value of firm assets (Berger et al. 2005, Berger and Udell 1995). Thus, by impeding relationship lending, competition can hinder effective liquidity creation.
In contrast, theory also suggests two mechanisms through which competition can boost liquidity creation. First, competition tends to spur financial innovation and improve efficiency (Boot and Thakor 2000, Laeven et al. 2015). One dimension along which the bank might innovate is liquidity creation. Second, competition tends to make banks more transparent (Jiang et al. 2016b), which can encourage bank executives to devote more effort to screening borrowers and monitoring firms. In turn, the improvements in credit allocation can encourage more bank lending and liquidity creation. Thus theory provides differing views on the effect of competition on liquidity creation.
To evaluate these predictions empirically, we employ the two-step method developed in Jiang et al. (2016b) for constructing time-varying measures of the competitive pressures facing 15,081 US banks over the period from 1984 through 2006. First, as in Goetz et al. (2013, 2016), we exploit the process of interstate bank deregulation that lowered barriers to competition between banks in different states. States started deregulating in different years and followed different paths of deregulation as they signed bilateral and multilateral agreements with different states in different years. The process ended with the passage of the Riegle-Neal Act of 1994. Second, we integrate this dynamic process of interstate bank deregulation with the ‘gravity model’ of investment. For any state j, the process of interstate bank deregulation provides time-varying information on the ability of banks from other states to enter and compete in state j. The gravity model differentiates among banks within state j. It predicts that the costs to banks in state k of establishing a subsidiary somewhere in state j are positively related to geographic distance. Thus, by integrating the dynamic process of interstate bank deregulation with the gravity model, we construct time-varying measures of the competitive pressures facing each bank.
We use a difference-in-differences estimation strategy to assess the impact of competition on liquidity creation. The dependent variable is one of the Berger and Bouwman (2009) measures of liquidity creation. The key independent variable is a measure of the deregulation-induced competition pressures facing each bank in each year. We include state-year fixed effects to control for all time-varying state characteristics. We include bank fixed effects to control for all time invariant bank traits. Furthermore, we show that the results are robust to controlling for various time-varying bank-specific characteristics. Moreover, we find that liquidity creation by banks in a state does not predict the timing of interstate bank deregulation. We discover no evidence that differential pre-trends in liquidity creation across different states or banks account for the results.
We discover that an intensification of competition in the banking industry materially reduces liquidity creation. For example, we find that a one standard deviation increase in the competitive pressures facing a bank is associated with a 3.5 percentage point reduction in liquidity creation, which is large considering that the sample average level of liquidity creation is 20% of total assets. When applying this estimate to the average (median) bank in our sample, which has gross total assets of $104 million ($627 million), the 3.5 percentage point reduction in the ratio of liquidity creation to assets implies a loss of $3.6 million ($21.9 million) in liquidity creation by the average bank.
We next push the analyses beyond our core question of assessing the net effect of competition on liquidity creation and explore two potential mechanisms. Specifically, one view is that by squeezing profit margins, competition reduces the willingness of banks to absorb more risk through liquidity creation and hence reduces liquidity creation. If competition affects liquidity creation through this profitability channel, then the negative impact of competition on liquidity creation should be smaller among more profitable banks that have a large risk-absorbing buffer that can better hedge liquidity risk. To test whether the data are consistent with this profitability channel, we examine whether the negative impact of competition on liquidity provision is smaller among more profitable banks. A second view is that by reducing the incentives of banks to establish long-term relationship with their customers, an intensification of competition impedes liquidity creation. If competition reduces liquidity creation through this relationship-lending channel, the negative effect of competition on liquidity creation should be stronger among banks that engage more intensively in relationship lending. To test this conjecture, we use small-sized banks to proxy for relationship lenders.
We find evidence consistent with the view that a regulatory-induced intensification of competition reduces bank liquidity creation both by squeezing profit margins and by impeding relationship lending. Specifically, we find that more profitable banks, as measured by net interest margins, experience a smaller reduction in liquidity creation in response to interstate bank deregulation. Similarly, we find that an intensification of competition reduces liquidity creation more among small banks. Taken together, this evidence on profitability and size are consistent with two views on how competition affects liquidity creation.
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