This study examines the relationship between funding liquidity and bank risk taking. Using quarterly data for U.S. bank holding companies from 1986 to 2014, we find evidence that banks having lower funding liquidity risk as proxied by higher deposit ratios, take more risk. A reduction in banks’ funding liquidity risk increases bank risk as evidenced by higher risk-weighted assets, greater liquidity creation and lower Z-scores. However, our results show that bank size and capital buffers usually limit banks from taking more risk when they have lower funding liquidity risk. Moreover, during the Global Financial Crisis banks with lower funding liquidity risk took less risk. The findings of this study have implications for bank regulators advocating greater liquidity and capital requirements for banks under Basel III

Relying on theories in which bank create private money by making loans that create deposits—a process we call “funding liquidity creation”—we measure how much funding liquidity the U.S. banking system creates. Private money creation by banks enables lending to not be constrained by the supply of cash deposits. During the 2001–2020 period, 92 percent of bank deposits were due to funding liquidity creation, and during 2011–2020 funding liquidity creation averaged $10.7 trillion per year, or 57 percent of GDP. Using natural disasters data, we provide causal evidence that better-capitalized banks create more funding liquidity and lend more even during times when cash deposit balances are falling or unchanged. Large banks as well as the top banks in Federal Reserve districts create more liquidity

This study empirically investigates the relationship between banking integration and liquidity management. To measure banks’ connectivity, we use the number of partnerships proxied via the syndicated loan arrangements in which they serve as lead arrangers. If banks establish more business partnerships through syndicated loan arrangements, those under market stress are more likely to face increased funding costs, create reduced liquidity, and originate declined small business loans and mortgages. Those banks with more partners are shown to have a lower liquidity coverage ratio, suggesting that business partnerships create a disincentive toward liquidity risk management

We test whether and how U.S. commercial banks actively managed their liquidity positions between 1992 and 2012, prior to the implementation of the Basel III liquidity rules. On average, the data are consistent with a liquidity management regime in which banks targeted the traditional loans-to-core deposits (LTCD) ratio. Perhaps surprisingly, the data are also consistent on average with the net stable funding ratio (NSFR), a regulatory liquidity ratio that was not formally introduced by the Bank for International Settlements until 2010. We find evidence of LTCD and (implicit) NSFR targeting at banks of all sizes, but concordance is strongest for small banks and weakest for so-called SIFI banks. As banks increase in size, they set lower liquidity targets—often in violation of the coming Basel III standards—but manage those targets more efficiently

Funding liquidity risk has played a key role in all historical banking crises. Nevertheless, a measure for funding liquidity risk based on publicly available data remains so far elusive. We address this gap by showing that aggressive bidding at central bank auctions reveals funding liquidity risk. We can extract an insurance premium from banks’ bids which we propose as a measure of funding liquidity risk. Using a unique data set consisting of all bids in all auctions for the main refinancing operation conducted at the ECB between June 2005 and October 2008 we find that funding liquidity risk is typically stable and low, with occasional spikes especially around key events during the recent crisis. We also document downward spirals between funding liquidity risk and market liquidity. As measurement without clear definitions is impossible, we initially provide definitions of funding liquidity and funding liquidity risk

This paper examines the linkage between bank liquidity creation and systemic risk. Using quarterly data on U.S. bank holding companies from 2003 to 2016, we document that liquidity creation decreases systemic risk at the individual bank level after controlling for bank size, asset risk, and other bank-specific attributes. After decomposing systemic risk into bank-specific tail risk and systemic linkage, we find that the riskiness of individual banks is negatively linked to liquidity creation. Nevertheless, our results also demonstrate that liquidity creation strengthens the systemic linkage of individual banks to severe shocks in the financial system. Overall, our empirical findings demonstrate that the level of liquidity creation may have important implications for financial stability and the prudential supervision of financial institutions

We investigate the relationship between bank liquidity creation and recessions in the U.S. For the 1984–2010 sample, we find that (i) lower bank on-balance sheet liquidity creation signals recessions four quarters into the future; (ii) off-balance sheet liquidity creation is not a robust predictor of recessions at longer forecast horizons; (iii) off-balance sheet liquidity creation falls in tandem with on-balance sheet liquidity creation one quarter prior to recessions, and aggregate, on- and off-balance sheet bank liquidity creation continue to decline during and up to five quarters after recessions; and (iv) liquidity creation of larger banks contains more information about future recessions than that of smaller ones

We investigate the liquidity management of 62 Dutch banks between January 2004 and March 2010, when these banks were subject to a liquidity regulation that is very similar to Basel III’s Liquidity Coverage Ratio (LCR). We find that most banks hold more liquid assets against their stock of liquid liabilities, such as demand deposits, than strictly required under the regulation. More solvent banks hold fewer liquid assets against their stock of liquid liabilities, suggesting an interaction between capital and liquidity buffers. However, this interaction turns out to be weaker during a crisis. Although not required, some banks consider cash flows scheduled beyond 1month ahead when setting liquidity asset holdings, but they seldom look further ahead than 1year

Consistent with the credit channel theory of monetary policy transmission, this paper finds novel evidence that asset market liquidity as one of the proxies for the external finance premium explains bank liquidity creation. While efficacy of monetary policy depends on how banks create liquidity, the existing literature does not find any conclusive evidence that monetary policy variables explain aggregate bank liquidity creation. We use both stock market and the Treasury bond market liquidity as proxies for asset market liquidity, and find that: (1) asset market liquidity and credit-spreads explain aggregate bank liquidity creation and liquidity creation of larger banks; (2) stock market liquidity rather than credit-spreads or the Treasury bond market liquidity has robust and higher impact on aggregate liquidity creation; (3) while stock market liquidity better explains off-balance sheet liquidity creation, the short-term off-the-run Treasury bond liquidity has higher impact on on-balance sheet liquidity creation; (4) the Federal funds rate as a proxy for monetary policy impacts liquidity creation of smaller banks more than it does liquidity creation of larger banks

This paper proposes a new approach to evaluating banks’ liquidity needs, which is not only well-grounded theoretically, but is also easy to apply practically. Within the framework of a global game with imperfect information, we first establish a boundary condition for bank runs and show that there exists a unique Nash equilibrium for bank runs. Using the option-pricing approach, we then obtain a closed-form formula for the value of bank equity with both run risk and insolvency risk. Finally, a bank's optimal liquidity ratio is derived by maximizing the value of bank equity. Using data on Chinese listed banks, we show that the deviation of the actual liquidity ratio from the optimal liquidity ratio in a bank represents a robust proxy for its liquidity risk. An increased liquidity shortfall leads to worsening liquidity problems, and this is particularly pronounced when the liquidity shortfall is high