| Summary: | The theory of financial intermediation states that liquidity creation has been the main source of risk for banks. This points out to a possible correlation between banks’ liquidity creation and financial crisis. It is believed that that the period preceding the recent Global Financial Crisis (2007-2008) was characterised by abundant liquidity, excessive lending due to deterioration of lending standards and trend towards securitisation. This study attempts to examine empirically this possible correlation by studying the behaviour of liquidity creation of major UK banks/ building societies around the crisis, over the period 2001-2010 using the recently developed measure by Berger and Bouwman (2007). Further, the relationship between bank capital and liquidity creation is empirically tested to verify which alternative hypothesis ‘Financial fragility-crowding out’ or ‘Risk absorption’ dominates the relationship in case of UK banks.
Results show that positive ‘abnormal’ (relative to a trend line) liquidity creation preceded the financial crisis which emphasizes on the incremental explanatory power of liquidity creation in predicting banking crisis even after accounting for macroeconomic factors, which in turn provide important policy implications on the real sector. Also, results show that liquidity creation and bank capital are negatively related consistent with the empirical dominance of the ‘Financial-fragility-crowding out’ hypothesis, implying that higher bank capital crowds out deposits, reduce the financial fragility of the bank and hence reduce its ability to create liquidity. This puts the spot light on regulation behind capital requirements and liquidity management by financial authorities.
Key words: Financial Intermediation, Financial Crisis, Bank Capital and Liquidity Creation.
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