Institutions, capital control, and liquidity creation

Abstract

Purpose The purpose of this study is to conduct an empirical investigation on how country-specific characteristics such as the quality of the institutional environment and the restrictiveness of capital control policy affect domestic financial sector’s ability to provide liquidity to the economy. Design/methodology/approach This study uses panel regressions on international banking data across 102 countries from Bankscope. Findings The results show that strong institutions and looser capital control in a country enhance the banks’ role as the liquidity provider to the economy. The study also finds that institutional quality and capital control have a dynamic effect that influences the creation of liquidity. Better institutions benefit the creation of liquidity in either under normal economic conditions or during economic downturn. Loosened capital control, as a result of financial openness, facilitates liquidity creation under normal economic conditions. Originality/value This study complements the research on the role of country-level institutions in financial and economic development and suggests a liquidity channel through which a country’s institutions can further economic growth. The study also provides evidence on the impact of a country’s control of capital flows on the role of banking sector in domestic economy.