Bank capital and liquidity creation: evidence of relation from India

Abstract

Purpose This study analyzes the impact of changes in bank capital on liquidity creation. More specifically, it tests “financial fragility – crowding out” and “risk absorption” hypotheses for Indian banks. Design/methodology/approach It uses the data of 136 listed and unlisted banks, ranging from the year 2000 to 2014. The analysis is based on panel data techniques. Findings There is negative relationship between narrow measure of bank liquidity creation and capital. Therefore, in the case of India, “financial fragility – crowding out” hypothesis holds for “cat nonfat” measure of liquidity creation. However, there is no relationship between “cat fat” measure of liquidity creation and capital, except for listed banks, and the banks in the pre-crisis period. In these two cases, “risk absorption” hypothesis holds. Furthermore, none of the hypotheses holds in the post-crisis period. Practical implications The higher capital requirements posed by the Basel III will result in lower on-balance-sheet liquidity creation, which may result in lower profitability for the banks. However, increase in capital does not affect off-balance-sheet liquidity creation, rather enhances it in case of listed banks. So, the managers may use risky off-balance-sheet liquidity creation to improve profitability. Therefore, the regulators must be vigilant to the off-balance-sheet activities of banks to avoid banking turmoil. Originality/value To the best of authors’ knowledge, this is the first study to explore which hypothesis regarding the relationship between bank capital and liquidity creation holds for Indian banks. It contributes to the existing literature by providing the empirical evidence that “financial fragility – crowding out” hypothesis holds for on-balance-sheet liquidity creation and “risk absorption” hypothesis holds for listed banks. It also points to the new direction that neither of the hypotheses holds in the post-crisis period in India.