Does raising bank capital limit bank liquidity creation? Evidence from commercial banks in Vietnam

Abstract

Little is known about the trade-off mechanism underlying raising bank capital and enhancing bank liquidity creation, as empirical evidence is sparse. Pursuing Basel II target capital seems challenging and costly because it could generate unintended consequences, such as reducing liquidity creation. Thus, the aim of this study is to point out that the pursuit of raising capital to meet Basel II standards in recent years has limited the liquidity creation function of banks.  This finding is reliable and consistent across different research methods, i.e. least absolute shrinkage and selection operator (LASSO regression) and the simultaneous equations model (SEM). We chose Vietnam's banking system for this study because applying Basel II in Vietnam has been topical in recent years and also more challenging than in the rest of the world. Our finding strengthens academically the financial fragility-crowding out hypothesis developed by Diamond & Rajan (2000).