Allen N. Berger

Understanding Financial Statements

To understand how bank liquidity creation is measured, it is important to comprehend bank financial statements. Since these are very different from financial statements of nonfinancial firms, this chapter briefly examines the differences among the financial statements of a large nonfinancial firm, a large commercial bank, and a small commercial bank. The key takeaway is a deeper understanding of how financial statements differ across types of firms, so that the liquidity creation measures, which use data from these statements, become intuitive and easier to comprehend.

How Can Bank Executives, Financial Analysts, Researchers (including Academics and Students), and Policy Makers (including Legislators, Regulators, and Central Bankers) Use Bank Liquidity Creation Data to Their Advantages?

This chapter shows how various parties can use the bank liquidity creation data on the book’s website ( http://booksite.elsevier.com/9780128002339 ) to their advantages. Liquidity creation may be used by bank executives and financial analysts to assess a bank against its peers and against its own past behavior to pick an appropriate scale of liquidity creation (in dollar terms and/or relative to assets). Policy makers can use the data in designing legislation, prudential regulation, and supervision. Researchers and policy makers can use the data when investigating the effects of prudential regulation and supervision, as well as monetary policy. Researchers and policy makers can also use the data to investigate many existing and future issues in banking. The key takeaway is that the bank liquidity creation data are useful to a broad audience interested in benchmarking, research, and policy work.

Measurement of Bank Liquidity Creation

This chapter introduces the “cat fat” measure of bank liquidity creation that is used in the empirical analyses in this book. This measure classifies virtually all bank activities as liquid, semiliquid, or illiquid using information on product category and maturity combined, but classifies loans purely by category (“cat”) due to data limitations, and includes off-balance sheet activities (“fat”). It also compares this measure to several alternative measures of liquidity creation that classify loans purely by maturity (“mat”), exclude off-balance sheet activities (“nonfat”), take into account takedown probabilities of off-balance sheet guarantees, and take into account securitization frequencies. It discusses why the “cat fat” measure is preferred to these alternative measures. The key takeaways are the method for calculating “cat fat” liquidity creation and the understanding that the “cat fat” measure is preferred because it is most consistent with the liquidity creation theories.

Where We Stand Now and the Open Research and Policy Questions

This chapter identifies open research and policy questions. Existing research centers on the United States and a few other nations, but should be expanded to nations around the world. Unanswered questions include: how liquidity creation is affected by bank mergers and acquisitions, competition or market power, deregulation, deposit insurance, and corporate governance; the relation between liquidity creation and risk; the effects of bank liquidity creation on real economic activity; the existence of an optimal scale of liquidity creation for the banking sector and individual banks; liquidity creation dynamics; the effects of liquidity creation in different financial and legal systems; liquidity created by financial institutions other than commercial banks, markets, and their interactions. In all cases, it is helpful to examine whether the results hold during normal times and financial crises. The key takeaway is that there are many important questions left to address using the liquidity creation data and methodology.

How Much Liquidity Do Banks Create During Normal Times and Financial Crises

This chapter gives summary statistics and shows graphically how liquidity creation by US commercial banks changed from 1984:Q1 to 2014:Q4, and how it behaved during normal times and financial crises. It first examines “cat fat” liquidity creation and its on- and off-balance sheet components, both in levels and normalized by assets. It does this for the entire commercial banking sector and also separately by bank size class. Two alternative liquidity creation measures – takedown probability-adjusted and securitization-adjusted “cat fat” liquidity creation – and three other measures of bank output are also shown. The key takeaways are that US bank liquidity creation has grown tremendously over time, that about half is created off the balance sheet, that large banks create the vast majority of it while constituting only a small percentage of the banking sector in numbers, and that liquidity creation tends to be high before financial crises and then falls during the crises.

Defining and Dating Financial Crises

This chapter first outlines a number of existing approaches used to define and date financial crises: some rely on the use of policy interventions and some focus on liquidity shocks. It then picks one approach that best suits the empirical analyses shown in this book, which focus on the United States over the period 1984:Q1–2014:Q4. The chosen approach allows for the examination of crises that do not have significant policy interventions, and are generated by banking and market shocks that do not necessarily involve liquidity problems. The key takeaway is that there is no single formula or set of rules for defining and dating financial crises that is best for every situation – some judgment is needed.

Using Liquidity Creation to Measure Bank Output

This chapter explores the measurement of bank output using liquidity creation versus traditional measures. It discusses traditional approaches of measuring bank output using total assets, gross total assets, and lending. It explains that “cat fat” liquidity creation is superior to these measures because it is more consistent with the theory. A numerical example drives home these points. The key takeaway is that “cat fat” liquidity creation is superior to other measures of bank output.

Bank Liquidity Creation: Value, Performance, and Persistence

This chapter examines the effects of bank liquidity creation on value, the relation between liquidity creation and performance, and the extent to which liquidity creation is persistent. It first reviews the limited existing research on the effects of bank liquidity creation on bank value. The evidence suggests that banks that create more liquidity are valued more highly. It then provides new empirical evidence on the relations between bank liquidity creation and bank performance, by focusing on several key performance measures. Finally, it analyzes winning and losing liquidity creation persistence. The key takeaways are that high liquidity creation appears to be associated with higher market values and mixed performance; and that liquidity creation is both winning and losing persistent.

How Do Government Policies and Actions Affect Bank Liquidity Creation During Normal Times and Financial Crises

This chapter examines how government policies and actions affect liquidity creation. The effects of Basel III’s higher capital requirements and the stress tests on liquidity creation are difficult to assess, since existing evidence focuses on actual, rather than required, capital. No studies have examined how Basel III’s liquidity requirements will affect liquidity creation, but they are expected to reduce it. The limited evidence suggests that regulatory interventions reduce liquidity creation, while the evidence on capital support is mixed. Funds from the central bank appear to increase lending, an important component of liquidity creation. Traditional monetary policy tools seem to only affect small bank liquidity creation, and the effects are less during financial crises. The key takeaway is that government policies and actions can have important effects on bank liquidity creation that should be studied carefully before changing these policies or actions.

The Links Between Bank Liquidity Creation and Future Financial Crises

This chapter discusses theoretical and empirical links between bank liquidity creation and future financial crises. The theories suggest that high on- and off-balance sheet liquidity creation might be the predictors of future financial crises. To address this empirically, it is important to remove the upward trend in liquidity creation over time. The empirical evidence suggests that high aggregate detrended liquidity creation, particularly its off-balance sheet component, helps predict future financial crises. An alternative explanation that high liquidity creation relative to real activity predicts future financial crises is not supported by the data. The key takeaways are that the theories suggest that a future financial crisis is more likely when on- or off-balance sheet liquidity creation is abnormally high, and the empirical evidence is consistent with the theory, particularly for off-balance sheet liquidity creation.