CHAPTER ONE

INTRODUCTION

            Background of the study

The modern theory of financial intermediation posits that banks exist to perform two central roles within the economy: liquidity creation and risk transformation. According to the risk transformation theory, banks transform risk by issuing riskless deposits to finance risky loans. The liquidity creation theory, on the other hand, states that banks create liquidity on the balance sheet by using illiquid assets to fund liquid liabilities. The intuition behind the liquidity creation theory is that banks create liquidity because they hold illiquid assets (through the provision of long-term loans to the public), and give the public liquid liabilities (an example being transaction deposits which are paid to customers on demand). On the other hand, banks destroy liquidity by holding illiquid liabilities (through long-term borrowing of funds from the public) and investing in liquid assets which the bank can easily convert to cash to meet their need for liquid funds. Capturing these opposing effects gives a comprehensive measure of liquidity created by banks operating within an economy (Berger & Bouwman, 2009).

The need for efficiency in the banking industry depends on banks’ ability to spot and manage high-risk and high-return opportunities, and effectively control costs. For banks to sustain their growth and profitability, they need to introduce differentiated products and services; and this tends to expose them to various risks. As a result, banks need to recapitalise so they can absorb massive economic shocks and significantly contribute to the real growth of the economy (Morrison & Associates, 2016). The Basel Committee on Banking Supervision (BCBS), which was formed in 1974, is an international committee which develops standards for banking regulation. Over the years, it has developed a series of highly influential policy

recommendations known as the Basel Accords, and these have been adopted by central banks in various countries worldwide.

The Basel Committee on Banking Supervision (BCBS) in the aftermath of the recent global financial crisis, introduced new macro-prudential regulatory measures designed to address the systemic risk which results from banks’ interconnectedness in the global banking system. This regulatory framework, known as Basel III, requires banks to hold a higher amount of common equity in Tier 1 capital (4.5% of total risk-weighted assets). This percentage is a substantial increase in capital requirements from Basel I and II (which required that Tier 1 capital in total make up 4% of risk-weighted assets). Minimum total capital ratio, however, remains at 8%. Also, per the framework, additional capital requirements (ranging between 1% and 3.5%) can be imposed on banks that are seen to be very important within the financial system; thus, raising the minimum ratio to 13% of total risk-weighted assets in such conditions (9.5% common equity capital + 3.5% additional capital). Banks may also be required to build up capital buffers during periods of excessive credit growth for potential losses during economic downturns (Tran, Lin & Nguyen, 2016).

Berger and Bouwman (2009) posit two hypotheses that frame the causal link moving from banks’ capital to liquidity creation: the risk absorption hypothesis and the financial fragility/crowding-out hypothesis. The risk absorption hypothesis predicts that increased capital enhances a bank’s ability to create liquidity. As banks create more liquidity, they face a greater risk of becoming illiquid as an increasing share of their balance sheet becomes filled with illiquid assets. However, a larger capital base allows the bank to absorb any losses that may arise from the increased risk hence, enhancing the bank’s ability to create more liquidity. The “financial fragility/crowding-out” hypothesis, on the other hand, predicts that greater capital hampers liquidity creation. According to Diamond and Rajan (2001) financial fragility, which is characterised by lower capital and a higher share of liquid deposits, tends

to favour liquidity creation (since banks have more deposits to enable them to finance more loans). However, as the banks’ capital base increases, they become less fragile, and this hampers the credibility of its commitment to depositors. This increase in the capital base may result in a fall in deposits and consequently, a fall in liquidity creation. Hence, greater capital tends to diminish liquidity creation.

Berger and Bouwman (2009) examined the effect of capital on liquidity creation using data on US banks. They found support for both the ‘risk absorption’ and the ‘financial fragility- crowding out’ hypothesis for various bank sizes. They further stated that, though the theories suggest a causal relationship from capital to liquidity creation, in practice both may be jointly determined, making it challenging to establish causation. Horvath, Seidler & Weill (2014) also proposed a mechanism through which the relation moves from liquidity creation to capital, using the illiquidity risk hypothesis. This hypothesis suggests that an increase in the amount of liquidity created by banks exposes them to a higher risk of becoming illiquid because illiquid assets tend to occupy a larger share of their total balance sheets; thus, incentivising banks to strengthen their solvency through an increase in capital.

A few other studies have been done on bank capital and liquidity creation following Berger and Bouwman (2009), and per the existing literature, a bi-causal relationship may exist between bank capital and liquidity creation. In the case of the causal link moving from capital to liquidity creation, most of the studies found support for the financial fragility- crowding out hypothesis (Berger & Bouwman, 2009; Fungacova, Weill & Zhou, 2017; Freitas, 2014); with a few finding support for the risk absorption hypothesis (Berger & Bouwman, 2009; Tran et al., 2016). For the causal link moving from liquidity creation to capital, a negative relationship is mostly reported (Casu, Di Pietro & Trujillo-Ponce, 2016; Horvath et al., 2014; Distinguin, Roulet & Tarazi, 2013), with a few studies reporting a positive relationship (Tran et al., 2016; Distinguin et al., 2013).

According to Laevine and Levine (2009), recent financial regulatory reforms target banks’ risk-taking behaviours without considering their ownership and governance. It is argued that bank governance influences how regulations alter a bank’s incentives. Banks with more powerful owners tend to take more risks, and greater capital requirements tend to increase risk-taking in banks with influential shareholders. As such, bank regulations (an example being regulations on bank capitalisation) should condition on bank governance and the ownership structure of the banks.