An IMF working paper published today entitled “High Liquidity Creation and Bank Failures”, suggests that regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.
Identifying vulnerabilities which may lead to bank failure is a persistent challenge to regulators of financial systems and market analysts. Regulators seek timely warning of bank failures for an efficient deployment of monitoring resources and for enhancing regulation enforcement, and shareholders and taxpayers want to avoid substantial resolution costs as well as reduce the time involved in loss resolution.
Two hypotheses in the literature on bank fragility explain bank failures: the “Weak Fundamentals Hypothesis” (WFH) and the “Liquidity Shortage Hypothesis” (LSH). Under the WFH, poor bank fundamentals foreshadow an impending bank failure and CAMELS components are often used as the basis for an early warning system. Bank failures are thus information-based, as decaying capital ratios, reduced liquidity, deteriorating loan quality, and depleted earnings signal an increased likelihood of bank failure. In contrast, the LSH assumes that banks are solvent institutions but fragility is due to the irrational behavior of uninformed depositors who are unable to distinguish between liquidity and solvency shocks. According to this hypothesis, bank vulnerability to crises stems from the financing of illiquid assets with liquid liabilities. When exposed to an external shock and under the sequential servicing constraint, first-in-line depositors seek to withdraw all their deposits and, as the bank’s ability to meet deposit withdrawals declines, liquidity shortages become pronounced and the probability of failure increases.
The WFH focuses on asset risk to explain bank fragility and bank risk under the LSH arises from the liability side of the balance sheet. In this paper, we propose that bank vulnerability may result from the interaction between both asset and liability risks. Using new measures on liquidity creation, we postulate that banks’ vulnerability to failure may resultfrom a proliferation in the core activity of liquidity creation. We propose the “High Liquidity Creation Hypothesis” (HLCH) to explain bank failures, complementing the WFH (which identifies banks with weak fundamentals) and the LSH (which focuses on the inability of banks to meet liquidity commitments). According to the HLCH, a bank’s vulnerability increases when the core output measured by liquidity creation reaches high levels compared to other banks’ activities in the system.
To test this, we need a banking system that witnessed a number of bank failures which are unrelated to economic business cycles or triggered by adverse exogenous shocks. In Russia, over 200 banks failed between 2000 and 2007 and many of those failures were not associated with the business cycle. Thus, the banking system in Russia provides a natural field experiment to test as we are able to isolate the reasons for bank fragility independently from exogenous events.
To gauge the impact of high liquidity creation on the probability of bank failures, we perform logit regressions with bank random effects. We use different thresholds to define high liquidity creation in a given quarter, based on the distribution of the entire liquidity creation in the banking system. Our findings confirm the hypothesis that high liquidity creation increases the probability of bank failure, and the results are robust to several validity checks. Rather than suggesting an absolute cut-off value, we propose to screen financial intermediaries based on their liquidity creation ranking in the system. The identification of high liquidity creators allows regulators to at least place these banks on the watch list for enhanced oversight in view of reducing the number of failures in the system and strengthening incumbent institutions.
We propose a screening procedure of banks, ranking them based on their liquidity creation in the system. Specifically, we define high liquidity creators as banks with a liquidity creation level in a given quarter that exceeds the 90th percentile of the distribution. When liquidity creation becomes high, the probability of failure for such a bank increases significantly more than for other banks. Our results are robust to alternative measures of liquidity creation and definitions of bank failure, and controlling for bank location, market concentration, and regulatory changes. They are also in line with the theoretical predictions of Allen and Gale (2004) and empirical results for the U.S. (Berger and Bouwman, 2011).
The HLCH has two main implications. First, it suggests that liquidity creation by banks can be counterproductive when it becomes high. Liquidity creation above a certain threshold increases the probability of bank failure, eventually leading to the disappearance of the high liquidity-creating institution and even a reduction in the volume of aggregate liquidity creation in the economy. Therefore, regulatory authorities may need to give more attention to the liquidity-creating activities by banks when identifying vulnerabilities in the financial system. Second, our main finding provides insight for regulatory authorities to predict bank failures. Specifically, regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.
