Berger, A., & Bouwman, C. (2009) .

Bank Liquidity Creation
Allen N. Berger
University of South Carolina, Wharton Financial Institutions Center, CentER,
Tilburg University
Christa H. S. Bouwman
Downloaded from http://rfs.oxfordjournals.org/ at Univ. of Massachusetts/Amherst Library on September 8, 2012

Case Western Reserve University, Wharton Financial Institutions Center
Although the modern theory of financial intermediation portrays liquidity creation as an

essential role of banks, comprehensive measures of bank liquidity creation do not exist. We
construct four measures and apply them to data on virtually all U.S. banks from 1993 to
2003. We find that bank liquidity creation increased every year and exceeded $2.8 trillion
in 2003. Large banks, multibank holding company members, retail banks, and recently
merged banks created the most liquidity. Bank liquidity creation is positively correlated
with bank value. Testing recent theories of the relationship between capital and liquidity
creation, we find that the relationship is positive for large banks and negative for small
banks. (JEL G21, G28, G32)
According to the modern theory of financial intermediation, banks exist be-

cause they perform two central roles in the economy—they create liquidity and
they transform risk.1 Analyses of banks’ role in creating liquidity and thereby
spurring economic growth have a long tradition, dating back to Adam Smith
(1776).2 Modern reincarnations of the idea that liquidity creation is central to
banking appear most prominently in the formal analyses in Bryant (1980) and
A previous version of this article was entitled “Bank Capital and Liquidity Creation.” Our bank liquidity creation
data is available for research purposes at: http://wsomfaculty.case.edu/bouwman/data.html. The authors thank
two anonymous referees and Paolo Fulghieri, the editor, for helpful suggestions; Bob Avery, Bill Bassett, Sreed-
har Bharath, Arnoud Boot, Bob DeYoung, Doug Diamond, Phil Dybvig, Mark Flannery, Michael Gordy, Diana
Hancock, Gautam Kaul, Lutz Kilian, Beth Kiser, Vikram Nanda, Charlotte Ostergaard, George Pennacchi,
Jianping Qi, Rich Rosen, Doug Skinner, Anjan Thakor, Bent Vale, Egon Zakrajsek, and participants at presenta-
tions at the Western Finance Association Meeting, the Financial Intermediation Research Society Meeting, the
European Finance Association, the Federal Reserve Bank of Chicago’s Bank Structure and Competition Con-
ference, the FDIC/JFSR Conference on Liquidity and Liquidity Risk, the University of Michigan, Case Western
Reserve University, Ohio State University, ESCP-EAP European School of Management, Stockholm School
of Economics, Yale School of Management, Binghamton University, the Federal Reserve Board, the Federal
Reserve Bank of Cleveland, the Federal Reserve Bank of Chicago, the Norges Bank, and Sveriges Riksbank for
useful comments; Ron Borzekowski for providing data; and Phil Ostromogolsky for excellent research assis-
tance. Send correspondence to Christa H. S. Bouwman, Case Western Reserve University, Wharton Financial
Institutions Center, 10900 Euclid Avenue, 362 Peter B. Lewis Building, Cleveland, OH 44106; telephone: (216)
368-3688; fax: (216) 368-6249. E-mail: [email protected].
1
These two roles are often jointly referred to as banks’ qualitative asset transformation (QAT) function (e.g.,
Bhattacharya and Thakor 1993).
2
Smith (book II, chapter II, 1776) highlights the importance of liquidity creation by banks and describes how it
helped commerce in Scotland. In particular, he notes “That the trade and industry of Scotland, however, have
increased very considerably during this period, and that the banks have contributed a good deal to this increase,
cannot be doubted.”

C The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies.
All rights reserved. For Permissions, please e-mail: [email protected].
doi:10.1093/rfs/hhn104 Advance Access publication January 8, 2009
The Review of Financial Studies / v 22 n 9 2009
Diamond and Dybvig (1983). These theories argue that banks create liquid-
ity on the balance sheet by financing relatively illiquid assets with relatively
liquid liabilities. Holmstrom and Tirole (1998) and Kashyap, Rajan, and Stein
(2002) suggest that banks also create liquidity off the balance sheet through
loan commitments and similar claims to liquid funds.3
Banks’ role as risk transformers is also well studied. A vast literature has
emerged on bank risk taking and prudential regulation, supervision, and mar-
ket discipline to control risk-taking behavior. According to the risk transfor-

mation theories, banks transform risk by issuing riskless deposits to finance
risky loans (e.g., Diamond 1984; Ramakrishnan and Thakor 1984; Boyd and
Prescott 1986). Risk transformation may coincide with liquidity creation, as
for example, when banks issue riskless liquid deposits to finance risky illiq-
uid loans. However, liquidity creation and risk transformation do not move in
perfect tandem—the amount of liquidity created may vary considerably for a
given amount of risk transformed. It is therefore essential to study both roles
of banks and to distinguish between them.
Most of the empirical literature has focused on banks’ role as risk transform-
ers, rather than on their role as liquidity creators. Consequently, comprehensive
empirical measures of bank liquidity creation are conspicuously absent, making
it difficult to address numerous questions of research and policy interest. How
much liquidity does the banking sector create? How has bank liquidity creation
changed over time? How does it vary in the cross section? Which banks create
the most and least liquidity? What are the value implications of bank liquidity
creation? Moreover, without measures of liquidity creation in hand, it is not
possible to examine policy-relevant issues, such as the effect of bank capital on
bank liquidity creation.
Our main goals here are threefold. Our first goal is to develop comprehensive
measures of bank liquidity creation. We create four such measures that differ
in how off-balance sheet activities are treated and how loans are classified. Our
second goal is to use these measures to gain a deeper insight into banks’ role as
liquidity creators by addressing the questions highlighted above. Specifically,
we explore how much liquidity banks create, how liquidity creation has changed
over time, how it varies in the cross section, which banks create the most and
least liquidity, and how liquidity creation is related to bank value. We do
this by applying our liquidity creation measures to data on virtually all U.S.
banks over 1993–2003, by splitting the data in various ways (by bank size,
bank holding company status, wholesale versus retail orientation, and merger
status), by contrasting the top 25% and bottom 25% of liquidity creators in each
size class, and by examining correlations between liquidity creation and bank
3
Other theoretical contributions explain the existence of bank loan commitments as providing a mechanism
for optimal risk sharing (Campbell 1978; Ho and Saunders 1983), reducing credit rationing (James 1981;
Blackwell and Santomero 1982; Morgan 1994; Thakor 2005), and ameliorating informational frictions between
the borrower and bank (Berkovitch and Greenbaum 1991; Boot, Thakor, and Udell 1991; Boot, Greenbaum,
and Thakor 1993). Melnik and Plaut (1986); Shockley and Thakor (1997); and Sufi (2007) provide detailed
overviews of the contractual features of loan commitments and lines of credit.
3780
value. The current financial crisis raises the additional question of how bank
liquidity creation responds during crises. This is one of the issues addressed in
a follow-up paper that uses one of the measures of liquidity creation developed
here (Berger and Bouwman 2008). Our third goal is to use our liquidity creation
measures to examine the policy-relevant issue mentioned above—the effect of
bank capital on bank liquidity creation. Some recent theories predict that bank
capital reduces bank liquidity creation, while others predict that capital makes
banks capable of absorbing more risk, and thereby allows them to create more

liquidity. We develop economic intuition about the types of banks for which
these opposing effects may dominate, and test the relationship between capital
and liquidity creation predicted by the theories.
To construct our liquidity creation measures, we use a three-step procedure.
In step 1, we classify all bank assets, liabilities, equity, and off-balance sheet
activities as liquid, semiliquid, or illiquid. We do this based on the ease, cost,
and time for customers to obtain liquid funds from the bank, and the ease, cost,
and time for banks to dispose of their obligations in order to meet these liquid-
ity demands. Our use of just three liquidity classifications (liquid, semiliquid,
and illiquid) is a necessary simplification—any finer distinctions would have
to be made rather arbitrarily. In step 2, we assign weights to the activities
classified in step 1. The weights are consistent with the theory—maximum
(i.e., dollar-for-dollar) liquidity is created when illiquid assets are transformed
into liquid liabilities and maximum liquidity is destroyed when liquid assets
are transformed into illiquid liabilities or equity. In step 3, we construct four
liquidity creation measures by combining the activities as classified in step 1
and as weighted in step 2 in different ways. The measures classify all activi-
ties other than loans by both product category and maturity but—due to data
limitations—classify loans based either solely on category (“cat”) or solely on
maturity (“mat”). To assess how much liquidity banks create on the balance
sheet versus off the balance sheet, we alternatively include off-balance sheet ac-
tivities (“fat”) or exclude them (“nonfat”). We thus construct liquidity creation
measures based on the four combinations: “cat fat,” “mat fat,” “cat nonfat,”
and “mat nonfat.” As explained below, “cat fat” is our preferred measure.
When we apply our measures to the data, we find that the U.S. banking
industry created $2.843 trillion in liquidity in 2003 using our preferred “cat
fat” measure.4 This equals 39% of bank gross total assets or GTA (total assets
plus allowance for loan and lease losses and the allocated transfer risk reserve)
and is 4.56 times the overall level of bank equity capital, suggesting that
the industry creates $4.56 of liquidity per $1 of capital. To provide further
perspective on liquidity creation relative to bank size, note that bank liquidity
creation equals 70% of gross loans and 58% of total deposits.
Liquidity creation has grown dramatically over time: it increased every year
and virtually doubled between 1993 and 2003 based on our preferred “cat fat”
measure. This evidence contradicts the notion that the role of banks in creating
4
All liquidity creation measures in the article are as of December 31 of a given year.
3781
liquidity has declined due to the development of capital markets. Our results are
fairly similar when we calculate liquidity creation using our “mat fat” measure,
which classifies loans based on maturity instead of category. Results based on
our “nonfat” measures reveal that the banking sector only creates about half
of its liquidity on the balance sheet, highlighting the importance of liquidity
created off the balance sheet as in Holmstrom and Tirole (1998) and Kashyap,
Rajan, and Stein (2002).
Liquidity creation differs considerably among large banks (GTA exceeding

$3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA
up to $1 billion) (measured in real 2003 dollars). We split our sample by bank
size because size differences among banks are substantial and various empirical
studies have shown that components of liquidity creation vary greatly by bank
size. Based on our preferred “cat fat” measure, large banks are responsible for
81% of industry liquidity creation, while comprising only 2% of the sample
observations. All size classes generate substantial portions of their liquidity
off the balance sheet, but the fraction is much higher for large banks. All
size classes increased liquidity creation in real terms over the sample period.
While large banks showed the greatest growth in the dollar value of liquidity
creation, small banks had the greatest growth in liquidity creation divided by
GTA, equity, loans, and deposits.
Liquidity creation also varies with several key bank characteristics. It is
starkly different for banks split by bank holding company status, wholesale
versus retail orientation, and merger status. Based on our preferred “cat fat”
measure, banks that are members of a multibank holding company, have a retail
orientation, and engaged in M&A activity during the prior three years created
most of the banking industry’s overall liquidity. These banks also show the
strongest growth in liquidity creation over time.
Liquidity creation is also positively linked with value. We examine the value
implications of liquidity creation by focusing on listed independent banks and
banks that are part of listed bank holding companies. We find that banks and
bank holding companies that create more liquidity have significantly higher
market-to-book and price-earnings ratios.
Turning to the theories on the relationship between bank capital and liquid-
ity creation, some recent contributions suggest that bank capital may impede
liquidity creation by making the bank’s capital structure less fragile (e.g.,
Diamond and Rajan 2000, 2001). A fragile capital structure encourages the
bank to commit to monitoring its borrowers, and hence allows it to extend
loans. Additional equity capital makes it harder for the less-fragile bank to
commit to monitoring, which in turn hampers the bank’s ability to create
liquidity. Capital may also reduce liquidity creation because it “crowds out”
deposits (e.g., Gorton and Winton 2000). For expositional ease, we refer to this
first set of theories jointly as the “financial fragility-crowding out” hypothesis.
An alternative view—related to banks’ role as risk transformers—is that
higher capital improves banks’ ability to absorb risk and hence their ability
3782
to create liquidity. Liquidity creation exposes banks to risk—the greater the

liquidity created, the greater are the likelihood and severity of losses associated
with having to dispose of illiquid assets to meet customers’ liquidity demands
(Allen and Santomero 1998; Allen and Gale 2004). Capital absorbs risk and
expands banks’ risk-bearing capacity (e.g., Bhattacharya and Thakor 1993;
Repullo 2004; Von Thadden 2004; Coval and Thakor 2005), so higher capital
ratios may allow banks to create more liquidity. We refer to this second set of
theories collectively as the “risk absorption” hypothesis, while recognizing that

the theories together rather than separately produce this prediction.
Both the “financial fragility-crowding out” and the “risk absorption” effects
may apply in differing degrees to liquidity creation by different banks, so the
relevant empirical issue is discovering the circumstances under which each
effect empirically dominates. We address this by testing whether the net effect
of bank capital on liquidity creation is negative or positive for different sizes of
banks. We expect that the “financial fragility-crowding out” effect is likely to be
relatively strong for small banks. One reason is that small banks deal more with
entrepreneurial-type small businesses, where the close monitoring highlighted
in Diamond and Rajan (2000, 2001) is important. A second reason is that small
banks tend to raise funds locally, so that capital may “crowd out” deposits as
in Gorton and Winton (2000).5 This effect is likely to be relatively weak for
large banks that can more easily access funding from national or international
capital markets. In contrast, the “risk absorption” effect is likely to be stronger
for large banks because they are generally subject to greater regulatory scrutiny
and market discipline than small banks, which may affect their capacity to
absorb risk. Since medium banks fall somewhere in the middle, we expect that
either effect may dominate for these banks or that these effects may simply
offset each other.
While the theories suggest a causal relationship from capital to liquidity
creation, in practice both may be jointly determined. This makes it challenging
to establish causation. Although we present regression results using lagged
capital to mitigate the endogeneity problem, we interpret our results with care
and do not claim to have established causation. Nonetheless, at a minimum,
the results should be viewed as interesting correlations between capital and
liquidity creation that are consistent with the theories. We also address the
endogeneity problem more directly with instrumental variable regressions and
obtain consistent results.
Keeping these precautions in mind, we test the relationship between capital
and liquidity creation by regressing the dollar amount of bank liquidity creation
(calculated using our four measures and normalized by GTA) for each bank-
year observation on the bank’s lagged equity capital ratio and a number of
5
Gorton and Winton (2000) develop a general equilibrium model, so it theoretically applies to all banks, small
and large. However, we argue in Section 1.2 that as an empirical matter, it is likely to be more applicable to small
banks.
3783
control variables. Since the effect of capital on liquidity creation may be driven
by banks’ role as risk transformers rather than their role as liquidity creators, all
our regressions control for bank risk. We use three-year lagged average values
of capital and the other exogenous variables to mitigate potential endogeneity
problems, as lagged values represent earlier bank decisions. We run the tests
separately for large, medium, and small banks to allow for the possibility that
capital may affect these banks differently.
We find empirical support for both hypotheses. For large banks, the rela-

tionship between capital and liquidity creation is positive, consistent with the
expected empirical dominance of the “risk absorption” effect. In sharp con-
trast, for small banks, the relationship between capital and liquidity creation
is negative, consistent with the expected dominance of the “financial fragility-
crowding out” effect for these institutions. The relationship is not significant
for medium banks, suggesting that the two effects cancel each other out for
this size class. To understand more deeply why these differences exist, we also
examine the relationship between capital and the individual components of
liquidity creation and find substantial differences across size classes in which
components are significantly correlated with capital.
We test the robustness of our main regression results in various ways. First,
our main liquidity creation measures are based on the ease, cost, and time for
customers to obtain liquid funds, and the ease, cost, and time for banks to dis-
pose of obligations to provide liquid funds. Since buyers of loan commitments
and letters of credit may not fully draw down committed funds, we construct
an alternative measure that incorporates the likelihood with which these cus-
tomers request actual funds. Second, we construct a liquidity creation measure
that uses an alternative way to establish which assets are securitizable. Third,
to address a potential concern that our dependent variable (liquidity creation)
includes current equity capital with a weight of −½ while our key independent
variable is the lagged equity capital ratio, we construct an alternative liquidity
creation measure that does not include current capital. Fourth, since the theo-
ries sometimes use a broader definition of equity that includes other funds that
cannot easily run on banks, we use an alternative capital ratio that includes
equity plus other financial instruments, such as long-term subordinated debt
(total capital specified in the Basel I capital standards). Fifth, because the in-
tertemporal and cross-sectional liquidity creation patterns are so different for
banks split by holding company status, wholesale versus retail orientation, and
merger status, we rerun our regressions for these subsamples. The results of
all of these robustness checks reinforce our main findings and suggest that the
relationship between capital and liquidity creation is positive for large banks,
insignificant for medium banks, and negative for small banks.
Since capital and liquidity creation may be jointly determined and the use
of three-year lagged average values of capital may not be sufficient to mitigate
such endogeneity concerns, we use an instrumental variable approach as our
final robustness check. We select the effective state income tax rate and the
3784
fraction of seniors in the markets in which a bank operates as potentially

valid instruments for lagged capital. Based on first-stage regression results,
we use the tax rate as an instrument for large banks only and the fraction of
seniors as an instrument for small banks only. Using these instruments, we
find—consistent with our main findings—that the effect of capital on liquidity
creation is significantly positive for large banks and significantly negative for
small banks.
The remainder of the article is organized as follows. Section 1 reviews

the literature. Section 2 describes the construction of our liquidity creation
measures. Section 3 discusses our panel dataset of U.S. banks over 1993–2003,
shows how bank liquidity creation varies over time and in the cross section,
contrasts high and low liquidity creators, and explores the value implications
of bank liquidity creation. Section 4 outlines our regression framework, and
Section 5 contains our regression results. Section 6 addresses robustness issues,
and Section 7 concludes.
1. Literature Review
In this section, we provide a brief review of the literature to place our article in
context. Our research is related to three strands of literature: the measurement
of bank liquidity creation; the theories of the effect of capital on liquidity
creation; and the empirical studies of capital and liquidity creation. We discuss
these three literatures in turn.
1.1 Measurement of bank liquidity creation

We are aware of only one paper that attempts to measure bank liquidity creation.
Deep and Schaefer (2004) construct a measure of liquidity transformation and
apply it to data on the two hundred largest U.S. banks from 1997 to 2001. They
define the liquidity transformation gap or “LT gap” as (liquid liabilities − liquid
assets)/total assets. They consider all loans with maturity of one year or less to
be liquid, and they explicitly exclude loan commitments and other off-balance
sheet activities because of their contingent nature. They find that the LT gap
is about 20% of total assets on average for their sample of large banks. The
authors conclude that these banks do not appear to create much liquidity, and
run some tests to explain this finding, examining the roles of insured deposits,
credit risk, and loan commitments.
The LT gap is an intuitive step forward, but we do not believe that it is
sufficiently comprehensive. To illustrate, we highlight a few key differences
between their approach and ours. First, we include virtually all commercial
banks and compare findings for large, medium, and small banks, rather than
including only the largest institutions. Second, our preferred “cat fat” liquidity
creation measure classifies loans by category (“cat”), rather than by maturity.
We treat business loans as illiquid regardless of their maturity because banks
generally cannot easily dispose of them to meet liquidity needs, but we treat
3785
residential mortgages and consumer loans as semiliquid because these loans

can often be securitized and sold to meet demands for liquid funds. Third,
our preferred measure includes off-balance sheet activities (“fat”), consistent
with the arguments in Holmstrom and Tirole (1998) and Kashyap, Rajan, and
Stein (2002). In our less-preferred liquidity measures, we classify loans by
maturity (“mat”) and exclude off-balance sheet activities (“nonfat”) to deter-
mine the effects of these assumptions. As discussed in Section 2, the LT gap is
conceptually close to our “mat nonfat” measure.

1.2 Bank liquidity creation and capital: the theories
In the seminal theories on financial intermediary existence highlighted above,
banks do not hold any capital. Bank capital was introduced in subsequent
papers, which argue that the primary reason why banks hold capital is to absorb
risk, including the risk of liquidity crunches, protection against bank runs,
and various other risks, most importantly credit risk. Although the reason why
banks hold capital is motivated by their risk transformation role, recent theories
suggest that bank capital may also affect banks’ ability to create liquidity. These
theories produce opposing predictions on the link between capital and liquidity
creation.
One set of theories, which we refer to collectively as the “financial fragility-
crowding out” hypothesis, predicts that higher capital reduces liquidity creation.
Diamond and Rajan (2000, 2001) focus on financial fragility. They model
a relationship bank that raises funds from investors to provide financing to
an entrepreneur. The entrepreneur may withhold effort, which reduces the
amount of bank financing attainable. More importantly, the bank may also
withhold effort, which limits the bank’s ability to raise financing. A deposit
contract mitigates the bank’s holdup problem, because depositors can run on
the bank if the bank threatens to withhold effort, and therefore maximizes
liquidity creation. Providers of capital cannot run on the bank, which limits
their willingness to provide funds, and hence reduces liquidity creation. Thus,
the higher a bank’s capital ratio, the less liquidity it will create.6 Note that
the negative effect of capital on liquidity creation as suggested by Diamond
and Rajan (2000, 2001) depends crucially on deposit insurance coverage being
incomplete. If insurance were complete, depositors would have no incentive to
run on the bank, and a deposit contract would not mitigate the bank’s holdup
problem.
Gorton and Winton (2000) show how a higher capital ratio may reduce
liquidity creation through the crowding out of deposits.7 They argue that
6
Diamond and Rajan’s (2000, 2001) model builds on Calomiris and Kahn’s (1991) argument that the ability of
uninsured depositors to run on the bank in the event of expected wealth expropriation by bank managers is an
important disciplining mechanism. A related idea is proposed by Flannery (1994), who focuses on the disciplining
effect of depositors’ ability to withdraw funds on demand, and thus prevent the bank from expropriating depositor
wealth through excessively risky investments.
7
A similar argument regarding capital requirements is made by Van den Heuvel (2008).
3786
deposits are more effective liquidity hedges for investors than investments
in equity capital and higher capital ratios shift investors’ funds from deposits
to bank capital. Since deposits are liquid and bank equity is illiquid, there is a
reduction in overall liquidity for investors when the capital ratio is higher.8
While the theories underlying the “financial fragility-crowding out” hypoth-
esis apply to banks of all sizes, we argue that they are most applicable to small
banks. An essential feature of the Diamond and Rajan (2000, 2001) model is the
bank’s monitoring of the borrower using its borrower-specific skills, without

which the loan’s value diminishes. As the analyses in Berger et al. (2005) sug-
gest, small banks engage in more relationship-specific lending involving bank
monitoring than large banks. The Gorton and Winton (2000) model is general
equilibrium and theoretically applies to all banks, but as an empirical matter
the assumptions of their model seem to fit small banks better. In their model,
there is a single, unsegmented capital market, so more bank equity capital im-
plies less bank deposits. In reality, however, this is the case only in the smaller
markets in which small banks operate. The larger (especially national and inter-
national) capital markets are often quite segmented, with investors segmenting
themselves based on various characteristics, including investment style (e.g.,
choice of equity versus debt instruments). This implies that an increase in the
bank’s demand for equity capital may simply cause “equity investors” to shift
out of other equities, rather than inducing a shift out of bank deposits. That
is, changes in bank capital may induce general equilibrium effects, but these
effects may be manifested in securities other than bank deposits. Further, bank
equity capital in practice accounts for a relatively small fraction of total equity
capital held by investors in the national/international capital markets. Thus,
even if the “crowding out” effect by Gorton and Winton (2000) exists for large
banks, it is likely to be empirically smaller than for small banks. Small banks
operate in smaller, less segmented markets, where there is significant overlap
between those who invest in bank equity and those who invest in bank deposits,
and any increase in bank capital is more likely to crowd out deposits. A final and
related reason why the crowding out effect may be stronger for small banks is
that these banks fund themselves largely with deposits and capital. In contrast,
large banks also use other liabilities that are less liquid than deposits (such as
subordinated debt), suggesting that an increase in capital may lead to a drop in
other liabilities rather than deposits. Thus, capital is more likely to crowd out
deposits at small banks than at large banks.
Under the alternative “risk absorption” hypothesis, which is directly linked
to the risk-transformation role of banks, higher capital enhances banks’ ability
to create liquidity. This insight is based on two strands of the literature. One
strand consists of papers that argue that liquidity creation exposes banks to risk
8
Gorton and Winton’s (2000) analysis suggests that even if equityholders did not reduce funding to the bank in
Diamond and Rajan (2000), there would be less liquidity creation with a higher capital ratio.
3787
(e.g., Allen and Santomero 1998; Allen and Gale 2004). The more liquidity that
is created, the greater is the likelihood and severity of losses associated with
having to dispose of illiquid assets to meet the liquidity demands of customers.
The second strand consists of papers that posit that bank capital absorbs risk
and expands banks’ risk-bearing capacity (e.g., Bhattacharya and Thakor 1993;
Repullo 2004; Von Thadden 2004; Coval and Thakor 2005). Combining these
two strands yields the prediction that higher capital ratios may allow banks to
create more liquidity.

We argue that the risk absorption hypothesis applies more strongly to large
banks than to small banks. The reasons are threefold. First, large banks are
typically exposed to more intense regulatory scrutiny, increasing the value
of capital to the banks as part of its overall risk management. Second,
large banks are also subject to greater market discipline from uninsured
providers of finance, so capital has a greater effect on both the cost and the
availability of uninsured financing. Third, some large banks may see new oppor-
tunities to offer large loan commitments or engage in other off-balance sheet
activities. Since these activities involve risk, these banks may boost equity
capital in anticipation of engaging in these new activities.
Finally, we point out one additional contribution of some of the recent the-
ories. The standard view of liquidity creation is that banks create liquidity by
transforming illiquid assets into liquid liabilities. Diamond and Rajan (2000,
2001) and Gorton and Winton (2000) show, however, that banks can create
more or less liquidity by simply changing their funding mix on the liability
side. Thakor (1996) shows that capital may also affect banks’ asset portfolio
composition, thereby affecting liquidity creation through a change in the asset
mix. Our measures of liquidity creation incorporate these insights—they ex-
plicitly recognize that liquidity creation by banks occurs through changes in
the mixes on both sides of the balance sheet, as well as through off-balance
sheet activities.
1.3 Bank capital and liquidity creation: the existing empirical evidence
Some empirical studies examine issues related to liquidity creation, but do
not focus on the role of capital. Kashyap, Rajan, and Stein (2002) provide
empirical evidence of synergies between commitment lending and deposits,
consistent with their model. Gatev, Schuermann, and Strahan (2006) and Gatev
and Strahan (2006) find that banks have a comparative advantage in hedging
liquidity risk in the economy because banks experience deposit inflows fol-
lowing a market crisis or liquidity shock that allow them to have more funds
to provide the additional loans drawn down under commitments at such times.
Pennacchi (2006) confirms the existence of synergies between loan commit-
ments and deposit taking, but finds that such synergies do not hold prior to the
creation of FDIC deposit insurance. These studies do not focus on the role of
bank capital, but they do in some cases include the capital ratios in regressions
3788
of some liquidity creation components, yielding ambiguous predictions related

to the effect of capital on liquidity creation.9
The credit crunch literature tests hypotheses about bank capital and one type
of liquidity creation, usually business lending or real estate lending, during
the early 1990s when bank lending declined significantly. Several studies find
that the decline in bank capital ratios arising from loan losses in the late
1980s and early 1990s contributed significantly to the reduction in lending
(e.g., Peek and Rosengren 1995). This is consistent with a positive relationship

between capital and liquidity creation during a period of distress. In the early
1990s, U.S. regulators also imposed new leverage requirements, as well as
the Basel I risk-based capital standards. Most of the studies found that the
leverage requirements contributed to the decline in lending, consistent with the
hypothesis of a negative effect of bank capital on liquidity creation (e.g., Berger
and Udell 1994; Hancock, Laing, and Wilcox 1995; Peek and Rosengren 1995),
and generally concluded that the risk-based capital requirements had little effect
on lending. Unfortunately, the unusual combination of several major changes in
bank capital regulation and a recession makes it difficult to parse the different
effects and draw general conclusions.
Finally, some studies of bank lending behavior include capital ratios, but
focus on other issues. For example, Berger and Udell (2004) study procyclical
lending and find positive, statistically significant effects of capital on the annual
growth of business loans. Holod and Peek (2007) examine monetary policy
effects and find that the capital ratio has significant positive effects on loan
growth. Gambacorta and Mistrulli (2004) use Italian data and find that the
impact of monetary policy and GDP shocks on bank lending depends on bank
capitalization.
Thus, the existing empirical literature sheds relatively little light on the
relationship between bank capital and liquidity creation. Some studies test
the liquidity creation theories, but do not focus on the role of bank capital.
Others include capital in their regressions, but specify only limited components
of liquidity creation, and often under unusual circumstances. Our empirical
analysis uses a significantly different approach.
2. Construction of Our Liquidity Creation Measures

In this section, we pursue our first main goal of developing measures of liquidity
creation. We explain the construction of our four liquidity creation measures
and clarify which is our preferred measure. We also show how Deep and
Schaefer’s (2004) liquidity transformation measure can be viewed as a special
case of one of our measures.
9
For example, Gatev and Strahan (2006) find that a higher bank capital ratio tends to be followed by greater loans
and deposits (which may increase liquidity creation) and greater liquid assets and nondeposit liabilities (which
may reduce liquidity creation).
3789
We construct the liquidity creation measures using a three-step procedure.

In step 1, we classify all bank balance sheet and off-balance sheet activities
as liquid, semiliquid, or illiquid. In step 2, we assign weights to the activities
classified in step 1. In step 3, we combine the activities as classified in step 1
and as weighted in step 2 in different ways to construct our four liquidity
creation measures: “cat fat,” “mat fat,” “cat nonfat,” and “mat nonfat.” Table 1
illustrates the three-step procedure. We discuss these steps in turn.

2.1 Step 1: Classifying activities as liquid, semiliquid, or illiquid
In step 1, we classify all assets as liquid, semiliquid, or illiquid based on the ease,
cost, and time for banks to dispose of their obligations to obtain liquid funds to
meet customers’ demands. We similarly classify bank liabilities plus equity as
liquid, semiliquid, or illiquid, based on the ease, cost, and time for customers to
obtain liquid funds from the bank. Off-balance sheet guarantees and derivatives
are classified consistently with treatments of functionally similar on-balance
sheet items.10
Ideally, we would use information on both product category and maturity
to classify all bank activities. For example, as noted above, business loans
are generally more illiquid than residential mortgages and consumer loans,
as the latter can often be more easily securitized and sold to meet liquidity
demands. Within each category, shorter maturity items are more liquid than
longer maturity items because they self-liquidate without effort or cost sooner.
For bank activities other than loans, Call Reports provide sufficient detail
on category and maturity, so our classifications incorporate both aspects. Un-
fortunately, this is not the case for loans. Call Reports split loans into various
loan categories and into different maturity classes, but do not provide maturity
information for individual loan categories. We therefore either classify loans
entirely by category (“cat”) or entirely by maturity (“mat”). Thus, our “cat”
and “mat” liquidity creation measures constructed below classify loans either
by category or maturity, but in all cases incorporate both key characteristics for
other bank activities.
2.1.1 Assets
• Classifying loans
(a) Category (“cat”): For the “cat” measures of liquidity creation, we
classify business loans and leases as illiquid assets, because these
items typically cannot be sold quickly without incurring a major loss.
Residential mortgages and consumer loans are generally relatively
easy to securitize, and loans to depositories and governments are likely
to be comparatively easy to sell or otherwise dispose of because the
10
In a robustness check, we use an alternative approach to measuring the liquidity contribution of some of these
items (see Section 6.1).
3790
Table 1
Liquidity classification of bank activities and construction of four liquidity creation measures
Step 1: We classify all bank activities as liquid, semiliquid, or illiquid. For activities other than loans, we combine information on product category and maturity. Due to data limitations,
we classify loans entirely by product category (“cat”) or maturity (“mat”)
Step 2: We assign weights to the activities classified in step 1
Assets
Illiquid assets (weight = 1/2 ) Semiliquid assets (weight = 0) Liquid assets (weight = –1/2 )
(cat) (mat) (cat) (mat)

Commercial real All loans and leases with Residential real All loans and leases with Cash and due from
estate loans (CRE) a remaining maturity estate loans (RRE) a remaining maturity other institutions
Loans to finance agricultural >1 year Consumer loans ≤1 year All securities (regardless
production Loans to depository of maturity)
Commercial and industrial institutions Trading assets
loans (C&I) Loans to state and Fed funds sold
Other loans and lease local governments
financing receivables Loans to foreign governments
Other real estate owned (OREO)

Customers’ liability on bankers acceptances
Investment in unconsolidated subsidiaries
Intangible assets
Premises
Other assets
Liabilities plus equity
Liquid liabilities (weight = /2 )

1
Semiliquid liabilities (weight = 0) Illiquid liabilities plus equity (weight = –1/2 )
Transactions deposits Time deposits Bank’s liability on bankers acceptances

Savings deposits Other borrowed money Subordinated debt
Overnight federal funds purchased Other liabilities
Trading liabilities Equity
(continued overleaf)
3791

Table 1
(Continued)
Off-balance sheet guarantees (notional values)
3792

Illiquid guarantees (weight = 1/2 ) Semiliquid guarantees (weight = 0) Liquid guarantees (weight = –1/2 )
Unused commitments Net credit derivatives Net participations acquired

Net standby letters of credit Net securities lent
Commercial and similar letters of credit
All other off-balance sheet liabilities
Off-balance sheet derivatives (gross fair values)
Liquid derivatives (weight = −1/2 )

Interest rate derivatives
Foreign exchange derivatives
Equity and commodity derivatives
Step 3: We combine bank activities as classified in step 1 and as weighted in step 2 in different ways to construct four liquidity creation measures by using the “cat” or “mat” classification
for loans, and by alternatively including off-balance sheet activities (“fat”) or excluding these activities (“nonfat”)
cat fat = +½ ∗
illiquid assets (cat) +0 ∗ semiliquid assets (cat) −½ ∗
liquid assets
+½ ∗
liquid liabilities +0 ∗ semiliquid liabilities −½ ∗
illiquid liabilities
−½ ∗
equity
+½ ∗
illiquid guarantees +0 ∗ semiliquid guarantees −½ ∗
liquid guarantees
−½ ∗
liquid derivatives
cat nonfat = +½ ∗
illiquid assets (cat) +0 ∗ semiliquid assets (cat) −½ ∗
liquid assets
+½ ∗
−½ ∗
equity
mat fat = +½ ∗
illiquid assets (mat) +0 ∗ semiliquid assets (mat) −½ ∗
liquid assets
+½ ∗
−½ ∗
equity
+½ ∗
illiquid guarantees +0 ∗ semiliquid guarantees −½ ∗
liquid guarantees
−½ ∗
liquid derivatives
mat nonfat = +½ ∗
illiquid assets (mat) +0 ∗ semiliquid assets (mat) −½ ∗
liquid assets
+½ ∗
−½ ∗
equity
This table explains our methodology to construct liquidity creation measures in three steps.

counterparties are relatively large and informationally transparent. We

classify these loan categories as semiliquid assets.11
(b) Maturity (“mat”): Shorter maturity items are more liquid than longer
maturity items because they self-liquidate sooner. We therefore clas-
sify all short-term loans of up to one year as semiliquid and all long-
term loans of over one year as illiquid for the “mat” measures.
• Classifying assets other than loans: We classify premises and investments

in unconsolidated subsidiaries as illiquid assets, because typically these
items cannot be sold quickly without incurring a major loss. We clas-
sify cash, securities, and other marketable assets that the bank can use
to meet liquidity needs quickly without incurring major losses as liquid
assets.
2.1.2 Liabilities plus equity

• Classifying liabilities: We count funds that can be quickly withdrawn with-
out penalty by customers, such as transactions deposits, savings deposits,
and overnight federal funds purchased, as liquid liabilities. We classify
deposits that can be withdrawn with slightly more difficulty or penalty as
semiliquid. This includes all time deposits regardless of maturity. We do not
differentiate between short-term and long-term time deposits since all time
deposits can be borrowed against with a penalty regardless of maturity. We
also classify as semiliquid the balance sheet item “other borrowed money,”
which contains other short and medium maturities with terms longer than
overnight, such as term federal funds, repurchase agreements, and bor-
rowings from Federal Reserve Banks and Federal Home Loan Banks. We
classify long-term liabilities that generally cannot be withdrawn easily or
quickly, such as subordinated debt, as illiquid.
• Classifying equity: We classify equity as illiquid because investors cannot
demand liquid funds from the bank and the maturity is very long. Although
the equity of some banks is publicly traded and may be sold relatively
easily, the investors are able to retrieve liquid funds through the capital
market, not from the bank. Thus, while traded equity may be liquid from
an individual investor’s point of view, such liquidity is created by the
capital market, rather than by the bank, the focus of this article.
2.1.3 Off-balance sheet activities

• Classifying guarantees: We classify loan commitments and letters of credit
as illiquid guarantees. These items are functionally similar to on-balance
sheet business loans in that they are obligations that are illiquid from the
11
In a robustness check, we use a different method to establishing which loans are securitizable (see Section 6.2).
3793
point of view of the bank; except in very unusual circumstances, the bank
must provide the funds to the customer upon demand.12 As well, in most
cases, the bank cannot sell or participate these items. We classify net credit
derivatives (i.e., the amount guaranteed minus the beneficiary amount) and
net securities lent (i.e., the amount lent minus the amount borrowed) as
semiliquid guarantees since they can potentially be sold or participated,
analogous to semiliquid on-balance sheet residential mortgages and con-
sumer loans. We classify net participations acquired from other institutions

(i.e., the amount acquired minus the amount conveyed to others) as liquid
guarantees, since they are functionally similar to on-balance sheet liquid
securities.
• Classifying derivatives: We classify all derivatives (other than credit
derivatives, which we classify above as guarantees)—interest rate, for-
eign exchange, and equity and commodity derivatives—as liquid because
they can be bought and sold easily and are functionally similar to liquid
securities. We focus on the gross fair values of these derivatives (which are
sometimes positive and sometimes negative), which measure how much
liquidity the bank is providing to or absorbing from the public.
2.2 Step 2: Assigning weights to the activities classified in step 1

In step 2, we assign weights to all of the bank activities classified in step 1. That
is, we assign weights to the classes of liquid, semiliquid, and illiquid assets,
liabilities plus equity, and off-balance sheet guarantees and derivatives shown
in Table 1.
We base the weights on liquidity creation theory. According to this theory,
banks create liquidity on the balance sheet when they transform illiquid assets
into liquid liabilities. An intuition for this is that banks create liquidity because
they hold illiquid items in place of the nonbank public and give the public liquid
items. We therefore apply positive weights to both illiquid assets and liquid
liabilities, so when liquid liabilities (such as transactions deposits) are used to
finance illiquid assets (such as business loans), liquidity is created. Following
similar logic, we apply negative weights to liquid assets, illiquid liabilities, and
equity, so that when illiquid liabilities or equity is used to finance a dollar of
liquid assets (such as treasury securities), liquidity is destroyed. Note that the
negative weight on equity only captures the direct effect of capital on liquidity
creation. Any indirect (positive or negative) effects on liquidity creation are
attributed to the individual items that are affected. For example, if capital
allows banks to extend more illiquid loans, this positive effect is captured by
the positive weight applied to illiquid loans multiplied by the associated dollar
increase in loans.
12
We acknowledge that banks could dispose of loan commitments by invoking the material adverse change (MAC)
clause and the customer would not have access to the funds. However, failing to honor loan commitments is
generally very costly since it may create legal liabilities and reputational losses, and is therefore rarely done.
3794
The magnitudes of the weights are based on simple dollar-for-dollar adding-

up constraints, so that $1 of liquidity is created when banks transform $1
of illiquid assets into $1 of liquid liabilities. Similarly, we require that $1 of
liquidity is destroyed when banks transform $1 of liquid assets into $1 of illiquid
liabilities. Based on these constraints, we assign a weight of ½ to both illiquid
assets and liquid liabilities and a weight of −½ to both liquid assets and
illiquid liabilities. Thus, when a dollar of liquid liabilities (such as transactions
deposits) is used to finance a dollar of illiquid assets (such as business loans),

liquidity creation equals ½ ∗ $1 + ½ ∗ $1 = $1. In this case, maximum
liquidity ($1) is created. Intuitively, the weight of ½ applies to both illiquid
assets and liquid liabilities, since the amount of liquidity created is only “half”
determined by the source or use of the funds alone—both are needed to create
liquidity. Similarly, when a dollar of illiquid liabilities or equity is used to
finance a dollar of liquid assets (such as treasury securities), liquidity creation
equals −½ ∗ $1 + −½ ∗ $1 = −$1, as maximum liquidity is destroyed.
Using these weights, banks do not create liquidity when they use liquid
liabilities (e.g., transaction deposits) to finance liquid assets (e.g., treasuries),
or when they use illiquid liabilities or equity to finance illiquid assets (e.g.,
business loans). In these cases, banks hold items of approximately the same
liquidity as they give to the nonbank public.
We apply the intermediate weight of 0 to semiliquid assets and liabilities,
based on the assumption that semiliquid activities fall halfway between liquid
and illiquid activities. Thus, the use of time deposits to fund residential mort-
gages would yield approximately zero net liquidity creation, since the ease,
cost, and time with which the time depositors may access their funds early and
demand liquidity roughly equals the ease, cost, and time with which the bank
can securitize and sell the mortgage to provide the funds.
We apply weights to off-balance sheet guarantees and derivatives using the
same principles, consistent with the functional similarities to on-balance sheet
items discussed in step 1. For example, illiquid off-balance sheet guarantees
(such as loan commitments) are functionally similar to on-balance sheet illiquid
loans (such as business loans) in that they are obligations of the bank to provide
funds that cannot be easily sold or participated. We therefore apply the same
weight of ½ to illiquid guarantees as we do to illiquid assets. Similarly, we
apply the same weight of 0 to semiliquid guarantees as we do to functionally
similar semiliquid on-balance sheet assets, and we apply the same weight of
−½ to liquid guarantees that we do to functionally similar on-balance sheet
liquid assets.
Analogously, the gross fair values of derivatives are assigned the same weight
of −½ as on-balance sheet liquid assets.13 As discussed in step 1, these
13
Fair values reported in Call Reports are as in FASB 133: the amount at which an asset (liability) could be
bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced
or liquidation sale. The fair value equals the quoted market price, if available. If a quoted market price is not
available, the estimate of fair value is based on the best information available in the circumstances.
3795
contracts can be bought and sold easily and are functionally similar to liquid
securities. Like securities, derivatives with gross positive fair values reduce
bank liquidity creation as the bank effectively holds a valuable liquid asset in
place of the public. Derivatives with gross negative fair values increase bank
liquidity creation as the bank effectively holds a negatively valued liquid asset
in place of the public. Since the Call Reports assign positive values to contracts
with gross positive fair values and negative values to those with gross negative
fair values, we capture these opposing effects on liquidity creation by simply

applying weights of −½ to the dollar values of both.14,15
We arrange the columns in Table 1 such that all the bank activities that
contribute to liquidity creation are on the left, all those that subtract from
liquidity creation are on the right, and all those with an approximately neutral
effect on liquidity creation are in the center. Thus, those that are assigned a
weight of ½ —illiquid assets, liquid liabilities, and illiquid guarantees—are
grouped together on the left. Liquid assets, illiquid liabilities plus equity, and
liquid guarantees and derivatives, which are assigned a weight of −1/2 , are
grouped on the right. Finally, semiliquid assets, liabilities, and guarantees with
0 weights are grouped in the center.
2.3 Step 3: Constructing liquidity creation measures by combining

activities as classified in step 1 and as weighted in step 2
In step 3, we combine the activities as classified and weighted in step 1 and step
2, respectively, in different ways to construct our liquidity creation measures.
The measures are similar in that they all classify activities other than loans
using information on product category and maturity, as discussed in step 1.
The measures differ in that we alternatively classify loans by category or ma-
turity (“cat” versus “mat”), and—to gauge how much liquidity banks create off
the balance sheet—alternatively include or exclude off-balance sheet activities
(“fat” versus “nonfat”). Hence, we have four measures: “cat fat,” “cat nonfat,”
“mat fat,” and “mat nonfat.” The formulas are shown in Table 1. In Table 1, we
again arrange the bank activities that add to liquidity creation on the left, those
that subtract from liquidity creation on the right, and those with an approxi-
mately neutral effect in the center. For all measures, we multiply the weights of
1
/2 , −1/2 , or 0, respectively, times the dollar amounts of the corresponding bank
activities and add the weighted dollar amounts to arrive at the total dollar value
14
While the gross positive and negative fair values of derivatives are often quite substantial, most banks operate
with nearly matched books, so these values tend to offset each other, yielding a small net contribution to liquidity
creation.
15
The seminal papers say nothing about the role that derivatives play in the liquidity creation function of banks.
Rather, derivatives play a more major role in the risk-transformation function of banks. Nonetheless, it is
important to consider the contribution of all balance sheet and off-balance sheet activities to liquidity creation in
our measurement, whether or not the theory has spoken on these activities. Thus, for measurement purposes, we
take the gross fair values of liquid derivatives and assign a weight consistent with that of a functionally similar
on-balance sheet item, which in this case is liquid securities.
3796
of liquidity creation at a particular bank. We sum across all banks to obtain the
total dollar value of liquidity created by the entire industry.
We recognize that our liquidity creation measures are rough approximations.
We classify all bank activities as liquid, semiliquid, or illiquid, and use three
weights, 1/2 , 0, and −1/2 . Differences in liquidity obviously exist within each
of the three classifications, but the data generally do not allow for much finer
distinctions, and there are no other unambiguous weights to apply. The use of
1
/2 , −1/2 , and 0 are the clear demarcations of full liquidity, full illiquidity, and

neutrality, respectively, and no other clear choices present themselves.
Note that Deep and Schaefer’s (2004) LT gap measure is conceptually close
to our “mat nonfat” measure and may be viewed as a special case of it. If we
classified all assets and liabilities as either liquid or illiquid (none as semiliquid)
using maturities, excluded off-balance sheet activities, and specified assets (A)
rather than gross total assets (GTA), our “mat nonfat” formula reduces to their
formula.16
We next discuss why we consider “cat fat” to be our preferred liquidity
creation measure. First, we argue that the “cat” measures are preferred to the
“mat” measures primarily because what matters to liquidity creation on the
asset side is the ease, cost, and time for banks to dispose of their obligations to
obtain liquid funds. The ability to securitize loans is closer to this concept than
the time until self-liquidation. For example, a 30-year residential mortgage may
be securitized relatively quickly even though it is a long-term loan. Second, we
argue that the “fat” measures are preferred to the “nonfat” measures because
off-balance sheet activities provide liquidity in functionally similar ways to
on-balance sheet items. Hence, “cat fat” is our preferred measure.
3. Bank Liquidity Creation over Time, in the Cross Section, and Value
Implications
In this section, we pursue our second main goal of gaining a deeper insight
into banks’ role as liquidity creators by applying our four measures to data
on the U.S. banking sector. We first describe how we construct our sample.
We then measure how much liquidity banks create. We next explore the time-
series and cross-sectional variation in bank liquidity creation, and examine
the characteristics of banks that create the most and least liquidity over the
sample period. In all of these analyses, we split the sample by size. In addition,
we divide the data by bank holding company status, wholesale versus retail
orientation, and merger status. Finally, we explore the value implications of
bank liquidity creation.
16
Applying these changes, our formula becomes [½ ∗ illiquid assets − ½ ∗ liquid assets + ½ ∗ liquid liabilities −
½ ∗ illiquid liabilities − ½ ∗ equity]/A = [½ ∗ (A − liquid assets) − ½ ∗ liquid assets + ½ ∗ (liquid liabilities)
− ½ ∗ (A − liquid liabilities)]/A = [liquid liabilities − liquid assets]/A, which is their LT gap measure.
3797
3.1 Sample description

Our sample includes almost all commercial banks in the United States that are
in business during the 1993 to 2003 period. To ensure that our sample only
contains “true,” viable commercial banks, we impose the following restrictions.
We exclude a bank if it (1) has no commercial real estate or commercial and
industrial loans outstanding; (2) has zero deposits; (3) has zero or negative
equity capital in the current or lagged year; (4) is very small (average lagged
GTA below $25 million);17 (5) has unused commitments exceeding four times

GTA; (6) resembles a thrift (residential real estate loans exceeding 50% of
GTA); or (7) is classified by the Federal Reserve as a credit card bank or
has consumer loans exceeding 50% of GTA.18 We also eliminate 0.7% of all
bank-year observations because some of the exogenous variables used in our
regression analysis are missing.
For all the banks in our sample, we obtain annual Call Report data as of
31 December of each year. In all of our analyses, we split the sample by size for
several reasons. First, there are many empirical studies that show that size mat-
ters when studying components of bank liquidity creation. For example, Berger
et al. (2005) argue that large and small banks have comparative advantages in
handling different types of credit information, and hence will extend different
types of loans. They split their sample by bank size, and indeed find that large
and small banks make very different loans. Furthermore, Kashyap, Rajan, and
Stein (2002) provide empirical evidence that the relationship between commit-
ments and transactions deposits is different for banks in different size classes.
Second, although there are no theories that argue that the effect of capital on
liquidity creation depends on bank size, we expect that the net effect of capital
on liquidity creation would be different for banks of different size classes. As
shown in Sections 5 and 6, we find confirming empirical evidence. Thus, we
split the sample into large banks (GTA exceeding $3 billion), medium banks
(GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion).19
Our definition of small banks with GTA of up to $1 billion conforms to the
usual notion of “community banks” that primarily create liquidity by trans-
forming locally generated deposits into local loans on the balance sheet.20 We
divide the remaining observations roughly in half with the $3 billion cutoff for
17
Banks with lagged average GTA below $25 million are not likely to be viable commercial banks in equilibrium.
This exclusion reduced the sample size by 12,955 bank-year observations (from 96,953 to 83,998), but does
not materially affect our findings. Inclusion of these banks increases liquidity creation of small banks by only
0.1% ($0.0027 trillion) in 2003 based on our “cat fat” measure, and leaves our regression results qualitatively
unchanged.
18
The Federal Reserve Board defines a credit card bank as having (1) 50% or more of its total assets in the form
of loans to individuals; (2) 90% or more of its loans to individuals in the form of credit card outstandings; and
(3) $200 million or more in loans to individuals.
19
We apply the $3 billion and $1 billion cutoffs, measured in real 2003 dollars, in each year to separate the banks
in our sample into large, medium, and small banks.
20
We also tried splitting small banks into banks with GTA up to $100 million and banks with GTA $100 million–$1
billion. Since the regression results presented in Sections 5 and 6 yielded very similar results for both size classes,
we decided not to pursue this finer partitioning of the data.
3798
GTA. Large banks with GTA over $3 billion create much more liquidity off the
balance sheet than small banks. Large institutions also tend to generate and
disperse on-balance sheet funds on more national and international bases than
small institutions. Medium banks with GTA between $1 billion and $3 billion
tend to have portfolios that mix some of the characteristics of small and large
banks.
Our sample contains 83,998 bank-year observations: 1804 for large banks,
2132 for medium banks, and 80,062 for small banks.

3.2 Liquidity creation over time and in the cross section for banks split
by size and by bank holding company status, wholesale versus retail
orientation, and merger status
We next measure how much liquidity banks create and explore how liquidity
creation has changed over time and how it varies in the cross section. We
initially split banks only by size, and then we also divide banks by bank
holding company status, wholesale versus retail orientation, and merger status.
Panel A of Table 2 shows the summary statistics on bank liquidity creation
based on our four measures for the entire banking sector and separately for
large, medium, and small banks in 1993 and in 2003, the first and last years of
our sample period, respectively. It also shows graphs of liquidity creation over
the entire sample period using the corresponding measures. As shown, due to
consolidation of the banking industry, the numbers of observations of large and
small banks fell by about one-quarter each, while the number of medium banks
remained approximately constant. Overall, the number of banks in the sample
fell by about 23% from 9095 in 1993 to 6968 in 2003.
We find that banks created liquidity of $2.843 trillion in 2003 based on our
preferred “cat fat” measure, which classifies loans by category and includes
off-balance sheet activities (see panel A of Table 2).21 Liquidity creation equals
39% of industry GTA and represents $4.56 of liquidity per $1 of equity capital.
It is about 70% as large as gross loans and 58% as large as total deposits,
which are standard asset and liability measures of bank size. Overall liquidity
creation almost doubled in real terms between 1993 and 2003. As shown,
liquidity creation also increased as a fraction of GTA, equity, gross loans, and
total deposits, suggesting that liquidity creation grew at a faster rate than these
items.
Large banks created 81% of industry liquidity at the end of the sample period,
despite representing only about 2% of the sample observations. Medium and
small banks generated only about 5% and 14% of industry liquidity creation as
of 2003, respectively, despite their greater numbers of observations. Medium
21
Applying the formula given in step 3 of Table 1: liquidity creation = ½ ∗ illiquid assets of $2.752 trillion + 0
∗
semiliquid assets of $1.905 trillion − ½ ∗ liquid assets of $2.550 trillion + ½ ∗ liquid liabilities of $3.718
trillion + 0 ∗ semiliquid liabilities of $1.777 trillion − ½ ∗ illiquid liabilities of $0.370 trillion − ½ ∗ equity of
$0.624 + ½ ∗ illiquid guarantees of $2.781 trillion + 0 ∗ semiliquid guarantees of $0.782 trillion − ½ ∗ liquid
guarantees of −$0.001 trillion − ½ ∗ liquid derivatives of $0.023 trillion = $2.843 trillion.
3799
Table 2
3800

Summary statistics on bank liquidity creation
Panel A: Bank liquidity creation over time (1993–2003) and in the cross section using our four liquidity creation measures for banks split by size
1993 liquidity creation 2003 liquidity creation Liquidity creation 1993–2003

Liquidity creation
measure N LC $ bill LC/GTA LC/EQ LC/LNS LC/DEP N LC $ bill LC/GTA LC/EQ LC/LNS LC/DEP $ billion
cat fat All banks 9095 1523 0.34 4.36 0.60 0.46 6968 2843 0.39 4.56 0.70 0.58
(preferred) Large 205 1154 0.40 5.44 0.70 0.58 143 2298 0.41 4.93 0.75 0.64
Medium 208 115 0.30 3.73 0.53 0.38 205 149 0.38 3.69 0.61 0.51
Small 8682 254 0.21 2.40 0.39 0.25 6620 396 0.33 3.37 0.51 0.40
cat nonfat All banks 9095 830 0.19 2.38 0.33 0.25 6968 1463 0.20 2.35 0.36 0.30
Large 205 562 0.19 2.65 0.34 0.28 143 1041 0.19 2.23 0.34 0.34
Medium 208 73 0.19 2.37 0.33 0.24 205 108 0.27 2.68 0.44 0.44
Small 8682 195 0.16 1.84 0.30 0.19 6620 315 0.26 2.67 0.41 0.41
mat fat All banks 9095 1693 0.38 4.85 0.67 0.51 6968 3234 0.45 5.18 0.79 0.66
Large 205 1224 0.42 5.77 0.74 0.61 143 2647 0.47 5.68 0.86 0.86
Medium 208 144 0.38 4.68 0.66 0.48 205 160 0.41 3.98 0.66 0.66
Small 8682 324 0.27 3.06 0.50 0.32 6620 427 0.35 3.63 0.55 0.55
mat nonfat All banks 9095 1000 0.22 2.87 0.40 0.30 6968 1855 0.26 2.97 0.45 0.38
Large 205 633 0.22 2.98 0.38 0.32 143 1391 0.25 2.98 0.45 0.45
Medium 208 102 0.27 3.32 0.47 0.34 205 119 0.30 2.96 0.49 0.49
Small 8682 265 0.22 2.50 0.41 0.26 6,620 345 0.28 2.93 0.45 0.45

Panel B: Bank liquidity creation over time (1993–2003) and in the cross section using our preferred “cat fat” measure for banks in each size class split by bank holding company status,
wholesale versus retail orientation, and merger status

Liquidity creation Liquidity creation
N N 1993–2003 N N 1993–2003
1993 2003 $ billion 1993 2003 $ billion
Multibank holding company (MBHC) Wholesale banks (below average number

members of branches)
All banks 3323 2681 All banks 6659 4809
Large 195 136 Large 131 106
Medium 168 164 Medium 131 113
Small 2960 2381 Small 6397 4590
One-bank holding company (OBHC) Retail banks (above average number of

members branches)
Large 4 3 Large 74 37
Small 3379 2997 Small 2285 2030
Independent banks Recent M&A activity (engaged in M&As

during prior three years)
Large 6 4 Large 95 98
Small 2343 1242 Small 526 405
No recent M&A activity

All banks 8401 6392
Large 110 45
Medium 135 132
3801
Small 8156 6215

3802

Table 2
(Continued)
Panel C: Characteristics of banks that create the most and least liquidity over 1993–2003 in each size class using our preferred “cat fat” measure
Large banks Medium banks Small banks
High liquidity Low liquidity High liquidity Low liquidity High liquidity Low liquidity
creators creators creators creators creators creators
Banks split by (top 25%) (bottom 25%) (top 25%) (bottom 25%) (top 25%) (bottom 25%)
Overall LC A. Average liquidity creation ($ billion) 36.00 0.67 1.20 0.12 0.12 −0.00
Composition of high and low liquidity creators
a. MBHC members 0.99 0.85 0.93 0.56 0.54 0.20
b. OBHC members 0.01 0.05 0.05 0.16 0.31 0.46
c. Independent banks 0.00 0.10 0.01 0.28 0.15 0.34
a. Wholesale banks 0.25 0.97 0.47 0.76 0.29 0.91
b. Retail banks 0.75 0.03 0.53 0.24 0.71 0.09
a. Recent M&A activity 0.74 0.47 0.52 0.28 0.16 0.02
b. No recent M&A activity 0.26 0.53 0.48 0.72 0.84 0.98
LC/GTA B. Average liquidity creation/GTA 0.66 0.15 0.57 0.08 0.43 0.00
a. MBHC members 0.99 0.84 0.89 0.59 0.45 0.22
b. OBHC members 0.00 0.06 0.07 0.14 0.36 0.45
b. Retail banks 0.40 0.14 0.38 0.32 0.42 0.17

LC/EQ C. Average liquidity creation/equity 8.56 1.78 6.9 0.92 5.35 0.07
a. MBHC members 1.00 0.84 0.89 0.58 0.46 0.21
b. OBHC members 0.00 0.06 0.07 0.13 0.36 0.45
b. Retail banks 0.43 0.12 0.40 0.32 0.43 0.16
Panel A shows liquidity creation of the banking sector in $ billion and divided by gross total assets (GTA, i.e., total assets plus the allowance for loan and lease losses and the allocated
transfer risk reserve (a reserve for certain foreign loans)), equity (EQ), gross loans (LNS), and deposits (DEP) from 1993 to 2003. Panel B contains graphs of liquidity creation by banks
split by BHC status, wholesale versus retail orientation, and merger status. Panel C uses these bank characteristics to contrast banks that create the most and least liquidity (top 25% and
bottom 25% in each size class, respectively) over 1993–2003. All panels show results for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small
banks (GTA up to $1 billion). Panel A measures liquidity creation using all four liquidity creation measures as defined in Table 1, while panels B and C only show liquidity creation based
on our preferred “cat fat” measure. All financial values are expressed in real 2003 dollars using the implicit GDP price deflator. The cat (mat) liquidity creation measures classify all bank
activities other than loans based on product category and maturity, and loans by category (maturity) only. The fat (nonfat) liquidity creation measures include (exclude) off-balance sheet
activities.
3803

and small institutions also had slightly lower ratios of liquidity creation divided
by GTA, equity, gross loans, and total deposits than large banks. As will be
shown, this is because these institutions generated much less liquidity off the
balance sheet. At large banks, liquidity creation doubled in real dollars, although
it only rose as a fraction of GTA from 40% in 1993 to 41% in 2003. Perhaps
surprisingly, small banks showed the greatest increase in liquidity creation
divided by GTA, equity, gross loans, and total deposits.
As shown in the “cat fat” graph in panel A of Table 2, liquidity creation

based on this measure increased in every year from 1993 to 2003. This was
primarily driven by large banks—medium and small banks experienced smaller,
nonmonotonic increases in liquidity creation. The increase in overall liquidity
creation was driven by substantial growth in illiquid assets, liquid liabilities,
and illiquid guarantees, which outweighed smaller increases in liquid assets,
illiquid liabilities, and equity.
Liquidity creation is almost 50% less based on our “cat nonfat” measure,
which is the same as “cat fat” except for the exclusion of off-balance sheet
activities. Large banks still created most of the industry’s liquidity, although
the percentage is lower (71% as of 2003 versus 81% based on our “cat fat”
measure). As shown in the “cat nonfat” graph, liquidity creation based on
this measure also increased in every year of the sample period, primarily due
to increases by large banks. Liquidity creation by medium and small banks
experienced smaller, nonmonotonic increases in liquidity creation.
A comparison of liquidity creation based on the “cat fat” and “cat nonfat”
measures reveals that banks create almost half of their liquidity off the balance
sheet. This highlights the importance of including off-balance sheet activities.
Although banks engage in a variety of off-balance sheet activities, the main
drivers of off-balance sheet liquidity creation are illiquid guarantees of $2.781
trillion, in particular unused commitments ($2.426 trillion) and, to a lesser
extent, net standby letters of credit ($0.287 trillion).22 Derivatives ($0.023
trillion) are not among the major components of off-balance sheet liquidity
creation. As noted in Section 2.2, while banks may have substantial derivatives
portfolios, most operate with nearly matched books, so gross positive and
negative fair values tend to offset each other. As an interesting side note, we
also find that unused commitments, C&I commitments (a subset of unused
commitments), net standby letters of credit, and commercial and similar letters
of credit are all highly positively and significantly correlated with transactions
deposits (ρ = 0.73, 0.81, 0.80, and 0.68, respectively), consistent with the
predictions and findings of Kashyap, Rajan, and Stein (2002).
A second insight gained from comparing liquidity creation based on our
“cat fat” and “cat nonfat” measures is that large, medium, and small banks
create liquidity in very different ways. For example, as of 2003, unused loan
22
Commercial and similar letters of credit and other off-balance sheet liabilities only amounted to $0.024 trillion
and $0.043 trillion, respectively.
3804
commitments equal 48% of total liquidity created by large banks, while only
amounting to 26% and 19% of liquidity created by medium and small banks,
respectively. Commercial real estate, on the other hand, equals only 12% of to-
tal liquidity creation for large banks, while equaling 36% and 42% of liquidity
creation for medium and small banks, respectively. Similarly, for large banks,
transactions deposits equal only 9% of total liquidity creation, whereas the cor-
responding figures for medium and small banks are 15% and 31%, respectively
(not shown for reasons of brevity).

We now turn to liquidity creation based on our “mat” measures. Liquidity
creation is the highest in all years using our “mat fat” measure, which differs
from our preferred “cat fat” measure by using loan maturities in place of
categories to classify loans. Treating all loans with maturity of at least one year
as illiquid assets increases measured liquidity creation primarily because most
residential mortgages are classified as illiquid (weight = 1/2 ). Recall that these
mortgages are classified as semiliquid (weight = 0) in the “cat fat” measure
because they are relatively easy to securitize. The “mat fat” pattern of liquidity
creation over time is similar to the “cat fat” pattern. The “mat nonfat” measure,
which uses loan maturities and excludes off-balance sheet activities, yields
much smaller measured liquidity creation. The “mat nonfat” liquidity creation
pattern resembles the pattern of the other measures, increasing in all periods,
driven by the large banks.
To understand more deeply how liquidity creation has changed over time
and how it varies in the cross section, we split banks in each size class based on
three additional characteristics. First, we divide banks by bank holding company
status into multibank holding company (MBHC) members, one-bank holding
company (OBHC) members, and independent banks. Second, we divide banks
by wholesale versus retail orientation, defined here as having below-average
and above-average numbers of branches for their size class, respectively. Third,
we split banks by merger status: those that did and did not engage in merg-
ers and acquisitions during the prior three years. For each subsample, we
show the numbers of banks in 1993 and 2003, and present graphs that high-
light how liquidity creation has changed over time (see panel B of Table 2).
For brevity, we focus on liquidity creation based on our preferred “cat fat”
measure.
Panel B of Table 2 contains the results. As shown on the left, the vast majority
of large and medium banks are in MBHCs, while small banks are more evenly
divided among the three governance structures. As the graphs make clear,
MBHC members created most of the overall industry liquidity creation, and
these banks also experienced the greatest increase in liquidity creation. Within
each size class, MBHC members also created the most liquidity.
As shown on the top right in panel B of Table 2, most of the banks have
wholesale orientation by our definition, but retail banks create most of overall
industry liquidity. This result is driven by large and small banks; among medium
banks, liquidity created by retail and wholesale banks is similar. As shown,
3805
liquidity creation grows in each year for both retail and wholesale banks,
except for the spikes in 2002 and 2003. These spikes occur because Citibank
shifted from a wholesale bank to a retail bank in 2002 and back to wholesale
status in 2003.
Finally, as shown in the bottom right in Table 2, panel B, most banks did not
engage in M&As, but most of overall industry liquidity is created by recently
merged institutions. This result is purely driven by large banks; among medium
and small banks, institutions that did not engage in recent merger activity

create more liquidity than those that did. This explains why liquidity creation
by recently merged banks increased in almost every year, whereas liquidity
creation remained relatively constant over the sample period for banks that did
not engage in M&As.
3.3 Characteristics of banks that create the most and least liquidity
We next examine the characteristics of banks that create the most and least
liquidity. In each size class, we split banks into “high liquidity creators” and
“low liquidity creators” based on our preferred “cat fat” measure. We define
high and low liquidity creators as those in the top 25% and bottom 25%, re-
spectively, based on (1) overall liquidity creation; (2) liquidity creation divided
by GTA; and (3) liquidity creation divided by equity.
The top, middle, and bottom parts of panel C in Table 2 show the results
based on overall liquidity creation (LC), LC/GTA, and LC/EQ, respectively.
Each part shows the average amount of liquidity created by high and low
liquidity creators, and some key characteristics (BHC status, wholesale versus
retail orientation, and merger status) of these banks. For example, among large
banks, each of the high liquidity creators on average created $36 billion in
liquidity. Splitting these high liquidity creators by BHC status, we find that 99%
of these banks are MBHC members, and 1% are OBHC members. Similarly,
25% have a wholesale orientation, while 25% are retail banks; 74% engaged
in recent M&A activity, while 26% were not involved in recent M&A activity.
Several findings are noteworthy. First, not surprisingly, high liquidity creators
create substantially more liquidity than low liquidity creators in each size
class. What may be surprising, however, is just how small the numbers are
for the low liquidity creators. In particular, the bottom 25% of small banks
in terms of overall liquidity creation create slightly negative liquidity. This
raises the question of whether these institutions should still be considered to
be banks. To address this question, it is important to recall that banks perform
two central roles in the economy, liquidity creation and risk transformation.
While these banks may not create liquidity, they may still provide valuable
risk-transformation services, although a deeper investigation of this issue is
beyond the scope of this article.
Second, MBHC members tend to create the most liquidity in every size
class by every measure of liquidity creation. In all cases, OBHC members and
independent banks tend to be more prevalent among the low liquidity creators.
3806
Third, based on overall liquidity creation, retail banks tend to be high liquidity
creators in every size class. Maybe surprisingly, we find opposite results when
we split banks based on liquidity creation divided by GTA and equity. One
explanation may be that retail banks tend to be the largest banks in each size
class. While these banks create substantial amounts of liquidity, they create far
less liquidity per dollar of assets or equity. Wholesale banks tend to be low
liquidity creators in every size class.
Fourth, a far more diverse picture arises when we look at banks’ M&A

history. Among large banks, high liquidity creators tend to be banks with
recent M&A activity, while low liquidity creators are approximately evenly
distributed among those that did and those that did not engage in M&As. Since
most of the small banks did not engage in recent M&As, it is not surprising
that among these banks, most of both the high and low liquidity creators had no
recent M&A activity. However, it is clear that small banks that did engage in
M&As in the prior three years are better represented among the high liquidity
creators. The medium bank pattern falls somewhere in between the patterns for
large and small banks.
3.4 Value implications of bank liquidity creation

We next investigate the value implications of bank liquidity creation. If liquidity
creation creates a net surplus to be shared between the bank, its borrowers, and
its depositors, then liquidity creation should be positively associated with the
market value of the bank or its holding company. To examine this issue, we
focus on banks that are individually traded or part of a traded bank holding
company. For the purposes of this analysis, we include listed independent banks
and OBHCs, and we aggregate the liquidity creation of all the banks in a listed
MBHC. To ensure that any relationship between liquidity creation and value
is likely to be due to the liquidity created by our sample banks, we exclude
holding companies in which these banks account for less than 90% of holding
company assets.23 Imposing this restriction reduces our sample from 3686 to
3223 bank-year observations.
Since we are not aware of any theories that predict a causal link between
liquidity creation and value, we focus on correlations. In particular, we present
correlations between liquidity creation and value, where liquidity creation is
measured by the dollar amount of liquidity creation and liquidity creation
divided by GTA and equity (all calculated using our “cat fat” measure), and
value is measured as the Market-to-Book ratio and the Price-Earnings ratio
(based on earnings before and after extraordinary items).
Table 3 contains the results. As shown, the dollar amount of liquidity creation
and liquidity creation divided by GTA and equity are all significantly positively
correlated with the market-to-book ratio, with correlations between 0.115 and
0.164. The correlations with the price-earnings ratio (based on earnings before
23
The findings are similar if we instead impose an 85% or a 95% cutoff. If we do not impose any restriction, results
based on the market-to-book ratio are unchanged, but the findings based on the price-earnings ratio are somewhat
weaker (significant in only two of six cases).
3807
Table 3
Value implications of liquidity creation
N Market-to-Book ratio Price-Earnings ratio Price-Earnings ratio
(based on earnings before (based on earnings after
extraordinary items) extraordinary items)
Liquidity creation: LC ($) 3223 0.115 0.042 0.042

(0.00)∗∗∗ (0.02)∗∗ (0.02)∗∗
Liquidity creation: LC/GTA 3223 0.151 0.041 0.042
(0.00)∗∗∗ (0.02)∗∗ (0.02)∗∗
Liquidity creation: LC/EQ 3223 0.164 0.024 0.025

(0.00)∗∗∗ (0.18) (0.16)
This table shows correlations between liquidity creation and valuation of listed banks and bank holding companies.
For independent banks, these are direct correlations between the amount of liquidity created by the bank and
its valuation. For multibank holding companies, we aggregate liquidity created by all the banks in the holding
company. For one-bank holding companies and multibank holding companies we require that the total assets
of the banks comprise at least 90% of the total assets of the bank holding company, and calculate correlations
between total bank liquidity created and the valuation of the holding company. The dollar amount of liquidity
creation (LC) is calculated using our preferred “cat fat” liquidity creation measure as defined in Table 1. GTA
equals total assets plus the allowance for loan and lease losses and the allocated transfer risk reserve (a reserve
for certain foreign loans). EQ is total equity capital. The valuation measures used are the market-to-book ratio
and the price-earnings ratio. The market-to-book ratio is defined as the market value of equity measured as of
31 December divided by the book value of equity measured as of the previous fiscal year end. The book value
of equity is defined as the Compustat book value of stockholder’s equity, plus balance sheet deferred taxes and
investment tax credit, minus the book value of preferred stock. All accounting data are winsorized at the 1% and
99% level to reduce the impact of outliers. As in Fama and French (1993), we use the redemption, liquidation, or
par value (in that order) to estimate the value of preferred stock. The price-earnings ratio is defined as the share
price as of 31 December divided by earnings (before and after extraordinary items) per share measured as of the
previous fiscal year end. p-values are in parentheses. ∗ , ∗∗ , and ∗∗∗ denote significance at the 10%, 5%, and 1%
levels, respectively.
and after extraordinary items) are also all positive, but they are smaller in
magnitude, and are significant in only four of six cases. These results suggest
that banks that create more liquidity are valued more highly by investors.
4. Analytical Framework
We next turn to our third main goal of analyzing the effect of bank capital on
liquidity creation. In this section, we describe our regression framework and
explain our regression variables. In Section 5, we present our empirical results,
and in Section 6, we examine the robustness of our results.
Before we present our regression framework, we note that the theories sug-
gest a causal link between capital and liquidity creation. According to the
“financial fragility-crowding out” hypothesis, the effect of capital on liquidity
creation is negative, and according to the “risk absorption” hypothesis the ef-
fect is positive. The negative effect of capital on liquidity creation as suggested
by Diamond and Rajan (2000, 2001), i.e., the financial fragility effect, only
arises if deposit insurance coverage is incomplete. Deposit insurance is indeed
incomplete for banks in all three of our size classes over our sample period:
most banks fund themselves partly with uninsured deposits and with overnight
federal funds purchased, another funding source that can run on the bank.24
24
For example, as of 2003, large banks fund 21.4% and 7.5% of their GTA with uninsured deposits and overnight
federal funds purchased, respectively. For medium banks, the corresponding figures are 24.3% and 5.7%,
respectively, while for small banks, the figures are 19.8% and 2.2%, respectively.
3808
In practice, capital and liquidity creation are to some extent jointly deter-
mined. To mitigate this potential endogeneity problem, our exogenous variables
are lagged values, as discussed above. Nonetheless, this may not be sufficient.
We therefore interpret all our regression results with care. We do not claim
to establish causation in our regressions, but at a minimum, our results yield
interesting correlations between capital and liquidity creation that are consis-
tent with the theories and are robust to a variety of checks, including tests that
involve instrumental variables for capital.

4.1 Regression framework
To examine whether the “financial fragility-crowding out” effect or the “risk ab-
sorption” effect empirically dominates, we use panel datasets on large, medium,
and small banks from 1993 to 2003. We regress the dollar amount of bank liq-
uidity creation (calculated using our four liquidity creation measures) divided
by GTA on the lagged equity capital ratio while controlling for other factors
that may affect bank liquidity creation. Normalization by GTA is necessary to
make the dependent variables meaningful and comparable across banks and to
avoid giving undue weight to the largest institutions. Use of dollar amounts of
liquidity creation without normalization would primarily amount to a regres-
sion of bank size on capital and other exogenous variables because banks differ
so greatly in size even within each size class.
Our control variables include bank risk, bank size, BHC membership, merger
and acquisition history, and local market competition and economic environ-
ment, as explained in detail below. We include bank fixed effects to account for
average differences over time across banks that are not captured by the other
exogenous variables and to reduce correlations across error terms. Time fixed
effects are added to control for average differences in liquidity creation across
years that are not captured by the other exogenous variables, and to reduce
serial correlation problems. All regressions are estimated with robust standard
errors, clustered by bank, to control for heteroskedasticity, as well as possible
correlation among observations of the same bank in different years.
Table 4 gives descriptions and summary statistics for the exogenous vari-
ables. All financial values are expressed in real 2003 dollars using the implicit
GDP price deflator.25 The exogenous variables are lagged values created using
annual data averaged over the three years prior to observation of the dependent
variables to reduce potential endogeneity problems, as lagged values are more
likely to reflect earlier decisions.26 The use of three-year averages, rather than a
single lagged year, also reduces the effects of short-term fluctuations and prob-
lems with the use of accounting data. As well, portfolio changes take time to
occur and likely reflect decisions made on the basis of historical experience, so
25
We obtain similar results if we express all values in real 1993 dollars.
26
Exceptions are two of our risk measures, which are calculated using data from the previous twelve quarters (see
Section 4.3).
3809
3810

Table 4
Definitions and summary statistics for exogenous variables
Variable Definition Mean for all Mean for Mean for medium Mean for small
banks large banks banks banks
Bank capital ratio

EQRAT Equity capital ratio: total equity capital as a proportion of GTA, where 0.10 0.08 0.09 0.10
GTA equals total assets plus the allowance for loan and lease losses
and the allocated transfer risk reserve (a reserve for certain foreign
loans)
Bank risk
EARNVOL Standard deviation of the bank’s quarterly return on assets measured 0.12 0.12 0.11 0.12
over the previous twelve quarters, multiplied by 100
CREDITRISK Credit risk measure: calculated as the bank’s Basel I risk-weighted assets 0.61 0.72 0.66 0.61
and off-balance sheet activities divided by GTA. To reduce
multicollinearity, this variable is orthogonalized in all analyses
ZSCORE Distance to default: measured as the bank’s return on assets plus the 1.43 1.24 1.52 1.43
equity capital/GTA ratio divided by the standard deviation of the
return on assets. To reduce multicollinearity, this variable is
orthogonalized in all analyses
Bank size
Ln(GTA) Natural log of GTA 11.61 16.18 14.30 11.44
Bank holding company status
D-MBHC A dummy that equals 1 if the bank has been part of a multibank holding 0.44 0.95 0.81 0.42
company over the past three years
D-OBHC A dummy that equals 1 if the bank has been part of a one-bank holding 0.34 0.02 0.09 0.35
company over the past three years
Mergers and acquisitions
D-BANK-MERGE A dummy that equals 1 if the bank was involved in one or more mergers 0.09 0.64 0.43 0.07
over the past three years, combining the charters of two or more banks
D-DELTA-OWN A dummy that equals 1 if the bank was acquired in the last three years, 0.09 0.06 0.10 0.09
indicated by a change in top-tier holding company with no change in
charter

Local market competition
HERF A bank-level Herfindahl index based on bank and thrift deposits (the 0.21 0.15 0.16 0.21
only variable for which geographic location is publicly available). We
first establish the Herfindahl index of the markets in which the bank
has deposits and then weight these market indices by the proportion of
the bank’s deposits in each of these markets
SHARE-ML Share of market bank and thrift deposits held by medium and large banks 0.32 0.58 0.56 0.31
(GTA exceeding $1 billion)
Local market economic
environment
Ln(POP) Natural log of weighted average population in all markets in which a 11.90 14.30 13.81 11.79
bank has deposits, using the proportion of deposits held by a bank in
each market as weights
Ln(DENSITY) Weighted average population density (natural log of population per 4.68 6.50 6.15 4.60
square mile) in all markets in which a bank has deposits, using the
proportion of deposits held by a bank in each market as weights
INC-GROWTH Weighted average income growth in all markets in which a bank has 0.05 0.05 0.05 0.05
deposits, using the proportion of deposits held by a bank in each
market as weights
Fixed effects
Time fixed effects Set of dummies for all but one year
Bank fixed effects Set of dummies for all but one bank
The exogenous variables are created using annual data and are three-year lagged averages (i.e., the average of three years prior to observation of the dependent variable), except for the
risk measure, which is calculated using data on the previous twelve quarters. All of the annual lagged values are merger adjusted; the bank capital ratio and size are pro forma values, the
mergers and acquisitions dummies simply take a value of 1 or 0 based on the combined experience of the banks in the case of mergers or acquisitions, and the local market competition
and environment variables are weighted averages for the merging banks using their GTA values in constructing the weights. Sample period: 1993–2003. Sample means are provided for all
banks, large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion). All financial values are expressed in real 2003 dollars
using the implicit GDP price deflator.
Data sources: Bank Call Reports, Bank Holding Company Y-9 reports, FDIC Summary of Deposits, NIC Database, Bureau of Economic Analysis, and U.S. Census Bureau.
3811

three years of data may more accurately reflect the inputs into liquidity creation
decisions.27 All of the annual lagged values are merger adjusted. We collect
information from the Federal Reserve Board’s National Information Center
(NIC) database on a bank’s prior M&As, and use it to construct historical pro
forma values.
4.2 Variable descriptions

The key exogenous variable is the lagged capital ratio. For our main analysis, we

use EQRAT, the ratio of equity to GTA. Equity meets the most straightforward,
narrow definition of capital as funds that cannot be easily withdrawn. GTA is
the simplest measure of bank size, although it excludes off-balance sheet ac-
tivities. GTA equals total assets plus the allowance for loan and lease losses
and the allocated transfer risk reserve—two reserves held for potential credit
losses—so that the full value of the loans financed and liquidity created by the
bank on the asset side are included. In Section 6, we perform two robustness
checks on the capital ratio. First, we replace EQRAT with an alternative capital
ratio. Second, realizing that to some extent, a bank chooses its capital ratio,
we use an instrumental variable approach to resolve any potential endogeneity
problems.
We control for bank risk using three risk measures.28 The first measure is
earnings volatility (as in Berger et al. 2008, and Laeven and Levine forthcom-
ing). EARNVOL is measured as the standard deviation of the bank’s return
on assets over the previous twelve (minimum: eight) quarters. The second
measure is a bank’s credit risk, a key risk of banks. CREDITRISK is cal-
culated as a bank’s Basel I risk-weighted assets and off-balance sheet ac-
tivities divided by GTA. The third risk measure is the z-score, which indi-
cates a bank’s distance from default (e.g., Boyd, Graham, and Hewitt 1993).
ZSCORE is measured as a bank’s return on assets plus the equity capital/GTA
ratio divided by the standard deviation of the return on assets. A higher z-score
indicates that a bank is more stable. It is important to appropriately control for
bank risk because a primary reason why banks hold capital is to absorb risk.
The inclusion of risk measures helps to isolate the role of capital in supporting
the liquidity creation function of banks from the role of capital in supporting
banks’ function as risk transformers. It is standard practice in the literature to
include risk measures one at a time.29 Nonetheless, we include all three risk
measures in every regression in order to capture all of the information in all
three measures in a single specification. However, because all three measures
27
Using one-year lagged values weakens the significance of the results for large banks, but leaves our results for
medium and small banks qualitatively unchanged.
28
Since our analyses are performed at the bank level, risk measures typically used at the BHC level (including
stock return volatility, bond ratings, and beta) cannot be used.
29
See, e.g., Brockman and Turtle (2003); Acharya, Bharath, and Srinivasan (2007); John, Litov, and Yeung (2008);
and Kadan and Swinkels (2008).
3812
assess the same underlying unobservable variable (risk), there is a serious mul-
ticollinearity problem associated with introducing them simultaneously. We
deal with this problem by orthogonalizing two of the risk measures.30 In all
of the analyses reported in the article, we include EARNVOL, orthogonalized
CREDITRISK, and orthogonalized ZSCORE. (For simplicity, we use the terms
CREDITRISK and ZSCORE instead of orthogonalized CREDITRISK and or-
thogonalized ZSCORE throughout.) Since our approach is a departure from the
standard approach of introducing risk measures one at a time, we also run the

base regressions by alternatively including these three risk measures individu-
ally. The results are qualitatively similar to those reported in the article and are
available upon request.
To control for bank size, we include the natural log of bank size, Ln(GTA),
in every regression, as well as running the regressions separately for large,
medium, and small banks. The natural log is used for all of the continuous
exogenous variables that may take on large values to avoid potential specifi-
cation distortions, given that the dependent variables are generally in the [0,1]
interval.31
We control for the bank’s bank holding company (BHC) status with two
variables: D-MBHC, a dummy variable that equals one if the bank has been
part of a multibank bank holding company (MBHC) in any of the past three
years and zero otherwise, and D-OBHC, a dummy variable that equals one if
the bank has been part of a one-bank holding company (OBHC) in any of the
past three years and zero otherwise. BHCs and other banks in the same BHC
may serve as internal capital markets to provide capital in times of stress. This
view is supported by both regulation and the literature.32
We also control for the bank’s merger and acquisition history. The D-BANK-
MERGE and D-DELTA-OWN dummies indicate whether a bank was involved
in a merger or acquisition over the past three years, where a merger is defined
as the combination of bank charters into an institution with a single set of
books, and an acquisition is defined as a case in which the bank’s top-tier
holding company changed with no change in charter status. Controlling for
mergers and acquisitions is important because banks often substantially alter
their lending behavior following such events.
To construct controls for local market competition and economic environ-
ment, we define the local market as the Metropolitan Statistical Area (MSA)
30
We regress CREDITRISK on EARNVOL, ZSCORE, and all of the control variables. The residuals of this regression
represent the variation in CREDITRISK not captured by EARNVOL, ZSCORE, or the other explanatory variables.
We follow a similar procedure for ZSCORE.
31
For example, based on our preferred “cat fat” measure, liquidity creation divided by GTA (our dependent variable)
is in the [0,1] interval 90.5% of the time.
32
U.S. regulations require BHCs to be a source of strength for the banks they own and require other banks in the
same BHC to cross-guarantee the other bank affiliates. Empirical research finds, for example, that bank loan
growth depends on the BHC (e.g., Houston, James, and Marcus 1997).
3813
or non-MSA county in which the offices are located.33 For banks with offices
in more than one local market, we use weighted averages across these mar-
kets, using the proportion of the bank’s deposits in each of these markets as
the weights.34 To control for local market competition, we include HERF, the
Herfindahl index of concentration for the market or markets in which the bank
is present. We base HERF on the market shares of both banks and thrift insti-
tutions, given that thrifts compete vigorously with banks for deposits. We also
include SHARE-ML, the local market share of medium and large institutions,

to allow for the possibility that banks of different sizes may compete differ-
ently. It is important to control for local market competition because various
studies have shown that market concentration affects credit availability (e.g.,
Petersen and Rajan 1995) and that the loan portfolios of large and small banks
are markedly different (e.g., Berger et al. 2005). Hence, competition likely
affects liquidity creation through both the amount and types of loans a bank ex-
tends and the way it funds its activities.35 To control for local market economic
conditions, we include the log of population Ln(POP), the log of population
density Ln(DENSITY), and income growth INC-GROWTH.
5. Regression Results
In this section, we present our regression results. We first present our main
results and find that the relationship between capital and liquidity creation
differs for large, medium, and small banks. We then investigate why the results
differ by size class using the components of liquidity creation. In all cases,
we examine whether the findings are consistent with the economic intuition
discussed earlier. In Section 6, we conduct a number of robustness checks.
Before proceeding, we note the important distinction between the liquidity
creation weight on capital and the regression coefficient on lagged capital. We
assign a weight of −½ to equity when forming our liquidity creation measures,
the dependent variables in the regressions. This does not imply that when we
regress the dollar amount of liquidity creation (normalized by GTA) on the
lagged equity ratio, EQRAT, the coefficient on EQRAT should necessarily be
negative or close to −0.5. Rather, the measured effect depends on bank behavior.
For example, if banks with more lagged equity capital extend significantly more
illiquid loans and hold significantly fewer liquid assets than banks with lower
levels of capital, we may find a positive association between lagged capital and
liquidity creation.36
33
In some cases, we use New England County Metropolitan Areas (NECMAs) in place of MSAs, but for conve-
nience, we use the term MSA to cover both MSAs and NECMAs.
34
We use shares of deposits because this is the only banking service for which geographic location is publicly
available.
35
We obtain similar regression results if we exclude the local market competition variables.
36
A potential concern about our regression specification is that current bank equity is included in our dependent
variable (liquidity creation divided by GTA), while the lagged equity ratio is our key exogenous variable. To
3814
5.1 The net effect of capital on liquidity creation for large, medium, and
small banks
Panels A, B, and C of Table 5 contain the regression results for large banks
(GTA exceeding $3 billion), medium banks (GTA $1 billion—$3 billion), and
small banks (GTA up to $1 billion), respectively. All of our regressions include
the full set of control variables and have time and bank fixed effects, but the
results are similar if we control only for size and include fixed effects (not
shown for brevity’s sake).

The results in panel A of Table 5 suggest that for large banks, the relation-
ship between capital and liquidity creation is positive and significant when
liquidity creation includes off-balance sheet activities, i.e., when we use our
“fat” liquidity creation measures (“cat fat” or “mat fat”). The magnitude of the
coefficient on the lagged equity capital ratio in the “cat fat” regression, 1.146,
suggests that large banks with a 1 percentage point higher equity capital ratio
for the prior three years (i.e., an increase in EQRAT of 0.01) create additional
liquidity of over 1 percentage point of a large bank’s GTA, which appears to
be a substantial effect. Using the “nonfat” measures, capital is not significantly
correlated with liquidity creation, suggesting that off-balance sheet activities
constitute an important part of the effect of capital on liquidity creation for
large banks. The EQRAT coefficients in the “cat” and “mat” specifications are
of similar magnitude, suggesting that use of maturities in place of categories
for loans has little impact on the measured net effect of capital.
The results for medium banks in panel B of Table 5 are mixed. For these
banks, the relationship between capital and liquidity creation is positive and
not significant for the “fat” measures and negative and marginally significant
for the “nonfat” measures.
The results in panel C of Table 5 suggest that for small banks, the relation-
ship between capital and liquidity creation is negative, in sharp contrast to the
positive or mixed relationship found for large and medium banks. All of the
coefficients on the lagged capital ratio are negative and significant at the 1%
level, yielding a fairly clear result that is robust across the liquidity creation
measures. Using our preferred “cat fat” measure, the magnitude of the coeffi-
cient on the lagged equity capital ratio, −0.330, suggests that small banks with
a 0.01 higher EQRAT create less liquidity by about a third of a percentage point
of their GTA. As for the large banks, the magnitudes of the net effect of capital
on liquidity creation are similar for the “cat” and “mat” measures for small
banks. However, a key difference for small banks is that the “fat” and “nonfat”
magnitudes are also similar. The inclusion of off-balance sheet activities makes
little difference to the net effect of capital on liquidity creation, reflecting the
lesser role of these activities for small institutions.
address this, we also construct a liquidity creation measure that excludes equity and obtain similar results (see
Section 6.3).
3815
3816

Table 5
The effect of capital on liquidity creation
Panel A: Regression results for large banks Panel B: Regression results for medium banks Panel C: Regression results for small banks
cat fat/ cat nonfat/ mat fat/ mat nonfat/ cat fat/ cat nonfat/ mat fat/ mat nonfat/ cat fat/ cat nonfat/ mat fat/ mat nonfat/
GTA GTA GTA GTA GTA GTA GTA GTA GTA GTA GTA GTA
EQRAT 1.146 0.465 1.171 0.490 0.219 −0.438 0.260 −0.397 −0.330 −0.341 −0.394 −0.405
(3.23)∗∗∗ (1.22) (3.19)∗∗∗ (1.31) (0.29) (−1.83)∗ (0.37) (−1.71)∗ (−7.26)∗∗∗ (−8.73)∗∗∗ (−9.90)∗∗∗ (−11.83)∗∗∗
EARNVOL −0.129 −0.103 −0.128 −0.102 0.025 −0.034 0.037 −0.023 −0.019 −0.012 −0.013 −0.005
(−2.48)∗∗ (−2.24)∗∗ (−2.32)∗∗ (−2.16)∗∗ (0.29) (−1.19) (0.38) (−0.72) (−3.54)∗∗∗ (−2.42)∗∗ (−2.30)∗∗ (−1.02)
CREDITRISK −0.018 0.013 −0.008 0.024 0.043 0.023 0.056 0.036 −0.002 −0.003 −0.021 −0.022
(−1.03) (1.23) (−0.38) (1.89)∗ (1.76)∗ (1.65)∗ (2.12)∗∗ (2.06)∗∗ (−0.72) (−1.28) (−7.40)∗∗∗ (−8.58)∗∗∗
ZSCORE 0.006 0.011 0.000 0.004 0.008 0.008 0.006 0.006 −0.003 −0.003 −0.002 −0.002
(0.82) (2.16)∗∗ (0.02) (0.89) (1.98)∗∗ (2.43)∗∗ (1.32) (1.63) (−4.82)∗∗∗ (−5.18)∗∗∗ (−3.51)∗∗∗ (−3.61)∗∗∗
Ln(GTA) −0.018 0.013 −0.008 0.024 0.043 0.023 0.056 0.036 −0.002 −0.003 −0.021 −0.022
(−1.03) (1.23) (−0.38) (1.89)∗ (1.76)∗ (1.65)∗ (2.12)∗∗ (2.06)∗∗ (−0.72) (−1.28) (−7.40)∗∗∗ (−8.58)∗∗∗
D-MBHC 0.004 −0.005 0.012 0.002 −0.004 −0.001 −0.004 −0.001 0.010 0.010 0.014 0.013
(0.38) (−0.96) (1.03) (0.30) (−0.71) (−0.24) (−0.80) (−0.34) (5.82)∗∗∗ (6.39)∗∗∗ (7.83)∗∗∗ (8.41)∗∗∗
D-OBHC 0.090 0.099 0.099 0.109 0.021 0.026 −0.004 0.001 0.033 0.032 0.034 0.033
(0.74) (1.10) (0.84) (1.24) (0.66) (1.13) (−0.12) (0.03) (10.82)∗∗∗ (11.37)∗∗∗ (10.65)∗∗∗ (10.99)∗∗∗
D-BANK-MERGE 0.004 −0.005 0.012 0.002 −0.004 −0.001 −0.004 −0.001 0.010 0.010 0.014 0.013
(0.38) (−0.96) (1.03) (0.30) (−0.71) (−0.24) (−0.80) (−0.34) (5.82)∗∗∗ (6.39)∗∗∗ (7.83)∗∗∗ (8.41)∗∗∗
D-DELTA-OWN −0.026 0.021 −0.001 0.046 −0.097 −0.053 −0.106 −0.062 0.019 0.015 0.020 0.016
(−0.50) (0.53) (−0.02) (1.06) (−2.21)∗∗ (−1.98)∗∗ (−2.11)∗∗ (−1.85)∗ (3.90)∗∗∗ (3.42)∗∗∗ (3.84)∗∗∗ (3.30)∗∗∗
HERF −0.027 −0.241 0.107 −0.106 −0.270 −0.176 −0.113 −0.020 0.032 0.028 0.008 0.005
(−0.12) (−1.31) (0.45) (−0.57) (−1.89)∗ (−1.45) (−0.68) (−0.15) (2.15)∗∗ (2.13)∗∗ (0.52) (0.34)
SHARE-ML −0.026 0.021 −0.001 0.046 −0.097 −0.053 −0.106 −0.062 0.019 0.015 0.020 0.016
(−0.50) (0.53) (−0.02) (1.06) (−2.21)∗∗ (−1.98)∗∗ (−2.11)∗∗ (−1.85)∗ (3.90)∗∗∗ (3.42)∗∗∗ (3.84)∗∗∗ (3.30)∗∗∗
Ln(POP) 0.803 −0.361 0.665 −0.498 −0.318 −0.372 −0.249 −0.303 0.080 0.039 0.035 −0.006
(1.42) (−1.26) (1.10) (−1.58) (−1.11) (−2.07)∗∗ (−0.77) (−1.31) (4.09)∗∗∗ (2.24)∗∗ (1.78)∗ (−0.31)
Ln(DENSITY) −0.089 −0.020 −0.043 0.026 −0.015 −0.022 −0.019 −0.026 0.017 0.015 0.010 0.008
(−1.50) (−0.95) (−0.62) (0.80) (−0.29) (−0.56) (−0.35) (−0.63) (2.64)∗∗∗ (2.60)∗∗∗ (1.48) (1.25)

INC-GROWTH 0.803 −0.361 0.665 −0.498 −0.318 −0.372 −0.249 −0.303 0.080 0.039 0.035 −0.006
(1.42) (−1.26) (1.10) (−1.58) (−1.11) (−2.07)∗∗ (−0.77) (−1.31) (4.09)∗∗∗ (2.24)∗∗ (1.78)∗ (−0.31)
Constant −0.149 −0.143 −0.051 −0.045 −0.332 −0.160 −0.415 −0.242 0.053 0.041 0.318 0.306
(−0.42) (−0.60) (−0.13) (−0.17) (−0.77) (−0.53) (−0.87) (−0.66) (1.32) (1.14) (7.76)∗∗∗ (8.04)∗∗∗
Time fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Bank fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Observations 1804 1804 1804 1804 2132 2132 2132 2132 80,062 80,062 80,062 80,062
Adjusted R-squared 0.82 0.85 0.81 0.85 0.76 0.90 0.72 0.88 0.89 0.89 0.88 0.87
This table presents our main regression results. The dependent variable is the dollar amount of liquidity a bank has created, calculated using the four liquidity creation measures as defined
in Table 1, normalized by GTA. GTA equals total assets plus the allowance for loan and lease losses and the allocated transfer risk reserve (a reserve for certain foreign loans). Panels A, B,
and C contain the results for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion), respectively.
EQRAT is the equity capital ratio (total equity capital as a proportion of GTA). EARNVOL is the standard deviation of the bank’s quarterly return on assets measured over the previous twelve
quarters, multiplied by 100. CREDITRISK is a credit risk measure, calculated as the bank’s Basel I risk-weighted assets and off-balance sheet activities divided by GTA. This variable is
orthogonalized to avoid multicollinearity. ZSCORE is the distance to default, measured as the bank’s return on assets plus the equity capital/GTA ratio divided by the standard deviation
of the return on assets. This variable is orthogonalized to avoid multicollinearity. Ln(GTA) is the log of GTA. D-MBHC and D-OBHC are dummy variables that equal 1 if the bank has
been part of a multibank holding company or a one-bank holding company over the prior three years. D-BANK-MERGE is a dummy that equals 1 if the bank was involved in one or more
mergers over the past three years, combining the charters of two or more banks. D-DELTA-OWN is a dummy that equals 1 if the bank was acquired in the last three years, indicated by a
change in top-tier holding company with no change in charter. HERF is a bank-level Herfindahl index based on bank and thrift deposits (the only variable for which geographic location
is publicly available). We first establish the Herfindahl index of the markets in which the bank has deposits and then weight these market indices by the proportion of the bank’s deposits
in each of these markets. SHARE-ML is the share of market bank and thrift deposits held by medium and large banks (GTA exceeding $1 billion). Ln(POP) is the natural log of weighted
average population in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. Ln(DENSITY) is the weighted average population
density (natural log of population per square mile) in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. INC-GROWTH is
the weighted average income growth in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. All regressions are run with
both time fixed effects and bank fixed effects.
The sample period is 1993–2003. t-statistics based on robust standard errors clustered by bank are in parentheses. ∗ , ∗∗ , and ∗∗∗ denote significance at the 10%, 5%, and 1% levels,
respectively.
3817

In sum, we find that for large banks, capital and liquidity creation are posi-
tively correlated when we use measures that include off-balance sheet activities,
while this relationship is insignificant when we exclude those activities. For
small banks, capital and liquidity creation are negatively correlated using all
of our measures, while for medium banks, the relationship is mixed. Thus, the
data suggest that, consistent with our economic intuition, the “risk absorption”
hypothesis dominates for large banks when off-balance sheet activities are
included and the “financial fragility-crowding out” hypothesis strongly domi-

nates for small banks. The two effects are largely offsetting for medium banks.
We next investigate what drives these differences.
5.2 Why is the net effect of capital on liquidity creation different by bank
size class?
To understand more deeply why the relationship between capital and liquidity
creation differs by bank size class, we examine the relationship between capital
and the individual components of liquidity creation (e.g., liquid, semiliquid, and
illiquid assets). Specifically, we use the individual components based on our
“cat fat” liquidity creation measure normalized by GTA as dependent variables
in our regressions.
Panels A, B, and C of Table 6 show the coefficients on EQRAT from these
regressions for large, medium, and small banks, respectively. All of the control
variables from the full specification are included in these regressions, but are
not shown in the interest of brevity. Importantly, since liquidity creation equals
the weighted sum of the individual components (using the ½ , 0, and −½
liquidity creation weights discussed above), the weighted sums of the EQRAT
coefficients on the individual liquidity creation components in Table 6 equal the
coefficient on EQRAT using the “cat fat” measure in Table 5.37 Therefore, the
EQRAT coefficients in the individual component regressions help us understand
which components of liquidity creation yield the different results for large,
medium, and small banks.
The results in panel A of Table 6 suggest that for large banks, lagged capital
is positively related with liquidity creation on the asset side of the balance
sheet, as well as off the balance sheet. Banks with higher lagged capital ratios
have significantly more illiquid assets, fewer liquid assets, and more illiquid
guarantees. These positive effects of capital are partially offset by the fact that
large banks with higher lagged capital ratios have significantly higher capital
ratios in the current period (i.e., the coefficient on EQRAT in the equity/GTA
regression is positive and significant). Thus, the positive relationship between
lagged capital and liquidity creation calculated using our “cat fat” measure
in panel A of Table 4 is the net result of the positive relationship between
37
For example, for large banks, ½ ∗ 0.356 + 0 ∗ 0.186 + (−½ ) ∗ (−0.541) + ½ ∗ 0.191 + 0 ∗ (−0.276) + (−½ ) ∗
(−0.195) + (−½ ) ∗ 0.353 + ½ ∗ 1.353 + 0 ∗ (−0.664) + (−½ ) ∗ 0.000 + (−½ ) ∗ (−0.009) = 1.146.
3818
Table 6
The effect of capital on the components of liquidity creation
Assets/GTA Liabilities/GTA Equity/GTA Guarantees/GTA Derivatives/GTA
Illiquid Semiliquid Liquid Liquid Semiliquid Illiquid Illiquid Illiquid Semiliquid Liquid Liquid
Weight ½ 0 −½ ½ 0 −½ −½ ½ 0 −½ −½
Panel A: Regression results for large banks

EQRAT 0.356 0.186 −0.541 0.191 −0.276 −0.195 0.353 1.353 −0.664 0.000 −0.009
(1.77)∗ (1.42) (−2.85)∗∗∗ (0.58) (−1.41) (−0.99) (2.69)∗∗∗ (2.19)∗∗ (−1.70)∗ (0.20) (−0.87)
Observations 1804 1804 1804 1804 1804 1804 1804 1804 1804 1804 1774
Adjusted R-squared 0.88 0.85 0.84 0.85 0.87 0.80 0.70 0.76 0.74 0.44 0.34
Panel B: Regression results for medium banks
EQRAT 0.097 0.000 −0.097 −0.506 −0.113 0.083 0.480 1.304 0.043 0.000 −0.010
(0.43) (0.00) (−0.44) (−2.21)∗∗ (−0.46) (1.25) (4.28)∗∗∗ (1.02) (0.93) (0.28) (−1.59)
Observations 2132 2132 2132 2132 2132 2132 2132 2132 2132 2132 2132
Panel C: Regression results for small banks
EQRAT −0.003 −0.153 0.156 −0.184 −0.161 −0.018 0.357 0.023 −0.001 0.001 0.000
(−0.07) (−6.60)∗∗∗ (4.40)∗∗∗ (−8.01)∗∗∗ (−5.90)∗∗∗ (−3.25)∗∗∗ (21.02)∗∗∗ (0.83) (−0.22) (1.53) (0.35)
Observations 80,062 80,062 80,062 80,062 80,062 80,062 80,062 80,062 80,062 80,062 78,595
This table presents regression results. The dependent variables are the dollar amounts of the individual liquidity creation components normalized by GTA. The dollar amount of liquidity
created is calculated using our preferred “cat fat” liquidity creation measure as defined in Table 1. GTA equals total assets plus the allowance for loan and lease losses and the allocated
transfer risk reserve (a reserve for certain foreign loans).
Panels A, B, and C contain the results for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion), respectively. All
panels show only the coefficients on EQRAT (total equity capital as a proportion of GTA) in the interest of parsimony, although the regressions include all the exogenous variables from the
full specification as defined in Table 4. All regressions are run with both time fixed effects and bank fixed effects.
respectively.
3819

lagged capital and assets and illiquid guarantees being larger than the negative
relationship with current capital. The insignificant relationship between lagged
capital and liquidity creation calculated using the “cat nonfat” measure in panel
A of Table 4 occurs because the positive relationship between lagged capital
and illiquid guarantees is excluded—the positive relationship between lagged
capital and assets approximately offsets the negative relationship with current
capital.
The findings in panel A of Table 6 are also consistent with the economic

intuition that the “risk absorption” effect is relatively strong for large banks.
Higher capital allows large banks to bear significantly more portfolio risk, and
the data suggest that they do so. Large banks with higher capital hold more
risky illiquid assets such as commercial loans and risky illiquid guarantees such
as loan commitments, and fewer relatively safe liquid assets such as treasuries.
Panel B of Table 6 suggests very different effects for medium banks. Banks
with higher lagged capital ratios tend to have fewer liquid liabilities. The
negative relationship between lagged capital and liquid liabilities approximately
offsets the positive relationship between lagged capital and current capital,
yielding the overall insignificant effect for our “cat fat” measure.
Panel C of Table 6 reveals that similar to large and medium banks, small
banks with higher lagged capital ratios have significantly higher capital ratios
in the current period. However, in stark contrast to large banks, for small banks,
capital is negatively related with liquidity creation on the asset and liability
sides of the balance sheet, and essentially unrelated to liquidity creation off the
balance sheet. Small banks with higher lagged capital ratios have significantly
more liquid assets and fewer liquid liabilities. Thus, the effect of lagged capital
is consistently negative for small banks, as opposed to the positive effect for
large banks, because the negative effect on current capital is augmented by
negative effects of capital on the asset and liability sides, and is not offset by a
positive effect off the balance sheet.38
The results in panel C of Table 6 are also consistent with the economic
intuition that the “financial fragility-crowding out” effect is relatively strong
for small banks. On the asset side, lagged capital is not positively related
with illiquid assets, but instead is positively related with liquid assets. This
is consistent with the spirit of the financial fragility arguments put forth in
Diamond and Rajan (2000, 2001). Capital reduces the financial fragility needed
to commit to monitoring its borrowers. As a result, banks with higher lagged
capital ratios may invest more in liquid assets, rather than increasing their loans.
On the liability side, lagged capital is negatively related to liquid liabilities,
consistent with the “crowding out” of transactions deposits as in Gorton and
Winton (2000).
38
Lagged capital also has a negative effect on illiquid liabilities (which enhances liquidity creation), but the effect
is small.
3820
6. Robustness Issues
In Section 5, we found that, based on our preferred “cat fat” measure of liquidity
creation, the relationship between capital and liquidity creation is positive and
significant for large banks (when off-balance sheet activities are included),
insignificant for medium banks, and negative and significant for small banks.
We now examine the robustness of these main findings to (1) using an alternative
method to measuring off-balance sheet bank liquidity creation; (2) using an

alternative way of establishing which assets are securitizable; (3) excluding
equity from the liquidity creation measure; (4) using an alternative capital ratio;
(5) splitting the sample by bank holding company status, wholesale versus retail
orientation, and merger status; and (6) using an instrumental variable approach.
We show that our main results are qualitatively unchanged.
6.1 Using an alternative method to measuring off-balance sheet liquidity

creation
Our liquidity creation measures are based on the ease, cost, and time for
customers to obtain liquid funds from the bank, and the ease, cost, and time for
banks to dispose of their obligations in order to meet these liquidity demands.
An alternative would be to use the probability or frequency with which the bank
or customers actually liquefy the items and obtain liquid funds. We argue that
the ability or option to obtain funds when needed or desired is more important
than the actual drawdown frequency. This is also what the theories suggest:
banks create liquidity on the balance sheet because they give depositors a
liquid claim to their funds (i.e., the option to withdraw funds when needed)
instead of forcing them to hold illiquid loans directly (e.g., Diamond and
Dybvig 1983). Similarly, banks create liquidity off the balance sheet through
guarantees that allow customers the option to draw down liquid funds when
needed (e.g., Kashyap, Rajan, and Stein 2002).
Despite our reservations, we construct a liquidity creation measure that
incorporates the frequency with which customers obtain liquid funds on off-
balance sheet guarantees. Our alternative liquidity creation measure is identical
to our “cat fat” measure, except that we multiply the dollar amount of illiquid
off-balance sheet guarantees by 0.30, the observed frequency of drawdown as
documented in recent research (Sufi 2007).39
Using this alternative “cat fat” measure, we find that liquidity creation of
the banking sector is about one-third lower than using our preferred “cat fat”
measure in every year and amounts to $1.869 trillion in 2003 (not shown for
brevity). The overall pattern of liquidity creation, however, is fairly similar to
the “cat fat” pattern.
In panel A of Table 7, we regress the dollar amount of liquidity creation
using this alternative “cat fat” measure normalized by GTA on EQRAT and
39
Sufi (2007) uses data on letters of credit and loan commitments over 1996–2003, which corresponds closely with
our sample period, and finds that conditional on having a letter of credit or a loan commitment, the probability
of drawdown over this time period was approximately 30% in every year.
3821
3822

Table 7
The effect of capital on liquidity creation based on three alternative methods of measuring liquidity creation
Regression results based on a “cat fat” liquidity creation measure which
Panel A: Measures off-balance sheet liquidity Panel B: Uses an alternative way to establishing Panel C: Excludes equity
creation differently which assets are securitizable
Large banks Medium banks Small banks Large banks Medium banks Small banks Large banks Medium banks Small banks
LC/GTA LC/GTA LC/GTA LC/GTA LC/GTA LC/GTA LC/GTA LC/GTA LC/GTA
EQRAT 0.672 −0.238 −0.338 1.251 0.259 −0.380 0.747 0.259 −0.212
(1.96)∗ (−0.68) (−8.33)∗∗∗ (3.58)∗∗∗ (0.36) (−8.80)∗∗∗ (2.30)∗∗ (0.36) (−6.39)∗∗∗
EARNVOL −0.111 −0.017 −0.014 −0.147 0.019 −0.021 −0.103 0.019 −0.013
(−2.52)∗∗ (−0.46) (−2.82)∗∗∗ (−2.62)∗∗∗ (0.21) (−3.75)∗∗∗ (−2.01)∗∗ (0.21) (−2.75)∗∗∗
CREDITRISK 0.355 0.370 0.437 0.533 0.524 0.482 0.266 0.524 0.433
(5.80)∗∗∗ (5.39)∗∗∗ (40.08)∗∗∗ (5.32)∗∗∗ (2.64)∗∗∗ (40.09)∗∗∗ (4.05)∗∗∗ (2.64)∗∗∗ (39.24)∗∗∗
ZSCORE 0.009 0.008 −0.003 0.004 0.007 −0.003 0.009 0.007 −0.002
(1.80)∗ (2.37)∗∗ (−5.12)∗∗∗ (0.53) (1.68)∗ (−4.16)∗∗∗ (1.76)∗ (1.68)∗ (−2.70)∗∗∗
Ln(GTA) 0.004 0.029 −0.003 −0.013 0.046 −0.021 0.019 0.046 −0.019
(0.39) (1.81)∗ (−1.11) (−0.72) (1.94)∗ (−7.39)∗∗∗ (1.71)∗ (1.94)∗ (−7.80)∗∗∗
D-MBHC 0.075 0.034 0.014 0.053 0.014 0.016 0.079 0.014 0.014
(0.74) (1.67)∗ (5.55)∗∗∗ (0.42) (0.44) (5.48)∗∗∗ (0.85) (0.44) (5.15)∗∗∗
D-OBHC 0.096 0.025 0.032 0.092 0.004 0.035 0.094 0.004 0.030
(0.98) (1.01) (11.31)∗∗∗ (0.73) (0.12) (11.02)∗∗∗ (1.06) (0.12) (10.61)∗∗∗
D-BANK-MERGE −0.003 −0.002 0.010 0.009 −0.004 0.013 −0.001 −0.004 0.012
(−0.39) (−0.43) (6.25)∗∗∗ (0.80) (−0.77) (7.51)∗∗∗ (−0.11) (−0.77) (7.65)∗∗∗
D-DELTA-OWN −0.018 −0.002 −0.003 −0.010 0.023 −0.004 −0.014 0.023 −0.003
(−1.27) (−0.17) (−2.10)∗∗ (−0.47) (0.76) (−2.52)∗∗ (−1.02) (0.76) (−2.28)∗∗
HERF −0.176 −0.206 0.029 0.121 −0.175 0.028 −0.048 −0.175 0.023
(−0.98) (−1.71)∗ (2.15)∗∗ (0.54) (−1.12) (1.86)∗ (−0.28) (−1.12) (1.72)∗
SHARE-ML 0.008 −0.066 0.016 −0.037 −0.109 0.014 0.015 −0.109 0.009
(0.21) (−2.21)∗∗ (3.60)∗∗∗ (−0.68) (−2.24)∗∗ (2.77)∗∗∗ (0.36) (−2.24)∗∗ (1.97)∗∗
Ln(POP) 0.035 0.017 0.006 0.070 0.007 0.008 0.006 0.007 0.008
(1.29) (0.61) (1.64) (1.17) (0.19) (2.10)∗∗ (0.25) (0.19) (2.14)∗∗
Ln(DENSITY) −0.040 −0.020 0.015 −0.072 −0.008 0.012 −0.007 −0.008 0.010
(−1.42) (−0.49) (2.64)∗∗∗ (−1.18) (−0.15) (1.91)∗ (−0.32) (−0.15) (1.75)∗

INC-GROWTH 0.009 0.062 0.086 0.012 0.025 0.074 −0.043 0.025 0.056
(0.42) (3.44)∗∗∗ (38.87)∗∗∗ (0.48) (0.99) (30.26)∗∗∗ (−1.87)∗ (0.99) (25.45)∗∗∗
Constant 0.672 −0.238 −0.338 1.251 0.259 −0.380 0.747 0.259 −0.212
(1.96)∗ (−0.68) (−8.33)∗∗∗ (3.58)∗∗∗ (0.36) (−8.80)∗∗∗ (2.30)∗∗ (0.36) (−6.39)∗∗∗
Time fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes
Bank fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Yes
Observations 1804 2132 80,062 1804 2132 80,062 1804 2132 80,062
Adjusted R-squared 0.85 0.88 0.89 0.82 0.75 0.88 0.85 0.75 0.86
This table presents regression results. The dependent variable is LC/GTA, the dollar amount of liquidity a bank has created (calculated using alternative “cat fat” liquidity creation measures
as explained below) normalized by GTA. GTA equals total assets plus the allowance for loan and lease losses and the allocated transfer risk reserve (a reserve for certain foreign loans).
Panel A shows results for an alternative method to measuring off-balance sheet liquidity creation (discussed in Section 7.1). Panel B shows results for an alternative way to establishing
which assets are securitizable (discussed in Section 7.2). Panel C shows results based on a liquidity creation measure which excludes equity (discussed in Section 7.3). All panels show
results for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion).
EQRAT is the equity capital ratio (total equity capital as a proportion of GTA). EARNVOL is the standard deviation of the bank’s quarterly return on assets measured over the previous twelve
quarters, multiplied by 100. CREDITRISK is a credit risk measure, calculated as the bank’s Basel I risk-weighted assets and off-balance sheet activities divided by GTA. This variable is
orthogonalized to avoid multicollinearity. ZSCORE is the distance to default, measured as the bank’s return on assets plus the equity capital/GTA ratio divided by the standard deviation
of the return on assets. This variable is orthogonalized to avoid multicollinearity. Ln(GTA) is the log of GTA. D-MBHC and D-OBHC are dummy variables that equal 1 if the bank has
been part of a multibank holding company or a one-bank holding company over the prior three years. D-BANK-MERGE is a dummy that equals 1 if the bank was involved in one or more
mergers over the past three years, combining the charters of two or more banks. D-DELTA-OWN is a dummy that equals 1 if the bank was acquired in the last three years, indicated by a
change in top-tier holding company with no change in charter. HERF is a bank-level Herfindahl index based on bank and thrift deposits (the only variable for which geographic location
is publicly available). We first establish the Herfindahl index of the markets in which the bank has deposits and then weight these market indices by the proportion of the bank’s deposits
in each of these markets. SHARE-ML is the share of market bank and thrift deposits held by medium and large banks (GTA exceeding $1 billion). Ln(POP) is the natural log of weighted
average population in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. Ln(DENSITY) is the weighted average population
density (natural log of population per square mile) in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. INC-GROWTH is
the weighted average income growth in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. All regressions are run with
both time fixed effects and bank fixed effects.
respectively.
3823

the other exogenous variables. As shown, based on this alternative method to

measuring liquidity creation, we obtain consistent results: the coefficient on
EQRAT is positive for large banks, negative for small banks, and insignificant
for medium banks.
In principle, this methodology could be applied to all bank activities. For
example, the drawdown frequency is 1 for loans since customers have already
received liquid funds. However, constructing measures using this methodology
is difficult, since data on the frequency of drawdown or sale are unavailable

for many activities. More importantly, the use of drawdown rates goes directly
against the liquidity creation theories, which argue that banks create liquidity
by giving customers the option to obtain liquid funds when needed or desired.
6.2 Using an alternative way of establishing which assets are securitizable

The amount of liquidity a bank creates is affected by the bank’s ability to
securitize its assets. Our “cat” liquidity creation measures incorporate this by
classifying loan categories that are relatively easy to securitize (residential real
estate loans and consumer loans) as semiliquid and all other loan categories
as illiquid.40 Our “cat” measures do not incorporate, however, the fact that the
ability to securitize assets has developed greatly over our sample period. In
every loan category, a larger fraction of loans was securitized in 2003 than
in 1993. We now construct an alternative “cat fat” liquidity creation measure
that takes this development into account.
Our alternative “cat fat” measure is identical to the “cat fat” measure de-
scribed in Section 2, except for the way we classify loans. For each loan
category, we obtain year-end U.S. Flow of Funds data on the total amount of
loans outstanding and the total amount of loans securitized. We use these data
to calculate the fraction of loans that has been securitized in the market in each
year. Following Loutskina (2006), we then assume that each bank can securi-
tize that fraction of its own loans. To give an example, in 1993, $3.1 trillion in
residential and real estate loans were outstanding in the market, and 48.4% of
these loans were securitized. If a bank has $10 million in residential and real
estate loans in that year, we assume that 48.4% thereof can be securitized, and
hence, we classify $4.84 million of these loans as semiliquid and the remainder
as illiquid.
We raise two reservations regarding this alternative approach for our pur-
poses. First, it uses the actual amount of securitization, whereas the theories
suggest that the ability to securitize matters for liquidity creation, not the
amount securitized. Second, this alternative approach assumes that each bank
securitizes the same fraction of loans in a particular category, even though in
practice major differences may exist across banks. That is, when we assume
that 48.4% of all residential and real estate loans can be securitized in 1993, one
40
Our “mat” measures classify loans entirely based on maturities and hence do not take differences in securitizability
into account.
3824
bank may have securitized virtually its entire residential real estate portfolio in
that year, while another bank may have securitized nothing.
Using this alternative approach, the banking sector created more liquidity,
but the growth pattern is similar to the “cat fat” pattern described in Section 3.
Based on this alternative measure, liquidity creation equaled $1.843 trillion in
1993 and increased by about 70% to $3.168 trillion in 2003.
The regression results presented in panel B of Table 7 reinforce our prior
findings. That is, for large banks, the relationship between capital and liquidity

creation is positive and significant. For small banks, the relationship between
capital and liquidity creation is negative and significant. For medium banks,
the relationship is again statistically insignificant.
6.3 Excluding equity from the measurement of liquidity creation

Our regression specification is inspired by the theories of bank liquidity cre-
ation. These theories argue that banks create liquidity when illiquid assets are
transformed into liquid liabilities, not when they are transformed into illiquid
claims such as equity. The theories also suggest that equity may affect a bank’s
ability to create liquidity. For example, having more equity capital may allow
a bank to extend more illiquid loans. However, as noted in Section 5, a po-
tential concern about our regression specification is that current bank equity is
included (with a weight of −½ ) in our dependent variables, while the lagged
equity ratio is our key exogenous variable. To ameliorate this potential con-
cern, we create an alternative “cat fat” liquidity creation measure that excludes
equity. This measure does not penalize banks for funding part of their activities
with equity capital. As a result, the measured amount of liquidity creation is
higher for all banks, and this increase is greatest for banks that hold the most
capital. We rerun our regressions using this alternative measure.
The results shown in panel C of Table 7 suggest that our main findings are
robust to the exclusion of equity from our dependent variable. The coefficient
on EQRAT is again positive and significant for large banks, insignificant for
medium banks, and negative and significant for small banks.
6.4 Using an alternative capital ratio

In our main analysis, we use EQRAT, the ratio of equity to GTA, as our key
exogenous variable. We now replace EQRAT with TOTRAT, the ratio of total
capital (as defined in the Basel I capital standards) to GTA. Total capital includes
equity plus limited amounts of other financial instruments, such as long-term
subordinated debt.41,42
41
Before 1996, banks were not required to report total capital, and from 1996 to 2000, banks with total assets less
than $1 billion were not required to report total capital if they indicated on the Call Report that their total capital
exceeded 8% of adjusted total assets. We estimate the missing numbers using a special Federal Reserve program
based on other Call Report information.
42
Note that we do not use the official Basel I total risk-based capital ratio, which is defined as total capital divided
by risk-weighted assets, where risk-weighted assets is the weighted sum of assets and off-balance sheet activities,
with the weights based on the perceived credit risk of each activity. This capital ratio is clearly endogenous and
its use would result in significant bias, since our dependent variable, bank liquidity creation, is also a weighted
sum of assets and off-balance sheet activities (as well as liabilities).
3825
One motivation for using this alternative capital ratio is to see if there is
a different effect of regulatory capital from conventional equity capital on
liquidity creation. A second motivation is to allow for a broader definition of
capital in line with some of the theoretical studies. For example, Diamond and
Rajan (2000, 2001) indicate that capital in their analysis may be interpreted as
either equity or long-term debt, sources of funds that cannot run on the bank.
The results based on this alternative capital ratio are shown in Table 8 and
are qualitatively similar to our main results. The relationship between capi-

tal and liquidity creation is positive and significant for large banks, statisti-
cally insignificant for medium banks, and negative and significant for small
banks.
6.5 Splitting the sample by bank holding company status, wholesale versus
retail orientation, and merger status
In all of the regression results presented thus far, we have split our sample
only by size. In Section 3, however, we also split our sample by bank holding
company status, wholesale versus retail orientation, and merger status, and
showed that substantial time-series and cross-sectional variation exists among
these banks in terms of their ability to create liquidity. We now test the robust-
ness of our main results by rerunning our regressions by size class for MBHC
Table 8
The effect of capital on liquidity creation based on an alternative capital ratio
cat fat/GTA cat fat/GTA cat fat/GTA
TOTRAT 1.696 0.048 −0.343

(4.48)∗∗∗ (0.05) (−9.16)∗∗∗
EARNVOL −0.136 0.024 −0.019
(−3.15)∗∗∗ (0.37) (−4.87)∗∗∗
CREDITRISK 0.506 0.582 0.465
(7.43)∗∗∗ (3.46)∗∗∗ (59.19)∗∗∗
ZSCORE 0.007 0.009 −0.003
(1.38) (1.76)∗ (−6.95)∗∗∗
Ln(GTA) −0.008 0.040 −0.003
(−0.69) (0.67) (−1.39)
D-MBHC 0.079 0.007 0.016
(0.82) (0.54) (18.42)∗∗∗
D-OBHC 0.045 0.000 0.000
(0.46) (0.00) (0.00)
D-BANK-MERGE 0.006 −0.003 0.009
(0.64) (−0.53) (7.62)∗∗∗
D-DELTA-OWN −0.012 0.018 −0.003
(−0.62) (0.54) (−3.22)∗∗∗
HERF 0.028 −0.259 0.031
(0.17) (−0.64) (3.23)∗∗∗
SHARE-ML −0.007 −0.100 0.019
(−0.20) (−1.90)∗ (6.26)∗∗∗
Ln(POP) 0.081 0.014 0.006
(2.84)∗∗∗ (0.47) (2.22)∗∗
3826
Table 8
(Continued)
cat fat/GTA cat fat/GTA cat fat/GTA
Ln(DENSITY) −0.087 −0.018 0.017

(−2.95)∗∗∗ (−0.42) (3.78)∗∗∗
INC-GROWTH 0.993 −0.320 0.078
(2.67)∗∗∗ (−1.36) (5.30)∗∗∗
Constant −0.346 −0.272 0.062
(−1.48) (−0.34) (2.34)∗∗

Time fixed effects Yes Yes Yes
Bank fixed effects Yes Yes Yes
Observations 1804 2132 80,062

Adjusted R-squared 0.78 0.67 0.88
This table presents regression results using an alternative capital ratio (discussed in Section 7.4). The dependent
variable is cat fat/GTA, the dollar amount of liquidity a bank has created (calculated using our preferred “cat fat”
liquidity creation measure as defined in Table 1) normalized by GTA. GTA equals total assets plus the allowance
for loan and lease losses and the allocated transfer risk reserve (a reserve for certain foreign loans). Results are
shown for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks
(GTA up to $1 billion).
TOTRAT is the ratio of total capital (as defined in the Basel I capital standards) to GTA. EARNVOL is the standard
deviation of the bank’s quarterly return on assets measured over the previous twelve quarters, multiplied by 100.
CREDITRISK is a credit risk measure, calculated as the bank’s Basel I risk-weighted assets and off-balance sheet
activities divided by GTA. This variable is orthogonalized to avoid multicollinearity. ZSCORE is the distance
to default, measured as the bank’s return on assets plus the equity capital/GTA ratio divided by the standard
deviation of the return on assets. This variable is orthogonalized to avoid multicollinearity. Ln(GTA) is the log of
GTA. D-MBHC and D-OBHC are dummy variables that equal 1 if the bank has been part of a multibank holding
company or a one-bank holding company over the prior three years. D-BANK-MERGE is a dummy that equals 1
if the bank was involved in one or more mergers over the past three years, combining the charters of two or more
banks. D-DELTA-OWN is a dummy that equals 1 if the bank was acquired in the last three years, indicated by a
change in top-tier holding company with no change in charter. HERF is a bank-level Herfindahl index based on
bank and thrift deposits (the only variable for which geographic location is publicly available). We first establish
the Herfindahl index of the markets in which the bank has deposits and then weight these market indices by the
proportion of the bank’s deposits in each of these markets. SHARE-ML is the share of market bank and thrift
deposits held by medium and large banks (GTA exceeding $1 billion). Ln(POP) is the natural log of weighted
average population in all markets in which a bank has deposits, using the proportion of deposits held by a bank
in each market as weights. Ln(DENSITY) is the weighted average population density (natural log of population
per square mile) in all markets in which a bank has deposits, using the proportion of deposits held by a bank in
each market as weights. INC-GROWTH is the weighted average income growth in all markets in which a bank
has deposits, using the proportion of deposits held by a bank in each market as weights. All regressions are run
with both time fixed effects and bank fixed effects.
The sample period is 1993–2003. t-statistics based on robust standard errors clustered by bank are in parentheses.
∗ ∗∗
, , and ∗∗∗ denote significance at the 10%, 5%, and 1% levels, respectively.
members, OBHC members, and independent banks; banks with wholesale and
retail orientations; and banks with and without recent M&A activity.
The results are shown in Table 9. For large banks, the coefficient on EQRAT
is positive and statistically significant (except for the small subsample of in-
dependent banks, which has only fifty-four observations). For medium banks,
the coefficient on EQRAT is positive and significant for OBHC members, and
not significant for any of the other subsamples. For small banks, the coefficient
is negative in all cases, and significant in all but one case. Thus, our main
findings are generally robust to splitting the data by bank holding company
status, wholesale versus retail orientation, and merger status.
3827
3828

Table 9
The effect of capital on liquidity creation for banks in each size class split by bank holding company status, wholesale versus retail orientation, and merger status
MBHC members OBHC members Independent banks Wholesale banks Retail banks Recent M&A activity No recent M&A activity
cat fat/GTA cat fat/GTA cat fat/GTA cat fat/GTA cat fat/GTA cat fat/GTA cat fat/GTA
Panel A: Regression results for large banks

EQRAT 1.314 3.924 −0.365 1.709 0.553 1.275 1.261
(3.74)∗∗∗ (2.01)∗ (−0.39) (3.74)∗∗∗ (1.80)∗ (2.35)∗∗ (2.12)∗∗
Observations 1717 33 54 1255 549 1152 652
Adjusted R-squared 0.80 1.00 0.96 0.87 0.78 0.82 0.90
Panel B: Regression results for medium banks
EQRAT 0.762 0.853 0.316 0.216 −0.107 0.366 0.321
(0.64) (1.94)∗ (0.42) (0.26) (−0.29) (0.88) (0.32)
Observations 1722 187 223 1246 886 920 1212
Panel C: Regression results for small banks
EQRAT −0.380 −0.196 −0.282 −0.370 −0.231 −0.340 −0.345
(−2.85)∗∗∗ (−3.10)∗∗∗ (−4.49)∗∗∗ (−6.16)∗∗∗ (−3.50)∗∗∗ (−1.51) (−7.42)∗∗∗
Observations 33,864 28,426 17,772 55,314 24,748 5392 74,670
This table presents regression results. The dependent variable is cat fat/GTA, the dollar amount of liquidity a bank has created (calculated using our preferred “cat fat” liquidity creation
measure as defined in Table 1) normalized by GTA. GTA equals total assets plus the allowance for loan and lease losses and the allocated transfer risk reserve (a reserve for certain foreign
loans).
The sample is split in three ways. First, by bank holding company status: multibank holding company (MBHC) member, one-bank holding company (OBHC) member, and independent
bank. Second, by wholesale versus retail orientation: banks with below versus above average number of branches. Third, by merger status: banks that engaged in M&A activity during the
previous three years versus banks that did not engage in M&A activity recently.
Panels A, B, and C contain the results for large banks (GTA exceeding $3 billion), medium banks (GTA $1 billion–$3 billion), and small banks (GTA up to $1 billion), respectively. All
panels show only the coefficients on EQRAT (total equity capital as a proportion of GTA) in the interest of parsimony, although the regressions include all the exogenous variables from the
full specification as defined in Table 4. All regressions are run with both time fixed effects and bank fixed effects.
respectively.

6.6 Using an instrumental variable approach

All the analyses presented so far suggest that, based on our preferred “cat
fat” liquidity creation measure, the relationship between capital and liquidity
is positive and significant for large banks, and negative and significant for
small banks. We have been careful thus far to interpret our results merely as
showing strong correlations consistent with the theories rather than as evi-
dence of a causal relationship, even though our main analysis used three-year
lagged average values of capital to mitigate potential endogeneity concerns.43

We now address this endogeneity issue more directly. Specifically, we use an
instrumental variable approach to examine whether our statistically significant
results about the positive relationship between capital and liquidity creation for
large banks and the negative relationship between capital and liquidity creation
for small banks represent the causal effects of capital on liquidity creation for
large and small banks.44
Since we have panel data and use time and bank fixed effects in all of the
regressions presented so far, we should also use fixed effects in our instrumental
variable regressions.45 We can do so if the instruments show sufficient variation
over time. Provided this is the case, in the first stage, we will regress our
potentially endogenous variable, EQRAT, on an instrument and all of the control
variables and time and bank fixed effects. In the second stage, we will regress
liquidity creation (using our preferred “cat fat” measure) divided by GTA on
the predicted value for EQRAT from the first stage and all the control variables
and fixed effects.
An instrument must satisfy two requirements. First, to be valid, the instrument
should be correlated with the amount of lagged capital (once the effects of
the other exogenous variables have been netted out), but should not directly
affect the amount of liquidity a bank creates. Second, as noted above, since
we want to include bank fixed effects in the regressions, it is important that
the instrument shows sufficient variation within a bank’s observations over
time. We select two instruments: the first one meets both requirements, while
the second one meets only the first requirement. Regressions that include the
43
In an earlier version of the article, we also investigated whether omitted variables could drive our results. For
example, increased corporate governance pressures over time may have forced management of small banks to
more aggressively court deposits and create liquidity, causing the observed negative relationship between capital
and liquidity creation for these banks. To address this, we tested whether the negative effect is stronger for small
banks in the second half of the sample period and examined whether capital ratios of small banks decreased over
time. The results of these analyses were inconsistent with the alternative corporate governance explanation of
our results.
44
An alternative way to establish causality would be to shock banks with more capital (e.g., by imposing higher
capital requirements) and examine the effect on liquidity creation. This is not possible for us, however, since
such exogenous shocks did not occur during our sample period.
45
We explained in Section 4.2 why it is important to include time and bank fixed effects in the main regressions.
Our use of fixed effects in OLS and IV regressions is in line with the recent literature (e.g., Rajan and Zingales
1998; Anderson and Reeb 2003; Desai, Foley, and Hines 2004; Berger et al. 2008; Klapper, Laeven, and Rajan
2006). Although many papers do not elaborate on the first-stage regressions, it is clear from Levitt (2002) and
Faulkender and Petersen (2006) that they explicitly include fixed effects in this stage.
3829
instrument that meets both requirements are therefore carried out following the
approach highlighted above. After discussing our instruments, we explain our
approach for regressions that use the other instrument.
Our first instrument is EFF-TAX, the state income tax rate a bank has to
pay. Since interest on debt is tax deductible while dividend payments are not,
banks that operate in states with higher income tax rates are expected to have
lower equity ratios, keeping all else equal. Furthermore, there is no reason to
believe that the state income tax rate directly affects liquidity creation. Similar

to Ashcraft (2008), we use the effective income tax rate to be paid on $1 million
in pretax income as our instrument.46,47 If a bank operates in multiple states,
we use the bank’s weighted average state income tax rate, calculated using the
share of deposits in each state (relative to the bank’s total deposits) as weights.48
Our second instrument is SENIORS, the fraction of seniors (people aged
sixty-five and over) in the markets in which a bank is active. Seniors own larger
equity portfolios than the average family. According to the Survey of Consumer
Finances, families headed by a senior were slightly less likely to own stock
(36.1% owned stock versus 47.5% of all families), but the dollar value of the
stock portfolio of those that did own stock was roughly three times as large
($81,200 versus $27,000 for the average family) (see Bucks, Kennickell, and
Moore 2006).49 Furthermore, using U.S. data, Coval and Moskowitz (1999)
document that investors have a strong preference for investing close to home.
They find that this preference is greater for firms that are smaller, more highly
levered, and those that produce goods that are not traded internationally. In
combination, this evidence suggests that banks—particularly small banks—that
operate in markets with more seniors have easier access to equity financing and
hence, will use more equity financing. We calculate the fraction of seniors using
county- and MSA-level population data from the 2000 decennial Census.50
46
In each state (except Ohio), the highest tax bracket starts at or below $1 million in pretax profits: when we use
the marginal tax rate on $1 million in pretax profits as our instrument, we obtain similar results. In Ohio, banks
pay 0.015 times the book value of their stock. However, for comparability reasons, we use the corporate income
tax rate to calculate Ohio taxes.
47
In contrast to Ashcraft (2008), we use the income tax rate banks have to pay rather than the corporate income tax
rate. These rates differ in ten states. To illustrate, in South Dakota, corporations did not pay income tax between
1993 and 2003, while banks paid 6%. In North Dakota, corporations paid 10.35%, while banks were taxed at
7%. Also, unlike Ashcraft (2008), we do not average the tax rate over our sample period. This ensures that we
do not use forward-looking data in our regressions.
48
It would be preferable to use the share of pretax income earned in each state as weights, but Call Reports (and
other data sources) do not provide these data.
49
These calculations are based on data from the triennial Survey of Consumer Finances in 1995, 1998, 2001, and
2004, as presented in Tables 3 and 6 in Bucks, Kennickell, and Moore (2006). In particular, we compare average
values for families headed by a senior (65–74-year-olds and 75-year-olds and above) with values for an average
family.
50
Becker (2007) uses Survey of Consumer Finances data to show that seniors also hold more deposits than the
average family, and hence uses the fraction of seniors as an instrument for deposits of small banks. However,
the impact of age on deposits is dwarfed by the impact of age on equity holdings. For example, in 2001, the
median value of transaction accounts plus CDs for families headed by seniors was $13,400 (65–74-year-olds)
and $15,900 (75-year-olds and up) versus $6000 for all families. In contrast, the median value of stock held by
3830
Panel A of Table 10 examines the extent to which the instruments vary. The
data suggest that there is substantial time-series variation for the tax rate for
both size classes. We therefore use the entire sample and include time and bank
fixed effects in all the analyses in which we employ the effective tax rate. The
fraction of seniors shows sufficient variation in the cross section, but not over
time since we only have information on the fraction of seniors from the 2000
Census. In the analyses that use SENIORS, we therefore do not use the entire
sample and do not include time and bank fixed effects. Rather, we use liquidity

creation data only from the year 2001 and lagged values of the instrument (i.e.,
the 2000 Census values) and the other exogenous variables.
Panel B of Table 10 shows the results of our first-stage regressions. The
state income tax rate has a significantly negative effect on capital for large
banks, consistent with Ashcraft (2008). The tax rate does not significantly
affect capital at small banks, potentially because the tax benefit of debt may be
outweighed by safety and soundness considerations that induce those banks to
hold higher capital ratios. The fraction of seniors has a significantly positive
effect on capital for small banks. It does not significantly affect capital at large
banks, possibly because these banks are not limited by geography in terms of
their access to a variety of funding sources.
Panel C of Table 10 contains the second-stage instrumental variable regres-
sion results. For completeness, we show results for both size classes using both
instruments. However, since the first-stage results showed that the tax rate can
only be used as an instrument for large banks while the fraction of seniors can
only be used as an instrument for small banks, we focus our attention on those
two regressions. When we use instruments for capital, our results are consistent
with our earlier findings. The effect of capital on liquidity creation is positive
and statistically significant for large banks, and negative and significant for
small banks.
For both large and small banks, the coefficients on EQRAT are larger when
we use instruments, suggesting that the effect of capital on liquidity creation is
several times the previously estimated effect. Using similar logic as in Levitt
(1996), this suggests that in our main liquidity creation regressions, EQRAT
is correlated with the residuals, inducing a bias toward zero in our coeffi-
cient estimates. When we use instruments for capital, we obtain consistent
estimates.51 However, since we had no a priori reason to believe that our EQRAT
families headed by seniors was $58,800 (65–74-year-olds) and $41,000 (75-year-olds and up) versus $17,900
for all families. Values are calculated as the likelihood of holding a particular asset times the median dollar value
of the holdings of those that do own that asset. The underlying data are from the 2001 Survey of Consumer
Finances as presented in Tables 5B and 6 in Aizcorbe, Kennickell, and Moore (2003).
51
Levitt (1996) finds that the number of prisoners has a negative effect on crime that is five times larger when
he uses instruments for the prison population. He argues that the coefficients in his original regressions are too
low because the number of prisoners is negatively correlated with the residuals and that he obtains consistent
estimates when he uses instruments.
3831
Table 10
The effect of capital on liquidity creation based on instrumental variable regressions
3832

Panel A: Summary statistics on the instruments
Large banks Small banks Fraction of seniors Large banks Small banks
Same tax rate in all years 31% 62% Minimum 0% 0%

Tax rate changes >10% 44% 23% Average 12% 14%
Tax rate changes >20% 19% 13% Maximum 23% 35%
Panel B: First-stage regression results
Instrument: EFF-TAX Instrument: SENIORS (2001 data only)
Large banks Small banks Large banks Small banks

EQRAT EQRAT EQRAT EQRAT
EFF-TAX −0.003 0.000
(−2.48)∗∗ (1.44)
SENIORS −0.024 0.060
(−0.27) (3.66)∗∗∗
Observations 1752 79,228 143 6493
Panel C: Second-stage regression results
Instrument: EFF-TAX Instrument: SENIORS (2001 data only)
Large banks Small banks Large banks Small banks

cat fat/GTA cat fat/GTA cat fat/GTA cat fat/GTA
EQRAT (instrumented) 4.820 −9.604 9.804 −2.531
(1.75)∗ (−1.45) (0.25) (−3.08)∗∗
Observations 1752 79,228 143 6493
This table contains results from our instrumental variable approach for large banks (GTA exceeding $3 billion), and small banks (GTA up to $1 billion). GTA equals total assets plus the allowance for
loan and lease losses and the allocated transfer risk reserve (a reserve for certain foreign loans). Panel A shows summary statistics on the instruments. Panel B contains first-stage regression results. The
dependent variable is EQRAT, total equity capital as a proportion of GTA. Panel C shows second-stage regression results. In these regressions, the dependent variable is cat fat/GTA, the dollar amount of
liquidity a bank has created (calculated using our preferred “cat fat” liquidity creation measure as defined in Table 1) normalized by GTA and EQRAT is alternatively instrumented with EFF-TAX and
SENIORS.
EFF-TAX is the effective state income tax rate a bank has to pay on $1 million in pretax income (see Ashcraft 2006). All regressions that include EFF-TAX are run with both time fixed effects and bank
fixed effects. SENIORS is the fraction of seniors in all markets in which a bank has deposits, using the proportion of deposits held by a bank in each market as weights. The fraction of seniors is calculated
using county- and MSA-level population data from the 2000 decennial Census. All regressions that include SENIORS are run with liquidity creation data only from the year 2001 and lagged values of the
instrument (i.e., the 2000 Census values) and the other exogenous variables; since these are cross-sectional rather than panel regressions, time fixed effects and bank fixed effects are not included.
Panel B shows only the coefficients on the instruments, and panel C shows only the coefficients on EQRAT (total equity capital as a proportion of GTA) in the interest of parsimony, although the regressions
include all the exogenous variables from the full specification as defined in Table 4 (except that bank and time fixed effects are excluded when SENIORS are used as the instrument).
The sample period is 1993–2003. t-statistics based on robust standard errors clustered by bank are in parentheses. ∗ , ∗∗ , and ∗∗∗ denote significance at the 10%, 5%, and 1% levels, respectively.

coefficients were understated in our main regressions, we are hesitant to put

too much weight on this explanation.52
7. Conclusion
According to banking theory, banks exist because they create liquidity and
transform risk. Our understanding of the liquidity creation role is hampered by
the absence of comprehensive liquidity creation measures. The first contribu-

tion of this article is the development of four bank liquidity creation measures.
Our second contribution is that we use our measures to gain a deeper insight into
banks’ role as liquidity creators. We determine the magnitude of bank liquidity
creation, its intertemporal patterns, its cross-sectional variation, characteristics
of high and low liquidity creators, and examine the relationship between liquid-
ity creation and bank value. Our third contribution is that we use our measures
to study an issue of significant research and policy relevance—the effect of
bank capital on liquidity creation—and thereby test the predictions of recent
theories about the relationship between capital and liquidity creation.
Our calculations suggest that liquidity creation by the U.S. banking sector
exceeded $2.8 trillion as of 2003 based on our preferred liquidity creation
measure, and nearly doubled in real terms between 1993 and 2003. Interestingly,
banks create only about half of their liquidity on the balance sheet, highlighting
the importance of off-balance sheet liquidity creation. Large banks (gross total
assets exceeding $3 billion) create 81% of the liquidity while comprising
only 2% of all banks. Multibank holding company members, retail banks, and
recently merged banks create most of the industry’s overall liquidity and show
the greatest growth in liquidity creation over time. Liquidity creation is also
positively associated with bank value.
When we test the relationship between capital and liquidity creation, we find
empirical support for both the theories which predict that higher capital may
suppress liquidity creation and those which suggest that higher capital may
enhance banks’ ability to create more liquidity. Based on our preferred “cat
fat” liquidity creation measure, the relationship between capital and liquidity
creation is positive and significant for large banks, insignificant for medium
banks, and negative and significant for small banks. We perform a variety of
robustness checks and find consistent results.
Our finding that the relationship between bank capital and bank liquidity
creation differs by bank size raises interesting policy issues. It is well known
that regulators impose capital requirements on banks for safety and soundness
reasons. Our findings suggest that while regulators may be able to make banks
safer by imposing higher capital requirements, this benefit may have associated
52
Because our liquidity creation measure includes current capital, we also rerun the instrumental variable regres-
sions with our liquidity creation measure that excludes capital as a robustness check. While we lose statistical
significance for large banks, the results are similar for small banks.
3833
with it reduced liquidity creation by small banks, but enhanced liquidity creation
by large banks.
Our liquidity creation measures may also be used to address a number of
other interesting issues that are beyond the scope of this article, but may be
pursued in future research. Does liquidity creation affect economic growth?
How do monetary policy initiatives by central banks, changes in deposit insur-
ance, and other policy innovations affect liquidity creation? How does liquidity
creation differ across nations? How much liquidity do banks create compared to

nonbank financial intermediaries? How much liquidity do banks create relative
to financial markets, and what are the complementarities, if any, in liquidity cre-
ation between banks and capital markets? Addressing these questions holds the
promise of substantially improving our understanding of the liquidity creation
function of banks and how it affects the economy.
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Bank Liquidity Creation

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Although the modern theory of financial intermediation portrays liquidity creation as an

According to the modern theory of financial intermediation, banks exist be-

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to create liquidity. Liquidity creation exposes banks to risk—the greater the

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fraction of seniors in the markets in which a bank operates as potentially

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1.1 Measurement of bank liquidity creation

residential mortgages and consumer loans as semiliquid because these loans

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of some liquidity creation components, yielding ambiguous predictions related

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2. Construction of Our Liquidity Creation Measures

We construct the liquidity creation measures using a three-step procedure.

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(cat) (mat) (cat) (mat)

Other real estate owned (OREO)

Liquid liabilities (weight = /2 )

Transactions deposits Time deposits Bank’s liability on bankers acceptances

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The Review of Financial Studies / v 22 n 9 2009

Unused commitments Net credit derivatives Net participations acquired

Liquid derivatives (weight = −1/2 )

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counterparties are relatively large and informationally transparent. We

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2.1.2 Liabilities plus equity

2.1.3 Off-balance sheet activities

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2.2 Step 2: Assigning weights to the activities classified in step 1

The magnitudes of the weights are based on simple dollar-for-dollar adding-

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2.3 Step 3: Constructing liquidity creation measures by combining

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3.1 Sample description

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The Review of Financial Studies / v 22 n 9 2009

1993 liquidity creation 2003 liquidity creation Liquidity creation 1993–2003

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Bank Liquidity Creation

Multibank holding company (MBHC) Wholesale banks (below average number

One-bank holding company (OBHC) Retail banks (above average number of

Independent banks Recent M&A activity (engaged in M&As

No recent M&A activity

Small 8156 6215

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The Review of Financial Studies / v 22 n 9 2009

Large banks Medium banks Small banks

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