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 U.S. banks from 1993-2003. 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 create the most liquidity. Bank liquidity creation is also positively correlated with bank value. Testing recent theories, we find that bank capital has a positive (negative) effect on liquidity creation for large (small) banks.

. . .

1. Introduction

According to the modern theory on financial intermediation, banks exist because they perform two central roles in the economy – they create liquidity and they transform risk. Analyses of banks’ role in creating liquidity and thereby spurring economic growth have a long tradition, dating back to Adam Smith (1776). Modern reincarnations of the idea that liquidity creation is central to banking appear most prominently in the formal analyses in Bryant (1980) and Diamond and Dybvig (1983). These theories argue that banks create liquidity 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. Banks’ role as risk transformers is also well-documented. A vast literature has emerged on bank risk taking and prudential regulation, supervision, and market discipline to control risk-taking behavior. According to the risk transformation theories, banks transform risk by issuing riskless deposits to finance risky loans (e.g., Diamond 1984, Ramakrishnan and Thakor 1984). Risk transformation may coincide with liquidity creation, as for example, when banks issue riskless liquid deposits to finance risky illiquid 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.

. . .

The standard view of liquidity creation is that banks create liquidity by transforming illiquid assets into liquid liabilities.