Financial Crises and Bank Liquidity Creation



This paper examines the aggregate liquidity creation of banks across five financial crises in the U.S. over the past quarter century, and the effects of pre-crisis capital ratios on the competitive positions, profitability, and stock returns of individual banks during and after each crisis. These crises are 1) the 1987 stock market crash, 2) the credit crunch of the early 1990s, 3) the Russian debt crisis plus LTCM bailout in 1998, 4) the bursting of the bubble plus Sept. 11, and 5the current subprime lending crisis.  The results regarding aggregate liquidity creation around the times of financial crises suggest the following.  First, there seems to have been a significant build-up or drop-off of “abnormal” liquidity creation before each crisis, where “abnormal” is defined relative to a time trend and seasonal factors.  Second, banking and non-banking crises differ in terms of the effects of the crisis itself on aggregate liquidity creation by banks.  The crisis seems to change the trajectory of aggregate liquidity creation during banking crises, but not during other crises.  Third, both the credit crunch of 1990-1992 and the current subprime lending crisis were preceded by abnormally positive liquidity creation by banks.  Fourth, while lending is typically considered to be procyclical, liquidity creation during crises has been both procyclical and countercyclical.  Fifth, because the subprime lending crisis was preceded by a dramatic build-up of positive abnormal liquidity creation, our analysis hints at the possibility that while financial fragility may be needed to create liquidity, “too much” liquidity creation may also lead to increased financial fragility.

Our main findings regarding the effect of pre-crisis capital on individual banks’ competitive positions, profitability, and stock returns around each financial crisis are as follows.  First, higher-capital large banks are able to improve their competitive position in terms of market share and profitability during the two banking-related crises (credit crunch and subprime lending crisis), but not during the other crises, and were able to hold on to their improved position after the credit crunch.  Second, small banks with higher capital ratios improved their competitive positions during virtually every crisis and were able to hold on to their improved positions.  Third, based on a four-factor asset pricing model, an investment strategy that buys high-capital traded small banks and shorts low-capital traded small banks before the crisis and liquidates the portfolio at the end of the crisis or after the crisis does not yield significant returns, implying that the improved competitive position of higher-capital small banks does not translate into higher stock returns.  An investment strategy that buys high-capital large banks and shorts low-capital large banks four quarters before the crisis and liquidates the portfolio at the end of the crisis yields significantly positive returns around the credit crunch.  These findings suggest that, at least in the case of large banks, high capital contributes to an enhancement of the bank’s competitive position and shareholder returns during a banking crisis.
Contact information:
Ingolf Dittmann