Regulatory capital, liquidity creation, bank characteristics and profitability: Evidence from developed and developing countries

The aim of this study is to examine the bidirectional relationship between regulatory capital and liquidity creation in a global setting comprising diverse bank-specific and country-level characteristics. This study utilises the theory of financial intermediation and investigates various channels through which regulatory capital and liquidity creation are interrelated. More specifically, this study examines how bank-level and country-specific characteristics interact with regulatory capital to determine liquidity creation, and vice versa for Asia-Pacific and European banks. This study uses a dynamic panel generalized method of moments (GMM) estimator and the results support the financial fragility-crowding out hypothesis and liquidity substitution hypothesis, indicating an inverse bidirectional relationship between regulatory capital and liquidity creation. The findings further suggest that this relationship varies with several bank-level and country-level characteristics. The negative impact of regulatory capital on liquidity creation is more negative for banks with (i) high-ability managers; (ii) optimistic CEOs; and (iii) country of origin in advanced economies. Where, this inverse relationship is weakened for (i) banks with larger board sizes; (ii) banks with more experienced board members; (iii) Asia-Pacific banks; and (iv) banks having total assets greater than 50 billion USD. Moreover, regarding the reverse causality, the significant inverse impact of liquidity creation on bank capital is reinforced for (i) banks with larger board sizes; (ii) Asia-Pacific banks; and (iii) extra-large banks. While this impact is weakened in the presence of (i) high-ability managers; (ii) optimistic CEOs; and (iii) banks with their country of origin in one of the advanced economies. These findings have interesting recommendations for bank regulators, managers, and policymakers