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Financial Crises and Bank Liquidity Creation
Allen N. Berger † and Christa H.S. Bouwman ‡

October 2008

Financial crises and bank liquidity creation are often connected. We examine this connection from two perspectives. First, we examine the aggregate liquidity creation of banks before, during, and after five major financial crises in the U.S. from 1984:Q1 to 2008:Q1. We uncover numerous interesting patterns, such as 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. Banking and market-related crises differ in that banking crises were preceded by abnormal positive liquidity creation, while market-related crises were generally preceded by abnormal negative liquidity creation. Bank liquidity creation has both decreased and increased during crises, likely both exacerbating and ameliorating the effects of crises. Off-balance sheet guarantees such as loan commitments moved more than on-balance sheet assets such as mortgages and business lending during banking crises.

Second, we examine the effect of pre-crisis bank capital ratios on the competitive positions and profitability of individual banks during and after each crisis. The evidence suggests that high capital served large banks well around banking crises – they improved their liquidity creation market share and profitability during these crises and were able to hold on to their improved performance afterwards. In addition, high-capital listed banks enjoyed significantly higher abnormal stock returns than low-capital listed banks during banking crises. These benefits did not hold or held to a lesser degree around marketrelated crises and in normal times. In contrast, high capital ratios appear to have helped small banks improve their liquidity creation market share during banking crises, market-related crises, and normal times alike, and the gains in market share were sustained afterwards. Their profitability improved during two crises and subsequent to virtually every crisis. Similar results were observed during normal times for small banks.

University of South Carolina, Wharton Financial Institutions Center, and CentER – Tilburg University. Contact details: Moore School of Business, University of South Carolina, 1705 College Street, Columbia, SC 29208. Tel: 803-576-8440. Fax: 803-777-6876. E-mail: ‡

Case Western Reserve University, and Wharton Financial Institutions Center. Contact details: Weatherhead School of Management, Case Western Reserve University, 10900 Euclid Avenue, 362 PBL, Cleveland, OH 44106. Tel.: 216-368-3688. Fax: 216-368-6249. E-mail: Keywords: Financial Crises, Liquidity Creation, and Banking. JEL Classification: G28, and G21.

The authors thank Asani Sarkar, Bob DeYoung, Peter Ritchken, Greg Udell, and participants at presentations at the Summer Research Conference 2008 in Finance at the ISB in Hyderabad, the International Monetary Fund, the University of Kansas’ Southwind Finance Conference, and Erasmus University for useful comments.

Financial Crises and Bank Liquidity Creation
1. Introduction
Over the past quarter century, the U.S. has experienced a number of financial crises. At the heart of these crises are often issues surrounding liquidity provision by the banking sector and financial markets (e.g., Acharya, Shin, and Yorulmazer 2007). For example, in the current subprime lending crisis, liquidity seems to have dried up as banks seem less willing to lend to individuals, firms, other banks, and capital market participants, and loan securitization appears to be significantly depressed. This behavior of banks is summarized by the Economist: “Although bankers are always stingier in a downturn, […] lots of banks said they had also cut back lending because of a slide in their current or expected capital and liquidity.”1 The practical importance of liquidity during crises is...
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