Bank Liquidity Creation and Systemic Risk

Abstract

This paper examines the linkage between bank liquidity creation and systemic risk. Using quarterly data on U.S. bank holding companies from 2003 to 2016, we document that liquidity creation decreases systemic risk at the individual bank level after controlling for bank size, asset risk, and other bank-specific attributes. After decomposing systemic risk into bank-specific tail risk and systemic linkage, we find that the riskiness of individual banks is negatively linked to liquidity creation. Nevertheless, our results also demonstrate that liquidity creation strengthens the systemic linkage of individual banks to severe shocks in the financial system. Overall, our empirical findings demonstrate that the level of liquidity creation may have important implications for financial stability and the prudential supervision of financial institutions.

Keywords: bank liquidity creation, systemic risk, systemic linkage, tail risk

JEL Classification: G21, G28, G32