Cyclicality of Liquidity Creation: Non-linear Evidence from US Bank Holding Companies

Abstract

Using panel smooth transition regression framework on a new proxy of business cycle (BC) index and quarterly data of US bank holding companies from 1993Q1 to 2020Q1, our results provide the empirical support to the theory that BC has non-linear effect on liquidity creation. We find a positive and highly significant non-linear effect of BC on liquidity creation, which not only supports the pro-cyclicality of liquidity creation but also improves the liquidity creation estimation compared to the existing studies. The results are robust to different proxies of BC and model specifications. We also document that the US bank holding companies involve in higher magnitude of liquidity creation during the expansion phase (normal times) compared to recession phase (crisis times) of the BC, suggesting an asymmetrical effect of BC changes on liquidity creation. Our findings have important implications for financial market participants by suggesting to keep alternative sources of funding in hand during the recession phase of BC. The insights from study also provide policy implications for central banks and prudent supervisors to consider incentivizing the banks for instance by lowering the regulatory requirements, adjusting the policy rate or through any other quantitative easing policy during recession phase of BC to keep the financial system efficient.

Keywords: Bank holding company; Liquidity creation; Business cycle; Panel smooth transition regression

JEL Classification: G21, O40, O43