High Liquidity Creation and Bank Failures

Abstract

We formulate the “High Liquidity Creation Hypothesis” (HLCH) that a proliferation in the core activity of bank liquidity creation increases failure probability. We test the HLCH in the context of Russian banking, where many failures occurred albeit not triggered by swings in business cycles or an exogenous shock such as a crisis. Using Berger and Bouwman (2009) liquidity creation measures, we find that high liquidity creation is associated with greater probability of bank failure and this finding survives multiple robustness checks. Our results suggest that regulatory authorities can mitigate systemic distress and reduce the costs to society from bank failures through early identification of high liquidity creators.