Bank Supervision and Liquidity Creation

Abstract

This paper examines whether different supervisory practices affect banks’ liquidity creation. Using a sample of commercial banks in the 27 European countries over 1996-2013, we document a negative association between regulators’ supervisory power and bank liquidity creation. However, the level of liquidity creation is unaffected by market-based monitoring. Further analysis reveals that the quality of the institutional environment and market incentives play a crucial role in explaining the cross-country variation in bank liquidity creation. The results of additional analyses suggest that supervisory power and private monitoring affect bank liquidity creation by mitigating liquidity risk, and these two supervisory practices are complementary mechanisms in reducing bank illiquidity. Overall, the results provide new insights into the design of regulatory and supervisory practices of financial institutions.