Examining the impacts of bank competition and stock market liquidity on bank liquidity creation: evidence from Malaysia

Abstract

Standard bank liquidity creation theory asserts that banks create liquidity by issuing credit for liquidity-constrained agents who have production opportunities with returns increasing on the investment horizon, and in the meantime, allowing prompt deposit withdrawals by agents who wish to invest their excess liquidity, but face random future consumption shocks. By holding illiquid non-monetary assets on behalf of the public, banks bestow upon the economy new liquidity created for economic development activities. A well-functioning liquidity creation role of banks is thus of vital importance in promoting the long-run economic growth of a country, particularly a country that adopts a bank-oriented financial system. Commercial banks in Malaysia have faced a formidable increase in competitive pressure exerted from both within the banking industry and the domestic stock market since the 1990s, a process triggered by financial liberalisation, innovation and disintermediation. These developments have drawn attention to the influences of bank competition and stock market liquidity on the liquidity creation role of commercial banks in the country. The extant theoretical literature has enhanced our understanding of the relationships between bank competition and bank liquidity creation and between stock market liquidity and bank liquidity creation, and very often, the relationships come from two contradictory directions and are empirically inconclusive for countries that remain unexamined. Hence, this study aims to examine the relationship of bank competition and stock market liquidity on liquidity creation by Malaysian commercial banks. The study also investigates how the bank competition-liquidity creation relationship differs by bank size, given consideration of the discernible differences in the type of lending technology specialisation and capacity between large and small banks. To address the research objectives, a fixed effects estimator is employed on a panel dataset of Malaysian commercial banks for the period 2001 to 2013. This study documents several key findings. First, when facing a rise in bank competition small banks cut down their liquidity creation through both on-balance sheet and off-balance sheet activities. Credit rationing is more severe for small banks that have lower market power, in particular, by reducing their specialised soft lending arrangements to informationally-opaque or risky customers to avoid bearing costly information production and customer monitoring. Second, large banks that encounter greater competition tend to increase liquidity creation mainly through on-balance sheet activities. The specialisation in hard lending technologies and the strong capacity of large banks, for example, in terms of extensive branch networks, technology diffusion and capital, provide possible explanations for the ability of the large banks to tolerate a lower interest spread to leverage their liquidity creation business in existing and new market segments. Third, this study finds that a negative bank competition-liquidity creation relationship dominates the Malaysian commercial banking industry, which implies that banks take informational asymmetry-related costs into greater consideration in their lending decisions when competition increases. Another possible explanation for the moderation of bank liquidity creation is greater income diversification from interest-based towards fee-based activities in the midst of rising bank competition. Finally, the result shows that increased stock market liquidity does stimulate bank liquidity creation, and such an impact is carried through to both on- and off-balance sheet liquidity creation.