Bank diversification, competition and liquidity creation: Evidence from Malaysian banks

Abstract

This paper examines the effect of bank competition on bank liquidity creation and explores whether the effect varies by the diversification level of banks, using a sample of Malaysian banks from 2001 to 2017. Our preliminary analysis shows that the aggregate, on- and off-balance sheet liquidity creation of banks decreases when their market power drops, suggesting an adverse effect of bank competition on bank liquidity creation. However, the adverse effect diminishes or disappears for highly diversified banks, and this result holds for both asset and income diversification. The results identify diversification as a "buffer" through which banks could insure their liquidity creation business against competition by generating new income sources for the banks and enhancing their tolerance to intermediation margin compression.