Global Finance Journal 24 (2013) 188202

Contents lists available at ScienceDirect

Global Finance Journal

journal homepage: www.elsevier.com/locate/gfj

Liquidity creation and bank capital structure

in China
Adrian C.H. Lei , Zhuoyun Song
Faculty of Business Administration, University of Macau, Macau

a r t i c l e

i n f o

Article history:
Accepted 8 August 2013
Available online 28 October 2013
JEL classication:
G21
G28
Keywords:
Liquidity creation
Bank capital structure
Financial fragility-crowding-out
Risk absorption
China

a b s t r a c t
This paper investigates the relationship between liquidity creation
and bank capital structure in China. We test the so-called nancial
fragility-crowding out hypothesis and the risk absorption hypothesis on Chinese banks and nd that bank capital is negatively related
to liquidity creation, which supports the nancial fragility-crowding
out hypothesis. In contrast, we nd that foreign banks in China have a
weaker relationship between liquidity creation and bank capital,
which is consistent with the risk absorption hypothesis and ndings
in prior studies.
2013 Elsevier Inc. All rights reserved.

1. Introduction
The Chinese banking system has undergone rapid privatization for the transition from a planned
economy to a socialist market economy.1 Despite this transition, the government still controls major
Chinese banks,2 and, according to the Index of Economic Freedom,3 the Chinese banking system operates
We would like to thank an anonymous referee and the editor (Manuchehr Shahrokhi) for their valuable suggestions that greatly
improved the paper. We are also grateful to the comments made by M.H. Liu, Frank Song, and the participants of AFAANZ 2012 at
Melbourne, Australia. We acknowledge the nancial support from the University of Macau.
Corresponding author. Tel.: +853 8397 4162.
E-mail address: .adrianl@umac.mo (A.C.H. Lei).
1
People's Bank of China was established as a central bank in 1979 and transferred its commercial activities and treasury functions
mainly to the four state-owned commercial banks (SOCBs). In the 1990s, policy banks were established to take over the policy
lending issues of SOCBs, and asset-management companies managed the transfer of the non-performing loans of the SOCBs to
prepare for the privatization of major banks.
2
After the partial privatization, the major banks in China are still controlled by state-based regulatory entities or state-related
corporate entities. See McGuinness and Keasey (2010).
3
This index is compiled by the Heritage Foundation of the US. Here we refer to Financial Freedom, which is the one related to
banking and nance out of the ten economic freedom indicators.
1044-0283/$ see front matter 2013 Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.gfj.2013.10.004

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

189

under extensive government inuence. Berger, Hasan, and Zhou (2009) suggest that China's high growth
rate cannot be sustained if banking reform cannot reach the necessary efciency. Lin and Zhang (2009)
show that the Big Four state-owned banks are less efcient and less protable than other types of banks.
China's institutional settings thus may impair banks' qualitative asset transformation function, which is
essential for the existence of nancial intermediaries (Bhattacharya & Thakor, 1993). It is unclear,
however, how banks create liquidity under the government's strong inuence.
Banks create liquidity in two ways: through transforming illiquid assets to liquid liabilities (Diamond &
Dybvig, 1983) or through off-balance-sheet activities, such as loan commitments and lines of credit
(Kashyap, Rajan, & Stein, 2002). Banks' role as risk transformers has been well studied in the past, and
recent studies focus on the role of liquidity creators. Deep and Schaefer (2004) construct liquidity creation
measures that focus purely on maturity transformation and include onbalance sheet activities only. Later,
Berger and Bouwman (2009) further investigate the measurement that is based on categories of assets,
liabilities, equity, and off-balance-sheet issues and analyze US banks' liquidity creation. Their new liquidity
creation measures enable the quantitative examination of liquidity creation in China.
The so-called nancial fragility-crowding out hypothesis (Diamond & Rajan, 2000, 2001; Gorton &
Winton, 2000) and the risk absorption hypothesis (Berger & Bouwman, 2009) explain the relationships
between the bank capital ratio and liquidity creation. Banks' nancial fragility-crowding out hypothesis
argues that under a fragile bank structure (i.e., with lower bank capital), banks expend more effort to
provide funds and therefore create more liquidity. Also, higher capital ratios reduce liquidity creation by
shifting investors' funds from liquid deposits to relatively illiquid bank capital. The risk absorption
hypothesis argues that higher capital ratios expand banks' risk-bearing ability, and thus banks can create
more liquidity (e.g., Bhattacharya & Thakor, 1993; Coval & Thakor, 2005; Repullo, 2004; Von Thadden,
2004). Banks' liquidity creation exposes banks to risk, and thus it is associated with greater likelihood and
severity of losses (e.g., Allen & Gale, 2004; Allen & Santomero, 1997; Diamond & Dybvig, 1983). The effects
of these hypotheses, however, are unknown in the setting of the Chinese banking system, which consists
mainly of marketized state-owned banks. If bank capital ratios affect liquidity creation, then what would
be the potential impact of liquidity creation on these banks?
To explore the effects of the nancial fragility hypothesis and the risk absorption hypothesis in China's
banking market, we use annual bank data from China over the 19882009 period and estimate liquidity
creation, following Berger and Bouwman (2009). Our results show that the capital ratio and liquidity
creation are negatively related, supporting the fragility crowding-out hypothesis for banks in China. Also,
consistent with Berger and Bouwman (2009), we nd that foreign banks exhibit a less negative relation
between bank capital and liquidity creation. These results suggest that the effect of risk absorption is still
important in foreign banks of China, nullifying the effect of nancial fragility.
This study contributes in several ways to the banking literature and policy implementation in China. To
the best of our knowledge, we are the rst to estimate a detailed quantitative measure of the liquidity
creation of all Chinese banks. We show that the effects of liquidity creation on the policy-oriented banking
system are different from those on the market-based banking system. Raising the capital reserve ratio
would negatively affect liquidity creation, because our results are tilted towards predictions of the
nancial fragility-crowding out hypothesis. And consistent with Berger and Bouwman (2009), we nd
that the risk absorption hypothesis still signicantly inuences foreign banks in China.
The remainder of the paper is organized as follows. Section 2 presents the related literature and
develops the hypotheses. Section 3 describes the data and methodology. Section 4 discusses the empirical
results. Section 5 presents the conclusion.
2. Literature review and hypothesis development
Based on liquidity creation theory, Berger and Bouwman (2009) suggest that when banks transform
illiquid assets into liquid liabilities, or nance illiquid assets with liquid liabilities, they function as liquidity
creators. The intuition is that banks create liquidity when they hold illiquid items for the nonbank public
and provide the public with liquid liabilities. For example, when banks absorb corporate long-term loans
using savings deposits, they transform illiquid items (i.e., long-term corporate investments) into liquid
ones (i.e., saving deposits) for the nonbank public, which creates liquidity. Alternatively, when banks issue
long-term subordinated debt to hold marketable securities, they transform liquid items (i.e., marketable

190

Variables

Denition

Sources

Dependent variables
LC / TA cat fat
LC / TA cat nonfat

Measure of liquidity creation under the cat fat method divided by total assets
Measure of liquidity creation under the cat nonfat method divided by total assets

BankScope
BankScope

Bank capital ratio

EQ / TA

The ratio of total equity to total assets

BankScope

Bank management efciency

CO/INC
Cost to income ratio

BankScope

Bank size
Ln(TA)

Natural log of total assets to represent bank sizes

BankScope

BankScope

CREDITRISK
ZSCORE

The standard deviation of annual return on assets over previous 5 years. If there is no such long previous
years' period, it is calculated based on previous available years' data.
The sum of the risk-weighted assets and off-balance-sheet activities divided by total assets
The sum of return on assets and equity / TA ratio divided by the standard deviation of annual return on assets

Banking governance
DPS / TA
NL / TA
GL-GROWTH

Total deposits divided by total assets

Net loans divided by total assets
Gross loans growth rate

BankScope
BankScope
BankScope

Bank risk
Y-STD

BankScope
BankScope

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

Table 1
Denitions and sources of the regression variables.
This table provides the denitions and sources for all the regression variables, including dependent and independent variables. They are all calculated in nominal values for each year. LC / TA cat fat
equals to liquidity-creation (LC) over total assets (TA), where the LC is based on the activities categories (cat) including off-balance-sheet activities (fat) and LC / TA cat nonfat excludes
off-balance-sheet activities (cat nonfat).

Local market competition

HHI
Bank-level Herndahl index based on the deposits share
ML-SHARE
The share of medium and large banks' deposits to total deposits

BankScope
BankScope

Bank types
State-owned banks
Foreign banks
Domestic banks
D-M&A

Almanac of China's Finance and Banking

Almanac of China's Finance and Banking
Almanac of China's Finance and Banking
BankScope

D-LISTED

Dummy variable that is used to check whether the bank is a state-owned commercial bank; if yes = 1, otherwise = 0
Dummy variable that is used to check whether the bank is a foreign bank; if yes = 1, otherwise = 0
Dummy variable that is equal to one if the bank is not a state-owned, foreign or policy bank
Dummy variable that is used to check whether the bank has a merger and acquisition history over the previous 3 years;
if yes = 1, otherwise = 0
Dummy variable that is used to check whether the bank is a bank listed in the stock market; if yes = 1, otherwise = 0

Almanac of China's Finance and Banking

(IMF) Balance of Payments (BOP) Statistics

General local economy

GNI-GROWTH
Ln(POP)
GDP-GROWTH
Ln(M1)

(IMF) International Financial Statistics (IFS)

World Economic Outlook
(IMF) International Financial Statistics (IFS)
National Bureau of Statistics of China

DPSR
Banking reform
D1995
D2001

Annual nominal growth rate of gross national income GNI

Natural log of population
Annual nominal growth rate of gross domestic product GDP
Natural log of that sum of legal tender notes and coins held by the public, plus customers demand deposits placed
with licensed banks
Deposit rate at the end of each year

Dummy variable that is used to indicate the year of the time period of the observation; if in between
year 1995 and 2001 = 1, otherwise = 0
Dummy variable that is used to indicate the year of the time period of the data; if in or after
year 2001 = 1, otherwise = 0

Fixed and random effects

Time xed effects
Dummies for all time but one
Bank xed effects
Dummies for all banks but one

(IMF) International Financial Statistics (IFS)

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

Financial market openness

BOR
Benet of openness ratio, measured as the share of income inow to the share to income outow in the country's global trades

191

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securities) into illiquid ones (i.e., subordinated debt for the public), which destroys the liquidity. Finally,
when banks use savings deposits to buy securities, they transform liquid assets into liquid liabilities, and
liquidity remains unchanged. Banks create economic value through this transformation of illiquid assets
into liquid liabilities.
There are two mainstream hypotheses related to bank capital and liquidity creation: the nancial
fragility-crowding out hypothesis and the risk absorption hypothesis. The nancial fragility-crowding
out hypothesis suggests that when a bank's capital structure is fragile, it will cause the bank to monitor its
borrowers more, and then the bank can extend loans and create more liquidity. Diamond and Rajan (2000,
2001) point out that having more bank capital will make the bank's capital structure less fragile and thus
inhibit liquidity creation. Gorton and Winton (2000) argue that as capital and deposits are crowding out,
more capital will reduce deposits and cause a decrease of liquidity creation. Some empirical studies also
nd that leverage requirements lead to a decrease in bank loans, which suggests a negative relationship
between bank capital and liquidity creation (Berger & Udell, 1994; Hancock, Laing, & Wilcox, 1995; Peek &
Rosengren, 1995). Berger and Bouwman (2009) apply this hypothesis to test small banks. They argue that
small banks need to monitor borrowers more, because their borrowers are usually smaller with higher
risks, which is consistent with Diamond and Rajan (2000, 2001), and small banks' sources of funds are
mainly local residents and corporations; thus the crowding-out effect between capital and deposits may
be signicant, as in Gorton and Winton (2000).
The risk absorption hypothesis suggests that banks are able to absorb more risk with more capital, and
thus they create more liquidity when they have higher risk tolerance (Allen & Gale, 2004; Allen &
Santomero, 1997; Bhattacharya & Thakor, 1993; Coval & Thakor, 2005; Repullo, 2004; Von Thadden,
2004). Several empirical studies nd that the decrease in bank capital ratios incurred from loan losses
reduces lending (e.g. Peek & Rosengren, 1995). This hypothesis suggests a positive relationship between
capital and liquidity creation. Berger and Bouwman (2009) nd supporting evidence for this hypothesis in
large US banks. Large Chinese banks, however, even though privatized, are backed by the government,
because the Chinese government is still the largest shareholder of these banks. Therefore, the role of
capital to absorb risk and create liquidity may not apply to China's large banks. We expect that the
nancial fragility crowding-out effect dominates China's banks.
Hypothesis 1. The nancial fragility-crowding out hypothesis dominates Chinese banks' liquidity
creation. Bank capital is negatively related to liquidity creation for banks in China.
Foreign banks in China are mainly global banks, such as JP Morgan Chase, Citibank, and HSBC. Others
are major banks from Hong Kong. These banks may not be backed by the Chinese government if they run
into nancial distress. Furthermore, providing loans in China is generally considered higher risk than other
developed markets. Also, Berger and Bouwman (2009) nd that large banks' liquidity creation is
dominated by the risk absorption effect. Therefore, we expect that the risk absorption effect should have
greater inuence on the liquidity creation of foreign banks.
Hypothesis 2. For foreign banks, the negative relationship of liquidity creation and bank capital is
reduced because of the risk absorption effect.

3. Data and methodology

3.1. Data
In our study, we use the annual bank data of China over the 19882009 period from BankScope. All
variables are winsorized at the 1st and 99th percentiles to reduce the impact of outliers. We drop
observations that do not have time-series to run the xed-effects model (i.e., banks that have only a
single-year observation). Our sample contains 4 state-owned commercial banks (SOCBs) with 64
observations, 113 domestic banks with 694 observations, and 18 foreign banks (FB) with 78 observations.
Note that the decrease in the number of banks for 2008 and 2009 is because of unavailable data, especially
for the small banks city commercial banks, and not because of mergers or defaults. There are 836
bank-year observations in our full sample.

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193

We use unconsolidated statements whenever they are available. Otherwise, we refer to the consolidated
statements.4 Unconsolidated data are preferred because they have more detailed categories than consolidated
data. Also, we can analyze based on banks instead of groups. Macroeconomic variables are obtained from
International Monetary Funds' (IMF) World Economic Outlook (WEO), International Financial Statistics (IFS),
and Balance of Payments Statistics (BOPS) databases, including gross domestic product (GDP) growth, gross
national income (GNI) growth, ination, population, exchange rate, and balance of national payments. Table 1
lists the main regression variables, sources of data, and brief descriptions.
3.2. Construction of liquidity-creation measures
We construct two alternative liquidity-creation measures, according to Berger and Bouwman (2009).
First, bank-balance-sheet and off-balance-sheet activities are classied as liquid, semi-liquid, or illiquid.
Second, activities are classied and weighted, following the liquidity-creation intuition. Third, activities
are combined as classied and weighted to construct two liquidity-creation measures: One includes
off-balance-sheet activities (cat fat), and the other excludes them (cat nonfat). Because of data availability,
we calculate only the two measures that are based on the activities categories.5 Nevertheless, of the
measures based on the activities category, including the off-balance-sheet item, the cat fat measure is
preferred. This is because how costly, timely, and easy it is to dispose of obligations on the asset side is
more important than the time until self-liquidation (maturity). Table 2 Panel A illustrates how bank
activities are classied and weighted. Panel B illustrates the calculations of cat fat and cat nonfat.
3.3. Liquidity creation over time and in the cross section for different bank sizes
We sort the total assets of all banks and dene the banks with total assets (TA) under $1 billion as
small banks, over $3 billion as large banks, and those in between as medium banks.6 We split the sample
by bank type to test the nancial fragility crowding-off hypothesis and the risk absorption hypothesis,
similar to Berger and Bouwman (2009).
After calculating the liquidity creation (LC) by cat fat and cat nonfat methods, we explore the change of
liquidity creation and how it varies for the subsamples of different bank sizes and types. Table 3 summarizes the
entire bank liquidity creation in China based on the cat fat method, using the 1988, 1998, and 2008 data. In
1988, only 7 commercial banks are available. This restricts the feasibility of analyzing liquidity over the long
horizon from the 1980s. Following rapid growth in 1998, there are 27 banks, and this number increases to 94 in
2008. Liquidity creation increases from 22 billion RMB in 1988 to 2463 billion RMB in 1998 to 11,404 billion
RMB in 2008. Fig. 1 shows the rapid increase of liquidity creation over the two decades. Also around the major
banking reform, there are substantial changes of liquidity creation, suggesting the possible effect of banking
reform on the nancial system. With the rst bank reform, liquidity creation begins to grow slowly starting in
1995, which is brought about mainly by large banks. After the second reform, liquidity creation grows rapidly.
In 2008, large banks still maintain over 80% of the share of liquidity creation.
The trends for liquidity creation / total assets (LC / TA) and liquidity creation / total equity (LC / EQ)
are different, however. The ratios increase in the rst 10 years (e.g., LC / TA increases from 0.24 to 0.32)
and decrease in the second 10 years (e.g., LC / TA decreases from 0.32 to 0.28), which indicates that the
liquidity creation per asset or equity, or the efciency of liquidity creation, is stagnant in the recent decade,
compared with the expanding total liquidity creation.
For the bank-size subsamples, we can observe that the number of banks for each size increases
substantially, especially the number of small banks, nowadays 11 times as many as that in 1998. Liquidity
creation of cat fat and cat nonfat seems to be consistent across different bank sizes. It seems that
4
Among the total 145 banks, 17 lack unconsolidated data. They are: Agricultural Bank of China Limited, Bank of Chongqing, Bank
of Dalian, Bank of Jilin Co., Ltd., China CITIC Bank, Corporation Limited, China State Bank, Ltd., Xiamen International Bank, Bank of
Communications Co., Ltd., Bank of Luoyang Co., Ltd., and Bank of Weifang Co., Ltd.
5
Berger and Bouwman (2009) develop four measures, the two are based on the activities category and the others are based on
activities maturity.
6
The $3 billion and $1 billion cutoffs are determined with reference to Berger and Bouwman's (2009) ndings. The cutoffs are
based on 1987 real dollar values; then we adjust the cutoff points with the nominal GDP growth of China per year and the exchange
rate for US dollars per RMB. In each year, we separate the banks into small, medium, and large banks in our sample.

194

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

Table 2
Liquidity classication of bank activities and construction of two liquidity creation measures.
Step 1: Bank activities are classied as liquid, semiliquid, and illiquid, based on the activities category in Panel A.
Step 2: We assign weights to all bank activities classied in Step 1. Based on the liquidity-creation theory, banks create liquidity on
the balance sheet when they transform illiquid assets into liquid liabilities. According to Berger and Bouwman (2009), when banks
transform $1 of illiquid assets into $1 of liquid liabilities, that $1 of liquidity is created. Thus, they assign a weight of 1/2 for illiquid
assets and liquid liabilities, since the amount of liquid created is only half by the use of the funds alone both are needed to create
one liquidity. Similarly, they apply a weight of 1/2 to liquid assets, illiquid liabilities, and equity. By transferring $1 of liquid
assets into $1 of illiquid liabilities, $1 of liquidity is destroyed. The semi-liquid items are weighted to 0, and 1/2 to illiquid
off-balance-sheet activities.
Step 3: We combine the bank activities classication in Step 1 with weights in Step 2 in two ways to construct liquidity-creation
measures by using the cat based on the activities category, and by alternatively including off-balance-sheet activities (fat) or
excluding these activities (nonfat), which is in Panel B.
Panel A: Liquidity classication of bank activities
Illiquid assets (weight = 1/2)

Semiliquid assets (weight = 0)

Liquid assets (weight = 1/2)

Assets
Corporate & commercial loans
Investments in property

Residential mortgage loans

Other mortgage loans

Cash and due from banks

Trading securities and at fv
through income
Tradable derivatives
Available-for-sale securities
Held to maturity securities
At-equity investments in associates
Other securities

Foreclosed real estate

Fixed assets
Goodwill
Other intangibles
Other assets

Other consumer/retail loans

Loans and advances to banks
Reverse repos and cash collateral

Liabilities plus equity

Liquid liabilities (weight = 1/2)
Customer deposits current
Customer deposits savings
Tradable derivatives
Trading liabilities

Off-balance-sheet activities
Illiquid activities (weight = 1/2)
Acceptances and documentary credits
reported off-balance-sheet
Committed credit lines
Other contingent liabilities

Semiliquid liabilities (weight = 0)

Customer deposits term
Deposits from banks
Repos and cash collateral
Other deposits and short-term
borrowings
Fair value portion of debt

Semiliquid activities (weight = 0)

Managed securitized assets reported
off-balance-sheet
Other off-balance-sheet exposure
to securitizations
Guarantees

Illiquid liabilities plus equity

(weight = 1/2)
Senior debt maturing after 1 year
Subordinated borrowing
Other funding
Credit impairment reserves
Reserves for pensions and other
Current tax liabilities
Deferred tax liabilities
Other deferred liabilities
Other liabilities
Total equity
Liquid activities (weight = 1/2)

Panel B: cat fat and cat nonfat formulas

Cat fat=

Cat nonfat=

+1/2 * illiquid assets

+1/2 * liquid liabilities

+0 * semiliquid assets
+0 * semiliquid liabilities

+1/2 * illiquid activities

+1/2 * illiquid assets
+1/2 * liquid liabilities

+0 * semiliquid activities
+0 * semiliquid assets
+0 * semiliquid liabilities

1/2
1/2
1/2
1/2
1/2
1/2
1/2

*
*
*
*
*
*
*

liquid assets
illiquid liabilities
equity
liquid activities
liquid assets
illiquid liabilities
equity

mid-size banks are the most efcient in creating liquidity, as their LC / TA is the largest. For the bank-type
subsamples, as expected, the state-owned banks, even though there are only four of them, are the major
creators of liquidity in China.

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

195

Table 3
Summary of bank liquidity creation in China.
This table shows liquidity creation (LC) in RMB million and divided by total assets (LC / TA) and total equity (LC / EQ) for 1988,
1998, and 2008. The LC RMB mil presented are the total volumes for that sample, respectively, and the LC ratios including LC / TA and
LC / EQ are the mean values of that sample. We sort the gross total assets of all banks and dene the banks with total assets (TA)
under $1 billion as small banks. All banks with over $3 billion are dened as large banks, and the others are medium banks. The
bank-types are dummy variables for Domestic banks, State-owned banks, and Foreign banks. Cat fat and cat nonfat methods are
two methods that measure liquidity creation, which classify all bank activities based on product category. The cat nonfat liquidity
creation measures include (exclude) off-balance-sheet activities. The $3 billion and $1 billion cutoffs are estimated with reference to
Berger and Bouwman (2009).
Liquidity creation measure

Cat fat

All banks
Large
Medium
Small
Foreign
Domestic
State-owned
Cat nonfat All banks
Large
Medium
Small
Foreign
Domestic
State-owned

1988 liquidity creation

1998 liquidity creation

2008 liquidity creation

N LC RMB LC / TA LC / EQ
bil

7
3
4

22
13
8

0.24
0.24
0.24

3.17
3.79
2.70

27 2463
12 2317
10
137
5
9

0.32
0.32
0.33
0.31

4.45
5.25
4.41
2.60

22

0.24

3.17

7
3
4

14
8
6

0.15
0.15
0.15

2.03
2.48
1.70

23
405
4 2059
27 2101
12 1969
10
124
5
8

0.33
0.37
0.29
0.28
0.30
0.29

4.60
5.95
4.11
4.75
4.12
2.54

14

0.15

2.03

23
364
4 1737

0.31
0.32

4.26
5.02

LC RMB LC / TA LC / EQ
bil

LC RMB LC / TA
bil

94 11403
18 10366
20
683
56
355
17
261
73
3706
4
7408
94
8732
18
7903
20
545
56
283
17
219
73
2585
4
5900

0.28
0.28
0.34
0.25
0.32
0.31
0.24
0.21
0.21
0.28
0.19
0.27
0.22
0.19

LC / EQ
4.27
5.89
5.25
3.50
3.22
5.66
4.07
3.30
4.29
4.11
2.72
2.69
3.95
3.24

Comparing the gures of liquidity creation in China with Berger and Bouwman's (2009) US results, the
LC / TAs are around 0.3 in China, which is relatively smaller than the United States' 0.4.7 The LC / EQs,
which are around 4 to 6 in China, however, are much larger than the US banks' 3 to 5 in 2008, but very
similar to the US banks' LC / EQ in 1993. These gures indicate that the base of total assets for Chinese
banks is a bit larger relative to liquidity creation, while the total equity is smaller, compared with those of
US banks. This is consistent with the argument that bank equity is abnormally small for Chinese banks
(Garca-Herrero, Gavil, & Santabrbara, 2009), and it seems that the liquidity-creation speed cannot
match the growth of bank sizes.

3.4. Regression framework

To test the effect of bank capital on liquidity creation, we employ the following model, similar to that of
Berger and Bouwman (2009). The model is as follows:

Lit c 1 EQ =TAit1 it1 ;

where Lit is liquidity creation divided by total assets of ith bank at time t, with i = 1,, N, and t = 1,, T.
We use lagged variables for all of the independent variables to mitigate endogeneity problems, yet we do
not establish a causal claim and interpret the results with care. (EQ / TA)it 1 is the lagged one-period
total equity divided by total assets, and it 1s are the lagged one-period control variables, including bank
size Ln(TA), bank risk Y-STD, CREDITRISK, ZSCORE, merger and acquisition history D-M&A, local market
competition HHI, ML-SHARE, and local market economic environment, such as population Ln(POP) and
GNI growth GNI-GROWTH. Detailed denitions are displayed in Table 1.
7

Details about liquidity creation in the United States are available in Page: 11Berger and Bouwman (2009, table 2).

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A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

A: Cat fat liquidity-creation measure with and without equity effects10

B: Cat nonfat liquidity creation measure with and without equity effects

Fig. 1. Liquidity creation under cat fat and cat nonfat measures over the sample period. The sample contains all commercial banks
in China from 1988 to 2009. Panel A shows the rst liquidity-creation measure using the cat fat method, where cat fat denes loans
with category, not maturity, and includes loan commitments and off-balance-sheet activities in China. The measure in the left graph
contains equity effects, and the right one excludes equity.8 Panel B shows the second liquidity-creation measure calculated by the cat
nonfat method, where cat nonfat also differs according to loans based on category, while excluding off-balance-sheet activities. The
vertical lines represent the start of a major banking reform. All calculating values are expressed in nominal terms.

3.5. Descriptive statistics

Table 4 shows the summary statistics of all variables in our regression models, before and after
winsorization. Table 5 is the correlation matrix of key variables. Correlations larger than an absolute value
of 0.50 are in bold in Table 5.
HHI, ML-SHARE, and Ln(POP) are highly correlated, because they are all related to market competition.
Following the model described in Berger and Bouwman (2009), we include all three variables in our
models. In addition, we test these models by dropping one or both of the variables that are collinear, and
the coefcients on our main variables in all the following models are mostly similar. So even though

8
The equity effect includes means conferring the weight of 1/2 to equity to calculate liquidity creation. The right-graph
liquidity-creation measure is without setting 1/2 for equity.

Variables

Observations

LC cat fat
LC cat nonfat
LC / TA cat fat
LC / TA cat nonfat
NIM
ROA
EQ / TA
CO / INC
Ln(TA)
Y-STD
CREDITRISK
ZSCORE
DPS / TA
NL / TA
GL-GROWTH
D-M&A
D-LISTED
HHI
ML-SHARE
BOR
GNI-GROWTH

836
836
836
836
836
836
836
830
836
836
836
836
834
836
725
836
836
836
836
836
836

Unwinsorized data

Winsorized data

Mean

Median

Maximum

Minimum

Std. dev.

Mean

Maximum

Minimum

Std. dev.

122339
102607
0.369
0.314
2.713
0.00774
0.07
48.06
10.52
0.303
0.271
0.64
0.871
0.524
0.222
0.311
0.0478
0.178
0.976
2.509
0.159

10760
8833
0.377
0.325
2.56
0.00715
0.0565
42.94
10.36
0.239
0.119
0.309
0.906
0.524
0.198
0
0
0.151
0.971
1.986
0.171

3238000
2723000
0.948
0.921
9.41
0.0314
0.591
350.8
16.28
2.729
6.624
11.41
1.101
0.966
0.99
1
1
0.339
1
9.302
0.364

99062
99062
0.413
0.413
0.17
0.0653
0.137
2.03
0.923
0.00707
0
0.372
0.00339
0.0732
0.482
0
0
0.134
0.965
0.315
0.0636

398234
344685
0.2
0.194
1.141
0.00633
0.0606
21.22
2.206
0.296
0.388
1.101
0.109
0.109
0.211
0.463
0.214
0.055
0.0116
2.202
0.0601

118506
98637
0.369
0.314
2.699
0.00786
0.0695
47.47
10.52
0.295
0.264
0.625
0.873
0.524
0.223
0.311
0.0478
0.178
0.976
2.509
0.159

2394000
2058000
0.804
0.743
6.68
0.0235
0.363
95.32
15.76
1.201
1.07
6.194
0.971
0.838
0.864
1
1
0.339
1
9.302
0.364

7349
8352
0.253
0.27
0.73
0.0049
0.0121
17.62
2.286
0.01
0
0.0344
0.466
0.258
0.203
0
0
0.134
0.965
0.315
0.0636

371746
317050
0.195
0.189
1.064
0.00553
0.0529
16.8
2.174
0.248
0.316
0.993
0.0915
0.106
0.206
0.463
0.214
0.055
0.0116
2.202
0.0601

197

(continued on next page)

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

Table 4
Summary statistics of the regression variables.
This table provides summary statistics of all the regression variables. We drop the observations that do not have time-series to run the xed-effects model (i.e., banks that have only a single-year
observation). The remaining observations in our sample are 836 over the 19882009 period. All variables are winsorized at the 1st and 99th percentiles. We display the unwinsorized and
winsorized summary statistics, and the medians for winsorized variables are omitted as they are of the same value.Liquidity creation measures are as follows: (1) LC cat fat and LC cat nonfat, the
liquidity creation volumes measured by cat fat and cat nonfat methods, respectively; and (2) LC / TA cat fat and LC / TA cat nonfat, the liquidity creation divided by total assets. Performance
measures are: (1) NIM, net interest margin, and (2) ROA, return on average assets.
EQ / TA is the capital ratio, measured as total equity divided by total assets. Ln(TA) is bank size, measured as natural log of total assets. Y-STD is the standard deviation of return on assets.
CREDITRISK is a credit risk measure, calculated as the bank's risk-weighted assets and off-balance-sheet activities divided by total assets. ZSCORE is the sum of return on assets and the equity / TA
ratio divided by the standard deviation of annual return on assets. DPS / TA is total deposits divided by total assets. NL / TA is net loans divided by total assets. GL-GROWTH is growth of gross loans.
D-M&A is a dummy that equals to 1 if the bank was involved in mergers and acquisitions over the past 3 years. D-LISTED is a dummy that equals to 1 if the bank is listed on the stock market. HHI is a
bank-level Herndahl index based on deposits. ML-SHARE is the share of large and medium banks' deposits to the total deposits in the market. BOR is the benet-of-openness ratio, measured as the
share of income inow to the share to income outow in the country's global trades. GNI-GROWTH is the growth of gross national income in China. Ln(POP) is the natural log of population.
GDP-GROWTH is the growth of the gross domestic product. Ln(M1) is the natural log of M1, the sum of legal tender notes and coins held by the public plus customers' demand deposits placed with
licensed banks. DPSR is the annual deposit rate at the end of each year. PB, SOCB, JSCB, and FB are the dummies that equal to 1 if the banks are Policy banks, State-owned commercial banks, Joint
stock commercial banks, or Foreign banks; if the above 4 dummies are all equal to 0, the bank is a city commercial bank. All variables are measured in nominal values, and currency units are in terms
of RMB.

198

Variables

Observations

Unwinsorized data
Mean

Ln(POP)
GDP-GROWTH
Ln(M1)
DPSR
FB
JSCB
SOCB
PB

836
836
836
836
836
836
836
836

7.165
10.55
9.061
0.0343
0.123
0.207
0.0766
0.00598

Winsorized data

Median
7.179
10.03
9.281
0.0225
0
0
0
0

Maximum
7.205
14.24
9.999
0.113
1
1
1
1

Minimum
7.009
3.837
6.308
0.0198
0
0
0
0

Std. dev.
0.0395
2.193
0.793
0.0234
0.329
0.405
0.266
0.0772

Mean
7.166
10.55
9.061
0.0343
0.123
0.207
0.0766
0.00598

Maximum
7.205
14.16
9.999
0.11
1
1
1
1

Minimum
7.026
4.066
6.368
0.0198
0
0
0
0

Std. dev.
0.0391
2.186
0.792
0.0233
0.329
0.405
0.266
0.0772

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

Table 4 (continued)

Table 5
Correlation matrix of the regression variables.
This table provides correlations of all the regression variables. Some observations that display 1.00 are not perfectly collinear, but instead are a result of rounding.
Figures in bold are correlations large than 0.5.

BOR
GNI-GROWTH
Ln(POP)
NIM
ROA
NL / TA
GL-GROWTH
DPS / TA
D-LISTED
DPSR
Ln(M1)

LC / TA cat fat

LC / TA cat nonfat

EQ / TA

CO / INC

Y-STD

CREDITRISK

ZSCORE

Ln(TA)

D-M&A

HHI

ML-SHARE

GDP-GROWTH

1
0.94
0.27
0.06
0.07
0.15
0.11
0.01
0.07
0.15
0.30
0.19
0.01
0.07
0.13
0.02
0.12
0.28
0.01
0.39
0.06
0.17
0.10

1
0.30
0.01
0.08
0.03
0.09
0.00
0.02
0.10
0.27
0.15
0.04
0.03
0.10
0.00
0.14
0.24
0.01
0.37
0.11
0.18
0.07

1
0.39
0.46
0.00
0.04
0.28
0.14
0.11
0.16
0.15
0.06
0.11
0.04
0.00
0.12
0.06
0.08
0.48
0.05
0.03
0.03

1
0.33
0.16
0.04
0.14
0.23
0.23
0.21
0.33
0.05
0.31
0.23
0.27
0.67
0.10
0.33
0.18
0.12
0.17
0.24

1
0.05
0.35
0.21
0.08
0.03
0.02
0.13
0.13
0.13
0.15
0.17
0.07
0.10
0.11
0.10
0.04
0.12
0.16

1
0.09
0.09
0.23
0.32
0.27
0.20
0.02
0.12
0.31
0.22
0.10
0.24
0.03
0.13
0.22
0.12
0.32

1
0.05
0.10
0.08
0.06
0.01
0.06
0.05
0.14
0.12
0.07
0.01
0.03
0.12
0.07
0.12
0.14

1
0.25
0.04
0.06
0.04
0.00
0.02
0.00
0.09
0.02
0.05
0.06
0.06
0.36
0.02
0.01

1
0.44
0.38
0.16
0.08
0.08
0.42
0.03
0.01
0.07
0.05
0.22
0.26
0.26
0.42

1
0.81
0.33
0.07
0.13
0.83
0.09
0.10
0.17
0.06
0.33
0.17
0.58
0.82

1
0.50
0.05
0.28
0.78
0.10
0.17
0.24
0.04
0.37
0.10
0.57
0.75

1
0.07
0.79
0.23
0.17
0.15
0.10
0.01
0.15
0.03
0.26
.23

GNI-GROWTH

Ln(POP)

NIM

ROA

NL-TA

GL-GROWTH

D-TA

D-LISTED

DPSR

Ln(M1)

1
0.35
0.14
0.05
0.08
0.02
0.08
0.01
0.01
0.33
0.11

1
0.08
0.16
0.25
0.01
0.05
0.00
0.02
0.57
0.07

1
0.19
0.11
0.29
0.08
0.35
0.19
0.73
1.00

1
0.41
0.23
0.07
0.12
0.03
0.03
0.20

1
0.08
0.07
0.10
0.08
0.35
0.08

1
0.10
0.14
0.01
0.18
0.29

1
0.05
0.03
0.10
0.07

1
0.07
0.30
0.33

1
0.08
0.20

1
0.68

1
199

BOR

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

LC / TA cat fat
LC / TA cat nonfat
EQ / TA
CO / INC
Y-STD
CREDITRISK
ZSCORE
Ln(TA)
D-M&A
HHI
ML-SHARE
GDP-GROWTH
BOR
GNI-GROWTH
LN(POP)
NIM
ROA
NL / TA
GL-GROWTH
DPS / TA
D-LISTED
DPSR
Ln(M1)

200

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

multicollinearity does exist in our regression models, the overall results are consistent. Additional control
variables are chosen carefully to avoid multicollinearity.
4. Empirical results
4.1. Liquidity creation and bank capital all banks
Table 6 displays the results of the pooled, xed-effects, and random-effects regressions of liquidity
creation on bank capital. A DurbinHausman test between our models suggests the use of a xed-effects
model. In the xed-effects and other models, the lagged EQ / TA is negative and signicant at the 1% level.
This means that Chinese banks with more capital create less liquidity, which is in line with the nancial
fragility hypothesis and contrast with Berger and Bouwman's (2009) results. There may be several reasons
Table 6
Liquidity creation on bank capital (all banks) pooled, xed, and random effects.
This table presents the regression results using different modeling methods based on data from all banks. The dependent variable is
LC / TA cat fat, the liquidity creation divided by total assets according to the cat fat method. The cat fat method measures liquidity
creation by classifying all bank activities based on product category and includes off-balance-sheet activities.
EQ / TA is the capital ratio, measured as total equity divided by total assets. Y-STD is the standard deviation of return on assets.
CREDITRISK is a credit-risk measure, calculated as the bank's risk-weighted assets and off-balance-sheet activities divided by total
assets. ZSCORE is the sum of return on assets and equity / TA ratio, divided by the standard deviation of annual return on assets.
Ln(TA) is bank size, measured as the natural log of total assets. D-M&A is a dummy that equals to 1 if the bank was involved in
mergers and acquisitions over the past 3 years. HHI is a bank-level Herndahl index based on deposits. ML-SHARE is the share of
large and medium banks' deposits to the total deposits in the market. BOR is the benet-of-openness ratio, measured as the share of
income inow to the share to income outow in the country's global trades. GNI-GROWTH is the growth of gross national income in
China. Ln(POP) is the natural log of population.
The regressions run a pooled panel model in the rst column, a xed-effects model in the second column, a model with bank xed
effects and time xed effects in the third column, and a random effects model with bank xed effects in the fourth column.
t-statistics based on robust standard errors clustered by bank are in parentheses. *, **, and *** denote signicance at the 10%, 5%, and
1% levels, respectively.
LC / TA cat fat

EQ / TA
Ln(TA)
D-MA
HHI
ML-SHARE
GNI-GROWTH
Ln(POP)
Y-STD
CREDITRISK
ZSCORE
c
F test for no xed effects (Pr.)
Hausman test for random effects (Pr.)
Time xed effects
Bank xed effects
Observations
R-square

Pooled

Fixed effects

0.864
(6.29)***
0.004
(1.22)
0.006
(0.42)
0.898
(4.50)***
10.82
(9.19)***
0.495
(3.99)***
1.462
(4.36)***
0.006
(0.20)
0.094
(4.31)***
0.049
(2.29)**
21.407
(6.57)***

1.068
(5.83)***
0.049
(2.91)***
0.029
(1.84)*
0.536
(3.24)***
7.648
(8.46)***
0.4
(4.37)***
0.709
(1.49)
0.049
(1.66)*
0.184
(8.03)***
0.034
(1.76)*
13.76424
(3.65)***

0.801
(4.54)***
0.007
(0.43)
0.024
(1.56)

Random effects

0.019
(0.65)
0.181
(7.96)***
0.006
(0.33)
0.58
(2.66)***

0.9
(5.75)***
0.014
(1.97)**
0.02
(1.36)
0.652
(4.26)***
8.568
(9.92)***
0.435
(4.83)***
1.565
(5.04)***
0.034
(1.21)
0.153
(7.35)***
0.039
(2.11)**
20.088
(7.34)***

836
0.1993

No
Yes
836
0.7095

Yes
Yes
836
0.7501

0.001
No
Yes
836
0.2401

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

201

for this nding. First, large bank size and frequent mergers and acquisitions obstruct banks' liquidity
creation efciency, as the asset base increases rapidly. Also, large state-owned commercial banks and
policy banks are subject to heavy intervention by the government, and they have lower protability (Lin &
Zhang, 2009). Further investigation of different bank sizes may provide explanations for this result.
4.2. Effects of capital on liquidity creation interactions of bank capital and bank types
Table 7 shows the regression results for the capital ratio on both cat fat and cat nonfat liquidity
ratios, including the interaction terms of bank-type dummies. We create dummy variables to represent
domestic, state-owned, and foreign banks. Note that these bank type dummies are omitted because they
are time-invariant. Coefcients of both cat fat and cat nonfat lagged EQ / TA are negative and signicant at
the 1% level for all models except in the rst two columns. The interaction terms for domestic banks are
negative and signicant. Domestic banks are the major type of banks in the sample; therefore, their
interaction showing negative signicance is consistent with the results for the full sample regression.
State-owned banks show a similar relationship with other domestic banks, with insignicant coefcients
of the interaction terms EQ / TQ*State-owned banks. These results are in line with the government-backed
intuition, such that the government should support Chinese banks if under nancial distress. For foreign
banks, we nd a positive and signicant interaction term with EQ / TA. The interaction terms for the
Table 7
The effect of capital on liquidity creation for different bank-type subsamples.
This table presents the regression results based on different bank-type subsamples, using both xed bank effects and time effects
models. The sample period is from 1988 to 2009. The dependent variable is LC / TA cat fat or LC / TA cat nonfat, the liquidity creation
divided by total assets according to the cat fat and cat nonfat methods. Cat fat and cat nonfat methods are two methods used
to measure liquidity creation, which classify all bank activities based on product category. The fat (nonfat) liquidity-creation
measures include (exclude) off-balance-sheet activities. Please refer to Table 1 for variable denitions. The bank types are dummy
variables Domestic banks, State-owned banks, and Foreign banks. These dummy variables are omitted in the regression because of
their time-invariant nature; thus only the interaction terms and the EQ / TA coefcients are shown. The regressions are run with
both bank xed effects and time xed effects, which cause variables HHI, ML-SHARE, BOR, GNI-GROWTH, and Ln(POP) to be omitted,
because they have only one value in each year. Therefore, they are not displayed in the table.
c is the intercept. t-statistics based on robust standard errors clustered by bank are in parentheses. *, **, and *** denote signicance at
the 10%, 5%, and 1% levels, respectively.
Dependent variable

EQ / TA
EQ / TA*Domestic banks

Domestic banks

State-owned banks

Foreign banks

LC / TA
cat fat

LC / TA
cat nonfat

LC / TA
cat fat

LC / TA
cat nonfat

LC / TA
cat fat

LC / TA
cat nonfat

0.677
(1.56)
0.592
(1.24)

0.575
(1.43)
0.863
(1.96)**

1.14
(6.07)***

1.285
(7.38)***

1.294
(6.52)***

1.44
(7.87)***

0.534
(0.59)

0.073
(0.09)
0.951
(1.76)*
0.047
(1.34)
0.126
(7.87)***
0.029
(1.44)
0.032
(3.35)***
0.030
(1.94)*
0.784
(7.63)***
Yes
Yes
836
0.4021

1.135
(2.28)**
0.019
(0.58)
0.035
(2.38)**
0.023
(1.22)
0.037
(4.26)***
0.039
(2.76)***
0.812
(8.56)***
Yes
Yes
836
0.3871

EQ / TA*State-owned banks
EQ / TA*Foreign banks
Y-STD
CREDITRISK
ZSCORE
Ln(TA)
D-MA
c
Time xed effects
Bank xed effects
Observations
R-square

0.049
(1.38)
0.127
(7.91)***
0.033
(1.62)
0.031
(3.30)***
0.032
(2.04)**
0.782
(7.59)***
Yes
Yes
836
0.4038

0.019
(0.59)
0.036
(2.42)**
0.026
(1.38)
0.037
(4.21)***
0.041
(2.88)***
0.809
(8.52)***
Yes
Yes
836
0.3875

0.054
(1.53)
0.128
(7.96)***
0.038
(1.86)*
0.031
(3.25)***
0.032
(2.03)**
0.782
(7.59)***
Yes
Yes
836
0.4203

0.026
(0.79)
0.037
(2.5)**
0.033
(1.77)*
0.036
(4.11)***
0.042
(2.92)***
0.808
(8.49)***
Yes
Yes
836
0.4026

202

A.C.H. Lei, Z. Song / Global Finance Journal 24 (2013) 188202

foreign bank dummy and the capital ratio are signicantly positive at 10% and 5% levels for LC / TA cat fat
and LC / TA cat nonfat, respectively (t-statistics are 1.76 and 2.28, respectively). Consistent with Berger
and Bouwman (2009), where large banks are dominated by the risk absorption effect, liquidity creation of
foreign banks in China is still affected by risk absorption effect. The overall effects (nancial fragility vs risk
absorption) seem to be offset, however, when foreign banks are operating in China. These results suggest
that even though Chinese banks' liquidity creation is dominated by the nancial fragility hypothesis,
foreign banks are more affected by the risk absorption effect. This result supports the notion that
government-backed banks do not require additional capital to absorb the risk of providing loans.
5. Conclusion
This paper explores liquidity creation in China and the relationship between liquidity creation and
bank capital. Our results support the nancial fragility-crowding out hypothesis for Chinese banks. We
nd that bank capital is negatively related to liquidity creation in general. For foreign banks, however, the
risk absorption hypothesis nullies the nancial fragility effect as the negative relationship of bank
capital and liquidity creation is reduced. These results are in line with Berger and Bouwman's (2009)
ndings for large US banks. The information asymmetry in the recent years between banks and investors
has declined substantially, especially for listed large banks, thus reducing the nancial fragility that leads
to lower liquidity creation (Diamond & Rajan, 2000, 2001).
There are several potential implications from this study. State-owned or government-backed banks,
which are nancially less fragile, may have lower liquidity creation. The recent European debt crisis and
sub-prime crisis lead to the temporary nationalization of some major banks.9 Most banks in developed
markets have been operating under laissez faire for decades. Shifting to complete government control
would decrease their ability to create liquidity, since according to our ndings of government-controlled
banks, the nancial fragility-crowding out hypothesis dominates. As a result, the government can then
decrease bank capital to increase liquidity creation, yet resources are prone to misallocation. The
government then absorbs the risk of these nationalized banks, putting the public interest in jeopardy.
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There are previous crises that induce nationalization of banks, for example, in Japan during the 1990s.