Capital and liquidity creation: does the capital adequacy matter?

This study investigates whether the capital adequacy framework with two capital ratios affects the liquidity creation (LC) of a bank by using 18,247 commercial banks from 1996 to 2016. Different from studies that use a single capital ratio to proxy capital adequacy, we follow the spirit of Basel III by using a novel combination of two capital ratios to classify strong and weak capital adequate banks. Thus, we can examine the effectiveness of our capital adequacy framework. We then propose that a weak capital adequate bank is less cautious of risk, whereas a strong capital adequate bank is prudent of risk. The former creates more liquidity and has a negative correlation between capital and LC, which is consistent with the financial fragility view, whereas the latter shows the opposite, which follows the risk-absorption view.