Liquidity creation, regulatory capital, and bank profitability

- We examine the interrelationships among liquidity creation, capital, and bank profitability.
- We find a positive relationship between capital and liquidity creation.
- The positive relationship is driven by small banks.
- Banks which create more liquidity have lower profitability.
- The relationship between capital and bank profitability depends on capital level.

We examine the interrelationships among liquidity creation, regulatory capital, and bank profitability of US banks. We find that regulatory capital and liquidity creation affect each other positively after controlling for bank profitability. However, this relationship is largely driven by small banks and primarily during non-crisis periods. It is also sensitive to the level of banks' regulatory capital and how it is measured. Furthermore, we find that banks which create more liquidity and exhibit higher illiquidity risk have lower profitability. Finally, the relationship between regulatory capital and bank performance is not linear and depends on the level of capitalization. Regulatory capital is negatively related to bank profitability for higher capitalized banks but positively related to profitability for lower capitalized banks. Therefore, a change in regulatory capital has differential impacts on bank performance. Our findings have various implications for policymakers and bank regulators.