Bank liquidity creation and asset market liquidity

• Existing literature find that monetary policy cannot explain bank liquidity creation.
• However, the effectiveness of monetary policy depends on how it affects banks’ liquidity creation.
• Market liquidity explains bank liquidity creation.

Consistent with the credit channel theory of monetary policy transmission, this paper finds novel evidence that asset market liquidity as one of the proxies for the external finance premium explains bank liquidity creation. While efficacy of monetary policy depends on how banks create liquidity, the existing literature does not find any conclusive evidence that monetary policy variables explain aggregate bank liquidity creation. We use both stock market and the Treasury bond market liquidity as proxies for asset market liquidity, and find that: (1) asset market liquidity and credit-spreads explain aggregate bank liquidity creation and liquidity creation of larger banks; (2) stock market liquidity rather than credit-spreads or the Treasury bond market liquidity has robust and higher impact on aggregate liquidity creation; (3) while stock market liquidity better explains off-balance sheet liquidity creation, the short-term off-the-run Treasury bond liquidity has higher impact on on-balance sheet liquidity creation; (4) the Federal funds rate as a proxy for monetary policy impacts liquidity creation of smaller banks more than it does liquidity creation of larger banks.