Management of Financial Institutions and Services

Project Report

Title- Liquidity Creation

Submitted to:

Prof. Abhay Pant

Submitted by:

Group 5 Section A

Misha Garg (PGP10094)

Sonali Rajore (PGP10053)

Sneha Bharti (PGP10234)

Sindhu Bharathi (PGP10176)

M Aishwarya Krishna (PGP10152)

Introduction

Liquidity creation is a vital service provided by banks to the economy of any country. It allows
bank to improve the flow of credit to the economy. Banks create liquidity by transforming
relatively liquid liabilities, such as demand deposits, to fund relatively illiquid assets, such as
business loans. This in return satisfies the demand for liquidity by depositors and the demand for
longer-term financing commitments by borrowers(Diamond and Dybvig 1983, Gatev and
Strahan 2006). Not only this, banks also create liquidity off the balance sheet through loan
commitments and standby letters of credit which is further utilized by firms in developing and
modifying long-run investment strategies efficiently (Boot et al 1993, Kashyap et al. 2002). By
creating liquidity, theory suggests that banks improve the capital allocation and drives economic
growth (Bencivenga and Smith 1991, Levine 1991). It has been found by Berger and Sedunov
(2016) that the positive impact of liquidity creation on economic growth is larger than the growth
effects of other services provided by banks.

Literature Review

Liquidity creation is an important part of banking function. It converts their liquid assets into
illiquid liabilities or finance illiquid assets with liquid liabilities to create liquidity. It also
considers off-balance sheet activities to create liquidity (Holmström and Tirole, 1998; Kashyap,
2002). Giving long-term loans from their customer deposits is another way of liquidity creation.
In other words, liquidity creation is a result of the incompatibility between long-term (illiquid)
assets and short-term (liquid) liabilities. By issuing long-term debts banks may reduce their
liquidity creation by increasing their cash balance. However, do no liquidity is created by these
institutions while purchasing securities (liquid liabilities) by using customer deposits (liquid
assets).

Many theories related to liquidity creation have evolved over the years. For example- In 2009
Berger and Bouwman found that before the financial crisis i.e between 1993 and 2003 liquidity
creation by USA banks had increased. After their research they revealed that bank can create
liquidity either on balance sheet activities or off balance sheet activities. In 2012 Fungacova and
Weill found that large banks contribute more to the liquidity creation. Many such researches has
been conducted for decades to identify the factors affecting bank profitability and liquidity
creation and relationship between the two. Following points gives briefs about the evolution in
liquidity creation concept:-

● First Attempt- Deep and Schaefer (2004)

o Introduced liquidity transformation (LT) gap as (Liquid liabilities -Liquid
assets)/total assets.
o To define liquidity of assets and liabilities they took maturity instead of product
category
o All the assets and liabilities within one year were taken as liquid
o They excluded off-balance sheet activities because they are contingent
o Limitations of this approach:
▪ It wasn’t comprehensive as it hasn’t taken the off-balance sheet activities
which plays an important role in liquidity creation
▪ Also, since they took maturity , it is considered that many a time the
nature of activities matter more than the time period.
▪ It can happen that some assets are of longer duration but they are liquid

● Second Attempt- Berger and Bouwman (2009)

o Created four different measures of liquidity creation
o Included off balance sheet items
o Classified loan by category and maturity
o It is comprehensive, hence it is used by many researcher for liquidity creation
estimation, and also in understanding its relation with macroeconomic and firm-
specific variables

● Third- Steffen, Hackethal, and Tyrell (2010)

o Measured liquidity creation by German Banks
o Determined the factors affecting liquidity creation by using multivariate dynamic
panel regression
 o They also tried to differentiate between macroeconomic factors and firm’s
specific factors

● Fourth- Fungáčová and Laurent Weill (2012)

○ Estimated liquidity created by banks in Russia
○ Developed three measures. Estimation was done in general, on the basis of
ownership, and size
○ Found state-owned and large banks contributed the most towards liquidity
creation

● Fifth- Sabahat (2017) estimated liquidity created by banks in Pakistan in more or less
similar way using four measures of liquidity creation
○ Liquidity creation relation with the bank size was also estimated

Project Objectives

In this project we have chosen two public and two private sector Indian banks to study the
liquidity creation by these banks over 10 years. We have tried to compare the liquidity creation
by these two category banks. Also, we will try to understand the pattern between the liquidity
creation and other financial parameters of the banks.

Data and Methodology

We have taken the secondary data from RBI website and the annual reports of the banks to
calculate the Liquidity creation by four banks- Bank of India, Bank of Maharashtra, RBL Bank
and South Indian Bank. We have collected the data for 10 years from 2008 to 2018.

In methodology, we have found the liquid creation in three steps. In the first step we have
classified the bank’s liabilities, equity, assets and off-balance sheet activities into liquid, semi-
liquid, or illiquid depending on how easily they can be converted into cash. In the second step,
we have assigned the weights to the different items depending upon their category (Refer table
1). We have calculated our liquidity based on the category of loan rather than their maturity.
Under this, we have divided balance sheet activities into liquid liabilities, illiquid liabilities and
Semi- liquid liabilities; Liquid assets, illiquid assets and semi-liquid assets. Also, we have
included on balance sheet as well as off-balance sheet items categorized as Catfat and Noncatfat
respectively (refer Figure 1). The formula used for calculation and categorization of balance
sheets items are listed in figure 2. In the third and last step, we put the value of different category
items deducted from step 1 and Step 2 into the following formula:-

Liquidity Creation = (0.5 * illiquid assets + 0 ∗semi-liquid assets -0.5 * liquid assets) + (0.5 ∗
liquid liabilities +0 ∗semi-liquid liabilities −0.5 ∗ illiquid liabilities) − 0.5 ∗ equity + (0.5 *
illiquid guarantees +−0.5 ∗ liquid guarantees)

Weights
Illiquid Assets, Liquid Liabilities, Illiquid 0.5
Activities
Semiliquid assets, Semiliquid liabilities, 0
Semiliquid Activities
Liquid Assets, Illiquid Liabilities, Equity, -0.5
Liquid Activities

Table 1: Weights of different category item

Figure 1: Types of measures of Liquidity creation

For categorical measure of liquidity creation we have divided the balance sheet items in the
following way:-

Division of Liabilities and Equity

Capital, and Reserves and Surplus are considered as illiquid liabilities because capital can be
demanded by its investors from the bank. Even if they can be sold in the secondary market,
liquidity will be created by financial markets not by banks. Hence, they are illiquid liabilities.

Demand deposits and saving deposits can be repaid on demand, hence they are classified as
liquid liabilities. While in Term deposits, customers have to pay a penalty fee if it is withdrawn
before the due period, therefore it is categorised as semi-liquid liabilities.

Long term liabilities which cannot be withdrawn easily such as borrowings in form of capital
instruments such as debt instruments, subordinated debt instruments are classified as illiquid
liabilities. While borrowing from RBI and other banks are classified as semi-liquid liabilities.

Another important classification is of borrowings from outside India in the form of capital
instruments like innovative perpetual debt, notes and bonds. Since they are of illiquid nature,
they are considered as illiquid liabilities.

Items like drafts, travellers’ cheque, email transfer, or any other type of Bills payable are treated
as liquid liabilities because of their liquid nature (relatively). Provisions and other liabilities
such as deferred tax liabilities, provisions are treated as illiquid liabilities.

Division of Assets

Cash and cash balances with RBI are considered as liquid assets because it consists of gold,
foreign currencies, cash in hand and balances with RBI in the current account form.

Funds provided by banks to other financial institutions at interbank rate which is also known as
balances with banks and money at call, short notices etc are treated as semi-liquid assets.

Investments such as government securities, other approved securities, shares, bonds and
debentures, investment in subsidiaries and others, joint ventures and associates which are held to
maturity are treated as illiquid assets. All investments other Investments apart from investments
in subsidiaries, joint ventures and associates are treated as liquid assets.

It should be noted that we have treated loans and advances in a different way. We have treated
both business loans as well as residential loans as illiquid assets. We did this because our bank is
of a developing country while Berger and Bouwman(2009) researched on a developed country.
While loans and advances given to the bank and public sector are treated as semi-liquid.

Fixed assets, deferred tax assets, interest accrued etc. are also treated as illiquid assets.

Division of Off-balance Sheet activities

Endorsements, acceptances, and other obligations and Guarantees have been classified as illiquid
because they function similarly to loans i.e. banks have to pay the customer when an obligation
arises. Also, they cannot be sold or participated easily. Moreover, Guarantees are irrevocable.

If a bank is contingently liable to any claim against which contains demand on tax and legal
matters are treated as illiquid.

Liabilities for partly paid investments/ Venture Funds are treated as liquid assets.

It should be noted that derivatives and other seminal papers that talk about its role have been
excluded from off-balance sheet activities.
Figure 2: Steps of Bank Liquidity Creation
Findings

General findings in all four banks-

  Catfat is greater than catnonfat. It infers that off-balance sheet plays a significant role in
liquidity creation
 Catfat as well as catnonfat shows a similar trend with total assets. These increases and
decreases in a similar fashion w.r.t total assets.
 If look at the relation between the ROA and ROE and the liquidity creation by all the four
banks, we aren’t able to find any trend in these factors

 Liquidity creation by public banks are greater than that of private sector banks

 Private bank such RBL has in fact destroyed the liquidity

Graphs of comparison of Liquidity creation and other financial factors of chosen banks are
as follows:
Graph 1: Bank of India
 Graph 2: South Indian Bank

Graph 3: Bank of Maharashtra

 Graph 4: RBL Bank

References:

1. Estimation of liquidity created by banks in India, 2019, By Sinha, Grover, and Pankaj,
FMS, DU
2. Reserve Bank of India website : https://www.rbi.org.in/home.aspx
3. Annual Reports of Bank of India
4. Annual Report of Bank of Maharashtra
5. Annual Report of RBL
6. Annual Report of South Indian Bank