RELATIONSHIP BETWEEN BANK CAPITAL AND LIQUIDITY CREATION: A Disaggregated Analysis of Banking Industry of Pakistan

Hamid ILYAS* and Saima SARWAR**

This study aims to explore the impact of bank capital on liquidity creation in Pakistan by using dataset of the scheduled banks of Pakistan, (under the State Bank of Pakistan) from 2004 to 2013. The analysis is based on various classifications of the banks; i.e., overall, small, medium and large. Using Generalized Least Squares (GLS) model, the results show a positive relationship between the desired variables for large banks and negative for small and medium banks. Hence, these findings confirm that the hypothesis of ‘risk absorption’ effects dominate the large banks and ‘financial fragility’ hypothesis governs in case of small and medium size banks. Moreover, banks’ liquidity is positively related to bank governance measures and negatively with the bank-size variable. On the other hand, bank risks’ measures are positively connected to liquidity creation. On the basis of findings of this study, it is suggested that if regulatory authorities set higher capital requirements for banks, it may result in greater liquidity creation by large banks but it can restrict the liquidity creation by small banks.