Expanding the Bank Liquidity Creation Concept: Bank Capital and Secondary Market Loan Liquidity

Abstract

We expand the bank liquidity creation concept from its current focus on bank portfolios to include providing liquidity to secondary markets for financial assets. We test opposing theories of the effects of bank capital on secondary market liquidity of syndicated loans. We find that higher bank capital significantly increases secondary market loan liquidity, consistent with risk absorption theory. The data also support the loan riskiness and bank balance sheet quality channels behind this theory. We use the exogenous capital shock from the 2012 JPMorgan Chase ‘London Whale’ incident to help establish causality. Our findings have important research and policy implications.

Keywords: Bank liquidity creation, bank capital, syndicated loans, secondary loan market

JEL Classification: G12, G21, G23