Bank liquidity, macroeconomic risk, and bank risk: Evidence from the Financial Services Modernization Act

• Author: Yu‐Yi Lee,Yong‐Chin Liu,I‐Ju Chen
• DOI: http://doi.org/10.1111/eufm.12208
• Published date: 01 January 2020
• Date: 01 January 2020

DOI: 10.1111/eufm.12208

ORIGINAL ARTICLE

Bank liquidity, macroeconomic risk, and bank risk:

Evidence from the Financial Services

Modernization Act

I-Ju Chen

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Yu-Yi Lee

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Yong-Chin Liu

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1

Discipline of Finance, College of

Management, Yuan Ze University,

Taoyuan, Taiwan

Emails: ijchen@saturn.yzu.edu.tw;

s1017441@mail.yzu.edu.tw

2

Department of Finance, College of

Management, Asia University, Taichung,

Taiwan

Email: chinyda@asia.edu.tw

Funding information

Ministry of Science and Technology in

Taiwan (MOST 106-2632-H-155-001; 106-

2410-H-155-005-MY2)

Abstract

We investigate the empirical relationship between macro-

economic risk, bank liquidity, and bank risk surrounding the

1999 Financial Services Modernization Act. We propose

that bank risk and liquidity are positively related as

macroeconomic risk increases, and that this effect is

particularly strong after the Gramm–Leach–Bliley Act

(GLBA). We test our hypotheses by collecting data from

1994 to 2006 for banks in the United States. The results

show that banks flush with liquid assets in a high

macroeconomic risk environment conducted more lending

activities following the enactment of the GLBA, leading to

higher bank risk. Our study complements the understanding

of bank liquidity management.

KEYWORDS

bank liquidity, bank risk, Financial Services Modernization Act

JEL CLASSIFICATION

G21, G30

We would like to thank John A. Doukas (the Editor), the anonymous referees, Sheng-Syan Chen, Yanzhi Wang, Yan-Shing

Chen, and participants at the 2015 FMA conference for very insightful comments and helpful suggestions. I-Ju Chen

acknowledges funding from the Ministry of Science and Technology in Taiwan (MOST 106-2632-H-155-001; 106-2410-H-

155-005-MY2). All errors are our own.

Eur Financ Manag. 2019;1–33. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons, Ltd.

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INTRODUCTION

Commercial banks that serve as financial intermediaries engage in deposit-taking and lending

activities. Banks must be able to disburse their payments at any time, as depositors withdraw from their

accounts on a first-come, first-serve basis. Meanwhile, banks provide loans to borrowers, creating

liquidity for those in need. As depositors can withdraw funds on demand, and banks must also fulfill

obligations to loan borrowers as necessary, banks face liquidity risks from both the asset and liability

sides (Gatev, Schuermann, & Strahan, 2009). Liquidity risk typically refers to the probability that a

bank with insufficient liquidity, usually including cash and marketable assets or other forms of near-

cash assets, cannot pay its short-term obligations as they come due. This inability will lead to financial

problems for banks and ultimately a bank run (Diamond & Dybvig, 1983; Hong, Huang, & Wu, 2014;

Ratnovski, 2013).

However, the liquidity problem among banks during the crisis highlighted the importance of

liquidity holding, which had not been emphasized before the 2007–2009 crisis. For example,

Morkoetter, Schaller, and Westerfeld (2014) find that failing banks have different liquidity positions

from non-failing banks at least 5 years prior to default. Calomiris, Heider, and Hoerova (2015) develop

a theoretical model of the bank liquidity requirement and suggest that it is held voluntarily as a

commitment device to manage risk properly and cash reserve requirements are needed to incentivize

prudent behaviors by banks. Furthermore, the Basel III accord introduces global liquidity standards to

ensure the ability of an institution to withstand a severe liquidity freeze and to address liquidity

mismatches (Allen & Gale, 2017; Du, 2017).

Recent studies suggest that bank liquidity not only acts as a ‘buffer’against unexpected shocks

from the business environment, but also affects the degree of banks’risk-taking incentives. Acharya

and Naqvi (2012) argue that commercial banks assume more risk and make excessive loans when they

have abundant liquidity, as their payoffs are based on the loans advanced. When the market experiences

a downturn, depositors’lack of confidence in capital market investments compels them to deposit

funds in financial institutions. Because a flight to safety takes place, commercial banks in this situation

receive abundant funds and liquidity during a market recession. In addition, deposit insurance creates a

moral hazard for excessive risk-taking by banks (Keeley, 1990). They then begin to pay less attention to

the quality of loans and make excessive loans. This leads to higher bank risk or even a crisis (Acharya &

Naqvi, 2012; Gatev & Strahan, 2006). Wagner (2007) theoretically shows that higher liquidity can

increase the instability of the banking system and may lead to bank failure. Similar to Acharya and

Naqvi (2012) and Wagner (2007), Khan, Scheule, and Wu (2017) find that banks take higher risks

when they have lower liquidity funding risk.

This study provides empirical evidence for Acharya and Naqvi's (2012) theoretical proposition

about bank liquidity and the risk-taking behaviors of commercial banks in the United States during

1994–2006. In addition, we also expect that the passage of the 1999 Financial Services Modernization

Act (also known as the Gramm–Leach–Bliley Act; hereafter, GLBA), which liberalized the firewall

between commercial and investment banks and created more flexibility in the financial industry's

provision of services, would strengthen the relationship between bank liquidity and such risk-taking

behaviors. Because the GLBA allows different types of financial institutions to become involved in

new business activities, banks are eager to provide a variety of products to meet customers’financial

needs and increase their profits (Santomero, 2001; Stiroh, 2006; Stiroh & Rumble, 2006). Commercial

banks faced with the pressure of intense competition will attempt to develop a more effective business

model by launching high-volume, low-cost ventures (Berger, Frame, & Miller, 2005; Carter &

McNulty, 2005). In addition, advances in technology and the development of the securitization market

enable banks to liquidate their illiquid loans through the securitization market (Loutskina, 2011). This

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development also induces banks to pay less attention to shortfalls in liquidity and makes them more

aggressive in loan making. The increase in liquidity or funds encourages managers to think that the

potential profits from loan making outweigh the potential losses due to defaults. Managerial neglect of

loan quality raises the bank risk and therefore the relationship between bank liquidity and bank risk is

expected to be particularly strong when the macroeconomic risk is high.

We test our hypotheses by obtaining data from the Compustat database for all banks operating in

the United States between 1994 and 2006. Our empirical findings show that banks with large amounts

of liquid assets during a market recession conducted more lending activities after the enactment of the

GLBA, leading to higher bank risk in an environment that already had high macroeconomic risk.

Further, our results are robust to different measures of bank risk, bank liquidity, extension of sample

period, and different research models controlling for the endogeneity issue in bank liquidity.

This study makes two valuable contributions to the literature. First, our study complements the

literature on bank liquidity. Although researchers have highlighted the unique role of bank liquidity

(Diamond & Dybvig, 1983; Gatev & Strahan, 2006; Kashyap, Rajan, & Stein, 2002; Myers & Rajan,

1998), few studies empirically investigate the effect of bank liquidity on bank risk-taking behavior,

except for Khan et al. (2017). They document that banks take more risk when they have lower funding

liquidity risk proxied by deposit ratios. Our empirical evidence further shows that banks flush with

liquid assets in a high macroeconomic risk environment conducted more lending activities following

the enactment of the GLBA, leading to higher bank risk, confirming the theoretical argument suggested

by Acharya and Naqvi (2012), Berger, Bouwman, Kick, and Schaeck (2016), and Wagner (2007). Our

study also implies that commercial banks’liquidity management is one reason for the 2007–2009

financial crisis, and that banks should contemplate liquidity management under the new Basel III

guidelines when macroeconomic risks rise.

Second, our study also documents that the GLBA leads to an increase in banks’risk-taking

behaviors, and that this effect is particularly strong for high-liquidity banks when macroeconomic risk

is high. As the passage of the GLBA eliminated the distinctions between different types of financial

institutions and dramatically changed the market for financial services (Geyfman & Yeager, 2009), the

intense competition triggered within the banking industry provides a natural laboratory for examining

how banks facing environmental change after the GLBA changed their liquidity policy and the effect

on bank risk. Therefore, our study also complements the literature on the effect of the GLBA.

The remainder of this paper is organized as follows. We review the literature and discuss our

research hypotheses in section 2. Section 3 describes the methodology and its summary statistics.

Section 4 presents our empirical results and the final section concludes.

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LITERATURE REVIEW AND DEVELOPMENT OF

HYPOTHESES

2.1

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The relationship between bank liquidity and bank risk-taking

Commercial banks serve as an intermediary for financial markets engaging in deposit-taking and

lending activities to provide market liquidity (Diamond & Dybvig, 1983; Diamond & Rajan, 2000;

Kashyap et al., 2002). Because of this specific role, they are required to hold sufficient liquidity to meet

depositors’withdrawal needs (Gatev et al., 2007; Kashyap et al., 2002; Loutskina, 2011), need for

unexpected conversion of illiquid to liquid assets (Acharya, Shin, & Yorulmazer, 2011), and the

difficulties with raising external finance (Morris & Shin, 2008), among other reasons. Therefore,

liquidity management has emerged as a risk management method for avoiding bank runs or liquidity

crises (Diamond & Dybvid, 1983; Ratnovski, 2013).

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