Philadelphia Fed, Report: Funding Liquidity Creation by Banks

“We have proposed a new empirical measure of funding liquidity creation by banks and argued that bank lending and the funding liquidity banks create are not constrained by deposit availability. We have also provided evidence of higher lending and funding liquidity creation by banks when their cash deposits are falling. Rather than deposits, it is the bank’s capital ratio that influences how much funding liquidity it can create. Given this, attempts by the central bank to stimulate economic growth by flooding the economy with liquidity that then shows up as higher deposit balances in banks will not necessarily be effective in increasing bank lending. This was recently evident during the period immediately following the official recognition of the COVID-19 pandemic in March 2020 in the U.S. Deposits at U.S. banks grew by an unprecedented $2 trillion between March and July 2020 as a variety of liquidity provision programs infused huge amounts of cash into the economy, but bank lending did not increase commensurately. Our paper sheds light on why—the important drivers of banks’ liquidity creation are bank capital and loan demand, suggests our analysis.”