Effect of shadow banking on the relation between capital and liquidity creation

Ting-Hsuan Chen, Chung-Hua Shen, Meng-Wen Wu and Kuo-Jui Huang

International Review of Economics & Finance, 2021, vol. 76, issue C, 166-184

Abstract: This research investigates the effects of shadow banking on the relation between capital and liquidity creation in China's banking industry. We consider three trust beneficiary rights as the proxies for shadow bank activities, which transform risky corporate loans into interbank loans inside the banking system. Findings present that these activities tend to exaggerate the regulatory capital ratios and liquidity creation measures and then distort the relationship between capital and liquidity creation ratios. The result shows that before removing the influence of shadow banking, banks with a lower capital ratio would engage in more liquidity creation, thus supporting the financial risk-taking hypothesis. By contrast, the risk-absorption hypothesis exists whereby banks would engage in more liquidity creation when they have a higher capital ratio if we consider the effect of shadow banking. Our study also contributes to policymaking by indicating that a failure to use correct information for the assessments of capital and liquidity creation can lead to false conclusion that China's banks are safe, which further mislead any regulatory policy.

Keywords: Shadow banking; Capital adequacy ratio; Liquidity risk; Risk-taking hypothesis; Risk-absorption hypothesis; Trust beneficial rights (search for similar items in EconPapers)
JEL-codes: C33 G21 G32 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:76:y:2021:i:c:p:166-184

DOI: 10.1016/j.iref.2021.05.006

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