#09-23
Bank Liquidity Creation, Monetary Policy, and Financial Crises
Allen N. Berger and Christa H.S. Bouwman, July 2009
Abstract:We study the relationship between aggregate bank liquidity creation and monetary policy in the U.S. from
1984:Q1 to 2008:Q4 by first examining the effectiveness of monetary policy during normal times and
financial crises, and by then analyzing the behavior of both monetary policy and liquidity creation around
financial crises.
Our main findings are as follows. First, liquidity creation has increased substantially over the sample
period, from $1.398 trillion to $5.304 trillion (in real 2008:Q4 dollars). The share of large banks (assets over
$3 billion) in aggregate liquidity creation has also gone up over this time period, as has the fraction of
liquidity created off the balance sheet.
Second, the effect of monetary policy on bank liquidity creation is significant only for small banks,
and additional interesting size-dependent differences appear after splitting liquidity creation into on- and offbalance
sheet components. There appears to be no significant difference between the effects of monetary
policy on liquidity creation during normal times and financial crises. If the Federal Reserve had used the
Taylor rule, liquidity creation would have been similar during normal times, but higher during financial
crises, and would have resulted in a 3.3% increase in liquidity creation over the sample period.
Third, detrended liquidity creation is relatively high prior to financial crises, tends to drop
significantly during financial crises and stays low afterwards. The data suggest that the level of detrended
liquidity creation is a better indicator of a crisis occurring than detrended GDP, the federal funds rate, or the
return on the stock market. The predicted probability of crisis striking was only 0.02% when detrended
liquidity creation was at its lowest point over the sample period, and 79.5% when detrended liquidity
creation was at its highest point.
Fourth, we find that the subprime lending crisis has made monetary policy more effective for small
banks, less effective for medium banks, and equally effective for large banks, and left undisturbed the result
that monetary policy has no different effect during normal times and crises. In addition, the high level of
detrended liquidity creation before the crisis was far more pronounced than that before other financial crises,
and it was driven by a high level of off-balance sheet illiquid guarantees (primarily loan commitments).
When the crisis hit, illiquid assets (primarily business loans) increased for several quarters before declining.
During the crisis, the drop in illiquid guarantees was far more pronounced than the drop in illiquid assets, and
contributed significantly to the decline in detrended liquidity creation.
Keywords: Financial Crises, Liquidity Creation, and Banking.
JEL classifications: G28, and G21.
