You are on page 1of 17

Impact of Bank Liquidity Creation on Real Economic

Output in Pakistan

By;

1

14 2 .9 Chapter 3: Methodology Variables ---------------------------------------------------------------------------------------------------------.6 Significance of the Study --------------------------------------------------------------------------------------.12 Multiple Linear Regression Model ---------------------------------------------------------------------------.7 Chapter 2: Literature Review Introduction ------------------------------------------------------------------------------------------------------.8 Bank Liquidity Creation and Economic Growth ------------------------------------------------------------.8 Finance and Economic Development Theories --------------------------------------------------------------.13 References --------------------------------------------------------------------------------------------------------.3 Problem Statement ---------------------------------------------------------------------------------------------.6 Research Question ---------------------------------------------------------------------------------------------.12 Data Source and Sample Size ---------------------------------------------------------------------------------. Table of Contents Chapter 1: Introduction Introduction -----------------------------------------------------------------------------------------------------.12 Correlation Analysis and Unit-root test ----------------------------------------------------------------------.6 Hypotheses ------------------------------------------------------------------------------------------------------.

Liquidity creation (LC) is one of the most important roles that banks play in the economy. bank-dependent firms (Kashyap and Stein. 1776. derivatives. in the arrangement of cash currency notes. etc. which are assembled in terms of money (i. provide liquidity and payments services which are essential to a well-functioning economy (Kashyap. a world without finance cannot be imagined. and Stein. unascertained liabilities pay compensations. Bernanke and Blinder. Off-balance sheet guarantees like loan commitments and standby letters of credit 3 . Nowadays.e. 2002).. Transactions deposits. Certain resources are needed to execute any economic undertaking. off-balance sheet guarantees. and all other balance sheet and off-balance sheet financial activities – is theoretically linked to the economy. another key component of LC. Smith. Bank loans.g. Finance is a precondition for attaining physical resources. coinage and other valuables. deposits. 1998). are often thought to be primary engines of economic growth (e. particularly for small banks that tend to cater to small. Jayaratne and Strahan.g.g. reserve for contingencies and consequently on. 1996). have fetched rehabilitated attention going on significance of the bank credit and its influence on commercial growth. That is needed to accomplish productive actions and performing business operations e. In simple words. 2014).). Berger and Bouwman. Rajan. Chapter 1 Introduction The ever changing tendencies in globalization. sales. forthcoming liberalization and the contemporary Asian business disaster. These loans also play an important role in affecting output through the bank lending channel of monetary policy (e.. 2000. finance is the soul for economic activities. particularly those to bank-dependent customers without capital market opportunities. Bank liquidity creation – which incorporates loans.

aid real economic activity by allowing firms to hedge risks related to future changes in interest rates. derivatives. In Pakistan. Businesses habitually do not construct their resources organization fully by their owner equity capitals. credit distribution was tilted towards capital intensive sector (industrial sector) and the flow of credit to priority sector like agriculture was found low. and other market prices (e. 1991. 2003). 1990. such as commercial paper and municipal revenue bonds. Greenwood and Jovanovic. Greenbaum. Levine and Zervos. Stulz. The distribution of credit to the different private sector has also significant impact upon the economic growth.g. The liquidity strains in the banking industry always limit the growth of the industrial sector of the country consequently taper the cumulative growth of the country. Similarly. the other main type of bank off-balance sheet activity. 1997). Moreover. these guarantees are often used as backups for other capital market financing. Boot. 1996.. These connections between the components of LC and real economic activity may be seen as part of the more general literature on the effects of finance on the real economy (e. and Thakor 1993).g. The basic function or role of banks and other financial institution in economy is to mobilize surpluses from income holders as their savings to others who need it on interest. in direction to fulfill their monetary needs of businesses particularly small partnerships which consume insufficient causes of floating resource.g.allow customers to expand their economic activities because they are able to plan their investments and other expenditures knowing that the funds to finance these expenditures will be forthcoming in the future when needed (e. Credit played an important role in economic growth and development of the developing countries like Pakistan. foreign exchange rates. These 4 .. Thus the banks convert the savings into loanable funds. Bencivenga and Smith. and in this way assist the capital markets in financing economic growth. Levine..

Finally. and off-balance sheet activities. such as total assets (TA) or gross total assets (GTA). illiquid liabilities. we hypothesize that the primary transmission mechanism through which LC impacts GDP is through bank-dependent industries. In addition. and equity because banks destroy liquidity when they transform liquid assets into illiquid liabilities or equity. Until recently. 1983). Similarly. Diamond and Dybvig. negative weights are given to liquid assets. measured LC is the weighted sum of all assets. the empirical literature until now is missing any test of whether LC affects real economic output. Despite the theoretical links between LC and the economy. after controlling for other determinants of real output. banks are 5 .. liabilities. In these cases. we measure how large this effect of LC on real economic output is. where the weights are based on the liquidity and the location on or off of the balance sheet of each item. liabilities.loanable funds are channel to investors who borrow to meet the financial need of their businesses. equity. Specifically. To summarize briefly. measurement of how large such an effect may be. Bryant.g. 1980. and off-balance sheet activities. positive weights are given to both illiquid assets and liquid liabilities (e. The goal of this paper is to fill these gaps in the literature. discussed further below. Banks in this situation are taking something illiquid from the public and giving it something liquid. LC was mostly relegated to a theoretical concept and was not often used in empirical studies. and whether this effect is stronger than that of more traditional measures of bank output. we test if real economic output is higher in local markets in which LC is relatively high. We also test whether LC is better than TA or GTA in predicting real economic output. Since liquidity is created when banks transform illiquid assets into liquid liabilities. Berger and Bouwman (2009) provide the first comprehensive measure of LC that takes into account the contributions of all bank assets. equity.

following are the hypotheses stated to answer the research questions. liberalization of the monetary policies and the liberalization of the overall financial institution have made the macro economy quite vulnerable to the shocks. it has been chosen as a matter of concern in this research. Problem Statement During the past few years. The impact of liquidity creation on the real economy is a matter of concern for policy makers and thus. Research Question Whether liquidity creation by private banks has any impact on the real economic output of the country? Also.taking something liquid from the public and giving it something illiquid. Off-balance sheet activities are assigned weights consistent with those assigned to functionally similar on-balance sheet activities. For example. unused loan commitments are assigned a positive weight because provide liquidity to the public similar to that of transactions deposits. coming from the private financial institutions. the research intends to answer the question whether the impact has characteristics of a short run or it prolongs in the long run? Hypotheses In the light of above discussion. H1: liquidity creation by private banks has direct relationship with the real economic output of the country. 6 . The validity of these hypotheses is being tested in this research and the stature of past research in this regard is also presented. The liquidity creation by the private banking sector is one of the critical subject in this regard which needs quite critique.

The results of this research are vital for the monetary economists and financial policy makers. The research is aiming to provide valuable insights of the how the two variables from financial market and macro economy are interrelated. Significance of the Study The importance of this study is vital in examining the impact of liquidity creation on the real economic growth of the country. 7 . H2: There is a long-run relationship between liquidity creation and real economic output.

the velocity of corporeal capital accretion etc. The basic aim of economic policies is to enhance to promote the wellbeing of the general public. It means that the impact of credit is not always being positive on economic growth. A rise of consumption and investments creates jobs and leads to a growth of both income and profit. the expansion of credit influences also the price of assets. consumers can borrow and spend more. When credit grows. Furthermore. spending goods in the economy are shaped from labour and capital. The connection between financial development and production growth is bidirectional for all countries (Luintel and Khan). This is usually measured in terms of the level of production within the economy. It is not difficult to understand the real way in which the growth of credit influences economic growth. We can define economic growth as positive change in the level of establishment of goods and national income and services which are provided by country over a specific period of time. thereby increasing their obtained value. who lends credit from the bank used for capital invested in the business. The rise of asset prices offers the 8 . Chapter 2 Literature Review Introduction Economic growth and bank credit adopted various studies. which he uses to utilize labour in respect to induce goods & services for the Economic Growth. According to (Bencivenca & Smith). Monetary Policy accomplish this important objective through promote the price stability. An entrepreneur. Bank Liquidity Creation and Economic Growth Economy of Pakistan cannot develop and promote without appropriate monetary policy. Other parameters of growth which ranges from real per capital GDP. and enterprises can borrow and invest more.

which produces the sensation of increased wealth. and promoting capital accumulation. There is completion of the privatization process as well as increased consumption of goods produced by economy. investments. a more relaxed economic policy is required. followed by a new loan. This has been empirically proven that credit to the public sector is weak in generating growth within the economy because they are prone to waste and politically motivated programmers which may not deliver the best result to the populace. Which is the cause and which is the effect? Is finance the leading engine for economic development or does it simply follow growth from elsewhere? 9 . However. all economic expansion induced by credit comes to an end when one or more essential economic sectors become unable of paying off their debts. This cycle of credit expansion leads to increased costs. the causal relationship is not clear. Finally. In order to increase economic growth with the help of credit. It is not implausible to posit a positive correlation between growth in the financial and real sectors. Moreover. due to the increase of wealth. Bank credit can be sub divided into two: credit to the private sector and credit to the public sector. Finance and Economic Development Theories One of the debates in growth theory is the extent to which financial development leads to economic growth. to prosperity. and which makes people feel happier as long as they are moving within the kingdoms of this ring. improving assigned efficiency of loanable funds.owner the chance to borrow more. a long sequence of contemporary empirical studies shows that a variety of financial indicators is strongly and positively associated with economic growth. Financial development can raise economic growth by increasing saving. to the creation of new jobs.

LC is also a measure of the output of a bank.g. According to the risk transformation theories. by exercising a demand for them. According to the modern theory of financial intermediation. the two roles often coincide. as their main measure of bank output. Miller. This “supply leading” argument says that financial development is a determinant of growth. 1986).g. The opposing argument is that the causality runs the other way: economic growth creates a demand for financial intermediation. and management of risk and reduction of transaction costs. Petersen.. Rajan. 1984.g. total assets (TA) or gross total assets (GTA). GTA equals TA plus allowances for loan and lease losses and the allocated transfer risk reserve. mitigation of the problem of asymmetric information.. Boyd and Prescott. Since there is as yet no empirical measure of risk transformation. Diamond. banks’ two major roles in the economy are liquidity creation and risk transformation.. 1984. The creation of modern financial institutions and services is then a response to the demand from investors and savers in the economy. among others. Laeven and Levine. and thereby to force the economic system into new channels”. The empirical research includes studies of the effects of bank output or size on corporate governance (e. given that both riskless deposits and risky loans contribute positively to LC. Berger. small business lending (e. LC may be viewed as the best available measure of total bank output. This is accomplished by the mobilization of savings and efficient allocation of resources. The vast majority of empirical studies in banking use one of two measures of bank assets. banks transform risk by issuing riskless deposits to finance risky loans (e.“The essential function of credit consists in enabling the entrepreneur to withdraw the producers’ goods which he needs from their previous employments. and 10 . While LC is only one of the two major functions of a bank. Ramakrishnan and Thakor. 2009). and monitoring of firms. It is therefore expected that the output of LC is highly correlated with the output of risk transformation.

The measures of bank assets are also used as a size cutoff to determine which banks are classified as community banks (e.. stress tests.. Duchin and Sosyura.g. 2005).Stein. Hunter. and consumer protections. 2004). and Udell. and which banks are subject to different regulatory treatment. and many other topics.g. 11 . DeYoung. such as extra supervision as Systemically Important Financial Institutions (SIFIs). 2014). the effects of government interventions and bailouts (e.

Economic growth is considered as the representation of the real economic output of the country. (WDI) that is the database of World Bank. unit root test will be conducted to test the likelihood of autocorrelation between the variables. Correlation Analysis and Unit-root test Correlation analysis will be done to check the direct the relationship of the variables. The research intends to utilize both the descriptive and statistical modeling to analyze the hypotheses. Chapter 3 Methodology Bank credit plays an important role in the economy of any nation. The current study will examine the association among bank liquidity and real economic output in Pakistan. 12 . Since. inflation. The data will be of time series nature and will range from the period 1973 to the latest. stationarity of the variables can be an issue. while bank credit. Data Source and Sample Size Secondary data will be collected from World Development Indicator. While. interest rate. Variables Economic growth is ought to be taken as dependent variable. the data will be of time series nature. The variables considered in this research have been selected by considering the theoretical background of the variables and their relationship according to the economic theory. the Unit root test will be used to check the stationarity of variables. investment to GDP and government consumptions will be the independent variables. So.

13 . where: RGDP = Real Gross Domestic Production which is dependent variable.Multiple Linear Regression Model The research includes multiple linear regression model to analyze the relationship of dependent and independent variables. e denotes the error term. these are all control variables. α = Intercept. INF is Inflation/change in consumer price index. IGDP is investment to GDP and GC is government consumption to GDP. Following model will be used in this study. β shows coefficients. The specifications of econometric model based on econometric theory and on any information relating to the phenomenon being stated. BP is bank credit to private sector which is independent variable. IR is Interest rate/rate of banks on lending to private sector.

Allen. lending technologies.. 195-209. V. 724-735. F. and Naqvi. S.. and Bouwman. L. 1023- 1061. B.” Journal of Finance. Berger. Allen.. Acharya. A. D. F. and Gale. C.. A. and Black. “Bank liquidity creation. “Financial intermediaries and markets. 349-366. Bank of England.. Aiyar. “Financial intermediation and endogenous growth. and Smith. “The seeds of a crisis: A theory of bank liquidity and Risk Taking Over the Business Cycle.H. V. and Wieladek.” Journal of Financial Economics." Bank of England Working Papers 445 (2012). C.K. “Does macropru leak? Evidence from a UK policy experiment. 146-176. “The theory of financial intermediation.R. Berger.. A. H. 3779-3837. Bencivenga. C. 72 (2004).H.W. and small business finance. 14 .N.D. “A crisis of banks as liquidity providers..43. “Bank size.” Review of Financial Studies 22 (2009). T. 1461-1485. and Bouwman.N.S.V. Berger. N. Calomiris.” Journal of Banking and Finance 21 (1997). A.V.N. 70 (2015).” Journal of Banking and Finance 35 (2011). “How does capital affect bank performance during financial crises?” Journal of Financial Economics 109 (2009).. and Mora. 106 (2012).” Econometrica.References Acharya. V.S. and Santomero. 1...” Review of Economic Studies 58 (1991).

A. and Thakor.. J.” American Economic Review 83 (1993).N. P.” Journal of Financial Economics 101 (2011). and financial crises. money and aggregate demand.J. and Stein.. Bernanke. Greenbaum.M.N. A. Rajan. and Thakor. Petersen. M. C. Elsevier – North Holland. G.. Berger.Berger.N. 2-50. “Reputation and discretion in financial contracting. and Edge. A.A. N.N. 435–439. Boot. C. S. Strahan. “Did risk-based capital allocate bank credit and cause a "credit crunch" in the United States?” Journal of Money. 585-628. M..” Working Paper (2014). and Bouwman. Cornett.V.S.F. and Bouwman. S. “Contemporary banking theory.. R. 297-312.W.M.. (2016). “Credit. “Bank liquidity creation. Berger.S.I. and Tehranian..S.” Journal of Financial Economics 76 (2005). Papers and Proceedings 75 (1988). J. A. 5-54. B. “The effects of bank capital on lending: What do we know.. monetary policy. J. and what does it mean?” International Journal of Central Banking 6 (2010).. and Udell... A.. “Liquidity risk management and credit supply in the financial crisis..H.H.H.” American Economic Review. 237–269.C.” Journal of financial Intermediation 3 (1993). “Does function follow organizational form? Evidence from the lending practices of large and small banks. A. 1165-1183. Bank Liquidity Creation and Financial Crises. and Blinder. Bhattacharya.V. 15 ... McNutt. Berrospide. A. Miller. Credit and Banking 26 (1994).G. H. Berger. A. M. R.E. A.

R. A.” Journal of Financial Economics 75 (2005). R.. Diamond. 85-133. A. Hunter. D.H. L.. “A theory of bank capital.” working paper (2014).2465..V.W.” Journal of Financial Services Research 25 (2004). 287-327. and Muir. P. “The past. Diamond. and Zhou. DeYoung. “Bank capital. and Rajan. Gorton.C. J. and Thakor. Z.Coval.W. “Liquidity risk. present. 2431. and financial fragility: a theory of banking. 535-569. liquidity creation.” Econometrica 37 (1969). “Bank runs. and Dybvig. C.W.” Bank of Finland BOFIT Discussion Papers 17.F. T.G.” The Journal of Finance 55 (2000). “Financial intermediation as a beliefs-bridge between optimists and pessimists. G. Diamond.. (2010). G..” The Journal of Political Economy (1983). liquidity creation.” Review of Economic Studies 51 (1984). and deposit insurance. Fungacova. Diamond. “Financial intermediation and delegated monitoring.. Gorton. 393-414.W. Weill. Granger.” Journal of Political Economy 109 (2001). G. D.J. “Liquidity provision. and Winton. “Mobile collateral versus immobile collateral... 401-419. W.G. bank capital. 16 . and Udell. and Rajan.. deposit insurance. and liquidity. D. R.W. and probable future for community banks. “Investigating causal relations by econometric models and cross-spectral methods. M.D.” working paper (2015). 424-438. and the macroeconomy. D..

Greenwood.com/articles/banks-urge-big-customers-to-take-cash- elsewhere-orbe-slapped-with-fees-1418003852.A. Hancock.. 1076-1107. J. and Chung. J. J. Laing. and Jovanovic. http://www. and the distribution of income. The Wall Street Journal. Dec. J.” Journal of Banking and Finance 19 (1995).. and Wilcox. Banks urge clients to take cash elsewhere.. Sterngold. 7. B. 2014. 661. “Financial development.J. “Bank balance sheet shocks and aggregate shocks: their dynamic effects on bank capital and lending.677.” Journal of Political Economy 98 (1990).wsj.. D. Grind. K. A. growth. 17 .