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Working Paper/Document de travail

2010-38
The Impact of Liquidity on Bank Profitability
by tienne Bordeleau and Christopher Graham


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Bank of Canada Working Paper 2010-38
December 2010
The Impact of Liquidity on Bank Profitability
by
tienne Bordeleau and Christopher Graham

Financial Stability Department
Bank of Canada
Ottawa, Ontario, Canada K1A 0G9
ebordeleau-labrecque@bankofcanada.ca
cgraham@bankofcanada.ca
Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in
economics and finance. The views expressed in this paper are those of the authors.
No responsibility for them should be attributed to the Bank of Canada.

ISSN 1701-9397 2010 Bank of Canada

ii
Acknowledgements
The authors would like to thank, in alphabetical order, Jason Allen, James Chapman,
Allan Crawford, Evren Damar, Christopher DSouza, Prasanna Gai, Cline Gauthier,
Toni Gravelle, Frank Milne, and Jonathan Witmer.
iii
Abstract
The recent crisis has underlined the importance of sound bank liquidity management. In
response, regulators are devising new liquidity standards with the aim of making the
financial system more stable and resilient. In this paper, the authors analyse the impact of
liquid asset holdings on bank profitability for a sample of large U.S. and Canadian banks.
Results suggest that profitability is improved for banks that hold some liquid assets,
however, there is a point at which holding further liquid assets diminishes a banks
profitability, all else equal. Moreover, empirical evidence also suggests that this
relationship varies depending on a banks business model and the state of the economy.
These results are particularly relevant as policymakers devise new standards establishing
an appropriate level of liquidity for banks. While it is generally agreed upon that banks
undervalued liquidity prior to the recent financial crisis, one must also consider the trade-
off between resilience to liquidity shocks and the cost of holding lower-yielding liquid
assets as the latter may impact banks ability to generate revenues, increase capital and
extend credit.
JEL classification: G21, G32, G33
Bank classification: Financial system regulation and policies; Financial institutions;
Financial stability
Rsum
La rcente crise financire a fait ressortir limportance dune saine gestion du risque de
liquidit par les banques. Cest pourquoi les organismes de rglementation sont en train
dlaborer de nouvelles normes de liquidit en vue daccrotre la stabilit et la rsilience
du systme financier. Les auteurs analysent lincidence de la dtention dactifs liquides
sur la rentabilit dun groupe de grandes banques amricaines et canadiennes. Daprs
leurs rsultats, les tablissements qui conservent des liquidits seraient plus profitables,
mais au-del dun certain volume, la possession dactifs liquides pserait sur la rentabilit
de linstitution, toutes choses gales par ailleurs. En outre, la relation entre liquidits et
rentabilit serait influence par le modle de fonctionnement de la banque et ltat de
lconomie. Ces rsultats sont susceptibles de grandement intresser les dcideurs publics
au moment o ces derniers doivent dfinir de nouvelles normes qui tabliront le niveau
appropri des liquidits bancaires. Bien que lon saccorde gnralement dire que les
banques sous-estimaient limportance de la gestion du risque de liquidit avant la crise
financire, il convient aussi de rflchir larbitrage oprer entre le degr de rsilience
souhaitable face aux chocs de liquidit et le cot de la dtention dactifs liquides moins
bien rmunrs, puisque celle-ci peut rduire la capacit des tablissements de gnrer
des revenus, daccrotre leurs fonds propres et doctroyer du crdit.
Classification JEL : G21, G32, G33
Classification de la Banque : Rglementation et politiques relatives au systme financier;
Institutions financires; Stabilit financire
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1.0Introduction
Liquiuity was an instiumental factoi uuiing the iecent financial ciisis. As unceitainty leu funuing
souices to evapoiate, many banks quickly founu themselves shoit on cash to covei theii
obligations as they came uue. In extieme cases, banks in some countiies faileu oi weie foiceu into
meigeis. As a iesult, in the inteiest of bioauei financial stability, substantial amounts of liquiuity
weie pioviueu by authoiities in many countiies, incluuing Canaua anu the 0niteu States
(Longwoith 2u1u; Beinanke 2uu8).
In the afteimath of the ciisis, theie is a geneial sense that banks hau not fully appieciateu the
impoitance of liquiuity iisk management anu the implications of such iisk foi the bank itself, as
well as the wiuei financial system.
1
As such, policymakeis have suggesteu that banks shoulu holu
moie liquiu assets than in the past, to help selfinsuie against potential liquiuity oi funuing
uifficulties. This has leu to an inteinational uesiie foi common measuies anu stanuaius foi
liquiuity iisk, culminating in ongoing woik by the Basel Committee on Banking Supeivision (BCBS
2u1u).
Since liquiu assets such as cash anu goveinment secuiities geneially have a ielatively low ietuin,
holuing them imposes an oppoitunity cost on a bank. In the absence of iegulation, it is ieasonable
to expect banks will holu liquiu assets to the extent they help to maximize the fiims piofitability.
Beyonu this, policymakeis have the option to iequiie laigei holuings of liquiu assets, foi instance,
if it is seen as a benefit to the stability of the oveiall financial system. That saiu, the aim of this
papei is not to establish the iueal level of liquiu asset holuings, but iathei to help uistinguish
empiiically, whethei banks holuings of liquiu assets have a significant impact on theii
piofitability. Shoulu this be the case, such basic empiiical infoimation is ciucial to piopei
calibiation in the context of uomestic anu inteinational liquiuity iegulation. While iegulation can
make the financial system moie iesilient to liquiuity shocks, calibiation shoulu iecognize any
associateu costs to the efficiency of financial inteimeuiation as this coulu iesult in highei
boiiowing costs foi othei agents in the system.
In shoit, while contiolling foi othei factois, this papei finus eviuence, baseu on a panel of
Canauian anu Ameiican banks fiom 1997 to the enu of 2uu9, that piofitability is impioveu foi
banks that holu some liquiu assets, howevei, theie is a point at which holuing fuithei liquiu assets
uiminishes a banks piofitability, all else equal. These finuings aie conceptually in line with
ielevant liteiatuie anu aie consistent with the iuea that the oppoitunity cost of holuing lowietuin
assets eventually outweighs the benefit of any inciease in the banks liquiuity iesiliency as
peiceiveu by funuing maikets.
In the context of this ielationship, estimateu iesults suggest some eviuence of fuithei positive
benefit to holuing auuitional liquiu assets foi institutions that follow a less tiauitional, moie
volatile (i.e., moie maiketbaseu) banking mouel. Likewise, theie is a similai estimateu benefit to
holuing moie liquiu assets when economic conuitions ueteiioiate.
The iemainuei of this papei sets foith this eviuence, beginning with some stylizeu facts anu
iegulatoiy context. This is followeu by a biief uesciiption of the ielevant liteiatuie anu the

1
Foi a fiamewoik assessing systemic liquiuity iisk, see uauthiei, Be anu Souissi (2u1u).
5
empiiical fiamewoik as applieu in this papei. Finally, the empiiical iesults aie piesenteu anu
policy implications aie uiawn.
2.0StylizedFactsandRegulatoryContext
As shown in Figuie 1, banks in Canaua anu the 0niteu States hau been holuing a ueclining shaie of
theii balance sheet in liquiu assets, such as cash anu goveinment secuiities, piioi to the onset of
the iecent financial ciisis.
2
Inueeu, in ieaction to the funuing anu liquiuity piessuies expeiienceu
uuiing the ciisis, banks, in aggiegate, began to holu consiueiably moie liquiu assets. While theie
was an oppoitunity cost of holuing liquiu assets given theii ielatively low ietuin, banks anu
supeivisois iecognizeu the opeiational benefits of auuitional liquiuity, along with the benefits in
teims of maiket peiception. A ielatively stiong liquiu asset pool coulu iepiesent a moie iobust
bank to investois anu funuing maikets.

In fact, it was uuiing the ciisis that authoiities in vaiious countiies saw the neeu foi a consistent
stanuaiu to monitoi anu impiove bank liquiuity. As such, the u2u iecommenueu that the Basel
Committee on Banking Supeivision (BCBS) establish a global fiamewoik foi piomoting stiongei
liquiuity buffeis at financial institutions (Woiking uioup 1 of the u2u 2uu9). This fiamewoik,
publisheu in Becembei 2u1u anu subject to an obseivation peiiou ovei coming yeais, woulu
incluue, among othei things, a iequiiement that inteinationallyactive banks holu enough liquiu
assets to covei theii net cash outflows ovei a Suuay stiess scenaiio (BCBS 2u1u). In bioau teims,
this iegulatoiy stanuaiu is meant to ensuie banks aie selfinsuieu to withstanu a specifieu
iuiosynciatic anu maiketwiue liquiuity shock. Not suipiisingly, howevei, the calibiation of such a
stanuaiu is key to its impact on banks anu the financial system as a whole. Foi ieasons such as

2
As an asiue, accounting uiffeiences help explain the level uiffeience between the liquiu asset iatio foi Canauian anu
0.S. banks. As is uiscusseu latei in this papei anu in Appenuix B, 0.S. accounting allows banks to iepoit theii
ueiivative positions net of mastei netting agieements, while Canauian banks iepoit ueiivatives on a gioss basis. All
else equal, this will ueflate the 0.S. measuie of total assets ielative to the Canauian measuie.
1u%
1S%
2u%
2S%
Su%
SS%
197S 1977 1979 1981 198S 198S 1987 1989 1991 199S 199S 1997 1999 2uu1 2uuS 2uuS 2uu7 2uu9
Figuie 1: Liquiu assets as a peicentage of total assets
Canaua 0.S.
Souice: 0.S. Flow of Funus & Canaua TBS uatabase
Liquiu assets aie uefineu as cash, inteibank ueposits anu goveinmentissueu anu insuieu secuiities
6
this, it is ciucial to unueistanu the impact that a change in banks liquiu asset holuings has on its
stability anu piofitability.
Figuie 2 piesents histoiical uata on a weighteu aveiage of ietuin on equity (R0E) foi Canauian
anu 0.S. banks since 1997. 0f note, banks in the 0niteu States expeiienceu consiueiable losses
thioughout the financial ciisis, while those in Canaua geneially uiu not. Combining the
infoimation in both Figuie 1 anu Figuie 2, it is uncleai thiough visual obseivation what the impact
of auuitional liquiu assets has been on the piofitability of Canauian anu 0.S. banks. As such, this
papei takes an empiiical appioach to investigate this question while contiolling foi othei ielevant
factois.



3.0LiteratureandEmpiricalFramework
A bioau liteiatuie exists suiiounuing the analysis of liquiuity holuings foi fiims.
S
While a veiy
limiteu numbei of stuuies appeai to incluue liquiuity as an explanatoiy vaiiable foi bank
piofitability, this ielationship is not the focus of those papeis anu the empiiical iesults aie mixeu.
4

To oui knowleuge, theie is no existing empiiical woik uiiectly focusing on the specific question
consiueieu in the cuiient papei: whethei banks holuings of liquiu assets have a significant impact
on theii piofitability. Bowevei, we aie able to uiaw on ielevant concepts in some ielateu

3
The economics anu finance liteiatuie analyse foui possible ieasons foi fiims to holu liquiu assets; the tiansaction
motive (Nillei anu 0ii 1966), the piecautionaiy motive (0plei, Pinkowitz, Stulz, anu Williamson 1999), the tax
motive (Foley, Baitzell, Titman, anu Twite 2uu7) anu finally the agency motive (}ensen 1986). An oveiview of the
iationale behinu those motives can be founu in Bates, Kahle anu Stulz (2uu8).
4
Foi example, Bouike (1989) finus some eviuence of a positive ielationship between liquiu assets anu bank
piofitability foi 9u banks in Euiope, Noith Ameiica anu Austialia fiom 1972 to 1981, while Nolyneux anu Thointon
(1992) anu uouuaiu, et al (2uu4) finu mixeu eviuence of a negative ielationship between the two vaiiables foi
Euiopean banks in the late 198us anu miu199us, iespectively. Liquiu assets aie geneially incluueu as a contiol
vaiiable in these stuuies with veiy limiteu uiscussion aiounu the estimateu paiametei.
Su%
1S%
u%
1S%
Su%
1997 1998 1999 2uuu 2uu1 2uu2 2uuS 2uu4 2uuS 2uu6 2uu7 2uu8 2uu9
Figuie 2: Retuin on Equity
Canaua 0.S.
Souice: 0.S. FRY9C Repoits & Canaua TBS uatabase, weighteu aveiage.
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liteiatuie uealing with the impact of capital on bank piofitability anu of the impact of liquiu assets
on bank cieuit iisk.
Beigei (199S) analyses the statistical ielationships between bank eainings anu capital foi 0.S.
banks ovei the peiiou of 198S1989 anu finus that, contiaiy to what one might expect in
situations of peifect capital maikets with symmetiic infoimation (see Nouigliani anu Nillei
(19S8, 196S)), theie is a positive ielationship between capital anu ietuin on equity. This iesult,
accoiuing to the authoi, is consistent with the expecteu bankiuptcy cost hypothesis. Noie
specifically, Beigeis iesults suggest that banks with highei levels of capital see theii funuing costs
ueciease to such an extent that it moie than offsets the cost of issuing auuitional capital.
S
While
Beigei (199S) applies the concept of the expecteu bankiuptcy cost hypothesis in the iealm of
capital, it is also conceptually applicable to the impact of liquiu assets on piofitability, wheieby
banks holuing moie liquiu assets benefit fiom a supeiioi peiception in funuing maikets, ieuucing
theii financing costs anu incieasing piofitability.
At the same time, a iecent papei by Noiiis anu Shin (2u1u) uevelops a mouel wheie the total
cieuit iisk of a bank is uecomposeu into insolvency iisk (the conuitional piobability of uefault
uue to ueteiioiation of asset quality if theie is no iun by shoitteim cieuitois) anu illiquiuity
iisk (the piobability of a uefault uue to a iun when the institution woulu otheiwise have been
solvent). The mouel pioviues a foimula foi illiquiuity iisk anu the authois show that an
inciease in the liquiuity iatio of a bank uecieases the piobability of an illiquiu uefault.
6

These two concepts can be uiawn togethei in the context of the cuiient papei. If an inciease in the
ielative liquiu assets holuings of a bank uecieases its piobability of uefault, anu if the expecteu
bankiuptcy cost hypothesis is inueeu coiiect, then holuings of liquiu assets shoulu exhibit a
positive ielationship with bank piofits. At the same time, holuing liquiu assets imposes an
oppoitunity cost on the bank given theii low ietuin ielative to othei assets, theieby having a
negative effect on piofitability. Thus, oveiall, we expect liquiu assets to exhibit a nonlineai
ielationship to bank piofitability in which incieasing liquiu assets woulu impiove a banks
piofitability thiough the expecteu bankiuptcy cost hypothesis, as long as the maiginal benefit of
holuing auuitional liquiu assets outweighs the oppoitunity cost of theii low ielative ietuin.
Concuiiently, the impact of liquiu assets on piofitability can be affecteu by othei factois such as
the banks business mouel, oi exogenous economic conuitions. This iuea is, in fact, analogous to
existing liteiatuie on inteinational ieseive holuings. This liteiatuie has aigueu that emeiging
maiket economies accumulate ieseives to selfinsuie against capital flow volatilities anu suuuen
stops (Aizenman anu Naiion 2uuS; Stiglitz 2uu6).
7
Fuitheimoie, iecent woik by }eanne anu

S
These finuings aie consistent with liteiatuie on maiket uiscipline in banking (see uilbeit (199u), Beigei (1991)).
6
Noiiis anu Shin (2u1u) conceptually uefines the liquiuity iatio as iealizable cash on the balance sheet to shoit teim
liabilities. In tuin, iealizable cash is uefineu as liquiu assets plus othei assets to which a haiicut has been applieu.
7
A suuuen stop is geneially uefineu as a suuuen slowuown in emeiging maiket capital inflows, with an associateu
shift fiom laige cuiient account ueficits into smallei ueficits oi small suipluses. Suuuen stops aie uangeious anu they
may iesult in bankiuptcies, uestiuction of human capital anu local cieuit channels (Calvo, 1998).
8
Rancieie (2uu9) suggests that the optimal level of a small countiys inteinational ieseives
incieases with the amount of shoitteim uebt the countiy has, anu with the piobability of a
suuuen stop. Cleai paiallels can be uiawn between this liteiatuie anu the neeu foi banks to self
insuie against liquiuity anu funuing shocks, as illustiateu by the iecent financial ciisis.
Theiefoie, in oui fiamewoik, we suppose that the impact on piofitability of a banks holuings of
liquiu assets (i.e., ieseives), uepenus on the amount of funuing that comes uue in the shoitteim
anu on the geneial state of the economic cycle. The lattei can be inteipieteu as a pioxy foi the
likelihoou of a suuuen stop oi fieeze in funuing maikets.
8
All else equal, if a bank is moie ieliant
on shoitteim funuing, it may neeu to holu moie liquiu assets in oiuei to maximize piofits.
Likewise, if the economic cycle is in a uowntuin anu investois inteipiet this as an inciease in the
likelihoou of a fieeze in funuing maikets, banks woulu likely neeu to selfinsuie (by incieasing
theii holuings of liquiu assets) in oiuei to maximize piofits.
Finally, to contiol foi othei factois affecting bank piofitability, we iefei to the liteiatuie
auuiessing ueteiminants of bank piofitability (BemiigucKunt anu Buizinga, 1998, 2uuu;
uouuaiu, Nolyneux anu Wilson, 2uu4; Bo anu Saunueis 1981; Nolyneux anu Thoiton, 1992).
Biawing fiom this woik, we incluue macioeconomic factois such as inteiest iates, unemployment,
inflation anu output giowth as contiol vaiiables in oui piofit equation.
4.0DataandEmpiricalEstimation
The econometiic fiamewoik is piesenteu in Equation (1). In shoit, the uepenuent vaiiable,
piofitability, is iegiesseu against a nonlineai expiession of ielative liquiu asset holuings, as well
as a set of contiol vaiiables, X.

n
,t
= o
0
+ o
1
lo
,t-1
+ o
2
lo
,t-1
2
+ o
3
lo
,t-1
stunJing
,t
+ o
4
lo
,t-1
gJp

,t
+ X[ + u
,t
(1)

Noie specifically, to test foi the key ielationship of inteiest between liquiu assets anu piofitability
(), Equation (1) expiesses the liquiu asset iatio (la) as a nonlineai polynomial of oiuei two, as
well as the piouuct of ieal uBP giowth (gup), anu a pioxy foi shoitteim funuing ieliance
(stfunuing), iespectively. Noieovei, since cieuitois must fiist obseive the ielative liquiuity of a
bank befoie aujusting theii views on its cieuit iisk, all liquiu asset teims aie laggeu by one
peiiou.
9


8
Note that Noiiis anu Shin (2u1u) also consiuei the amount of shoitteim funuing anu cieuit conuitions when
mouelling bank cieuit iisk.
9
Neasuies of leveiage oi capital auequacy, incluueu as contiol vaiiables, aie also laggeu, given that the inteipietation
is similai unuei the expecteu bankiuptcy cost hypothesis.
9
To moie cleaily illustiate the foim of the estimateu ielationship between liquiu assets anu
piofitability, Equation (2) piesents the maiginal impact on piofits of the liquiu assets iatio. As
noteu above, this ielationship is a function of the liquiu assets iatio, a measuie of shoitteim
funuing ieliance anu geneial macioeconomic conuitions. Inueeu, setting Equation (2) equal to
zeio allows one to solve foi the ieuuceufoim piofitoptimizing level of the liquiu assets iatio,
given by Equation (S).
on
,t
olo
,t-1
= o
1
+ 2 - o
2
lo
,t-1
+o
3
stunJing
,t
+o
4
gJp

,t
= u, (2)

lo
,t-1
-
=
-(o
1
+ o
3
stunJing
,t
+ o
4
gJp

,t
)
2 - o
2
. (S)
4.1Data
Table A.1 in Appenuix A pioviues a summaiy of the vaiiables useu foi empiiical estimation, along
with theii uefinitions anu some uesciiptive statistics. 0f note, the uepenuent vaiiable, piofitability
(n), is measuieu as ietuin on equity oi ietuin on assets as noteu, anu ielative liquiu assets, la, aie
measuieu as the iatio of cash, goveinmentissueu anu goveinmentguaianteeu secuiities anu
inteibank ueposits ielative to a banks total assets. Note that, because of accounting uiffeiences in
the netting of ueiivatives on the balance sheet between 0.S. uAAP anu Canauian uAAP, we
impeifectly aujust Canauian banks total assets, as useu in the liquiu assets iatio, using the impact
of mastei netting agieements (See Appenuix B foi uetails).
Contiol vaiiables incluue quaiteily giowth in ieal uBP, unemployment anu coie inflation, as well
as a measuie of balance sheet leveiage, measuieu as the iatio of assets to shaieholueis equity (in
the baseline mouel).
With iespect to the shoitteim funuing vaiiable, iueally, one wants to measuie a banks ieliance
on ielatively flighty shoitteim funuing. 0nfoitunately, available uata aie not as gianulai as
uesiieu, since they covei all types anu souices of funuing coming uue within one yeai.
1u
Theie
may be veiy significant uiffeiences in the stability of vaiious souices of shoitteim funuing. Foi
instance, insuieu ietail uemanu ueposits aie likely to be much moie stable than shoitteim
maiket (wholesale) funuing. To auuiess this uata issue, we assume that a banks business mouel
(i.e.: commeicial bank veisus univeisal bank) anu the stiuctuie of its funuing (shoitteim veisus
longteim) aie ielateu anu use the foimei as a pioxy. Inueeu, sample coiielations between the
maiketielateu piopoition of a banks income (i.e., tiauing anu investment income ielative to
gioss income) anu measuies of the teim of funuing aie positive anu statistically significant at the

1u
Noieovei, available Canauian uata aie baseu on matuiity of the inteiest iate iathei than the matuiity of the funuing
itself.
10
1% level.
11
As a iobustness check, equation (1) will also be estimateu using iepos as a pioxy foi
the teim of funuing.
The uataset useu foi estimation contains a panel of quaiteily obseivations foi SS 0.S. bank
holuing companies (BBC) anu 1u Canauian banks, spanning the peiiou fiom 1997Q1 to 2uu9Q4.
12

0.S. BBC uata aie taken fiom the FRY9C iegulatoiy filings while Canauian uata aie uiawn fiom
iegulatoiy iepoits to the 0ffice of the Supeiintenuent of Financial Institutions (0SFI).
The mouel is estimateu using a panel twostep uNN pioceuuie with bank anu time fixeueffects,
in which only the macioeconomic vaiiables aie tieateu as exogenous. To help coiiect foi
enuogeneity, all othei explanatoiy vaiiables aie instiumenteu with thiee lags of themselves.
1S

Noieovei, we use a keinelbaseu methou with automatic banuwiuth selection uevelopeu by
NeweyWest (1994) to obtain heteioskeuastic anu autocoiielation consistent (BAC) stanuaiu
eiiois anu covaiiance estimation.
4.2BaselineResults
Column 1 of Table A.2 piesents the baseline estimation iesults in which ietuin on equity is
iegiesseu on the liquiu asset iatio (in level foim anu as a piouuct of uBP giowth anu a piouuct of
maiket income shaie), along with the contiol vaiiables foi uBP giowth, inflation anu balance
sheet leveiage. Note that the estimation gives an aujusteu Rsquaieu (aiounu u.S8) that is in line
with the cuiient liteiatuie, anu also shows uesiiable chaiacteiistics with iespect to the
instiumental vaiiables useu.
14

Tuining to the key iesults, the estimateu ielationship between liquiu assets anu bank piofitability
is as expecteu. Coefficients foi the liquiu assets iatio, its squaie, its piouuct with uBP giowth, anu
its piouuct with a pioxy foi ieliance on shoitteim funuing aie all statistically significant at the
1% level. As expecteu, we finu eviuence of a nonlineai ielationship between piofitability anu
liquiu asset holuings. Noie specifically, as illustiateu in Figuie S, the negative coefficient on
2

inuicates that piofitability is maximizeu, accoiuing to this ieuuceufoim mouel, at lo
,t-1
-
. In othei
woius, the ielationship takes the foim of a uownwaiuconcave paiabola anu to the extent the

11
Funuing teim is measuieu by eithei iepuichase agieements oi funuing matuiing within one yeai as a shaie of total
liabilities.
12
Banks weie incluueu in the sample if they helu at least $0SB1u billion in assets as of 2uu8Q4.
1S
Enuogeneity may be piesent with iespect to liquiuity in the sense that piofits may be a souice of auuitional liquiuity
foi banks. Pieliminaiy woik by Aspachs, Niei anu Tiesset (2uuS), foi instance, mouels the liquiuity of 0.K. banks
using piofits as one explanatoiy vaiiable. Bowevei, the estimateu paiametei on piofits is geneially not statistically
significant.
14
We test foi the valiuity of oui instiuments (i.e.: uncoiielateu with the eiioi teim) using the SaiganBansen test of
oveiiuentifying iestiictions (Saigan, 19S8; Bansen 1982). Pvalues of oui Bansens }Statistics inuicate that we cannot
ieject the null hypothesis that the instiuments aie valiu. We also test foi unueiiuentification (i.e.: that the excluueu
instiuments aie coiielateu with the enuogenous iegiessois) using the KleibeigenPaap (2uu6) ik iank statistic, a
heteioskeuasticityiobust LN veision of the Anueison (19S1) canonical coiielations test. Pvalues foi this test
statistic inuicate that we cannot ieject the null hypothesis that the mouel is iuentifieu (i.e.: the matiix of the ieuuceu
foim coefficients is full iank) foi all oui iegiessions.
11
ielationship is ielatively flat aiounu the maximum (lo
,t-1
-
), the cost associateu with holuing moie
oi less liquiu assets will be limiteu in iange aiounu the maximum. Estimation also suggests a
negative coefficient, as anticipateu, foi the inteiaction teim with uBP giowth anu a positive
coefficient foi the piouuct with the pioxy foi ieliance on shoitteim funuing.

Taken togethei, these iesults suggest that, all else equal, piofitability is impioveu foi banks that
holu some liquiu assets, howevei, theie is a point at which holuing fuithei liquiu assets uiminishes
a banks piofitability, all else equal.
1S
This finuing is consistent with the iuea that funuing maikets
iewaiu banks foi holuing some liquiu assets, but at some point this benefit is outweigheu by the
oppoitunity cost of holuing such lowyieluing assets. At the same time, as macioeconomic
conuitions ueteiioiate, incieasing the likelihoou of maiket illiquiuity, the ieuuceufoim piofit
optimal level of liquiu assets lo
,t-1
-
incieases (iecall Equation (S) above), confiiming the intuition
uiawn fiom }eanne anu Rancieie (2uu9). Likewise, as a bank incieases its ieliance on capital
maiketielateu ievenues (a pioxy foi ieliance on shoitteim funuing), the estimateu ieuuceu
foim piofitoptimal level of liquiu assets also incieases, as in Noiiis anu Shin (2u1u). In shoit,
piofit incentives shoulu encouiage banks to holu moie liquiuity in times of weak economic giowth
oi when they maintain a lesstiauitional business mouel.
16

Estimateu coefficients on the macioeconomic contiol vaiiables aie geneially in line with the
existing liteiatuie. uBP giowth is estimateu to have a positive anu statistically significant impact
on bank piofitability, while the level of unemployment, thiough a highei piobability of uefault on
loans, has a negative impact. Neanwhile, the laggeu iate of inflation exhibits a negative anu
statistically significant ielationship with piofitability. This iesult uiffeis fiom the empiiical
liteiatuie (Beckmann, 2uu7; BemiigucKunt anu Buizinga, 1998), which typically finus a positive
ielationship. Bowevei, since banks, thiough theii tiauitional iole of matuiity tiansfoimation, lenu

1S
uiven the fact that banks may choose to inciease the iiskiness anu ietuin of nonliquiu assets to impiove
piofitability all else equal, the positive (negative) impact of liquiu assets on piofitability may be ovei (unuei)
estimateu. The iatio of iiskweighteu assets to total assets was useu in an attempt to contiol foi the iiskiness of
assets, but was founu not to be statistically significant at conventional levels, in pait because of high multicollineaiity
with the liquiu assets iatio. Noieovei, iiskweighteu assets might not auequately ieflect the iiskiness of a banks
activities as it tenus to exhibit piocyclical bias (Boiueleau, Ciawfoiu anu uiaham 2uu9).
16
Not suipiisingly, the nonlineaiities between liquiu assets anu piofitability piesenteu heie aie paiticulaily ielevant
ovei the peiiou of the iecent economic ciisis.
0.15
0.2
0.25
0.3
0.35
0%

Liquiu Assets Ratio


Figuie S
la
*
12
long anu boiiow shoit, it is to be expecteu that highei inflation woulu ueciease theii maigins anu
piofitability.
17
Similaily, inflation can penalize banks thiough theii holuings of longeiteim low
yieluing liquiu assets.
In geneial, the baseline iesults aie intuitively consistent with the ielateu liteiatuie.
4.3SomeRobustnessChecks
In this section, the iobustness of oui key iesults is testeu using a vaiiety of alteinative estimation
specifications. Fiist, ietuin on assets (R0A) is useu as an alteinative measuie of bank piofitability.
0sing R0A as the uepenuent vaiiable of the mouel, the estimateu sign anu significance of all
vaiiables iemain consistent with the baseline specification, as shown in column 1 of Table A.S. The
sole exception to this is leveiage, which takes a negative estimateu coefficient when iegiesseu on
R0A.
18
This, howevei, makes sense conceptually, given the use of a uiffeient uepenuent vaiiable.
Consiuei an example wheie a bank incieases its leveiage by acquiiing auuitional assets ielative to
a constant equity base. The estimation iesults suggest that, in this case, the auuitional assets
woulu inciease banks net income ielative to this constant equity base (i.e., R0E), but not in
ielation to the expanueu level of assets (i.e., R0A).
19

As a seconu iobustness test of the baseline mouel, an alteinative pioxy foi shoitteim funuing
ieliance is inteiacteu with the liquiu assets iatio. As shown in column two of Table A.2, using the
iatio of outstanuing iepuichase agieements to total liabilities gives the expecteu sign, but is not
statistically significant.
2u

Column S of Tables A.2 anu A.S, piesent iesults using iiskweighteu Tiei 1 iegulatoiy capital as an
alteinative measuie of leveiage oi capital auequacy in lieu of simple balance sheet leveiage. uiven
that the Tiei 1 iatio is expiesseu as capital pei iiskweighteu asset, the inveise of balance sheet
leveiage (assets to equity), its statistically significant negative (positive) coefficient with iegaiu to
R0E (R0A) gives the same inteipietation as the baseline leveiage iesults. Thus, oveiall, incieasing
assets (eithei iiskweighteu oi noniiskweighteu) ielative to balance sheet oi iegulatoiy capital
will impiove bank piofitability.

17
Noie specifically, consiuei the situation wheie a bank lenus money at a ceitain iate of inteiest. If inflation iises
going foiwaiu, the bank will still ieceive the same inteiest on the loan, while it will neeu to pay highei iates of inteiest
(ieflecting inflation) on theii shoiteiteim boiiowing.
18
Recall that leveiage is measuieu as a multiple of equity, so incieaseu leveiage means less capital foi a given level of
assets.
19
These finuings aie consistent with the expecteu bankiuptcy cost hypothesis wheie the benefits of lowei ielative
capital inciease R0E uespite highei associateu funuing costs.
2u
0thei potential pioxies foi shoitteim funuing ieliance weie also tiieu, incluuing the iatio of iepos to total assets oi
total funuing, as well as the iatio of total ueposits to total assets, total liabilities oi total funuing. In each case, the
estimateu coefficient hau the expecteu sign (positive foi iepo iatios anu negative foi ueposit iatios), but was not
statistically significant. 0nfoitunately, 0.S. anu Canauian iegulatoiy bank uata uo not pioviue sufficient gianulaiity to
constiuct bettei measuies of ieliance on shoitteim funuing.
13
Results of the baseline specification weie also iobust to the exclusion of the time uummy vaiiables
(see Tables A.4 anu A.S). This alteinative specification geneially coiioboiates the baseline iesults,
although it geneiates significantly uecieaseu explanatoiy powei, anu the estimateu impact of
macioeconomic contiol vaiiables is somewhat incieaseu.
The baseline mouel was also estimateu using twostage least squaies iathei than uNN, giving
qualitatively the same iesults.
21

4.4DifferenceintheImpactofLiquidityforCanadianRelativetoU.S.Banks
To test whethei Canauian bank piofitability exhibits a uiffeient ielationship towaiu holuings of
liquiu assets ielative to 0.S. banks, we intiouuce a countiy uummy vaiiable foi Canaua inteiacteu
with the liquiu assets iatio. Equations (1), (2) anu (S) above become Equations (4), (S) anu (6),
with CAB iepiesenting a uummy vaiiable taking the value of one foi Canauian banks anu zeio foi
0.S. banks. Estimation iesults aie piesenteu in Table A.6 with column one coiiesponuing to the
baseline specification iefeiieu to in the pievious section (Column 1 of Table A.2).

n
,t
= o
0
+o
1
lo
,t-1
+ o
2
lo
,t-1
2
+ o
3
lo
,t-1
stunJing
,t
+ o
4
lo
,t-1
gJp

,t
+ u
5
lo
,t-1
CAD
+ X[ + u
,t
, (4)

on
,t
olo
,t-1
= o
1
+ 2 - o
2
lo
,t-1
+ o
3
stunJing
,t
+ o
4
gJp

,t
+ u
5
CAD = u, (S)

lo
,t-1
-
=
-(o
1
+ o
3
stunJing
,t
+ o
4
gJp

,t
+ u
5
CAD)
2 - o
2
. (6)
Coefficients foi the inteiactive uummy vaiiable aie estimateu to be negative anu statistically
significant in the baseline specification. This iesult is iobust with iespect to the use of ietuin on
assets as the uepenuent vaiiable, as shown in column 2 of Table A.6. In geneial, these finuings
suggest that, ceteiis paiibus, the level of liquiu assets iequiieu to maximize piofits is lowei foi
banks in Canaua than in the 0niteu States. Bowevei, this iesult may piimaiily ieflect uata issues.
As mentioneu pieviously, accounting uiffeiences tenu to inflate total assets foi Canauian banks,
ielative to theii 0.S. counteipaits. Although an attempt has been maue to ieuuce this uiveigence,
the aujustment is impeifect anu such stiuctuial uissimilaiities coulu still exaggeiate uiffeiences in
the estimateu impact of liquiu assets on bank piofitability in Canaua ielative to the 0niteu States.
Noieovei, the sample peiiou useu foi estimation is significantly influenceu by the iecent financial
ciisis. 0vei this peiiou, Canauian banks geneially peifoimeu bettei than 0.S. banks, piouucing
compaiatively moie piofits foi a given level of liquiu assets. Nonetheless, setting asiue uata

21
Results available upon iequest.
14
conceins, this iesult coulu ieflect uiffeiences in maiket peiception acioss Canauian anu 0.S.
banks. Noie specifically, investois anu funu pioviueis coulu uemanu that 0.S. banks holu
auuitional liquiu assets in compaiison to Canauian banks uue to unobseiveu stiuctuial factois
(e.g., iegulatoiy fiamewoik, conseivative management, univeisal banking mouel, etc.).
5.0ConclusionandPolicyImplications:
This papei piesents empiiical eviuence iegaiuing the ielationship between liquiu asset holuings
anu piofitability foi a panel of Canauian anu 0.S. banks ovei the peiiou of 1997 to 2uu9. In shoit,
iesults suggest that a nonlineai ielationship exists, wheieby piofitability is impioveu foi banks
that holu some liquiu assets, howevei, theie is a point beyonu which holuing fuithei liquiu assets
uiminishes a banks piofitability, all else equal. Conceptually, this iesult is consistent with the iuea
that funuing maikets iewaiu a bank, to some extent, foi holuing liquiu assets, theieby ieuucing its
liquiuity iisk. Bowevei, this benefit is can eventually be outweigheu by the oppoitunity cost of
holuing such compaiatively lowyieluing liquiu assets on the balance sheet.
At the same time, estimation iesults pioviue some eviuence that the ielationship between liquiu
assets anu piofitability uepenus on the banks business mouel anu the iisk of funuing maiket
uifficulties. Auopting a moie tiauitional (i.e., ueposit anu loanbaseu) business mouel allows a
bank to optimize piofits with a lowei level of liquiu assets. Likewise, when the likelihoou of
funuing maiket uifficulties is low (pioxieu by economic giowth), banks neeu to holu less liquiu
assets to optimize piofits.
Although, to oui knowleuge, theie is no existing liteiatuie auuiessing these specific issues, the
empiiical iesults piesenteu in this papei aie in line with similai concepts in the bioauei liteiatuie
ielateu to capital, cieuit iisk anu inteinational ieseives.
Fiom a policy peispective, the iesults of this papei aie highly ielevant, paiticulaily given ongoing
iegulatoiy iefoim following the iecent financial ciisis. As policymakeis uevise new stanuaius
establishing an appiopiiate level of liquiuity foi banks, helping to ensuie auequate stability foi the
oveiall financial system, the empiiical iesults of this papei suggest they shoulu beai in minu the
tiaueoff between iesilience to liquiuity shocks anu the cost of holuing loweiyieluing liquiu
assets. While holuing liquiu assets will make banks moie iesilient to liquiuity shocks, thus
ieuucing the negative exteinalities they might impose on othei economic agents, holuing too
many may impose a significant cost in teims of ieuuceu piofitability. Inueeu, as ietaineu eainings
aie the piimaiy means of oiganic capital geneiation, low piofits may pievent banks fiom
expanuing anu extenuing auuitional cieuit to the ieal economy. These benefits anu costs aie
equally applicable both foi inuiviuual institutions anu the financial system as a whole.
Pieliminaiy iesults in this papei also suggest that Canauian banks may have neeueu to holu less
liquiu assets ovei the estimation peiiou than uiu 0.S. banks, in oiuei to optimize piofits. While this
coulu peihaps point to favouiable maiket peiception of the iegulatoiy fiamewoik anu
15
conseivative, univeisal banking mouel in Canaua, these iesults shoulu be inteipieteu with caution
uue to uata conceins.
Noie geneially, this papei maiks a fiist attempt to empiiically auuiess the ielationship between
liquiu assets anu bank piofitability. In inteipieting the estimation iesults, it shoulu be kept in
minu that this woik uses a ieuuceu foim mouel anu, uespite econometiic aujustments, may not
fully account foi enuogeneity between vaiiables (e.g., availability of liquiu assets). This is
paiticulaily impoitant in teims of uiscussing any optimal level of liquiu asset holuings ielative to
piofits.
uoing foiwaiu, this papei coulu seive as a stepping stone foi auuitional woik. 0ne coulu apply the
cuiient fiamewoik to auuitional countiies, peihaps focusing on those with anu without pie
existing bank liquiuity iequiiements. 0ne coulu also explicitly mouel the ueteiminants of bank
liquiu asset holuings oi go one step fuithei anu establish a geneial equilibiium mouel incluuing
bank piofitability anu liquiuity.
In any event, the cuiient papei seives as an initialstep, highlighting an impoitant, if elementaiy,
ielationship, ielevant to the iegulation of banks.

16
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18
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19
AppendixA:
Table A.1: vaiiable uefinitions anu uesciiptive statistics
Symbol Befinitions Sample
mean
Stanuaiu
Beviation
R0E Pietax annualizeu ietuin on total shaieholueis equity u.1799 u.1276
R0A Pietax annualizeu ietuin on total assets u.u1S4 u.uu8S78
gup

Quaiteioveiquaitei giowth iate of ieal uBP u.u1194 u.uu791S


cp Quaiteioveiquaitei giowth iate of coie CPI (coie inflation iate) u.uuS988 u.uu6u14
0nemployment 0nemployment iate S.SSS9 1.1SSS
Leveiage Ratio of total assets to total shaieholueis equity 12.69S8 4.6222
Tiei1 Tiei 1 capital iatio (Tiei 1 capital as a shaie of iiskweighteu assets
Basel I uefinition foi 0.S. banks; Foi Canauian banks Basel I
uefinition until 2uu7Q1 anu Basel II uefinition fiom 2uu7Q2 on).
22
u.u967S u.u2262
la Liquiu assets as a shaie of total assets.
23
u.1926 u.u9S2u
Nkt_income Tiauing anu investmentbankingielateu ievenues as a shaie of
gioss income (inteiest income anu noninteiest income)
24
u.uSS94 u.uSS7u
Repos Reveise iepuichase agieements as a shaie of total liabilities u.u7928 u.u6S22


Table A.2: Estimation Results with Bank anu Time FixeuEffects RetuinonEquity
(1) (2) (S)
vARIABLES
R0E R0E R0E

unemployment u.uS97*** u.uS79*** u.uSS1***
gup

S.1S2*** S.S2S*** 4.u82***


cp
t-1
u.u286 u.u16S u.474
lo
t-1
u.69S*** u.61S*** u.948***
lo
t-1
2
1.uu6*** u.76S*** 1.112***
lo
,t-1
mkt_incomc
,t
1.78S** 1.96S**
lo
,t-1
rcpos
,t
u.SS2
lo
,t-1
gJp

,t
16.98*** 18.4u*** 22.S4***
leveiage
t1
u.uu747*** u.uu6uS***
Tiei1
t1
1.u68***
0bseivations 287S 2877 28SS
Rsquaieu u.S8u u.S77 u.S81
Rbai u.S62 u.SS9 u.S6S
pvalue of Bansens }Statistic u.S7S u.449 u.74S
pvalue of unueiiuentification LN statistic u.uuu u.uuu u.uuu



22
0.S. banks have not yet officially auopteu Basel II.
2S
Liquiu assets aie uefineu as: cash anu equivalents, ueposits at othei financial institutions, goveinment anu
goveinmentguaianteeu secuiities.
24
Noie specifically, maiketielateu income is uefineu as tiauing income, fees anu commissions fiom secuiities
biokeiage anu investment banking auvisoiy anu unueiwiiting fees anu commissions, baseu on available uata.
20
Table A.S: Estimation Results with Bank anu Time FixeuEffects RetuinonAssets
(1) (2) (S)
vARIABLES
R0A R0A R0A

unemployment u.uuSS8*** u.uuS2u*** u.uuS7S***
gup

u.SS6*** u.S86*** u.S7u***


cp
t-1
u.u2SS u.uSu9 u.u2u4
lo
t-1
u.u674*** u.u611*** u.uS74***
lo
t-1
2
u.u8S8*** u.u64S*** u.u78S***
lo
,t-1
mkt_incomc
,t
u.u977** u.122**
lo
,t-1
rcpos
,t
u.u171
lo
,t-1
gJp

,t
1.872*** 2.u12*** 1.9S8***
leveiage
t1
u.uuuSu6** u.uuuSS8***
Tiei1
t1
u.u112
0bseivations 287S 2877 28SS
Rsquaieu u.788 u.786 u.788
Rbai u.779 u.777 u.779
pvalue of Bansens }Statistic u.186 u.2SS u.72S
pvalue of unueiiuentification LN statistic 7.66eu6 6.SSeu6 S.4Seu6


Table A.4: Estimation Results with Bank FixeuEffects
2S
RetuinonEquity
(1) (2) (S)
vARIABLES
R0E R0E R0E

unemployment u.u272*** u.u24u*** u.uS4S***
gup

6.442*** 6.848*** 6.672***


cp
t-1
S.97S*** S.971*** 4.S7u***
lo
t-1
1.uS9*** u.998*** 1.SS2***
lo
t-1
2
1.111** u.86S*** 1.S16***
lo
,t-1
mkt_incomc
,t
2.uu1** 2.1S4**
lo
,t-1
rcpos
,t
u.272
lo
,t-1
gJp

,t
2u.S1*** 21.SS*** 22.88***
leveiage
t1
u.uu8SS*** u.uuS7S***
Tiei1
t1
u.791***
0bseivations 287S 2877 28SS
Rsquaieu u.112 u.1u7 u.114
Rbai u.u88S u.u8SS u.u9u9
pvalue of Bansens }Statistic u.4Su u.S22 u.76S
pvalue of unueiiuentification LN statistic u.uuu27S S.uSeuS u.uuu1S4



2S
In the case of bank fixeueffects only, the vaiiancecovaiiance matiix is maue iobust to autocoiielation anu
heteioskeuasticity using the Aiellano (1987) methou as suggesteu by Wooluiiuge (2uu2).
21
Table A.S: Estimation Results with Bank FixeuEffects RetuinonAssets
(1) (2) (S)
vARIABLES
R0A R0A R0A

unemployment u.uu21u*** u.uu184*** u.uu2u7***
gup

u.S48*** u.S81*** u.SS4***


cp
t-1
u.S68*** u.S6S*** u.S78***
lo
t-1
u.u94S*** u.u88u*** u.u889***
lo
t-1
2
u.u992*** u.u788*** u.1u4***
lo
,t-1
mkt_incomc
,t
u.124** u.142**
lo
,t-1
rcpos
,t
u.u162
lo
,t-1
gJp

,t
1.81S*** 1.91S*** 1.77S***
leveiage
t1
u.u171
Tiei1
t1
u.uuuS6S** u.uuu4SS***
0bseivations 287S 2877 28SS
Rsquaieu u.17S u.169 u.174
Rbai u.1SS u.147 u.1S2
pvalue of Bansens }Statistic u.164 u.197 u.S92
pvalue of unueiiuentification LN statistic u.uuu27S S.uSeuS u.uuu1S4


Table A.6: Estimation Results with Countiy Bummy vaiiable
26
Retuin on Equity anu Retuin on Assets
(1) (2)
vARIABLES
R0E R0A

unemployment u.uS88*** u.uuSS1***
gup

S.171*** u.SSu***
cp
t-1
u.uuS81 u.u221
lo
t-1
u.748*** u.u678***
CA - lo
t-1
u.41S* u.u29S*
lo
t-1
2
1.u9u*** u.u862***
lo
,t-1
mkt_incomc
,t
1.8S7** u.1uu**
lo
,t-1
gJp

,t
16.6u*** 1.782***
leveiage
t1
u.uu78S*** u.uuu298**

0bseivations 287S 287S
Rsquaieu u.S8u u.788
Rbai u.S62 u.779
pvalue of Bansens }Statistic u.S47 u.2S7
pvalue of unueiiuentification LN statistic u.uu6u2 u.uu6u2



26
Bank anu time fixeueffects.
22
AppendixB:
This appenuix aims to explain one majoi uiffeience acioss 0.S. anu Canauian accounting
stanuaius: the tieatment of offsetting ueiivative positions unuei 0.S. uAAP anu IFRS.
27
0nuei
IFRS, ueiivatives aie accounteu foi on the balance sheet as positive maiket values fiom
ueiivatives (asset siue) anu negative maiket values fiom ueiivatives (liabilities siue) wheieas
unuei 0.S. uAAP, they aie accounteu foi as ueiivatives post netting. This means that, unuei 0.S.
uAAP, if a mastei netting agieement exists between two counteipaities, then they aie alloweu to
iepoit theii net ueiivatives positions on theii balance sheets.
Table B.1: Stylizeu example of 0TC ueiivative netting
Counteipaities Positive maiket value
(assets)
Negative maiket value
(liabilities)
Beiivatives post netting
(0.S. uAAP)
C1 12 S +7
C2 2u 2u u
CS S 1u S
Total unuei IFRS S7 SS

To pioviue a numeiical example, Table B.1 shows how netting can affect the balance sheet of a
bank with thiee counteipaities (C1, C2, CS) with uiffeient 0TC ueiivatives exposuies. Positive
values aie classifieu as assets, while negative values aie classifieu as liabilities. Assume that
mastei netting agieements exist between the bank anu its counteipaities. Thus, unuei IFRS, the
value of ueiivatives assetsliabilities woulu be the veitical sum of the seconu anu thiiu columns of
Table A.1. Alteinatively, unuei 0.S. uAAP, banks can net the value of positive anu negative
exposuies to a single counteipaity. In this example, the same bank woulu iepoit ueiivative assets
of 7 anu liabilities of S unuei 0.S. uAAP, compaieu to S7 anu SS, iespectively, unuei IFRS.
Thus, any ciosscountiy compaiison of total bank assets must account foi such uiffeiences in
ueiivatives accounting stanuaius.


27
Canauian uAAP follows veiy closely the IFRS iules in this case.