Breaking the ceiling: Interest rate deregulation and liquidity creation

This paper exploits the 1999 Gramm–Leach–Bliley Act, which eliminated Arkansas’s longstanding interest rate cap for Arkansas-headquartered banks, to identify how releasing a strict pricing constraint alters bank liquidity creation. We find clear differences across bank size: large banks increase liquidity creation after deregulation, while small banks reduce it, a pattern consistent with established differences in how banks of different sizes adjust to regulatory constraints. The composition of liquidity creation also changes, with large banks shifting toward commercial, industrial, and mortgage lending and small banks increasing individual loans. Competitive pressures intensify once the ceiling is lifted, contributing to the divergent responses among banks. We further show that the ceiling muted the responsiveness of liquidity creation to monetary policy and that this friction disappears following deregulation. Overall, the findings advance the literature by connecting interest rate (de)regulation to core banking functions and the effectiveness of monetary policy, with broader implications for regulated credit markets across countries.