The Bright Side of Bank Liquidity Creation for Financial Stability: Evidence from China

Based on data from China commercial banks from 2005Q1 to 2022Q4, this paper systematically studies the impact of liquidity creation on systemic risk, emphasizing the crucial role of liquidity creation in maintaining financial stability. Our findings consistently reveal a positive relationship, indicating that liquidity creation by commercial banks can reduce the probability of individual bank liquidity risks through capital channel, and limit the contagion and amplification effects of systemic risk through market liquidity channel. Further analysis reveals that large banks, compared to smaller banks, have a more significant positive impact on financial stability through liquidity creation per unit of assets. However, for banks overly reliant on wholesale funding, increased liquidity creation may lead to the accumulation of systemic risk. This study provides important empirical evidence for the formulation of future bank liquidity regulation policies and the prevention and management of financial crises.