Roles Writing – original draft * E-mail: lihuan_zhuang@163.com Affiliations School of Economics, Jinan University, Guangzhou, P.R. China, Guangzhou Branch of the People’s Bank of China, Guangzhou, P.R. China
This paper addresses the impact of bank liquidity on risk-taking behaviour of Chinese banks, and provides evidence for a risk-taking channel of monetary policy operating through bank liquidity. By using bank-level panel data from 123 Chinese commercial banks during 2003–2018, it is found that banks facing lower liquidity risk will be encouraged to take more risk. Moreover, loose monetary policy leads to more aggressive risk-taking by reducing the bank liquidity risk, namely a liquidity risk-taking channel of monetary policy. These findings suggest that authorities should give full consideration to the influence of the monetary policy on bank risk-taking through bank liquidity channels.
Citation: Wang C, Zhuang L (2022) Bank liquidity and the risk-taking channel of monetary policy: An empirical study of the banking system in China. PLoS ONE 17(12): e0279506. https://doi.org/10.1371/journal.pone.0279506
Editor: Daphne Nicolitsas, University of Crete, GREECE
Received: July 5, 2022; Accepted: December 8, 2022; Published: December 27, 2022
Copyright: © 2022 Wang, Zhuang. This is an open access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.
Data Availability: All relevant data are within the paper and its Supporting Information files.
Funding: YES - This work was supported by Chinese National Funding of Social Sciences (18BJL116). The funders had no role in study design, data collection and analysis, decision to publish, or preparation of the manuscript.
Competing interests: The authors have declared that no competing interests exist.
Liquidity risk has been recognized as a significant threat to financial institutions management and financial system stability. During the recent Global Financial Crisis, financial institutions in advanced economies faced severe liquidity risk which led to the bankruptcy or restructuring of many banks. After the Global Financial Crisis, bank liquidity has become an important focus of financial regulatory reform and financial regulators in many countries have tightened bank liquidity requirements in an effort to allay concerns about liquidity risk. However, although the increase of bank liquidity is conducive to reducing liquidity risk, it is uncertain whether the liquidity requirements will reduce the risk appetite of banks and make the whole financial system more stable. It is therefore important to better understand the underlying relationship between bank liquidity and bank risk-taking in light of the global wave of banking regulatory reforms that have made banks more liquid than ever.
Although recent studies have examined the role of liquidity risk and bank risk-taking in the context of both advanced market and developing economies [1–4], yet the results have been mixed and very little attention has been paid to an emerging market economy such as China where bank liquidity remains at a high level. As shown in Fig 1, the aggregate deposit-to-asset ratio for all Chinese bank stood at an average of 75% from 2003 to 2010 and decreased to an average of 65% in recent years, yet it is considered to be high compared to banks in 18 countries with a substantial presence of Islamic banking [3]. As China’s influence on the global economy and finance is on the rise and it is regarded as the role model for the other developing countries in adopting the swift economic transformation and financial reformation, the role of liquidity risk and bank risk-taking in China is of great significance to other developing countries.
PowerPoint slide larger image original image Fig 1. The aggregate deposit-to-asset ratio for all Chinese bank from 2003 to 2018.Moreover, the existing literature typically identifies two main notions related to bank liquidity, namely funding liquidity and market liquidity, which are mutually reinforcing and influence the degree of bank liquidity [5–7]. As monetary policy is an important factor affecting funding liquidity and market liquidity, it is necessary to consider the influence of monetary policy when examining the relationship between bank liquidity and bank risk-taking. After the Global Financial Crisis, the linkage between monetary policy and bank risk-taking has attracted increasing attention from both academia and policymakers. An number of studies have found that a prolonged period of relatively low interest rates can induce banks’ excessive risk taking and financial imbalances [8–10]. Distinct from the traditional monetary transmission mechanism, Borio and Zhu [6] coin the term ‘‘risk-taking channel of monetary policy”, and a number of studies have proved the existence of the risk-taking channel and explored the mechanisms it operates, such as the impact of interest rates on valuations, incomes and cash flows, incentives to “search for yield”, the communication policies and reaction function of the central bank [6, 8, 11, 12]. However, previous studies on the link between monetary policy and bank risk-taking have not fully considered the impact of bank liquidity. They just consider bank liquidity as a control variable, and rarely discuss a dimension of the risk-taking channel operating through bank liquidity.
To fill this gap, we investigate the linkage between monetary policy, bank liquidity risk and risk-taking behaviour of banks in China. In this paper, we examine the effect of banks’ liquidity risk on risk-taking behaviour, and the existence of a risk-taking channel of monetary policy operating through bank liquidity, namely a liquidity risk-taking channel of monetary policy.The paper has two contributions to the existing literature. First, we provide empirical evidence to reveal the potential relationship between bank liquidity and bank risk-taking in an emerging market economy which received only limited attention in related research thus far. Second, we expand the risk-taking channel theory by introducing an additional dimension of the transmission mechanism of monetary policy through bank liquidity and prove its existence in China.
The remainder of the paper is organized as follows. Section 2 reviews the literature on the bank risk-taking and develops the hypotheses of the study. Section 3 presents data and variables used and descriptive statistics. Section 4 presents the model and methodology. Section 5 discusses the estimated results and robustness tests. Section 6 presents study summary and conclusions of the study.
Liquidity risk, as one of the important risks, contributes to banks’ probability of default. Hong et al. [13] point out that, systemic liquidity risk is a major contributor to bank failures in American during the Global Financial Crisis, and an effective framework of liquidity risk management needs to target liquidity risk at both the individual level and the system level. The harm of liquidity risk has become the focus of academic and regulatory authorities. However, will strengthening bank liquidity supervision and improving bank liquidity reduce banks’ risk appetite and their risk? Vazquez and Federico [14] find that higher funding stability as measured by the net stable funding ratio in the new Basel III guidelines, reduces the possibility of bank failures in American and European. However, King [15] estimates the net stable funding ratio for banks in 15 countries and finds that strategies to increase the net stable funding ratio are estimated to reduce bank profitability and increase bank risk. Consistent with this view, the theoretical predictions of Wagner [16] suggests that high levels of asset liquidity can potentially increase banking instability and the externalities associated with banking failures because higher asset liquidity makes crises less costly for banks and encourages banks to take on an amount of new risk. Similarly, the theoretical research of Acharya and Naqvi [17] also shows that low liquidity risk as a result of large amounts of deposit inflows can induces risk-taking behaviour on the part of bank managers. Following Acharya and Naqvi [17], Khan et al. [1] use the ratio of total deposits to total assets as the proxy for funding liquidity risk and find that a reduction in funding liquidity risk increases bank risk by using data for U.S. bank holding companies. Dahir et al. [2] and Smaoui et al. [3] also find that lower funding liquidity risk leads to higher bank risk-taking in BRICS countries and 18 countries with a substantial presence of Islamic banking, respectively. However, Rokhim and Min [4] find that banks with lower liquidity risk indicated by higher deposit ratios tend to take lower risks. As the effects of liquidity risk on bank risk-taking are mixed in prior literature and we know very little about the effect in China, it is necessary to further study the situation in China. Building on the prediction of Acharya and Naqvi [17] and Khan et al. [1], we test the following hypothesis.
Hypothesis 1. The risk-taking of Chinese banks has a positive relationship with bank liquidity.
Borio and Zhu [6] coin the term "risk-taking channel of monetary policy transmission" to denote the impact of monetary policy on banks’ appetite for risk-taking and explain three transmission mechanisms of this channel. The first effect operates through the impact of interest rates on valuations, incomes, and cash flows. Lower interest rates boost the value of assets and collaterals as well as incomes and profits which in turn reduce risk perceptions, increase risk tolerance and incentivize banks’ risk-taking behaviour. The second effect operates through inducing the “search for yield” effect. Loose monetary policy leads to the decline of risk-free assets yield, which drives banks to increase their investment in risky assets to meet the fixed or targeted level of returns. The third effect operates through the communication policies and reaction function of the central bank. Higher monetary policy transparency reduces market uncertainty and risk premiums and encourages bank risk-taking. Based on the research of Borio and Zhu [6], some scholars have supplemented the other mechanisms of the risk-taking channel. For example, Chen et al. [18] suggest that monetary policy would affect banks’ risk-taking via causing banks to adjust their leverage, its impact on the adverse selection problem and generating competing effects.
The majority of current empirical research has documented the existence of risk-taking channel. For example, Delis and Kouretas [9] conduct an empirical test of euro bank data between 2001 and 2008, which prove that low interest rate greatly increases banks’ risk-taking, and the impact of interest rate on risk would be reduced for banks with higher equity capital, while the impact of interest rate on risk would be increased for banks with large proportion of off-balance sheet business. Jimenez et al. [19] use a unique micro-level data set for Spain, and find that after the monetary expansion, Spanish banks increased their loans to less creditworthy borrowers, thus increasing bank risk. Chen et al. [18] find that banks’ riskiness increases when monetary policy is eased by using bank-level panel data from more than 1000 banks in 29 emerging economies during 2000–2012.
However, previous studies on the link between monetary policy and bank risk-taking have not fully considered the impact of bank liquidity. Although Borio and Zhu [6] suggest that the link between liquidity and risk-taking can add to the strength of the monetary policy transmission mechanism-a sort of “liquidity multiplier”, they don’t regard bank liquidity as a transmission mechanism of risk-taking channel. Nguyen and Boateng [20] examine the impact of monetary policy on the risk-taking behaviour of Chinese banks in the presence of involuntary excess reserves which indicates unwanted surplus liquidity, yet they haven’t examined the mechanism that monetary policy affects bank risk-taking through involuntary excess reserves or bank liquidity. Chen et al. [18] take bank liquidity as a control variable while examine the role of monetary policy and banks’ riskiness. As bank liquidity is an important factor affecting bank risk, it is necessary to consider the mechanism of risk-taking channel operates through bank liquidity. It is therefore hypothesized that there is a transmission mechanism of monetary policy through bank liquidity channels, namely a liquidity risk-taking channel of monetary policy, that is, loose monetary policy reduces bank liquidity risk, and the reduction of liquidity risk encourages bank managers to engage in more active lending behaviour, which leads to the increase of bank risk.
Hypothesis 2. There is a transmission mechanism of risk-taking channel of monetary policy operating through bank liquidity.
We use unbalanced bank-level panel data of 123 banks in China during the period of 2003–2018 obtained from Bureau van Dijk’s Bankscope database and the annual reports of the sample banks. Only commercial banks are included in our sample (state-owned commercial banks, joint-stock commercial banks, city commercial banks and rural commercial banks). Policy banks, cooperative banks and investment banks are excluded because they have different objectives rather than profitability. Macro data (including national and economic and financial indicators are obtained from Wind Economic Database.
Our main proxy for bank risk is the banks’ z-score which is widely used in the literature [21–24]. The z-score is computed as follows: (1) where ROA is the return on assets, CAR is the capital asset ratio, and σ(ROA) is the standard deviation of ROA over a rolling window of 3-year period. The z-score measures the distance from insolvency in standard deviations. It represents the number of standard deviations that profits have to fall for the bank to become insolvent [22]. Following Laeven and Levine [21], we use the logarithmic transformation for z-score to deal with extreme values, denoted LnZ. A higher z-score value indicates lower probability of insolvency and greater bank stability. To facilitate interpretation, we denote “–LnZ” as the negative of the log transformed z-score values. We later use the change in non-performing loan ratio (dNPL) to measure banks’ risk-taking when we conduct robustness tests.
Bank liquidity has been measured in the literature in many different ways and there is little consensus from the theoretical literature on how to measure bank-specific funding liquidity risk. Drehmann and Nikolaou [7] define bank funding liquidity risk as the bank’s failure to solve obligations immediately. Diamond and Dybvig [25] argue that banks with excessive deposits face lower liquidity risk in the presence of deposit insurance because depositors are unlikely to “run” when their deposits are protected. The theoretical research of Acharya and Naqvi [17] measure banks’ funding liquidity risk by deposits because deposits shield banks from “run” risk and find that banks having higher deposits will take more risk. Khan et al. [1] argue that banks having higher deposits face lower liquidity risk because they have enough funds to solve their obligations and there is less “run” risk in the presence of deposit insurance. Although China only officially implemented the deposit insurance system in 2015, China has in fact implemented the hidden deposit insurance for a long time. Therefore, this paper refers to Khan et al. [1] and Acharya and Naqvi [17], and takes the ratio of deposits to total assets as the proxy variable of bank liquidity. In order to verify the robustness of the results, we also employ the negative of loans to deposits ratio (LTD) to measure bank liquidity. A higher value of deposits to total assets ratio (Liquidity) and LTD denote higher funding liquidity and face lower liquidity risk.
Interest rate, money supply and reserve requirement rate are the main instruments of monetary policy in China. Although China has basically liberalized the interest rate control in 2015, interest rate is yet to be fully marketized. Therefore, we use the 7-day interbank lending rate (Interbank) as interest rate indicators. As the reserve requirement rate is one of monetary policy instruments which has a direct impact on the volume of credit and thus the willingness of the financial system to take risks [26] and the M2 growth is managed as an intermediary monetary goal, we also use the reserve requirement rate (Reserve) and the negative of M2 growth rate (M2) to strengthen the robustness of our results. The reserve requirement ratio and the interbank lending rate are all weighted by time to obtain annual data. The higher value of the three monetary policy variables indicate the tighter monetary policy.
In order to avoid omitted-variable bias, we control for a series of bank-specific characteristics and general economic conditions that may also affect banks’ risk-taking behaviour. We include five bank-specific characteristics that are commonly adopted in the literature.
Bank size(Size)-this variable is proxied by the natural logarithm of real total assets. Bank size is an important factor affecting banks’ risk-taking behaviour. Banks will make risk decisions based on their size, and Khan et al. [1] suggest that larger banks will take less risk in response to lower funding liquidity risk. Considering the possible endogeneity of this variable, we refer to Khan et al. [1]and adopt its first lag value.
Loans to assets ratio (Loan)- Loan is measured as the ratio of loans to total assets. Some empirical studies find that banks that lend higher are generally riskier [1, 4]. Consistent with Khan et al. [1] and Rokhim and Min [4], we adopt its first lag value to deal with possible problems of endogeneity.
Bank capitalization (Capitalization)-this variable is measured as the ratio of capital to total assets. Some empirical studies provide evidence that higher capitalization effectively limit the risk-taking incentives of banks [9, 18], while Calem and Rob [27] suggest that banks may take more risk as their capitalization exceeds a certain threshold.
Bank efficiency (Efficiency)- Efficiency is represented by the cost income ratio. A higher value in our measure implies lower bank efficiency. Efficient banks may be more capable in managing risks, and thus bank riskiness declines [9].
National banks (National)-We also control for different types of banks by including National dummy which has the value of 1 for national banks and 0 for province banks.
In addition, we also include three macroeconomic variables into our control variables, namely, the growth rate of real GDP (GDP), the growth rate of house price (House) and Crisis. In consideration of the business area of different banks, national banks use country-level data of the three macroeconomic variables, while local banks use the province-level data. Crisis is a dummy variable which have a value of 1 in the year 2008 and 0 otherwise which control for the effect of Global Financial Crisis on Chinese banks.
Table 1 presents the definition of various variables and the characteristics of our sample, which consists of annual data of 123 banks in China during the period of 2003–2018. The negative of log transformed z-score has the mean of -4.86 and ranges from -8.12 to -0.25. The fairly high standard deviation and the wide range of Z-scores imply a considerable variation on the level of riskiness across banks. On average, bank liquidity, capitalization and efficiency for our sample constitute 73.4%, 6.7% and 38.9%. With regard to monetary policy, Reserve, Interbank and M2 constitute 16.6%, 3.0% and 14.7% on average.