Are Banks Liquidity Transformers?

Abstract

Although much of banking theory and regulation is based on banks modeled as fragile liquidity transformers, this view does not appear to have solid empirical foundation. We show that the amount of liquidity transformation - measured as the scaled difference between liquid liabilities and assets - performed by US commercial banks is surprisingly low. Deposit insurance has limited success in promoting liquidity transformation because insured deposits mostly replace uninsured liabilities rather than expand the deposit base or loans. Instead, it is the credit risk in loan portfolios that appears to discourage liquidity transformation.