br Introduction A balance sheet provides
Introduction A balance sheet provides vital information regarding a bank’s financial position at any given point of time. The asset side includes loans forwarded to borrowers while the liabilities side, among other things, shows deposits made by customers (Diamond & Rajan, 1999). Banks not only support the economy by providing finance, but also assist in transactions carried out by an economic agent (Horváth, Seidler, & Weill, 2014). Further, banks play a crucial role of transforming illiquid assets into liquid assets through demand deposits (Diamond & Dybvig, 1983). However, an unexpected increase in liquidity demand forces banks to sell their illiquid assets at lower prices resulting in losses and increased risk (Allen & Gale, 2004; Allen & Santomero, 2001). A study on the association between capital level and risk explains that bank capital behaves as a buffer against the risk faced by banks (Bhattacharya & Thakor, 1993). On the other hand, Diamond and Rajan (2001) argued that greater capital buffer in banks led to less liquidity. Horváth et al. (2014) studied the relationship between capital and liquidity creation by banks and found that small banks with high level of capital created less liquidity whereas large banks having excessive capital consistently created more liquidity. According to the guidelines of the Reserve Bank of India (2012), “liquidity is a bank’s capacity to fund increase in assets and meet both expected an unexpected cash and collateral obligations as they become due”. Many researchers have emphasized that the fundamental role of banks as creators of liquidity makes them susceptible to liquidity risk (Ratnovski, 2013). Liquidity risk is the incapability of a bank to fulfill its financial commitments without losing assets or incurring undesirable expenditure. To avoid such a situation and maintain financial stability, it HOBt manufacturer is preferable for banks to maintain a sufficient liquid buffer (Arif & Nauman Anees, 2012). After the global financial turmoil, low solvency of banks was assumed to be its root cause. The Basel Committee on Banking Supervision (2010) emphasized solvency of, and liquidity creation by banks, and proposed new capital rules to avoid such a situation in future. These rules included maintaining higher capital reserves by banks. Liquidity risk had mostly been considered secondary risk in banking literature before the global financial crisis (Matz & Neu, 2007). However, after the crisis, attention of policy makers and researchers was drawn towards the grave effects of liquidity risk. It is noteworthy however, that extant literature does focus on banks’ insufficient risk management practices (Crowe, 2009). Consequently, inadequate liquidity gained significant attention, and became a solemn concern for banks (Jenkinson, 2008). Literature immediately after the global financial crisis suggested that the crisis mainly affected developed economies, but when the Indian banking sector observed transfer of deposits from private sector banks to the public sector banks, neutron drew the attention of practitioners and researchers alike. Eichengreen and Gupta (2013), and Acharya and Kulkarni (2012) also asserted that post-crisis liquidity risk affected the Indian banking system. Similarly, studies on liquidity of Indian banks by Shukla (2014) highlighted that liquidity pressure affected Indian economy because of the extraction of investments made in the financial system of India. While it is generally believed that the Indian banking system has stringent rules and regulations and its policies would act as an insulator and protect Indian banking system from such a crisis, it is noteworthy that the liquidity problems faced by the Indian banking sector was not due to the inefficiency of the banking system or laxity in regulations, but because of the insecurity of the customers. Thus, it was customer sentiment that affected liquidity in Indian banks, especially in the private banking sector (Eichengreen & Gupta, 2013). Bhati and De Zoysa (2012) mentioned mismanagement of liquidity as one of the major reasons behind liquidity problems.