The Nexus between Bank Capital, Liquidity and the Business Cycles: Empirical Evidence from the UK Banking Sector

Abstract

Financial stability and liquidity creation are fundamental to economic growth.  As a result of the recent financial crisis, there has been a huge debate on the minimum capital level that is able to absorb credit risk, especially during a downturn. Using 10 largest banks in the UK, with the annual data from 2004 to 2013, this research examines the linkage among bank capital, bank liquidity, and the business cycle. Employing both dynamic and static models in line with other previous work,[1] the literature gives evidence that financial institution health is profoundly affected by its capital-asset ratio, its liquidity, and business-cycle variables. The results show that adequate capital level will mitigate the extent of the financial shocks. The positive association between loan to deposit and changes in the gross domestic product implies that credit extension falls as the economy contracts.

[1] Barth, (1991) and Cebula and Hung, (1992)