The effect of banks’ cost efficiency and competition on liquidity creation

Abstract

This study examines the role of a bank’s cost efficiency and competition when creating liquidity. It also investigates the different abilities to create liquidity between conventional banks and Islamic banks. This study employs data from annual reports for 117 banks, including 103 conventional banks and 14 Islamic banks from the Association of Southeast Asian Nations 4 (ASEAN-4). Using the dynamic panel regression with the GMM system, this study finds that cost-efficient banks have a higher ability to create liquidity, while high banking competition deteriorates that ability. However, these effects decrease as banks manage their costs more efficiently. The findings imply that banks’ ability to create liquidity is impacted by their market power to win the competition. Additionally, this study found that Islamic banks create more liquidity than conventional banks. This phenomenon indicates that by being more focused on activities using on-balance sheet items, Islamic banks are spared from risky off-balance sheet commitments. Furthermore, efficient banks are more able to generate liquidity in competitive markets.