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| Capital Instrument Innovation and Bank Liquidity Creation: Evidence from Perpetual Bonds |
| LI Zhisheng, LIU Zhouyi
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School of Finance, Southwestern University of Finance and Economics;
School of Finance, Zhongnan University of Economics and Law |
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Abstract As financial regulation tightens, banks face growing capital pressures. This can limit their ability to support the real economy. While capital regulation is crucial for managing risks, it can also lead to credit crunches, increased loan interest rates, reduced corporate credit availability, and even intensified economic cycle fluctuations. In China, commercial banks have been facing the challenges in maintaining adequate capital ratios. To ease these pressures, regulators have relaxed the rules for issuing capital instruments, especially by promoting perpetual bonds in December 2018. On January 25, 2019, Bank of China successfully issued the first bank perpetual bond in the interbank bond market. Since then, perpetual bonds have become a key method for banks to boost their Tier 1 capital, with both the number of issuing banks and the scale of issuance growing rapidly. These bonds offer benefits like low issuance thresholds and high market acceptance; however, their impact on bank liquidity creation is not yet clear. This study examines how perpetual bonds affect bank liquidity creation, assessing the effectiveness of capital instrument innovation policies.
Theoretically, banks create liquidity by financing relatively illiquid assets with relatively liquid liabilities. According to the process of liquidity creation, perpetual bonds can enhance bank liquidity creation from both the asset and liability sides, as well as by improving the efficiency of liquidity creation. On one hand, perpetual bonds can increase the amount of capital and enhance banks' credibility, which is conducive to attracting short-term funds into the banking system and creating liquidity on the liability side. On the other hand, they can improve bank's risk absorption capacity, which helps to provide more long-term funds to the society and create liquidity on the asset side. In addition, perpetual bonds can also minimize idle funds within the banking system, accelerate the transformation of liquid liabilities into illiquid assets, and improve the efficiency of liquidity creation.
Empirically, this study uses data on Chinese commercial banks from 2015 to 2023 to test the impact of perpetual bonds. The results show that issuing perpetual bonds has a positive effect on bank liquidity creation. Various robustness tests confirm the consistency of these findings. The study also finds that the positive impact is more significant for banks with relatively sufficient capital and for non-listed banks. In terms of credit demand, perpetual bonds are more effective in enhancing liquidity creation during periods of high credit demand, but less effective during periods of low credit demand. Further analysis shows that perpetual bonds can improve bank capital buffers and quality, reducing the procyclicality of liquidity creation. They also have a positive impact on credit allocation to the real economy, and are helpful to guide funds back to real economic activities.
This study extends the research on capital regulation policies. While most studies focus on the negative impacts of tighter regulations, this study looks at the positive effects of capital instrument innovation. By analyzing the impact of perpetual bonds on bank liquidity creation, this paper reveals the important role of capital instrument innovation in easing bank capital pressure and enhancing banks' ability to serve the real economy, which provides empirical evidence for the coordinated development of capital regulation policies and capital instrument innovation. Our study also has explicit policy implications. The intensification of capital regulation leads to an increase in banks' capital pressure. Capital instrument innovation offers banks a way to replenish capital, which not only helps alleviate the capital pressure on banks but also enhances the liquidity creation, mitigate the procyclicality of liquidity creation, and optimize banks' credit structure, thereby improving banks' ability to serve the real economy. Regulators should actively promote capital instrument innovation, and while maintaining strict capital regulation, encourage banks to issue perpetual bonds and other capital instruments. Regulators should also refine the complementary policies. For example, simplify issuance procedures and provide tax incentives in the issuance phase, and in the secondary market broaden the application of central bank bill swap tools to increase the liquidity of perpetual bonds.
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Received: 05 January 2024
Published: 02 January 2025
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