The relationship between bank liquidity and stability: Does market power matter?

This paper investigates whether liquidity increases stability and if this association is affected by bank market power across 113 developed and developing countries during 1996-2010. We find that liquidity enhances bank stability. Specifically, banks with more liquid assets or those that are net-lenders in the interbank markets are more stable. Market power, however, reduces this positive impact of liquidity on bank stability. This suggests that in order to offset the low returns from holding liquidity, banks with greater market power in both deposit and loan markets increase their portfolio risks to generate more monopoly rents and hence are less stable. These results remain consistent across all models.