Bank Capital, Liquidity Creation, and Institutional Quality: Evidence from Africa

This study examines the bidirectional relationship between bank capital and liquidity creation in Africa and how this is shaped by institutional quality. We employ a system of simultaneous equations with a two-step system GMM estimator using a sample of 484 commercial banks in 50 African countries from 2011 to 2020 and find a significant and negative bidirectional relationship between bank capital and liquidity creation and evidence of the interactive effect of institutional quality on this relationship. Our findings indicate that as institutional quality improves, the capital–liquidity creation bidirectional relationship shifts from negative to significantly positive. This suggests that improvements in institutional quality in Africa reduce information asymmetry and enhance regulatory capacity, incentivizing banks to simultaneously increase liquidity creation and reinforce their capital levels. These results hold true across African sub-regions, different bank sizes, and alternative proxies. Our findings offer valuable policy implications for policymakers and regulators in Africa.