The paper entitled “Bank soundness and liquid asset allocation from the perspective of financial regulation”, which was written by our school’s Professor Wang Hui and PhD student Zhu Jiayun from the School of Finance of CUFE, has been published in the 2022 12th issue of Economic Research Journal.
While China's financial reform and development has made great achievements, the country's financial industry has been constantly tested by the impact of complex environments. Problems such as gradual exposure of commercial bank risks and concentration of regional risks need to be solved urgently. In the face of profound changes in the domestic and international economic and financial environment, strengthening the supervision and governance of fragile financial institutions and improving the local financial ecological environment are crucial to promoting high-quality economic and financial development. Therefore, we study the role of bank soundness on its liquidity reserve from the perspective of financial regulation, and analyzes the comprehensive impact of regional financial soundness.
We introduce the bank soundness into the research framework of banks’ asset allocation to study the optimal liquidity reserves of fragile banks and stable banks when the externality of assets’ fire-sale exists, and comprehensively discuss the impact of regional financial soundness and financial regulation on bank asset allocation decisions. The propositions and corollaries of the theoretical model are empirically tested with the unbalanced panel data of 312 commercial banks in China from 2007 to 2019. We provide empirical evidence on how bank soundness, regional financial soundness and financial regulation affect bank liquidity reserve decision-making behavior. We further discuss the influence of bank soundness and liquidity allocation decisions on the contribution of systemic financial risk, and the influence of bank soundness on bank liquidity reserve under different ownership and different stages.
The theoretical research shows that: Firstly, in decentralized economy, the impact direction of bank soundness on banks’ liquidity reserves is not clear. Homogenization equilibrium, taking precautions equilibrium and adverse selection equilibrium may occur. Secondly, under the central planner economy, there are only two kinds equilibrium. Financial regulation will increase the liquidity reserves of banks. The stricter the financial regulation, the more the liquidity reserves of fragile banks will be. Thirdly, for both economic conditions, regional financial soundness represented by the proportion of fragile banks has a significant negative impact on institutional liquidity reserves. Fourthly, The tighter the financial regulation, the greater the liquidity reserves of fragile banks.
The empirical results show that: Firstly, there is a U-shaped relationship between bank soundness and banks’ liquidity reserves in China, and the relationship is mainly reflected in urban commercial banks and rural commercial banks. And bank fragility will impair banks’ liquidity creation capacity. Secondly, regional financial soundness has a significant negative effect on bank cash reserves. The less sound the local financial system, the more incentive local weak banks have to reduce the proportion of cash assets and liquid assets. Thirdly, measures to strengthen financial supervision, such as increasing confiscation income or financial supervision and other business expenses, will weaken the negative impact of bank soundness on banks' liquidity reserves. But financial regulations will order state-owned commercial banks and joint-stock commercial banks to avoid reluctance to lend, thus reducing their reserves of liquid assets. Fourthly, bank fragility has a non-linear effect on the contribution index of systemic risk. The increase of bank liquidity reserves will reduce the implied default rate of banks and weaken their total contribution to systemic risk. The influence of bank soundness on its contribution to systemic risk is partly mediated by their liquidity reserves.
The findings of this study have three policy implications．Firstly, the financial supervision in our country now effectively restrains the negative influence of bank fragility on bank liquidity reserves, therefore, regulators should continue to carry out differentiated supervision over various banks, strengthen punishment for violations of laws and regulations, and promptly take risk correction measures for vulnerable banks with poor ratings. Secondly, authorities should attach great importance to monitoring and guiding the banking behaviors in provinces with high average non-performing loan ratio, and strengthen the rectification of the financial system in high-risk areas. Thirdly, comprehensive risk assessment of commercial banks based on asset quality and other dimensions is helpful to fully explore the risk characteristics of different types of banking institutions, and regulators can reasonably allocate regulatory resources to implement differentiated regulation according to the risk assessment results of banks.