Institutions, capital control, and liquidity creation

Abstract

Purpose

The purpose of this study is to conduct an empirical investigation on how country-specific characteristics such as the quality of the institutional environment and the restrictiveness of capital control policy affect domestic financial sector’s ability to provide liquidity to the economy.

Design/methodology/approach

This study uses panel regressions on international banking data across 102 countries from Bankscope.

Findings

The results show that strong institutions and looser capital control in a country enhance the banks’ role as the liquidity provider to the economy. The study also finds that institutional quality and capital control have a dynamic effect that influences the creation of liquidity. Better institutions benefit the creation of liquidity in either under normal economic conditions or during economic downturn. Loosened capital control, as a result of financial openness, facilitates liquidity creation under normal economic conditions.

Originality/value

This study complements the research on the role of country-level institutions in financial and economic development and suggests a liquidity channel through which a country’s institutions can further economic growth. The study also provides evidence on the impact of a country’s control of capital flows on the role of banking sector in domestic economy.

Citation

Baradwaj, B.G., Shao, Y. and Dewally, M. (2016), "Institutions, capital control, and liquidity creation", Journal of Financial Economic Policy, Vol. 8 No. 3, pp. 396-422. https://doi.org/10.1108/JFEP-11-2015-0073