I have written a fair share of papers on the real sector implications of financial sector development in the early part of my career, so this new paper provides a bit of a flashback; but then again, as I (and many others)
have dug deeper and deeper into the finance-growth relationship, more and more non-linearities have emerged.
this new paper with Robin Doettling, Thomas Lambert and Mathijs Van Dijk, we focus on one specific function of banks – converting liquid liabilities into illiquid assets, thus providing liquidity insurance to depositors and enabling long-term investment.
Using a large cross-country sample of up to 100 countries we show that liquidity creation is positively associated with economic growth, with an effect that is stronger for industries more dependent on debt finance (thus following the seminal Rajan-Zingales
technique). However, liquidity creation helps growth by boosting tangible, but not intangible investment, a finding which we confirm both on the country- and industry-level. Finally, we find that countries with a higher share of industries relying on
intangible rather than tangible investment benefit less or not at all from higher liquidity creation by banks.
Our findings thus speak to the role of banks in
the new ‘knowledge economy’ and suggest that they will have a more limited role, compared to other types of financial intermediaries and markets. These findings are also consistent with both theory and previous empirical evidence that banks are
less well positioned to help innovative industries and firms.
We rationalise our empirical findings with a theoretical model, adding liquidity risk and moral hazard
to the seminal Diamond and Dybvig (1983) model. Information asymmetries allow investors to divert assets and default on bank loans, a problem that is particularly strong if asset tangibility is low, for two reasons. First, intangible investments can be more
easily diverted as they are harder to assess by outsiders. Second, failing intangible investments leave the bank with relatively low collateral value, reducing the value of claims on the bank. This makes it attractive for investors with successful projects
to divert even if the bank can seize their deposit claims. The effect of liquidity creation by banks on investment is thus hampered by asset intangibility, as it is harder for banks to make loans against intangible assets, in line with our empirical findings.
For a somewhat longer summary, here is the Vox-column.