The study critically examines the impact of capitalization on bank liquidity creation in selected banks of Nigeria using the annual data of 10 banks for the period 2006 to 2010. The results of Levin, Lin and Chu unit root test show that all the variables are nonstationary at level. The results of Panel Least Square (PLS) regression reveal that bank size and capital asset ratio are positively related to bank capital but only bank size is significantly related to bank capital. In addition, the results show that bank liquidity and non-performing/assets ratio have a non-significant negative effect on bank capital. The implication is that better capitalized banks tend to create less liquidity, which supports the ‘financial fragility-crowding out’ hypothesis. This finding has important policy implications for emerging countries like Nigeria as it suggests that bank capital requirements, that is, recapitalization policy, implemented to support financial stability, may harm liquidity creation. The financial regulatory body needs to provide appropriate effective measures to adequately enhance transparent accountability. Measures such as relaxation or elimination of restrictions on profits and capital remittances, opening of formerly ‘priority’ sectors to investors, and provision of adequate security, among others, should be put in place.

Over the last decades global financial markets have become interdependent. Changes in the market have given rise to new risks that have influenced the stability of the financial system. Banks as financial market’s outlet are regarded as one of the important chains in the economy in performing resources distribution function which exposes it to liquidity risk arising from different terms of assets and liabilities maturity. According to the theory of financial intermediation, an important role of banks in the economy is to provide liquidity by funding long-term, illiquid assets with short-term, liquid liabilities. Through this function, banks create liquidity as they hold illiquid assets and provide cash and demand deposits to the rest of the economy. Liquidity creation is one of the pre-eminent functions of banks but it is also a major source of banks’ vulnerability to shocks. However, as banks are liquidity insurers, they face transformation risk and are exposed to the risk of run on deposits. More generally, the higher is the liquidity creation, the higher is the risk for banks to face losses from having to dispose of illiquid assets to meet the liquidity demands of customers. The theoretical literature produces two opposite predictions on the link between capital and liquidity creation: ‘Financial Fragility-Crowding Out’ Hypothesis and ‘Risk Absorption’ Hypothesis. The former predicts that higher capital reduces liquidity creation, while the latter suggests that capital positively affects liquidity creation.

The potential effects of bank capital on liquidity creation raise important research and policy issues. The research issues include the question as to why banks generally have the lowest capital ratios of any industry, and why banks tend to fund loans with demand deposits, creating potentially fragile institutions that are subject to runs. The key policy issues include validating minimum capital requirements that may suppress the liquidity creation process, upholding the prudential supervision and maintaining adequate regulatory actions.