How changes in global liquidity affect dynamics of banks’ leverage: A case in Hong Kong

• Author: Jim Wong,Kelvin Ho,Ka‐Fai Li,Cho‐Hoi Hui
• Published date: 01 August 2019
• DOI: http://doi.org/10.1111/1468-0106.12263
• Date: 01 August 2019

ORIGINAL MANUSCRIPT

How changes in global liquidity affect dynamics

of banks’leverage: A case in Hong Kong

†

Kelvin Ho | Cho-Hoi Hui | Ka-Fai Li | Jim Wong

Hong Kong Monetary Authority, Hong Kong

Correspondence

Ho, Kelvin Ka Wing, Research Department, Hong

Kong Monetary Authority, 55th Floor, Two

International Finance Centre, 8 Finance Street,

Central, Hong Kong.

Email: kkwho@hkma.gov.hk

Abstract

This paper examines how abundant global liquidity could

influence the adjustment of banks’leverage. Using banks

in Hong Kong as an example, we find that the global

liquidity effect is significant, and that mean reversion of

banks’leverage may under certain circumstances be more

than offset by abundant global liquidity. Furthermore, we

find that changes in global liquidity not only affect the

level of leverage adjustment but also the adjustment

speed of banks’leverage.

1|INTRODUCTION

In the aftermath of the global financial crisis, abundant global liquidity generated from unconven-

tional monetary policies in the advanced economies has altered the international banking landscape

significantly. A direct consequence of abundant global liquidity is more cross-border borrowing and

lending activities, which may have implications for banks’capital management decisions.

The celebrated trade-off theory of leverage is a well-known model for understanding banks’lever-

age adjustment. One implication of this theory is mean reversion of leverage towards a target level.

The feature of mean reversion implies a self-correcting adjustment mechanism in which overlever-

aged firms decrease their leverage and adjust towards the target level over time, and vice versa. Ber-

ger, DeYoung, Flannery, Lee, and Oztekin (2008) and Gropp and Heider (2010) find extensive

evidence of mean reversion of leverage for banks in the United States and Europe. However, these

studies have not examined the plausible impact of global liquidity on banks’leverage dynamics.

Using banks in Hong Kong as an example, this paper examines how mean reversion of bank leverage

towards a target level could at times be unduly disturbed by changes in global liquidity conditions.

As changes in global liquidity likely have a tangible impact on a bank’s funding cost and, hence,

its leverage adjustment, we introduce proxies for global liquidity into the standard partial adjustment

equation and find that the global liquidity effect is significant for different indicators of global

†

The views expressed in this paper are those of the authors, and do not necessarily reflect those of the Hong Kong Monetary

Authority. We thank the editor and the anonymous referee their valuable comments and suggestions.

Received: 17 July 2016 Revised: 27 November 2017 Accepted: 15 February 2018

DOI: 10.1111/1468-0106.12263

Pac Econ Rev. 2019;24:493–507. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 493