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The Canadian banking system is well-known worldwide for its financial stability and resilience to economic turmoil. Canadian banks survived the global financial crisis (GFS) in 2008 and the COVID-19 pandemic unscathed. What makes the Canadian banking system resistant to economic disruptions?

In our recent study, in the Asia-Pacific Journal of Financial Studies, my co-authors and I investigate the relationship between the Tier 1 capital ratio and on-balance-sheet liquidity creation. According to the , the Tier 1 capital ratio represents the highest quality of regulatory capital, as it can immediately absorb losses when they arise.

Liquidity creation measures a bank's ability to facilitate the flow of funds by transforming liquid deposits into illiquid loans. This function plays a crucial role in supporting the economy.

Bank capital contributes to financial system stability by reducing solvency risk and increasing the need for stronger monitoring incentives. Previous research presents two competing theories on the relationship between regulatory capital ratios and liquidity creation. The "financial fragility-crowding out" hypothesis suggests a negative correlation, while the "risk absorption" theory predicts a positive link between bank capital and liquidity creation.

My findings on Canada's Big Six banks indicate that the positive relationship between the Tier 1 capital ratio and liquidity creation suggests that large Canadian banks can take on risk, as capital provides a buffer to support illiquid assets.

On June 25, 2018, the Office of the Superintendent of Financial Institutions (OSFI) introduced the first Domestic Stability Buffer (DSB) at 1.5% of total risk-weighted assets. The serves as a financial safeguard, requiring Canada's largest banks to set aside funds to absorb potential losses during periods of economic uncertainty. As a key policy tool, the DSB strengthens the stability of Canada's financial system, while encouraging big banks to utilize this capital to support lending activities.

Since the DSB applies exclusively to Canada's Big Six banks, its initial level was designed to raise capital ratios rather than enhance bank liquidity creation. As a result, the introduction of the DSB can be viewed as an exogenous shock to regulatory capital.

I define a treatment group as Canadian Big Six banks and a control group as non-Big Six banks. Using the introduction of DSB as an exogenous shock, we investigate and find that the introduction of the Domestic Stability Buffer (DSB) for the Canadian Big Six had a significantly positive effect on their liquidity creation.

In terms of economic significance, a one standard deviation increase in the Tier 1 capital ratio increases liquidity creation by 5.24 percentage points after the initial DSB level in 2018 in comparison to non-Big Six banks. My finding is consistent with risk absorption theory.

This figure indicates that since the introduction of the DSB (2018q2), buffer increases in capital ratios have increased liquidity creation during 2018q2 and the next two quarters for Big Six banks compared to non-Big Six banks.

Canada presents a valuable setting for studying bank liquidity creation. Compared to banks in the United States and many other countries, Canadian banks have shown greater resilience during past crises, including the Great Depression, the 2008 Financial Crisis, and the 2023 banking crisis triggered by the collapse of Silicon Valley Bank and First Republic Bank in the U.S.

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Jie Zhang is an associate professor of finance at Trent University, Ontario, Canada. Zhang has a strong passion for empirical finance research, including corporate finance, corporate governance, financial institutions, and investments. Zhang's research findings have been featured in the New York Post and CBC News.