Bank Liquidity Creation and Recessions

We investigate the relationship between bank liquidity creation and recessions in the U.S. For the 1984-2010 sample, we find that (i) bank on-balance sheet liquidity creation forecasts recessions four quarters into the future: lower on-balance sheet liquidity creation signals recessions; (ii) while off-balance sheet liquidity is not a robust predictor of recessions at higher forecast horizons, approximately one quarter prior to recessions, bank off-balance sheet liquidity creation falls in tandem with on-balance sheet liquidity creation, and hence aggregate of on- and offbalance sheet liquidity creation falls; (iii) aggregate, on- and off-balance sheet bank liquidity creation continue to decline during and up to five quarters after recessions; (iv) liquidity creation of larger banks rather than that of smaller ones contains more information about future recessions. The findings have important preemptive macro-prudential policy implications.