Capital and liquidity are critical factors for the soundness of banks; thus, they are regulated in Basel III and their relationship has been discussed in literature. But the extant studies do not obtain the expected results in the link from liquidity creation to capital. This study argues that different capital states affect the effect of liquidity creation on capital. We combine capital adequacy ratio (CAR) and leverage ratio (LR) to define a sufficient-capital bank when it is well-capitalized in both capital ratios, and define two types of deficient-capital banks when they are not well-capitalized in either CAR or LR. We propose illiquidity risk effect and buffer cost effect. We find a negative relationship in sufficient-capital banks that the banks decrease their capital after conducting excessive liquidity creation, which support the buffer cost effect, but a positive relationship in deficient-capital banks that the banks increase their capital after conducting excessive liquidity creation, supporting the illiquidity risk effect. We further investigate the components in the changes of capital ratios and find that sufficient-capital banks raise Tier 1 capital, whereas deficient-capital banks raise Tier 2 capital. Our study confirms that capital states play an important role in the relationship between liquidity creation and capital.
