where xit stands for the log of total assets, as a measure of size and for the capital ratio as
a capitalisation indicator28. By defining size and capitalisation in this way we ensure that
the zit variable captures pure differential effects. For each time period, the zit variable
averages to zero, being negative for banks whose specific characteristic (size and
capitalisation ratio) is below average (these will be called small or less capitalised banks)
and positive for banks whose specific characteristic is above average (these will be
designated large or well capitalised banks). In case of liquidity the zit variable is instead
taken in the form of differences from a per-bank average, i.e.,
zit
1T
=xit - ∑xit
T t=1
= xtt - x
(7.4)
where xit stands for the liquidity ratio as a measure of bank liquidity29. The rationale for
such a definition is the following. Theoretically, if anything, banks are expected to react to
monetary policy according to their own concept of positive or negative excess liquidity.
But, the concept of excess liquidity is bank specific and so it has to be seen as the
difference between the actual liquidity ratio and what (in the banks’ opinion) is its
optimum liquidity ratio (which is expected to vary according to bank size, the degree of
bank risk aversion, the customers mix, etc.). If, a monetary policy shock occurs when the
liquidity ratio is above the optimum (long run equilibrium) liquidity ratio, the bank
reaction will be smaller (less lending channel effect) than otherwise. Definition (7.4)
assumes that the bank specific long run equilibrium liquidity level may be proxied by the
bank average liquidity ratio during the sample period30. If, with the zit variable as defined
in (7.4) we compute the average banks reaction to changes in deposits we get from (7.2)
ɪ ∑ ∂ ln(C / P)tt
N ∑ ∂ ln(D / P)tt
1N
N Σ β + β2 zit ) = β1 + β2( X - x )
(7.5)
28 The capital ratio is computed as “capital and reserves” over total assets.
29 The liquidity ratio is computed as the sum of cash plus inter-bank deposits plus government securities
divided by total assets.
30 In samples in which general positive excess liquidity during a large period of time is not compensated
by an equally long period of negative excess liquidity, it may be the case that the sample average liquidity
ratio is not a good proxy for the long run equilibrium liquidity ratio. This is also to be the case whenever the
time dimension of the panel is too short (so that it does not allow computing a meaningful bank average
liquidity ratio) or too long (in this case one should allow for a time varying optimum long run equilibrium
liquidity ratio)
28