Iranian Journal of Finance

Abstract Banks play a vital role in the economy by offering various financial services. One of their core functions is channelling surplus funds from units with excess resources to those with deficits, even when the latter have viable investment opportunities. This intermediary role is particularly crucial in developing economies, where capital markets are often underdeveloped and limited in scope. This study focuses on one of the most essential functions of banks—liquidity creation. Liquidity is generated when banks transform liquid liabilities into illiquid assets. While this process is fundamental to banking operations, it also introduces potential risks, especially when liquidity levels decline. In such cases, banks may become vulnerable to liquidity and credit risks. The capital adequacy ratio (CAR), disclosed in financial statements, serves as an important indicator of a bank’s resilience and its capacity to absorb losses and manage financial risks. This study investigates the relationship between liquidity creation and CAR using data from a sample of banks over the period 2011–2019, incorporating several control variables. The results support the financial fragility–crowding out hypothesis, indicating a negative relationship between liquidity creation and capital adequacy. Among the control variables, the deposit-to-asset ratio, non-interest income ratio, and bank size negatively influence CAR. In contrast, return on assets (ROA) shows a positive association, enhancing capital adequacy.