The Effect of Liquidity Risk and Credit Risk on Bank Stability: A Comprehensive Analysis
This research paper aims to investigate whether liquidity risk and credit risk factors within a
commercial bank have an economically meaningful impact on its stability and further model
an empirical relationship between the three, if it holds true.
The first objective is to analyze the relationship between liquidity risk and bank stability.
Through an examination of historical data and key indicators, we evaluate the impact of
liquidity risk on the financial stability of banks.
The second objective focuses on exploring the impact of credit risk on bank stability. By
analyzing various methodologies and models used to measure credit risk, we aim to assess
its role in determining the stability of banks. Through the investigation of historical patterns
and trends in credit risk within the banking sector, we seek to discover its implications for
bank stability.
The third objective is to understand the combined effect of liquidity risk and credit risk on
bank stability. By examining how these risks interact and influence the stability of banks, we
aim to provide a comprehensive analysis of their joint impact.
1. Bank Liquidity India Al-Homaidi Tabash Farhan Almaqtari
Common factors being used:
Liquidity risk
Return on assets
Return on Equity
Bank Size
NPA %
Capital adequacy
Deposits ratio
Assets quality ratio
Bank-specific determinants contain bank-size, deposit rate, profitability, asset quality,
funding cost and the rate of capitalization in a bank. While the macroeconomics factors
include GDP and inflation rate. The results indicated that among internal (bank-specific)
determinants, the size, profitability level, funding cost, and the quality of assets negatively
impact the LQD risk of Indian commercial banks. Whereas, the rate of deposits and the
capitalization rate have a positive influence. Amongst the macroeconomic determinants,
inflation rate and GDP growth rate have a positive and negative association with bank LQD
respectively.
Note : The most common ratios used by investors to measure a company's level of risk are
the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and
the debt-to-equity ratio.
Factors effecting bank stability:
Endogenous variables –
Credit risk
Liquidity risk
Other managerial enterprise risks
Exogenous variables –
Macroeconomic factors
Regulatory policies and Govt. intervention
Natural calamities/disasters/Pandemics
Talk about CRR and SLR in the paper.
2. Bank Stability in the MENA Region
We define bank stability is equal to the mean of return on assets plus the capital asset ratio
(equity capital/total assets) divided by the standard deviation of asset returns, this definition
is a better proxy to capture the bank stability.
They find that operating efficiency, overheads and reserves are significant determinants of
conventional banks’ performance, whereas deposits, operating efficiency, and market
concentration are significant determinants of Islamic one. They also conclude an impact of
GDP and the lending interest rate on performance for Islamic and conventional banks.
Banks' default risk is mainly driven by low capitalization, low earnings, over-exposure to
certain categories of loans and excessive loan defaults.
On the other hand, Calomiris et al. (2015) develop a theory on banking liquidity requirement
where they show that banks should be regulated on the side of the assets instead of that of
the capital.
Dependence of banks on the interbank market increases the probability of their bankruptcy.
Bankji;t and Bankpi;t represent the bank-specific control variables, namely the size of the
bank, the return on assets (ROA), the return on equity (ROE), the capital adequacy ratio
(CAR), the net interest margin (NIM), the liquidity gaps, the asset growth, the income di-
versity, the crisis, and the efficiency. Macrojt represents the real GDP growth, and the
inflation rate.
The most important factors that can positively affect bank’s stability are equity-to-asset ratio,
bank size, loans-to-assets ratio, revenue diversi- fication, and total assets- based foreign
investment.
Questions to explore:
Why were capital adequacy ratios like CRR and SLR insufficient
Magnitude of impact of credit and liquidity risk
Gaps in the current credit risk monitoring system
Why collaterals were insufficient to recover NPAs
Table 4 shows that the revenue diversification (HHI) variable is statistically significant and
negatively associated with the stability of a bank in the long run. The results depict that if
increasing in the revenue diversification will harm bank’s stability in the long run. It is
supported by the studies of Baele et al. (2007), Sanya and Wolfe (2011), and Lepetit et al.
(2008). More specifically, the market entry of foreign and privately owned banks in the
banking sector, forcing other existing banks have to expand their products and services at
low fees instead of focusing on traditional activities. This process can increase operating
costs, and decrease in bank stability. Adversely, Nguyen et al. (2012) conduct on a study in
South Asian economies, a bank will be more stable when a bank can diversify revenue across
from interest-income and non-interest income activities.
