The Relationship Between Liquidity Risk and Credit Risk in the Banking Sector

Over the past five decades, there have been many studies that have discussed the liquidity and credit risks of banks. The reasons for the way banks operate, and their main risks and sources of revenue have been two major branches of research concerning the microeconomics of banking. Diamond and Dybvig (1983) came up with the financial intermediation paradigm which suggests that banks are pools of liquidity that facilitate borrowers and depositors with cash that is readily available. This internalizes the liquidity risk of an economy and increases economic welfare. The industrial approach paradigm states that banks are price takers whose aim is to maximize profits in the oligopolistic deposit and loan markets.

Numerous studies suggest that, theoretically, there is a relationship between credit and liquidity risk. Nonetheless, research is vague about the question of whether this association is negative or positive. The Mont-Klein framework, as suggested by Prisman, Slovin, and Sushka (1986), suggests that borrower defaults decrease the profit a bank. Since equity and other marketable and debt funding securities are taken as constant, banks maximize their income by maximizing the range between loan rates and deposits. As liquidity risk is perceived as a cost that lowers profits, a loan default enhances this liquidity risk due to the decreased inflow of cash and depreciation. Theoretically, credit risk and liquidity risk should have a positive correlation. This notion is reinforced by the theory of financial intermediation as proposed by Diamond and Dybvig (1983). According to this model, credit and liquidity risk should be positively associated and contribute to the instability of banks.

The notion of a positive relationship between credit and liquidity risk is also reinforced by recent literature developed in the wake of the 2007/2008 financial crisis. In their study, Acharya and Viswanathan’s (2011) sought to illustrate why the accumulation of leverage in conducive economic times results in substantial asset shocks and reduction of liquidity in adverse economic conditions. The primary assumption is that financial organizations increase debt which has to be constantly rolled over and used to finance assets. They assert that increased debt in the banking sector creates an increased risk of a bank run. During the crisis, when the prices of assets decrease, banks find it hard to roll over debt. In other words, they have a problem with liquidity. He and Xiong (2012) also place their focus on the risk of debt roll over. They suggest that the debt maturities of lenders, like investment banks, in the short run are distributed over time and rolled over to evade the risk of a bank run if all contractual debts expire at once. He and Xiong (2012) came up with an equilibrium whereby each firm will not roll over the contractual debt if the basic value of assets does not attain a certain standard. The consequence is a scramble whereby firms are likely to run if the value of assets decreases.

Gorton and Metrick (2011) offer a different viewpoint on the relationship between credit and liquidity risk. Their empirical examination reveals how a bank run instigated by investor panic can occur in the conventional banking sector; these banks provide loans on the basis of security. They suggest that the latest financial crisis was facilitated by credit risk; this was in the form of subprime loans that resulted in higher refinancing rates and cuts in funding in the banking sector. Even though investors were not familiar with the subprime risks that were in banks, the worry for their investments resulted in critical liquidity issues for banks since the market for short-term funding dried up. This is due to the higher refinancing rates and cuts in funding.

In regards to the aforementioned ideologies and results of various studies, it can be assumed that there is an association between credit and liquidity risk. Second, credit risk and liquidity risk are positively correlated, that is, credit and liquidity risk increase or reduce together.  The first assumption appears straightforward as suggested in past literature. However, in regards the second assumption, there is a growing body of research that suggests the probability that the association between credit and liquidity risk in banks can be negative if particular economic conditions and assumptions are considered. A study by Wagner (2007) illustrates that enhanced liquidity of a bank’s assets resulted in increased instability. Wagner (2007) argues that even though banks gain from more asset liquidity in regards to stability, this, in turn, makes them ignore prevention measures. Gatev, Schuermann and Strahan (2009) state that transaction deposits favor the liquidity risk of a bank when there is increased credit risk since they assist banks in hedging against the drawbacks of loan obligations.

According to Wagner (2007), the cash assets of banks increased significantly during the 2007/2008 crisis. He developed a model whereby liquidity assets dictate the strategic choice of a bank’s management to buy the assets of other banks at reduced prices in harsh economic conditions. This model assumes the relationship between credit and liquidity risk is negative. A paper by Cai and Thakor (2008) is centered on competition among banks. They state that with little completion among banks, increased credit risk may decrease liquidity risk.  Acharya and Naqvi (2012) illustrate that that in harsh macroeconomic conditions, like a financial crisis, corporate and household depositors tend to deposit their assets with banks. Banks are then left with an increased amount of cash which then decreases their quality and observation of existing and new borrowers. The result is that credit and liquidity risk do not shift together; banks with increased liquidity assets can fill their loan book with bad loans.

All of the aforementioned studies state that the association between credit and liquidity risk can theoretically either be negative or positive, subject to the type of bank under observation, the assumption underlying the firm’s business model and the economic climate. Therefore, from a theoretical viewpoint, the association between credit risks and liquidity risks is clear. On this account, it is logical to investigate the impact of this relationship on the risk structure of banks. A profound comprehension of bank risk needs to center on the reasons for bank default. There are numerous studies that investigate this issue. Some illustrate that the risk of bank default is facilitated by low earnings, low capitalization, exposure to a certain variety of loans, and a substantial number of loan defaults. Recent studies examine bank defaults in the wake of the 2007/2008 financial crisis. They reveal that excessive investment activities, low equity, excessive real estate loans, and harsh macroeconomic conditions increased the vulnerability of banks during the crisis. These studies illustrate clearly that credit risk is vital in the stability of a bank.

Acharya and Mora (2012) illustrate the function of banks as providers of liquidity in times of financial crises. They highlight that the banks that failed during the recent financial crisis were experiencing liquidity shortages shortly before the default occurred. Indeed, the banks that were distressed were facing critical liquidity problems, particularly if compared to the healthy banks. He and Xiong (2012) also illustrate how credit and liquidity risk can combine to cause a default.  They examine the relationship between credit and liquidity risk from the viewpoint of company’s funding needs. The authors attribute the debt rollover risk as the link between credit risk and liquidity risk.  Results of the study also show that investors demand increased premiums for corporate bonds because of liquidity risk. Consequently, this increases the risk of default from the equity holders due to the lack of liquidity in the market. These findings are especially applicable in the wake of recent studies illustration that corporation,s particularly finance intuitions, are susceptible to short-term debt structures that enhance the occurrence of debt rollovers.

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