The Relationship between Liquidity Risk and Credit Risk in Banks
Shortened Version published in Journal of Banking & Finance 40(1), 242-256
43 Pages Posted: 13 Jul 2011 Last revised: 18 Jun 2014
Date Written: June 17, 2014
This paper investigates the relationship between the two major sources of bank default risk: liquidity risk and credit risk. We use a sample of virtually all U.S. commercial banks during the period 1998 to 2010 to analyze the relationship between these two risk sources on the bank institutional-level and how this relationship influences banks’ probabilities of default (PD). Our results show that both risk categories do not have an economically meaningful reciprocal contemporaneous or time-lagged relationship. However, they do influence banks’ probability of default. This effect is twofold: whereas both risks separately increase the PD, the influence of their interaction depends on the overall level of bank risk and can either aggravate or mitigate default risk. These results provide new insights into the understanding of bank risk, as developed by the body of literature on bank stability risk in general and credit and liquidity risk in particular. They also serve as an underpinning for recent regulatory efforts aimed at strengthening banks (joint) risk management of liquidity and credit risks, such as the Basel III and Dodd-Frank frameworks.
Keywords: Liquidity Risk, Credit Risk, Bank Default Probability, Bank Risk
JEL Classification: G21, G28, G32, G33
Suggested Citation: Suggested Citation