On the interrelation of liquidity and credit risk in banks

This paper analyzes the interrelation of liquidity and credit risk in all U.S. commercial banks over the period 1998-2010. Although both the literature on credit risk and that on bank liquidity have established the implications each risk category has for bank stability, empirical understanding of the interrelation between the two risk factors is still very limited. A major lesson from the financial crisis of 2007/2008 is that a severe increase in credit risk paired with a contemporaneous drying up of bank liquidity can cause major distress for the financial system. Analyzing both factors jointly is thus pivotal for a thorough understanding of bank risk. To discover any possible relationship between the factors, we employ several liquidity and credit risk proxy variables in different analyses. First, we test a simultaneous equations model to analyze the contemporaneous and time-lagged interrelation between the risk factors across all U.S. banks. Second, we analyze the reaction of bank-specific liquidity risk to changes in the bank-external credit risk environment to account for one of the most significant features of the 2007/2008 financial crisis: the absolute and relative subprime mortgage loan allocation in the banks’ immediate vicinity. Finally, we analyze the separate and joint impact of liquidity and credit risk on banks’ default probability by testing a logit model of bank default for all 254 commercial bank failures in the period 2007-2010. Our results show that there is a weak but positive interrelation between liquidity and credit risk employing bank-specific risk measures only. This positive relationship between liquidity and credit risk is confirmed in our analysis of bank-internal liquidity and bank-external credit risk, in which we find a strong positive connection. We are finally able to show that both sources of risk contribute not only separately but also jointly to the probability of banks defaulting.