Bank solvency: The role of credit and liquidity risks, regulatory capital and economic stability

Abstract

Banking stability is essential to any economy due to its many functions, including intermediation, payment facilitation, and credit creation. Thus, the stability of the banking industry is one of the critical ingredients in economic growth. This paper analyzes how bank capital requirements, credit, and liquidity impact bank solvency using ten major banks that control 90% of the market share in the UK in 2009–2018. The GMM model indicates a strong association between credit and liquidity risks. That is, when banks finance a risky or distressed project, this will lead to an increase in non-performing loans (NPL), which reduces bank liquidity. Poor liquidity profile of the bank may restrict it from providing financial intermediation role. In addition, the findings indicate that efficiency, asset quality, and economic growth have a significant positive effect on the solvency of banks. The results also show that the regulatory capital (tier1) has a positive significant influence on solvency of the banks. Further, the results indicate that during the economic boom, banks tend to increase their regulatory capital. Therefore, there is a need to ensure that during the “good time”, banks can accumulate enough capital that is genuinely capable of absorbing negative shock. Also, it is important for banks to ensure that they are efficient but also have robust credit appraisal system to reduce NPL. This paper also demonstrates the implication of increased capital requirements. That is, increased capital requirements ensure not only banks are liquid but also solvent which enables them to provide financial intermediation.

Is bank risk appetite relevant to bank default in times of Covid-19?

“…Profit level has a positive and significant influence on bank risk-taking when the latter is measured by the risk assets-to-total assets ratio, but the relationship turned negative when bank risk is measured by non-performing loans ratios in Delis and Kouretas (2011) . Likewise, in a recent study, ROE is reported as positive in impacting bank insolvency ( Oino, 2021 ).…”

“…It is used extensively in measuring bank default, for instance in Ghenimi et al. (2017) , Salami (2018) , Di Tommaso and Thornton (2020) , Oino (2021) , among others.…”

Audit Committee Independence, Director Ownership, Audit Quality and Non-Performing Loans

“…So as a major part of policy making of a country, the importance of ensuring solvency in banks is out of denial. It is extensively outlined in literature with high media coverage that bank insolvency creates economic vulnerabilities by backsliding foreign investments, rising capital short-fall, and dipping the major industries into crises (Oino 2021). The fall of the industries eventually creates high level of unemployment and inflation in the economy.…”