Dynamics of Funding Liquidity and Risk-Taking: Evidence from Commercial Banks

Faisal Abbas,Wing-Keung Wong,Shoaib Ali,Imran Yousaf

doi:10.3390/jrfm14060281

Abstract

The purpose of this study is to investigate the impact of funding liquidity risk on the banks’ risk-taking behavior. To test the hypotheses, we apply the two-step system GMM technique on US commercial banks data from 2002 to 2018. We find that funding liquidity increases the banks’ risk-taking of US commercial banks. Furthermore, banks with higher deposits are less likely to face a funding shortage, and bank managers’ aggressive risk-taking activity is less likely to be monitored. Our findings infer that increases in bank funding liquidity increase both risk-weighted assets and liquidity creation, and deposit insurance creates a moral risk issue for banks taking excessive risks in response to deposit rises. The relationship between funding liquidity and the banks’ risk-taking varies with their capitalization and market conditions; the impact of funding liquidity on risk-taking is pronounced for well-capitalized banks and the Global Financial Crisis 2007. Our tests are robust for the usage of alternate proxy of funding liquidity and by controlling economic conditions. The findings of this study have implications for regulators to develop guidelines for the level of liquidity and risk-taking of commercial banks.

Highlights

After the world financial crisis 2007–2008, rapidly growing literature has been investigating numerous essential elements of Basel III1, such as bank regulations for higher capital requirements (Bitar et al 2018; Cohen and Scatigna 2016; Deli and Hasan 2017), and its impact on the bank performance (Abbas et al 2019; Asongu and Odhiambo 2019; Berger and Bouwman 2013; Ding et al 2017), and bank risk-taking (Balla and Rose 2019; Bougatef and Mgadmi 2016)
We extend the work of Khan et al (2017) by using similar assets risk measures risk-weighted assets to total assets, loan loss provision to total loans, and overall risk measure as liquidity creation and Z-scores and funding liquidity measure as deposits to total assets
The results show that an increase in funding liquidity increases the risk-taking of commercial banks, as evidenced by risk-weighted assets, loan loss provisions, liquidity creations, and Z-scores

Summary

Introduction

After the world financial crisis 2007–2008, rapidly growing literature has been investigating numerous essential elements of Basel III1, such as bank regulations for higher capital requirements (Bitar et al 2018; Cohen and Scatigna 2016; Deli and Hasan 2017), and its impact on the bank performance (Abbas et al 2019; Asongu and Odhiambo 2019; Berger and Bouwman 2013; Ding et al 2017), and bank risk-taking (Balla and Rose 2019; Bougatef and Mgadmi 2016). The first stream of research is to examine the effects of funding liquidity on the risk of assets and the overall risk-taking of US commercial banks; the line examines the actions that well-capitalized, undercapitalized, too-big-to-fail banks conduct to take risks due to liquidity funding. It is unclear if the current focus on bank liquidity conditions laid out in the recent Basel III rules internationally and in the US Dodd–Frank Act would render banks less volatile and the whole financial sector more resilient in the future (Khan et al 2017; Tran 2020). Is the impact of funding liquidity similar for well-capitalized, undercapitalized, and too-big-to-fail commercial banks?

Objectives

Results

Conclusion