Effect of Credit and Liquidity Risks on Bank Stability: Empirical Evidence from Afghanistan

Abstract

This study investigates the effects of liquidity and credit risks on the stability of banks with empirical evidence from the Afghanistan banking sector over the period 2014–2020. The stability of a bank is measured through the dependent variable of its capital adequacy ratio. Credit risk (calculated by the ratio of impaired loans) is included as an independent variable along with liquidity risk. The bank specific factors, namely bank net interest margin, size of the bank, return on assets, loan growth rate, liquidity gap, return on equity, loan to asset and macro-economic factors, inflation and GDP growth rate are included as control variables. This study includes all 10 operationalized banks in Afghanistan, excluding the two branches of foreign banks. The panel dataset was collected from banks’ websites and the macroeconomic data was derived from World Bank reports. This study employed the simultaneous equation approach of a two-stage least square and a fixed effect panel regression model to investigate the affiliation between liquidity and credit risks and their effects on the stability of banks. The results of this study indicate that liquidity and credit risks don’t have a mutual relationship, while the interaction of both types of risks jointly impacts bank stability. It shows that NIM, loan assets, ROA, liquidity gap, loan growth rate, and ROE have positive impacts on bank stability, whereas the size of the bank has negative effects on bank stability. Among the macroeconomic variables, only the growth rate of GDP signifies a negative effect on the stability of banks. The finding under this paper recommends that the governance body of the banking sector drafts policies aimed at strengthening bank capital and taking liquidity measurement according to the best standards introduced by the Basel committee. Also, to create frameworks for measuring liquidity and capital standards.