Interaction between liquidity risk and bank solvency, a crucial effect in a framework of simultaneous equations

Abstract

The “2008-09” global financial crisis has underlined that the interaction between liquidity risk and bank solvency forms an important factor that makes banks particularly vulnerable to a global crisis. At the same time, stress-testing models do not consider the dynamics between solvency and liquidity risk the possibility of reducing the impact of stress on bank solvency and financial stability. In this context, the aim of this paper is to examine this highly relevant issue in the financial literature, and answer to the main question: Is the interaction between solvency and liquidity risk empirically significant in the context of the Algerian banks? Based on an econometric model using a simultaneous equation approach on panel data of 19 banks over 6 years running from (2016 to 2021). Our results validate our hypothesis about the interaction and show that these two risks are determined simultaneously. Building on this finding, we suggest that the authorities should emphasise developing integrated liquidity and solvency stress tests. Our results also show the need of the Algerian banks to set up a regulatory framework for liquidity in line with the international prudential regulations to enhance the performance of this sector.