Liquidity risk and credit risk: a relationship based on the interaction between liquid asset ratio, non-performing loans ratio and systemic liquidity risk

Abstract

This paper investigates the relationship between credit risk and liquidity risk, based on the potential interdependence between liquid asset ratio and non–performing loans ratio, as well as systemic liquidity risk. The data used cover the period 2007–2012 and the country of study is Greece. We find that the liquid asset ratio decreases as non–performing loans ratio increases, with or without systemic liquidity risk, and consequently that liquidity risk increases as credit risk increases, and vice versa. We show that there is a causal relationship between these two ratios and thus between credit risk and liquidity risk. We also show that the negative effect of systemic liquidity risk on liquidity risk level is less serious than that of non–performing loans, at least in the case of a small–sized bank. Since the above–mentioned ratios are considered as basic measures of the corresponding banking risks, the derived results may be of interest to bank regulators and to the Basel III.