Liquidity Risk Exposure Research Articles

Are ESG scores driven by financial information? Evidence from European banks

In recent years, investors' increasing focus on sustainable investments and the sustainability orientation of companies has led to parallel growth in the market for environmental, social and governance (ESG) performance and ESG rating agencies. However, even though ESG rating agencies have become very influential institutions, the literature has found that ESG performance ratings provided by different agencies often differ from each other. This causes consequences that should be considered, such as complex evaluation of companies' ESG performance and uncertainty in ESG investment decisions. Therefore, it is necessary to identify which determinants influence ESG performance. This study aims to identify the internal determinants of an ESG score using bank-specific balance sheet indicators such as capital and risk ratios. The analysis focuses on the European banking sector from 2018 to 2022. Banks mainly foster the transition to a more inclusive and sustainable economy. Moreover, after the recent financial crises, banks have increased their social responsibility practices, strengthening their credibility, trust and reputation. Generalised estimating equations with standard error robust to heteroscedasticity were used. The results reveal that the factors that most influence the ESG score provided by ESG rating agencies are bank size and liquidity risk exposure. The larger the size of the bank and the lower the exposure to liquidity risk, the higher the ESG score assigned.

Liquidity Risk Exposure and Earnings Management—Results on an Unexplored Relation in the European Banking Sector

ABSTRACT This study investigates the relation between liquidity risk exposure and earnings management in banks. We use a dynamic panel-data one-step system generalized method of moments estimation and measure exposure to liquidity risk from balance sheet positions. We detect earnings management through income-increasing and -decreasing strategies. We find that the higher the exposure to liquidity risk due to higher liquidity creation, the greater is upward earnings management. Our findings suggest that banks use earnings management to opportunistically conceal high liquidity risk exposure. These findings should be useful for investors and users of financial statements interested in analyzing earnings quality and financial statement reliability. Data Availability: Data are available from specific sources cited in the text. JEL Classification: G21; G30; G32; M41.

Bank liquidity risk management through stable and volatile markets: The role of the asset-liability committee and lessons learned for the balance sheet governance operating model

This study examines the balance sheet management governance operating model of selected failed banks from 2007, 2008, 2009 and 2023, with emphasis on the corporate governance structure in place and the position of the asset-liability committee (ALCO), and draws conclusions and recommendations for future policy. All failed sample banks exhibited near-identical governance frameworks for management and oversight of balance sheet risk: namely an ALCO that reported to the senior executive management committee, and was at least two levels, if not three levels, below board level. It is inferred that, as the ultimate responsible and accountable forum for ensuring balance sheet viability and continuing going concern of the bank, the board would benefit from being closer to the balance sheet risk management process. This implies changing the governance structure such that the ALCO is closer to the board itself, and able to provide direct comfort to the board that the bank's capital and liquidity risks are being managed appropriately. The following bank governance measures are recommended, to be imposed by regulatory fiat if necessary: •Direct delegated authority of the ALCO to manage the balance sheet, from a long-term robustness and viability perspective, directly on behalf of the board. •The ALCO to report directly to the board, rather than via the executive management committee (or as an alternative approach, changed to become a sub-committee of the board). This recognises that the asset-liability management (ALM) discipline is at least as important as, if not more important than, the ‘audit’ oversight function undertaken by the board audit committee. •Technical expertise at ALCO and board level that is capable of discerning the genuine capital and liquidity risk exposure position of the bank, on a medium-term forward-looking basis, at all times.

Unraveling the Loan Growth Threshold Effect on Non-Performing Loans During Total Dollarization in Zimbabwe

The availability of bank loans is a vital component in determining the investment and spending patterns that influence economic growth. This article examines the threshold effect of loan growth on non-performing loans (NPLs) in the Zimbabwean banking industry during dollarization. The study employed panel threshold regression models developed by Seo et al. (2019) and Kremer et al. (2013) on a panel of thirteen banks from 2009 to 2017. The study revealed that locally owned banks held a higher percentage of NPLs (12.7%) than foreign-owned banks (6.1%) during the period under study. The study also documents a loan growth threshold level of 38%. On average, the industry lends excessively, as demonstrated by the 48% loan growth rate. Primarily, local banks dominate this rate by lending above the threshold compared to foreign banks. The study observed that, below and above the threshold, loan growth exerts a negative and significant effect on NPLs. Based on the results, it can be recommended that banks should devise strategies to maintain a steady loan growth rate, enhance profitability, and effectively monitor liquidity risk exposure. The findings provide insights into reviewing bank credit policies and prudential guidelines.

Drawdown-based risk indicators for high-frequency financial volumes

In stock markets, trading volumes serve as a crucial variable, acting as a measure for a security’s liquidity level. To evaluate liquidity risk exposure, we examine the process of volume drawdown and measures of crash-recovery within fluctuating time frames. These moving time windows shield our financial indicators from being affected by the massive transaction volume, a characteristic of the opening and closing of stock markets. The empirical study is conducted on the high-frequency financial volumes of Tesla, Netflix, and Apple, spanning from April to September 2022. First, we model the financial volume time series for each stock using a semi-Markov model, known as the weighted-indexed semi-Markov chain (WISMC) model. Second, we calculate both real and synthetic drawdown-based risk indicators for comparison purposes. The findings reveal that our risk measures possess statistically different distributions, contingent on the selected time windows. On a global scale, for all assets, financial risk indicators calculated on data derived from the WISMC model closely align with the real ones in terms of Kullback–Leibler divergence.

Optimizing Financial Performance: Deciphering the Interplay of Liquidity and Profitability in Bank Muscat, Sultanate of Oman

This study explores the intricate relationship between liquidity and profitability at Bank Muscat, Oman, examining various financial indicators such as Cash Reserve Ratio (CRR), Total Deposits to Total Assets (TDTA), Capital Adequacy Ratio (CAR), Total Loans to Total Deposits (TLTD), Liquid Assets to Total Assets (LATA), Liquid Assets to Total Deposits (LATD) and Liquidity Risk Exposure (LRE). The findings reveal that Liquid Assets to Total Assets (LATA) significantly correlates with Return on Assets (ROA), while other indicators show varied relationships. Notably, the Capital Adequacy Ratio (CAR) has a substantial negative impact on both ROA and Return on Equity (ROE). Cash Reserve Ratio (CRR), Total Deposits to Total Assets (TDTA), and Total Loans to Total Deposits Ratio (TLTD) have significant impact on ROE. Regression models exhibit exceptional explanatory power, highlighting liquidity and financial indicators' role in explaining profitability variability. Despite some liquidity ratios affecting profitability, others like Liquid Assets to Total Assets (LATA), Liquid Assets to Total Deposit Ratio (LATD), and Liquidity Risk Exposure (LRE) lack conventional significance levels. The recommendations encompass optimizing liquidity management, fortifying capital adequacy, monitoring deposit-to-asset ratios, evaluating liquidity risk exposure, assessing liquid asset allocation, and implementing dynamic risk management frameworks. Future research should consider comparative analyses across banks or regions, advanced statistical methodologies, and exploration of nuanced factors influencing liquidity-profitability dynamics, contributing to comprehensive financial management strategies for banks.

Corporate Liquidity Risk: A Case Study on the Evergrande Group in China

Purpose - Given that China Evergrande Group has recently been caught in a liquidity risk, the purpose of this study is to identify and assess its liquidity using traditional financial indexes. We analyze the reasons for the liquidity risk exposures, so as to provide practical implications for real estate companies. Design/Methodology/Approach - This study combines the principal-agent and the trade-off theories in order to analyze China Evergrande Group’s exposure to liquidity risk under the leverage effect. In addition, China Evergrande Group’s financial position is analyzed in depth, and its liquidity risk is defined and identified. Findings - The results show that under the high leverage effect, the company suffers from a high liquidity risk, and eventually falls into a financial crisis due to the shortage of cash for short-term debt accumulated in previous periods, and the long delay in returns on property sales. Research Implications - This study provides a new perspective for debt research by examining the leverage and liquidity risk of real estate-related enterprises. During the golden era of the real estate industry, real estate enterprises should uphold the principle of moderation in debt management, make reasonable use of financial leverage, clarify the strategic goal of diversification, and avoid credit risk.

Drivers of Global Banking Stability in Times of Crisis: The Role of Corporate Social Responsibility

AbstractThis study examines the effect of environmental and social (ES) activities on global banking stability in the shadow of the COVID‐19 pandemic. Using a sample of 244 commercial banks across 52 countries from 2002 to 2020, we provide evidence that during the global health crisis, banks with higher levels of ES activities are more financially stable (i.e. lower credit and liquidity risk exposures). Drawing on social capital and stakeholder theories, we find that ES activities increase firm‐level social capital and establish a stakeholder‐centred culture within a bank, strengthening social trust and public confidence in the bank's risk oversight. Accordingly, ES activities constrain excessive and aggressive bank risk‐taking during turbulent times when short‐termism prevails. Our additional analysis reveals that investors value such beneficial effects of ES activities. The findings offer new insights into the increasingly significant roles of social capital creation and stakeholder‐centred culture in maintaining banks’ financial stability.

Bank complexity, governance, and risk

Bank holding companies (BHCs) can be complex organizations, conducting multiple lines of business through many distinct legal entities and across a range of geographies. While such complexity raises the costs of bank resolution when organizations fail, the effect of complexity on BHCs’ broader risk profiles is less well understood. Business, geographic, and organizational complexity can engender explicit tradeoffs between the agency problems that increase risk and the diversification, liquidity management, and synergy improvements that reduce risk. The balance of outcomes may depend on the strength of bank governance. We test these conjectures using data on large U.S. BHCs for the 1996–2018 period. Business, geographic, and organizational complexity provide diversification benefits and some reduced idiosyncratic and liquidity risk exposure. All forms of complexity tend to increase BHC systemic risks. A regulatory tightening focused on complexity reduced organizational complexity, while also curtailing systemic risk but increasing liquidity risk.

Relationship between Financial Risk Exposure and Financial Performance of Manufacturing Companies Listed at the Nairobi Securities Exchange Kenya

Companies face various risks in the market. While studies have focused on business and market risk as a major risk that of companies in the market, there is still a wide gap that needs to be filled in determining the relationship between the financial risk exposure and financial performance of manufacturing companies listed at the NSE. This was after the literature review of the study established that most studies on financial risk exposure have concentrated mostly on the financial sector with a limited review on the manufacturing sector. Currently, the Kenyan government seeks to achieve its vision 2030 by ensuring that the country is well transformed into manufacturing capacity, which is one of its key pillars. Transformation of the manufacturing sector is one of the Big 4 Agenda that the current government seeks to achieve by the year 2022. The purpose of this study, therefore, was to determine the relationship between financial risk exposure and financial performance of manufacturing companies listed at the Nairobi Securities Exchange emphasizing the fast-moving consumer goods. The predictor variables are liquidity risk, credit risk, operational risk, and interest rates risk exposures. Shift-ability, Transaction cost, and agency theories guided the study. The study adopted a descriptive research design on the 9 listed manufacturing companies which were used as the target population. Secondary data from the financial statements for each company was considered from 2013 to 2018. Panel data were analyzed using statistical software (STATA). Descriptive analysis was performed and inferential statistics were regression and correlation analysis where moderated multiple regression model was used to test the relationship between the study variables. The results of the study revealed that both liquidity risk exposure (p=0.025) and operational risk exposure (p=0.047) had a significant positive relationship with the financial performance of listed manufacturing firms at the NSE. Also, the study established that there is an insignificant positive relationship between credit risk exposure and financial performance (p=1.113). Consequently, the study findings revealed that there is an insignificant positive relationship between interest rates and the financial performance of listed manufacturing firms at the NSE(p=0.083). This study was carried out on manufacturing companies listed at the NSE. At the center of the discussion was the current economic conditions that have seen some companies closing due to various economic conditions among them financial risk exposures. The study, therefore, recommends that there is a need for future study not only on big manufacturing corporations but also on the small manufacturing companies that are still struggling with understanding issues related to financial risk exposure. The study also recommends that other financial risk exposures such as market risk, foreign exchange, and currency risk need to be included in the future study and their effect investigated in relation the financial performance. While this study may have used ROA as the measure, there is a need for using other different accounting measures to determine financial performance.

The European hedge funds industry: An empirical analysis of performance, liquidity, and growth

While the performance of hedge funds has grabbed much attention from researchers, a few studies have been conducted on the drivers of hedge fund liquidity and performance (Shaub & Schmid, 2013). This study proposes new approaches to investigate the effect of share restrictions on European hedge fund performance and liquidity. We run different regressions of 1) returns, 2) flows, and 3) exposure to market liquidity risk on share restrictions, managerial incentives, and a set of control variables as independent variables. Using a sample of 1423 European hedge funds, our results suggest that restrictions imposed by European hedge funds add economic value to investors. Furthermore, we find that European hedge funds with strong share restrictions take on lower liquidity risk. There is a weak difference in liquidity risk exposure across directional European hedge funds with and without share restrictions. In addition, European hedge funds’ experience, large outflows during a crisis, and all share restrictions do not seem to be significantly related to funding flows in the crisis period, as well as in times of non-crisis. Finally, only the groups of young funds are associated with significant funds exposure to market liquidity risk

An Early Warning Signal (EWS) Model for Predicting Financial Crisis in Emerging African Economies

The devastating effects of the global financial crisis (GFC) have led to a renewed, global interest in the development of an early warning signal (EWS) model. The purpose of the EWS model is to alert policymakers and other stakeholders to the possibility of the occurrence of a crisis. This study estimates a EWS model for predicting the financial crisis in four emerging African economies using a multinomial logit model and a data set covering the period of January 1980 to December 2017. The result of the study suggests that emerging African economies are more likely to face financial crisis as debts continue to rise without a corresponding capacity to withstand capital flow reversal as well as excessive foreign exchange risk due to currency exposure. The result further indicates that rising debt exposure raises the likelihood of the economies remaining in a state of crisis. This result confirms the significance of a financial stability framework that addresses the issues confronting Africa’s emerging economies such as rising debt profile, liquidity and currency risk exposure.

Liquidity risk exposure and its determinants in the banking sector: A comparative analysis between Islamic, conventional and hybrid banks

This study aims to explore and examine the liquidity risk that Islamic banks are exposed to in a comparison with conventional and hybrid banks in the case of 145 commercial banks for the period of 1996–2015. This study also examines the factors determining the liquidity risk exposure of the sampled banks by employing a panel data regression model with the random effect technique by considering bank specification, macroeconomy, governance and ownership-related variables. The findings for the sampled banks demonstrate that Islamic banks are more exposed to liquidity risk than conventional and hybrid banks. In addition, the results show that the stringency of capital regulations and credit risk have a negative and significant impact on liquidity risk. Moreover, the results demonstrate that liquid assets and long-term debts are positively associated with liquidity risk exposure. While the empirical results show that long-term debt significantly affects liquidity risk, the results indicate an insignificant impact of liquid assets on the liquidity risk exposure of the sampled banks. The results also depict that bank size, governance and ownership concentration as well as GDP are important control variables in reducing the liquidity risk exposure of Islamic banks.

Student Loan Asset-Backed Securities: The Next Market in Crisis?

Recent media reports highlight the looming student debt crisis, with its link to the student loan asset-backed securities (SLABS) market, as the potential catalyst for the next financial crisis. Contrary to these reports, the authors show that tighter underwriting standards, stronger internal credit enhancement, and stricter credit ratings during the last decade have reduced the credit and liquidity risk exposures of SLABS, and the yield spread has rationally reflected the degree of credit enhancements in private SLABS and the risk of “technical” defaults in public SLABS. However, as public policy debates on student loans come under the spotlight, investors should still be vigilant of the potential impact of any policy actions that could increase the systemic risk of the SLABS market. <b>TOPICS:</b>Asset-backed securities (ABS), financial crises and financial market history <b>Key Findings</b> • Despite the looming student loan crisis, credit and liquidity risks of student loan asset-backed securities (SLABS) have been well contained and rationally reflected in the yield spread. • The SLABS market’s strong credit enhancement, small market size, and low return comovement with stocks and bonds do not justify the fear that the SLABS market will be the catalyst for the next major financial crisis. • Investors should still monitor the ongoing public debate and policy propositions of student loans, which could potentially change the landscape of student loans and indirectly affect the systemic risk of SLABS.

The Effects of the Volcker Rule on Corporate Bond Trading: Evidence from the Underwriting Exemption

Using a novel within-dealer, within-security identification strategy, we examine intended and unintended effects of the Volcker rule on covered firms' corporate bond trading using dealer-identified regulatory data. We use the underwriting exemption to isolate the Volcker rule's effects separate from other post-crisis changes in bank regulation and broader trends in market liquidity. We find no evidence of the rule's intended reduction in the riskiness of covered firms' trading in corporate bonds. We find significant adverse liquidity effects on covered firms' corporate bond trading with 20-45 basis points higher costs for customers even for roundtrip trades of shorter duration. These effects do not appear to be transitional. The Volcker rule appears to have increased the cost of the liquidity provided by covered firms and has not decreased the liquidity risk exposure of covered firms. Finally, the Volcker rule has decreased the market share of covered firms. Customers appear to be trading more with non-bank dealers, who are exempt from the Volcker rule but also lack access to emergency liquidity support at the Fed's discount window.

The Effects of the Volcker Rule on Corporate Bond Trading: Evidence from the Underwriting Exemption

Using a novel within-dealer, within-security identification strategy, we examine intended and unintended effects of the Volcker rule on covered firms’ corporate bond trading using dealer-identified regulatory data. We use the underwriting exemption to isolate the Volcker rule’s effects separate from other post-crisis changes in bank regulation and broader trends in market liquidity. We find no evidence of the rule’s intended reduction in the riskiness of covered firms’ trading in corporate bonds. We find significant adverse liquidity effects on covered firms’ corporate bond trading with 20-45 basis points higher costs for customers even for roundtrip trades of shorter duration. These effects do not appear to be transitional. The Volcker rule appears to have increased the cost of the liquidity provided by covered firms and has not decreased the liquidity risk exposure of covered firms. Finally, the Volcker rule has decreased the market share of covered firms. Customers appear to be trading more with non-bank dealers, who are exempt from the Volcker rule but also lack access to emergency liquidity support at the Fed’s discount window.

Financial Risk and Profitability: Evidence from Liquidity Risk Exposure, Long-Term and Short-Term Liquidity Risk

Financial Risk and Profitability: Evidence from Liquidity Risk Exposure, Long-Term and Short-Term Liquidity Risk

Correlated Flows, Portfolio Similarity and Mutual Fund Liquidity Management

We contend that the confluence of portfolio similarity and correlated liquidity shocks within mutual fund styles can exacerbate fund exposure to liquidity risk. We find that mutual funds mitigate such liquidity risk exposure by systematically reducing portfolio overlap with peer funds when their flows become more correlated (Overlap Management). Overlap Management is highly persistent and is more pronounced among funds with liquidity concerns. Funds engaging in overlap management tend to avoid stocks that are more vulnerable to flow-driven trading when facing correlated flows. As a result, this type of liquidity management independently contributes to higher fund performance after controlling for the direct relation between portfolio overlap and fund performance. The benefit of Overlap Management is therefore distinct from that of strategy uniqueness as studied in prior literature. An examination of the channel through which Overlap Management contributes to fund performance suggests that overlap management effectively alleviates the negative feedback effect of outflows on future performance.

Liquidity Risk and Mutual Fund Performance

This paper demonstrates that the ability of fund managers to create value depends on market liquidity conditions, which in turn introduces a liquidity risk exposure (beta) for skilled managers. We document an annual liquidity beta performance spread of 4% in the cross section of mutual funds over the period 1983–2014. Liquidity risk premia explain an insubstantial fraction of this spread; instead, the spread can be attributed to the differential ability of high liquidity beta funds to outperform across high and low market liquidity states, due to a differential rate of either mispricing correction or intensity of informed trading. Tests based on mispricing, proxied by a comprehensive set of 68 anomalies, and tick-by-tick trades, from a large proprietary institutional trading data set, corroborate the contribution of these channels. The results highlight the interaction between informed investors, mispricing, and liquidity beta. The Internet appendix is available at https://doi.org/10.1287/mnsc.2017.2851 . This paper was accepted by Neng Wang, finance.

Rising Interest Rates, Lapse Risk, and the Stability of Life Insurers

This paper sheds light on the life insurance sector's liquidity risk exposure. Life insurers are important long-term investors on financial markets. Due to their long-term investment horizon they cannot quickly adapt to changes in macroeconomic conditions. Rising interest rates in particular can expose life insurers to run-like situations, since a slow interest rate pass-through incentivizes policyholders to terminate insurance policies and invest the proceeds at relatively high market interest rates. We develop and empirically calibrate a granular model of policyholder behavior and life insurance cash flows to quantify insurers' liquidity risk exposure stemming from policy terminations. Our model predicts that a sharp interest rate rise by 4.5pp within two years would force life insurers to liquidate 12% of their initial assets. While the associated fire sale costs are small under reasonable assumptions, policy terminations plausibly erase 30% of life insurers' capital due to mark-to-market accounting. Our analysis reveals a mechanism by which monetary policy tightening increases liquidity risk exposure of non-bank financial intermediaries with long-term assets.