Chen, Y.-K., Shen, C.-H., Kao, L., & Yeh, C. Y. (2018) .

Review of Pacific Basin Financial Markets and Policies
Vol. 21, No. 1 (2018) 1850007 (40 pages)

c World Scientific Publishing Co.
°
and Center for Pacific Basin Business, Economics and Finance Research
DOI: 10.1142/S0219091518500078
Bank Liquidity Risk and Performance
Yi-Kai Chen
Department of Finance
Rev. Pac. Basin Finan. Mark. Pol. Downloaded from www.worldscientific.com
by UNIVERSITY OF NEW ENGLAND on 01/10/18. For personal use only.
National University of Kaohsiung, Taiwan

chen@nuk.edu.tw
Chung-Hua Shen*
Department of Finance and Banking
Shih Chien University, Taiwan
chshen01@ntu.edu.tw
Lanfeng Kao
Department of Finance
National University of Kaohsiung, Taiwan
lanfeng@nuk.edu.tw
Chuan-Yi Yeh
Cathay United Bank, Taiwan
james7449@yahoo.com.tw
Published 29 December 2017
This study employs an alternative measure of liquidity risk to investigate its deter-
minants by using an unbalanced panel dataset of commercial banks in 12 advanced
economies over the period 1994–2006. Dependence on liquid assets for external
funding, supervisory and regulatory factors, and macroeconomic factors are all
determinants of liquidity risk. Because of higher funding costs for obtaining liquidity,
liquidity risk is regarded as a discount for bank profitability, yet liquidity risk shows
a premium on bank performance in terms of banks’ net interest margins. Liquidity
risk has reverse impacts on bank performance in a market-based financial system.
Keywords: Liquidity risk; bank performance; market-based financial system; bank-
based financial system.
*Corresponding author.
1850007-1
Yi-Kai Chen et al.
1. Introduction
The US subprime crisis that erupted in August 2007 severely impacted the
US economy and global financial markets. The Basel Committee on Banking
Supervision (BCBS, 2008) indicates that the problem of liquidity was one of
the root causes of the crisis. The crisis indicated that those banks relying
heavily on the short-term money market to finance their asset operations
tended to suffer from a shortage of liquidity. For example, Northern Rock,
one of the five largest British mortgage lenders, was unable to acquire
funding from markets, because it mostly relied on wholesale money markets
and mortgage securitizations instead of customer deposits. In September
2007, Northern Rock experienced a severe liquidity squeeze, forcing it to

receive a bailout from the Bank of England on 22 February 2008. Swary
(1986), discussing a much earlier case regarding the failure of the Conti-
nental Illinois National Bank in the US, suggested that its failure was a
result of its heavy reliance on large deposits from other domestic banks,
foreign deposits, and on interbank lines of credit for the funding of an
undiversified loan asset portfolio. When lenders did not roll over the lending,
it failed.1 Chen et al. (2015) concluded that countries with better macro-
economic and monetary environments and healthier bank institution were
less likely to suffer systemic banking crisis.
In contrast to the large amount of discussion regarding credit risk, em-
pirical investigations of liquidity risk are relatively scant.2 In Basel I and II
Accords (BCBS, 1988, 2004), the regulatory standards for credit risk,
market risk, and operational risk are thoroughly discussed, but there is little
presented about liquidity risk. Landskroner and Paroush (2008) also indi-
cated that there has been extensive academic and regulatory discussion of
different major banking risks: credit risk, market risk, and operational risk.
However, little attention has been paid to liquidity risk, which has become
one of the major types of risks faced by banks and other financial institutions
1
During 1980, Continental Illinois National Bank lent a considerable amount of money to
oil production companies. When oil prices dropped, Japanese banks became concerned about
the oil producing loan exposures of the bank and withdrew their lines of credit. This caused
other banks to do the same and caused a bank run. Consequently, the bank was unable to
fund its assets, and the bank eventually was taken over by the Federal Deposit Insurance
Corporation.
2
Diamond and Dybvig (1983) developed a model to explain why banks choose to issue
deposits that are more liquid than their assets. They specifically investigated bank liquidity and
found out that a lack of it may lead to a bank run. A bank run is the sudden and unexpected
increase in bank deposit withdrawals. Their model has been widely used to understand bank
runs and other types of financial crises, as well as ways to prevent such crises.
1850007-2
in recent years. Berger and Bouwman (2009) and Deep and Schaefer (2004)
employed liquidity creation and liquidity transformation to measure li-
quidity risk. Thus, even though liquidity risk caused severe damage to the
banking sector during the subprime mortgage crisis in 2007 and the financial
crisis in 2008, there is relatively little discussion about it.
The credit crunch of 2007 certainly revives the importance of liquidity
risk (Matz, 2008). BCBS (1997) indicated that liquidity risk arises from the
inability of a bank to accommodate decreases in liabilities or to fund
increases in assets. An illiquid bank means that it cannot obtain sufficient
funds, either by increasing liabilities or by converting assets promptly at a
reasonable cost. Therefore, bank profitability deteriorates because of the

illiquidity. Decker (2000) further divided liquidity risk into funding liquidity
risk and market liquidity risk.3 BCBS (2008) proposed 16 liquidity guidance
documents for bank liquid soundness. Accordingly, liquidity risk has become
increasingly important, but empirical studies examining how liquidity is
determined are few and far between. Akhigbe et al. (2016) showed that
the passage of Dodd–Frank in July 2010 effectively reduced the credit and
liquidity risks that were within the institution’s control.
The objectives of this study are twofold. First, this study investigates the
determinants of liquidity risk and the impact of liquidity risk on bank per-
formance. For the first aim, because liquidity crises have rarely occurred,
there are few studies regarding the factors causing liquidity risk. Thus, this
study is the first one in this regard. Earlier studies typically use liquidity
ratios (liquid assets/total assets) as a micro-prudential ratio to assess
whether a bank has sufficient liquidity. However, Poorman and Blake (2005)
noted that using the liquidity ratio is not sensitive enough to measure li-
quidity. For example, a large regional bank, Southeast Bank in the US,
whose liquidity ratio is more than 30, finally failed due to liquidity risk.
Berger and Bouwman (2009) proposed the liquidity creation, but their focus
is only on this part. BCBS (2000) proposed the maturity laddering method
for measuring liquidity risk, but it can only be applied to one country and
cannot easily obtain short-term and long-term borrowing globally. Matz and
Neu (2007) also presented that banks can apply balance sheet liquidity
3
Funding liquidity risk is the risk in which a bank is unable to meet its obligations as they
come due, because of an inability to liquidate assets or obtain adequate funding sources.
However, market liquidity risk is when banks cannot easily unwind or offset specific exposures
without significantly lowering market prices, because of inadequate market depth or market
disruptions.
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Yi-Kai Chen et al.
analysis, cash capital position, and the maturity mismatch approach to

assess liquidity risk. However, this study uses the measurement of the
financing gap by Saunders and Cornett (2006) and DeYoung and Jang
(2016) to assess bank liquidity risk, where the financial gap is the difference
between loans and core deposits.4 This measure is easily accessed cross-
country and can also avoid the shortcoming of the above criticism.
With regard to the second aim, while earlier studies examine the deter-
minants of bank performance by considering the liquidity risk variable,
liquidity risk is often used as one of the controlled variables. The liquidity
ratio is also used for its simple calculations (Bourke, 1989; Molyneux and
Thornton, 1992; Demirgüç-Kunt and Huizinga, 1999; Shen et al., 2001;

Barth et al., 2003; Demirgüç-Kunt et al., 2003; Kosmidou et al., 2008;

Athanasoglou et al., 2006; Pasiouras and Kosmidou, 2007; Athanasoglou
et al., 2008; Kosmidou, 2008; Naceur and Kandil, 2009; Mustika et al.,
2015). Among existing studies, their empirical evidence regarding the effect
of liquidity risk on bank profitability is mixed. Molyneux and Thornton
(1992) and Barth et al. (2003) found positive impacts, whereas Bourke
(1989), Demirgüç-Kunt and Huizinga (1999), Kosmidou et al. (2008), and
Kosmidou (2008) found negative ones. Thus, the influence of liquidity risk
on bank performance is still not solved.
This study collects data on 12 advanced economies’ commercial banks
over the period 1994–2006. The fixed effects regression model obtains the
estimations of the causes of liquidity risk. Furthermore, this study classifies
countries into a bank-based or market-based system and investigates the
differences in the causes of liquidity risk among various financial systems.
The contribution of this study is to use alternative liquidity risk measures
aside from the liquidity ratio to investigate the determinants of liquidity
risk. Liquidity risk is identified as an endogenous determinant of bank per-
formance. In a subsample analysis, this study further classifies countries into
a bank-based or market-based system and investigates the differences in the
causes of liquidity risk under various financial systems. The results also
present the investigation of the effect of liquidity risk on bank performance
in different financial systems.
4
Saunders and Cornett (2006) indicated that banks can use sources and uses of liquidity, peer
group ratio comparisons, liquidity index, financing gap and financing requirement, and
liquidity planning to measure their liquidity exposure. Matz and Neu (2007) also noted that
banks can apply balance sheet liquidity analysis, cash capital position, and the maturity
mismatch approach to assess liquidity risk.
1850007-4
The remainder of this study is organized as follows. Section 2 provides the

literature review. Section 3 describes the sample selection and variables.
Section 4 involves the econometric specification. Section 5 presents the
empirical results, and Sec. 6 concludes this study.
2. Literature Review of Liquidity Risk Measures

The influence of liquidity risk on profitability is mixed in the banking
industry. Studies supporting the positive view include Molyneux and Thornton
(1992) and Barth et al. (2003); whereas studies supporting the negative view
include Bourke (1989), Demirgüç-Kunt and Huizinga (1999), Kosmidou
(2008), and Kosmidou et al. (2008). Previous studies have found that banks
with high liquidity have lower net interest margins (NIMs) (e.g., Demirgüç-
Kunt and Huizinga, 1999; Shen et al., 2001; Demirgüç-Kunt et al., 2003;
Naceur and Kandil, 2009). Sharma et al. (2015) showed an insignificantly
negative relationship between liquidity and bank efficiency. See Table 1 for
the existing literature of the relationship between bank liquidity risk and
performance.
Bonner (2015) examined the effects of regulatory liquidity coverage ratios
on 17 Dutch banks and concluded that liquidity regulation causes banks to
increase their investments in government bonds and decrease their invest-
ments in loans. Delechat et al. (2014) found that liquidity buffers are posi-
tively related to bank profitability, but negatively related to bank size,
market concentration, and the business cycle. Vazquez and Federico (2015)
concluded that banks with weaker structural liquidity and higher leverage in
the pre-crisis period were more likely to fail afterward. Raddatz (2010) and
Demirgüç-Kunt and Huizinga (2010) also showed evidence that banks,
relying on wholesale funding, had a negative effect on the performance of
their stock prices after the outbreak of the crisis and resulted in increased
volatility of bank stock returns. Furthermore, Pasiouras et al. (2006) indicated
that less cost efficient banks with higher liquidity risk tended to have lower
ratings.
Liquidity risk is commonly measured by the liquidity ratio, which is
operatically defined in two different directions in the literature. The first
type of definition considers the liquidity assets adjusted by size as the
measure of the liquidity ratio, including the liquid assets to total assets ratio
(e.g., Bourke, 1989; Molyneux and Thornton, 1992; Barth et al., 2003;
Demirgüç-Kunt et al., 2003), liquid assets to deposits ratio (Shen et al.,
2001), and liquid assets to customer and short-term funding (Kosmidou
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Table 1. Empirical results of the relationship between bank liquidity risk and performance.
Previous Studies Liquidity Risk Measures Empirical Results
Bourke (1989) The ratio of liquid assets to total The liquidity ratio is positively related to return on assets (ROA).
assets
Molyneux and The liquidity ratio is negatively related to ROA.
Yi-Kai Chen et al.
Thornton (1992),
Barth et al. (2003)
Sharma et al. (2015) The liquidity ratio is negatively but not significantly related to bank
efficiency.
Demirgüç-Kunt et al. (2003) Banks that hold a high fraction of liquid assets have lower NIMs.
This is consistent with banks receiving lower returns on holding
cash or securities, but facing a competitive market for deposits.
Demirgüç-Kunt and The ratio of loans to total assets The liquidity ratio is negatively related to ROA and positively
Huizinga (1999) related to NIMs.
Athanasoglou et al. (2006) The liquidity ratio has no effect on ROA and return on equity
(ROE).
1850007-6
Shen et al. (2001) The ratio of liquid assets to deposits Banks with a high fraction of liquid assets have lower NIMs.
Kosmidou et al. (2008) The ratio of liquid assets to customer The ratio of liquid assets to customer and short-term funding has a
and short-term funding positive effect on ROAA. It has a negative effect on NIMs, but is
only significant in the presence of external factors.
Pasiouras and The ratio of net loans to customer The liquidity ratio is positively related to ROAA of domestic banks
Kosmidou (2007) and short-term funding operating in the 15 European Union countries. It is negatively
related to ROAA of foreign banks.
Kosmidou (2008) The liquidity ratio is negatively related to ROAA.
Naceur and Kandil (2009) The liquidity ratio is positively and significantly related to NIMs of
domestic banks, indicating a negative relationship between NIMs
and the level of liquid assets held by the bank. However, banks’
liquidity risk does not determine returns on assets or equity
(ROA or ROE) significantly.
et al., 2008). The second type of definition considers loans adjusted by size,
such as the loans to total assets ratio (e.g. Demirgüç-Kunt and Huizinga,
1999; Athanasoglou et al., 2006) and net loans to customer and short-term
funding ratio (e.g., Pasiouras and Kosmidou, 2007; Kosmidou, 2008; Naceur
and Kandil, 2009). In the first group, a higher value of the liquidity ratio
indicates more liquidity and therefore being less vulnerable to failure.
In contrast, in the second group, a higher value of these ratios implies the
banks will suffer from greater liquidity risk.
There are alternatives to assess bank liquidity risk besides traditional
liquidity ratios, divided into quantitative measurement and qualitative
measurement. According to quantitative measurement, Basel Committee on

Banking Supervision (2000) proposed the maturity laddering method for

measuring liquidity risk. Saunders and Cornett (2006) indicated that banks
can employ sources and uses of liquidity, peer group ratio comparisons,
liquidity index, financing gap, and liquidity planning to measure their
liquidity exposure. Matz and Neu (2007) also noted that banks can apply
balance sheet liquidity analysis, cash capital position, and the maturity
mismatch approach to assess liquidity risk. Moreover, Matz and Neu (2007)
presented that a qualitative assessment of liquidity risk is at least as im-
portant as a quantitative measurement based on models. They provided
some qualitative liquidity risk measures other than quantitative measures.
Up to the present, there is no specific standard for measuring bank
liquidity risk. Banks usually use a variety of methodologies to measure
current and future liquidity, because no single metric provides a compre-
hensive view. In the past, better practices for liquidity risk measures focused
on the use of liquidity ratios. However, Poorman and Blake (2005) indicated
that measuring liquidity just using liquidity ratios is not enough and is not
the solution.5 Beyond mere liquidity ratios, banks must develop a new view
of liquidity measurement. Thus, there is a large number of ways to assess
bank liquidity risk aside from liquidity ratios in recent years.6 Based on the
existing literature, most studies used the liquidity ratio as the measurement
for liquidity risk, but this study utilizes the financing gap ratio (FGAPR) of
Saunders and Cornett (2006) and DeYoung and Jang (2016).
Saunders and Cornett (2006) stated that banks measure liquidity risk
exposure by determining their financing gap. Bank managers often regard
5
A large regional bank, Southeast Bank, used over 30 liquidity ratios for liquidity mea-
surement. However, it finally failed due to liquidity risk.
6
See Saunders and Cornett (2006) and Matz and Neu (2007).
1850007-7
Yi-Kai Chen et al.
their core deposits as a stable source of funds, and thus they can perma-
nently fund bank loans. DeYoung and Jang (2016) indicated that the fi-
nancing gap is consistent with the spirit of Basel III’s net stable funding ratio
(NSFR) requirement in which banks must hold enough stable funding (e.g.,
core deposits) to fully fund their illiquid assets (e.g., loans).7 In general, core
deposits are regarded as lower cost funding sources, while the financing gap
is defined as the difference between a bank’s average loans and average core
deposits. If the financing gap is positive, then the bank must fund it by using
its cash, selling liquid assets, and borrowing funds in the money market.
Therefore, the financial gap can be estimated by borrowed funds subtracting
the amount of liquid assets. This financing gap indicates the financing re-
quirement of the bank after selling its liquid assets. When banks lend out more
loans with fewer liquid assets and receive fewer deposits, banks might have
more exposure to liquidity risk. Therefore, this study asserts that the financing
gap is more appropriate to be the proxy of bank liquidity risk. In order to
standardize the financing gap, we divide it by total assets. Moreover, the net
loans to customer and short-term funding ratio (NLCS), which is usually
regarded as the liquidity ratio, is used in the robustness test to verify the results.
3. Data and Variables

This study uses annual bank-level, market structure, supervisory, and
macroeconomic data covering the period 1994–2006 for 12 advanced econ-
omies: Australia, Canada, France, Germany, Italy, Japan, Luxembourg,
Netherlands, Switzerland, Taiwan, United Kingdom, and the United
States.8 The objectives of this study are to find the determinants of bank
liquidity risk and the relationship between bank liquidity risk and perfor-
mance. To prevent any disturbance from the subprime mortgage crisis in
2007, the financial crisis in 2008, and the structural change of liquidity
regulation of Basel III after 2010, the sampling period is from 1994 to 2006.
Moreover, we focus on commercial banks and delete observations that are
7
DeYoung and Jang (2016) used funding gap instead financing gap. The definitions of both
are identical.
8
Advanced economies are chosen as our sample, because of their transparent information and
well-developed financial system. According to the definition in the April 2006 World Eco-
nomic Outlook Database WEO Groups and Aggregates Information published by IMF,
there are 29 advanced economies. For data completeness, banks of 12 countries are chosen as
the samples in this study. The data were initially collected from 1993–2007. Due to large
amounts of missing data in 1993 and 2007, the examination period was modified from 1994 to
2006.
1850007-8
unavailable or incomplete. If the sampling bank is acquired or merged during

the sampling years, then the observed bank is dropped at the specified year.
This study employs unbalanced panel data consisting of 14,360 observa-
tions.9 Table 2 lists bank observations in each country and year. The number
of banks is decreasing due to mergers and acquisitions in the banking in-
dustry.
The data for calculation of bank-specific and market structure variables
are available from the Bankscope database. This study uses unconsolidated
bank statements (Bankscope consolidation codes U1, U2) where such
statements are available. U* statements were used only if no other uncon-
solidated statements existed. If no unconsolidated statements were avail-

able, then we used consolidated statements (C1, C2, C*). Banks with a
consolidation status of A1 were dropped. All variables available from the
database are adjusted for inflation. The data unit of each bank in a given
year is US$1 million. Supervisory and regulatory variables are available from
Barth et al. (2004).10 Macroeconomic variables are available from the In-
ternational Monetary Fund’s (IMF) World Economic Outlook (WEO) Da-
tabase. The followings describe variables in terms of liquidity and bank
performance.
3.1. Determinants of liquidity risk

In this model, we consider liquidity risk measures, bank-specific variables,
supervisory and regulatory variables, and macroeconomic conditions.
Table 3 defines all variables used in this study. Following Saunders and
Cornett (2006), this study measures liquidity risk by computing a bank’s
financing gap.11Gatev and Strahan (2006) indicated that the financial gap is
9
The panel data are unbalanced, because they contain banks entering or dropping out of the
market during the sample period (e.g., due to mergers). However, unbalanced panel data are
more likely to be the norm in typical economic empirical settings (Baltagi, 2005).
10
Barth et al. (2004) conducted a survey of national regulatory agencies and obtained in-
formation on numerous bank regulations and supervisory practices in 107 countries. How-
ever, they conducted pure cross-country regressions, because information on regulations and
supervisory practices is available only for one point in time. They also indicated that they
were able to collect historical data for a few variables, however, and found very little change
over time. Moreover, controlling for any changes does not alter their findings. Barth et al.
(2001) described the survey questions and data collection process in detail.
11
Saunders and Cornett (2006) indicated that banks can measure liquidity risk exposure by
determining their financing gap. Bank managers often regard the average core deposits as a
stable source of funds, and thus they can permanently fund a bank’s average loans. The
financing gap is defined as the difference between a bank’s average loans and average core
deposits.
1850007-9
Table 2. Bank observations in each country and year.

Yi-Kai Chen et al.
Year/ United United

Country Australia Canada France Germany Italy Japan Luxembourg Netherlands Switzerland Taiwan Kingdom States Total
1994 17 21 151 124 76 144 51 26 144 27 41 337 1159

1995 19 24 159 135 91 144 67 22 130 28 45 363 1227
1996 20 25 153 135 91 144 61 24 140 27 51 366 1237
1997 17 29 143 147 94 137 73 24 131 31 52 388 1266
1998 16 30 132 138 102 131 68 24 117 33 46 368 1205
1999 13 29 124 121 100 127 70 20 117 38 43 358 1160
2000 14 27 113 128 99 127 68 13 110 37 48 386 1170
2001 15 24 104 129 97 125 55 20 90 34 47 373 1113
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2002 14 26 98 128 94 123 35 16 89 36 51 362 1072
2003 13 25 96 113 99 122 32 19 89 38 50 321 1017
2004 12 18 87 107 103 123 26 18 92 37 45 279 947
2005 12 24 78 98 98 122 32 14 78 37 46 265 904
2006 15 23 71 102 88 121 33 15 83 32 40 260 883
Total 197 325 1509 1605 1232 1690 671 255 1410 435 605 4426 14360
Table 3. Variable description.
Category Variables Description/Calculation

Liquidity Risk FGAPR The ratio of financing gap to total assets. Financing gap is defined as the difference between a bank’s loans
and customer deposit.
NLCS The ratio of net loans to customer and short-term funding.
Profitability ROAA Net profit after tax divided by average total assets.
ROAE Net profit after tax divided by average total equities.
NIM Interest income minus interest expense over earning assets.
Bank-specific SIZE Natural logarithm of total assets.
SIZE 2 Natural logarithm of total assets squared.
LRLA The ratio of less risky liquid assets to total assets. Less risky liquid assets are the sum of cash, due from
central banks, treasury bills, and government securities.
RLA The ratio of risky liquid assets to total assets. Risky liquid assets are the sum of the deposits with banks,
due from other banks, due from other credit institutions, other bills, and trading securities.
EFD The ratio of external funding to total liabilities. We add money market funding and other funding as
external funding.
ETA The ratio of equity to total assets.
LLPL The ratio of loan loss provision to loans.
1850007-11
Market Structure CON The ratio of total assets of the three largest commercial banks to total assets of all commercial banks in
each country.
Supervisory OSP It is OSP and used to measure the legal power of the supervisory agency. The value is the principal
component indicator of 14 variables.
PMI It is a PMI and used to measures regulations that empower private monitoring of banks. Principal
component indicator of nine variables.
BAR Indicator of a bank’s ability to engage in the business of securities underwriting, insurance underwriting,
and selling, and in real estate investment, management, and development.
Macroeconomic GDPC Annual percent change of GDP.
GDPCt1 GDP annual percent change of last year.
INF Annual percentage change of inflation.
INFt1 Annual percentage change of Inflation of last year.
Dummy variable MB Market-based countries ¼ 1, otherwise ¼ 0.
Source: Bank-specific data and market structure variables are available from the BankScope database. The data unit of each bank in a
given year is US$1 million. Supervisory variables are available from Barth et al. (2004). Macroeconomic variables are available from World
Economic Outlook Database (IMF).

Yi-Kai Chen et al.
best estimated by using retail liabilities and not wholesales funds, because
the former are a more stable source of bank financing than the latter. Our
financing gap ratio (FGAP) is defined as the difference between a bank’s
loans and customer deposits divided by total assets.12 Banks with a higher
financing gap ratio face greater liquidity risk and must sell liquid assets or
obtain external funds to fill the demand for liquidity.
3.1.1. Bank-specific risk causes

Bank-specific determinants of liquidity risk include size, square of size, less
risky liquid assets, risky liquid assets, and EFD. The natural logarithm of a
bank’s total assets (SIZE) is the proxy for bank size, and the square of bank
size (SIZE2) captures the nonlinear relationship. Because of the too-big-to-

fail argument, large banks benefit from an implicit guarantee, which
decreases their cost of funding and allows them to invest in riskier assets
(Iannotta et al., 2007). Therefore, this study hypothesizes that large banks
usually hold more loans and have a larger financing gap ratio. However, the
largest banks will face less liquidity risk, because of this too-big-to-fail
argument. Thus, the effect of size on bank liquidity risk might be nonlinear.
The credit crunch of 2007 reminded many banks of the importance of
liquidity risk management. Although liquidity risk may cause bank failures,
Davis (2008) noted that banks can protect against liquidity risk. On the
asset side, this can be done by holding a significant proportion of liquid
assets. Cash can be used immediately to meet liquidity needs, while govern-
ment securities can be used readily as collateral. On the liability side, banks
should ensure enough diversified funding sources to reduce liquidity risk.
Because banks can sell or collateralize their liquid assets to obtain liquid
funds, holding liquid assets can reduce their liquidity risk. However, banks
may find it difficult to sell or collateralize their liquid assets, because of a
credit freeze. Liquid assets can be categorized into two types of assets: less
risky liquid assets and risky liquid assets. To standardize less risky liquid
assets and risky liquid assets, the model employs the less risky liquid assets
to total assets ratio (LRLA) and the risky liquid assets to total assets ratio
(RLA). Banks can sell their less risky liquid assets such as treasury bills with
little price risk and low transaction costs, but they may find it difficult to
collateralize their risky liquid assets like trading securities due to a credit
12
Saunders and Cornett (2007) stated that core deposits are generally defined as demand
deposits, negotiable order of withdrawal (NOW) accounts, money market deposit accounts
(MMDAs), other savings accounts, and retail certificates of deposit (CDs). In our study, we
use customer deposits to proxy for core deposits.
1850007-12
freeze to get liquid funds. Thus, we expect that LRLA has a negative effect
and RLA has a positive effect on liquidity risk. Moreover, this study
takes advantage of the ratio of external funding to total liabilities (EFD) to
proxy the dependency of external funding. External funding is the sum of
money market funding and other funding. Banks, relying on the short-term
money market rather than on core deposits to fund loans, may face a
liquidity problem in the future (Saunders and Cornett, 2006). The larger the
funds they need to borrow in the money markets, the greater the liquidity
problems from such reliance they will face. Thus, it is predicted that EFD
and bank liquidity risk have a positive relationship.
3.1.2. Supervisory and regulatory risk causes

After the subprime mortgage crisis, government regulation and supervisory
practices became important issues in the banking industry. Following Barth
et al. (2004), this study uses the official supervisory power index (OSP),
private monitoring index (PMI), and overall bank activities and ownership
restrictiveness (BAR) to proxy government regulation and supervisory practices.
The OSP index aggregates information on whether bank supervisors can
take specific actions against bank management, bank owners, and bank
auditors in both normal times and times of distress. A larger OSP indicates
greater government supervisory power. Supervisory agencies can use these
powers to improve the governance of banks. The PMI includes information
on the degree to which bank regulations force banks to disclose accurate
information to the public and induces private sector monitoring of banks. A
larger PMI denotes greater regulatory empowerment of the private moni-
toring of banks. The index of overall bank activity restrictions (BAR)
measures the degree to which banks face regulatory restrictions on their
activities in securities markets, insurance, real estate, and owning shares in
non-financial firms. A larger BAR represents higher restrictiveness.
This study designs the interactive terms to examine the effects of super-
visory and regulatory variables.13 The interactive terms include the inter-
actions between annual percent change of GDP and OSP index (GDPC OSP),
interactions between annual percent change of GDP and PMI (GDPC PMI),
and interactions between annual percent change of GDP and overall bank
activities and ownership restrictiveness (GDPC BAR).
13
Barth et al. (2004) conducted pure cross-country regressions, because information on
regulations and supervisory practices is available only for one point in time. We finish our
model estimator by using interactive terms.
1850007-13
Yi-Kai Chen et al.
A powerful government will ask its domestic banks to increase liquidity

hoarding. Banks, forced to disclose accurate information to the public, will
increase their liquidity hoarding. Gonz alez (2005) specified that relaxing
restrictions on banking activities may encourage bank risk-taking by
expanding a bank’s range of activities. In this situation, we expect that
higher restrictiveness on banking activities will make them decrease risk-
taking and increase liquidity hoarding. Relaxing restrictions may also increase
opportunities for bank diversification and thereby reduce risk-taking. In this
situation, strict restrictiveness on bank activities has the opposite effect.
3.1.3. Macroeconomic risk causes

In order to capture the effect of the macroeconomic environment, the two

macroeconomic variables used are annual percentage change of GDP
(GDPC) and annual percentage change of inflation (INF). We further add
GDP annual percent change of last year (GDPCt1 ) and inflation annual
percent change of last year (INFt1 ) to capture the lagged effects. Aspachs et
al. (2005) showed that banks hoard liquidity during periods of economic
downturn, when lending opportunities may not be as good, and they run
down liquidity buffers during economic expansions when lending opportu-
nities may have picked up. Thus, higher economic growth makes banks run
down their liquidity buffer and induces banks to lend more. However, banks
will attract fewer deposits during economic expansions, consequently in-
creasing their financing gap.
Change of inflation rate also affects bank liquidity risk. When the per-
centage change of inflation becomes higher, banks tend to hold more illiquid
assets to earn higher interest incomes. Banks tend to lend more loans to earn
higher interest rate caused by higher percentage change of inflation. Deposi-
tors tend to invest in illiquid assets instead of depositing in bank accounts to
prevent from the depreciation of their money. Banks attract fewer deposits
and banks’ financing gaps increase. In other words, a higher percentage
change in the inflation rate make banks lend out more loans and receive fewer
customer deposits. Therefore, the annual percentage change of the inflation
rate is expected to have a positive effect on bank liquidity risk (FGAPR).
3.2. Determinants of bank performance

This model considers performance measures, liquidity risk measures, bank-
specific variables, market structure variables, supervisory and regulatory
variables, and macroeconomic conditions. This study uses return on average
assets (ROAA), return on average equities (ROAE), and NIM as the proxies
1850007-14
of bank performance. ROAA reflects the ability of a bank’s management to

generate profits from the bank’s assets. ROAE designates the return to
shareholders on their equity. Average assets and equities are used to capture
any differences that occurred in assets and equities during the fiscal year
(or seasonal effects). NIM measures the gap between what the bank pays
savers and what the bank receives from borrowers. Thus, NIM focuses on the
traditional borrowing and lending operations of the bank.
3.2.1. Bank-specific performance determinants

This study uses the ratio of financing gap to total assets (FGAPR) to proxy
liquidity risk and regards liquidity risk as an endogenous determinant of

bank performance. Banks with a higher financing gap ratio use their cash,
while selling liquid assets and employing more external funding to fund their
gap. This consequently increases their cost of funding and reduces profit-
ability. However, Demirgüç-Kunt et al. (2003) indicated that banks with
high levels of liquid assets in cash and government securities may receive
lower interest incomes than banks with less liquid assets. If the market for
deposits is reasonably competitive, then greater liquidity will tend to be
negatively associated with interest margin. Thus, the proportion of in-
creasing liquid assets will decrease bank liquidity risk, leading to a lower
liquidity risk premium of the NIM (Angbazo, 1997; Shen et al., 2001; Dra-
kos, 2003). Banks with higher liquidity risk (FGAPR) tend to fund their
assets with a higher interest rate from the financial markets. Consequently,
higher liquidity risk (FGAPR) is expected to have a negative effect on bank
profitability (ROAA and ROAE). However, banks with higher liquidity risk
(FGAPR) tend to take more risk to target more interest incomes in order to
cover higher funding costs. As a result, FGAPR is expected to have a negative
relationship with ROAA and ROAE and a positive relationship with NIM.
This study also considers other factors affecting bank performance aside
from liquidity risk. These factors are in four categories: bank-specific factors,
market structure factors, supervisory and regulatory factors, and macro-
economic condition factors. Bank-specific determinants of performance
include size, square of size, capital, and credit risk. Bank size is generally
used to measure economies or diseconomies of scale in the banking industry.
The cost differences may cause a positive relationship between size and bank
performance, if there are significant economies of scale (Bourke, 1989;
Molyneux and Thornton, 1992; Goddard et al., 2004). In addition, as Short
(1979) argued, size is closely related to the capital adequacy of a bank since
relatively large banks tend to raise less expensive capital and hence appear
1850007-15
Yi-Kai Chen et al.
more profitable. Some existing studies have found scale economies for large
banks (e.g., Berger and Humphrey, 1997; Altunbaş et al., 2001; Athanasoglou
et al., 2006; Kosmidou, 2008), while others have found diseconomies for larger
banks (e.g., Kosmidou et al., 2008; Pasiouras and Kosmidou, 2007). However,
Eichengreen and Gibson (2001) suggested that the effect of a growing bank’s
size on profitability may be positive up to a certain limit. Beyond this point,
the effect of size could be negative due to bureaucracy. Thus, the relationship
may be expected to be nonlinear. As mentioned in previous studies, we use the
natural logarithm of a bank’s total assets (SIZE) to proxy size and the square
of bank size (SIZE2) to capture the relation of nonlinearity.
The ratio of equity to assets (ETA) likewise proxies the capital strength of
banks. Banks with high capital-asset ratios are considered relatively safer in
the event of loss or liquidation. In addition, an increase in capital may raise
expected earnings by reducing the expected costs of financial distress
(Berger, 1995). The lower risk increases banks’ creditworthiness and con-
sequently reduces their cost of funding. Previous studies that use capital
ratios as an explanatory variable of bank profitability found a positive
relationship (e.g., Demirgüç-Kunt and Huizinga, 1999; Barth et al., 2003;
Kosmidou et al., 2008). Thus, banks with a higher equity to assets ratio will
have lower needs for external funding and therefore higher profitability.
The loan loss provisions to loans ratio (LLPL) is used to proxy credit risk.
Changes in credit risk may reflect changes in the health of the bank’s loan
portfolio (Cooper et al., 2003), which may affect bank performance. Miller
and Noulas (1997) declared that the more financial institutions are exposed
to high-risk loans, the higher the accumulation of unpaid loans will be and
the lower their profitability. However, riskier loans should produce higher
interest incomes. Maudos and Fern andez de Guevara (2004) indicated that
the risk of non-repayment or default on a credit (credit risk) requires the
bank to apply a risk premium implicitly in the interest rates charged for the
operation. Banks that assume greater credit risk present higher interest
margins. Doliente (2005) also revealed that the impact of credit risk may
reflect the additional risk premium charged by banks for the financial costs
of forgone interest revenues. Thus, we assume that LLPL has a negative
relationship with ROAA and ROAE and a positive relationship with NIM.
3.2.2. Market structure performance determinants

Regarding market structure variables, the three-bank concentration ratio
(CON), calculated as the total assets held by the three largest commercial
banks divided by the total assets of all commercial banks in each country
1850007-16
(CR3) is the proxy for market competition. The higher the value is, the
lesser competition they have. According to the structure-conduct-perfor-
mance (SCP) hypothesis, banks in highly concentrated markets tend
to collude and thus earn monopoly profits (Short, 1979; Gilbert, 1984;
Molyneux et al., 1996).14
3.2.3. Supervisory and regulatory performance determinants

The OSP index (OSP), PMI, and overall bank activities and ownership
restrictiveness (BAR), created by Barth et al. (2004), are proxies to gov-
ernment regulation and supervisory practices. The use of interactive terms is
for examining the effects of supervisory and regulatory variables. The in-
teractive terms include the interactions between annual percentage change

of GDP and OSP index (GDPC OSP), interactions between annual per-
centage change of GDP and PMI (GDPC PMI), and interactions between
annual percentage change of GDP and overall bank activities and ownership
restrictiveness (GDPC BAR).
Barth et al. (2004) revealed that strong supervision can help prevent
banks from engaging in excessive risk-taking behavior and thus improve
bank development, performance, and stability. However, powerful super-
visors may use their powers to benefit favored constituents, attract cam-
paign donations, and extract bribes (Djankov et al., 2002; Quintyn and
Taylor, 2002). Under these circumstances, powerful supervision is positively
related to corruption and does not improve bank development, performance,
and stability.
Barth et al. (2003) indicated that it is possible that a wider range of
activities induces greater profit opportunities for banks. However, banks
may systematically fail to properly manage a diverse set of financial activ-
ities beyond traditional banking, and hence profitability would be lower.
3.2.4. Macroeconomic performance determinants

In order to capture the effect of the macroeconomic environment, the two
macroeconomic variables used are annual percentage change of GDP
(GDPC) and annual percentage change of inflation rate (INF). Additionally,
annual percentage change of last year GDP (GDPCt1 ) and annual per-
centage change of last year inflation rate (INFt1 ) are included to capture
14
Previous studies indicated that collusion may cause a higher interest rate spreads (higher
interest rates being charged on loans and less interest rates being paid on deposits) and higher
fees being charged (e.g., Goldberg and Rai, 1996; Goddard et al., 2001).
1850007-17
Yi-Kai Chen et al.
the lagged effects. GDP is a measure of total economic activity within an

economy. Higher economic growth encourages banks to lend more and
permits them to charge higher margins, improving the quality of their assets.
Previous studies found that economic growth has a positive effect on bank
performance (e.g., Kosmidou et al., 2008; Pasiouras and Kosmidou, 2007;
Athanasoglou et al., 2008; Kosmidou, 2008). Thus, GDPC and GDPCt1 are
expected to have a positive impact on bank performance.
The relationship between inflation and bank performance is ambiguous.
Perry (1992) indicated that the relationship between inflation and bank
performance depends on whether inflation expectations are fully anticipated.
An inflation rate fully anticipated by the bank’s management implies that

banks can appropriately adjust interest rates to increase their revenues

faster than their costs and thus acquire higher economic profits. If inflation is
unanticipated, then banks may be slow in adjusting their interest rates. This
results in a faster increase of bank costs than bank revenues that conse-
quently have a negative impact on bank profitability. Most studies found a
positive relationship between inflation and bank profitability (e.g., Bourke,
1989; Molyneux and Thornton, 1992; Kosmidou et al., 2008; Athanasoglou
Table 4. Descriptive statistics.
Variable Mean SD Min Max
FGAPR 0.0244 0.3090 0.9403316 0.9967066

NLCS 73.6351 41.0074 0.03 908.06
ROAA 0.7540 1.4016 18.44 40.26
ROAE 8.8241 15.4351 99.6 536.85
NIM 3.0135 2.2128 3.29 66.94
SIZE 7.9856 2.0053 2.714695 14.57717
SIZE 2 67.7904 33.6525 7.369567 212.494
LRLA 0.0246 0.0288 1.07E06 0.7407508
RLA 0.1426 0.2005 1.63E06 0.9757636
EFD 0.1324 0.1607 0 0.9891557
ETA 0.0806 0.0466 0.0033 0.3
LLPL 0.0103 0.0259 0 0.9166667
CON 0.3447 0.1741 0.1599831 0.9260695
OSP 0.1922 1.1167 2:15 1.14
PMI 0.9110 0.2528 0.29 1.46
BAR 2.2490 0.8170 1.25 3.25
GDPC 2.5156 1.6111 2:171 8.443
GDPCt1 2.3836 1.7119 2:171 8.443
INF 1.7797 1.1022 0.887 5.393
INFt1 1.8637 1.1431 0.887 5.393
Obs 14360
Notes: For the notation of the variables, see Table 3.
1850007-18
et al., 2006; Pasiouras and Kosmidou, 2007; Athanasoglou et al., 2008).

However, Kosmidou (2008) presented a negative relationship. Huybens and
Smith (1999) developed a theoretical model in which interest margins tend
to rise in the presence of inflation. Empirical studies found that inflation has
a positive effect on a bank’s NIM (e.g., Demirgüç-Kunt and Huizinga, 1999;
Kosmidou et al., 2008). Table 4 shows the descriptive statistics of the
variables used herein.
4. Econometric Specification
To provide an economic analysis of the causes of liquidity risk, causes of
liquidity risk are divided into internal and external factors. In order to ex-
amine the relationship between liquidity risk and the bank-specific, super-
visory, and macroeconomic variables, the panel fixed effect regression model
has been developed as:
Lit ¼ ci þ 1 SIZEit þ 2 SIZE 2it þ 3 LRLAit þ 4 RLAit þ 5 EFDit
þ 1 GDPCjt OSPjt þ 2 GDPCjt PMIjt þ 3 GDPCjt BARjt
þ 1 GDPCjt þ 2 GDPCjt1 þ 3 INFjt þ 4 INFjt1 þ "it ; ð1Þ
where Lit denotes liquidity risk, and bank-specific variables include size
(SIZE), square of size (SIZE2), less risky liquid assets (LRLA), risky liquid
assets (RLA), and external funding dependence (EFD). Macroeconomic
variables include change of GDP (GDPC), GDP change of last year
(GDPCt1 ), change of inflation (INF), and inflation change of last year
(INFt1 ). Table 3 lists the summary descriptions of the variables. Supervi-
sory and regulatory variables include the interactions between change of
GDP and OSP index (GDPC OSP), interactions between change of GDP
and PMI (GDPC PMI), and interactions between change of GDP and
overall bank activities and ownership restrictiveness (GDPC BAR). Here,
"it is the error term.
Equation (1) is estimated through a fixed effects regression by taking each
bank’s FGAPR as the dependent variable. We employ the Hausman test on
this and reject the null hypothesis of random effects as the suitable model.
Thus, we use the fixed effects rather the than random effects model.
This model provides an economic analysis of the relationship between
bank liquidity risk and performance. From the determinants of the liquidity
risk model, there are many factors that may affect bank liquidity risk. This
study regards liquidity risk as an endogenous determinant of bank perfor-
mance and applies panel data instrumental variables regression to estimate
1850007-19
Yi-Kai Chen et al.
this model.15 In previous studies, determinants of bank profitability were

usually divided into internal and external determinants. In order to examine
the relationship between bank liquidity risk and performance, the panel
instrumental variables regression model has been developed. Thus, Eq. (2) is
estimated simultaneously with Eq. (1):
Pit ¼ c þ l Lit þ 1 SIZEit þ 2 SIZE 2it þ 3 ETAit þ 4 LLPLit þ !1 CONjt
þ 1 GDPCjt OSPjt þ 2 GDPCjt PMIjt þ 3 GDPCjt BARjt
þ 1 GDPCjt þ 2 GDPCjt1 þ 3 INFjt þ 4 INFjt1 þ "it ; ð2Þ
where Pit is bank performance of the ith bank at time t, with i ¼ 1; . . . ; N ;
t ¼ 1; . . . ; T. In our study, this is ROAA, ROAE, and NIMs; j refers to

the country in which bank i operates; Lit is liquidity risk and is regarded
as an endogenous variable; c is a constant term; and "it is the error term.
Bank-specific variables include liquidity risk (LRGAP), size (SIZE), square
of size (SIZE2), capital (ETA), and credit risk (LLPL). Liquidity risk is an
endogenous variable. The estimated equation is shown as Eq. (1). The
market structure variable is the three-bank concentration ratio (CON).
Macroeconomic variables include change of GDP (GDPC), GDP change of
last year (GDPCt1 ), change of inflation (INF), and inflation change of last
year (INFt1 ). Supervisory and regulatory variables include the interactions
between change of GDP and OSP index (GDPC OSP), interactions
between change of GDP and PMI (GDPC PMI), and interactions between
change of GDP and overall bank activities and ownership restrictiveness
(GDPC BAR).
5. Empirical Results
5.1. Regression results
Table 5 presents the estimated results of the liquidity risk equation using
Eq. (1), where the dependent variable is FGAPR. Regarding the bank-
specific variable, the relationship between size (SIZE) and liquidity risk is
significantly positive, while that of the square of size (SIZE2) and liquidity
risk is significantly negative. Large banks believe they are too big to fail and
thus have an incentive to increase risk-taking and hold more loans. Conse-
quently, they have a larger financing gap ratio. The results are consistent
with Distinguin et al. (2013) in that small banks strengthen their solvency
15
The ordinary least squares estimator will cause bias. However, instrumental variables
regression provides a way to obtain consistent parameter estimates (Dunning, 2008).
1850007-20
Table 5. Causes of liquidity risk results using FGAPR to measure liquidity risk.
Pre. Sign (1) (2) (3) (4)
CONSTANT ? 0.3377*** 0.3379*** 0.3380*** 0.3334***

SIZE þ 0.0717*** 0.0718*** 0.0717*** 0.0709***
SIZE 2 0.0039*** 0.0040*** 0.0039*** 0.0039***
LRLA 0.8144*** 0.8125*** 0.8144*** 0.8141***
RLA þ 0.6231*** 0.6241*** 0.6232*** 0.6233***
EFD þ 0.6420*** 0.6424*** 0.6420*** 0.6423***
GDPC OSP 0.0029***
GDPC PMI 0.0004
GDPC BAR 0.0019**
GDPC þ 0.0015** 0.0023*** 0.0011 0.0059***
þ
GDPCt1 0.0027*** 0.0029*** 0.0027*** 0.0026***

INF þ 0.0053*** 0.0052*** 0.0053*** 0.0056***
INFt1 þ 0.0068*** 0.0064*** 0.0068*** 0.0066***
Obs 14360 14360 14360 14360
R2 0.2049 0.2167 0.2048 0.2123
Notes: All variables in these regressions have been defined in Table 3. ***, **, and *
denote significance at the 1%, 5%, and 10% levels, respectively.
The model is estimated using fixed effects regression. Dependent variable is the
financing gap ratio (FGAPR) defined as the ratio of the financing gap to total assets.
The financing gap is the difference between a bank’s loans and customer deposits.
standards when they are exposed to higher illiquidity. However, over the
limit point, the effect of size becomes negative. The size effect on liquidity
risk is nonlinear. This result shows that both the less risky liquid assets to
total assets ratio (LRLA) and risky liquid assets to total assets ratio (RLA)
are significantly negative to liquidity risk. Banks can reduce their liquidity
risk by holding much liquid assets. However, external funding dependence
(EFD) has a positive effect on a bank’s liquidity risk, and banks heavily
depending on external funding face a larger liquidity problem. de Haan and
van den End (2013) found that most banks hold more liquid assets against
their stock of liquid liabilities, such as demand deposits, than are strictly
required under the regulation. Thus, banks can diversify their funding
sources to reduce liquidity risk.
With reference to the perspectives on supervision and regulation, the
interactions between annual percent change of GDP and OSP index (GDPC
OSP) and the interactions between annual percent change of GDP and
overall bank activities and ownership restrictiveness (GDPC BAR) have a
significantly negative effect on a bank’s liquidity risk. The greater official
power or higher restrictiveness will diminish the positive effect of GDPC. A
powerful government enforces banks to increase liquidity and places strict
1850007-21
Yi-Kai Chen et al.
restrictiveness on bank activities, making banks decrease their risk-taking

and increase liquidity. However, the interactions between annual percent
change of GDP and PMI (GDPC PMI) have no significant effect on a
bank’s liquidity risk. Thus, we find that direct government supervision and
regulation of bank activities could reduce bank liquidity risk.
Regarding the macroeconomic environment, both annual percent change
of GDP (GDPC) and previous year annual percent change of GDP
(GDPCt1 ) have a positive effect on a bank’s liquidity risk. Higher economic
growth for the current year and last year makes banks run down their li-
quidity buffer and induce them to lend more. Moreover, the bank financing
gap increases, because of fewer customer deposits when the economic growth
of the current and previous year is high. In addition, annual percent change
of inflation (INF) and inflation annual percent change of last year (INFt1 )
have a significantly positive correlation with a bank’s liquidity risk. The
results are consistent with the expected positive signs. When the current and
previous annual percentage changes of inflation rate increase, banks tend to
lend more loans to earn more interest incomes and depositors are reluctant
to deposit their money in banks to prevent from the decline of the real
purchase power. Liquidity risk (FGAPR) thus turns higher.
Table 6, using FGAPR to measure liquidity risk, reports the empirical
results of the model of bank liquidity risk and performance. In panel A of
Table 6, using ROAA as the proxy for bank performance, the results show
that liquidity risk (FGAPR) is negatively and significantly related to bank
performance. It indicates that banks with a larger gap lack stable and cheap
funds, and thus banks have to use liquid assets or more external funding to
meet the demand for funding. Banks’ credit risk increases when borrowings
become large. Borrowed funds are imposed with higher premiums and costs
of funds increase. Consequently, bank performance deteriorates, because of
higher funding costs.
In terms of bank-specific variables, the relationship between size (SIZE)
and bank performance is significantly positive, while that of the square of
size (SIZE2) and bank performance is significantly negative. The result
supports the economies of scale theory and is consistent with previous
studies (e.g., Berger and Humphrey, 1997; Altunbaş et al., 2001; Athana-
soglou et al., 2006; Kosmidou, 2008). However, over the optimum point the
effect of size becomes negative due to bureaucracy. Thus, the effect of size on
bank performance is nonlinear. We also find that capital (ETA) has a pos-
itive effect on bank performance. Banks with a sound capital position have
more time and flexibility to deal with problems, because of unexpected
1850007-22
losses. Well-capitalized banks involve in more allowed activities with lower

costs of bankruptcy. Thus, a reduced cost of funding or less need for external
funding enhances bank performance. These findings are consistent with the
results of existing literature (e.g., Demirgüç-Kunt and Huizinga, 1999;
Barth et al., 2003; Kosmidou et al., 2008; Athanasoglou et al., 2006;
Pasiouras and Kosmidou, 2007; Iannotta et al., 2007; Athanasoglou et al.,
2008; Kosmidou, 2008). However, the ratio of loan loss provision to loans
(LLPL), which is a proxy of bank credit risk, has a significantly negative
effect on bank performance, showing that higher credit risk exposure hurts
bank performance. This finding is aligned with the results of Athanasoglou
et al. (2006, 2008).

According to the perspective of the market structure, the concentration

ratio (CON) shows a significantly positive correlation with bank perfor-
mance, which is consistent with the SCP hypothesis. Some studies in the
literature (Bourke, 1989; Molyneux and Thornton, 1992; Lloyd-Williams
et al., 1994; Demirgüç-Kunt and Huizinga, 1999; Kosmidou et al., 2008;
Pasiouras and Kosmidou, 2007) present similar results. In relation to
supervision and regulation of the financial system, the interactions between
annual percent change of GDP and OSP index (GDPC OSP), PMI
(GDPC PMI), and overall bank activities and ownership restrictiveness
(GDPC BAR) have a significantly positive effect on bank performance at
the 1%, 5%, and 10% levels, respectively. The results indicate that greater
official power, greater regulatory empowerment of private monitoring of
banks, and higher restrictiveness with higher GDPC can significantly
improve bank performance. With regard to the macroeconomic environ-
ment, both current and previous annual percent changes of GDP (GDPCt
and GDPCt1 ) have a positively significant effect on bank performance. The
results provide evidence that higher economic growth improves bank per-
formance. Previous studies also find that an economic boom has a positive
effect on bank profitability (e.g., Kosmidou et al., 2008; Pasiouras and
Kosmidou, 2007; Athanasoglou et al., 2008; Kosmidou, 2008). Moreover,
annual inflation percent change of current and last year (INFt and INFt1 )
has no significant effect on bank performance at the 1% significance level.
In panel B of Table 6, the model uses ROAE as the proxy bank perfor-
mance. The results are similar to those of the model that uses ROAA as the
proxy of bank performance. Except for INFt1 , it has positive impact on
bank ROAE at the 1% significant level. When NIM is the proxy of bank
performance, in panel C of Table 6, liquidity risk (FGAPR) is positively and
significantly related to NIM. Naceur and Kandil (2009) indicated that banks
1850007-23
Yi-Kai Chen et al.
Table 6. Bank liquidity risk and performance results using FGAPR to measure liquidity risk.
Pre. Sign (1) (2) (3) (4) (5)
Panel A: ROAA As Dependent Variable

CONSTANT ? 1.4499*** 1.5426*** 1.4726*** 1.5675*** 1.5239***
FGAPR 0.4304*** 0.3556*** 0.2526*** 0.3654*** 0.3412***
SIZE þ 0.3754*** 0.3379*** 0.3225*** 0.3400*** 0.3330***
SIZE 2 0.0210*** 0.0184*** 0.0177*** 0.0185*** 0.0182***
ETA þ 6.7337*** 6.8674*** 6.8642*** 6.8372*** 6.8332***
LLPL 8.8578*** 8.6854*** 8.6230*** 8.6494*** 8.6511***
CON þ 0.4317*** 0.4183*** 0.4353*** 0.4296*** 0.4560***
GDPC OSP ? 0.0240***
GDPC PMI ? 0.0403**
GDPC BAR ? 0.0112*

GDPC þ 0.0572*** 0.0498*** 0.0268** 0.0314*
GDPCt1 þ 0.0224*** 0.0203*** 0.0236*** 0.0227**
INF þ 0:0145 0:0142 0:0159 0:0174
INFt1 þ 0.0179 0.0207* 0.0185 0.0192*
Obs 14360 14360 14360 14360 14360
R2 0.0998 0.1196 0.1339 0.1226 0.1211
Panel B: ROAE As Dependent Variable
CONSTANT ? 7.3998** 10.0715*** 8.5036*** 10.3304*** 9.5045***
FGAPR 4.8768*** 3.5992*** 1.1088 3.7688*** 3.2287***
SIZE þ 3.4143*** 2.5645*** 2.2698*** 2.5891*** 2.4322***
SIZE 2 0.1888*** 0.1315*** 0.1184*** 0.1330*** 0.1258***
ETA þ 16.3567*** 17.0167*** 15.2060*** 16.3557*** 15.7693***
LLPL 90.3370*** 86.2048*** 84.4944*** 85.6749*** 85.2673***
CON þ 3.4842*** 4.8125*** 5.1443*** 4.9883*** 5.6851***
GDPC OSP ? 0.4957***
GDPC PMI ? 0.4531**
GDPC BAR ? 0.2458***
GDPC þ 1.0815*** 0.9261*** 0.7456*** 0.5165***
GDPCt1 þ 0.3692*** 0.3210*** 0.3879*** 0.3762***
INF þ 0.1550 0.1607 0.1291 0.0840
INFt1 þ 0.5794*** 0.6347*** 0.5871*** 0.6047***
Obs 14360 14360 14360 14360 14360
R2 0.024 0.0785 0.0959 0.0811 0.0776
Panel C: NIM As Dependent Variable
CONSTANT ? 3.9625*** 3.4496*** 3.5182*** 3.2849*** 3.4913***
FGAPR þ 0.8107*** 0.8104*** 0.9220*** 0.8166*** 0.9110***
SIZE þ 0.0565 0.0302 0.0162 0.0428 0.0140
SIZE 2 0.0188*** 0.0156*** 0.0149*** 0.0158*** 0.0147***
ETA þ 3.3076*** 3.3948*** 3.4209*** 3.4198*** 3.3587***
LLPL þ 3.3562*** 3.5696*** 3.6128*** 3.7416*** 3.7589***
CON þ 1.7725*** 1.7689*** 1.7711*** 1.7548*** 1.6046***
GDPC OSP ? 0.0349***
GDPC PMI ? 0.2261***
GDPC BAR ? 0.0705***
GDPC þ 0.0541*** 0.0433*** 0.1176*** 0.1089***
1850007-24
Table 6. (Continued )
Pre. Sign (1) (2) (3) (4) (5)
GDPCt1 þ 0.0323*** 0.0296*** 0.0380*** 0.0344***

INF þ 0.0725*** 0.0734*** 0.0703*** 0.0585***
INFt1 þ 0.0787*** 0.0826*** 0.0822*** 0.0873***
Obs 14360 14360 14360 14360 14360
R2 0.1208 0.1634 0.1757 0.2126 0.2007
Notes: All variables in these regressions have been defined in Table 3.***,**, and* denote
significance at the 1%, 5%, and 10% levels, respectively.
The model is estimated by instrumental variables regression, using two-stage least squares
(2SLS) estimators. Dependent variables are ROAA defined as net profit after tax divided by
average total assets, ROAE defined as net profit after tax divided by average total equities,
NIM defined as interest income minus interest expense over earning assets, and using the
financing gap ratio (FGAPR) to assess bank liquidity risk.
with high levels of illiquid assets in loans may receive higher interest income
than banks with less illiquid assets. In order to pursue higher ROAE and
ROAA, banks with higher FGAPR tend to lend out more risker loans to earn
more NIMs. Because banks own more risker loans, market funding costs for
the funding gap increase. Therefore, banks with higher liquidity risk, mea-
sured by FGAPR, lead to higher NIMs and lower returns on average total
asset and equities, respectively. Credit risk, measured by LLPL, presents
similar significant results, which is consistent with previous studies (Maudos
and Fern andez de Guevara, 2004; Iannotta et al., 2007; Valverde and
Fernandez, 2007; Maudos and Solís, 2009). However, economies of scale do
not exist in the NIM model. Moreover, concentration (CON), the proxy
for market structure, shows a significantly reverse influence on bank NIM.
In this case, this result does not support the SCP hypothesis. We infer
that banks operating in a high concentration environment will decrease
their NIM, because of strong competition from the peer competing banks.
Regarding the macroeconomic environment, we find that both annual per-
cent change of inflation (INF) and inflation annual percent change of last
year (INFt1 ) have a positive effect on NIM. The positive relationship
indicates that inflation is anticipated, thus giving banks the opportunity
to adjust interest rates accordingly and consequently increase their NIM.
This finding is consistent with Huybens and Smith (1999).
5.2. Regression results in di®erent ¯nancial systems

There are differences in financial systems across countries. Demirgüç-Kunt
and Levine (1999) constructed the conglomerate index of financial structure,
1850007-25
Yi-Kai Chen et al.
producing two categories of countries: bank-based and market-based.16

It expresses the relative development of bank and stock markets in an
economy and is captured by the relative reliance on bank and stock market
finance in the economy. Thus, financing behavior is very different between
bank-based and market-based financial systems. Most studies analyze the
impact of financial structure on firm-financing behavior (e.g., Demirgüç-
Kunt and Maksimovic, 2002; Schmukler and Vesperoni, 2004) or economic
growth (e.g., Beck et al., 2000; Levine, 2002). However, Demirgüç-Kunt
and Huizinga (2000) focused on the performance of the banking sector
itself across different systems. Their results indicate that after controlling
for the level of financial development, there is no significant difference

in bank profits or margins between bank-based and market-based systems.

In subsample analyses, this study additionally classifies countries into
bank-based or market-based system and investigates the causes of liquidity
risk in different financial systems.17 We use a dummy variable (MB), which
takes the value of one if the country is classified as a market-based system
and takes the value of zero if classified as a bank-based system to examine
the relationship between the financial system and bank performance.
Finally, we investigate the relationship between bank liquidity risk and
performance in different financial systems.
Financing behavior varies differently among bank-based and market-
based financial systems. Table 7 reports the results of the causes of liquidity
risk in different financial systems. Comparing the results of the two financial
systems, the bank-specific variable has similar effects on bank liquidity risk
in the two financial systems. However, considering supervision and regula-
tion factors, greater official power and higher activity restrictiveness
diminish bank liquidity risk in the market-based financial system at the 1%
and 5% significance levels. Higher government supervisory power (OSP) and
activity restriction (BAR) help banks in the market-based system reduce
liquidity risk effectively. However, greater regulatory empowerment of pri-
vate monitoring (PMI) increases bank liquidity risk in the bank-based
16
In bank-based financial systems, there is a greater reliance on bank finance, and banks play
a leading role in mobilizing savings, allocating capital, overseeing the investment decisions of
corporate managers, and in providing risk management vehicles. In market-based financial
systems, there is a greater reliance on stock market finance, and securities markets share
center stage with banks in terms of getting society’s savings to firms, exerting corporate
control, and easing risk management.
17
Bank-based countries include France, Germany, and Italy. Market-based countries include
Australia, Canada, Japan, Luxembourg, Netherlands, Switzerland, Taiwan, United King-
dom, and the United States.
1850007-26
Table 7. Causes of liquidity risk results in different financial system (dependent

variable: FGAPR).
Pre. Sign (1) (2) (3) (4)
Panel A: Market-Based Financial System

CONSTANT ? 0.4005*** 0.3968*** 0.3997*** 0.3945***
SIZE þ 0.0753*** 0.0748*** 0.0754*** 0.0742***
SIZE 2 0.0043*** 0.0042*** 0.0043*** 0.0042***
LRLA 0.8819*** 0.8784*** 0.8819*** 0.8813***
RLA þ 0.6580*** 0.6578*** 0.6577*** 0.6576***
EFD þ 0.7270*** 0.7265*** 0.7270*** 0.7280***
GDPC OSP 0.0034***
GDPC PMI 0.0010
GDPC BAR 0.0020**

GDPC þ 0.0016** 0.0037*** 0.0024 0.0066***

GDPCt1 þ 0.0018** 0.0020*** 0.0018** 0.0017**
INF þ 0.0078*** 0.0075*** 0.0078*** 0.0082***
INFt1 þ 0.0098*** 0.0092*** 0.0097*** 0.0097***
Obs 10014 10014 10014 10014
R2 0.214 0.2264 0.2143 0.2232
Panel B: Bank-Based Financial System
CONSTANT ? 0.1236 0.1220 0.1277 0.1235
SIZE þ 0.0603*** 0.0601*** 0.0616*** 0.0603***
SIZE 2 0.0038*** 0.0038*** 0.0039*** 0.0038***
LRLA 0.6039*** 0.6039*** 0.6014*** 0.6039***
RLA þ 0.5783*** 0.5782*** 0.5784*** 0.5783***
EFD þ 0.4734*** 0.4729*** 0.4748*** 0.4734***
GDPC OSP 0.0022
GDPC PMI 0.0150*
GDPC BAR 0.0000
GDPC N 0.0028 0.0055 0:0117 0.0028
GDPCt1 N 0.0018 0.0018 0.0021 0.0018
INF N 0.0009 0.0011 0:0006 0.0009
INFt1 N 0.0014 0.0012 0.0018 0.0014
Obs 4346 4346 4346 4346
R2 0.231 0.2308 0.2373 0.231
Notes: All variables in these regressions have been defined in Table 3. ***, **, and *
denote significance at the 1%, 5%, and 10% levels, respectively.
The model is estimated using fixed effects regression. We use market-based system
countries and bank-based system countries as the sample, respectively. Dependent
variable is the financing gap ratio (FGAPR) defined as the ratio of the financing gap to
total assets. Financing gap is the difference between a bank’s loans and customer deposit.
financial system. Regarding the macroeconomic environment, the result

indicates that booming economies for the last and current years enhance
bank liquidity risk in the market-based financial system. However, the
proxies for the macroeconomic condition have no significant effect on bank
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Yi-Kai Chen et al.
liquidity risk in a bank-based financial system. The results imply that in-
flation significantly affects banks in the market-based system, because of the
need for external funding from the market. Because of the dependence on
funding from customer deposits, banks in a bank-based system see no sig-
nificant impact from inflation.
This study investigates the effect of the financial system on bank per-
formance. Table 8 reports the results of the relationship between financial
system and bank performance using FGAPR to measure liquidity risk.
Panel A shows the results using ROAA to evaluate bank performance.
Panel B shows the results using ROAE to evaluate bank performance. Panel C
shows the results using NIM to evaluate bank performance. The empirical
results show that a market-based system plays a significantly positive role on

bank performance in different proxies, such as ROAA, ROAE, and NIM.
The development of stock markets improves bank performance. For
instance, stock markets generate information about firms that is also useful
to banks. The development of stock markets allows firms to be better
capitalized, reduces risks of loan default, and boosts bank performance. At
a higher level of stock market development, much information about
publicly traded firms is available that also enables banks to better evaluate
credit risk.
This study further investigates the liquidity risk effect on bank perfor-
mance in different financial systems, shown in Tables 9–11. The summaries
of the models are listed in Tables 12 and 13. When ROAA and ROAE
represent the proxies of bank performance, liquidity risk has a significantly
reverse influence on bank performance in the market-based financial system,
but no significant influence in the bank-based financial system (Tables 9
and 10). The results imply that banks in the market-based financial system
have to use liquid assets or more external funding to meet the demand for
funding. Dependence on external funding through financial markets instead
of customer deposits exhibits a risk discount for liquidity risk on bank per-
formance. Compared to the costs of attracting deposits in the bank-based
financial system, funding through the financial markets in the market-based
financial system is costly. That might be the reason why liquidity risk has
a risk discount on bank performance. Table 11 shows the results of bank
liquidity risk and performance in different financial systems using NIM as a
dependent variable. Liquidity risk is positively and significantly related to
NIM in both financial systems. Logically, when FGAPR becomes larger, the
interest rate spread to banks increases. Therefore, liquidity risk, measured
1850007-28
Table 8. The relationship between financial system and bank performance using FGAPR to
measure liquidity risk.
Pre. Sign (1) (2) (3) (4) (5)
Panel A: ROAA As Dependent Variable

CONSTANT ? 1.5382*** 1.6071*** 1.5496*** 1.6311*** 1.5973***
FGAPR 0.3006*** 0.2687*** 0.2235** 0.2794*** 0.2655***
SIZE þ 0.3508*** 0.3221*** 0.3150*** 0.3245*** 0.3205***
SIZE 2 0.0202*** 0.0180*** 0.0176*** 0.0181*** 0.0179***
ETA þ 6.6174*** 6.7598*** 6.7814*** 6.7280*** 6.7415***
LLPL 8.7244*** 8.5915*** 8.5664*** 8.5578*** 8.5792***
CON þ 0.3907*** 0.3910*** 0.4094*** 0.4021*** 0.4098***
GDPC OSP ? 0.0161***
GDPC PMI ? 0.0394**

GDPC BAR ? 0.0054
GDPC þ 0.0537*** 0.0494*** 0.0241* 0.0414**
GDPCt1 þ 0.0185*** 0.0177*** 0.0197*** 0.0187***
INF þ 0.0104 0.0108 0.0117 0.0119
INFt1 þ 0.0152 0.0176 0.0157 0.0158
MB ? 0.3700*** 0.2875*** 0.2318*** 0.2852*** 0.2802***
Obs 14360 14360 14360 14360 14360
R2 0.1082 0.1216 0.129 0.1243 0.1219
Panel B: ROAE As Dependent Variable
CONSTANT ? 7.5903*** 10.0383*** 8.3832*** 10.2841*** 9.5390***
FGAPR 3.0654*** 2.6684** 1.1158 2.8531** 2.5214**
SIZE þ 3.1657*** 2.4622*** 2.2721*** 2.4895*** 2.3676***
SIZE 2 0.1810*** 0.1290*** 0.1177*** 0.1307*** 0.1246***
ETA þ 14.6752*** 16.0122*** 15.4622*** 15.3950*** 15.1347***
LLPL 88.7818*** 85.4606*** 84.5534*** 84.9772*** 84.8004***
CON þ 2.8062** 4.4225*** 5.2599*** 4.5983*** 5.2610***
GDPC OSP ? 0.5197***
GDPC PMI ? 0.4365**
GDPC BAR ? 0.2147***
GDPC þ 1.0567*** 0.9292*** 0.7337*** 0.5687***
GDPCt1 þ 0.3420*** 0.3300*** 0.3607*** 0.3543***
INF þ 0.1877 0.1549 0.1612 0.1184
INFt1 þ 0.5587*** 0.6485*** 0.5662*** 0.5852***
MB ? 2.9495*** 1.3848** 0.4418 1.3430** 1.0833*
Obs 14360 14360 14360 14360 14360
R2 0.0293 0.0786 0.0979 0.0811 0.0776
Panel C:NIM As Dependent Variable
CONSTANT ? 3.7810*** 3.3173*** 3.4186*** 3.1589*** 3.3953***
FGAPR þ 0.9074*** 0.9000*** 0.9598*** 0.8986*** 0.9635***
SIZE þ 0.0382 0.0167 0.0087 0.0290 0.0042
SIZE 2 0.0182*** 0.0151*** 0.0147*** 0.0155*** 0.0145***
ETA þ 3.2358*** 3.3588*** 3.3784*** 3.3585*** 3.3059***
LLPL þ 3.4308*** 3.6386*** 3.6498*** 3.8057*** 3.7960***
CON þ 1.7917*** 1.8002*** 1.7836*** 1.7747*** 1.6221***
GDPC OSP ? 0.0307***
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Yi-Kai Chen et al.
Pre. Sign (1) (2) (3) (4) (5)
GDPC PMI ? 0.2272***

GDPC BAR ? 0.0675***
GDPC þ 0.0519*** 0.0431*** 0.1206*** 0.1037***
GDPCt1 þ 0.0301*** 0.0283*** 0.0358*** 0.0325***
INF þ 0.0756*** 0.0751*** 0.0728*** 0.0609***
INFt1 þ 0.0770*** 0.0809*** 0.0804*** 0.0855***
MB ? 0.4433*** 0.3463*** 0.2383*** 0.3412*** 0.2582***
Obs 14360 14360 14360 14360 14360
R2 0.1216 0.1635 0.1724 0.2112 0.1961
(2SLS) estimators. Dependent variables are ROAA defined as net profit after tax divided by
average total assets, ROAE defined as net profit after tax divided by average total equities,
NIM defined as interest income minus interest expense over earning assets, and using the
financing gap ratio (FGAPR) to assess bank liquidity risk. We add a dummy variable (MB),
and the value is 1 if the countries are classified into the market-based system.
Table 9. Bank liquidity risk and performance in different financial systems using FGAPR to
measure liquidity risk (dependent variable: ROAA).
Pre. Sign (1) (2) (3) (4) (5)

CONSTANT ? 0.8124*** 0.9914*** 1.0062*** 1.0310*** 0.9849***
FGAPR 0.4341*** 0.4222*** 0.3101*** 0.4429*** 0.4169***
SIZE þ 0.2671*** 0.2267*** 0.2207*** 0.2285*** 0.2229***
SIZE 2 0.0162*** 0.0130*** 0.0127*** 0.0131*** 0.0129***
ETA þ 7.4036*** 7.5794*** 7.5908*** 7.5308*** 7.5324***
LLPL 10.6581*** 10.3236*** 10.2521*** 10.2440*** 10.2661***
CON þ 0.3325*** 0.3722*** 0.4325*** 0.3919*** 0.4274***
GDPC OSP ? 0.0372***
GDPC PMI ? 0.0473***
GDPC BAR ? 0.0129*
GDPC þ 0.0496*** 0.0283*** 0.0163 0.0183
GDPCt1 þ 0.0135 0.0126* 0.0146** 0.0146**
INF þ 0.0099 0.0087 0.0092 0.0059
INFt1 þ 0.0312*** 0.0380*** 0.0325*** 0.0322***
Obs 10014 10014 10014 10014 10014
R2 0.1399 0.1677 0.191 0.1734 0.1687
CONSTANT ? 2:3196*** 2.4337*** 2.4454*** 2.4571*** 2.4502***
FGAPR N 0.0549 0.0954 0.0985 0.1012 0.0996
SIZE þ 0.5259*** 0.5439*** 0.5482*** 0.5432*** 0.5477***
SIZE 2 0.0282*** 0.0286*** 0.0287*** 0.0285*** 0.0287***
ETA þ 5.3223*** 5.5812*** 5.6675*** 5.6337*** 5.6714***
1850007-30
Pre. Sign (1) (2) (3) (4) (5)
LLPL 6.6247*** 6.5659*** 6.5666*** 6.5923*** 6.5727***

CON þ 0.4313* 0.2288 0.1595 0.2305 0.1668
GDPC OSP ? 0.0721
GDPC PMI ? 0:0798
GDPC BAR ? 0:0435
GDPC þ 0.0818*** 0.1680** 0.1585** 0.1546***
GDPCt1 þ 0.0162 0.0158 0.0145 0.0154
INF þ 0.0445 0.0364 0.0348 0.0349
INFt1 þ 0.0154 0.0214 0.0168 0.0211
Obs 4346 4346 4346 4346 4346
R2 0.0334 0.0401 0.0397 0.0412 0.04
(2SLS) estimators. We use market-based system countries and bank-based system countries
as the sample, respectively. Dependent variable is ROAA defined as net profit after tax divided
by average total assets and using the financing gap ratio (FGAPR) to assess bank liquidity risk.
Table 10. Bank liquidity risk and performance in different financial systems using FGAPR
to measure liquidity risk (dependent variable: ROAE).
Pre. Sign (1) (2) (3) (4) (5)

CONSTANT ? 3.2886 8.4868*** 8.9957*** 9.0135*** 8.3712***
FGAPR 3.0750*** 3.2422*** 1.2287 3.6237*** 3.1837***
SIZE þ 3.3960*** 2.4160*** 2.3212*** 2.4463*** 2.3542***
SIZE 2 0.2122*** 0.1351*** 0.1278*** 0.1366*** 0.1320***
ETA þ 9.6326** 12.8136*** 11.9211*** 11.7461*** 12.2231***
LLPL 122.0364*** 111.7293*** 110.0775*** 110.4951*** 110.8957***
CON þ 1.8137 4.1434*** 5.4497*** 4.5136*** 4.7971***
GDPC OSP ? 0.6222***
GDPC PMI ? 0.6082***
GDPC BAR ? 0.1428*
GDPC þ 1.2362*** 0.9007*** 0.8123*** 0.8928***
GDPCt1 þ 0.0680 0.0754 0.0899 0.0837
INF þ 0.4958*** 0.4547*** 0.4681*** 0.4491***
INFt1 þ 1.0262*** 1.1679*** 1.0439*** 1.0417***
Obs 10014 10014 10014 10014 10014
R2 0.0275 0.1397 0.1732 0.1466 0.1384
CONSTANT ? 6.0904 6.1449 6.2930 5.9175 6.2901
FGAPR N 0.6513 0.4029 0.4020 0.4719 0.3888
SIZE þ 1.6742 1.7744 1.8208 1.7747 1.8045
SIZE 2 0.0562 0.0588 0.0601 0.0591 0.0596
1850007-31
Yi-Kai Chen et al.
Pre. Sign (1) (2) (3) (4) (5)
ETA þ 19.1891** 21.3397** 22.1635** 20.9143** 21.9611**

LLPL 57.7052*** 56.9908*** 57.1035*** 56.6921*** 57.1109***
CON þ 6.3136* 2.5468 1.8638 2.4369 2.1392
GDPC OSP ? 0.5549
GDPC PMI ? 0.5283
GDPC BAR ? 0.2315
GDPC þ 0.5017** 1.1640 0.0016 0.8872
GDPCt1 þ 0.6233*** 0.6244*** 0.6353*** 0.6214***
INF þ 0.3164 0.2373 0.3898 0.2532
INFt1 þ 0.3212 0.3646 0.3181 0.3487
Obs 4346 4346 4346 4346 4346

R2 0.0132 0.0202 0.0201 0.0195 0.0203
as the sample, respectively. Dependent variable is ROAE defined as net profit after tax
divided by average total equities and using the financing gap ratio (FGAPR) to assess bank
liquidity risk.
Table 11. Bank liquidity risk and performance in different financial systems using FGAPR
to measure liquidity risk (dependent variable: NIM).
Pre. Sign (1) (2) (3) (4) (5)

CONSTANT ? 2.7964*** 2.3576*** 2.3397*** 2.1310*** 2.3348***
FGAPR þ 0.7113*** 0.7865*** 0.9354*** 0.7585*** 0.8748***
SIZE þ 0.3298*** 0.3093*** 0.3034*** 0.3179*** 0.2977***
SIZE 2 0.0315*** 0.0284*** 0.0282*** 0.0283*** 0.0278***
ETA þ 3.1089*** 3.6809*** 3.6930*** 3.6828*** 3.6944***
LLPL þ 3.5939*** 4.1131*** 4.1218*** 4.4835*** 4.5738***
CON þ 1.7715*** 2.0162*** 1.9332*** 1.9878*** 1.7358***
GDPC OSP ? 0.0659***
GDPC PMI ? 0.2595***
GDPC BAR ? 0.0857***
GDPC þ 0.0470*** 0.0076 0.1373*** 0.1625***
GDPCt1 þ 0.0390*** 0.0359*** 0.0427*** 0.0445***
INF þ 0.0434*** 0.0434*** 0.0484*** 0.0250
INFt1 þ 0.0590*** 0.0695*** 0.0664*** 0.0665***
Obs 10014 10014 10014 10014 10014
R2 0.1464 0.2031 0.2267 0.2933 0.2655
1850007-32
Pre. Sign (1) (2) (3) (4) (5)

CONSTANT ? 7.4037*** 6.4184*** 6.4041*** 6.4271*** 6.4092***
FGAPR þ 0.8536*** 1.0784*** 1.1005*** 1.0772*** 1.0969***
SIZE þ 0.7487*** 0.7411*** 0.7443*** 0.7335*** 0.7412***
SIZE 2 0.0187* 0.0185* 0.0183* 0.0180* 0.0181*
ETA þ 2.6204*** 2.4666*** 2.2721*** 2.3993*** 2.2783***
LLPL þ 2.9342*** 2.9809*** 2.9590*** 3.0151*** 2.9739***
CON þ 1.5347*** 0.8163*** 0.6425** 0.8028*** 0.6640**
GDPC OSP ? 0.2280***
GDPC PMI ? 0.1679**
GDPC BAR ? 0.1300***

GDPC þ 0.0583*** 0.2148*** 0.1040 0.1598***
GDPCt1 þ 0.0311* 0.0334** 0.0344** 0.0341**
INF þ 0.1728*** 0.1513*** 0.1540*** 0.1482***
INFt1 þ 0.1070*** 0.1270*** 0.1115*** 0.1255***
Obs 4346 4346 4346 4346 4346
R2 0.119 0.1389 0.1412 0.141 0.1416
Notes: All variables in these regressions have been defined in Table 3. ***, **, and *denote
as the sample, respectively. Dependent variable is NIM defined as interest income minus
interest expense over earning assets and using the financing gap ratio (FGAPR) to assess
bank liquidity risk.
Table 12. The summary of the determinants of liquidity risk.
Pre. Sign All Market-Based Bank-Based
CONSTANT ? ()*** ()*** N

SIZE þ (þ)*** (þ)*** (þ)***
SIZE 2 ()*** ()*** ()***
LRLA ()*** ()*** ()***
RLA þ ()*** ()*** ()***
EFD þ (þ)*** (þ)*** (þ)***
GDPC OSP ()*** ()*** N
GDPC PMI N N (þ)*
GDPC BAR ()** ()** N
GDPC þ (þ)*** (þ)*** N
GDPCt1 þ (þ)*** (þ)*** N
INF þ (þ)*** (þ)*** N
INFt1 þ (þÞ*** (þÞ*** N
Obs 14,360 10,014 4346
Notes: All variables in these regressions have been defined in Table 3.

***, **, and * denote significance at the 1%, 5%, and 10% levels,
respectively. N represents non-significant.
1850007-33
Yi-Kai Chen et al.
Table 13. The summary of the model to test the relationship between liquidity risk and bank performance.
ROAA and ROAE All Market-Based Bank-Based NIM
Pre. Sign ROAA ROAE ROAA ROAE ROAA ROAE Pre. Sign All Market-Based Bank-Based
CONSTANT ? ()*** ()*** ()*** ()*** ()*** N ? (þ)*** (þ)*** (þ)***

FGAPR ()*** ()*** ()*** ()*** N N þ (þ)*** (þ)*** (þ)***
SIZE þ (þ)*** (þ)*** (þ)*** (þ)*** (þ)*** N þ N (þ)*** ()***
SIZE 2 (Þ*** (Þ*** (Þ*** (Þ*** (Þ*** N (Þ*** (Þ*** (þÞ*
ETA þ (þÞ*** (þÞ*** (þÞ*** (þÞ*** (þÞ*** (þÞ** þ (þÞ*** (þÞ*** (þÞ***
LLPL (Þ*** (Þ*** (Þ*** (Þ*** (Þ*** (Þ*** þ (þÞ*** (þÞ*** (þÞ***
1850007-34
CON þ (þÞ*** (þÞ*** (þÞ*** (þÞ*** N N þ (Þ*** (Þ*** (Þ***
GDPC OSP ? (þÞ*** (þÞ*** (þÞ*** (þÞ*** N N ? (þÞ*** (þÞ*** (Þ***
GDPC PMI ? (þÞ** (þÞ** (þÞ*** (þÞ** N N ? (þÞ*** (þÞ*** (þÞ**
GDPC BAR ? (þÞ* (þÞ*** (þÞ* (þÞ* N N ? (þÞ*** (þÞ*** (þÞ***
Obs 14360 14360 10014 10014 4346 4346 14360 10014 4346
Notes: All variables in these regressions have been defined in Table 3. ***, **, and * denote significance at the 1%, 5%, and 10%
levels, respectively. N represents non-significant.
by FGAPR, has a risk premium on NIMs, which is the proxy of bank per-
formance, no matter in the market- or bank-based financial system.
5.3. Robust test

This study checks the robustness of our results using traditional liquidity
risk measures used in Pasiouras and Kosmidou (2007); Kosmidou (2008),
and Naceur and Kandil (2009). The net loans to customer and short-term
funding ratio (NLCS), regarded as the ratio to present liquidity risk, is
applied to re-examine two models (causes of liquidity risk and bank liquidity
risk and the performance model). Most results are consistent to those of the
model using the financing gap ratio (FGAPR) to measure liquidity risk.18
6. Conclusions
This study investigates the causes of liquidity risk and the relationship be-
tween bank liquidity risk and performance for 12 advanced economies over
the period 1994–2006. The liquidity risk model divides the determinants of
liquidity risk into bank-specific, supervisory, and macroeconomic factors.
The model is estimated through fixed effects regression. In the bank liquidity
risk and performance model, liquidity risk is an endogenous determinant of
bank performance. Panel data instrumental variables regression is the ap-
proach used to estimate the models. Additionally, the bank performance
model considers not only liquidity, but also bank-specific factors, market
structure factors, supervisory factors, and macroeconomic variables. The
contribution of this study is to use alternative liquidity risk measures instead
of the liquidity ratio and being the first to investigate the determinants of
liquidity risk. Furthermore, we find that liquidity risk is an endogenous
determinant of bank performance. From the analyses in the subsample, this
study further classifies countries into a bank-based or market-based system
and investigates the different determinants of liquidity risk and the impact of
liquidity on bank performance in different financial systems.
These results show that liquidity risk is an endogenous factor of bank
performance. The determinants of liquidity risk include components of liquid
assets and dependence on external funding, supervisory and regulatory
factors, and macroeconomic factors. Liquidity risk represents a risk discount
on performance, which lowers bank profitability (ROAA and ROAE).
However, liquidity risk will increase a bank’s NIMs. This indicates that
18
Because of the length of the paper, the results are available upon request.
1850007-35
Yi-Kai Chen et al.
banks with high levels of illiquid assets in loans may be compensated by

higher net interest incomes.
This study sets up subsamples into a bank-based or market-based system
and investigates the difference of the determinants of liquidity risk in dif-
ferent financial systems. The empirical results indicate that the bank-specific
variable has the same effect on bank liquidity risk in the two financial sys-
tems. In the aspect of supervision and regulation, greater government OSP
and higher activity restrictiveness will diminish bank liquidity risk in the
market-based financial system. However, greater regulatory empowerment
of private monitoring of banks will increase bank liquidity risk in the market-
based financial system. Regarding the macroeconomic environment,

the results indicate that a booming economy increases bank liquidity risk
in the market-based financial system. This study further investigates
bank liquidity risk and performance in different financial systems. Liquidity
risk is negatively related to bank performance in a market-based financial
system; however, it has no effect on bank performance in a bank-based
financial system. Finally, the robustness test uses traditional liquidity
risk measures, net loans to customers, and short-term funding to verify the
robustness of the study’s results. The robustness test supports the results
found herein.
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Review of Paciﬁc Basin Financial Markets and Policies

Vol. 21, No. 1 (2018) 1850007 (40 pages)

Bank Liquidity Risk and Performance

National University of Kaohsiung, Taiwan

Published 29 December 2017

2007, Northern Rock experienced a severe liquidity squeeze, forcing it to

reasonable cost. Therefore, bank proﬁtability deteriorates because of the

analysis, cash capital position, and the maturity mismatch approach to

Thornton, 1992; Demirgüç-Kunt and Huizinga, 1999; Shen et al., 2001;

Barth et al., 2003; Demirgüç-Kunt et al., 2003; Kosmidou et al., 2008;

The remainder of this study is organized as follows. Section 2 provides the

2. Literature Review of Liquidity Risk Measures

Previous Studies Liquidity Risk Measures Empirical Results

measurement. According to quantitative measurement, Basel Committee on

Banking Supervision (2000) proposed the maturity laddering method for

3. Data and Variables

unavailable or incomplete. If the sampling bank is acquired or merged during

solidated statements existed. If no unconsolidated statements were avail-

3.1. Determinants of liquidity risk

Table 2. Bank observations in each country and year.

Year/ United United

1994 17 21 151 124 76 144 51 26 144 27 41 337 1159

Table 3. Variable description.

Category Variables Description/Calculation

Economic Outlook Database (IMF).

3.1.1. Bank-specific risk causes

size (SIZE2) captures the nonlinear relationship. Because of the too-big-to-

3.1.2. Supervisory and regulatory risk causes

A powerful government will ask its domestic banks to increase liquidity

3.1.3. Macroeconomic risk causes

In order to capture the eﬀect of the macroeconomic environment, the two

3.2. Determinants of bank performance

of bank performance. ROAA reﬂects the ability of a bank’s management to

3.2.1. Bank-specific performance determinants

liquidity risk and regards liquidity risk as an endogenous determinant of

3.2.2. Market structure performance determinants

3.2.3. Supervisory and regulatory performance determinants

teractive terms include the interactions between annual percentage change

3.2.4. Macroeconomic performance determinants

the lagged eﬀects. GDP is a measure of total economic activity within an

An inﬂation rate fully anticipated by the bank’s management implies that

banks can appropriately adjust interest rates to increase their revenues

Table 4. Descriptive statistics.

Variable Mean SD Min Max

FGAPR 0.0244 0.3090 0.9403316 0.9967066

Notes: For the notation of the variables, see Table 3.

et al., 2006; Pasiouras and Kosmidou, 2007; Athanasoglou et al., 2008).

this model.15 In previous studies, determinants of bank proﬁtability were

t ¼ 1; . . . ; T. In our study, this is ROAA, ROAE, and NIMs; j refers to

Pre. Sign (1) (2) (3) (4)

CONSTANT ? 0.3377*** 0.3379*** 0.3380*** 0.3334***

GDPCt1 0.0027*** 0.0029*** 0.0027*** 0.0026***

restrictiveness on bank activities, making banks decrease their risk-taking

losses. Well-capitalized banks involve in more allowed activities with lower

et al. (2006, 2008).

According to the perspective of the market structure, the concentration

Pre. Sign (1) (2) (3) (4) (5)

Panel A: ROAA As Dependent Variable

GDPC BAR ? 0.0112*

Pre. Sign (1) (2) (3) (4) (5)

GDPCt1 þ 0.0323*** 0.0296*** 0.0380*** 0.0344***

5.2. Regression results in di®erent ¯nancial systems

producing two categories of countries: bank-based and market-based.16

CONSTANT ? 0.3377* 0.3379* 0.3380* 0.3334*

GDPCt1 0.0027* 0.0029* 0.0027* 0.0026*

GDPCt1 þ 0.0323* 0.0296* 0.0380* 0.0344*

GDPC þ 0.0016 0.0037* 0.0024 0.0066***

LLPL 6.6247* 6.5659* 6.5666* 6.5923* 6.5727***

ETA þ 19.1891 21.3397 22.1635 20.9143 21.9611**

CONSTANT ? ()* ()* N

CONSTANT ? ()* ()* ()* ()* ()* N ? (þ)* (þ)* (þ)*