Int. J. Financial Engineering and Risk Management, Vol. 1, No.

4, 2014

Liquidity risk and credit risk: a relationship based

on the interaction between liquid asset ratio, nonperforming loans ratio and systemic liquidity risk
Ioannis K. Malandrakis
Cooperative Bank of Chania,
28-32, El. Venizelou Str.,
73132 Chania, Greece
Email: gmalandrakis@chaniabank.gr
Email: imal44@otenet.gr
Abstract: This paper investigates the relationship between credit risk and
liquidity risk, based on the potential interdependence between liquid asset ratio
and non-performing loans ratio, as well as systemic liquidity risk. The data
used cover the period 20072012 and the country of study is Greece. We find
that the liquid asset ratio decreases as non-performing loans ratio increases,
with or without systemic liquidity risk, and consequently that liquidity risk
increases as credit risk increases, and vice versa. We show that there is a
causal relationship between these two ratios and thus between credit risk and
liquidity risk. We also show that the negative effect of systemic liquidity risk
on liquidity risk level is less serious than that of non-performing loans, at least
in the case of a small-sized bank. Since the above-mentioned ratios are
considered as basic measures of the corresponding banking risks, the derived
results may be of interest to bank regulators and to the Basel III.
Keywords: risk management; liquidity; liquidity risk; systemic liquidity risk;
liquid asset ratio; liquidity risk management; credit risk; non-performing loans
ratio; past due loans; Basel II; Basel III.
Reference to this paper should be made as follows: Malandrakis, I.K. (2014)
Liquidity risk and credit risk: a relationship based on the interaction between
liquid asset ratio, non-performing loans ratio and systemic liquidity risk,
Int. J. Financial Engineering and Risk Management, Vol. 1, No. 4, pp.375400.
Biographical notes: Ioannis K. Malandrakis is a Chief Risk Officer at the
Cooperative Bank of Chania, Greece. He holds an MSc degree in Engineering
Management (Technical University of Crete), also an MSc degree in Integrated
Rural Development/Management (Mediterranean Agronomic Institute of
Chania), and a BSc degree in Economics (National and Kapodistrian
University of Athens). His research interests include issues related to banking
risks management and modeling (mainly in the fields of credit risk and
liquidity risk). He has presented papers on credit risk modeling and liquidity
risk in three national conferences (in Chania, 2008; in Athens, 2012), and on
fisheries economics in one national conference (in Thessaloniki, 1992). His
research papers have been published in conference proceedings.
This paper is a revised and expanded version of a paper entitled Liquidity
risk and credit risk: a relationship based on the interaction between
liquid asset ratio and non-performing loans ratio presented at the 11th
Conference of the Hellenic Finance & Accounting Association (HFAA),
Athens, 1415 December 2012.

Copyright 2014 Inderscience Enterprises Ltd.

375

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Introduction

Financial institutions1 have to deal with a significant number of risks (such as credit risk,
interest-rate risk, liquidity risk, market risk, operational risk, etc.) as a consequence of
their internal structure and organisation, of the great number of products they offer, of the
economic environment, of the globalisation of economies and of the economic situation
of businesses and households.
The U.S. subprime mortgage crisis had led to the 2007-2008 financial crises. The
subprime crisis was transmitted to Europe through banks assets and transformed to a
liquidity crisis, which affected the financial sectors of the weaker European economies
(Greece, Portugal, Ireland, Spain and Italy) and, finally, their economies.
In Greece, the public debt negatively affected its banking sector, which had to deal
with the rapid increase of non-performing loans, and the significant deposits outflow
after 2009. The severe liquidity shortage is reflected in the significant reduction in the
mean value of the liquid asset ratio which fell from 24.7% in Sept. 2009 to 12.80% in
Sept. 2011 (Bank of Greece, 2010, p.88; 2012, p.114). The total amount of deposits and
repos of non-monetary financial institutions (households, businesses, etc) was reduced
by approximately 32 billion euros between January 2009 and September 2011, and by
70 billion euros between January 2009 and September 2012 (from 279.6 billion euros in
January 2009 to 247.2 in September 2011, and to 209.9 billion euros in September 2012)
(Bank of Greece, 2013b). Hardouvelis (2011) mentions that the liquidity shortage of
Greek banks must also be attributed to the sharp fall of interbank lending as the Greek
State Bonds (which previously had been used to borrow) ceased to be credible and,
hence, acceptable for lending, forcing the banks to resort to the European Central Bank.
As a result, the Greek banking system has significantly increased its dependence on
European Central Bank lending; at the end of September 2009, Greek banks financing
by the European Central Bank was 38 billion euros, reaching a peak of 158 billion euros
at the end of February 2012. As a result, new loans to enterprises and households were
dramatically reduced as Greek banks faced serious difficulties in meeting their
obligations with ease.
Nevertheless, the most significant banking risks are credit risk and liquidity risk.
Next, the concepts of liquidity, liquidity risk and credit risk are presented.
Liquidity is the ability of a bank to fund increases in assets and meet obligations as
they come due, without incurring unacceptable losses (Basel Committee on Banking
Supervision, 2008, p.1). Banks can fulfil their liquidity needs through several sources.
More specifically, these sources are: (a) operating cash flows arising from interest and
principal payments, service fees and the receipt of funds from various transactions;
(b) repurchase agreements (repos)2, (c) assets securitisation3, (d) issuance of debts
obligations (short-term repos, bond issuance which include access to central bank
liquidity, etc.), and other short-term unsecured debt instruments (Lopez, 2008; Strahan,
2012). Strahan (2012) argues that these sources become scarce during crises, and banks
must find new and presumably expensive liquidity sources.
Liquidity risk is defined as the risk that a bank would not be able to respond to both
expected and unexpected (current and future) cash outflows and collateral needs, without
either its daily operation or its financial condition being affected (Basel Committee on
Banking Supervision, 2008, p.1). Strahan (2012) mentions that liquidity risk stems from
the possibility of bank runs where depositors lose their faith in their bank and withdraw
their money. Systemic liquidity risk is the possibility of a systemic liquidity shock; the

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377

latter is defined as an aggregate shortage of liquidity, i.e. a situation in which many

financial institutions face liquidity shortages simultaneously (Barnhill and Schumacher,
2011).
Credit risk is the risk that a borrower will not be able to fulfil his contractual
obligations. Moreover, credit risk is considered as the likelihood that a borrower will
default over a particular time horizon. Other definitions with equal meaning are given by:
Basel Committee on Banking Supervision (2000, p.1)4, and Kalfaoglou (2012, p.55)5.
ihk (2004) defines credit risk as the risk that is connected to the loss associated with
unexpected changes in credit quality.
This paper investigates the relationship between credit and liquidity risk in terms of
the liquid asset ratio (as a basic measure of liquidity risk) and the non-performing loans
ratio (as a basic measure of credit risk). Liquid asset ratio represents the ability of a bank
to respond timely to its obligations (to depositors, etc.) on a daily basis and hence it is the
basic indicator of liquidity risk level, given that a steady low liquidity ratio exhibits
increasing liquidity risk level, and vice versa. On the other hand, the non-performing
loans ratio is the primary indicator of the perceived credit risk level, given that high
values of this ratio denote increasing credit risk level, and the opposite. The model used
is estimated with and without systemic liquidity risk in order to examine the effect of an
aggregate liquidity shortage on liquid asset ratio and, consequently, on liquidity risk, for
a sample period that involves both stressed and non-stressed sub-periods. The country of
study is Greece and the data used (72 monthly observations that span the period January
2007December 2012) were obtained from a small-sized Greek bank.
The main findings of this paper are as follows: (a) As non-performing loans ratio
increases, then liquid asset ratio will decrease; given that non-performing loans ratio
measures credit risk and that liquid asset ratio measures liquidity risk, the above result
implies that as credit risk increases so does liquidity risk and vice versa. (b) There is a
causal relationship between liquid asset ratio and non-performing loans ratio and,
consequently, between liquidity risk and credit risk. (c) Systemic liquidity risk is
negatively related to the liquid asset ratio, and its effect on the later and thus on liquidity
risk level is likely to be less serious for a small-sized bank (whose funding sources are
mainly traditional deposits) compared to a big one (which funding sources are not only
deposits, but also special financial instruments). (d) High non-performing loans ratios
may affect more significantly liquidity and liquidity risk levels of a small-sized credit
institution, compared to a big one.
As the above-mentioned ratios measure credit risk and liquidity risk, which are
perhaps the most important banking risks and define banks solvency, we believe that our
results are of interest to bank regulators and important to the new Basel III framework.
The innovation of this study lies mainly in the fact that it seeks to examine the
aforementioned relationship for the Greek banking sector where, up to now, there were
no relevant studies, at least to the best of our knowledge. More specifically, it examines
simultaneously liquidity risk and credit risk in terms of liquid asset ratio and nonperforming loans ratio, respectively, from the perspective of a small-sized Greek credit
institution, using data that cover both normal and stressed periods for both risks. In
addition, the existence of systemic liquidity risk is also taken into account after the 2nd
quarter of 2011.
The remainder of this paper is organised as follows. The next section discusses the
existing methodologies concerning liquidity risk management and strategy, and the
concepts of funding liquidity and liquidity risk. Section 3 provides a literature review.

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Section 4 explains variables selection and data used, discusses models selection and the
estimation methodology, and reports preliminary and final results; it also discusses the
main results and draws policy implications. The final section concludes and highlights
the limitations of the analysis, as well as topics for future research.

Theoretical background

2.1 Liquidity, and liquidity risk management and strategy

Having defined liquidity and liquidity risk in Section 1, we proceed to examine related
liquidity risk management and strategy issues. First, a liquidity risk management strategy
should include specific policies on such issues as: (a) definitions of liquidity risk, its
sources and effects divided in structural or long-term liquidity risk, and its interaction
with other risks (credit risk, market risk, etc.); (b) the composition of assets and liabilities
and the diversity and stability of funding sources; (c) the determination of liquidity needs
under normal and stressed conditions; (d) the liquidity costs that should be incorporated
into both on- and off-balance-sheet product pricing, etc. (Lopez, 2008; Bank of Greece,
2009, pp.3334).
Second, a liquidity risk management system, in order to be effective, has to
identify potential future funding problems: thus, the financial institution must be able to
measure and forecast the expected cash flows for its assets, liabilities, off-balance-sheet
commitments, etc. (Lopez, 2008). According to the Basel Committee on Banking
Supervision (2008, p.3), this management system must be able to assess a banks future
funding needs and ensure that the required funds are available at appropriate times
(incorporating its costs and profitability targets). A liquidity management system must
also ensure that the bank will be in position both to control effectively its daily
obligations and to withstand a period of liquidity stress.
An important aspect of a sound liquidity risk management system is the existence of
a Contingency Funding Plan (CFP). The Basel Committee on Banking Supervision
(2008, p.27) mentions that a CFP is the compilation of policies, procedures and action
plans for responding to severe disruptions to a banks ability to fund some or all of its
activities in a timely manner and at a reasonable cost. Such a plan should include
projections of future inflows and outflows, and an annual funding plan6 defining funding
requirements and funding sources (Bank of Greece, 2009, pp.4042). A CFP should be
regularly tested and updated to ensure that it is operationally robust.

2.2 Tools for quantifying and managing liquidity risk

A bank must use several management tools in order to assess its current liquidity needs
and to effectively manage liquidity risk. These tools are both quantitative and qualitative.
The quantitative tools include various inflow/outflow indicators, limits and methods.
These are: the liquidity ratios (liquid asset ratio and maturity mismatch ratio)7 (Bank of
Greece, 2009, pp.23), and the cumulative net funding requirements as a percentage to
total liabilities (Basel Committee on Banking Supervision, 2008, p.15). Other tools are:
the limits on inflow/outflow maturity gaps of different time gaps, and the limits on
the concentration of funding sources (e.g. limits on concentrations towards customers)
(Basel Committee on Banking Supervision, 2008, p.18). The methods that can be used

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for quantifying liquidity and liquidity risk are: (a) the net liquidity statement method,
(b) the liquidity gap approach, (c) modified versions of the classic Value-At-Risk
method, etc.
The qualitative methods include: (a) the limits on business activities by simply
bounding the banks risk exposures below a certain level (Lopez, 2008) (e.g. the loans to
deposits ratio must not exceed a certain percentage, say 100%); (b) the establishment of
early warning indicators, and (c) stress tests in order to identify sources of potential
liquidity strain.
Early warning indicators can be qualitative or quantitative in nature. The Basel
Committee on Banking Supervision (2008, p.16) defines a set of early warning indicators
that includes (but is not limited to):

increasing retail deposit outflows

serious deterioration in earnings

assets quality and overall financial condition

negative publicity

a credit rating downgrade

a constant increase of non-performing loans

a rapid assets growth, especially when funded with potentially volatile liabilities

growing concentrations in assets or liabilities

rising wholesale or retail funding costs (i.e. rising deposits interest rates)

correspondent banks eliminate or decrease their credit lines

difficulty in accessing longer-term funding

a decrease in the average maturity of liabilities

Kalfaoglou (2011, p.30) outlines a basic methodology for liquidity risk stress testing,
which aims to determine the coverage of liquidity gap. More specifically, the liquidity
gap depends on the assets/liability maturity mismatch. Inflows and outflows are
estimated at different periods, and the liquidity gap (either positive or negative) is
calculated. The liquidity gap is then compared with the liquidity buffer. According to
ihk (2004), a straightforward approach for stress testing for liquidity risk is reducing
the value of liquid resources by a certain percentage or amount. The percentage or
amount could be determined based on banks liquidity problems in the past or on a rule
of thumb, and it should generally be different for different maturities.

2.3 Funding liquidity and funding liquidity risk

Drehmann and Nikolaou (2009) define funding liquidity as the ability of a financial
institution to settle obligations immediately when due. Funding liquidity risk arises from
the possibility that over a specific time horizon the bank will not be able to settle its
obligations with immediacy. They point out that there are two important differences
between funding liquidity and funding liquidity risk. Liquidity is a binary concept
(i.e. the bank can either settle obligations or it cannot) and it is associated to one

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particular point in time; liquidity risk can take many values depending on the distribution
of future outcomes, and it is always forward-looking and measured over a particular time
horizon.
The concept of funding liquidity can be represented by a stock flow constraint,
which is:
O u tflo w s In flo w s S to ck o f M o n ey

(1)

A bank does not have liquidity problems if inequality (1) holds.

For the measurement of liquidity risk, Drehmann and Nikolaou (2009) focus on the
net volume of liquidity (i.e. Central Bank money or lending from the Central Bank)
needed in order to avoid illiquidity. For this purpose they use a new variable, the Net
Liquidity Demand (NLD), which is derived from inequality (1). The NLD is:
NLD t (Outflows Inflows M ) pD LD pIB LIB p A A pCB CB

(2)

If outflows are larger than inflows (minus the stock of money from the central bank), the
inequality shows that NLDt has to be financed either by new borrowing (from depositors
LD and from the interbank market LIB), by selling assets (A) or by accessing the Central
Bank (CB)8. If there is a positive net liquidity demand (outflows > inflows which cannot
be funded with new inflows, the bank will become illiquid and, without central bank
lending, it will default. Conversely, if the bank has surplus of liquidity (outflows <
inflows), then it does not need borrowing and it can sell the excess liquidity on the
interbank market (Drehmann and Nikolaou, 2009).

2.4 Liquidity risk in Basel III

Basel II Accord failed to manage liquidity risk effectively. A new Basel Accord, namely
Basel III, is on the road to implementation. Among other things (new capital
requirements, etc.), Basel III establishes a new liquidity framework which aims to set up
harmonised liquidity standards, as minimum requirements, in order to avoid banks
illiquidity.
For this purpose, Basel III introduces two new liquidity ratios; the Liquidity Coverage
Ratio (LCR) and the Net Stable Funding Ratio (NSFR) (Gortsos, 2011; Bank for
International Settlements Basel Committee on Banking Supervision, 2013).
LCR

stock of high quality liquid assets

100%
total net cash outflows over the next 30 calendar days

(3)

High Quality Liquid Assets (HQLA) are: Level 1 (cash, Central Bank reserves, and
certain marketable securities backed by Sovereigns and Central Banks), and Level 2
assets (certain government securities, covered bonds and corporate debt securities, lower
rated corporate bonds, residential mortgage backed securities, and equities that meet
certain conditions). HQLA refers to unencumbered high-quality liquidity assets that
banks must hold in order to cover the total net cash outflows over a 30-day period under
a stress condition (Bank for International Settlements Basel Committee on Banking
Supervision, 2013, p.7, 1215).
NSFR

amount of stable funding

100%
required amount of stable funding

(4)

Stable funding refers to capital, liabilities with effective maturities of one year or later, etc.

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Literature review

Cai and Thakor (2008) focus on liquidity risk, on how it is affected by interbank
competition and how it interacts with credit risk (with and without competition). The
key results of their paper is that interbank competition improves loans liquidity and that
loans with higher credit risk may result in lower liquidity risk with no interbank
competition. An important implication derived from their results is that there is a possible
coexistence of high credit risk and high liquidity risk, if the level of the undertaken credit
risk exceeds a certain threshold.
Sarkar (2009) examines Federal Reserve Bank of New York actions in order to
provide liquidity during the 20072008 financial crisis. He concludes that liquidity and
credit risks have both been important at different stages of the 2007 financial crisis and to
different degrees.
Barnhill and Schumacher (2011) propose a methodology for modelling correlated
systemic solvency and liquidity risk for a banking system. They employ a multiple model
and they use an extensive set of data (credit quality of commercial and industrial loans
19892010; detailed balance sheets for ten U.S. banks, etc.). They find that, significant
systemic risk factors are poor initial loan credit quality, credit risk concentration and
inadequate capital; they argue that the global financial crisis should not be attributed to a
systemic liquidity shock but in concerns about the value of bank assets (subprime
mortgages and structured products affected by the fall in houses prices).
Ericsson and Renault (2006) analyse a structural bond valuation model in order to
capture simultaneously liquidity and credit risk. They use U.S. corporate bonds data that
cover a fifteen-year period (19862001). The main finding of their paper is that the levels
of liquidity spreads are likely to be positively correlated with credit risk and that they
should be decreasing functions of time to maturity.
Wong and Hui (2009) developed a stress-testing framework (a Monte Carlo approach
and a system of equations for market risk, default risk and liquidity risk) in order to
investigate the interaction between liquidity risk, market risk and credit risk. Their
sample involves data for 12 listed banks in Hong Kong for the year 2007. One interesting
finding, which arises from the econometric estimation of the relationship between
probability of default and a basic liquidity ratio (named the monthly retail deposit
outflow rate), is that a bank with high credit risk levels will have a relatively high retail
deposit outflow rate.
Iqbal (2012) investigates liquidity risk between Conventional and Islamic banks in
Pakistan. He uses data for the period 20072010 for five Islamic and twenty-three
Conventional banks in Pakistan. Its model includes as dependent variable the liquidity
ratio (which stands for liquidity risk) and five explanatory variables: size of the bank,
non-performing loans ratio, return on equity, capital adequacy ratio and returns on assets.
One key finding of his study is that there is a significant negative relationship between
non-performing loans ratio and liquidity ratio (i.e. liquidity risk) further suggesting that
the higher the non-performing loans ratio the lower the liquidity ratio and thus the higher
the liquidity risk level. He also shows that the negative relationship between these two
ratios is stronger in the Conventional compared to the Islamic banks in Pakistan.
Arif and Anees (2012) examine liquidity risk in Pakistani banks in terms of banks
profitability. The data used were obtained from the balance sheets and income statements
of 23 Pakistani banks for the period 20042009. The main finding of their study is that
liquidity risk significantly affects banks profitability and that non-performing loans is
one of the two factors that give rise to increasing levels of liquidity risk.

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Rochet and Tirole (1996) analyse interbank lending and systemic risk by using
theoretical models (with or without interbank lending, with banking regulation, etc.). One
of their main findings is summarised as follows: in the presence of interbank lending,
systemic liquidity risk exists and its level depends on the size of the bank (i.e. big or
small) and how it interacts with other banks (e.g. through interbank loans) and the role of
supervising authority (central bank).
Strahan (2012) discusses credit risk and liquidity risk in the financial crisis of 2007
2008 and argues that liquidity risk could be attributed more to banks exposure to lending
and interbank financial arrangements and less to deposits outflows. He also emphasises
the importance of traditional deposits as a basic source of funds and unused credit
commitments (used extensively by the borrowers during the first stages of the crisis
because of the significant limitation of new loans due to banks liquidity shortage) as a
potential destabilising factor of liquidity.
Kaufman and Scott (2003) analyse the concept of systemic risk with respect to the
banking sector. Specifically, they discuss the alternative definitions, the sources of
various types of banking systemic risks (systemic liquidity risk, systemic credit risk, etc.)
and their consequences in the entire banking system in a single economy or across
countries. They cite various definitions and they point out that systemic risk generally
refers to the risk or the probability of breakdowns in an entire system evidenced by
correlation among most or all the parts. Thus, systemic risk in banking is evidenced by
high correlation and clustering of bank failures in a single country and even beyond.
They also put emphasis on relevant costs and they make some propositions to bank
regulators in order to handle effectively the systemic risk issue.
Tabak et al. (2010) investigate the effect of monetary policy in banks loans growth
and non-performing loans during the crisis period in Brazil. Their data on loans, nonperforming loans, assets value, equity and equity ratio, etc, come from the balance sheets
and income statements of 99 Brazilian banks (mostly commercial) for the period 2003
2009. One important point in their analysis is that they introduce a dummy variable
(named Crisis) in order to capture the effect of the economic crisis that started in
September 2008. Two important findings arise from their study: first, during periods of
loosening/tightening monetary policy, banks increase/decrease their loans and second,
lower interest rates lead into higher credit risk levels.
Drehmann and Nikolaou (2009) propose definitions of funding liquidity and liquidity
risk and present a measure of funding liquidity risk based on a set of data from open
market operations (135 main refinancing operation auctions conducted at the ECB
between June 2005 and December 2007). They argue that their proxies for funding
liquidity risk are stable and low especially during turmoil and they show that a higher
funding liquidity risk level leads to higher bids during open market operations conducted
by the central bank. One important point of their study is that, among other variables,
they involve central bank lending to define funding liquidity risk.
The Greek banking sector crisis provides sufficient evidence on the relationship
between liquidity risk and credit risk. The serious liquidity shortage was the combined
effect of many factors, such as the extensive deposits outflow, the dramatic reduction of
interbank lending, and the significant increase of non-performing loans (because of
the economic turmoil and of the low credit quality loans that were granted in the
pre-crisis era). It is worth mentioning that the non-performing loans ratio rose to 25.5%
in December 2012, from 4.5% in December 2007 (Bank of Greece, 2013a, p.94; 2012,
p.114).

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383

Empirical analysis

4.1 Data and variables

Three variables are used, one of them being a dummy variable. All the variables span the
period January 2007December 2012, giving 72 monthly observations. The data were
obtained from a small-sized Greek bank, and cover both normal and stressed periods.
Monthly data are used, since the monthly mean value of each variable (apart from the
dummy one) is considered to reflect better the true characteristics of the underlying
series, and also that it contributes in addressing seasonality which usually exists in daily
or monthly time series data.
To measure liquidity risk, we employ the ratio of liquid assets to short terms
liabilities (liquid asset ratioLAR) which is the dependent variable in our model(s). The
liquid asset ratio is the key measure of intraday liquidity and, hence, of the liquidity risk
level (Bank of Greece, 2009, p.2).
LARt

liquid assets t
100
short term liabilities t

(5)

where liquid assets are cash and cash equivalents, claims on other financial institutions
maturing within 30 days, other readily marketable assets and undrawn (unused)
committed credit lines obtained from credit institutions of the group, in the overnight
band and in the time bands of 27 days and 830 days. Short-term liabilities are
liabilities maturing within 12 months, including the 80% of the balance of sight deposits,
current accounts, and savings accounts. t subscript denotes per day or per month (mean
of daily observations) value of the LAR.
We measure credit risk by the ratio of non-performing loans to total loans
(non-performing loans ratioNPLR). This ratio measures the monthly (or daily) default
rate and it is the basic explanatory variable in our model(s).
NPLR t

loans amount t
100
non-performing loans t

(6)

where loans amount is the balance of loans at time t (t refers to per day or per month
loans amount), and non-performing loans is the balance of past due loans at time t
(t refers to past due loans amount per day or per month). We define as non-performing
loan or past due loan one that is past due for more than ninety days (Basel Committee on
Banking Supervision, 2004, p.33). t subscript denotes per day or per month (mean of
daily observations) value of NPLR.
We assume that the NPLR is endogenously determined. This assumption implies that
the non-performing loans ratio of an individual bank depends mainly on the default rate
of its borrowers and not on the non-performing loans ratios of other banks; thus the
systemic credit risk10 is assumed very low and its impact on the models robustness is
negligible if it is omitted.
Relevant studies (see Wong and Hui, 2009; Arif and Anees, 2012; Iqbal, 2012) and
empirical evidence show that non-performing loans ratio is the basic measure of credit
risk, and one of the determinant factors of liquidity risk level. Therefore, since NPLR
corresponds to credit risk and LAR corresponds to liquidity risk, it is evident that credit
risk and liquidity risk are connected through these two ratios.

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The effect of the serious liquidity shortage of the Greek banking system in the LAR
can be captured by including one dummy variable, given that in the literature there are
relevant examples (see Tabak et al., 2010, p.12). The introduction of an additional
explanatory variable, which captures the effect of systemic liquidity risk, is linked with
the expectation that systemic risk has a negative effect on liquidity ratio. Previous
literature shows that a possible systemic liquidity shock exerts significant influence on a
banks liquidity, and that poor loans quality are important systemic risk factors (see
Barnhill and Schumacher, 2011). Systemic liquidity risk is exogenously determined,
since a bank by itself and especially a small one cannot affect either positively or
negatively the banking systems liquidity, given also that one of the main components of
systemic liquidity risk is interbank lending (see Rochet and Tirole, 1996) where small
banks have relatively limited access (both in crisis and non-crisis periods). It is the
banking system as a whole, which defines systemic liquidity risk level. When liquidity
shortage exists, the central bank intervenes and allocates the amount of liquidity needed
(central bank lending) to the financial institutions depending on the collaterals given and
the liquidity needs of each bank with respect to its size (i.e. small, medium or large-sized
bank).
The signs of the explanatory variables (non-performing loans ratio and systemic
liquidity risk) are expected to be both minus, i.e. it is expected that both variables will
have a negative effect on the liquid asset ratio.

4.2 Methodology and models specification

For the purposes of the analysis a linear model is used, which has as dependent variable
the LAR and as basic independent (or explanatory) variable the NPLR. Both variables are
considered to be endogenously determined. The extended version of the baseline model
includes one additional explanatory variable, which incorporates systemic liquidity
risk and is a dummy variable (SLRdv); this variable may have the values zero and one: it
is zero when the systemic liquidity risk is assumed low (or relatively low), and one
in the opposite case. This last variable is exogenously determined because, as already
discussed, a bank by itself cannot exert significant influence on the banking systems
liquidity level.
In order to determine whether systemic liquidity risk (and consequently a systemic
liquidity shock) exist or not, the volume of deposits and repos of non-monetary financial
institutions (households, businesses, central government deposits, etc.) and the volume of
lending from the central bank (Bank of Greece), for the period January 2007December
2012, are compared. The data used are the monthly reports, on aggregate liabilities for
the Greek banks, from the Bank of Greece. As shown in Figure 1, after December 31,
2009 deposits exhibit a constant declining trend, while the lending of financial
institutions by the central bank start to increase. However, between May and July 2011
decline rate of deposits becomes steeper, while lending by the central bank continues to
increase, but at a higher rate than that of the previous months. Hence, it is assumed that
prior to July 2011 systemic liquidity risk was still relatively low.
Consequently, according to the available data (deposits versus Central bank lending
as depicted in Figure 1) and empirical evidence, the dummy variable takes a zero value
for the period January 2007June 2011 assuming that this period covers a non-systemic
liquidity risk period (or at least a non-serious systemic liquidity shock period). On the
other hand, it equals one for the period July 2011December 2012, capturing the effect of
the rising liquidity shortage of the Greek banking system11.

Liquidity risk and credit risk

Figure 1

385

Deposits and central bank lending in Greece: Jan. 2007Dec. 2012 (see online version
for colours)

350000

300000

amounts in million Euros

250000

200000

150000

100000

50000

Ja
nM 07
ar
M 07
ay
-0
Ju 7
lSe 07
pN 07
ov
Ja 07
nM 08
ar
M 08
ay
-0
Ju 8
lSe 08
pN 08
ov
Ja 08
nM 09
ar
M -09
ay
-0
Ju 9
lSe 09
pN 09
ov
Ja 09
nM 10
ar
M 10
ay
-1
Ju 0
lSe 10
pN 10
ov
Ja 10
nM 11
ar
M 11
ay
-1
Ju 1
lSe 11
pN 11
ov
Ja 11
nM 12
ar
M -12
ay
-1
Ju 2
lSe 12
pN 12
ov
-1
2

Date

Central Bank lending

Deposits and repos of non MFI (households etc)

Source: Bank of Greece (2013b)

In order to determine whether there is interdependence or not between the variables in

question and, specifically, to measure only the degree of linear association between each
pair of employed variables, a correlation analysis was conducted using the Pearson
sample correlation coefficient r.12
To investigate the type of relationship between the dependent (LAR) and the
independent variables under consideration (NPLR, SLRdv) and, specifically, to estimate
the mean of LAR in terms of NPLR and SLRdv, two linear models were used:
LAR 0 1 NPLRi ui

(7)

LAR 0 1 NPLRi 2 SLRdvi ui

(8)

Equation (7) is the baseline model and Equation (8) is an extended version of the baseline
model, which incorporates both the basic explanatory variable (NPLR) as well as the
aforementioned additional explanatory dummy variable (SLRdv) that is exogenously
determined. The above-mentioned equations were estimated by applying Ordinary Least
Squares (OLS) and Two-Stages Least Squares (TSLS) to a sample size of 72 monthly
observations.
To investigate the interaction between the variables of the baseline model (Equation
(7)) and specifically to see if it is only contemporaneous, a Vector Autoregressive Model
(VAR)13 is employed. A Granger Causality test14 is conducted to explore the direction of
the dependence between these variables and, specifically, to test whether there is a causal
relation between the endogenous variables. We employ a reduced form VAR model,
whose general mathematical form is:
yt 1 yt 1 p yt p xt ut

(9)

386

I.K. Malandrakis

where yt is a k vector of endogenous variables, xt is a d vector of exogenous variables,

that is other deterministic terms, which are important in practice such a constant term,
and a dummy variable (Luetkepohl, 2011), A1,,Ap and B are matrices of coefficients to
be estimated. ut is a vector of error terms that may be contemporaneously correlated but
are uncorrelated with their lagged values as well as with all of the right-hand side
variables. Reduced form VAR models can be estimated with standard methods such as
OLS.15 Hence, according to the theory, our reduced VAR model is formed with two
equations. The model is:
LARt c1 11 LARt 1 12 NPLRt 1 13 SLRdvt u1t

(10)

NPLRt c2 21 LARt 1 22 NPLRt 1 23 SLRdvt u2t

(11)

where LARt-1 and NPLRt-1 are endogenous variables, SLRdvt and c (constant term) are
exogenous, and uit are the error terms. The sample size is as above.

4.3 Results
Having specified the models and justified the selection of variables, we proceed to the
presentation of the empirical analysis results.
We start with correlation analysis. Pearsons correlation coefficients r are reported in
Table 1.
Table 1

Correlation analysis results

LAR
NPLR
SLRdv

LAR

NPLR

SLRdv

LARt-1

NPLRt-1

1.000

0.726

0.689

0.946

0.738

1.000

0.6631

0.699

0.930

1.000

0.693

0.681

1.000

0.720

LARt-1
NPLRt-1
Note:

1.000

Values refer to Pearsons r correlation coefficient.

The relatively high negative values of the correlation coefficients of LAR and NPLR, and
LAR and SLRdv, suggest a rather strong negative relationship between liquid asset ratio
and non-performing loans, as well as systemic liquidity risk. On the other hand, the
positive sign of the correlation coefficient of NPLR and SLRdv implies that there is a
positive association between non-performing loans and systemic liquidity risk. In
addition, the high negative values of r between LARt and LARt-1 and the high positive
values between NPLRt and NPLRt-1 exhibit a strong association (positive and negative,
respectively) between the value of each variable in time t and t1.
Table 2 reports descriptive and preliminary statistics.
For a normally distributed variable, skewness = 0, kurtosis = 3 and the J-B statistics is
expected to be zero. If the computed p value is reasonably high which will happen if
the value of the J-B statistics is close to zero the normality assumption is not rejected
(Gujarati, 2004, pp.148149). The skewness, the kurtosis and the J-B statistics16 of all
variables show that neither LAR nor NPLR follow the normal distribution. However, this
result is rather expected, especially for time series that refer to financial variables.

Liquidity risk and credit risk

Table 2

387

Descriptive and preliminary statistics for LAR, NPLR

N

Mean

Standard deviation

Skewness

Kurtosis

J-B

D-F
nn

LAR

72

0.195

0.072

0.097

2.280

1.646
(0.439)

2.01ns

NPLR

72

0.142

0.068

0.277

1.441

8.206nn
(0.016)

0.613ns

Notes:

N denotes number of observations (72 monthly observations).

J-B stands for JarqueBera statistics that tests for normality; values in
parentheses below each J-B statistics denote probability level (a small
probability value usually leads to the rejection of the null hypothesis of a
normal distribution at the 5% level of statistical significance); nn denotes nonnormality.
D-F stands for Augmented Dickey-Fuller statistics, which tests for a unit root
and for time series stationarity. The 5% critical value of this test is 2.9035;
ns denotes non-stationarity.

The computed D-F statistics tests whether a time series is stationary or not.17
Specifically, it tests for the existence of a Unit Root. The null hypothesis is that of a Unit
Root, i.e. we check the H0: =1 against the alternative H1: <1, where is the
autocorrelation coefficient (e.g. the first-order serial correlation coefficient). The H0 is
accepted when the t-statistics of at the 5% level of statistical significance is less than
that of the computed value of D-F statistics, and thus a Unit Root exits and the time
series is not stationary (and vice versa). Note that a time series is stationary if 1 < < 1
and it is not stationary if =1 (Gujarati, 2004, p.802). Since the computed value of D-F
statistics is greater than the 5% critical value (2.9035) for this test, the null hypothesis is
accepted and, consequently, all variables under investigation (i.e. the underlying time
series) are not stationary. This test provides an initial indication for autocorrelation
(first order or higher).
Having reported the correlation analysis results and the preliminary statistics, we
proceed to Table 3 which contains the models econometric estimation preliminary
results.
Table 3

Models estimation preliminary results

Dependent variable: LAR

N=72

Method of estimation: OLS

Model 1
(Eq.7)

Model 2
(Eq.8)

Constant term

0.305
(20.375)

0.284
(19.253)

NPLR

0.776
(8.759)

0.513
(5.804)

SLRdv

0.062
(4.889)

R2

0.526

0.604

Adjusted R2

0.519

0.592

S.E. of regression

0.050

0.046

F-statistics

77.19

52.55

Test statistics:

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I.K. Malandrakis

Table 3

Models estimation preliminary results (continued)

Dependent variable: LAR

N=72

Method of estimation: OLS

Model 1
(Eq.7)

Model 2
(Eq.8)

D-W statistics

0.347a

0.333 a

Whites statistics

2.976nh

8.326nh

0.189

0.361

Residuals skewness
Residuals kurtosis
Residuals J-B statistics
Notes:

2.385

2.730

1.563nn
(0.458)

1.784nn
(0.409)

Values in parentheses below each coefficient denote t-statistics values at

=5%.
S.E. denotes standard error of regression.
D-W statistics refers to the Durbin-Watson test statistics that tests for first-order
autocorrelation. D-W critical values from the tables at the 5% level of
significance are dL=1.583 and dU=1.641 for one regressor (excluding
constant term) and dL=1.554 and dU=1.672 for two regressors (excluding
constant term); a denotes autocorrelation.
Whites statistics denotes Whites test statistics for Heteroscedasticity. It is
computed as the number of observations (N) times the R2 from the test
regression and it is asymptotically distributed as a 2 with degrees of freedom
equal to the number of estimated coefficients (excluding the constant term) in
the auxiliary regression. Heteroscedasticity exists when the computed Whites
test statistics (NR2) exceeds the critical 2 value (alternative H1); there is no
heteroscedasticity when the computed Whites test statistics does not exceed
the critical 2 value (null H0) (Gujarati, 2004, pp.413414). nh denotes no
heteroscedasticity.
J-B stands for JarqueBera statistics that tests for normality; values in
parentheses below each J-B statistics denote probability level (a small
probability value usually leads to the rejection of the null hypothesis of a
normal distribution at the 5% level of statistical significance); nn denotes nonnormality.

The coefficients of both estimated equations are statistically significant at the 5% level
and have the correct sign (i.e. they have the expected signs see discussion in
Subsection 4.1). R2 values show that the 53% and the 60%, respectively, of the variation
in the dependent variable is explained by all explanatory variables: that is, the NPLR for
model 1, and the NPLR and the SLRdv for model 2. The reported values of the F-statistics
indicate that the overall statistical significance of both regressions is relatively high. The
Whites test shows that there is no heteroscedasticiy among the residuals in both
regressions. Specifically, the computed Whites statistics (2.976 and 8.326, respectively)
are lower than the critical values of 2 at =5% (5.99 and 9.49, respectively) and,
consequently, we accept the null hypothesis of homoscedasticity and we reject the
alternative of heteroscedasticity. Residuals skewness, kurtosis and J-B statistics values
from Table 3 provide evidence that residuals are not normally distributed.
D-W statistics values from Table 3 indicate strong first-order positive autocorrelation
in the residuals of both models. Additional tests (correlograms and Ljung-Box
Q-statistics) confirm the existence (at least) of first-order serial correlation. Because of
autocorrelation, the fundamental assumption of regression analysis (which says that the

Liquidity risk and credit risk

389

right-hand side variables are uncorrelated with the disturbance term) is violated and
consequently OLS estimates are no longer efficient (Gujarati, 2004, p.454) and under
certain circumstances they are biased (Dougherty, 2001, Ch.13). So, correction is needed.
A common practice to correct for autocorrelation (which, as already mentioned above,
is mainly attributed to the fact that some or all of the variables in question are
not stationary) is to employ a first-order autoregressive process or scheme, usually
denoted as AR(1) (Gujarati, 2004, pp.450452). In this case, our baseline model could be
formulated as18:
LARt 0 (1 ) LAR t-1 1 NPLR t 1 NPLR t-1 t

(12)

where is the autocorrelation coefficient and t is the innovation term. This model is
considered to be free of autocorrelation because the disturbance term ut has been reduced
to the innovation t (Dougherty, 2001, Ch.13).
We next re-estimate the models using an AR(1) term. The results derived show that:
(a) the estimated coefficient of NPLR in model 1 is statistically insignificant at the 5%
level (t-statistics = 1.360 < t-distribution critical value at the 5% level of significance =
1.993), and the estimated coefficients of NPLR and SLRdv in model 2 are not
statistically significant at the 5% level and higher (t-statistics = 0.953 and 0.202,
respectively); (b) autocorrorelation still exists, since the coefficient is almost equal to
one.
Next, the models are estimated using an instrumental variable regression method and,
specifically, the Two-Stage Least Squares (TSLS) procedure.19 TSLS estimation
procedure was adjusted to account for autocorrelation by adding an AR(1) term to the
new equations.20 Equations (7) and (8), which correspond to model 1 and 2, respectively,
become:
LARt 0 1 NPLR t 2 LAR t-1 ut

(13)

LARt 0 1 NPLR t 2 LAR t-1 3 SLRdvt ut

(14)

ut ut 1 t

(15)

The instrumental variables (or instruments) are: LARt-1, 0 (constant term), NPLRt-1 and
SLRdvt. It is considered that they fulfil the necessary conditions (that is the rank order
condition and the inclusion of the appropriate variables as instruments). Specifically, it is
assumed that the SLRdv is a correct instrument since it is somehow associated with the
NPLR (see correlation analysis results in Table 1). The same assumption holds for
NPLRt-1 and LARt-1. In addition, the order condition is satisfied since in both models
(now named 1.1 and 2.1) the number of coefficients being estimated (two excluding
constant term, and three excluding constant term, respectively) is at least equal to the
number of the instruments (four in both models).
Table 4 reports estimations results of the final models and the relevant test statistics.
The estimated coefficients in both models (1.1 and 2.1) are highly statistically
significant at the 5% level and have the correct sign (i.e. they have the expected signs
see Subsection 4.1). R2 values show that the explanatory power of both models is high
enough, since the 75% and the 83%, respectively, of the variation in the dependent
variable is explained by all explanatory variables (the NPLR for model 1.1, and the NPLR
and the SLRdv for model 2.1). The values of the F-statistics indicate that the overall
statistical significance of both regressions is high.

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I.K. Malandrakis

Table 4

Models final estimation results

Dependent variable: LAR

N=72

Method of estimation: TSLS

Model 1.1
Eq.13

Model 2.1
Eq.14

Constant term

0.388
(6.447)

0.342
(7.892)

NPLR

1.302
(3.453)

0.929
(3.879)

SLRdv

0.033
(2.322)

R2

0.746

0.832

Adjusted R2

0.739

0.824

S.E. of regression

0.037

0.031

F-statistics

120.8

119.5

Test statistics:

na

1.645na

D-W statistics

1.839

0.79 < 1

0.80<1

3.635s

nh

2.076nh

D-F statistics

2.930

Whites statistics

1.174

Residuals skewness

0.053

0.059

Residuals kurtosis

2.552

2.704

0.625n
(0.731)

0.299n
(0.861)

Residuals J-B statistics

Notes:

Values in parentheses below each coefficient denote t-statistics values at

=5%.
S.E. denotes standard error of regression.
AR(1) coefficients are 0.791 (10.536) for model 1.1 and 0.801 (11.246) for
model 2.1; values in parentheses denote t-statistics values at =5%.
D-W statistics refers to the Durbin-Watson test statistics that tests for first-order
autocorrelation. D-W critical values from the tables at the 5% level of
significance are dL=1.554 and dU=1.672 for two regressors (excluding
constant term) and dL=1.525 and dU=1.703 for two regressors (excluding
constant term); na denotes no-autocorrelation.
denotes autocorrelation coefficient.
D-F stands for Augmented Dickey-Fuller statistics for unit root test and time
series stationarity. The null hypothesis is that of a unit root. Number of lags: 6;
the 5% critical value of this test is 2.9076 in both models; s denotes
stationarity.
Whites statistics denotes Whites test statistics for Heteroscedasticity
(for details on this test see Table 3); nh denotes no heteroscedasticity.
J-B stands for JarqueBera statistics that tests for normality; values in
parentheses below each J-B statistics denote probability level (for details on
this test see Table 3); n denotes evidence of normality.

Liquidity risk and credit risk

391

The computed D-W statistics shows that autocorrelation does not exist in both models.
The above-mentioned results are also supported by: (a) the D-F statistics, which suggests
that the underlying time series is stationary, and (b) the coefficient value that is less
than one in both models. Additional tests (correlograms and Ljung-Box Q-statistics)
confirm that autocorrelation, and especially first-order serial correlation among the
residuals, no longer exists.
Whites test statistics show that no heteroscedasticiy exists in the residuals to both
regressions, since their values (1.174 for model 1.1 and 2.076 for model 2.1) are lower
than the critical values of 2 at the =5% (which is 5.99 with two degrees of freedom for
model 1.1, and 9.49 with four degrees of freedom for model 2.1). Hence, we accept the
null hypothesis of homoscedasticity and we reject the alternative of heteroscedasticity.
The skewness, the kurtosis and the J-B statistics of the residuals from Table 4 show
that they are almost normally distributed. The probabilities of obtaining such J-B
statistics is about 73% and 86%, respectively (i.e. p values are high). Consequently, we
could accept the hypothesis that the residuals are normally distributed in the corrected
equations.

4.4 VAR model results

We estimate a linear Vector Autoregressive Model (VAR) (see Equations (10) and (11))
to investigate the interaction between LAR and NPLR, and to explore if there is a causal
relation between the variables in question. Recall that the LAR and the NPLR are
considered as endogenous variables, while the constant term and the SLRdv as exogenous
variables. We perform a Granger Causality test to examine the direction of the
relationship between the two variables. The results of the estimation of the VAR models
and the Granger Causality test are reported in Tables 5 and 6, respectively.
Table 5

VAR model estimation results

VAR Eq. 1
Eq.10

VAR Eq. 2
Eq.11
Dependent Variable:

LAR

NPLR

Constant

0.044
(0.018)
[2.389]tss

0.027
(0.020)
[1.343]

LARt-1

0.856
(0.061)
[14.099]tss

0.043
(0.075)
[0.659]

NPLRt-1

0.117
(0.064)
[1.825]

0.876
(0.069)
[12.676] tss

SLRdv

0.004
(0.009)
[0.454]

0.005
(0.010)
[0.531]

R2

0.901

0.867

Adjusted R2

0.897

0.861

Test statistics:

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I.K. Malandrakis

Table 5

VAR model estimation results (continued)

VAR Eq. 1
Eq.10

VAR Eq. 2
Eq.11
Dependent Variable:

LAR
S.E. of equation

NPLR

0.023

0.025

F-statistics

204.515

145.969

Log likelihood

167.801

162.628

Log likelihood
Notes:

Table 6

Notes:

331.110

Values in parentheses below each coefficient denote standard errors; values in

brackets denote t-statistics at =5%.
t-tests critical value at =5% (two-tailed test) is 1.990 with =1=71 degrees
of freedom; tss denotes statistical significance at the 5% level.
S.E. denotes standard error.
Granger causality test
Direction of causality

Decision

NPLR LAR

3.331

Reject 0

LAR NPLR

0.434

Do not reject H0

Number of lags: 1.
The null hypothesis (H0) in each case is that the variable under consideration
does not Granger-cause the other variable.
2 is statistically significant at the 10% level for LAR taken as dependent
variable, and it is statistically insignificant for NPLR taken as dependent
variable.

The computed R2 values in both equations show that the explanatory power of the
regressions is high, since 90% of the variation in the dependent variable (LAR) of VAR
Equation (1) is explained by all independent variables, and 87% of the variation in the
dependent variable (NPLR) of VAR Equation (2) is explained by all independent
variables. The F-statistics are high in both estimated equations, but the estimated value of
the F-statistics is significantly higher in the first equation, compared with that in the
second equation. The last result implies higher overall statistical significance of VAR
Equation (1) versus Equation (2). In addition, both equations satisfy the stability
condition, since all Roots (0.937; 0.794) have modulus less than one, and no root lies
outside the unit circle. This result means that the variables under investigation (LAR and
NPLR) are stationary.21

4.5 Discussion of the results

The correlation coefficients between LAR and NPLR, and LAR and SLRdv suggest a
rather strong negative relationship between the liquid asset ratio and the non-performing
loans ratio, and between the liquid asset ratio and the systemic liquidity risk. The

Liquidity risk and credit risk

393

positive sign of the correlation coefficient between NPLR and SLRdv implies a positive
association between non-performing loans and systemic liquidity risk. This finding is
further supported by the fact that the lagged NPLR is positively associated with the
SLRdv, which means that not only the current but also the previous period nonperforming loans ratio seems to relate somehow with the existence or not of systemic
liquidity risk. Furthermore, the current LAR and NPLR are positively associated with the
lagged LAR and NPLR. In addition, the current LAR is negatively related with the lagged
NPLR (it seems that current liquidity level is affected by the previous values of the nonperforming loans ratio), and the lagged LAR is negatively related with the lagged NPLR,
further suggesting that the lagged NPLR exercises a negative effect to both current and
lagged LAR. To summarise: (a) the liquid asset ratio is negatively associated with the
current and the lagged non-performing loans ratio as well as with the systemic liquidity
risk, (b) the non-performing loans ratio is positively related with the systemic liquidity
risk, and (c) the liquid asset ratio and the non-performing loans ratio are positively
associated with their lagged values.
The coefficients of the explanatory variables have the expected signs, which is a
minus sign for the NPLR (it is expected that it will have a negative effect on LAR) and a
minus sign for the SLRdv (it is expected that it will have a negative effect on LAR). These
findings are generally in line with theory (see Section 3 and Section 4 Subsection 4.1),
and they are further validated by regressions analysis and VAR model estimation results
discussed below.
Regressions analysis shows that in the baseline model (see model 1.1 in Table 4) the
explanatory variable NPLR is statistically significant at =5% and has a minus sign,
which is the expected one (see discussion in Subsection 4.1). The estimated value
(1.302) of the corresponding coefficient implies that, for each change of one unit in
NPLR, the average change in the mean of LAR will be about 1.3 units. This result could
be interpreted as follows: since borrowers have defaulted (e.g. the payments of interest
and principal are past-due by more than ninety days), cash inflows from interest and
principal payments are significantly reduced. Since inflows from the loans (which are
one of the basic liquidity funding sources of a bank as discussed in Section 1) decrease,
the LAR decreases. Because the NPLR is the basic measure of credit risk and LAR is the
basic measure of liquidity risk, the negative relationship between these two ratios implies
a positive relationship between the above mentioned banking risks, which in turn means
that when credit risk increases, then liquidity risk increases, and vice versa.
The results of estimation of the extended model (model 2.1 in Table 4), which
incorporates an additional explanatory variable, the SLRdv that used to capture the impact
of systemic liquidity risk, shows that the NPLR is still negatively related with the LAR.
However, in this case the influence of the NPLR on the LAR is likely to be less serious
than that discussed above (model 1.1). Specifically, the estimated coefficients for the
NPLR and the SLRdv are statistically significant at =5% and they have the expected
signs, i.e. a minus sign in both cases. The estimated value (0.929) of the coefficient of
NPLR implies that for each change of one unit in NPLR, the average change in the mean
of LAR will be about 0.9 units (holding SLRdv constant). The value of the estimated
coefficient of SLRdv suggests that if systemic liquidity risk exists, the LAR will decrease
on the average by 0.03 units (holding NPLR constant). These results show that both
variables have a negative effect on LAR, but the effect of non-performing loans tends to
be more serious compared to that of a systemic liquidity shock. The last result probably

394

I.K. Malandrakis

holds for small and medium-sized banks, which are not significantly exposed to
interbank lending and probably they do not have special liquidity funding sources to rely
on (assets securisation, repos, unsecured debt instruments, etc.), which become scarce
during liquidity crisis periods, as Strahan (2012) states. To summarise, both the nonperforming loans and the systemic liquidity risk exercise a negative effect on liquidity
ratio, which means that as credit risk increases and systemic liquidity risk is high or
relatively high, liquidity risk rises.
From the results of the estimation of the baseline model (model 1.1)22 and the
assumption that the SLRdv is exogenously determined, we can infer that a high nonperforming loans ratio is one of the main factors that affect liquidity. Consequently,
liquidity risk mainly depends on the undertaken level of credit risk, at least in the case of
a small-sized credit institution. We must note, however, the likelihood of existence of
other factors that have contributed equally, or perhaps more, in determining the
appropriate liquidity ratio level and therefore the liquidity risk level, and they should be
taken into account. Such a factor could be the lending by the central bank, as discussed in
Subsection 2.3 (see Drehmann and Nikolaou, 2009), which has supported Eurozone
banks (banks liquidity assistance from the ECB through National banks) during crisis.
The estimation of a VAR model (Table 5) shows that the lagged LAR affects current
LAR, i.e. current LAR values depend on its recent past values. The lagged NPLR is
statistically significant at the 10% level in a two-tailed test and it is significant at the 5%
level in a single-tailed test. Thus, the lagged NPLR influences current LAR rather
significantly. The lagged NPLR appears to influence the current NPLR, therefore the
current value of non-performing loans ratio depends on its past value. Of the exogenous
variables, the SLRdv appears to exercise a negative effect on current LAR and a positive
effect on current NPLR. However, the SLRdv is not statistically significant in both
the regressions, which means that it does not affect significantly the current LAR and
NPLR. The last result suggests independence, further implying that there is no causal
relationship between LAR, NPLR and systemic liquidity risk. This is in contrast with the
result derived from Table 4 for model 2.1 and it shows that the relationship between LAR
and systemic liquidity risk, and especially between NPLR and systemic liquidity risk, is
likely to be only contemporaneous. To summarise, the LAR is affected by its previous
values (positive relationship) and by previous NPLR values (negative relationship).
The Granger Causality test (Table 6) suggests that the direction of causality is from
NPLR to LAR, i.e. the NPLR Granger-causes the LAR (the estimated 2 value is
statistically significant); thus, the null hypothesis that the NPLR does not Granger-cause
the LAR is rejected. On the contrary, when the NPLR is taken as the dependent variable,
Grangers test reveals that here is no reverse causation from LAR to NPLR (the estimated
2 value is statistically insignificant); hence, the null hypothesis is accepted and the LAR
does not Granger-cause the NPLR. In summary, the Granger Causality test indicates that
there is a causal relationship between LAR and NPLR (with p=93%) and, consequently,
the effect of NPLR on LAR is not temporary. Broadly speaking, credit risk Grangercauses liquidity risk whether systemic liquidity risk exists or not.
Our findings may be of interest to regulators and to the Basel Committee on Banking
Supervision. We suggest that: (a) Non-performing loans could be incorporated as an
explicit instrument into the liquid asset ratio formula to capture the effect of (rising) nonperforming loans ratio on liquidity. (b) A revised liquidity ratio should be considered to
include a term that would take into account the impact of a possible systemic liquidity

Liquidity risk and credit risk

395

shock. (c) The supervising authority should examine if the structural relationship of nonperforming loans ratio and liquid asset ratio has changed during crisis and, hence, to
investigate the impact of credit risk on liquidity risk during crisis and non-crisis periods.
(d) The non-performing loans ratio should be included in obligatory early warning
indicators set for liquidity risk. (e) A methodology that will manage simultaneously
credit risk and liquidity risk could be developed.

Conclusions

In this paper the relationship between credit risk and liquidity risk was examined, given
that liquidity risk has gradually become an important factor that affects banks solvency
and may be extremely harmful when it is combined with high credit risk levels and when
systemic liquidity risk exists. Liquidity risk and credit risk are modelled in terms of the
liquid asset ratio and the non-performing loans ratio, respectively. We show that the NonPerforming Loans Ratio (NPLR) is negatively related with the Liquid Asset Ratio (LAR)
(an increase of NPLR by one unit will have as a result an average change in the mean of
LAR by about 1.3 units); this result further implies that as credit risk increases, then
liquidity risk also increases, and vice versa. We find that the NPLR is still negatively
related with the LAR after incorporating in the baseline model a dummy variable (SLRdv)
accounting for systemic liquidity risk (an increase of NPLR holding SLRdv constant
by one unit will have as a result an average change in the mean of LAR by about 0.94
units). This result further implies that as credit risk increases, then liquidity risk also
increases when systemic liquidity risk exists, and vice versa. However, in the second case
the effect of NPLR on LAR is rather milder, comparing to that in the first case. This
means that systemic liquidity risk is likely to affect more big-sized rather than smallsized banks; big-sized banks may be more vulnerable to a systemic liquidity shock, due
to the fact that their liquidity funding sources are not only retail and wholesale
deposits and inflows from the loans, but also specific financial instruments that become
expensive and scarce during crisis periods. On the other hand, these findings suggest that
small-sized banks, whose main funding sources are traditional deposits23 and inflows
from the loans, are more exposed to credit risk than to systemic liquidity risk.
The econometric estimation of a VAR model shows that the LAR is positively
affected by its past values and negatively affected by past NPLR values and that the
relationship between LAR and systemic risk as well as between NPLR and systemic
liquidity risk is likely to be only contemporaneous. The Granger Causality test shows
that the NPLR Granger-causes the LAR, and that credit risk Granger-causes liquidity
risk whether systemic liquidity risk exists or not.
Our findings are of interest to supervising authorities and relevant for Basel III, since
they finally suggest that the non-performing loans should be explicitly taken into account
for the calculation of the liquidity ratios and for the assessment of liquidity risk level, and
that credit risk and liquidity risk should be treated simultaneously, with or without
systemic liquidity risk.
A limitation of the analysis performed is that similar data for other Greek banks
(small or medium-sized) are not available, given that they are not publicly available. If
these data were available, it would be interesting to investigate the relationship between
liquid asset and non-performing loans ratios, and the interaction between liquidity risk

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I.K. Malandrakis

and credit risk, with and without systemic liquidity risk, in order to see if the
aforementioned results hold for the whole or for a specific sector of the Greek banking
system.
Because the variables and the models used cannot capture all the potential factors that
affect liquidity and liquidity risk, a topic for future research could be the inclusion in the
models of other factors that contribute, more or less, in funding liquidity and liquidity
risk, such as central bank lending. Another topic is the investigation of the combined
effect of non-performing loans ratio on liquidity ratio and capital adequacy ratio (i.e. the
investigation of the simultaneous effect of credit risk on liquidity risk and banks
solvency). And last, the joint modelling of the above mentioned factors in a single
indicator that will reflect the true level of a banks liquidity risk level, in stressed and in
normal periods.

Acknowledgements
I would like to acknowledge the many helpful suggestions from two anonymous
reviewers and from Mr. I. Kampianakis on earlier versions of this paper. I also thank Mr.
F. Kalfaoglou for his helpful suggestions concerning systemic liquidity risk. Finally,
many thanks to Associate Professor M. Doumpos and Professor C. Zopounidis, the
Editor, and also to Mr. E. Sideridis for his proofreading.

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Notes
1
2

The terms financial institutions and credit institutions as used in this paper refer to banks.
A repo (or repurchase agreement) is the sale of securities (debt securities, equity securities and
derivative contracts) together with an agreement for the seller to buy back the securities at a
later date.
3
Securitisation refers to the transformation of portfolios of on-balance-sheet loans, such as
mortgages or credit cards debt, into securities sold to outside investors (Lopez, 2008).
4
Credit risk is the potential that a bank borrower or counterparty will fail to meet its
obligations in accordance with agreed terms.
5
Credit risk is the risk of loss due to default by bank borrowers.
6
The funding plan includes projections of expected future inflows/outflows (distributed in time
bands), the potential funding gap (positive or negative), estimates of the funds required to
finance the on-going operations and to cover any deficits of the same period (Bank of Greece,
2009, p.3).
7
These are important measures of the intraday liquidity as defined in the Governors Act
No.2614/2009 of the Bank of Greece (pp.2728). For the purpose of the analysis that was
performed, the liquid asset ratio was used.
8 All of these funding sources have different values p.
9 The supervisory minimum for this ratio is 20% while any downward deviation higher than
two percentage points must be notified to the Bank of Greece. However, in the current crisis
period these values presumably do not apply. It is expected that, the mean LAR for the Greek
banking system is still below 18%.
10 Considering Kaufman and Scotts (2003), and Barnhill and Schumachers (2011) definitions
on systemic risk and systemic liquidity risk follows that systemic credit risk occurs when a
bank with high non-performing loans ratio negatively affects other banks loans portfolios
(e.g. by contaminating their loans portfolios).
11 It seems that the serious liquidity shortage of the Greek banks after July 2011 and the systemic
liquidity shock, which lasted at least fourth months, from April to June 2012, was the
combined effect of: (a) the significant amount of deposits outflows, (b) the rapid increase of
non-performing loans, and (c) the significant reduction of interbank lending.
12

The sample correlation coefficient is defined by: rxy

Cov( X ,Y )
Var ( X )Var (Y )

For r = 1 there is perfect positive correlation between Y and X; for r = 1 there is perfect
negative correlation between Y and X; for r = 0 there is no correlation between Y and X i.e. the
variables under consideration are independent (Christou, 1982, p.53; Dougherty, 2001, p.12).
13 VAR models were introduced by Sims as alternatives to the multivariate simultaneous
equations models that were used extensively up to then for macroeconomic analysis (seeSims,
1980). Apart from forecasting, they can be used for economic analysis, because they describe
the joint generation mechanism of the variables involved. VAR approach treats all variables as
a priori endogenous (Luetkepohl, 2011) i.e. it treats every endogenous variable of the
equations system as a function of the lagged values of all the endogenous variables in the
system. A VAR process is generated by a reduced or a structural form model. The general
mathematical representation of a reduced form VAR model is:

yt t xt
where t is the deterministic part (which is at most a linear trend; it may also be zero or just a
constant) and xt is a purely stochastic process with zero mean (Luetkepohl, 2011).

Liquidity risk and credit risk

14

15

16
17

18

399

Granger developed this test in 1969 and it is more known as the Granger-causality. Grangers
test states that a variable y2t has a causal relation with a variable y1t if the information in past
and present values of y2t is helpful for improving the forecasts of y1t and that y2t is not
Granger-causal for y1t if and only the y2t variable does not appear in the y1t equation of the
model (Luetkepohl, 2011). In general, Grangers test investigates the causality or the direction
of influence between variables (Gujarati, 2004, p.696).
OLS can estimate efficiently the parameters for each equation separately. Simultaneity is not
an issue, because only lagged values of the endogenous variables appear on the right-hand
side of the equations so OLS yields consistent estimates. In addition, even though the error
terms ut may be contemporaneously correlated, OLS estimators are efficient.
J-B test of normality is a large-sample test (>50 observations) and thus it is accepted for our
models where sample size is 72 monthly observations.
Stationarity is a desired property for a time series. A time series is stationary if its basic
statistical properties remain constant over time and, specifically, its mean, variance and
autocovariance (at various lags) do not vary systematically over time. On the other hand, a
time series is non-stationary if its mean or variance or both vary over time (i.e. its basic
statistical properties change over time) (Gujarati, 2004, p.798). Non-stationarity is mainly
attributed to trend or seasonality, which usually exist in daily, monthly or quarterly data. If a
time series is not stationary, the phenomenon of spurious regression exists; this means that
the estimated coefficients do not have a logical interpretation and thus the stochastic analysis
does not lead in logical and safe conclusions.
This practically means to transform a non-stationary series into a stationary one, by employing
a difference equation which is an expression relating a variable Yt to its previous values plus
another variable t (also dependent on time t), which are often referred to as the error term or
innovation. More formally, Y follows an autoregressive model (AR), whose simplest and most
commonly used version is the first order autoregressive scheme AR(1) and it is generally
defined as: Yt=Yt-1+t, where a = and stands for the autocorrelation coefficient and t is the
innovation term. The spurious regression problem is usually averted because the difference
variables become stationary (Horvath and Johnston, n.d.). From the theory (see Dougherty,
2001, Ch.13) follows that the procedure for transforming our baseline model (model 1) so as
to include an AR(1) term in order to correct for autocorrelation, is:
LARt 0 1NPLR t u

(i)

with ut generated by the process

ut ut-1 t

(ii)

If we lag Equation (i) by one time period and multiply by , we have

LARt-1 0 1NPLR t-1 ut-1

(iii)

Then, we subtract Equation (iii) from Equation (i):

LARt LARt-1 0 (1 ) 1NPLR t 1NPLR t-1 u t ut-1

(iv)

Hence,
LARt 0 (1 ) LAR t-1 1NPLR t 1NPLR t-1

19

(v)

Two-Stage Least Squares (TSLS or 2SLS) developed independently by H. Theil in 1953 and
R. Basmann in 1957 (Gujarati, 2004, p.77). This method uses the so-called instrumental
variables or instruments. An instrumental variable (say z) has the property that changes in z
are associated with changes in regressors (say xi), but not to changes in regressands (say y)
aside from an indirect route via xi. That is, a variable z is introduced, which is associated with
x but not with u that is the error term. This z variable is called an instrument if: (a) it is
uncorrelated with the error term, and (b) it is correlated with the regressor x i.e. although it is
highly correlated with a stochastic explanatory variable, it is uncorrelated with the error term
(Gujarati, 2004; p.753, p.771). The 2SLS is an estimation procedure that accrues the relevant

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20
21
22
23

I.K. Malandrakis
estimators by two consecutive OLS regressions: the OLS regression of xi on z to get x
followed by OLS of y on x which gives TSLS. Two conditions must be fulfilled in order 2SLS
estimates to be correct: (a) the order condition for identification, which says that there must be
at least as many instruments as there are coefficient in the equation being estimated and (b)
any right-hand side variables that are not correlated with the disturbances should be included
as instruments.
By combining TSLS with an AR(1) term, we can estimate a model where there is correlation
between regressors and the innovations as well as serial correlation in the residuals.
See Gujarati (2004, p.698).
Its overall statistical significance is slightly higher than that of the extended version.
Thus, depositors faith in their bank is an important factor affecting banks liquidity and
liquidity risk levels.