Effect of Credit and Liquidity Risks on Bank Stability: Empirical Evidence from Afghanistan

Abstract

This study investigates the effects of liquidity and credit risks on the stability of banks with empirical evidence from the Afghanistan banking sector over the period 2014–2020. The stability of a bank is measured through the dependent variable of its capital adequacy ratio. Credit risk (calculated by the ratio of impaired loans) is included as an independent variable along with liquidity risk. The bank specific factors, namely bank net interest margin, size of the bank, return on assets, loan growth rate, liquidity gap, return on equity, loan to asset and macro-economic factors, inflation and GDP growth rate are included as control variables. This study includes all 10 operationalized banks in Afghanistan, excluding the two branches of foreign banks. The panel dataset was collected from banks’ websites and the macroeconomic data was derived from World Bank reports. This study employed the simultaneous equation approach of a two-stage least square and a fixed effect panel regression model to investigate the affiliation between liquidity and credit risks and their effects on the stability of banks. The results of this study indicate that liquidity and credit risks don’t have a mutual relationship, while the interaction of both types of risks jointly impacts bank stability. It shows that NIM, loan assets, ROA, liquidity gap, loan growth rate, and ROE have positive impacts on bank stability, whereas the size of the bank has negative effects on bank stability. Among the macroeconomic variables, only the growth rate of GDP signifies a negative effect on the stability of banks. The finding under this paper recommends that the governance body of the banking sector drafts policies aimed at strengthening bank capital and taking liquidity measurement according to the best standards introduced by the Basel committee. Also, to create frameworks for measuring liquidity and capital standards.

The complex relationship between credit and liquidity risks: a linear and non-linear analysis for the banking sector

“…The two biggest and most dangerous risks to bank performance and stability, according to banking literature, are credit and LRs. (Hamdi and Hakimi 2019;Reinhart and Rogoff 2011;Boussaada et al 2022;Magwedere and Marozva 2022;Faiz 2022). Strongly documented in the literature focused on the determinants of credit and LRs (Ghenimi et al 2021;Hakimi and Zaghdoudi 2017).…”

“…Several empirical studies concluded that the two risks are positively correlated (Cai and Zhang 2017;He and Xiong 2012;Magwedere and Marozva 2022. However, few studies supported either the negative (Cai and Thakor 2008;Wagner 2007;Faiz 2022) or the non-significant effect (Imbierowicz and Rauch 2014). Besides reviewing studies based on the positive or negative effect, the literature on the credit-LR relationships is divided into linear and non-linear analyses.…”

“…A well-capitalized bank seems to be less sensitive to bank risks and shocks (Abreu and Mendes 2002;Boussaada and Hakimi 2021). We used bank size to assess whether large or small banks manage bank risks (Boussaada and Hakimi 2021;Pasiouras and Kosmidou 2007;Faiz 2022). As bank performance, we introduce a variable that measures the net interest margin (NIM).…”

“…More profitable banks are less exposed to bank risks (Hamdi and Hakimi 2019). In banking literature, macroeconomic conditions are strongly used to explain either bank performance or bank risks (Boussaada and Hakimi 2021;Calza et al 2003;Ghenimi et al 2021;Faiz 2022). Hence, we include, the growth rate of gross domestic product (GDP) and the inflation rate (INF) in the econometric models.…”

“…Banking literature is abundantly reported by investigations focused either on the determinants of CR and LR (Antony 2023;Naoaj 2023;Alnabulsi et al 2022;Ferreira 2022;Ghenimi et al 2021;Zaghdoudi 2017, Misman andBhatti 2020) or the linkage between LR, CR and bank profitability or bank stability. (Hakimi and Zaghdoudi, 2017;Cofitalan, 2022;Setiawan et al 2021;Faiz, 2022). However, less abundant studies explored the complex relationship between the two risks.…”