Since August 2007, the U.S subprime mortgage crisis has not only threatened to the U.S. economy into a recession, but affected the global financial system. Furthermore, it brings a huge challenge to short-term and long-term development for global banking industry. Because the crisis has caused banks and other financial institutions became nervous about lending to other banks, banks generally lack of liquidity following the subprime mortgage crisis. Especially,banks depend heavily on the short-term money market or purchased funds market will be more likely to suffer liquidity problem in the future, and the Northern Rock is an example.
After subprime mortgage crisis, Northern Rock was unable acquire funding from money market because of credit freeze. In September 2007, Northern Rock was influenced by magnitude liquidity squeezes, and forced to a bailout from the Bank of England. It consequently suffered the bank run crisis. From Northern Rock crisis we can realize the importance of bank liquidity and diversified funding sources, though liquidity risk was rarely mentioned in the past. Swary (1986) also provided an explanation of the failure of the Continental Illinois National Bank in the U.S, which only had a small part of core deposit on its liability side. Thus, it is worth of discussing for bank liquidity risk.
According to the definition of the Basel Committee on Banking Supervision (1997), liquidity risk arises from the inability of a bank to accommodate decreases in liabilities or to fund increases in assets. When a bank has inadequate liquidity, it cannot obtain sufficient funds, either by increasing liabilities or by converting assets promptly, at a reasonable cost, thereby affecting profitability. Besides, Decker (2000) indicated that liquidity risk can be divided into funding liquidity risk and market liquidity risk.
Comparing to credit risk, there are fewer literature to discuss with liquidity risk. Basel I Accord (Basel Committee on Banking Supervision, 1988) set out regulatory standards for credit risk and market risk. Besides, Basel II Accord (Basel Committee on Banking Supervision, 2004) even takes operational risk into account. However, they seldom mention the liquidity risk. Landskroner and Paroush (2008) also indicated that there has been extensive academic and regulatory discussion of the different major banking risks: credit risk, market risk and even operation risk. However relative little attention has been paid to liquidity risk that has become one of the major risks faced by banks and other financial institutions in recent years.
Previously, the related literatures of liquidity risk mainly focus on bank run or failures. Besides, previous empirical studies were mainly to investigate the determinants of bank profitability or net interest margins. (e.g. 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., 2005; Athanasoglou et al., 2006; Pasiouras and Kosmidou, 2007; Athanasoglou et al., 2008; Kosmidou, 2008; Naceur and Kandil, 2009 ). They usually use liquidity ratios to measure bank liquidity, and regarded liquidity risk as exogenous variable. However, there are seldom studies to discuss the causes of liquidity risk. Furthermore, previous empirical evidence showed that the effect of liquidity risk on bank profitability is mixed. Some studies found out the positive effect (e.g. Molyneux and Thornton, 1992; Barth et al., 2003); others found out the negative effect (e.g. Bourke, 1989; Demirgüç-Kunt and Huizinga, 1999; Kosmidou, 2005; Kosmidou, 2008). Besides, previous studies found that banks with high liquidity have lower net interest margins. (e.g. Demirgüç-Kunt and Huizinga, 1999; Shen et al., 2001; Demirgüç-Kunt et al., 2003; Naceur and Kandil, 2009).
