Bank solvency: The role of credit and liquidity risks, regulatory capital and economic stability

Banking stability is essential to any economy due to its many functions, including intermediation, payment facilitation, and credit creation. Thus, the stability of the banking industry is one of the critical ingredients in economic growth. This paper analyzes how bank capital, credit and liquidity requirements impact bank solvency, using ten major banks controlling 90% of the UK market share in 2009-2018. The GMM model indicates a strong association between credit and liquidity risks. That is, when banks finance a risky or distressed project, this will lead to an increase in nonperforming loans (NPL), which reduces bank liquidity. Poor liquidity profile of a bank may restrict its ability to act as a financial intermediary. In addition, the findings indicate that efficiency, asset quality, and economic growth have a significant positive effect on the solvency of banks. The results also show that the regulatory capital (Tier1) has a positive significant influence on bank solvency. Further, the results indicate that during the economic boom, banks tend to increase their regulatory capital. Therefore, there is a need to ensure that during the "good time", banks can accumulate enough capital that is genuinely capable of absorbing negative shock. Also, it is important for banks to ensure that they are efficient but also have a robust credit appraisal system to reduce NPL. This paper also demonstrates the implications of increased capital requirements. That is, increased capital requirements ensure not only banks are liquid but also solvent, which allows them to provide financial intermediation.