The Impact of credit risk and liquidity risk on bank performance

Abstract

Imbierowicz and Rauch (2011) employed a structural equation (simultaneous) approach to examine panel data. This decision was made due to the failure of the underlying premise to establish a connection between credit risk and liquidity risk. The preliminary testing of the idea, conducted at both stages, demonstrated its potential for clear communication. At Habib Bank, there is a strong correlation (95% chance) between credit risk and liquidity risk, with credit risk tending to have a positive effect on liquidity risk. Additionally, there is a significant probability that liquidity risk would have a detrimental impact on credit probability. Hence, it is logical to deduce that the interconnection within the bank is mutually advantageous, with diverse risks exerting influence on each other. This highlights the significance of banks giving priority to the effective management of these risks. The findings from the initial stage of hypothesis 1, which investigated the impact of liquidity risk on credit risk, indicated that the bank's credit risk would escalate in direct correlation with the magnitude of the growth in the operational expenses to profits ratio. This outcome was entirely contrary to the anticipated result. Increasing the amount of short-term deposits compared to long-term deposits has the benefit of reducing the bank's vulnerability to credit risk. Conversely, reducing the bank's credit risk would increase both the interest margin ratio and the return on investment. Moreover, the results of the second stage of hypothesis 1 indicated that a drop in the bank's liquidity risk would result from a reduction in the ratio of the bank's operational costs to earnings. This outcome arose from the credit concerns of the bank. In addition, the bank's credit risk will rise when the proportion of short-term deposits compared to long-term deposits increases. Upon analysing such data, an increase in return on investment decreases the bank's liquidity risk. Liquidity risk, as defined by Tripe (1999), refers to the probability of a financial institution being unable to fulfil its obligations, such as timely loan extensions or deposit payments. The primary factor contributing to the risk being examined is a discrepancy between the time of banks' incoming and outgoing funds, resulting from the combination of their assets and liabilities (Crouhy and Mark, 2000). "Liquidity" is the term used to describe the presence of cash or other types of currency. In the context of banking, the term "credit risk" denotes the possibility that a financial organisation may be incapable of delivering authorised services or fulfilling its financial obligations within the specified timeframe (Banks, 2005).Assessing the significance of risk and risk management is crucial when evaluating reputable financial organisations globally. If the most unfavourable circumstances occur, this risk could lead to complete financial bankruptcy. The approval process for facilities or assets in banking typically requires more time compared to deposits or debt collections. This is due to the extended duration required to complete the approval process. The probability of the bank not receiving payment within the stated deadlines is higher, hence elevating the risk of inadequate liquidity. This is a result of a difference between the dates of payment and receipt. The correlation between credit risk and liquidity risk has not yet been determined. The researchers have not been able to ascertain this. However, there is a connection between the two forms of risk, which can be attributed to two distinct approaches of financial intervention and the bank's industrial element. In their study, Prizman, Slowin, and Soscheckt (1986) investigated the impact of borrower default and unexpected financial withdrawals on bank profit in the Manti kiln scenario and its subsequent iterations. This study demonstrated that these factors resulted in a decline in bank profitability.