Recent Bank Failures
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Many historical episodes have highlighted the crucial role of funding liquidity for banking crises (Drehmann and Nikolaou, 2009). This paper investigates the relationship between funding liquidity and banks performance during the 2007-09 recession.
The recent financial crisis has drawn attention to banks’ liquidity management. Despite this, few studies have examined the impact of funding liquidity on banks performance (Shen et al, 2009). The theory of bank asset management highlights the importance of funding liquidity and empirical evidence has stressed the impact of the recession on financial markets.
Well-functioning financial markets are key factors in producing high economic growth, and poorly performing financial markets are one reason that many countries in the world remain poor. Activities in financial markets affect the behaviour of businesses and consumers as well as performance of the economy (Mishkin and Eakins, 2006). Rose (1996) stated that “a lack of adequate liquidity is often one of the first signs that a bank is in serious financial trouble”. Many historical episodes have highlighted the crucial role of funding liquidity for banking crises (Drehmann and Nikolaou, 2009). For instance, it was the restricted access to funding liquidity that triggered the failures of Northern Rock, Bear Stearns and Lehman Brothers (Honohan, 2008).
As yet, few studies have examined the relationship between funding liquidity and bank profitability. The focus has been on the determinants of profitability and many have identified liquidity as a bank specific determinant. Some studies in this field have also examined liquidity management and bank profitability using untraditional measures of liquidity such as the cash conversion cycle (CCC) (Wang, 2002).
Compared to the body of studies on liquidity risk and profitability determinants our knowledge of the relationship between funding liquidity and profitability is rather scarce (Shen et al, 2009). Most studies in this area have examined liquidity as a determinant of profitability during normal economic conditions (Bourke, 1989, Kosmidou, 2008) exceptions to this are the studies of Dietrich and Wanzenried (2011), Albertazzi, and Gambacorta (2009) and Hunter (1982). However, these studies lack certain factors, for instance Dietrich and Wanzenried (2011) only examines Swiss banks and Albertazzi and Gambacorta (2009) uses European banks and banks in Anglo-Saxon countries, thus the findings cannot be generalised. Hunters study examines liquidity during a recession but excludes financial firms. This is an important gap in the literature given that the relationship between funding liquidity and profitability stretches beyond non-financial firms and these national contexts.
Studies on profitability determinants have increased our understanding about the impact of liquidity on profitability. However, there is a lack of evidence on whether the relationship is positive or negative in financial firms. It is important to research this, as funding liquidity is a crucial part of the operations of financial firms, particularly during a recession.
This study will respond to the above statement by examining whether funding liquidity effects banks profitability during the 2007-2009 recession.
1.2 Research Question
This study responds to the contradicting findings of Bourke (1989) and Molyneux and Thornton (1992) and the absence of financial firms in Hunter (1982) study of the relationship between liquidity and profitability
Therefore, the study addresses the following questions:
Did funding liquidity determine banks profitability during the recession of 2007-2009?
In order to do so we also had to examine other determinants that could have affected the variables.
1.3 Research Objectives
The objective of this study is to enhance our understanding on the impact of funding liquidity on banks profitability. Liquidity risk is considered a major threat to banks (Shen et al, 2009), so I wish to investigate it to acquire more knowledge that may help me in my pursuit for a career in finance. Developments from this study may suggest ways of determining the success or failure of banks by simply looking at the liquidity level of a firm.
1.4 Report Structure
The following chapters will look at how the research problem was addressed. Chapter two discusses a range of empirical evidence surrounding the topic and discusses the literature on funding liquidity as well as some important profitability determinants. Chapter three outlines the research process used to address the research problem. Chapter four is a presentation and analysis of the findings in context with empirical evidence as discussed in chapter two. Lastly, chapter five summaries the findings and discusses the contribution of this study. This chapter also gives an indication of practical recommendations for future research.