Liquidity Shock and Bank Risk

This paper studies banks' risk-taking behavior in response to negative liquidity shocks on their balance sheet, i.e., an unexpected event that leaves banks with a liquidity shortfall. Using data for European publicly traded banks from 2005 to 2020, we find that banks decrease their risktaking when they face a negative liquidity shock. A negative liquidity shock is associated with both lower credit risk and default risk. Further evidence shows that negative liquidity shocks affect large banks and banks operating under regulatory capital pressure to a greater extent. We also investigate how banks react to positive liquidity shocks and find that they do not take more risk when they experience a liquidity surplus. Our findings contribute to the literature on banks' liquidity management and bear several policy implications