Performance Analysis of Liquidity Indicators as Early Warning Signals

Abstract

This study compares the performance of an old liquidity ratio (LiqR) and two new liquidity indicators, namely, liquidity creation (LiqC) and net stable funding difference (NSFD), in sending early warning signals for distressed banks. Recent evidence shows that the old indicator appears incapable of measuring the liquidity condition of banks. However, the two new indicators have not yet been fully examined in terms of their possible role as indicators. We classify distressed banks into banks that have experienced a bank run, bailout, and failure. Sample data are collected from the United States and the European Union from before and after the crisis (2005-2009). We estimate a model using a sample before the crisis to predict liquidity shortages in 2008 and 2009. Evidence shows that the academic (LiqC) and officially recommended indicators (NSFD) outperform LiqR as early warning signal. Furthermore, LiqC is superior when banks actively engage in income diversification but not when banks engage in fund diversification. Therefore, a well income-diversified bank with a high LiqC tends to have a high distress probability in subsequent periods.

Keywords: Liquidity Creation, Net Stable Funding Difference, Liquidity Ratio, Funding Diversification, Income Diversification

JEL Classification: C23, G21, G32