The Relationship between Bank Credit Risk and Profitability and Liquidity

This paper’s objective is to study the relationship between bank credit risk and financial performance and the contribution of risky lending to lower bank profitability and liquidity. The sample data comes from the Mergent Online database, which stores ownership, executive, and financial information about public and private companies. This study focuses on the concept of prudent lending by public state commercial banks, insider ownership, and chief executive officer compensation and tenure, which are governance related bank characteristics. Performance variables in analysis of covariance models include net interest margin, return on assets, return on equity, and cash flow to assets. Preliminary results show a negative relationship between less prudent lending (which may be interpreted as a positive effect of more prudent lending) and net interest margin. However, findings were only statistically significant when the normality assumption was relaxed through the robust regression method. Insider holdings and longer chief executive officer tenure were negatively related to bank performance. This may be a consequence of an adverse effect of the agency problem. Further research should focus on obtaining a deeper understanding of these results and of the underlying causes of the most recent financial crisis, from the viewpoint of different market participants.