Investor sentiment and bank liquidity risk: Theory and evidence

This study investigates the impact of investor sentiment on bank liquidity risk. We first develop a theory of bank liquidity in markets influenced by sentiment risk. Our theory suggests that traditional commercial banks benefit from deposit inflows driven by investors seeking a safe haven, which serve as a natural hedge against liquidity risk. In contrast, modern banks may encounter heightened liquidity risk due to mark-to-market accounting and high leverage. Additionally, while banks that effectively manage sentiment risk tend to maintain prudent liquidity levels, they may still take on excessive leverage during periods of pronounced asset bubbles. Empirical analysis using data from China and the United States supports our theoretical predictions. In China, where the banking sector is predominantly composed of traditional commercial banks, investor sentiment has a countercyclical effect on deposit flows, thereby mitigating liquidity risk during periods of low sentiment. In the United States, by contrast, investor sentiment amplifies the procyclical nature of loan expansion and overall bank liquidity conditions. Moreover, banks with greater trading expertise or subject to stricter liquidity regulations are more effective at mitigating sentiment-induced liquidity risk. By highlighting the varying effects of investor sentiment on bank liquidity risk across different banking systems, this study provides new insights into bank risk management and financial regulation in sentiment-driven markets.