Funding liquidity risk and banks’ risk-taking behavior: the role of the COVID-19 crisis and bank size

PurposeThis study aims to investigate the impact of funding liquidity on bank risk-taking, in the context of developing countries. While high liquidity (low liquidity risk) as measured by ratio of total deposits to total assets may improve bank stability, other strand of literature shows that low liquidity risk may increase bank risk-taking (as measured by Z-score) and lowering bank stability. This study also aims to investigate the moderating influence of the COVID-19 crisis and bank size on the relationship between funding liquidity and bank risk-taking.Design/methodology/approachThe authors collect annual bank-level data from 86 commercial banks in Indonesia from 2014 to 2021, comprising 686 bank-year observations, on return on assets (ROA), equity-to-assets ratio, ROA standard deviation (to calculate Z-score, a proxy for bank risk-taking), ratio of total deposits to total assets (as a proxy for liquidity risk), bank size, bank equity, ratio of operating expenses to income, asset growth, ratio of cash to total assets and COVID-19 period. The authors collect data on gross domestic product growth and inflation. The authors perform system generalized method of moments to investigate the effect of liquidity risk on bank risk-taking, incorporating control variables.FindingsThe authors find negative impacts of funding liquidity on the Z-score. Lower liquidity risk tends to increase moral hazard and bank risk-taking. The authors also find that COVID-19 period increases the negative impact of liquidity on bank risk-taking. Thus, banks engage in higher bank risk-taking in COVID-19 period than in non-COVID-19 period. Bank size lower the negative impact of liquidity on bank risk-taking. Thus, larger banks tend to engage in less bank risk-taking than small banks when they face high liquidity (lower liquidity risk).Research limitations/implicationsThe results support the notion that liquidity risk has a negative impact on bank risk-taking, thus confirming a potential seed for bank instability. The COVID-19 period, which is characterized by liquidity abundance, tends to increase bank risk-taking when the banks face low liquidity risks. Size tends to lower bank risk-taking in the context of liquidity risk. Small sample size becomes the limitation of this study.Practical implicationsBank regulatory oversight is imperative all times. Even in a seemingly low-risk situation (high liquidity funding), bank stability may be threatened. The COVID-19 period, which is characterized by liquidity abundance, tends to increase bank risk-taking in the context of liquidity risk. Regulators should monitor small banks more closely because small banks tend to exhibit higher risk-taking in the context of liquidity risk.Originality/valueThe authors investigate the impact of liquidity risk on bank risk-taking, taking COVID-19 period and size as moderating variables. COVID-19 period is characterized by abundant liquidity. However, banks tend to restrict their activities because the risks increase during crisis period.