Financial stability, liquidity risk and income diversification: evidence from European banks using the CAMELS–DEA approach

Liquidity risk was at the heart of 2007–2008 global financial crisis, which has led to a series of financial institutions failure. We test whether and how liquidity risk impacts European banks’ stability (i.e., a bank risk-return profile) under different levels of engagement in non-traditional banking activities after the global financial crisis and during the implementation of the Basel III liquidity rules. To calculate financial stability, we adopt an efficiency perspective based on the combination of the CAMELS rating system with the data envelopment analysis technique. We implement a nonlinear panel smooth transition regression approach, where transitional factors of income diversification are endogenously captured from the data. We find that, liquidity risk stemming from liquidity creation has a positive impact on bank stability, implying that income diversification can serve as a “buffer” through which banks can ensure their liquidity creation and offset for the compression of intermediation margin in lending and deposit activities. This suggests that diversification does not impede the ability of banks to operate with lower liquidity holdings but allows them to make greater use of their balance sheets to fulfill their primary roles of credit provision and liquidity creation. The results offer interesting implications for regulators and bank managers in managing liquidity risk.