Political instability and bank liquidity in Asia: the role of environmental performance

This paper investigates the relationship between political instability and bank liquidity. Next, we investigate the possible transmission channels through which political instability impacts bank liquidity negatively. Also, we examine whether the environmental performance of banks could mitigate the effects of political instability towards bank liquidity. We employ a panel data set comprising 112 banks in 19 Asian countries from 2013 to 2023. Using the fixed effects, two-step system GMM and two-stage least squares estimation techniques, our findings show that political instability significantly reduces bank liquidity. We show that the impact of political instability is less pronounced in banks with high environmental performance. Our results are robust to alternative definitions of bank liquidity, specifications, and address endogeneity concerns. We present novel evidence that ‘depositor attitude’ and ‘interbank liabilities’ are the two possible transmission channels through which political instability negatively impacts bank liquidity. We find no support for the liquidity buffer constraint. Our findings extend flight-to-liquidity and bank lending theories by highlighting how political instability impacts bank liquidity and enrich the risk management theory by demonstrating the role of environmental performance in mitigating the impact of political instability on banks.This study addresses a critical gap in banking literature by focusing on how macro-political risks, e.g., political instability, could impact banks’ liquidity creation. This study reveals that depositor attitude and interbank liabilities are potential transmission channels through which political instability impacts bank liquidity negatively and how political risk could be mitigated by environmental initiatives/performance of banks across 19 Asian countries. The research holds significant academic and practical value. Banks should implement robust deposit insurance schemes and ensure that risk management and stress testing models include political instability shocks to assess banks’ resilience to transmission channels. Policymakers like central banks need to enforce Liquidity Coverage Ratio (LCR) implementation to cushion the effects of systemic liquidity risk and contagion risk of interbank liabilities. This would limit vulnerabilities, restore interbank trust, and limit panic withdrawals. This research bridges theoretical predictions of bank liquidity and enhances banks’ liquidity prediction during uncertain times and crises in emerging markets.