Liquidity Mismatch and Bank Failures
J. B. Cooke, Christoffer Koch and Anthony Murphy
Federal Reserve Bank of Dallas
U.S. commercial bank failures increased dramatically during the Great Recession and subsequent financial crisis, while numerous other banks were distressed (technically insolvent). The quarterly failure rate of banks peaked at 0.6 percent in second quarter 2009, while the combined failure and distress rate reached 2.5 percent in fourth quarter 2010, the highest rate since the 1980s. One possible reason for the heightened failures and distress was the large - possibly excessive - rise in liquidity mismatch in the mid-2000s, especially at larger banks. Such an increase in the risk of a bank being unable to fund increases in assets or meet its obligations as they come due was an important warning sign to which regulators may have paid insufficient attention.
We construct a measure of liquidity mismatch for individual U.S. commercial using regulatory filings (“call reports”) and liquidity weights for assets and liabilities similar to those in the proposed Basel III net stable funding ratio rules. We use our liquidity mismatch measure to model the incidence of commercial bank failure or distress since 2007. Controlling for standard CAMELS (Capital adequacy, Assets, Management, Earnings, Liquidity & Sensitivity to market risk) proxies, time series measures of financial stress, and other explanatory variables used in the literature, we find that liquidity mismatch helps predict bank failures and distress one to two years ahead during the recent financial crisis.