Risk contagion and bank stability: the role of credit risk and liquidity risk

Lei Ding, Yaming Zhuang and Hu Wang

Abstract

Financial crises have shown that credit risk and liquidity risk have an important impact on the stability of the banking system. Considering both credit risk and liquidity risk, we propose a systemic risk measurement model and measure systemic risk in banking by using 2013–18 data for China’s banking sector. Our results show that taking into account the two risk contagion channels together gives a significantly higher value of systemic risk in the banking system than when summing the credit and liquidity contagion channels individually. Credit risk is the main source of systemic risk in China’s banking system. Systemic risk can be lowered by reducing large single exposures. An increase in the credit guarantee ratio and the cash ratio can reduce systemic risk in banking, and the cash ratio is more efficient at reducing such exposure than a credit guarantee.