Correlation Between Liquidity and Loan Quality and Its Impact on Bank Health Dissertation or Thesis complete

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Liquidity and Loan Quality: the Impact it is having on Bank Health

Since the 1980's, there has been an emphasis on deregulation within the banking industry. Part of the reason for this, is because of shifts in the economy (thanks in part to globalization) as the markets and products have changed. This has forced many different governments around the world to reduce regulations to include: liquidity and loan quality standards. As a result, the underlying risks at many financial institutions have increased exponentially. In this research project, we will show how these reduced standards have contributed directly to: the financial crisis and stagnant economy. Once this takes place, it will provide the greatest insights as to how these two factors will determine the strengths of different of financial institutions. At which point, we can present specific ideas about how to effectively address these challenges in the future.


: Background

Over the last several years, the issues of loan quality and liquidity have been increasingly brought to the forefront. Part of the reason for this, is because the total number of bank failures is currently sitting at 365 financial institutions. According to the FDIC, this amount is expected to increase, with the government taking over 40 banks so far in 2011. This accounts for over $660 billion in assets that the FDIC has seized since the beginning of the financial crisis in 2007. ("FDIC Failed Banks," 2011) This is significant, because it is illustrating how the overall amounts of liquidity and the quality of loans have threatened the economic viability of many institutions.

Further evidence of this can be seen with a study that was conducted by Thies (1993). He determined the total number of bank failures was directly tied to the quality of the loans that were underwritten. As it revealed that between 1921 and 1932, financial institutions began to take on large amounts of risk. This is because, the lack of regulation made it easy for them to create a number of different mortgage products. (Theis, 1993, pp. 109 -- 114) Over the course of time, this meant that the total amounts of loans increased exponentially. However, some of weaker banks began to also reduce their liquidity standards and offered even greater numbers of mortgages. Once the economy began to slow and unemployment was rising; these loans set off a wave of defaults that shook the financial industry. The hardest hit during this time was state banks. This is because they were the institutions that had: the least amounts of liquidity and the highest number of poor quality loans. By the 1932, these risks were having an adverse effect on these entities, setting off a wave of foreclosures. This caused a number of financial institutions to fail leading to: bank runs and a lack of confidence in the system. The only way to deal with the situation was through: the implementation of the New Deal and various financial regulations (such as the Glass Steagall Act along with the Banking Act). (Theis, 2008, pp. 3 -- 4) These different laws are important, because they would place strict regulations on: the kinds of activities banks could become involved in, the quality of loans that they were underwriting and their levels of liquidity.

However, improvements in technology have meant that the kinds of loans and liquidity standards have become less stringent. The reason why, is because many financial institutions are arguing that these Depression era laws are making it difficult for them to compete globally. As a result, these standards and the enforcement of the different regulations were severely reduced. This caused the total quality of mortgages and the levels of liquidity at a variety of financial institutions to decrease. Over the course of time, this would lead directly to the current financial crisis and economic implosion. This is significant, because it is illustrating how the overall amounts of liquidity and the quality of the loans can have a direct impact on the health of variety of financial institutions.

1:2: Hypothesis

The different challenges in the banking sector are indicative of a negative trend that has been occurring since deregulation began during the 1980's. This has lead to series of financial crisis that are based upon same problems most notably: the quality of loans and liquidity. These two factors have been the root causes of: the Savings and Loan Crisis during the 1980's and the recent financial crisis. As a result, they underlying amounts of deregulation have meant that the risks many banks are taking are rising exponentially. Once this begins to occur, it can cause the economy to go through extreme boom and bust cycles. This leads us to introduce the following hypothesis:

The quality of loans that are being underwritten will have a direct impact on liquidity level. The reason why is because, the two different standards will work in conjunction with one another. When you see a reduction in one or both of these policies, it means that the overall risks that banks are taking will increase dramatically. This causes the economy to become unstable, creating extreme boom and bust cycles. To increase stability, the government should introduce strict regulations that will improve loan quality and liquidity standards. This will limit the risks to: the financial sector and improve economic growth / stability over the long-term.

Once we have supported or refuted the hypothesis that has been presented, we will be able to see the impact that loan quality and liquidity are having a wide variety of banks. This will help us to determine if having regulations that will address these areas are effective over the long-term.

1.3: Aims and Objectives

The purpose of this study is to see the total impact that the overall quality of loans and liquidity will have on the viability of different financial institutions. This is significant, because there have been many individuals inside the industry and within the political establishment who are trying water down any kind of attempts to address these issues. The reason why, is they believe that the Federal government and the states are ineffective at tackling these challenges. As, they think that the markets will determine: what kind of standards should be set and the underlying amounts of risks banks are allowed to incur. A good example of this can be seen with comments from Niall Ferguson (an Economics professor at Harvard University) who wrote, "Let us not believe we can abolish both bailouts and depressions, other than by creating another layer of government regulation." ("Criticism of Obama's Financial Reform Plan," 2010) This is important, because it is showing how many of critics of big government will claim that this approach is ineffective.

While at the same time, many proponents of having increased standards for financial institutions believe that this will provide added stability to the financial system. As, these different laws will be able to: create a universal standard that will prevent banks from engaging in activities that will put their businesses at risk. Evidence of this can be seen with comments from President Obama who said, "Unless these reforms are enacted, our house will continue to sit on shifting sands, leaving our families, businesses and the global economy vulnerable to future crises." ("Criticism of Obama's Financial Reform Plan," 2010) This is significant, because it is illustrating how some kind of strict regulations are necessary to prevent the economy from being exposed to the banking sector.

To determine if increased amounts of regulation will address these issues requires looking carefully at: the quality of loans that are being underwritten and the liquidity standards of these institutions. Once this takes place, it will provide specific insights as to if these regulation will improve the stability. This will be accomplished addressing the following aims and objectives.


To see the impact that the quality of loans had on the banking sector over the last ten years.

To see how liquidity had an effect on the kinds of loans that were being underwritten.


To examine the effect that past and current regulations are having on the quality of loans.

To see the long-term impact of different regulations on: liquidity standards.

To understand how loan quality and liquidity are changing.

Once these different aims and objectives have been addressed, we will be able to support or refute the ideas presented in the hypothesis.

1.4: Research Questions

To help effectively focus the research we will use various questions. They will concentrate on how the specific assets of loan quality and liquidity can have an impact on a variety of financial institutions. This leads us to the below research questions:

Is there a positive correlation between liquidity and loan quality?

If the answer is yes, what is the impact that this having on the financial health of banks?

Once these different questions have been answered, they will help to address the specific aims and objectives of the research project. This will support or refute the hypothesis that has been presented.…

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