Is excess of everything bad? Ramifications of excess liquidity on bank stability: Evidence from the dual banking system

ABSTRACT

After the 2008 financial crisis, the primary focus of global banking regulators has been to make banks more liquid by maintaining excess liquidity buffers. This paper investigates a paradox where high liquidity reduces bank stability instead of improving it by examining the relationship between excess liquidity and stability between Islamic and conventional banks. This paper uses data on 42 Islamic and 106 conventional banks from 6 emerging countries between 2009 and 2018, providing empirical evidence that excess banking liquidity impedes bank stability. The results show that conventional banks are more vulnerable to the adversities of excess liquidity, while Islamic banks exhibit more resilience. This study raises ‘red flags’ for policymakers and regulators advocating high liquidity as a source of financial stability. It suggests that regulators should be cautious when using the so-called ‘liquidity bazooka’ to guard banks against any economic downturn, such as during the COVID-19 era.