Liquidity and Credit Risks: Evidence from Commercial Banks in Vietnam

This study contributes to the current literature by examining the effect of bank liquidity on commercial banks' credit risk in Vietnam, a transition economy in Asia. This study closes the current literature gaps by examining the nexus between liquidity creation, funding diversity, and non-performing loans in Vietnam. This study is also unique because the State Bank of Vietnam offered stimulus packages to protect the local economy against the financial crisis in 2008. Therefore, commercial banks are motivated to provide credit to local enterprises, implying higher liquidity creation after the financial crisis. We employ the dynamic system Generalized Method of Moments to analyze a sample of 33 commercial banks in Vietnam from 2009 to 2020. Our results show that bank funding diversity positively affects credit risk, proxied by non-performing loans. Specifically, one point increase in the funding diversity index increases the non-performing loans by around 3%. Commercial banks relax their lending policies to archive higher lending revenue when they have diversified funding sources. These subprime lending practices increase the credit risk for commercial banks. However, a percentage increase in commercial bank liquidity reduces the non-performing loans by 2%. Liquidity creation improves economic growth and repayment capacity, reducing non-performing loans. Our findings are robust even though we employ Z-score as an alternative risk proxy. Finally, our study provides recommendations for bank managers and policymakers to develop a sustainable banking system. Expressly, policymakers should discourage commercial banks from shifting their liquidity creation towards non-lending activities during fast-growing periods. Moreover, policymakers must supervise liquidity creation to prevent subprime lending practices.