VOLATILITY MEASURES, LIQUIDITY AND CREDIT LOSS PROVISIONS DURING PERIODS OF FINANCIAL DISTRESS

Abstract

In this paper, we investigate the role of liquidity in banks lending activity and how liquidity provision is related to bank’s credit risk and others market-based risk measures, such as bank’s implied volatility skew from options traded on the market and realized volatility from futures contract on LIBOR, during periods of global financial distress. Credit risk is given by the ratio between loan loss reserves and total assets and we find that losses from lending activity force banks to build up new liquidity provisions only during the period of financial distress. Liquidity ratio is given by the sum of cash and short-term assets over total assets and we discovered that credit risk reduces liquidity ratio only in bad times, as this demand for liquid asset is suddenly switched on and the more reserves from loan losses the bank has, the more it cleans its balance sheet from long-term commitments in order to replenish its cash and short-term securities. When we control for market-based risk measures, we evidence that both implied volatility skew and LIBOR’s realized volatility are negatively related with the liquidity ratio and are useful in predicting a distress in bank’s liquidity holdings.