Liquidity mismatch helps predict bank failure, distress one year ahead, according to Dallas Fed's Economic Letter

DALLAS—A significant rise in liquidity mismatch in the years leading up to the 2007–08 financial crisis contributed to a subsequent increase in bank failures, according to the Federal Reserve Bank of Dallas’ latest Economic Letter.

In “Liquidity Mismatch Helps Predict Bank Failure and Distress,” J.B. Cooke, Christoffer Koch and Anthony Murphy find that liquidity mismatch—the higher risk of banks being unable to fund increases in assets or meet their obligations as they come due—helps predict bank failure and distress one year ahead. Mismatch has predictive power, even accounting for equity capital and the other indicators that regulators watch.

The rise in liquidity mismatch was larger and more persistent for the largest banks, representing the top 25 percent of institutions, the authors write. Between 2002 and 2007, the median liquidity mismatch for those banks rose about 8.5 percentage points, the authors note. Liquidity mismatch rose about 3 percentage points for the smallest 25 percent of banks.

“The higher risk that banks would be unable to meet their obligations as they came due was an important warning sign to which regulators may have paid insufficient attention,” the authors write.

The quarterly failure rate of banks peaked at 0.6 percent in second quarter 2009, according to the authors. In fourth quarter 2010, the combined failure and distress rate reached its highest level since the 1980s, at 2.5 percent.

Liquidity mismatch rises if banks have lower retail deposits and higher wholesale deposits, which are more short term and more likely to dry up in a crisis, the authors say. Increases can also occur if banks hold relatively more construction and land development loans, which are very illiquid in a crisis.

Cooke is an economic analyst, Koch is a research economist and Murphy is an economic policy advisor and senior economist in the Research Department of the Federal Reserve Bank of Dallas.

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Media contact:
Justin Jones
Federal Reserve Bank of Dallas
Phone: 214-922-5449
Email: Justin.Jones@dal.frb.org