[Podcast] Excess liquidity and banking stability – Experience in liquidity risk management in accordance with Basel III in Vietnam
15 August, 2024
Keywords: Excess liquidity, banking stability, commercial bank
The topic raises the current issue of concern regarding the impact of excess liquidity on banking stability. Increased liquidity coupled with reduced demand could lead to higher levels of excess, making banks more unstable. The research results by the author from University of Economics Ho Chi Minh City (UEH) provide important empirical evidence on the potential adverse impact of excess liquidity on banking stability in order to propose functions. Some policy ideas as well as solutions to provide liquidity in case that a crisis occurs in Vietnam, regulating liquid assets in accordance with the requirements of Basel III applied after the global financial crisis (GFC) during 2007 – 2009.

The banking system provides a complex range of financial products and services, directly and indirectly connecting all sectors in an economy (Hurd, 2018; Lokipp & Monnin, 2013). Following GFC, because of the importance of banking and the extent of damage that the crisis could cause to the banking and related industries, financial researchers and regulators have focused more on the various causes related to bank failure or the factors that pose any threat to the future stability of banks (Alam et al., 2019; Bai & Elyasiani, 2013; Bakoush et al. et al., 2022; Fugacova et al., 2021).
In terms of the banking sector, liquidity refers to the ability to pay short-term financial obligations when they come the deadline. However, excess liquidity is a state in which banks maintain more cash and other liquidity reserves than regulatory requirements (Aikaeli, 2011). Banks may hold excess liquidity voluntarily for precautionary motives or involuntarily for other reasons. Liquidity accumulation is considered as a safeguard against shocks when customers withdraw money massively, especially when the interbank market is inefficient (Agenor & El Aynaoui, 2010). Banks also hoard liquidity as a buffer against costs and reserves (Frost, 1971), liquidity risk (Hahm et al., 2012) and market risk vulnerability (Agenor et al., 2004). Banks trade their profitability with low-yielding liquid assets to hedge their risks. In addition, government intervention (Friedman, 1989) and large foreign capital investment (Zhang, 2009) contribute to the generation of large liquid capital flows that banks cannot allocate effectively. Because of the limited capacity, credit demand is lower because of the sluggish economy.
Regulations applicable to international banks always ensure that these banks can continue to manage risks and to return to normal operations without external support listed as government bailouts, multinational banking system integration, forced merger or acquisition, post-GFC. This can be effective by maintaining a liquidity buffer that protects banks against small liquidity shocks. However, when there is excess liquidity, it causes many risk problems because it is used as a credit buffer (Acharya & Naqvi, 2012; Wagner, 2007) in that excess liquidity signals safety against risk. Low liquidity risk encourages bankers to lend more, even to accept higher risk loans more easily (Kato & Tsuruga, 2016; Liu & Way, 2010). Afterthat, banks, furthermore, can use riskier deposits to lend and to invest in assets with real estate mortgages or accept high-risk customers with relaxed lending standards, often leading to adverse selection. As a result, banks increased bad debt (Klein, 2009), the actual estate bubbles put banking stability in danger, sowing the seeds for the upcoming crises (Acharya & Naqvi, 2012).
In accordance with the data published by the State Bank of Viet nam, at the end of February 2023, the system’s liquidity is currently 50,000 billion VND surplus compared to that of the minimum requirement. Although banks have excess capital, businesses still have difficulty accessing capital. This means that their business performance is not positive, warning that the risk of bad debt at banks may increase in the near future. In addition, with the interbank interest rate operating mechanism continuously decreasing in recent times with the goal of supporting credit, the bank capital planning strategy has many limitations: excess liquidity has not completely been supplementing capital markets in an efficient manner. The fact that the real estate market still has many risks is also another reason limiting credit expansion and releasing bank liquidity. This is gradually causing instability in the current financial market.
Therefore, studying the impact of excess liquidity on banking stability is very necessary. Does accepting excess liquidity at banks ensure solvency and stability or aggravate the risk of moral hazard in the banking industry, increasing the possibility of default and Borrower’s instability (Achrya & Naqvi, 2012)? What is the impact of excess liquidity on bank stability?
Using a quantitative method using a linear regression model with panel data of Vietnamese commercial banks in the 2010-2020 period, the research results provide the empirical evidence on the negative influence of excess liquidity towards banking stability in Vietnam. Despite recommendations from Basel III to maintain high liquidity for banking stability ensurance, the research results indicate that: when there is excess liquidity, there is an increased risk of behaviors related to the managers’ moral hazards as higher risks in credit or investment decisions are easily accepted.
Besides, the research presents important implications for policy makers. Recognizing the extent of this impact, banking regulators need to improve financial supervision, focusing on excessive risk-taking behavior in case of high liquidity buffers.
In terms of the newly-emerging economies, including Vietnam, the proposed liquidity regulations of Basel III may not be equally optimal and similar to other developed countries, it is necessary to flexibly adjust to suit the needs, the size and the characteristics of each individual bank. In addition, after the Covid-19 pandemic, management agencies need to focus on planning policies to overcome systemic risks of the banking industry and should not use liquidity to insure against the risk of economic crisis because of its potential in financial instability later. Providing liquidity support to the economy as a response to difficulties caused by Covid-19 may be successful in the short term; on the other hand, this can easily lead to incorrect credit allocation and increased bad debt.
The research results provide empirical evidence on the factors contributing to banking stability from the perspective of excess liquidity. The study also explores the potential adverse effects of involuntary liquidity reserves on banking stability to evaluate liquidity supply solutions when a crisis occurs in Vietnam. This increased liquidity coupled with reduced demand could lead to higher levels of excess, making banks more unstable. Finally, the study provides policy and management suggestions to help banks effectively plan policies related to liquidity risk management to increase stability, helping to regulate the bank’s liquid assets in accordance with the requirements of Basel III applied after the 2007-2009 Financial crisis.
Please refer to the full research titled Excess liquidity and banking stability -Experience in liquidity risk management in accordance with Basel III in Vietnam HERE.
Author: Dr. Nguyen Tu Nhu – University of Economics Ho Chi Minh City (UEH).
This is an article in a series of articles spreading research and applied knowledge from UEH with the message “Research Contribution For All – Research For The Community”, UEH respectfully invites dear readers to look forward to the upcoming UEH Research Newsletter Insights
News and photos: Author, UEH Department of Marketing and Communications

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