The impact of liquidity requirements on the profitability of banks in the Euro Area

The purpose of this study is to analyse the impact of the short-term liquidity ratio introduced in 2013 as one of the Basel III regulatory measures, the Liquidity Coverage Ratio (LCR), on Euro Area banks’ profitability. The theoretical framework draws upon previous research and assumes liquidity ratios to have a varying influence on bank profitability. If on the one hand these recent requirements may have impacted positively on banks’ profitability, due to an improved perception in funding markets about banks’ robustness, reducing their financing costs, on the other hand they may also constrain banks’ ability in their financial intermediation role, undermining profitability. Our empirical analysis relies on three panel data regressions taking as dependent variable the following accounting ratios used to assess banks’ profitability: Return on Assets (ROA), Return on Equity (ROE) and Net Interest Margin (NIM). With the goal of enhancing the robustness of our findings, by correcting for heteroscedasticity, cross-sectional correlation and autocorrelation, this study proposes Panel-Correlated Standard Errors (PCSEs) estimators. The data set consists of a panel of 21 active banks operating in the Euro Area, covering a period starting with the phasing-in of the LCR, between 2014Q2 and 2022Q4, i.e., 34 quarters, including G-SIBs and less significant universal banks. Our findings point to a significant negative relationship between the LCR and the NIM and a non-significant effect on the ROA and ROE. Higher liquidity requirements negatively influence a bank’s ability to perform its intermediary function, as banks with a higher level of liquid assets are penalized by lower net interest income.