Solvency vs. liquidity. A decomposition of European banks' credit risk over the business cycle.

Abstract: This paper provides evidence for the procyclicality of banks' credit risk by investigating the historical resilience of several European banking sectors before and after the 2008 banking crisis. It provides a decomposition of banks' probabilities of default between a solvency and a liquidity component. The results show a gradual build-up of fragilities before 2008 in most countries. Increased probabilities of default are shown to be mainly driven by a surge in liquidity risk, even when shocks of relatively low magnitude are imposed on the system. [Copyright &y& Elsevier]