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

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.