Liquidity Risk and Financial Stability in Commercial Banks: Panel Evidence from Tanzania

Abstract

This study assessed the relationship of liquidity risk on financial stability in commercial banks operating within developing financial systems. Using a balanced panel dataset covering the period of 2015 to 2023, the analysis constructs a multidimensional Liquidity Risk Score (LRS) combining liquidity position, liquidity pressure and funding structure indicators. Financial stability was measured using a composite Financial Stability Index (FSI) incorporating insolvency risk, asset quality, earnings volatility and capital adequacy. The study employed a Fixed-Effects model with Panel-Corrected Standard Errors, supported by comprehensive diagnostic tests to address heteroskedasticity and serial correlation. Empirical findings showed that higher liquidity risk significantly weakens bank stability, while bank size, profitability and favorable macroeconomic conditions enhance resilience. Conversely, high leverage, cost inefficiency and inflation exert downward pressure on financial stability. These results highlighted the critical role of liquidity management in safeguarding banking sector resilience and emphasize the need for strengthened regulatory oversight, diversified funding structures and proactive internal risk management practices. Keywords: Liquidity Risk, Financial Stability, Commercial Banks, Developing Financial Systems, LRS, FSI, PCSE Model