Non-performing assets, moral hazard and liquidity creation: evidence from Indian banks

This study looks into the incidence of the moral hazard hypothesis in the Indian banks using the liquidity creation concept. Liquidity creation measure is considered to be more inclusive and comprehensive in measuring the risk-taking of a bank. The study uses data from 2005 to 2019 extracted from the database of the Reserve Bank of India. A fixed-effect model with Driscoll and Kraay standard errors and system GMM is deployed to ascertain the association between liquidity creation and NPAs. This study determines a significantly positive relationship between NPAs and liquidity creation in public sector banks, but this relationship is not evident in private banks. This study testifies the moral hazard hypothesis in public sector bank. This study highlights the perils associated with the recent mergers in public sector banks and how 'too big to fail' might incentivise public banks to undertake more risks since there are already traces of the problem of moral hazard.