Do Credit and Liquidity Risks Interact to Shape Bank Stability? Evidence from an Emerging Banking System

This paper examines whether the interaction between credit risk and liquidity conditions helps explain bank stability in a fragile and institutionally constrained banking environment. Using an annual panel of 13 Palestinian banks over 2011–2024 and measuring stability by the (log) Z-score, we estimate static panel models (pooled OLS, fixed effects, and random effects), a simultaneous two-stage least squares (2SLS) system to probe the direction of causality between credit risk and liquidity, and a dynamic panel GMM specification to address persistence and endogeneity. The static models show that credit risk is negatively associated with stability and that the interaction term is economically meaningful but not robust across static specifications. In the dynamic GMM model, credit risk remains significantly destabilizing, liquidity holdings are stabilizing, and the interaction term is positive and significant—consistent with liquidity buffers mitigating the adverse stability implications of higher credit risk. The 2SLS system suggests no strong contemporaneous reciprocal causality between credit risk and liquidity once controls are included, while regulatory and conflict-period dummies are associated with shifts in the risk profiles. The results highlight the importance of integrated risk management and liquidity buffers for banking stability in high-uncertainty contexts.