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Liquidity risk was at the heart of 2007–2008 global financial crisis, which has led to a series of financial institutions failure. We test whether and how liquidity risk impacts European banks’ stability (i.e., a bank risk-return profile) under different levels of engagement in non-traditional banking activities after the global financial crisis and during the implementation of the Basel III liquidity rules. To calculate financial stability, we adopt an efficiency perspective based on the combination of the CAMELS rating system with the data envelopment analysis technique. We implement a nonlinear panel smooth transition regression approach, where transitional factors of income diversification are endogenously captured from the data. We find that, liquidity risk stemming from liquidity creation has a positive impact on bank stability, implying that income diversification can serve as a “buffer” through which banks can ensure their …