 2.

0 Introduction

This study is determined to discuss the variables that influence on the soundness and safety of

the Liquidity of large commercial and Islamic banks in Pakistan. We discussed the findings of

past research on internal and external factors affecting the liquidity of commercial and Islamic

banks in Pakistan and other countries. The researchers examine the factors influencing the

liquidity of banks and design a conceptual framework with the help of the theoretical framework.

A hypothesis is concluded based on the theoretical framework developed based on the analysis.

The chapter has four broad sections. Section 2.1 discusses about the theoretical aspects of banks

liquidity, the determinants of liquidity investigated by the study and the impact of liquidity on

financial performance. Section 2.2 extensively explains important empirical studies on the area of

bank liquidity determinants and the impact of bank liquidity on financial performance. Then, section

2.3 asses related empirical studies in Ethiopia. Finally, section 2.4 give summaries to the chapter and

briefly discusses knowledge gap in the relevant literatures.

2.1 Literature Review on Bank Liquidity

In the financial world there are many risks to consider before we take any action, Risks are

usually defined by the adverse impact on profitability of several distinct sources of

uncertainty. While the types and degree of risks an organization may be exposed to depend

upon a number of factors such as its size, complexity business activities, volume etc, it is
believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance,

legal, regulatory and reputation risks.

liquidity risk special attention in the financial world, the liquidity risk is the risk of the lack

of marketability of an investment that cannot be bought or sold quickly enough to prevent or

minimize a loss, There are two types of liquidity risk, first is funding liquidity risk and

second is market liquidity risk, funding liquidity risk involves in only one simple question

which is can we pay our obligations so what is funding liquidity risk it is the risk of not

having access to sufficient fund to make payment on time, market liquidity risk it is an asset

illiquidity or an inability to easily exit a position. Drehmann & Nikolaou (2010)

Banks are liquidity insurers, and are vulnerable to the risk of run on deposits. Generally for

banks, higher liquidity creation to the external public, leads to the higher risk to face losses from

having to dispose of illiquid assets to meet the liquidity demands of customers.

It is generally found in the banking literature that an asset is liquid if it contains low risk (such

as government debt) and if it has a short maturity (a short maturity indicates that the asset's price

is less sensitive to interest rate movements, Less probable making large capital losses) The

typical bank assets which are liquid include cash, reserves representing an excess of statutory

reserve (held in the account at the central bank), securities (e.g., government debt, commercial

paper), and interbank loans with very short maturity (one to three days). Tesfaye (2012)

Asset Side Liability side

Demands for Loan Large volume of deposit withdrawals

Expiry of financial instrument sold (Bonds) Large number of depositor withdrawals

Off- Balance Sheet Activites (L/C, L/G) Repayment of bonds sold

Anthony & Marcia. (2008). Financial Institutions Management. Stated:

There are two reasons for liquidity risk arising: First is a liability-side reason and second is

an asset-side reason.

The liability-side reason arises when a Bank liability holder, such as depositors seeks to cash

in their financial claims immediately. When liability holders want to withdraw their deposits,

the Banks need to borrow additional funds or sell assets to meet the withdrawal. The most

liquid asset is cash; Banks use this asset to pay claim holders who seek to withdraw their

funds. However, Banks are practiced to keep minimum cash reserves as an asset, because

these assets are not generating any interest income.

The second reason for liquidity risk is asset-side liquidity risk, such as the ability to fund the

exercise of giving loan commitments. A loan commitment allows a customer to borrow

funds from banks on demand. When a borrower demand for loan, the banks must fund the

loan immediately, this creates a demand for liquidity. Banks can meet such a liquidity need

by running down its cash assets, selling off other liquid assets, or borrowing additional funds.

Liquidity risk is the risk that a bank or DFI may not be able to meet its financial

commitments to customers (depositors) and market (interbank market). Liquidity risk may

emerge as a result of the mismatch of assets and liabilities or structured products. Another

facet of liquidity risk is contingency liquidity risk, i.e. risk of not being able to meet

contractual obligations due to insufficient funds. (Lending: Products, Operations and

Risk Management, IBP)

According to Anthony & Marcia. (2008) and Aspachs et al. (2005) Banks manage their

liquidity risk through Two approaches

(i) On the asset side of the balance sheet, banks hold the cushion of liquid assets, the liquid

asset can be converted into cash quickly and at a low cost with little or no loss in

principal value. It trades in an active market, therefore, very little chance in large

transactions fluctuate its price. Examples of liquid assets, cash, balance in the central

reserve bank, T-bills, notes, bonds or reverse repurchase agreement.

(ii) On the liability side of the balance sheet, on the occasion of shortage of liquidity

demand, i.e withdrawals, demand of loan, interest and non-interest expense, banks

borrow funds from other banks and also rely on the central bank in case of emergency

liquidity assistance and central bank acts as a last resort lender on the occasion of

liquidity shortage. However, mitigating liability side risk often comes at a cost because

liability sources are often more costly for the banks to utilize.

It is constructed due to the above definitions, that a bank must hold sufficient funds to

meet the requirements of its customers and may choose to other sources to meet the

liquid demands of customers. Some primary sources include interbank or central bank

borrowings to satisfy customer needs at times of distress. Banks may also opt to Repo

transactions( buy security for short-term) for their liquidity needs. It is important for us

to properly measure bank liquidity because financial institutions that unable to meet the

customers’ demands face illiquidity that may result to deteriorated financial system

stability. Accordingly, In the research we examined past studies and literatures on the

measurement of bank liquidity creation.

Measuring Liquidity

In studies the two approaches to measure liquidity risk of banks are used widely by the

bank first is liquidity gap approach and second is liquidity ratio approach The liquidity

gap approach deal with the measurement of mismatch between assets and liabilities, or

cash inflows and cash outflows, banks that wants to minimize the gap between its assets

(loans to customers) and liabilities (deposits of customers) will group the financial assets

and liabilities into maturity buckets based on their frequency of repricing or rate

resetting. (Horcher, 2005). A positive liquidity gap means for deficit, requiring for

liabilities to be increased (Bessis, 2009). The liquidity gap treats liquid reserves as a

reservoir the bank computes the required liquidity by comparing inflows and outflows

during a specified period.

On the other hand, liquidity ratio uses various ratios to identify liquidity tendency.

Banks’s liquidity exposure is also to compare certain key ratios and balance sheet

features of the banks .Various authors like Anthony & Marcia. (2008), Doris (2017),

Vodva (2013), Sheefeni & Nyambe (2016), Ferrouhi & Lehadiri (2013) have

provided understandings with liquidity ratios such as liquid assets to total assets, liquid

assets to deposits and short term financing, loans to total assets and loans to deposits and

short term borrowings, deposit to total assets.

Liquid Assets to Total Assets (LATA) ratio tells us the bank’s capability to absorb liquidity

shock, higher the ratio, the higher the ability to absorb liquidity shock Doris, (2017). Liquid

asset belongs to cash, balances with reserve banks and other banks, the bond issued by

governments and similar securities or reverse repurchase agreement trades.

Liquid Assets to Deposit (LAD) and Liquid Asset to Deposit plus Short Term Borrowing

(LADSTB) are two ratios which are bit similar with each other, LADSTB ratio is more focused

on the bank’s sensitivity of funding, it includes banks, financial institution, deposits of

households, enterprises’ deposits and funds from debt securities issued by the bank. However

LAD includes only deposit of households and enterprises and this ratio (LAD) measure the

liquidity of a bank assuming that the bank cannot borrow from other banks in case of liquidity

need. Vodva (2013). This ratio also tells the value of liquid assets that is easily

converted to cash to short-term funding plus total deposits. Liquid assets include cash

and reserve banks, securities ,fair value through income, loans and advances to banks,

reverse repos and cash collaterals. Deposits and short term funding includes total

customers’ current, savings and term deposits and short term borrowing (money market

instruments, CDs and other deposits). The higher is the value of the ratio; the higher is the

capacity to absorb liquidity shock. (theglobaleconomy.com)

Loan to Total Asset (LTA) ratio measures the share of loans in total assets. It indicates what

percentage of the assets of the bank occupied in illiquid loans. Therefore the higher ratio, the

less liquidity the bank has. Sheefeni & Nyambe (2016)

Loan To Deposit (LD) and Loan to deposit plus short term financing (LDSTF) are two ratios

which also are bit similar with each other, LDSTF ratio calculate the relationship of

illiquid asset(bank's loans) funded through with liquid liability(deposits) and it includes

banks, financial institution and deposit of household and enterprises, while LD includes

only house hold and enterprises’ deposits, when this ratio is high, it means that the bank

is less liquid. . Doris (2017), Ferrouhi & Lehadiri (2013)

In short, the liquidity ratio carries varies balance sheet ratios to identify liquidity needs.

Macroeconomic Determinants of Liquidity

Gross Domestic Product Growth Rate

The GDP growth rate measures how fast the economy is growing. It is calculated by

comparing one period of the country's gross domestic product to the previous period.

GDP measures the economic output of a nation. Amadeo, thebalance.com (2018)

Positive coefficient of GDP growth rate signals an inverse relation between liquidity and

business cycles. This conclusion is explained by the fact that many borrowers tend to

ask more loans to finance their projects during expansion. On the other side, banks want

to satisfy the increasing loan demand, thus facing less liquidity. The GDP growth rate

during these years has dropped and the investors try not borrowing during depression

periods. Banks try to be more prudent and to preserve their liquidity. (Doris, 2017;

Volva, 2013). During the economic downturn, banks hoard more liquidity due to lack of

lending opportunity at such time. This means that as GDP growth increases, the liquidity

of banks decreases, and as GDP growth falls, the liquidity of the banks increases.

(Animika & Anil, 2016). An increase in GDP leads to an increase in economic activity

and credit default activity which will cause a drop in bank liquidity. (Trenca & Corovi,

2015). Higher liquidity holdings in a period of economic downturn, when holding is

motivated by the principle of precaution from banks, but also by less demand for loans

from clients. (Lastuvkova, 2016)

The gross domestic products significantly impact on bank liquidity of Pakistan. The

State Bank of Pakistan should develop strategy about discount rate, reserve requirement

and open market operation on the basis of forecasted gross domestic product. Some

studies in literature established a negative relationship exist between gross domestic

product and bank liquidity, but some studies established positive relation because during

economic boom companies and household prefer less rely on external debt and raise
fund on internal sources of finance, while in recession, they prefer loan from financial

institutions Ahmed & Rasool (2017)

During the expension period in an economy the demand for differentiated financial products

is high and may bank are capable to increase rate in its loan and securities portfolios.

Similarly, economic downturns period banks reduce the credit supply. According to these

opinions, we can assume that banks to increase their transformation activities and their

illiquidity during economic booms.

GDP is a macroeconomic factor that affects bank liquidity, and it is because that period

of major recession or crises in business operations decreases borrowers’ ability to pay

borrowed amount which increases banks’ NPLs and eventually banks insolvency, banks

liquidity affection is low in the course of economic expension period and banks

assertively expect to make profit by expanding loan commitments to sustain economic

boom, while restrict loanable funds in order to avoid an increase in the number of loan

default during economic downturn to prioritize. Choon et al (2013)

Inflation

In an economy, Inflation is a numerical measure of the rate at which the average level of

price of a selected goods and services’ basket increases over a period of time. It is the

continuous rise in the general level of prices resulted a unit of currency buys less than it

did in prior periods. Chen (2019) Inflation. Reterived from Investopedia.com. An

increase in inflation lowers the purchasing power so people need more money to buy the

same products, this may increase bank lending and thus lower liquidity. Trenca et. al

(2015). Increase in inflation decreases bank liquidity Inflation rate decreases currency
value and increases susceptibility of banks which affects loans provided to customers.

Singh & Sharma (2016)

Inflation is important factor for banks because usually banks deal in nominal financial

instrument, that is instruments denominated in fixed dollar amounts, For instance when a

bank gives a loan, it accepts nominal finanicial instrurments (notes, mortgages,

commercial paper and other securities) as evidence of the borrower’s obligation to the

bank and same goes to creditor, when bank borrows it issues nominal financial

instruments to creditors( bond and debenture, deposit liabilities ) as evidence of its

obligation. Santoni (1986)

Inflation increase in a country which tends to decrease the returns of all business units.

In such specific situation, the banks makes less loans, resource allocation is less

efficient, as well as reduces the intermediary activities of banks. Hence, rise in inflation

in a country will increase the bank liquidity. Ahmed & Rasool (2017)

An increase in anticipated inflation raises the nominal interest rate. This increases the

number of dollars that creditor and debtor who are transacting in noiminal financial

instruments expected to receive or pay when loan mature, if these expectation are

realized all noiminal values will be higher at maturity. If the realized rate of inflation

exceed the anticipated rate, the price level has risen unexpectedly. The unexpected

increase in the price level causes a proportional reduction in the exchange value of both

nominal financial assets and liabilities in term of real goods. Because banks are typically

net creditors in nomional instruments, bank owners lose wealth(bank’s capital decline)

when there is unanticipated inflation. Santoni (1986)

A developing hypothetical literature describes mechanisms whereby even expected rises

in the rate of inflation restrict with the ability of the financial sector to allocate resources

effectively. More specifically, recent theories highlight the importance of informational

asymmetries in financial markets and validate how increases in the rate of inflation

adversely affect financial market frictions with negative effects for financial sector (both

banks and equity market) performance and therefore long-run real activity (Huybens and

Smith 1998, 1999). The common feature of these theories is that there is an

informational friction whose severity is endogenous. Given this feature, an increase in

the rate of inflation drives down the real rate of return not just on money, but on assets

in general. The implied reduction in real returns worsens finanical market frictions.

Since these market frictions lead to the rationing of credit, credit rationing becomes

more severe as inflation rises. As a result, the financial sector makes fewer loans,

resource Allocation is less efficient, and intermediary activity diminishes with adverse

implications for capital/long term investment. In turn, the amount of liquid or short term

assets held by economic agents including banks will rise with the rise in inflation.

Unemployment Rate

Unemployment occurs when people of working age do not have a job, have actively

wanted to be full time employment in the past four weeks, and are presently available

for work. Also, Temporary lay off people who are waiting to rejoin his company are

included in the unemployment . (Thebalance.com).

Estimated factors on the macroeconomic control variables like unemployemnt are

generally in line with the existing literature. the level of unemployment, through a
higher probability of default on loans, has a negative impact. Bordeleau & Graham

(2010)

An increase in the unemployment rate can be translated into an increasing of non-

performing loans and thus lowering bank liquidity. Trenca et al (2015)

Unemployment has a significantly negative impact on liquidity. Greater unemployment

reduced capital and hindered liquidity creation. Findings in this accordance with the fact

that banks suffer from a reduction in solvency and create lower liquidity in troubled

economic times. That increased unemployment rate of the economy results increased

bank liquidity. Singh & Sharma (2016)

The impact of unemployment on liquidity of banks demonstrate is negative impact

which means that high rate of unemployment affects liquidity of the banks. It is shown

that the loan demand by customers declines with the increasing rate of unemployment,

thereby impacting the overall bank portfolio. Shah Et. al (2018)

Bank Specific Determinants Of Liquidity

Capital Adequacy

Capital Adequacy is a measurement of a financial institution to determine if solvency

can be maintained due to risks that have been incurred as a course of business. The

primary measurement of CAD ratio is equity capital to average assets. Capital permits a

financial institution to grow , establish and maintain both public and regulatory

confidence, and provide a reserves to be capable to absorb huge loan losses above and

beyond identified problems. A financial institution must be able to generate capital

internally, through Profit retention, as a test of capital strength. credfinrisk.com (2015)

If capital adequacy and liquidity manage efficient at the bank it tends to create a solid

basis for a successful bank and it may enhance the bank’s competitiveness , decreasing

its financial costs and increasing the worth. Global financial crisis has exposed the

necessity to further improve liquidity risk management and capital adequacy,

governance and to enhance the transparency of the operations of financial institutions.

While experiencing a variety of risks in operations, bank’s capital is used primarliy for

compensation the losses that may incur, therefore the management of capital adequacy

risk of banks must be given particular attention. Accordingly, the accrued reserves

cushion of liquid assets must be sufficient to absorb the adverse liquidity shocks, banks

may reduce the risks to compliance with the capital adequacy and liquidity

requirements, perform in a safer manner, and strengthens confidence in banks and the

entire financial system. Zuk-Butkuviene et. al (2014)

Capital adequacy is the measurement of the minimum capital amount required to fulfill a

specified economic capital constraint. It is generally expressed as a

capital adequacy ratio (CAR) of equity that must be retain as a percentage of risk-

weighted assets. Capital requirements administrate the ratio of equity to debt, recorded

on the assets side of a bank's balance sheet. It should not be tangled with reserve

requirements, which administrate the liabilities side of a bank's balance sheet in

particular. Banks capital generates liquidity for the bank due to the fact that deposits are

most vulnerable to liquidity risk and prone to bank runs. Larger bank capital reduces the

chance of financial distress. Adequacy of capital of the financial institution is calculated

by capital adequacy ratio (CAR). CAR ratio tells the internal strength of the bank to

tolerate losses during liquidity crisis. capital adequacy is seen as an tool that restrictive

excessive risk taking of bank owners with limited liability and, thus, promoting optimal
risk sharing between bank owners and depositors. On the other hand, In insolvency

crises capital adequacy regulation is viewed as a buffer against, limiting the costs of

financial distress by reducing the probability of insolvency. Nyaundi (2015)

Meanwhile liquidity is a major factor of risk in banks, it seems logical that banks must

set aside funds of capital to mitigate this risk. In fact, there is evidence that banks

already do so. if banks endogenize the capital decision, they will keep capital reserves

above always those required by the minimal regulatory capital amount in order to have a

cushion against liquidty shocks. But the fact that banks set aside liquidity reserves

abstracts from the difficulties of implementing a common regulatory approach to

managing their liquidity risk.

Net interest margin

The Net interest margin is used as a performance metric for financial institutions.

Theoretically, This is a ratio that every bank uses because banks are engaged in the

business of taking deposits from investors and then using the same deposit (money) to

earn interests in other investments, Higher net interest margin denotes more profitable

the bank. Vaidya Reterived from wallstreetmojo.com

Net interest margin denotes the net interest income(difference between the interest

income earned and the interest paid) by a bank or financial institution relative to its

interest-earning assets like cash and reserve balances with central bank, due from banks,

trading and available for sale securities also include non-liquid assets (mainly other
financial assets designated at fair value, held-to-maturity investments and gross loans)

and the interest-earning components of other assets. Reterived from

economictimes.indiatimes.com

Bank-specific variables: The statistical results showed that there is a negative and

statistically significant effect of the clients’ deposits (liquidity) on the NIM. This shows

that the banks raise the interest rates on deposits in case these declined. Consequently,

the NIM declines. To compensate for the increase in the interest rate on deposits, the

banks raise the interest rates on loans. This raising of the interest rates increases the NIM

more the higher loans to deposits ratio (the increase in the interest rates on loans may

exceed the increase in the interest rates on paid on deposits, therefore the NIM may

increase) Obeid & Adeinat (2017)

If the banks has high amount of liquidity ratio, this means that the bank does not use

this amount as a loan. That is to say, this bank does not get interest income from these

liquid assets. Due to this situation, there should be negative relationship between

liquidity ratio and net interest margin. Yuksel & Zengin (2017)

banks with larger financing gap, lack stable and cheap funding and they depend on

liquid assets and external funding to meet their obligations. On the other hand, there was

a positive relationship between liquidity risk and Net Interest Margin, which in contrary

indicated that banks with high levels of illiquid assets, may receive higher income

through interest than more liquid banks. Kalanidis (2016)

the proportion of liquid assets increases, a bank‟s liquidity risks decreases, leading to a

lower liquidity premium component of the net interest margin. This indicates that

liquidity and liquidity premium component of interest rate margin goes in opposite

direction. Tesfaye (2012)

Conventional banks earned interest from the borrowers and provide interest to the

lenders. The difference between the interest income and interest expenses constitutes net

interest income and the net interest income is divided by total asset to calculate net

interest margin. In study there was an effort to determine the effect of liquidity risk

ratios to NIM of the conventional banks. After the analyzing the financial data of the

banks, it was found that there was a significant influence of liquidity risk on the NIM of

the selected banks. NIM had a positive relationship with Loan to deposit, Cash to Asset

,and Loan to Asset where the most significant relationship existed between Loan to

Deposit and Net Interest Margin. It indicated that the more loan and advances provided

compared to collect the deposit from customers the higher the Net Interest Margin of the

banks. Chowdhury et. al (2016)

Return on Equity

Return on equity is a key measure of financial performance calculated by dividing net

income(the amount of income that is net of expenses and taxes that a company generates

for a given period) by shareholders' equity(Total average common stock equity for a

given period). Because shareholders' equity is equal to a company’s assets minus its

liabilities. Hargrave (2019) ROE. Reterived from Investopedia.com. This ratio is

affected by the level of capitalization of the financial institution and measures the ability

to expand capital internally (increase net worth) and pay a dividend. credfinrisk.com

(2015)

Liquidity restrict a bank from investing all its cash though profitability

comes from either investing it or bank lending activities. Since banks need to be

both profitable by shareholders demands and liquid by legal regulations, there is

fundamental conflicts between the profitability and liquidity and the need to balance

both. Therefore, banks should always act a balance between liquidity and profitability to

satisfy shareholders’ wealth as well as regulator. There is a trade-off between

profitability and liquidity in that increase in either one would decrease the other, which

mean more liquidity implies less profitability, profitability will be improved for banks

that hold some liquid assets, But not so much to hold that liquid assets reduce a banks’

profitability. This is consistent with standard finance theory which underlines the

adverse relation of liquidity and profitability. It is constructed after study when a bank

needs to sacrifice liquidity to achieve a higher profitability which in turn increases the

liquidity risk and liquidity ratio. Liquidity need is actually a constraint for a bank from

investing all its cash as profit comes from either bank lending activities or by investing

it. Choon et al (2013)

Kalanidis (2016) studied on european banks liquidity impact on profitability found that

liquidity metrics cash and due from Banks and total customer deposits, were found to

have a negative relationship on return on equity, providing support that the opportunity

cost of holding low yield assets and on the other hand holding deposits which can not be

invested appropriately, comes to dominate the increased resilience of the banks due to

increased liquidity

The fact that an excessive bank’s asset liquidity keep safe it from illiquidity, but likely it

can reduce the banks profit because lesser amount available for the offering the financial

services. It is constructed after the result that, the estimation in which the return on

assets and return on equity is regressed on the liquidity holdings ratio, the finding shows

that the relationship takes the form of quadratic function with a downward concave

parabolic due to the insufficient amount of fund. This finding is consistent with the idea
that funding market reward banks for holding some liquid assets, but at some point this

benefit is outweighed by the opportunity cost of holding such low-yielding cash and

cash equivalent assets. Eventually, excessive liquidity asset holdings do offer safety to

the bank, but it will give lower returns. Excessive holding on liquidity reduces excess

fund for financing and consequently will catch up the bank from getting any profit.

Hence, bank portfolio management should consider and develop a strategy and liquidity

plan that able to balance the acceptable return and risks. Abu Bakar et. al (2018)

Contrary to most of the studies, chowdary & Zaman (2018) studied on Bangladeshi

Islamic bank found impact to Return on Equity of loan to deposit ratio and risky liquid

asset to total asset are positively related with retun on equity that indicate liquidity

indicators loan to deposit ratio, risky liquid asset to total asset have no relation with

Bank performance (ROA and ROE).

Provision to Loan

Cost To Income