Impact of Liquidity Ratio on Banks Profitability in Pakistan

Case of National Bank of Pakistan

CHAPTER NO 1
INTRODUCTION
1.1

Background of the Bank

National Bank of Pakistan is one of the largest commercial bank operating in Pakistan. It has
redefined its role and has moved from a public sector organization into a modern commercial
bank. The Bank's services are available to individuals, corporate entities and government. While
it continues to act as trustee of public funds and as the agent to the State Bank of Pakistan (in
places where SBP does not have presence). It has diversified its business portfolio and is today a
major lead player in the debt equity market, corporate investment banking, retail and consumer
banking, agricultural financing, treasury services and is showing growing interest in promoting
and developing the country's small and medium enterprises and at the same time fulfilling its
social responsibilities, as a corporate citizen.
In today's competitive business environment, NBP needed to redefine its role and shed the public
sector bank image, for a modern commercial bank. It has offloaded 23.2 percent share in the
stock market, and while it has not been completely privatized like the other three public sector
banks, partial privatization has taken place. It is now listed on the Karachi/Islamabad/Lahore
Stock Exchanges.

National Bank of Pakistan is today a progressive, efficient, and customer focused institution. It
has developed a wide range of consumer products, to enhance business and cater to the different
segments of society. Some schemes have been specifically designed for the low to middle
income segments of the population. These include NBP Advance Salary, NBP Saiban, NBP
Kisan Dost, NBP Cash n Gold.

The bank has implemented special credit schemes like small finance for agriculture, business and
industries, administrator to Qarz-e-Hasna loans to students, self employment scheme for
unemployed persons, public transport scheme. The Bank has expanded its range of products and
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services to include Shariah Compliant Islamic Banking products. For the promotion of literature,
NBP recently initiated the Annual Awards for Excellence in Literature. NBP will confer annual
awards to the best books in Urdu and in all prominent regional languages published during the
defined period. Patronage from NBP would help creative work in the field of literature. The
Bank is also the largest sponsor of sports in Pakistan. It has provided generously to philanthropic
causes whenever the need arose.
The bank has taken various measures to facilitate overseas Pakistanis to send their remittances in
a convenient and efficient manner. In 2002 the Bank signed an agreement with Western Union
for expanding the base for documented remittances. More recently it has started Electronic Home
Remittances Project. This project introduces technology based system to handle inward
remittances efficiently, by ensuring that the Bank's branches keep a track of the remittance
received from abroad till its final receipt. Bank has been signing different agreements with other
leading players in the remittance field for ensuring that remittance services are available to most
of the overseas Pakistanis.
A number of initiatives have been taken, in terms of institutional restructuring, changes in the
field structure, in policies and procedures, in internal control systems with special emphasis on
corporate governance, adoption of Capital Adequacy Standards under Basel II framework, in the
up-gradation of the IT infrastructure and developing the human resources.
National Bank of Pakistan has built an extensive branch network of 1361+ branches in Pakistan
and operates in major business centre abroad. The domestic branch network has been automated
and is online. The Bank has representative offices in Beijing, Tashkent, Chicago and Toronto. It
has agency arrangements with more than 3000 correspondent banks worldwide. Its subsidiaries
are Taurus Securities Ltd, NBP Exchange Company Ltd, NBP Capital Ltd, NBP Modaraba
Management Company Ltd, and CJSC Bank, Almaty, Kazakhstan. It has recently opened a
subsidiary in Dushanbe, Tajikistan.
The Bank's joint ventures are, United National Bank (UK), First Investment Bank and NAFA, an
Asset Management Company (a joint venture with NIB Bank & Fullerton Fund Management of
Singapore).
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1.1 Background of the Study

The development of international financial markets and rising variety of financial instruments
has increased the possibility of banks' achievement to financial resources at an extensive level.
Under such conditions, the market are rapidly developed and some opportunities are provided to
design new products and present more services. Although it seems that the speed of such changes
is different from a country to another country, but the banks generally compete with each other to
develop and expand the new financial instruments and services. Bank's profit is usually one of
the main resources to accumulation of asset. The safety of banking system is depending on the
profitability and capital adequacy of banks.

Profitability is a parameter which shows management approach and competitive position of bank
in market-based banking. This parameter helps the banks to tolerate some level of risk and
support them against short-term problems. Recent studies indicate that liquidity risk arises from
the inability of a bank to accommodate decreases in liabilities or to fund increases in assets. An
illiquidity bank means that it cannot obtain sufficient funds, either by increasing liabilities or by
converting assets promptly, at a reasonable cost. In periods the banks dont enjoy enough
liquidity, they cannot satisfy the required resources from debt without conversion the asset into
liquidity by reasonable cost. Under critical conditions, lack of enough liquidity even results in
bank's bankruptcy (Note 1) (Group of Studies and Risk Management of Eghtesad Novin Bank,
2008).

In recent years, European banking system has become progressively integrated and liberalized on
the path to greater product and service deregulation. (Altunbas, Carbo, Gardener & Molyneux
(2007) outlines that progressive process of financial integration has enhanced competition and
emphasized needs of improved efficiency within the banking sector, which leads to an incentive
of greater bank risk taking and eventual exposure; adversely, regulators have tried to offset these
incentives by giving capital adequacy a more prominent role in the banking regulatory process.
As a result, most European banks act cautiously to boast their capitalization due to pressures
from both regulatory and market sides.

Bank liquidity refers to the banks ability to match its deposit withdrawals and pay off liabilities
as they become due. Toby (2006) argues that some depositors write cheque while others make
lodgment, which implies under normal conditions with appropriate contingency planning, net
deposit withdrawal or the issuance of loan commitment poses few liquidity problems for banks
due to fund availability or excess reserve that are adequate to meet unanticipated needs. The
turbulence in the credits and funding markets since the summer 2007 is a sufficient evidence that
liquidity risk management in the banking system has been less effective than expected.
According to the Financial Stability Review (FRS 2008), investors appear to have acquired risks,
which they did not fully understand that major financial institutions were not able to manage
these risks so much as transferring them into their own business lines resulting in an unintended
concentration of risks on their own balance sheet.

The turmoil demonstrated the great importance of effective liquidity risk management practices
and high liquidity buffers may contribute to ensure institutional and systemic resilience in the

face of shocks. According to Molitor (2008), improvements such as strengthening prudential

oversight of capital, enhancing transparency and valuation in financial reports, changes in the
role, employment of credit rating agencies and robust arrangement for dealing with stress testing
will help stabilize the financial system.

1.2

Problem identification

Banks offer a menu of contracts to depositors and loans to firms which are intended to suit with
expected liquidity needs of agent. In the study of impacts of liquidity constraints on bank lending
policy, Webb (2000) points out that in an advent of poor information of liquidity risk
management from a bank, depositors of fund will choose to withdraw a greater portion or even
all of their deposits, causing liquidity shortfall, which banks will be unable to generate sufficient
financing to embark on profitable projects and consequently affect performance ratios such as
assets turnover and return on equity.
Recent research related to liquidity risk management reckons that managing liquidity risk
requires banks to have sufficient liquidity to meet up with depositors and investors demand of
funds. That bank creates liquidity by transforming illiquid loans into demand deposit which is
given to investors in the forms of credits lines and loans commitment to invest in the markets of
securities hence creating markets liquidity. Ford (2009) argues that stress testing in analyzing the
future possibility of liquidity exposure, management oversight and contingency planning will
help to mitigate the liquidity risk and ensure stability in the system.

1.3

Problem Statement

In this study: National Bank of Pakistan is holding majority of the assets within the KSE indexes
as a main public bank such contribution of this research will provide empirical evidence of the
impact of liquidity risk on bank performance.

1.4

Research Questions
How increase in deposits boost up the Profitability of the bank?
How increase in cash reserves decrease the Profitability of the bank?
How increase in the liquidity gap causes a reduction in the banks Profitability?
How high provisioning for NPLs will cause a decrease in the banks Profitability?

1.5

Research Objective

To evaluate: the increase in deposits boost up the Profitability of the bank.

To find out the Increase in cash reserves decrease the Profitability of the bank.
To evaluate: Increase in the liquidity gap cause a reduction in the banks Profitability.
To determine: High provisioning for NPLs cause a decrease in the banks Profitability.

1.6

Significance of the study

The primordial purpose of this study is to provide empirical evidence on the impact of liquidity
risk on performance of banks before and during crisis in Pakistan, given that the recent financial
turmoil has been attributed to defective liquidity risk management practices by financial
institutions, the target groups we expect this study to benefit are:
Regulatory authorities and policymakers
Investors
Other interested parties.

Ideally, banks are responsible for sound management of liquidity risk, this study will help listed
banks to establish a more robust liquidity risk management framework that ensures it maintains
sufficient liquidity position, high quality liquid assets to withstand a range of stress events, it will
help listed banks to establish a more robust liquidity risk management framework that ensures it
maintains sufficient liquidity position, high quality liquid assets to withstand a range of stress
events, it will equally provide an insight for bank management for a better understanding of the
liquidity risk variables that could impact on performance measurement.
As for the supervisors and policymakers, this study will help to assess the adequacy of both bank
liquidity risk management framework and its liquidity position and take prompt action if the
bank is deficient in either area in order to protect depositors and to limit damage in the system.
Given that investors (stockholders and bonds holders) usually exhibit great interest in the
management of their portfolio, this study will serve as a benchmark in understanding the
different liquidity risk ratios and how they can affect their investment in periods of high liquidity
and liquidity runs. Others interested parties (customers) will grasp an understanding of what
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constitute bank liquidity risk management and the implication of their day to day transaction on
the bank profitability during normal period and in time of liquidity runs.

1.7

Scope of the study

Banks are often concerned to be within the center of systemic risks. With the tremor of the
financial meltdown still reverberating around the world, changes to the regulatory landscape are
firmly underway to secure the path to stability. But while these regulatory reforms still on the
blueprint; one particular issue has caused serious influences within the banking industry, which is
called liquidity risk. (Ford 2009) points out that back to when liquidity was abundant in the
economy, banks were less concerned to where liquidity was coming from, and loans to investors
was simply upon presentation of the cash flow statement.
The purpose of this study is to examine liquidity risk in Pakistani banks and evaluate the effect
on banks profitability. Data are retrieved from the balance sheets, income statements and notes
of 22 Pakistani banks during 2009-2014. Multiple regressions are applied to assess the impact of
liquidity risk on banks profitability. However, the sample period does not impair the findings
since the sample includes 22 banks, which constitute the main part of the Pakistani banking
system. Moreover, only profitability is used as the measure of performance. Economic factors
contributing to liquidity risk are not covered in this study. This is the first study addressing the
liquidity risk faced by the Pakistani banking system. Past researchers and practitioners have not
given the proper attention to liquidity risk. This study helps in understanding the factors of
liquidity risk and their impact on the profitability of the banking system.

CHAPTER NO 2
LITERATURE REVIEW
2.1.1 Liquidity
According to the financial stability review from Banque de France (2008), liquidity is defined as
the ease with which value can be realized from the sales of assets. Value can be realized by using
credit worthiness to acquire funds from external markets or through the sales of assets in the
market place. Also liquidity can be easily understood as a measure of how likely a bank will
meet its short or long term obligations, such as will a bank able to settle its liabilities on time?
From the market point of view, liquidity means:
The degree of which an asset or security can be bought or sold in the market without affecting
their prices. Hereby, assets which can be bought or sold easily are known as liquid assets.
The ability to change assets to cash easily is called "marketability".

Expected and unexpected obligations can be met with liquidity issues during daily business
operations, while business should be operated uninterrupted. With insufficient cash resources,
business operating can be damaged; more importantly, it could be confronted to severe financial
distress of whole economy with serious liquidity constrain in banking system. Therefore,
liquidity could be a vital element of financial management and must be managed with caution.

2.1.2 Liquidity elements and theory of management in ECB

According to the ECB (2001), short term money market rates play a very important role in the
transmission of monetary policy. The CB guides short term money market rates by signaling its
monetary policy and managing the liquidity situation in the money market. As suggested by
Poole (1986), payment uncertainties are a necessary condition for a demand for working
balances. For instance, theoretically, a world made by perfectly efficient banks, interbank
markets and payment systems without relevant uncertainty regarding to payment flows would
arise, in which there would be no demand for working balances.

In contrast, reserve requirements are settled by the CB and there are two fundamentally different
approaches needs to be differentiated in the liquidity management practice of CB with depending
on which of these two factors dominates the demand of reserves.

The Euro system and the Bank of England provide extreme examples:
In the Euro zone, banks have to fulfill reserve requirements on average over a reserve
maintenance period of a month. The aggregate reserve requirements are substantial; it was
around EUR 130 billion in 2003. Short term fluctuations of actual reserves from the banking
system rarely push the actual reserves on any days since the introduction of the euro in 1999. In
such a framework, the logic of the ECBs liquidity management in the money market has been
described for instance by Binseil & Seitz (2001, p.11) as: The ECB attempts to provide liquidity
through its open market operations in a way that, after taking into account the effects of
autonomous liquidity factors, counterparties can fulfil their reserve requirements. If the ECB

10

provides more(less) liquidity than this benchmark, then counterparties need to use on aggregate
the deposit (marginal lending) facility.

According to ECB (2002), the demand and supply of liquidity are the interaction between the
Euro systems monetary policy operations; and the euro area. Credit institutions can be illustrated
by the consolidated balance sheet of Euro system, which is published on a weekly basis. Also
quoted from Binseil (2000, p.4): CB liquidity management refers to the shortest end of
implementation of monetary policy, and assumes that the only channel of communication
between the macro-economy and liquidity management is the operational target rate of the CB.
For the ECB, liquidity management takes place within a framework of operation, and the choice
of the operational framework is from the preceded of existence of environments. A theory of
liquidity management has clearly distinguished between these different categories. While the
theory outlined in this section concentrated on the liquidity management problem, but it is worth
listing the main elements of the operational framework briefly from the banks consolidated
balance. There are mainly two elements of the environment affecting the optimal choice of the
operational framework and the liquidity management strategy in ECB (2002)
The concept of a liquidity management strategy of the CB refers to the implementation of
monetary policy (Binseil, 2000, p.5). It reflects the idea that there are some systematic elements
for each liquidity management approach and if all these systematic components related to the
liquidity management decisions of the CB to specific information, then variables are defined as
the strategy, and the residual component of the actual liquidity management behavior should be
non-correlated (orthogonal) to those information variables.

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Specifically, the liquidity management strategy of a CB consists of several interrelated subelements, namely:
The liquidity provision through open market operations;
The choice of instruments and procedures in the different open market operations (e.g.
outright versus reverse operations, fixed versus variable rate tenders, etc.);
Further elements of the information policy (e.g. publishing or not autonomous factor
forecasts).

What should the CB follow when specifying its implementation of monetary policy (operational
framework and liquidity management strategy), as the function of all relevant environmental
parameters? The Framework Report by the European Monetary Institute (1997, p. 14)
discussed the reason and general principles that should guide both selections of the operational
framework and liquidity management strategy. The discussion in the Framework Report may be
summarized in the following three aims: The operational framework and the liquidity
management strategy, should aim at:
Enabling to control short term interest rates;
Allowing to be able to give signals of monetary policy intentions (and therefore to influence
other rates along the yield curve);
Generating simple, transparent and cost-efficient arrangements, which include a preference
for a low frequency of monetary policy operations.

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2.2 Problem with liquidity risk and liquidity risk management

This part will build a bridge between liquidity issues from central bank to commercial banks and
discuss issues that are common within liquidity risk and liquidity risk management. Mostly why
and how could managing liquidity risks in the banking section. The discussion takes it one step
closer to fully understand the complexity of liquidity issues and how CB could and commercial
banks can play their role for their liquidity risk management solutions. At the end, it will present
several calculations and ratios concerned with liquidity ratio in single banks within the liquidity
risk management framework.
2.2.1 Regulation of commercial banks liquidity by central bank

In further study, Rochet again (2008) indicates that uniform liquidity requirements could be
replaced by more flexible systems, where the liquidity requirement maybe more or less stringent
according to the banks solvency and / or to simple measures of banks exposure to several types
of macroeconomic shocks, deduced for example from VAR(value at risk) calculations under
different scenarios.

From the study of Holmstrom & Tirole (1998), it shows that the private solution can be sufficient
if there are no aggregate shocks. However a purely private solution is likely to be relatively
complex for implementation. It would consist in requiring banks to build pools of liquidity and to
sign multilateral commitments from credit lines, specifying clearly the conditions under which
an illiquid bank would be allowed to draw on its credit line? By contrast, CBs emergency
liquidity assistance is probably simpler to be organized, but may be intended to forbearance
13

under political pressure. However, some form of government intervention is needed due to the
possibility of economic shocks in any case. The issue here is to avoid excessive intervention,
such as ex-post bailouts of insolvent banks.

Finally, it should be noticed that systemic risk in payment systems and inter-bank markets could
be eliminated altogether if the CB decided to insure inter-bank transactions and payments finality
against credit risk. This system was implicitly in place in many countries during most of the last
century. Thus the only logical explanation for the recent movement towards RTGSs and
limitation of LLR3 interventions is that banking authorities want to promote peer monitoring by
banks. However, Rochet & Tirole (1996) shows that the effective implementation of peer
monitoring among banks may be difficult, due to commitment problems by governments.
Liquidity requirements may be a useful way to mitigate these commitment problems.
2.2.2 Liquidity risk

After the financial crisis in 2007, liquidity risk has been widely discussed worldwide since most
of the banks and corporations have suffered during this crisis badly especially with the liquidity
constriction. For this reason, liquidity risk again has been put on the table of whole banking
section.

Liquidity risk as one of the major risk from bank, it arises if the cushion provided by the liquid
assets is not sufficient to cover its obligation. In such a situation, bank has to fund their liquidity
requirements from market. However, conditions of funding through market highly relied on
liquidity in the market and borrowing institution. Accordingly, shortage of liquidity from an
14

institution may have to undertake transaction with heavy cost resulting in a loss of earning or it
could result in bankruptcy if it is unable to undertake transaction even at current market prices
for the worst case.

In finance, liquidity risk may not be seen as isolated since all financial risks are not mutually
exclusive and liquidity risk often caused by other financial risks such as credit risk, market risk,
etc. For instance, a bank increases its credit risk through assets may increase its liquidity risk as
well. Similarly, a large loan default can adversely impact a banks liquidity position. It will be
discussed more in the next section.

Liquidity and solvency are the heavenly twins of banking (Charles, 2008), frequently
indistinguishable. An illiquid bank can rapidly become insolvent, and an insolvent bank illiquid.
When the Basel Committee on banking supervision was first founded in 1975, the Chairman,
George Blunder tried to underpin the capital and liquidity adequacy performance of the main
international commercial banks. It turned prior downwards trend of banks capital ratios back up.
Later on, the idea of liquidity risk management was brought to Basel Committee in the 1980s,
but it failed to reach an agreement after all. In the note of Tim Congdon (2007) mentioned that
liquidity assets were typically 30 percent of British clearing banks total assets, and these largely
consisted of T-bills and short term government debt and it is about 0.5 percent of traditional
liquidity assets in the asset account of commercial banks right now.

15

2.3 Experimental Studies

Profitability of banks is influenced by different factors. These factors are generally classified into
internal factors and external factors. Different researches are performed about the effect of these
factors on the profitability of banks.

Bagheri (2007) estimated and analyzed the effective factors and determinants of profitability of
Refah Bank using of a linear regression pattern for time period of 1983-2001. Findings of this
research showed that the efficient management of costs is one of the significant explanatory
variables for profitability of bank. In addition, the management of liabilities has also an effect on
the profitability. Among external factors, economic growth has positive effect on profitability of
bank.

By calculating the parameters of banks' performance in four groups of profitability, liquidity,

efficiency and capital, Heibati et al. (2009) examine and compare the performance of private
banks in Iran and Arabic countries of Persian Gulf area. The results showed the acceptable
performance of private banks during the initial years of their activity.

Arbabian and Geraili (2009) addressed to study the effect of capital structure on the profitability
of companies accepted in Tehran's stock exchange. The results of their research showed that
there is a positive relationship between the ratio of short-term debt to the asset and profitability
of the company as well as between the ratio of total debt to the asset and profitability. But there
is a negative relationship between the ratio of long-term debt to the asset and profitability.

16

Bourke (1989) examined the performance of banks in twelve European, Northern American and
Australian countries. Using of international data for 1972-1981, he found that both ratios of
capital and liquidity have a positive relationship with the profitability. In comparison, Molyneux
& Thornton (1992) for the time period of 1986-1989, found that profitability is negatively related
to liquidity. Davidson & Dutia (1991) showed that the capital plays a very important role in
profitability of small firms, but due they do not able to obtain the capital; it is forced heavily
relay on loan and this may decrease their profitability. Also, they showed that using of high debt
is one of the important factors in decreasing the profitability of small firms.

Molyneux and Forbes (1995) examined the structure of market and its performance in 18
European countries using of panel data of several companies for four years of 1986-1989. Their
findings show that a regulatory guideline should be designed to change the structure of market.

In this way, the competition or the quality of bank's performance will be increased. The growing
focus on banking market should not be limited by the scales of regulatory guideline. Berger
(1995) examined the relationship between capital adequacy and return on equity. Using of
Granger's causality test, he found a positive relationship between these two variables. He pointed
out subsequent increase in capital adequacy ratio should be resulted in increasing return on
equity, which this is performed by decrease in insurance costs on unconfident debts. In 1992,
Berger (1995) calculated the liquidity risk of bank through on the ratio of cash asset to total asset
in order to study the performance of bank. In his research, he found that there is a positive
relationship between liquidity risk of bank and return on total asset.

17

Miller and Noulas (1997) found a negative relationship between credit risk and profitability
which represents that when there is a negative relationship between them, loans will be
encountered with more risk, and the greater is the value of loan loss; accordingly, the ability of
maximizing the profit of a bank will be encountered with difficulty.

Demirguc-Kunt et al. (1998) examined the determinants of bank's profit and net profit margin by
using the specific characteristics of bank, macroeconomic conditions, tax enactment, regulations,
financial structure and legal parameters for 80 countries. In this research, they evaluated liquidity
risk based on the ratio of loan to total asset. They found that foreign banks have more
profitability than domestic banks in developing countries, while in developed countries, this is
conversely. Despite of this, their general results indicated that there is a positive relationship
between net profit margin and liquidity risk and there is a negative relationship between return
on internal asset and liquidity risk of bank.

Bashir (2000) studied the effective factors on the performance of Islamic banks in 8 middle-east
countries during the years 1993-1998. The results show that by controlling the macroeconomic
environment and financial market situation, financial debts and long- term loans will be resulted
in more profitability. Also, he found that foreign banks are more profitable than domestic banks.

Chirwa (2003) studied the relationship between market structure and profitability of commercial
banks in Malawi using of data of time series during the years 1970-1994. The results of research
show that there is a negative relationship between profitability and capital adequacy ratio and
gearing ratio.

18

In his research, Abor (2005) addressed to examine the relationship between the criteria of capital
structure and profitability in a sample of companies in Ghana. The results of this research
showed that there is a positive relationship between the ratio of short-term debt to the asset and
profitability. But there is a negative relationship between the ratio of long-term debt to the asset
and profitability of companies. Havrylchyk and Emilia (2011) found a positive and direct
relationship between asset management and profitability of bank. Accordingly, a more effective
bank should have more profits because it can maximize its net profit income.

In a study, Chen et al. (2010) examined the pattern of liquidity risk of bank and its performance
using of imbalanced panel data set including commercial banks in 12 advanced economic
countries during the years 1994-2006. They found that liquidity risk is the endogenous
determinant of bank performance. The causes of liquidity risk include components of liquid
assets and dependence on external funding, supervisory and regulatory factors and
macroeconomic factors. Alper & Anbar (2011) examined special and macroeconomic
determinants of Turkey's bank during the years 2002-2010 using of a panel data set. The results
show that bank's size, liquidity and interest income have positive effect on the bank's
profitability, but credit risk and loans have a negative effect on the bank's profitability. Regarding
to macroeconomic variables, just real interest rate affects positively on the performance of banks.
Ali et al. (2011) performed a research about the important role of capital adequacy ratio,
operating efficiency, asset management and gross domestic product and their effect on the
profitability of commercial banks of Pakistan and concluded that conventional banks have better
Profitability than Islamic banks of Pakistan.

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In banking industry, liquidity risk has an opposite effect on profitability. Some studies such as
Molyneux & Thornton (1992) and Barth et al. (2003) supported the positive effect of risk on the
profitability; while some studies such as Bourke (1989) and Kosmidou et al. (2005) believed in
its negative effect. Liquidity risk is usually measured as liquidity ratio which is practically
calculated in two different forms. In first type, liquidity is adjusted by size which includes the
ratio of cash asset to total asset (Barth et al., 2003; Demirguc-Kunt et al., 1998), the ratio of cash
asset to deposits (savings) (Chen et al., 2010). Second type includes the adjusted loan by the size
which includes the ratio of total asset and/or the ratio of net loan to total asset (Kosmidou et al.,
2005).
2.4 Selected definitions

Liquidity: Kroszner (2008, p.161) defines liquidity as the ability to fund increase in marketable
securities and meet obligations as they become due.

Liquidity risk: the Banque de France Financial stability Report (BFFSR,p.47) refers to liquidity
risk as the inability of the bank to manage its liquidity position in order to cover mismatch
between future cash outflow and cash inflow.

Liquidity risk management: VandersVossen&Vaness (2010,p.3) defines liquidity risk

management as the ability of bank to own sufficient liquidity or cash to meet up with unexpected
demand from depositors so that bank can continue to perform its duties.

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Demand and Terms deposit: demand deposit can be referred to as an account from which
withdrawal can be made at any time without prior notice to the bank. During deposit term, banks
and depositors agree on predetermining a date for the deposit to be withdrawn.
(Diamond&Rajan (2005, p.616) finds out that by issuing demand deposit in large quantity, the
bank ties it collection to the loan it has made.

Credit lines& Terms loans: Agarwal et,al (2006,p.3) refers to credits lines as variable rate debts
in which the bank commit to provide a fixed amount to the borrower who pays interest only on
the sum drawn against commitment, while term loan is to finance long term investment with a
fixed and variable rate.
Liquidity funding: the Basel committee on banking defines funding liquidity as the ability of
banks to meet their liabilities, unwind or settle their position as they become due.

Capital adequacy: according to Mui et,al ( 2010,p.3) capital adequacy is referred as the ability
to raise capital level in view of ensuring that sufficient liquidity position is maintained during
stress periods.

Monetary policy: according to the Economic Times Monetary policy is a tool used by the
central.

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2.5 Conceptual framework

Liquidity risk has attracted significant attention of researchers and risk professionals alike, after
the leading banking crises in recent times. Liquidity risk may have a shattering impact on a bank
that may also cause a bank run (Diamond and Rajan, 2005). This risk stems from the description
of banking operations (Chaplin et al., 2000). It can affect the overall capital and Profitibility of
the bank adversely. The bank may face serious consequences if it is not properly managed. The
banks and the regulatory authorities are becoming increasingly vigilant to the liquidity positions
of the financial institutions. The deposits are the lifeline of the banking business. Most of the
banking operations are run through deposits. If the depositors start withdrawing their deposits
from the bank, it will create a liquidity trap for the bank (Jeanne and Svensson, 2007; Kumar,
2008) forcing the bank to borrow funds from the central bank or the inter-bank market at higher
costs (Diamond and Rajan, 2001). Every bank tries to keep up sufficient funds to meet the
unexpected demands from depositors (Majid, 2003) but maintaining the cash is extremely
expensive (Holmstrom and Tirole, 2000).

One of the prime causes of liquidity risk is the maturity mismatch between assets and liabilities.
In the banking business, the majority of the assets are funded with deposits most of which are
current with a possibility to be called at any time. This situation is known as the mismatch
between assets and liabilities (Central Bank of Barbados, 2008; Brunnermeier and Yogo, 2009).
This mismatch can be measured with the help of the maturity gap between assets and liabilities
(Falconer, 2001; Plochan, 2007). This is also called liquidity gap (Plochan, 2007). Higher
liquidity gap will create liquidity risk (Plochan, 2007; Goodhart, 2008; Goddard et al., 2009),

22

therefore: Many banks focus on the corporate or wholesale lending, which poses a challenge for
the management to maintain the required liquidity position (Akhtar, 2007). This lending is
mostly long-term, which may create liquidity problems for a bank (Kashyap et al., 2002).
The loan retirement process slows down in the banks during periods of poor production
of resources in the economy. This situation gives rise to non-performing loans (NPLs).
When NPLs experience a rapid increase, liquidity crisis becomes inevitable.

2.5.1 Theoretical Framework

Deposits
Cash
Banks
Profitability

Liquidity Gap
NPLs

Reference: Ahmed Arif, Ahmed Nauman Anees, (2012),"Liquidity risk and performance of banking system",
Journal of Financial Regulation and Compliance, Vol. 20 Iss: 2 pp. 182 - 195

2.5.2 Hypothesis
H1. Increase in deposits boosts up the Profitability of the banks profitability.
H2. Increase in cash reserves decreases the Profitability of the banks profitability.
H3. Increase in the liquidity gap causes a reduction in the banks profitability.
H4. High provisioning for NPLs will cause a decrease in the banks profitability.

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CHAPTER NO 3
RESEARCH METHODOLOGY
3.1 Sources of data
The preliminary data will be gathered from various secondary sources utilizing journals, books,
and annual reports of the bank. Unstructured interviews will also be conducted from risk
managers of the bank. The purpose of these interviews is to have a general understanding of the
liquidity risk management in the Pakistani banking system.
3.2 Nature of data
The data for analysis will be taken from the annual reports of the bank in Pakistan. This study
focuses only on National Bank of Pakistan. The nature of data is panel data; a combination of
time series and cross-sectional data. Because of the small size of the sample period (2009-2014)
and a small number of degrees of freedom.
3.3 Sample characteristics
This study focuses on National bank of Pakistan. (Melody Main Branch)
3.4 Procedure
A representative sample of NBP will be taken to evaluate the impact of liquidity risk on the
profitability of the bank. The balance sheets, income statements and their notes have been
studied to get the data for the variables mentioned in the developed model. All the taken values
for selected variables are in Pak rupees (PKR).

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3.4 Variables
3.4.1 Deposits. Deposits are accounts of the customers of banks. The data for deposits are taken
from the liability side of balance sheets without any classification of current or other types of
deposit accounts.

3.4.2 Cash. Data for the cash are taken from the assets side of balance sheets of banks. This
includes cash and balance with the treasury bank only. Accounts with other banks have not
been incorporated in cash.

3.4.3 Liquidity gap. The data for liquidity gap are obtained from the table of maturity of assets
and liabilities. The liquidity gap for one month has been taken, as a negative gap in one month
may create difficulties for the bank to meet the rising demands of depositors.

3.4.4 NPLs. NPLs affect the performance of a bank adversely. The provisioning for NPLs is
taken from profit and loss statement of banks for the analysis in this study.

3.4.5 Profitability. Profitability is taken from the profit and loss statement of banks. This
profit is calculated before tax as banks have different tax shields. The data from aforementioned
banks are collected to examine the relationship between the liquidity risk and performance of the
banks. Multiple regressions have been applied to examine the relationship of variables, after
testing data for normality.

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CHAPTER NO 4
RESULTS AND DISCUSSIONS

Multiple regressions will be applied to test the model. Before model testing, descriptive statistics
will be obtained to confirm the normality of the data and the ADF test will be run to satisfy the
requirements of regression. The mean value of profitability will be judged (positive/negative),
showing that the overall NBP banking system is enjoying a profitability scenario
(positive/negative), whereas the mean value of the liquidity gap will be calculated
(negative/positive). Moreover, the normality of the data is within acceptable ranges or not as
skewness is not high enough to affect the normality of the data and kurtosis value for all the
variables is positive/negative.

CHAPTER NO 5
CONCLUSION & RECOMMENDATIONS

5.1 Conclusion

Liquidity problems may adversely affect a given banks earnings and capital. Under extreme
circumstances, it may cause the collapse of an otherwise solvent bank. A bank having liquidity
problems may experience difficulties in meeting the demands of depositors. However, this
liquidity risk may be mitigated by maintaining sufficient cash reserves, raising deposit base,
decreasing the liquidity gap and NPLs. Adequate cash reserves will decrease the banks reliance

26

on the repo market. This will reduce the cost associated with over the night borrowing.
Moreover, it will also help the banks to avoid fire sale risk.

5.2 Recommendations

It is imperative for the banks management to be aware of its liquidity position in different
buckets. This will help them in enhancing their investment portfolio and providing a competitive
edge in the market. It is the utmost priority of a banks management to pay the required attention
to the liquidity problems. These problems should be promptly addressed, and immediate
remedial measures should be taken to avoid the consequences of illiquidity. This study paves the
way for more detailed studies into controlling the liquidity risk and to extending the proposed
model to incorporate other causes of liquidity risk.

5.3 Future Research

Further, the current study has focused primarily on earning of the bank as measure of the
performance of NBP. Further research may take a broader view of the performance and
profitability (together) and can also include economic factors.

27

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