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The Financial Health Of The Banking Industry Finance Essay

“The banks attend an industrial undertaking from its birth to its death, from promotion to liquidation, they stand by its side whilst it passes through the financial processes of economic life, whether usual or unusual, helping it and at the same time profiting from it” (Jiedals, 1905).

The financial health of the banking industry is an important prerequisite for economic stability and growth (Halling & Hayden, 2006). Banks are the main part of the financial sector in an economy performing valuable activities on both sides of the balance sheet and providing the financial support to other segments. On the assets side, they enhance the flow of funds by lending cash starved users of funds and supply liquidity to savers on the liability side (Diamond & Rajan, 2001).

Banks also facilitate the transactions of payments and help to ascertain the smooth transfer of goods and services. They make sure the capital to be invested productively to stimulate the economic growth. They make it possible to create new industries thereby increasing the employment and facilitating the growth. Primarily due to their varied nature of functions performed, the balance sheet of a typical bank is exposed to liquidity risk – the risk that a bank may not meet its obligations (Jenkinson, 2008) as the depositors can call their funds on demand, causing fire sale of the assets (Diamond and Rajan, 2001), negatively affecting profitability of the bank (Chaplin, Emblow, & Michael, 2000).

Over the past few years, bank managers did not pay the due attention to this vital element of liquidity risk (CEBS, 2008). Lately, it has obtained a great attention from the researchers, regulators and financial institutions in recent years after many financial and banking crises across the globe. There has been an imminent feeling that it has not been sufficiently covered by the prevailing risk management practices (Crowe, 2009). It is said to be assassin of banks (Ali, 2004) and failure of many banks from the past and present support this claim. So the banks and the regulators are keen to have a vigil on liquidity situation of banks. Liquidity risk primarily emanates from the nature of banking business, macro factors that are exogenous to the bank and the financing and working policies that are internal to the banking firm (Chaplin, Emblow, & Michael, 2000).

Liquidity risk not only affects the performance of a bank but also the reputation of a bank (Jenkinson, 2008). If a bank is unable to give the funds to its depositor timely then it may lose the confidence of its depositors and bank’s reputation will be at stake. In addition to this, a poor liquidity position may cause penalties from the regulator. Therefore it is very necessary for a bank to keep a sound liquidity arrangement.

Banks also need to be equipped to deal with the changing monetary stance, shaping the overall liquidity trends and the bank’s own transactional requirements and repayment of short term borrowings (Akhtar, 2007). There are also a number of other risks faced by banks such as credit risk, operational risk, interest rates risk etc. which may culminate in the form of liquidity risk (Brunnermeier & Yogo, 2009).


Honohan & Laeven (2005) state that increase in inflation unpredictability and precariousness of exchange rate after 1971 has increased the susceptibility of banking system more than any other sector of the economy. The frequency and severity of banking crises multiplied during the last quarter of the previous century. The costs of these banking crises have been very large which has not only been borne by its shareholders but also by the governments and tax payers. In addition to the fiscal cost, collapses of large banks across the World have contributed to longer economic downfalls, worsening poverty across the globe. Despite the presence of some advanced models; it is not an easy task to predict systemic banking crises, emanating originally from liquidity problems of the banking sector.

Broad problem area

Liquidity risk has become a greater concern and challenge for modern era banks (Comptroller of the Currency, 2001). High competition for consumer deposits, a wide array of wholesale and capital markets funding products with technological advancements have changed the funding and risk management structure (Akhtar, 2007). A bank having good asset quality, strong earnings and adequate capital may fail if it is not maintaining adequate liquidity (Crowe, 2009).

Saleem (2009) mentioned in his report that there are 53 banks in the banking sector of Pakistan which consists of 30 commercial banks, 4 specialized banks, 6 Islamic banks, 7 development financial institutions and 6 micro-finance banks. As of end-2008, data from the banking sector confirms a slowdown in the industry growth as compared to previous years. As of October 2008, total deposits fell from PKR 3.77 trillion in September to PKR 3.67 trillion. Provisions for losses over the same period went up from PKR 173 billion in September to PKR 178.9 billion in October.

According to SBP Quarterly Report (2010), due to heavy investments in government papers, liquidity strain became more severe for commercial banks which complicated the liquidity management by SBP. This has made the liquidity position difficult for the banking sector in Pakistan. Due to the focus over the last several years on market risk and credit risk (under Basel-I arrangement), liquidity risks have not been given the required attention.


What are the factors contributing to the liquidity risk faced by banking sector in Pakistan?

What is the impact of liquidity risk on performance of banking sector?

What are the ways through which liquidity risk can be mitigated?


Liquidity risk is a slayer for the banks (Ali, 2004) which may demolish the entire banking sector. Any of the financial institutions need to pay due attention to the liquidity risk. Poor liquidity positions can cause a number of problems for a bank that may lead to bankruptcy as well (Goddard, Molyneux, & Wilson, 2009). To manage the liquidity problems, without affecting the performance, is a big challenge for management of any bank (Goodhart, 2008). Liquidity risk may have adverse effect on the performance of bank in shape of decreased earnings or deteriorated reputation etc (Jenkinson, 2008).

The purpose of this study is twofold. Firstly, banks adapt different measure for managing the liquidity risk. The researchers have tried to analyze the effectiveness and efficiency of all these measures adapted by the banks. Secondly, the researchers have also tried to find whether there is any impact of these measures on the performance of the bank.

This study is trying to explore the factors that may create liquidity risk. The researchers have tried to find out the different kinds of internal or external forces putting a bank at liquidity risk? The researchers have made attempts to find out the areas in which liquidity risk may affect the performance of banking sector. There are many ways which help a bank to mitigate liquidity risk but on the other hand bank’s performance might be affected while mitigating this risk.

This study will contribute in mitigating the liquidity risk keeping in view the performance of banking sector. The researchers have analyzed all the potential measures that can be taken in this regards. Different pros and cons of these measures will be investigated and then recommendation will be made in the best interest of a bank by keeping in mind the both faces of the coin i.e. mitigating liquidity risk and increasing the performance of banking sector.


The researchers have put their efforts to find the sources of liquidity risk and how liquidity risk may affect the performance of banking system. The objectives of this study are:

To investigate the sources of a liquidity risk.

To highlight the factors exacerbating the liquidity risk.

To analyze the impact of liquidity risk management practices on performance of banking sector.

To study the ways in which liquidity risk may be mitigated effectively and efficiently.


The researchers have delimited themselves in the following ways:

This study is only focused on the Pakistani banking sector.

The researchers have only evaluated the financial performance.

The researchers have only taken earnings as the measure of financial performance.


The researchers have prepared the following literature review.

Liquidity Risk

“Liquidity risk is a risk arising from a bank’s inability to meet its obligations in time when they come due without incurring unacceptable losses” (Comptroller of the Currency, 2001). This risk can adversely affect both bank’s earnings and the capital. So it becomes the top priority of the bank management to make sure the availability of sufficient funds to meet potential demands of providers and borrowers, at reasonable costs.

According to State Bank of Pakistan, “Liquidity risk is the potential for loss to an institution arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable cost or losses”. In easier terms, liquidity risk can be defined as the risk of being unable to liquidate a position timely at a reasonable price (Muranaga & Ohsawa, 2002). If we analyze this definition, then there are two important parts i.e. (a) liquidating the assets as and when required and (b) at a reasonable price. Banks face a liquidity risk if it is not liquidating its assets at a reasonable price. The price fetching remains unsuitable due to stressed sale conditions, while liquidating any of its assets on urgent basis. Due to this situation banks face losses and a significant decrease in earnings.

The idea of liquidity risk in banking sector emphasizes on maintaining sufficient funds to meet a bank’s commitments to attract deposits (Majid, 2003). Banks, having insufficient funds to meet the unexpected depositor’s demand will be prone to liquidity crisis. Inefficiency in meeting the demand of depositors may also create a reputation risk for the bank that will make it difficult to attract depositors.

Large scale withdrawal of the deposits can put a bank in liquidity trap (Jeanne & Svensson, 2007; Kumar, 2008) but this may not be the major source of liquidity risk in all circumstances (Diamond & Rajan, 2005; Holmstrom & Tirole, 2000). There are a number of other factors that may create massive liquidity problems for the banks e.g. large-scale commitment based lending and long-term lending may create serious liquidity problems for a bank (Kashyap, Rajan, & Stein, 2002). Banks having large commitments will have to honor them when they will come due. Moreover, banks having a massive exposure in long-term lending will face problems of liquidating them in immense liquidity pressure. Kashyap et al., (2002) further explained that those banks having an advantage in offering demandable deposits (measured by the ratio of transactions deposits to total deposits) must hold more in cash and securities; and do a greater fraction of their lending on a commitment basis.

The very structure of a bank’s balance sheet – generally illiquid loans are funded by highly liquid short term deposits – exposes the bank to liquidity risk (Clementi, 2001). While short-terms deposits can be withdrawn at any time, the long term lending usually mature after the completion of their fixed term. This situation can be called the mismatch in assets and liabilities of the bank. This phenomenon has also been explained by Brunnermeier & Yogo (2009) who defined liquidity risk as the mismatch between the assets and liabilities of the bank. Banks taking short-term deposits and issuing long-term loans are more prone to liquidity risk i.e. the risk that they may not be able to fund increases in assets or meet obligations as they fall due, without incurring unacceptable losses (Central Bank of Barbados, 2008). The mismatch may also be referred to liquidity gap – the difference between the assets and liabilities of portfolio – which generates risk of not being able to raise funds without incurring a higher cost (Plochan, 2007). The relationship between longer term illiquid customer loans and stable funding, in the form of customer deposits and longer terms purchased funds, is the universal measure of liquidity (Falconer, 2001). If the relationship is not balanced then some urgent remedial actions are required by the bank.

Goddard et al., (2009) find out in their study on the financial crisis in Europe that whole sale funding and the interbank markets dried up in 2007-2008 because regulators overly emphasized on capital. This emphasize was made on the cost of liquidity. The viability of any financial institution cannot be guaranteed only with capital regulations.

According to Goodhart (2008), there are two important facets of liquidity risk: maturity transformation (the relative maturity of a bank’s liabilities and assets) and the inherent liquidity of a bank’s assets i.e. the degree to which an asset can be sold without incurring a significant loss of value under any market conditions. In fact, these two elements of a bank’s liquidity are intertwined. Banks do not need to be worried about the maturity transformation if they have the assets that can be sold without bearing any loss and if the banks have the assets that are going to be matured in a shorter time, then they have a lower level of need to hold the liquid assets.

But apart from the above cited mismatch, liquidity risk arises due to stoppage of production or even delay in production of resources in economy. This will increase the demand of depositors which will in turn create liquidity risk. This may cause the failure of a bank or even banking system (Diamond & Rajan, 2005). A very high liquidity increases the leverage of the bank and high leveraged banks can turn into consumer of liquidity from the providers (Clementi, 2001).

Major focus of researchers have been on the liquidity risk emanating from the liability side of a bank’s balance sheet and less attention has been given to the risk arising from the asset side of the balance sheet. Liquidity risk may arise due to the breakdown or delays in cash flows from borrowers or early termination of the projects (Diamond & Rajan, 2005).

Moreover, liquidity risk may also emanate from the nature of banking business; from the macro factors that are exogenous to the bank as well as from the financing and operational policies which are internal to the banking firm (Ali, 2004). A severe liquidity crisis can cause massive drowning in shape of bankruptcies and bank runs (Goodhart, 2008) which may lead to a severe financial crisis in the economy (Mishkin, Stern, & Feldman, 2006).

The major important reasons of liquidity risk identified by Ali (2004) are incorrect judgment or complacent attitude of the bank officials towards timing of its cash flows, unanticipated changes in the cost of capital or availability of funding, abnormal behavior of financial markets under stress, range of assumptions used in predicting cash flows, risk activation by secondary sources (e.g. business strategy failure, corporate governance failure, modeling assumptions), merger and accusations policy, breakdown in payments and settlement system, macroeconomic imbalances etc.

SBP’s 2nd Quarterly Report for the FY 2009-2010 shows that the continued strong credit demand from PSEs (Public sector enterprises) and low pace of retirement of outstanding commodity finance loans in FY10 exerted pressures on the market liquidity. Increase in loans to PSEs made it very difficult for SBP to manage the liquidity problems. Excessive borrowings from the GOP have created a challenging situation for the banks (SBP, 2008).

Most of the Pakistani bank’s lending is to textile sector which has suffered severe losses due to the ongoing severe energy crisis in Pakistan (SBP, 2010). This has negatively affected the pace of loan retirement from the textile industry. So the energy crisis may have created liquidity problems for banks in an indirect way.

Managing liquidity risk

Liquidity management is part of the larger risk management framework of the financial services industry, which concerns all financial institutions (Majid, 2003). A well-managed bank must have a very refined system for the identification, measurement, monitoring and control of liquidity risk (Comptroller of the Currency, 2001). A well established system will help the banks to recognize the sources of liquidity risk in a timely manner and uphold sufficient liquidity to avoid the losses.

The balance sheets of banks are growing in complexity and dependence upon the capital markets have made the liquidity risk management more challenging (Guglielmo, 2008). Guglielmo further states that institutions that plan to rely on the capital markets to fund future growth, need to show their understanding of the risks involved and have the appropriate measurement and management processes in place. A bank should have continuous awareness about the breakdown of its sources of funding in terms of different categories of customers, (consumers, whole sale customers etc.) financial markets and instruments (Falconer, 2001).

A large scale liquidity crisis can turn into a full-blown capitalization crisis in no time. This situation may evolve due to fire sale risk that may arise because of taking large positions in illiquid assets. This fire sale risk may have knock on effects on the balance sheet because the institutions are obliged to mark their assets to the fire-sale price. In order to avoid the liquidity crisis financial institutions should focus on the ratios like liquid assets to total assets and liquid liabilities to total liabilities (Goddard et al., 2009).

By holding very high quality liquid assets, a bank can improve the maturity transformation, as the high quality assets can be sold or pledged to meet the funding risk (Goodhart, 2008). A bank may have to increase its cash reserve to avoid the liquidity risk but it might be expensive in practice (Holmstrom & Tirole, 2000). An asset’s liquidity should be based on its capacity to generate the liquidity instead of its trading book classification or its accounting treatment (CEBS, 2008). CEBS further emphasizes that a liquidity buffers, composed of cash and liquid assets, must be sufficient to allow a bank to weather liquidity stress in a “survival period.”

Moreover, to overcome problem of liquidity, central bank imposes the condition of cash reserve requirement (a least amount which a bank has to keep with it in all circumstances). A bank always tries to avoid the capital injection from the government because this put a bank at government’s mercy (Jeanne & Svensson, 2007) and always keep up a minimum amount of cash in its account in order to avoid the liquidity problem (Jenkinson, 2008).

According to Gatev & Strahan (2003), deposits give a natural hedge to banks against the liquidity risk. In a period of market stress when the investors tend to draw funds from their loan commitments, the banks are perceived as a safe haven by these investors. The cash flows in any bank complement each other. The inflows of funds give a natural hedge to banks for outflows due to loan advancements. Therefore a bank use the deposits to hedge the liquidity risk. This argument also finds support from the work of Kashyap et al. (2002) who give a risk management rationale to define the features of a commercial bank, namely a financial intermediary combining demand deposits with loan commitments.

According to the risk management principle, an intermediary should pool the depositors and borrowers together as long as there is no high correlation between the demands for liquidity by these two classes of customers (Gatev & Strahan, 2003). This will help the bank to safeguard its need to grasp costly liquid assets – providing a buffer against the deposit withdrawal and loan take downs.

One potential countermeasure to liquidity pressures is to transform illiquid assets into cash. In the events of increased funding pressures, a number of banks plan to use securitization techniques more intensively to liquefy assets such as mortgages (Jenkinson, 2008). Faced with restrictions on raising liquidity, a bank must respond to a funding shortfall by acting on the asset side of its balance sheet to lower its financing need: in other words, by slowing or even reducing its lending to households and corporate customers (Goodhart, 2008; Jeanne & Svensson, 2007; Kashyap, Rajan, & Stein, 2002).

Ali (2004) has described two major drawbacks of this policy despite of its ability to aid funding pressures and boost liquidity. The first is that this strategy needs time to be effective. Many of lending decision are taken in advance and are difficult to be reversed instantly. So this will not generate liquidity drainage rapidly. The second drawback of this policy is that restricted lending will affect a large part of the economy. In the non-availability of funds to companies and households, it will be difficult to support long-term investment and consumption in the economy.

Liquidity risk and performance of banks

Liquidity problems may affect a bank’s earnings and capital and, in extreme circumstances, can cause a collapse of an otherwise solvent bank (Central Bank of Barbados, 2008). When a bank has liquidity problem, it will have to borrow from the market even at a very high rate to meet the demands of depositors. The bank’s expenses may go high enough due to this which causes a significant decline in bank’s earnings. Moreover bank’s further borrowing, for the purpose of meeting the demands of depositors, may put the bank’s capital at stake. Debt/equity ratio will rise affecting the bank’s effort to maintain optimal capital structure.

Liquidity risk may cause the fire sale of the assets by the bank (Diamond & Rajan, 2001; Falconer, 2001). This fire sale of assets by the bank rapidly spill over into impairment of bank’s capital base (Falconer, 2001). This fire sale risk arise from the need for institutions selling large positions in illiquid assets (perhaps in order to reduce leverage in compliance with capital-adequacy requirements) to offer price concessions in order to attract buyers, with knock-on effects for the balance sheets of other institutions obliged to mark their assets to the fire-sale price (Goddard et al., 2009).

Diamond and Rajan (2001) also states that a bank may refuse lending, even to a very potential entrepreneur, if it feels that the liquidity need of the bank is very high which is the opportunity lost for the bank. If a bank is unable to meet the requirements of demand deposits then there can be a bank run (Diamond & Rajan, 2005). No bank invests all of its resources in profitable long term projects; many of the investment resources are invested in short term liquid assets to have buffer against the liquidity shocks (Holmstrom & Tirole, 2000). Diamond and Rajan (2005) emphasize that a mismatch in depositors demand and production of resources forces a bank to produce the resources at a higher cost.

Liquidity has a greater impact on the tradable securities and portfolios and the liquidity refers to a loss emerging from liquidating a position (Zheng & Shen, 2008). From a marketing perspective, it is very important for a bank to be aware of its liquidity position to expand its customer loans in case of emergence of attractive opportunities (Falconer, 2001). With a liquidity problem, many of market opportunities are lost by the bank putting it at a competitive disadvantage, as those opportunities are captured by the competitors.

Due to the liquidity problems, Pakistani banks faced a great difficulty in lending to private sector during the year 2008 causing loss of a number of opportunities (SBP, 2010). One of the major causes of these liquidity problems were the heavy financing to government. Government has heavily relied on the banking sector as a source of funding in Pakistan.


Liquidity risk is a very important dynamic of banking sector and should be taken in consideration by the management while devising the strategies of bank. The past literature shows that researchers have been less focused on this risk. The major areas of their interest in risk management have been credit risk and market risk. Banks are considered as the providers of liquidity but it will be very undesirable situation if they become the users of liquidity (Clementi, 2001).

Most of the banks have focused on the liability side for the liquidity risk but it may also emerge from the asset side of the banks. If banks have more exposure in long-term investment, it will be difficult for them to liquidate their investment in the time of a liquidity crunch. Most of the researchers (Gatev & Strahan, 2003; Diamond & Rajan, 2005; Plochan, 2007; Goodhart, 2008; Crowe, 2009) have taken liquidity risk only as a mismatch between assets and liabilities. They have focused on the maturity transformation only.

The liquidity risk is more than a mismatch of assets and liabilities. There are several internal or external and micro or macro factors, contributing towards the liquidity risk. Researchers also need to study these factors that significantly contribute to liquidity risk. A liquidity risk can arise due to large loan disbursements and more commitment based lending. Large withdrawal of deposits can also lead to the liquidity crisis for a bank. A very important factor that affects the liquidity position of any bank is the poor production of resources in the economy. When there will be no production of resources in the economy, depositors will not only start withdrawing their deposits but loan retirement process will also be slow down. This will cumulatively cause a bank to face serious liquidity problems.


Liquidity risk has attracted significant attention of the researchers and the risk professionals alike after the major banking crises in recent times. Liquidity risk may have devastating effects on a bank that may also cause a bank run (Diamond & Rajan, 2005). This risk stems from description of banking operations (Chaplin, et al., 2000). It can affect the overall capital and earnings of the bank in an adverse way. The bank may face serious consequences if it is not properly managed. Now the banks and the regulatory authorities are becoming increasingly vigilant to the liquidity positions.

The deposits are the life line 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 & Svensson, 2007; Kumar, 2008) forcing the bank to borrow funds from the central bank or the interbank market at higher costs (Diamond & Rajan, 2001). On the contrary, a bank having adequate deposits in their accounts will not have the above said problems. Therefore, to increase its profitability it is very necessary for a bank to increase its deposits.

H1: Increase in deposits boost up the earnings of the bank.

Every bank tries to keep up adequate funds to meet the unexpected demands from depositors (Majid, 2003) but maintaining the cash is very expensive (Holmstrom & Tirole, 2000). The banks maintaining high cash reserve may not only lose a number of opportunities in the market but also have to bear high cost associated with cash.

H2: Increase in cash reserves decrease the earnings of the bank.

One of the prime causes of liquidity risk is the maturity mismatch between assets and liabilities. In a banking business most 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 mismatch between assets and liabilities (Central Bank of Barbados, 2008; Brunnermeier & Yogo, 2009). This mismatch can be measured with the help of maturity gap between assets and liabilities (Falconer, 2001; Plochan, 2007). This is also called liquidity gap (Plochan, 2007). Higher liquidity gap will cause liquidity risk (Plochan, 2007; Goodhart, 2008; Goddard, et. al., 2009).

H3: Increase in liquidity gap causes a reduction in bank’s earnings.

Many of the banks focus on the corporate or wholesale lending which has created a challenge for the management to uphold the required liquidity situation (Akhtar, 2007). This corporate or wholesale lending is long-term, which may create liquidity problems for a bank (Kashyap, et al., 2002). In the periods of poor production of resources in economy, banks will have the problems of slowing down of loan retirement which may give birth to increased NPLs. In a scenario of increased NPLs, liquidity crisis will be inevitable.

H4: High provisioning for NPLs will cause a decrease in bank’s earnings.

The researchers have developed the following hypothesized model.


Data Type

This is a secondary data base study.

Sources of Data

Preliminary data has been gathered through digital library and other libraries. A number of journals, thesis and research papers have been studied to prepare the literature review. The data for the analysis has been collected from the reports of the banks in Pakistan. The researchers have conducted some unstructured interviews from risk managers of different banks to give recommendation for the mitigation of liquidity risk.

Unit of Analysis

Unit of analysis in this study is organization.

Nature of Data

The data for analysis has been taken from the annual reports of banks in Pakistan. The time period selected for the data is 2005-2009. The nature of data is panel data i.e. combination of time series and cross-sectional data.


To check the empirical associations between liquidity and performance of the banks, researchers have used a representative sample of private and public sector banks as well as local and international banks in Pakistan. The banks that have been used as samples are as follows:

Allied Bank Ltd.

Askari Bank Ltd.

Bank Al-Falah Ltd.

Habib Bank Ltd.

Habib Metropolitan Bank Ltd.

MCB Bank Ltd.

National Bank of Pakistan


United Bank Ltd.

The balance sheets, incomes statements and their notes have been studied to get the data for the variables mentioned the model developed by the researchers. All the taken values for selected variables are in Pak Rupees. The dimensions of these variables are as follows:

Deposits: Deposits accounts are the accounts of the customer in banks. The data for deposits has been taken from the liability side of balance sheets without any classification of current or other types of deposit accounts.

Cash: The data for the cash has been taken from assets side of balance sheets of banks. This includes “cash and balance with treasury bank” only. “Accounts with other banks” have not been incorporated in cash.

Liquidity Gap: The data for liquidity gap has been obtained from the table of maturity of assets and liabilities. The researchers have taken the liquidity gap for one month, as a bank may need to fulfill the demand of a depositor and if it will have a negative gap in one month, there can be a serious problem of liquidity risk.

NPLs: Non-performing loans affect the performance of a bank adversely. The researchers have taken the provisioning for NPLs from “profit and loss statement” of banks, for the analysis in this study.

Profitability: profitability has been taken from the “profit and loss statement” of banks. This profit is profit before taxation (PBT), as banks have different tax shields.

Data has been collected from aforesaid banks to produce relationship between the liquidity risk and performance of the banks. After gathering all the relevant data, this data has been examined with the help of Eviews. The researchers have taken the log of all variables to smoothen the data. After that researchers have applied the tests of normality and then multiple regressions has been applied to test the relationship of variables.


The data in this study has been taken from the annual reports of 9 banks for the last 5 years i.e. 2005-2009. The researchers have applied multiple regressions to test the model. The researchers have taken the log of all series to make the data smooth. Before model testing, researchers obtained the descriptive statistics to check the normality of data to fulfill the requirements of regression.

Table I: Descriptive Statistics






























 Std. Dev.




































Table 1 is showing the descriptive statistics for the all the series. Skewness and Kurtosis are within the acceptable ranges. Overall the descriptive statistics is showing a normal distribution of the data. So the primary assumption of regression i.e. normality of data has been met and now regression can be applied to the data. Researchers also run the ADF test to check the unit root in data and found no unit root in the data. This proves the data is stationary.

In order to test the model and interpret the relationship of variables, the researchers have run multiple regressions. The results of multiple regressions are as follows:

Table II: Multiple Regression



Std. Error






























    Mean dependent var


Adjusted R-squared


    S.D. dependent var


S.E. of regression


    Akaike info criterion


Sum squared resid


    Schwarz criterion


Log likelihood




Durbin-Watson stat




Dependent Variable: LOG_PROFIT

The Table 2 is showing the results of regression. This table is showing an R2 of 0.749 that shows 74.9% variability in profitability accounted for by the developed model. The is an improved estimation of R2 in the population. The value of adjusted R2 is 0.724 in table 2. Use of this adjusted measure leads to a revised estimate i.e. 72.4% of the variability in profitability of banks due to the fitted model as shown in table 2.

Table 2 is also providing the value of F-test for the null hypothesis that none of the factor of liquidity risk is related to performance rating, or in other words, that R2 is zero. Here the null hypothesis is rejected (F (5) = 29.855, p < 0.05), and so it is concluded that at least one of factors of liquidity risk is related to profitability of banking sector. As p < 0.05 so the model is fit and it is assumed that there is a strong regression between factors of liquidity risk and profitability of banking sector.

The estimates of the regression coefficients, standard errors of the estimates, t-tests and p values are also shown in table 2. The estimated regression coefficients are given under the heading of “Coefficients”. These give, for each of the independent variables, the predicted change in the dependent variable when the independent variable is increased by one unit conditional on all the other variables in the model remaining constant. It can be estimated that there would be 3.86 degree positive change in profitability of banking sector as a result of one degree change in deposits of banking sector. The t statistic for this coefficient is 3.15189 i.e. significant. The p value for this coefficient is .0031, so we accept the H1 with a 99.69% confidence level. As the bank’s deposits will grow, it will help the banks to increase their profitability (Diamond & Raja, 2001; Jeanne & Svensson, 2007; Kumar, 2008).

H1: Increase in deposits boost up the earnings of the bank. (Accepted)

Similarly, profitability of banking sector is decreased by 2.3% with a one unit increase in cash and vice versa. So there is a negative relationship between cash and profitability of banking sector but the t value for this coefficient is -0.024531 i.e. not very significant and p = 0.9806. So the hypothesis H2 is rejected on the basis of t statistics.

H2: Increase in cash reserves decrease the earnings of the bank. (Rejected)

The coefficient of liquidity gap is -0.2778 which means there will be a 27.78% negative change in profitability of banking sector due to one degree change in liquidity gap. Its t statistics and p values are also significant i.e. -2.0817 and 0.0438 respectively. The liquidity gap is showing the maturity mismatch between assets and liabilities so larger liquidity gap will be affecting the performance of banking sector in a negative direction (Plochan, 2007; Goodhart, 2008; Goddard, et. al., 2009). The H3 is accepted with a 95.62% confidence level.

H3: Increase in liquidity gap causes a reduction in bank’s earnings. (Accepted)

The coefficient of NPLs is -1.026072 meaning a 1.026 degree negative variation in profitability due to one degree change in NPLs. The t-statistics for the same is -4.900463 i.e. very significant and p = 0.0000. The increase in NPLs causes a reduction in profitability of banking sector (Kashyap, et al., 2002). H4 is also accepted.

H4: High provisioning for NPLs will cause a decrease in bank’s earnings. (Accepted)

Structural model of the estimates is as follows:

The above results and discussion shows that all factors of liquidity risk, except cash, have a significant impact on the performance of banking sector. An increase in deposits will help the bank to increase its profitability. Bank will not have to rely on central bank or repo market to meet the demands of other depositors. Moreover the bank will be able to make use of this depositor’s money in a productive way.

Increase in liquidity gap and NPLs has a negative effect on the profitability of bank. In case of high liquidity gap, the banks may have to borrow from the repo market even at a higher cost which will increase the cost of bank. This increase in cost will ultimately affect the performance of banking sector.

High provisioning for NPLs will also cut down the profitability of banking sector. If a large number of loans are going to be provisioned in NPLs, there will be reduction in the profitability of banking sector.


Researchers openly acknowledge the limitations/weaknesses of this research.

The researchers have only focused a few banks of Pakistani Banking sector. Future research can be carried out by taking a larger sample.

The obtained data is for a short period of 5 years i.e. 2005-2009.

Researchers have not taken in consideration the economic factors creating liquidity problems. The future researchers can also take in consideration these factors while studying liquidity risk.

Researchers have not made a comparison between the different types of banks. Future researchers can also undertake comparative study e.g. public and private banks, national and international banks etc.

During the current study, researchers have not incorporated other measure of performance except earning of bank. Future researchers can also take in consideration the financial as well as non financial measures of performance.


The researchers have made the following recommendations on the basis of unstructured interviews with the CROs of different banks.

Few banks attempt to carry more cash in their reserves to meet the liquidity risk that affects the performance of bank as cash is always expensive. Banks should try to keep up more liquid assets other than cash.

Banks should not take very large exposure in the long-term assets.

Banks should continuously monitor the economic indicators to forecast the demands of depositors.

Special attention should be given to avoid the maturity mismatch between assets and liabilities.

Liquidity situation should be periodically monitored by the management of a bank.


Liquidity problems may adversely affect a given bank’s earnings and capital. In extreme circumstances, it may cause collapse of an otherwise solvent bank. When a bank has liquidity problems, it borrows from the market at high costs to meet the demands of depositors. Due to this liquidity problem, bank’s expenses may go high enough which causes a significant decline in its earnings. Moreover, bank’s further borrowing, for the purpose of meeting the demands of depositors, may put the bank’s capital at stake.

Liquidity risk may cause the fire sale of the assets by the bank. This fire sale of assets by the bank rapidly spills over into impairment of bank’s capital base. This fire sale risk arises from the need for institutions selling large positions in illiquid assets to offer price concessions to attract buyers, with knock-on effects for the balance sheets of other institutions obliged to mark their assets to the fire-sale price.

Liquidity has a greater impact on the tradable securities and portfolios of the banking system. For simple understanding, it refers to a loss emanating from liquidating a given position unexpectedly at an inappropriate time. From a marketing perspective, it is necessary for a bank to be aware of its liquidity status in all time buckets in order to position itself and expand its customer loans to capitalize profitable ventures. With liquidity problems, large numbers of market opportunities are lost by the banks putting them at a competitive disadvantage, as those opportunities are captured by the competitors. So it is the utmost priority of a bank management to pay due attention to the liquidity problems. These problems should be promptly addressed and immediate measures should be taken otherwise bank may face serious consequences.

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