Liquidity Risk and Performance of Banking System

Abstract

Purpose – The purpose of this paper is to examine liquidity risk in Pakistani banks and evaluate the effect on banks’ profitability.

Design/methodology/approach – Data are retrieved from the balance sheets, income statements and notes of 22 Pakistani banks during 2004-2009. Multiple regressions are applied to assess the impact of liquidity risk on banks’ profitability.

Findings – The results of multiple regressions show that liquidity risk affects bank profitability significantly, with liquidity gap and non-performing as the two factors exacerbating the liquidity risk. They have a negative relationship with profitability.

Research limitations/implications – The period studied in this paper is 2004-2009, due to availability of the data. 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 paper.

Originality/value – This is the first paper addressing the liquidity risk faced by the Pakistani banking system. Past researchers and practitioners have not given the proper attention to liquidity risk. This paper helps in understanding the factors of liquidity risk and their impact on the profitability of the banking system. The authors emphasise contemporary risk managers to mitigate liquidity risk by having sufficient cash resources. This will reduce the liquidity gap, thereby reducing the dependence on repo market.

Keywords: Pakistan, Banks, Risk management, Liquidity risk, Non-performing loans, Liquidity gap, Risk mitigation, Bank performance