In the recent financial crisis, liquidity was a very important and influential factor. As uncertainty led funding to vanish, various banks found themselves in a position whereby they were short of cash to pay back their debts when they fall due. In some cases, banks in various countries became bankrupt or were forced to mergers like for example, Countrywide Financial which was acquired by Bank of America. Therefore, in order to have financial stability, large amounts of liquidity were provided by authorities in various countries. After the crisis repercussion, banks had not fully appreciated the significance of liquidity risk management and the implications of such risk. As such policymakers have advocated that banks must hold more liquid assets than in the past so as to be more secure against potential liquidity problems. This has led to the Basel Committee on Banking Supervision (BCBS 2010) to set standard for liquidity risk. However, as liquid assets like cash and government securities have low return by keeping them, bank imposes an opportunity cost on them. If there is no regulation, banks will hold liquid assets to certain amount so as for them to maximise profitability and this give les to liquidity risk to rise.
1.2 Definition of liquidity risk
Liquidity risk can be said to be "the risk of insufficient liquidity for normal operating requirements, that is, the ability of the bank to meet its liabilities when they fall due. A shortage of liquid assets is often the source of the problems, because the bank is unable to raise funds in the retail or wholesale markets".
Source: Heffernan, S (2005) Modern Banking: John Wiley & Sons, Ltd
"A bank's liquidity risk refers to a comparison of its liquidity needs for deposit outflows and loan increases with the actual or potential sources of liquidity from either selling an asset it holds or acquiring an additional liability."
Source: Hassan, R. (2006) The performance of Pakistani Islamic Bank. Mohammad Ali Jinnah Universty, Islamabad.
The Bank of Mauritius, regulator of the Local Banking sector define liquidity risk as "the risk of financial loss to a bank arising from its inability to fund increases in assets and/or meet obligations as they fall due without incurring unacceptable cost or losses. For a bank's trading activities, it is the risk of not being able to meet its payment obligations on settlement date. Inability to access sufficient funds to meet liabilities can necessitate liquidation of assets at short notice, which normally results in divestment at significantly discounted prices," from Guideline on Liquidity Risk Management 2009.
1.3 Significance of Liquidity Risk Management
One of the most important risks which a bank needs to manage is liquidity risk. This risk can be very harmful to any bank or organisation and by not managing it well it may led to sever negative consequences, for instance, bank runs (large number of customers withdraw their deposits as they believe the bank might fail) might take place. This may lead to bankruptcy as bank will have to access large amount of funds quickly in order to be able to give pay back customers. Consequences of poor management of liquidity risk can be so drastic that local and international supervisory committees continuously seek for solution and ways to tackle this risk. Somehow, a poor management will also affect profit as if bank runs occur banks will have to give away large amount of cash which could have been use to generate more profit. There are various methods which can be used in order to manage liquidity risk. These are: Assets and Liabilities management, Maturity Matching, contingency planning of funding sources.
1.4 Liquidity issue in Mauritius
In Mauritius each bank is expected to plan their own strategy and regulation to manage risks which exist in the banking sector. However, there has been guideline on liquidity risk management which have been issued by the Bank of Mauritius and the Basel Committee so as for other bank to be able to use as model for their policies.
1.5 Aim and objective of the dissertation
The aim and objective of this dissertation is to examine the relationship between liquidity and profitability at the 2 chosen banks in Mauritius that is: The Mauritius Commercial Bank Ltd (MCB) and State Bank of Mauritius Ltd (SBM).
1.6 The Structure of the Dissertation
The remaining part of the dissertation is as follows:
Chapter Two deals with the literature review which provides an overview of liquidity risk and highlights the previous research that focussed on the possible relationship between liquidity and profitability of banks. The literature review is comprised of theoretical and an empirical evidence concerning the subject.
Chapter Three is about the methodology. This chapter is focussed on the methods employed to calculate the required data to analyse the effect between liquidity and profitability of the selected bank (MCB and SBM).
Chapter Four, entitled Analysis and Finding deals with mainly commenting on the results obtained after having gone through the regression process. The findings are discussed and an idea is formed as per the results recorded.
Chapter Five which is Conclusions and Recommendations is about the concluding comments that are formed after having studied the results obtained and a general opinion is shaped.
CHAPTER 2: REVIEW OF THE LITERATURE
2.1 Definition
Liquidity risk can be said to be the risk of financial loss to a bank arising from the probability that the bank will fail to meet its commitment and debts when they fall due because of not being able to have sufficient fund or to sell an asset at its highest price. These commitments can be in the form of outflows of cash like withdrawals and loans. Therefore, in order to operate smoothly bank should ensure that they have enough liquidity to meet current and future demand.
2.2 Origin of liquidity risk
"Liquidity transformation is considered by many to be the preeminent function of commercial banks, the primary source of their vulnerability to risk and the paramount justification for their protection through a public safety net in the form of deposit insurance. The fundamental task of liquidity transformation − accepting short-term, liquid deposits and making longer-term, illiquid loans, directly affects the successful channelling of savings to investment and hence plays a crucial role in facilitating production." Akash and Guido Schaefer (May 2004).
Banks cannot eliminate liquidity problems from their activities and as they are financial intermediaries, they move fund from the surplus unit to the deficit unit. Those characterise as surplus units would more likely save their money and have it back when they want it, on the other hand, the deficit units prefer to borrow big amount of money at once and to have longer time to settle their debts. However, banks assume that not all depositors will withdraw their whole amount of saving at the same time. Therefore, bank will keep only a certain amount of funds for its everyday use and invest the rest or give away as loan where it can gain from interest which will be paid by those who take loans.
Banks most profitable assets are mostly in illiquid states whereas the liabilities are very liquid. As banks are of profit marking organisation and because of the type of business they perform, liquidity risk cannot be completely eliminated. Therefore, banks try to minimise liquidity risk and at the same time try to gain maximum return
2.3 Sources of liquidity risk
Liquidity risk arises from the nature of banking activities, from the macro factors that are external to the bank and also from the financing and operational policies that are internal to the banking organisation.
Banks provide maturity transformation that is take deposits that can be withdrawn anytime or that has a shorter maturity than the maturity of the financing agreements that they sell. While maturity transformation provides liquidity insurance to the depositors, it exposes banks to liquidity risk. Since banks specialize in maturity transformation they take pool deposits and take care to match their cash inflows and outflows in order to deal with the liquidity risk that they face.
Somehow, maturity mismatch is not the only source of liquidity risk. Liquidity risk can occur in many ways due to various factors like:
Inappropriate decision or complacent attitude of the bank towards timing of its cash inflows and outflows.
In the sense that the timing of the cash flows can be predicted, the liquidity risk can be controlled. But gradually, banks are getting involved in giving contingent credit and liquidity facilities to borrowers whose source of funding mainly lies elsewhere in the capital markets and who only turn to banks in contingencies. Therefore, the bank decision on cash outflows can become bias. More, participation of banks in the derivative products with collateral requirements increases the opportunity of large amounts of contingent calls for cash or security.
Unanticipated change in the cost of capital or availability of funding.
This come from the unanticipated difference in the realized and expected availability of funding, marketability of its assets or their use as collateral in raising funds, and the amount of haircut anticipated. This can take place due to causes general to the banking sector or specific to the bank. Sometimes a major bank, on which the smaller bank(s) rely on, would experience a credit squeeze or a rating downgrade thus, affecting the funds availability to the other banks.
Abnormal behaviour of financial markets under stress.
This is not in the control of a bank but however, it does have an impact for liquidity of banks. An adverse movement in the capital markets will change the availability of funds to the bank if it wants to raise it through them. Also dependence of the banks on whole sale markets compare to small depositors affects the composition of risk sensitive market savvy depositors in the depositor pool of the bank and these depositors are quick to move funds away from the bank at the first negative impact, therefore, increasing the probability of a 'run' on the bank or a liquidity problem.
Range of assumptions used in predicting cash flows.
This factor determines how much a bank is prepared to liquidity shocks. The larger the number of scenarios and range of assumptions for which a bank has stress tested its strategies against liquidity crisis the greater is the likelihood of smooth management of the risk.
Risk activation by secondary sources such as:
Business strategy failure.
Corporate governance failure.
Modelling assumptions.
Merger and accusations policy
Risk activation by secondary sources are the most difficult to predict. It occurs by secondary risk source. Some examples of these happenings are the collapse of General American in the 1999 and the Long Term Capital Management (LTCM). The former closed down as it concentrated on sort term tools for its funding needs and had relied lots on a few market sensitive institutional investors for its funding. Somehow, the problem started when another company which was providing re-insurance facility to it. In respond to this General American try to recapture the re-insurance portfolio thereby self-insuring its obligations and as soon as the rating of General American was downgraded due to its self -insurance approach, its investors started recalling their funds which in turn create liquidity problem for General American leading it to fail.
Breakdown in payments and settlement system.
The smooth running of the banking sector depends on sound operation of this system. A breakdown in payment and settlement system can cause liquidity problems for the entire banking and financial sector which can result in a financial crisis.
Types of liquidity Needs
2.4.1 The short-term or seasonal liquidity needs
The short-term or seasonal liquidity needs of a bank may occur from many sources. For instance, seasonal factor often affect deposit flows and loan demand. As loans are generally to deposit customers, seasonal increases in loans tend to take place when deposits are at seasonal lows and vice versa. For example, a bank in a farming community might find high liquidity needs whens its loan demand rises and its deposits fall in the spring to meet farmers' funding needs for planting and fertilizing crops. After the crops are sold in the fall, loans fall while deposits increase. Banks that depends a lot on one or few types of customers may find seasonal liquidity needs particularly important. Most seasonal fluctuation can be estimated on the basis of the past experience.
2.4.2 Cyclical liquidity needs
Cyclical liquidity needs of a bank are more difficult to access. These needs are often out of control of bank. For instance, economic recession or boom and interest rate movements, particularly when banks may be constrained from changing their own rates because of political pressure or regulation, can cause significant liquidity pressures. Furthermore, the timing of such cyclical pressures can be very difficult to predict. A bank that provides all potential cyclical liquidity needs would probably end up holding primarily low-earning liquid assets at the cost of significantly lower profitability.
2.4.3 Trend liquidity needs
Trend liquidity needs are required by banks for liquidity demands that can be predicted over a longer time period. These longer-term liquidity needs are generally related to the secular trends of the community or markets that a bank serves. In rapidly expanding areas, loans often grow faster than deposits. A bank in this particular situation needs sources of liquidity so as to provide funds for loan expansion. However, in stable community deposits may show a steady rise, while loans remain unchanged. In such cases, the longer the view of liquidity requirements may enable a bank to keep more fully invested than it otherwise would. In either case, bank's needs for longer-term liquidity, a bank's management must attempt long-range economic forecasting as the basis on which it can reasonably estimate loan and deposit level for the next year and may be for the five coming years.
2.4.4Contingent liquidity needs
Contingent liquidity needs are caused by unusual events that are difficult to forecast. Examples include an unexpected outflow of deposits caused by a rumour about the bank, an unusual increase in loan demand, or the closing of an extensively used funding source. By their very nature, contingency liquidity needs are impossible to forecast accurately. At the same time, every bank should have a plan (and most regulators require plan) to remain liquid in case some contingency does occur.
2.5 Consequences of liquidity risk on banks
Liquidity risk can have a very harmful impact on banks, if a bank for instance, is having a persisting liquidity problem it may have to sell its assets so as to be able to meet its liquidity problem. Bank customers will also prefer to remove their saving as for them the bank will go bankrupt and since bank work under a sequential system that is first come first serve, customers will rush to the bank so as to obtain their money back, this is called bank runs and when this will occur the bank will have to give back these customers saving, therefore, this might create more problems due to the bank already having liquidity problem it will have to find more funds in a short time.it is said that bank runs are contagious as it will affect the whole financial system.
2.6 Tackling liquidity problem
2.6.1 Identification
The first things bank should do is to identify the risk, once this is done the bank will be able to know about future liquidity shortage which might take place and also know about the techniques which will be convenient to deal with the liquidity problem.
2.6.2 Risk Management
After the identification process, the bank should measure the risk and in order to do so they can make use of various techniques which available and each technique are use in specific circumstances.
2.6.3 Management
After the above steps have been performed, liquidity problem must be managed. Banks should keep in consideration the fact that long run profit will be affected when they hold too much of low earning liquidity assets or too little liquidity and this can lead to financial problems. Therefore, by managing risk this does not mean to eliminate the risk but rather to find the right balance between risk and return. The main goal in managing liquidity is to reduce cost like for instance, the cost of losing clients if a bank recall back loan or selling an assets quickly which will lead to the firm facing forced sales risk. The best approach is to try to restructure the balance sheet in a way to reduce gap and suitable level of risk is reached.
2.6.3.1 Assets Liability Management (ALM)
The management of liquidity consists of raising fund in case of deficit and invest where excess of fund is available which mean it deals with assets and liabilities. Asset Liability Management (ALM) can be defined as a tool to deal with the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. One technique of ALM is for managers to buy, hold and sell assets and liabilities in order to keep a fixed level of liquidity, it helps funding, investing ad hedging issues to achieve a predicted balance between risk and return. The aim is to make higher profit as well as controlling risk.
The assets hold by banks are their liquidity and by increasing it this will be a precautionary measure for the bank as it will help to match unanticipated outflows of funds. Bond, treasury bills and other securities are also source of liquidity for bank; these assets can be bought and sold easily without any loss and therefore, relieve liquidity problem and they also bear small risk of non-payment. Banks would more likely to keep these assets as they will gain some return with it. Somehow, a bank with declining liquidity can still give loan and then sell it to another party to earn some revenue.
Liabilities on the contrary increases the debts of bank and also incurred direct cost. In order to deal with unexpected demand of cash banks can borrow from other banks, this is known as the interbank market and in this market borrowing and lending are done among bank only. Generally this is done for short term period and the borrowing is normally kept a very low rate.
In case a bank has anticipated liquidity risk, they can design special schemes to attract customers. There are different schemes which banks can use, they can increase saving rate on fixed deposit or the can issue Certificates of Deposits (CDs). Certificates of Deposits will attract savers and investors due to producing higher rate of interest than saving rates therefore, this can be really beneficial to a bank which is in need of liquidity. For instance, Sales of CDs will result in more funds and therefore, help to deal with liquidity problem.
2.7 Ways measuring liquidity risk
There are various methods for a bank to measure liquidity risk and each one of them are used in a specific situations.
2.7.1 Liquidity ratios
Banks can make use of various types of ratios so as to measure liquidity risk these ratios are as shown in table 1:
Table 1. Ratios for measuring financial risk in financial institutions
Ratio Name
Definition
Comment
Core deposits-to-assets
Availability of most stable used to finance assets
Liquidity assets to earning assets
Most liquid assets available to cover investment in earning assets
Net loans-to-deposits
Share of deposits locked into loans (most no liquid assets)
Net loans-to-core deposits
Share of loans supported by most stable funds
Net loan-to- assets
Share of assets allocated to the least liquid assets
Net noncore funding dependence
Dependence on funds that are volatile (noncore) net of liquid assets to fund earning assets
Securities maturing < 1 year
Securities with cash outflow in 1 year (minimum loss exposure); portion of assets
Source: Hempel, G.H & Simonson D.G. fifth edition (1999) Bank Management.
England: John Wiley & Sons, Ltd Page 258
However, these ratios do not take into consideration the dynamic nature of liquidity. The noncore funds dependence ratio is said to be more appropriate as it shows how dependant a bank is on volatile sources to finance its non-liquid earnings assets, after removing short-term investment.
Non-core funds dependence ratio =
According to the equation above non-core liabilities represent banks liabilities which are vulnerable to unexpected withdrawals and short term investment are those which can easily be converted into cash without incurring loss.
Liquidity ratio is another ratio which indicates liquidity position of a bank. As assets are used to fund liabilities, it is important that short term assets are more than short term liabilities. This means that liquid ratio should be kept above one. Banking business of borrowing short and lending long will inevitably reduce the liquidity ratio. A bank should invest in short term assets to match any decline.
Liquidity ratio is calculated as follows:
2.7.2 Maturity Ladder
Banks can also make use of maturity ladder so as to compare the future cash outflow of funds to the future cash inflows of funds. Cash inflows can be from matured assets, saleable assets and agreed credit lines whereas cash outflows include liabilities due and contingent liabilities. The cash inflows and outflow are place on the maturity ladder in respect of to their maturity and the net mismatched positions are cumulated.
Table 1 Liquidity Funding - Maturity Ladder Approach (£000)
Week 1 Week 2 Week 3 Week 4
Cash inflows 12 000 10 000 10 000 8 500
Assets (week they mature) 1 500 8 000 2 000 1 000
Sales planned 10 000 1 000 3 000 2 500
Agreed credit lines 500 1 000 5 000 6 000
Cash outflows 11 700 9 500 10 700 8 900
Liabilities due 7 000 3 000 9 000 4 000
Contingent liabilities (e.g. credit lines) 4 500 6 000 1 500 4 500
Unplanned cash outflows 200 500 200 400
Net funding needs −300 −500 700 400
Cumulative net funding needs −300 −800 −100 300
It is assumed that each week is 5 working days, and all sums are received on the last working day of each week (Fridays).
Source: Heffernan,S. (2005) Modern Banking England: John Wiley & Sons, LTD page 125
According to the table above the net funding needs for week 1, 2, 3, 4 are -300 000, -500 000, 700 000 and 400 000 respectively. A negative funding needs means that there is an excess of fund like we can see in week 1 and week 2. A positive net funding needs on the contrary means that funds are required as in week 3 and 4. However, bank will take into account only cumulative net funding needs as the closing balance of one week will become the opening of the next week. The differences between cash inflows and outflows at a given point in time are the starting point for determining the future liquidity excess or shortage. Maturity ladder is of great help to understand the trend in cash flows and also an effective way to monitor liquidity risk.
2.7.3 Liquidity Gap Analysis
Gap analysis is the differences between assets and liabilities at current time and in the coming future. Liquidity gap analysis is similar to maturity ladder for interest rate risk, but items from the balance sheet are placed on a ladder according to the expected time the cash flow (which may be an outflow or an inflow) is generated. However, gap can be either static gap which will consider all the assets and liabilities which are present on the balance sheet in the current time or dynamic gaps which will only consider the actual plus projected inflows and outflows. This method is one of the main techniques used to measure liquidity position.
2.8 Liquidity Risk Management in Mauritius
2.8.1 The Bank of Mauritius Act 2004
The Bank of Mauritius which is the regulator of the Mauritian Banking Sector has the duty to make sure that banks in Mauritius are taking the necessary measures so as to protect the interest of customers. The harmful impact of liquidity risk on the financial system of a country has led to its management to become a very important issue. Under section 22 which is Liquid assets of banks it is stated that all bank should keep in Mauritius, adequate and appropriate forms of liquidity and comply with any guidelines or instructions issued by the central bank in relation thereto and it also state that "The level of liquidity to be maintained by a bank may be expressed as a percentage of such of that bank's deposits and other liabilities, including contingent liabilities, as may be determined by the central bank, averaged on a basis to be fixed by the central bank." from the Mauritius Banking act 2004
However section 91 of the act also state that if the financial institution become insolvent it shall dispose its assets so as to be able to repay its deposit liabilities first. This is specified in the Companies Act 1984 that priority should be given to liabilities in the event of a winding up.
2.8.2 Guideline on Liquidity Risk Management
The guideline was issued by the Bank of Mauritius on October 2009. In the guideline it can be clearly seen what is expected from other banks to do for instance, the first part consist of the role of Directors and Managers as regard to policy establishment.
The next important part of the guideline is about the liquidity risk management framework. According to the framework a bank must maintain a good risk management framework so as to maintain enough liquidity. The procedure to do so is to set a liquidity risk tolerance, the liquidity risk tolerance must take into consideration the level of liquidity risk that the particular bank is ready and willing to assume and it must reflect the bank financial position and its funding capacity. According to the guideline a bank must have adequate systems in place so as to ensure that information on liquidity is continuously reviewed and known to the board of directors.
The guideline also highlighted that fact that contingency planning is also an important part as a good planning will enable a bank to withstand a liquidity crisis. The plan should be unambiguous, realistic, and flexible and it should also indicate the priority, duty and the management members.
2.8.3 Basel Committee on Banking Supervision
In February 2008 the Basel Committee has issued a paper named "Risk Management and Supervisory Challenges. The difficulties outlined in the paper were that many bank failed to understand a number of principles of liquidity risk management when liquidity was plentiful and this led to many firms to have a severe and prolonged liquidity disruption. The Basel Committee therefore, review its "Sound Practices for Managing Liquidity in Banking Organisation" which was issued in the year 2000 and provide more detailed guidance on various section on the previous paper. The paper put more emphasis on the importance of supervisors assessing the adequacy of a bank liquid risk management framework and its level of liquidity. The paper also suggest what steps should be taken in case of liquidity being inadequate. Somehow, principles that have been given by the Basel Committee are also reflected on the guideline issued by the Bank of Mauritius.
2.8.4 The Mauritius Commercial Bank (MCB)
The Mauritius Commercial Bank Ltd funded in 1838 is one of the oldest and biggest financial institution in Mauritius it has a local network of 40 branches and about 159 automatic teller machines. The MCB has always had a tradition of being a leader by adapting to changes and corporate values are aligned to maintain this position. It is firmly established as the leading bank in Mauritius and a key financial services institution in sub- Saharan Africa. Apart from playing an important role in the socio-economic development of the country, the MCB relied on its business model to embark on a sensible diversification strategy along with consolidating its domestic banking operations. The MCB is now established in Maldives, Seychelles, Madagascar and Mozambique through subsidiaries. Somehow MCB is also present in France, Reunion Island and Mayotte via its associated company that is Banque Française Commerciale Océan Indien. Mauritius Commercial Bank consist of a huge amount of shareholders (around 18,000) both local and foreign investors. At September 2010 MCB market capitalisation was around Rs 36 billion making it the biggest on the Stock exchange of Mauritius.
2.8.5 The State Bank of Mauritius (SBM)
State Bank of Mauritius was funded in 1973 and it was quoted on the Stock Exchange of Mauritius in the 1995 and is considered to be among the biggest companies on the Stock Exchange of Mauritius with a market capitalisation of Rs 29 billion at January 2011. The State Bank of Mauritius is a leading financial services institution in Mauritius with a raising international presence. It is owned by approximately 17,000 domestic as well as international shareholders, and it has more than 1,100 employees and services over 375,000 customers through its network which consist of 48 service units and counters in Mauritius, India and Madagascar.
2.9 Empirical Evidence
There has been certain empirical evidence on the impact of liquidity on profitability. Étienne Bordeleau and Christopher Graham (2010) studied the impact of liquidity on bank profitability for a panel of Canadian and United States banks over a period 12 years. They suggest that a nonlinear relationship exist between liquidity and profitability. They state that profitability is improved for banks that hold a certain amount of liquid assets. However, they found that there is a point at which further holding of liquid assets cause a decrease in bank profitability. Their result was consistent with the idea that funding markets reward a bank to a certain level for holding liquid assets, thereby reducing liquidity risk but they also find out that this benefit is offset by the opportunity cost of holding such a low yielding liquid assets.
Bordeleau and Christopher Graham also provide some evidence that the relationship between liquid assets and profitability depends on the banks business model and the risk of funding market difficulties. They state that by making use of a traditional business model will enable a bank to maximise profit with a low level of liquid assets. Similarly, when the funding market difficulties are low banks need to hold less liquid assets in order to gain more profit.
The paper also state that policymaker who devise new standards in establishing an appropriate level of liquidity for banks and helping to ensure stability for the overall financial system should take into consideration the trade-off between resilience to liquidity shocks and the cost of holding lower- yielding liquid assets. By holding liquid this will make banks more able to withstand liquidity shocks and therefore this will reduce the negative externalities that might be impose on other economic agents but somehow, holding too much will impose a cost in term of reduced profitability. However, the work of Étienne Bordeleau and Christopher Graham suggest that Canadian banks should have hold less liquid assets in the estimated period than did U.S. banks so as to maximise profits.
Mahshid Shahchera also studied the impact of liquidity asset on Iranian bank profitability also find out that there is a non-linear relationship between profitability and liquid asset holdings. He stated that profitability is improved for banks that hold some liquid assets but at a particular point holding further liquid assets will decrease a banks' profitability. In his research it was found that the coefficient of the deposit ratio is positive and highly significant which mean that a bank with more deposit is able to earn more profits. The coefficient of loan asset ratio is also positive which implies that banks with a high proportion of loans asset ratio have higher profit. Somehow, Mahshid Shahchera also found out that business cycle affect the profitability of a bank. Business cycles are estimated to have a positive impact on bank profitability this means that profitability exhibit pro-cyclical behaviour. It has also been find out that when regulators reduce the constraints impose on banks they are able to obtain more profit.As we can see from these research there do exist a relationship between liquidity and profitability.
CHAPTER 3: METHODOLOGY
3.1 Introduction
In this chapter will explain the research process and also the way that data collections were undertaken. It will also point out the limitations of the research based on such methodology.
3.2 Objective of Research
The objective of the research is to look at the impact of liquidity on profitability at the Mauritius Commercial Banks (MCB) and State Bank of Mauritius (SBM). As liquid assets bear less risk than long term assets it is clear that return will also differ. Liquid assets will eventually generate small amount of return compare to a long term assets. Therefore, logically a bank would prefer to hold a large amount of long term assets so as to increase its profit however, by so doing liquidity risk will also increase. This research work will bring evidence of the relationship between liquidity and profitability.
3.3 Sources of Data
For this research, secondary data will be used. Secondary data are data that already exist and gathered by someone else for specific purpose. The secondary data that was intensively used was the Annual Reports of the selected banks. Wiseman (1982) classified annual reports of listed companies among the most accessible source of information; be it in hard copies or electronic format. In this study all information was readily available in financial statement which is found in selected banks annual reports.
3.4 The Sample Size
The sample size taken consists of 2 major banks which are The Mauritius Commercial Bank and The State Bank of Mauritius. Their financial statements for the period 2007-2011 have been analysed in order to obtain data needed.
3.5 Research Hypothesis
Hypothesis testing is an arithmetic decision making process with regard to an uncertain hypothesis. The aim is to test the statistics to determine the possibility that a given hypothesis is accurate.
The hypothesis:
H0: Profitability is affected by liquidity.
H1: Profitability is not affected by liquidity.
3.6 Regression
"In general terms, regression is concerned with describing and evaluating the relationship between a given variable and one or more variables. More specifically, regression is an attempt to explain movements in a variable by reference to movement in one or more other variables"
Source: brooks C., Introductory Econometrics for Finance
To be able to attain the goal of the research, we will start with the following assumption: one of the factors of bank profitability is liquidity. The regression will be as follows:
Where;
Î is the Bank Profitability
β is the coefficient of interception
β1 is the slope
Lr is the liquidity ratio
3.6.1 Dependent Variable
Dependent variable is a variable which depend on other variables. In this regression the dependent variable is Profitability (Ï€). Return on Assets will be used as indicator for profitability. It indicates the efficiency with which management employed the total capital resources available to it.
Net income after tax can be obtained from the income statement in the annual report of banks whereas Average total Assets can be calculated as follows:
Return on assets will be suitable for this research as increasing the return on assets is usually done at an expense of liquidity level.
3.6.2 Independent variable
An independent variable is a variable which can be changed at will which explain or control the dependent variable. The independent variable for this study is liquidity ratios. The work will consist of three different regressions with three different liquidity ratios.
Current Ratio
Current ratio is the first ratio to be used; it indicates the extent to which the claims of short-term creditors are covered by current assets. It is calculated as follows:
Current assets are the summation of cash resources, securities and investment and loans whereas current liabilities are the summation of the deposit, borrowing and other liabilities. A high current ratio means a high margin of safety.
Quick Ratio
Quick ratio can be calculated as follows:
The assets taken on this study are cash resources, investment and securities with maturity less than three month and loan and advances maturing with three month. Current liabilities are the summation of demand deposits, savings deposits , time deposit ( less or equal to 3 months), borrowing and other liabilities (less or equal to3 months).
Non-core funds dependence ratio
Non-core funds dependence ratio can be calculated as follows:
Non-core liabilities are given by the total of all liabilities which have a maturity of less or equal to 3 months, demand deposits and saving deposits. Earning assets consist of loan, investment and securities and short term investment consist of assets which maturities are within three months.
3.6.3 Disturbance Term
In the equation , the term of disturbance is µ. µ represent all omitted factors that can have an impact on Ï€. This is done because some determinant of the dependent variable maybe unavailable or immeasurable.
3.7 Analysis Methods
The three regressions which will be use are:
--------- Equation 1
--------- Equation 2
------- Equation 3
Where:
ROA is Return on Assets
β is the intercept coefficient
β1 is the coefficient of the slope
CR is Current Ratio
QR is Quick ratio
NCDR is Non-Core Dependence Ratio
µ is the error term
3.7.1 Chosen Software
The software chosen to perform the regressions of the study is Econometric Views (EViews). It is an econometrics software package which provides tools which are most frequently used in practical econometrics. There are many tests that can be made by using EViews, for instance, Ordinary Least Square (OLS). However, it is not the Best Linear Unbiased Estimator (BLUE). Other test can also be performed by making use of this software like for instance, multicollinearity and autocorrelation. These are important test that can be done but however, as we are only considering one independent these tests are useless.
3.8 Limitation of Study
According to the study different liquidity ratios are used for the regression. Somehow, as mention previously liquidity ratio are not the best method for this measurement as it is based on past information and also that the ratios obtained might not be accurate. A better test would have been the gap analysis but due to lack of information the best alternative was to make use of ratios.
On the other hand, profitability on the other hand can be affected by many other factors rather than liquidity like for example, assets utilisation. The disturbance term in the regression will capture all other factors apart from liquidity which may affect the Return on Assets (ROA)
Another limitation is that certain information are not available like three month maturity are used for liquid assets whereas according to the Guideline of liquidity a liquid asset is said to have a maturity of up to 30 days.
CHAPTER FOUR: ANALYSIS AND FINDINGS
4.1 Introduction
In this chapter, the focus will be on the effect of liquidity ratios on the profit of selected banks. A least squares regression analysis will be used to measure the link between profitability and different liquidity ratios.
4.2 Result and Discussion for Mauritius Commercial Bank
4.2.1 Relationship between Return on Assets and Current Ratio at Mauritius Commercial Bank (MCB)
Table : relation between ROA and CR
Dependent Variable: ROA
Method: Least Squares
Date: 10/27/12 Time: 13:36
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
0.080688
0.042066
1.918118
0.0914
CR
-0.055672
0.039636
-1.404601
0.1978
R-squared
0.197826
Adjusted R-squared
0.097555
F-statistic
1.972903
Prob(F-statistic)
0.197756
Return on Assets = 0.0806688 - 0.055672 (Current ratio) ------ equation 1
From the above equation it can be deducted that Current Ratio for MCB has a negative relationship with Return on Asset, this mean that they will cause a decrease of 0.055672 units in Returns of Asset and that a decrease of 1 unit of Current Ratio will increase Return on Asset by 0.055672. However, this equation does not explain much about liquidity as it consider all earnings that is both liquid and non-liquid assets
The constant term β
From the above regression we can see that the minimum return on asset is equal to β that is 0.086088.
The R Squared (R2)
The R2 is the coefficient of determination and it measures the goodness of fit of the model. It shows what fraction of the total variation in financial performance is explained by the model. R2, of necessity, lies between 0 and 1 and the closer it is to 1, the better is the fit. As we can see in the regression is 0.197826, which means that almost 20% of the variations in Return on assets can be explained by the variation in Current Ratio.
The F- Statistic
This tests the hypothesis that all the slope coefficients are simultaneously zero that is all the regressors mutually have no impact on the regress and. It studies whether the explanatory variables are significant or not. The F-statistic measures the joint power of the test undertaken and indicates whether the variables included are relevant to the model or not.
4.2.2 Relationship between Return on Assets and Quick Ratio at Mauritius Commercial Bank (MCB)
Table X relation between ROA and QR
Dependent Variable: ROA
Method: Least Squares
Date: 10/28/12 Time: 01:39
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Î’
0.041876
0.007636
5.484433
0.0006
QR
-0.028102
0.010528
-2.669397
0.0284
R-squared
0.471098
Adjusted R-squared
0.404986
Return on Assets = 0.041876- 0.028102 (Current ratio) ------ equation 2
From tabe X it can be deducted that there is a negative relationship between Return on Assets and quick ratio. An increase in Quick Ratio of 1 unit will lead to a decrease in Return on Assets by 0.028102. However, a decrease in Quick Ratio of 1 unit will increase Return on Assets by 0.028102. From the above regression we can also state that maximum Returns on Assets is gained at the expense of liquidity and in order to increase its profit MCB would prefer to invest in non-liquidity earnings assets compare to holding more liquid assets.
The constant term β
The minimum return on asset, given that there is no change in quick ratio is equal to β that is 0.041876.
The R Squared (R2)
The R2 is 0.471098, which means that almost 47% of the variations in Return on assets can be explained by the variation in Current Ratio.
4.2.3 Relationship between Return on Assets and Non-core Funds Dependence Ratio at Mauritius Commercial Bank (MCB)
Table X relation between ROA and NCDR
Dependent Variable: ROA
Method: Least Squares
Date: 10/30/12 Time: 03:18
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Î’
0.086779
0.036074
2.405570
0.0428
NCDR
-0.074127
0.047234
-1.569344
0.1552
R-squared
0.235389
Adjusted R-squared
0.139813
Return on Assets = 0.086779 - 0.074127 (non-core funds ratio) ------ equation 3
As we can see there exist a negative relationship between Return on Assets and Non0core Funds Dependence Ratio. 1 unit increase in Non-core Funds Dependence Ratio will induce an increase of 0.074127 in Return on Assets. However, it is also interesting to know that a decrease in Non-core Funds Dependence Ratio is an indicator of good liquidity management and Return on Assets should also have decrease.
The constant term β
From the above table we can also deduct that the minimum Return on Assets when Non-core Funds dependence Ratio tends to zero is 0.086779.
The R Squared (R2)
The regression is 0.235389, which means that 24% of the variations in Return on assets are explained by the variation in Non-core Funds Dependence Ratio.
4.3 Result and Discussion for State Bank of Mauritius
4.3.1 Relationship between Return on Assets and Current Ratio at State Bank of Mauritius (SBM).
Table X relation between ROA and
Dependent Variable: ROA
Method: Least Squares
Date: 10/30/12 Time: 06:37
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Î’
0.113549
0.206885
0.548853
0.5981
CR
-0.075358
0.187384
-0.402159
0.6981
R-squared
0.019816
Adjusted R-squared
-0.102707
Return on Assets = 0.113549 - 0.075358 (Current ratio) ------ equation 1
From the above equation it can be deducted that Current Ratio for SBM has a negative relationship with Return on Asset, this mean that 1 unit increase in Current Ratio will cause a decrease of 0.075358 units in Returns of Asset and that a decrease of 1 unit of Current Ratio will increase Return on Asset by the same amount.
The constant term β
From the above regression we can see that the minimum return on asset is equal to β that is 0.113549.
The R Squared (R2)
The R2 is the coefficient of determination and it measures the goodness of fit of the model. It shows what fraction of the total variation in financial performance is explained by the model. R2, of necessity, lies between 0 and 1 and the closer it is to 1, the better is the fit. In the case of SBM we can see in the regression is 0.019816, which means that almost 20% of the variations in Return on assets can be explained by the variation in Current Ratio.
4.3.2 Relationship between Return on Assets and Quick Ratio at State Bank of Mauritius (SBM)
Table X relation between ROA and
Dependent Variable: ROA
Method: Least Squares
Date: 10/30/12 Time: 06:46
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Î’
0.047380
0.012295
3.853563
0.0049
QR
-0.026915
0.018838
-1.428780
0.1909
R-squared
0.203299
Adjusted R-squared
0.103712
Return on Assets = 0.047380- 0.026915 (Current ratio) ------ equation 2
As we can see SBM has a negative relationship between Return on Assets and quick ratio. An increase in its Quick Ratio of 1 unit will induce to a decrease in Return on Assets by 0.026915 on the other hand a decrease in Quick Ratio of 1 unit will increase Return on Assets by the same amount. From the above regression we can also state that maximum
The constant term β
The minimum return on asset, given that there is no change in quick ratio is equal to β that is 0.047380.
The R Squared (R2)
The R2 is 0.0203299, which means that almost 20% of the variations in Return on assets can be explained by the variation in Current Ratio.
4.3.3 Relationship between Return on Assets and Non-core Funds Dependence Ratio at State Bank of Mauritius (SBM)
Table X relation between ROA and
Dependent Variable: ROA
Method: Least Squares
Date: 10/30/12 Time: 06:49
Sample: 2002 2011
Included observations: 10
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Î’
0.086779
0.036074
2.405570
0.0428
NCDR
-0.074127
0.047234
-1.569344
0.1552
R-squared
0.235389
Adjusted R-squared
0.139813
Return on Assets = 0.086779 - 0.074127 (non-core funds ratio) ------ equation 3
As we can see there exist a negative relationship between Return on Assets and Non0core Funds Dependence Ratio. 1 unit increase in Non-core Funds Dependence Ratio will induce an increase of 0.074127 in Return on Assets. However, it is also interesting to know that a decrease in Non-core Funds Dependence Ratio is an indicator of good liquidity management and Return on Assets should also have decrease.
The constant term β
From the above table we can also deduct that the minimum Return on Assets when Non-core Funds dependence Ratio tends to zero is 0.086779.
The R Squared (R2)
The regression is 0.235389, which means that 24% of the variations in Return on assets are explained by the variation in Non-core Funds Dependence Ratio.
4.4 General findings
The relationship between liquidity and profitability
As we can see the relationship between liquidity and profitability exist. By making use of liquidity ratios it has been shown that an increase in profitability will cause liquidity to decrease as predicted in theory. However, a high dependence non- core funds to finance earning assets means that large amount of current liabilities that is deposits is tied up in long term assets like loans and investment. Therefore, as non-core funds dependence and profitability increases liquidity decreases.
CHAPTER 5: CONCLUSION AND RECOMMENDATIONS
From the outcome of the research perform it can be said that there exist a negative relationship between liquidity and profitability. For both The Mauritius Commercial Bank Ltd and The State Bank of Mauritius Ltd, when profitability increase liquidity decrease this may be due to the holding of long term assets which increase profitability as they provide higher return for banks comparer to short term assets but somehow this decrease liquidity. Moreover, by so doing this give rise to liquidity risk which can have harmful effect on the bank itself as well as the economy.
In order to be able to operate smoothly banks should search for the prefect strike between the level of liquidity and profitability. They should be careful not to tie up big amount of deposit in illiquid assets so as to improve their profitability as this may led to bank runs. The relation between return on assets and non-core fund dependence ratio confirm the negative relationship between liquidity and profitability. According to the study we can therefore, agree on the fact that there exist a relationship between profitability and liquidity. However, the use of other method to determine liquidity such as liquidity gap could be more relevant than the use of liquidity ratios.
The greatest risk of all banks is not to take risk at all, therefore in order to be able to operate smoothly and profitably a bank should know the degree of risk that it must take.
