International Research Journal of Applied and Basic Sciences

© 2013 Available online at www.irjabs.com

ISSN 2251-838X / Vol, 4 (6): 1624-1631
Science Explorer Publications

The Effect of Liquidity Risk on the Performance of

Commercial Banks
Naser Ail Yadollahzadeh Tabari1, Mohammad Ahmadi2, Ma'someh Emami3

Department of Economics, Babol Branch, Islamic Azad University, Babol, Iran

Corresponding Author email: [email protected]

ABSTRACT: Banks, as the most important financial institutions, have a determinant role in circulating
currency and wealth of the society and enjoy a special position in financial system. Therefore, the desired
and effective performance of banks can create important effects on the development of different economic
sectors and increase in the quantitative levels of the output. This study attempts to examine the effect of
liquidity risk on the performance of commercial banks using of panel data related to commercial banks of
Iran during the years 2003 to 2010. In the estimated research model, two groups of bank-specific variables
and macroeconomic variables are used. The results of research show that the variables of bank's size,
bank's asset, gross domestic product and inflation will cause to improve the performance of banks while
credit risk and liquidity risk will cause to weaken the performance of bank.

Keywords: risk; internal rate of return; return on equity; panel data.

INTRODUCTION

The development of international financial markets and rising variety of financial instruments has increased
the possibility of banks' achievement to financial resources at an extensive level. Under such conditions, the market
are rapidly developed and some opportunities are provided to design new products and present more services.
Although it seems that the speed of such changes is different from a country to another country, but the banks
generally compete with each other to develop and expand the new financial instruments and services. Bank's profit
is usually one of the main resources to accumulation of asset. The safety of banking system is depending on the
profitability and capital adequacy of banks. Profitability is a parameter which shows management approach and
competitive position of bank in market-based banking. This parameter helps the banks to tolerate some level of risk
and support them against short-term problems. Recent studies indicate that liquidity risk arises from the inability of a
bank to accommodate decreases in liabilities or to fund increases in assets. An illiquidity bank means that it cannot
obtain sufficient funds, either by increasing liabilities or by converting assets promptly, at a reasonable cost. In
periods the banks don’t enjoy enough liquidity, they cannot satisfy the required resources from debt without
conversion the asset into liquidity by reasonable cost. Under critical conditions, lack of enough liquidity even results
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in bank's bankruptcy (Note 1) (Group of Studies and Risk Management of Eghtesad Novin Bank, 2008).
Determinants of banks' performance are divided into internal and external factors. Internal factors focus on
the special characteristics of banks such as bank size, bank size square, bank's capital, credit risk, and liquidity risk,
while, external factors include macroeconomic variables, i.e., gross domestic product and inflation. The aim of this
research is to study the effect of liquidity risk on the performance of commercial banks by panel data regression
method.
We consider two variables as the performance indicator for our analysis as dependent include: return on
asset and return on equity. Each of them is examined separately by the related explanatory variables. In the
following section, we will review the related empirical studies. Then, methodology and specified model are
addressed. After that, the estimation results conclusion will present.

Experimental Studies
Profitability of banks is influenced by different factors. These factors are generally classified into internal
factors and external factors. Different researches are performed about the effect of these factors on the profitability
of banks.
Bagheri (2007) estimated and analyzed the effective factors and determinants of profitability of Refah Bank
using of a linear regression pattern for time period of 1983-2001. Findings of this research showed that the efficient
management of costs is one of the significant explanatory variables for profitability of bank. In addition, the
management of liabilities has also an effect on the profitability. Among external factors, economic growth has
positive effect on profitability of bank.
By calculating the parameters of banks' performance in four groups of profitability, liquidity, efficiency and
capital, Heibati et al. (2009) examine and compare the performance of private banks in Iran and Arabic countries of
Persian Gulf area. The results showed the acceptable performance of private banks during the initial years of their
activity.
Arbabian and Geraili (2009) addressed to study the effect of capital structure on the profitability of companies
accepted in Tehran's stock exchange. The results of their research showed that there is a positive relationship
between the ratio of short-term debt to the asset and profitability of the company as well as between the ratio of total
debt to the asset and profitability. But there is a negative relationship between the ratio of long-term debt to the asset
and profitability.
Bourke (1989) examined the performance of banks in twelve European, Northern American and Australian
countries. Using of international data for 1972-1981, he found that both ratios of capital and liquidity have a positive
relationship with the profitability. In comparison, Molyneux & Thornton (1992) for the time period of 1986-1989,
found that profitability is negatively related to liquidity. Davidson & Dutia (1991) showed that the capital plays a very
important role in profitability of small firms, but due they do not able to obtain the capital; it is forced heavily relay on
loan and this may decrease their profitability. Also, they showed that using of high debt is one of the important
factors in decreasing the profitability of small firms. Molyneux and Forbes (1995) examined the structure of market
and its performance in 18 European countries using of panel data of several companies for four years of 1986-1989.
Their findings show that a regulatory guideline should be designed to change the structure of market. In this way, the
competition or the quality of bank's performance will be increased. The growing focus on banking market should not
be limited by the scales of regulatory guideline.
Berger (1995) examined the relationship between capital adequacy and return on equity. Using of Granger's

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causality test, he found a positive relationship between these two variables. He pointed out subsequent increase in
capital adequacy ratio should be resulted in increasing return on equity, which this is performed by decrease in
insurance costs on unconfident debts. In 1992, Berger (1995) calculated the liquidity risk of bank through on the
ratio of cash asset to total asset in order to study the performance of bank. In his research, he found that there is a
positive relationship between liquidity risk of bank and return on total asset.
Miller and Noulas (1997) found a negative relationship between credit risk and profitability which represents
that when there is a negative relationship between them, loans will be encountered with more risk, and the greater is
the value of loan loss; accordingly, the ability of maximizing the profit of a bank will be encountered with difficulty.
Demirguc-Kunt et al. (1998) examined the determinants of bank's profit and net profit margin by using the
specific characteristics of bank, macroeconomic conditions, tax enactment, regulations, financial structure and legal
parameters for 80 countries. In this research, they evaluated liquidity risk based on the ratio of loan to total asset.
They found that foreign banks have more profitability than domestic banks in developing countries, while in
developed countries, this is conversely. Despite of this, their general results indicated that there is a positive
relationship between net profit margin and liquidity risk and there is a negative relationship between return on
internal asset and liquidity risk of bank.
Bashir (2000) studied the effective factors on the performance of Islamic banks in 8 middle-east countries
during the years 1993-1998. The results show that by controlling the macroeconomic environment and financial
market situation, financial debts and long- term loans will be resulted in more profitability. Also, he found that foreign
banks are more profitable than domestic banks.
Chirwa (2003) studied the relationship between market structure and profitability of commercial banks in
Malawi using of data of time series during the years 1970-1994. The results of research show that there is a
negative relationship between profitability and capital adequacy ratio and gearing ratio.
In his research, Abor (2005) addressed to examine the relationship between the criteria of capital structure
and profitability in a sample of companies in Ghana. The results of this research showed that there is a positive
relationship between the ratio of short-term debt to the asset and profitability. But there is a negative relationship
between the ratio of long-term debt to the asset and profitability of companies.
Havrylchyk and Emilia (2011) found a positive and direct relationship between asset management and
profitability of bank. Accordingly, a more effective bank should have more profits because it can maximize its net
profit income.
In a study, Chen et al. (2010) examined the pattern of liquidity risk of bank and its performance using of
imbalanced panel data set including commercial banks in 12 advanced economic countries during the years
1994-2006. They found that liquidity risk is the endogenous determinant of bank performance. The causes of
liquidity risk include components of liquid assets and dependence on external funding, supervisory and regulatory
factors and macroeconomic factors. Alper & Anbar (2011) examined special and macroeconomic determinants of
Turkey's bank during the years 2002-2010 using of a panel data set. The results show that bank's size, liquidity and
interest income have positive effect on the bank's profitability, but credit risk and loans have a negative effect on the
bank's profitability. Regarding to macroeconomic variables, just real interest rate affects positively on the
performance of banks. Ali et al. (2011) performed a research about the important role of capital adequacy ratio,
operating efficiency, asset management and gross domestic product and their effect on the profitability of
commercial banks of Pakistan and concluded that conventional banks have better Profitability than Islamic banks of
Pakistan.

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Literature review
In banking industry, liquidity risk has an opposite effect on profitability. Some studies such as Molyneux &
Thornton (1992) and Barth et al. (2003) supported the positive effect of risk on the profitability; while some studies
such as Bourke (1989) and Kosmidou et al. (2005) believed in its negative effect. Liquidity risk is usually measured
as liquidity ratio which is practically calculated in two different forms. In first type, liquidity is adjusted by size which
includes the ratio of cash asset to total asset (Barth et al., 2003; Demirguc-Kunt et al., 1998), the ratio of cash asset
to deposits (savings) (Chen et al., 2010). Second type includes the adjusted loan by the size which includes the ratio
of total asset and/or the ratio of net loan to total asset (Kosmidou et al., 2005).
In first type, the higher is the liquidity ratio, the higher is the liquidity level, and therefore, it is less vulnerability
against bankruptcy. In contrast, in second type, the higher are the values of ratios, it will represent that banks will
undergo higher liquidity risk.
Financial gap ratio introduced by Saunders and Cornet (2007) is used in this study. They expressed that
liquidity risk criterion is determined based on financial gap. Bank managers mostly assume core deposits as stable
source of funds which can permanently finance the supply of banking loans. Generally, core deposits are regarded
as loan resources with the least cost. Financial gap is defined as the difference between loan and bank's core
deposits. If financial gap is positive, the bank should fill this gap by its cash funds through selling cash assets and
borrowing from money market. Therefore, financial gap can be estimated by subtracting the borrowed funds from
the cash assets. This financial gap represents financial needs of the bank after selling its cash assets. When the
economy is under stagnation and financial market increasingly demands for Cash funds, it is when the banks are
more exposed on liquidity risk. Therefore in this study, it seems that financial gap is a more appropriate alternative
for liquidity risk of the bank. For standardization of financial gap, the variable of financial gap is divided by total
asset.
Banking literature has presented various variables influencing on bank's profitability. Some of these include:
banks' size, the attitudes of banks' managers towards the risk, characteristics of banks' ownership (Chen et al.,
2010).
RESEARCH METHOD

Model specification
In comparison to the efficiency hypothesis, the positive relationship between concentration and profitability,
reflects the positive relationship between bank's size and bank's efficiency. Therefore, it is not yet precisely clear
whether high interest of big banks is the result of the concentrated and cooperated market structure or the result of
managerial techniques and superior production which decrease the costs and incur high revenues (Seyed Noorani
et al., 2012).
The profitability variable is represented by two alternative measures: the ratio of profits to assets, i.e. the
return on assets (ROA) and the profits to equity ratio, i.e. the return on equity (ROE). In principle, ROA reflects the
ability of a bank’s management to generate profits from the bank’s assets, although it may be biased due to
off-balance-sheet activities. ROE indicates the return to shareholders on their equity and equals ROA times the total
assets-to-equity ratio. The latter is often referred to as the bank’s equity multiplier, which measures financial
leverage. Banks with lower leverage (higher equity) will generally report higher ROA, but lower ROE. Since an
analysis of ROE disregards the greater risks associated with high leverage and financial leverage is often

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determined by regulation, ROA emerges as the key ratio for the evaluation of bank profitability. Both ROA and ROE
are measured as running year averages.
In this research, the performance of fifteen Iranian banks is examined (Note 2) during an eight-year period
from 2003 to 2010 using of panel data. The required data is drawn from the studied banks and the data related to
macroeconomic variables including the growth of gross domestic product, consumer price index are drawn from
central bank's site in order to calculate the inflation ratio. All the financial data are in billion Rials. According to Chen
et al. (2010) study, we estimate the following model to examine the effect of liquidity risk on the performance of
commercial banks.
ROE jt = 0 + 1 SIZE it+ 2 SIZE it2+ 3 LR it+ 4 CR it+ 5 ETA it+ 5 GDP jt+ 6 INF jt+ it

Table1. How to calculate research variables

Variables Explanations (Descriptions)

Return on Asset ROA Ratio of net profit to the average beginning and ending total asset of the bank
Bank's Size SIZE Natural(normal) logarithm of total asset of the bank
2
Bank's Size Square SIZE The squared normal logarithm of total asset of the bank
Difference between the liabilities of a bank and customer's deposits which is divided
Liquidity Risk LR
by total asset
Credit Risk CR Ratio of non- performing loans and previous deadline to total loans of banks
Bank's Capital ETA Ratio of equity to total asset of the banks
Contains the sum value of goods and services which are produced during a definite
Gross Domestic Product GDP
period (usually one year) in a country.
Inflation INF Growth of consumer's price (value) index (inflation index)

Table 2. The results obtained from pattern estimation by panel data method and using of the fixed effects
Return on Asset's rate
Variables Coefficient Std.Error t-statistic prob.

C 8.647966 1.334989 6.477932 0.0000

Liquidity Risk -2.71667 0.655632 -4.143587 0.0001
Bank's Size 0.575296 0.904197 0.636251 0.0261
Bank's Size Square -0.43895 0.411063 -1.06784 0.2882
Bank's Capital 3.380281 1.652677 2.045337 0.0435
Credit Risk -1.39247 0.973378 -1.430551 0.0557
Gross Domestic Product 0.450947 0.064957 6.942247 0.0000
Inflation 0.129827 0.019487 6.662294 0.0000
R-Squared 0.821622 Durbin-Watson Stat 1.954207
F-Statistic 21.49501 Prob(F-Statistic) 0.0000

Research Findings
Estimation of Model
To determine the kind of estimation method in panel data, different tests are used. To select between common
effects and the fixed effects, Limner's F-test was used and to select one of the model for the fixed effects against the

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random effects, Haussmann test was used. In F-test, the null hypothesis of common effect is versus the opposite
hypothesis of fixed effect. Therefore, if null hypotheses rejected, estimation method of panel data is accepted. In our
estimation, regarding to the value of the calculated F (11.55) is bigger than that of the F statistic (1.55) so, the
pooling method of estimation will be invalid. The second issue is the choice between fixed effects (FE) and random
effects (RE) model. According Hausman test the FE model prefer to RE model. Therefore, final estimation method in
this research is fixed effect. The results of our estimation are shown in table 2.

The value of the adjusted R-Squared is 0.82 in the model which confirms that 82 percent of changes in
dependent variable are explained by independent variables of the model. The value of F-statistic confirms the
accuracy of the estimated model in the research as a whole. The results show there is a negative relationship
between liquidity risk and bank's performance. When a bank has not enough liquidity, it is not able to obtain the
sufficient funds. To compensate the demands and needs, they are obliged to use the capital and cash asset or
external investment. As a result, the level of loans and investments portfolio decreases. This causes to decrease the
performance of banks. Bank's size has a positive and meaningful effect on the return on asset. This means that
bigger banks will achieve more return on asset which is compatible with the results of previous studies. Also, as
expected, bank's capital has a positive and meaningful effect on the performance of bank. Banks with higher capital
ratio will be encountered with less risk and enjoy more time and flexibility to remove their problems (due to the
absence of unpredicted and sudden losses). Credit risk has a negative effect on the performance of bank. This
shows that the more financial institutions are exposed on credit risk, the density of non – performing loans will
become more and the capability of profitability will become less. In respect of the effect of macroeconomic
environment variable, we found that the growth of gross domestic product has a positive effect on the performance
of bank. This means that more economic growth causes to improve the performance of banks. These results
indicate that higher economic growth encourages the banks to enhance their profit margin and asset quality through
awarding more loans and consequently, they will increase their capability of profitability. In addition, the positive
effect of inflation on the profitability shows that the inflation had been predicted previously. It means that banks have
this opportunity to adjust their interest rate and consequently improve their performance.

Robustness test
The results obtained from the estimation of the following model; i.e., return on equity (ratio of net profit to the
average return on equity at beginning and ending of the period) are reported in table 3. Also, as previously, this
model was estimated by the fixed effects' method. The results show that most of them are similar to the results of
return on asset's model.
ROE jt = 0 + 1 SIZE it+ 2 SIZE it2+ 3 LR it+ 4 CR it+ 5 ETA it+ 5 GDP jt+ 6 INF jt+ it

The adjusted R-Squared value is 0.73 in the model which confirms that 73 percent of changes in dependent
variable are explained by independent variables of the model. The value of F-statistic generally confirms the
accuracy of the estimated model of the research.
Therefore, in summary, regarding to the goal of research, it can be said that in both models, liquidity risk has a
significantly negative effect on both criteria of the performance i.e. return on asset and return on equity. It means that
liquidity risk will cause to weaken the performance of bank.

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Table3. The results from the fixed effects panel data method
Return on Equity
Variables Coefficient Std.Error t-statistic prob.

C 78.36002 10.70416 7.320522 0.0000

Liquidity Risk -39.1327 8.054192 -4.858669 0.0000
Bank's Size 1.91813 10.20962 0.187875 0.0514
Bank's Size Square -4.56757 4.807964 -0.95 0.3444
Bank's Capital 22.23011 11.31636 1.964423 0.0523
Credit Risk -7.95511 7.122547 -1.116892 0.0668
Gross Domestic Product 2.557277 0.611293 4.183392 0.0001
Inflation 0.836892 0.201822 4.14668 0.0001
R-Squared 0.734466 Durbin-Watson Stat 1.818562
F-Statistic 36.54335 Prob(F-statistic) 0.0000

CONCLUSIONS

During recent decades, most countries addressed to revive their banking system structure which in this
relation, the process of banks' privatization has further accelerated. In Iran, parallel to the world economy and the
necessity to respond the various needs of developing economy, the license for the activity of private banks was
issued in March 2000 and over more than eleven years from the beginning of activity of Iranian private banks, it
seems that the evaluation of their performance is necessary.
This study examined the effect of liquidity risk on the performance in 15 banks of Iran during the years
2003-2010. The above-mentioned factors are divided into two classes including bank- specific and economic
variables. Research model was estimated in order to examine the effect of liquidity risk on the performance of bank
using panel data regression. Findings of research show that bank's size, bank's capital, gross domestic product and
inflation cause to increase in the profitability of bank, while credit risk and liquidity risk will cause to decrease in the
bank's profitability. To assure the robustness of the obtained results, we tested the estimated model once more by
replacing return on equity as the criterion of the bank's performance (dependent variable), which almost the same
results of the previous model(return on asset) were obtained. Therefore, regarding to the goal of research, the
results generally show that liquidity risk will cause to decrease in the performance of bank.

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Notes
Note 1. Bankruptcy is essentially occurred in banking system of countries in which the banks are private.
Note 2. National bank of Iran, Sepah, Tejarat, Mellat, Refah, Post Bank, Keshavarzi, Maskan, Tose-e- Saderat
Iran, Industry and Mine (San'at-va-Ma'dan), Kar-afarin, Saman, parsian, Eghtesad-e-Novin, and Sina.

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