What factors determine the profitability and liquidity of banks?
• INTRODUCTION:
A commercial bank is a business entity that engages in banking for the purpose of making profits. Every commercial bank strives to earn in such a way that it does not compromise its liquidity objective which is vital to its own security and safety.
• Meaning:
Since a commercial bank has to make profits in such a way that its liquidity remains intact, it diversifies its funds into different assets. A well-diversified and balanced portfolio of assets ensures its stable and successful operation. Various factors play an important role in determining the profitability and liquidity of commercial banks. These factors are taken into account when forming the bank’s asset portfolio.
• EXPLANATION:
A) FACTORS AFFECTING THE PROFITABILITY OF COMMERCIAL BANKS:
1) Amount of working capital:
Funds invested by a bank in income-generating assets are the bank’s working capital. The profitability of the business is directly proportional to the amount of working capital used by the bank.
2) Cost of funds:
Cost of funds is the cost incurred in obtaining funds from various sources in the form of share capital, reserves, deposits and loans. Therefore, it usually refers to interest expense. Lower cost of funds, higher yield.
3) Profitability of funds;
The funds raised by the bank through various sources are placed in various assets. These assets earn income in the form of interest. So, higher interest, higher yield.
4) Spread:
The spread is defined as the difference between the interest received (interest income) and the interest paid (interest expense). A higher spread indicates a more efficient intermediate financial intermediary and a higher net income. Thus, a higher spread leads to a higher yield.
5) Operating costs:
Operating expenses are the expenses incurred in the functioning of the bank. Except for the cost of funds, all other costs are operating costs. Lower operating costs lead to greater profitability for banks.
6) Cost of risk:
This cost is related to the probable annual loss of assets. These include provisions for bad and doubtful debts. Lower risk costs increase banks’ profitability.
7) Non-interest income:
This is the income received from non-financial assets and services. Includes commissions and brokerage on returns, locker rental, signing fees and financial guarantees, etc. This income contributes to banks’ profitability.
8) Technology level:
The use of modernized technology usually results in a decline in banks’ operating costs. This improves the profitability of banks.
9) Level of non-performing assets (NPAs):
The profitability of a bank is inversely proportional to the level of NPAs. Consequently, NPAs of commercial banks have declined greatly over the years.
10) Level of Competition:
Increased competition usually leads to higher operating costs. This leads to lower profitability.
B) FACTORS DETERMINING THE LIQUIDITY OF COMMERCIAL BANKS:
1) LEGAL REQUIREMENTS:
The extent of liquidity reserves held by banks depends on the statutory requirements of the Central Bank (ie RBI) According to RBI commercial banks must maintain a certain CRR (cash reserve ratio) and SLR (required liquidity ratio) Higher CRR and SLR leads to lower liquidity.
2) People’s Banking Habits:
The nature of the economy affects people’s banking habits. In developing countries, check transactions are limited to businesses. Individuals are more dependent on cash transactions. Therefore, the need for liquidity is relatively higher.
3) Cash transactions:
The number and scale of monetary transactions determine banks’ liquidity. Higher cash transactions lead to higher liquidity.
4) Nature of the money market:
In the case of fully developed money markets, banks easily buy and sell securities. Therefore, the liquidity requirement is lower.
5) Structure of the banking system:
A branch banking system requires lower liquidity because cash reserves can be centralized at the head office. The single banking system requires a higher degree of liquidity.
6) Number and amount of deposits:
The number and size of deposits affect banks’ liquidity. Increasing the number and size of deposits will require higher liquidity.
7) Nature of deposits:
Deposits traded with banks are of various types such as time deposits, demand deposits, short term deposits, etc. larger demand deposits / short-term deposits need higher liquidity
8) Liquidity policies of other banks:
Different banks can operate in the same area. So the liquidity policies of other banks also affect the liquidity of the bank to build goodwill among the depositors.
• CONCLUSION:
SO, various factors determine the liquidity and profitability of commercial banks. So these factors are taken into account while creating the asset portfolio of commercial banks. These factors influence the combination of profitability and liquidity that results in a stable and successful banking system.
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