1.1 Background to the Study
The importance of liquidity and profitability of banks has received tremendous attention in the corporate world in recent years. The management of corporate liquidity is one of the most critical areas in determining whether a firm will be profitable or not. Liquidity of a firm represents its ability to carry out all its financial obligations without affecting the business operations. A business cannot run smoothly without the presence of adequate working capital. Therefore, the importance of liquidity makes it necessary for banks to maintain a reasonable amount of their assets in the form of cash in order to meet their short term obligations. According to Saleh, (2014), profit is the bottom line or ultimate performance result showing the net effects of bank policies and activities in a financial year.
Profitability being a measure of loan performance also refers to excess of firm’s revenue over her operational cost or measurement of the rate of return on investment. Enhancement of profitability is one of the ultimate goals of every firm, and generally, banks strive to strike a balance between profitability and liquidity (Niresh, 2012).
The Basel Committee on Banking Supervision (2008) defined liquidity as the ability of a bank to fund increases in assets and meet obligations as they fall due, without incurring unacceptable losses. Liquidity could be risky when a financial firm, though solvent, either does not have enough financial resources to allow it to meet its obligations as they fall due, or can obtain, such funds only at excessive cost (Vento & Laganga, 2009).
Liquidity risk appears when there are differences between the size and maturity of assets and liabilities on the balance sheet. There are generally two types of liquidity risks which are funding liquidity risk and market liquidity risk. Funding liquidity risk is the risk that the bank is not able to respond effectively to current needs as well as future cash needs without affecting its daily operations and financial condition. Market liquidity risk is defined as the risk that a bank cannot easily offset or eliminate a position without significantly affecting the market price (Ferrouhi & Lehadiri, 2014).
Profitability and liquidity as performance indicators are important to the major stakeholders of any firm and banks in particular. The shareholders are interested in the profitability of banks because it determines their returns on investment. Depositors are concerned with the liquidity position of their banks because it determines the ability to respond to their withdrawal needs, which are normally on demand or on a short notice as the case maybe. The tax authorities are interested in the profitability of the banks in order to determine the appropriate tax obligation (Olagunji, Adeyanju & Olabode, 2011). This study examined the effect of liquidity on the loan portfolio performance (profitability) of Nigerian banks in other to contribute to the gaps in the previous studies as stated below.
1.2 Statement of the Problem
In Nigeria and the competitive world, the banking sector has emerged as a key player, contributing its best to create employment, and improving the financial sector of the country. With the current and growing trend in Nigeria economy, it has become a challenge for the sector to create employment and contribute meaningfully to the economy due to inability to earn maximum profitability. Therefore, it is necessary for banks to take dynamic decisions to effectively manage their assets, particularly loan portfolio in order to bring about the needed improvement in their profitability.
Moreover, considering the public loss of confidence as a result of distress which bedevilled the financial sector especially banks in the recent past; and the intensity of competition in the banking sector due to the emergence of new banks, every deposit money bank should ensure that it operates profitably and at the same time meets the financial demands of its depositors by maintaining adequate liquidity (Olagunji, Adeyanju, & Olabode, 2011).
Deposit money banks are often confronted with the problem of how to choose and identify the optimum point or the level at which it can maintain its assets in order to optimize the set objectives (Ajibike & Aremu, 2015). This investigated the effect of liquidity (the proportion of the deposits that may be demanded by the depositors at any particular time) on the profitability of banks. It will investigated liquidity position of banks in Nigeria.
1.3 Objective of the Study
The main objective of the study is to examine how liquidity position of Nigerian banks affects their financial performance. The specific objectives are to:
- examine the liquidity position of selected quoted banks in Nigeria and
- estimate the effect of liquidity on Banks’ profitability in Nigeria
- Research Questions
- What is the liquidity position of the selected Nigerian Banks?
- What is the effect of Liquidity on the profitability of selected Nigerian Banks?
A null hypothesis has been formulated for this study which is:
H0: There is no significant relationship between liquidity and bank profitability
1.6 Significance of the Study
This study would be of immense value to investors, regulators, Managers, academia and other relevant stakeholders. By relating liquidity to loan portfolio performance using lending spread as proxy for profitability, the study would provide future researchers with an alternative measurement area which has little or no research within the Nigerian context. This study evaluated banks’ liquidity position and how it affects their profitability.
Various studies on liquidity and bank’s profitability concentrated on macroeconomic factors like Inflation and exchange rate, while a few concentrated on firm level. This study employed firm level data to examine the impact of liquidity on bank loan portfolio performance in Nigeria.
Furthermore, the reports from empirical studies on the subject matter still remain inconclusive. For instance, Ajibike and Aremu (2015) reported positive relationship between liquidity and profitability but, Olanrewaju and Adeyemi (2015) reported no significant relationship, while Eljelly, (2004) and Dahiyat, (2016) concluded that there is negative relationship between liquidity and profitability. The lack of consensus among literatures clearly shows that further study needs to be carried out. Also, this study differs from existing literatures that examined the relationship between liquidity and profitability by the use of Lending spread as proxy for measuring bank’s loan portfolio performance (profitability) whereas others used either Return on Assets(ROA) or Return on Equity (ROE).
1.7 Scope of the Study
The study covered 12 of the 22 deposit money banks listed on the Nigerian stock exchange as at Dec. 2015 over a period of 8 years from 2008 to 2015.
1.8 Operational Definition of Terms
Liquidity: This is the ability of a bank to fund increases in assets and meet obligations as they fall due, without incurring unacceptable losses.
Loan Portfolio: This refers to total of all loans held by a bank or finance company on any given day.
Profitability: Profitability is ability of a bank to use its resources to generate revenues in excess of its expenses.
Bank: This is an establishment authorized by a government to accept deposits, pay interest, clear cheques, make loans, act as an intermediary in financial transactions and provide other financial services to its customers.
Loan: An amount of money advanced at interest by a bank to a borrower, usually on collateral security, for a certain period of time.
Lending Spread: This refers to the difference in borrowing and lending rates of financial institutions (such as banks) in nominal terms. i.e the difference between interest paid on deposit to customers and the interest charged on loans and advances.
Deposit: This refers to money placed in banking institutions for safekeeping.