Liquidity Risk and Bank Profitability in Ghana

Abstract

The study examines the determinants of liquidity risk of Ghanaian banks and how it affects their profitability. Theory on the effects of liquidity risk on bank profitability is mixed; while some studies conclude that high liquidity risk increases bank profitability through high net interest margins, others indicate that it reduces profitability due to the high cost associated with securing funding at such times. With an unbalanced data set of 22 banks over a 10 year period spanning 2002 and 2011, the random effects GLS regression based on the Hausman test is used to estimate the determinants of bank liquidity risk. The instrumental variables regression through the two stage least squares (2SLS) approach is applied to estimate the effects of liquidity risk on bank profitability due to the endogenous nature of liquidity risk as a bank profitability determinant while controlling for other variables (bank size, capital adequacy, credit risk, operational expenditure, non-interest income, industry concentration and change in GDP). The study employs the financing gap ratio (FGAPR) as the measure of liquidity risk (dependent variable) with bank size, liquid assets ratio which is further divided into risky and less risky liquid assets, non-deposit dependence, ownership type, industry concentration and change in inflation as the explanatory variables. While bank size, non-deposit dependence and change in inflation exhibit a positive and a statistically significant relationship with liquidity risk (financing gap ratio); meaning that an increase in any of these variables leads to an increase in liquidity risk, risky liquid assets, less risky liquid assets and industry concentration show a negatively significant relationship. Ownership structure has no significant relationship with the financing gap ratio (dependent variable). In order to ascertain the robustness of the results, the ratio of net loans to total deposits (NLD) as an alternative measure for liquidity risk is also applied and the results show consistency with the results obtained from the use of the financing gap ratio as a measure for liquidity risk. Again, the results from the use of instrumental variables for liquidity risk while controlling for other variables (determinants) also show a positive relationship between liquidity risk (both the financing gap ration and the ratio of net loans to total deposits) and bank profitability measured by the return on assets (ROA) and the return on equity (ROE). The study suggests that banks institute strategies that provide effective diversification in the sources of funding while exploiting deposits as a stable cheap source of funding in order to mitigate their liquidity risk exposure. Again, banks in Ghana should strengthen their treasury departments mandated to manage liquidity risk to ensure a sound process for identifying, measuring, monitoring and controlling liquidity risk in order to maximize the positive risk return relationship.