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Archives of Business Research – Vol. 9, No. 4

Publication Date: April 25, 2021

DOI:10.14738/abr.94.9948.

Naseem, H. I. (2021). Determinants of Liquidity Risk: A Study Of Commercial Banks In Pakistan. Archives of Business Research, 9(4).

01-14.

Services for Science and Education – United Kingdom

Determinants of Liquidity Risk: A Study Of Commercial Banks In

Pakistan

Hafiza Iram Naseem

M.PHIL (Accounting & Finance), University of Central Punjab

ABSTRACT

The aim of this research is to examine the determinants of liquidity risk of

commercial banks in Pakistan. For this research, the data of 20 commercial banks

of Pakistan is collected annually for eight years ranging from 2012-2020. This study

uses the Panel data regression analysis approach. Liquidity ratio as a dependent

variable has been selected as measures liquidity risk whereas five independent

variables size of bank, liquid assets ratio, capital adequacy ratio, Leverage, Non- performing loans have been selected for different types of bank-specific factors.

Fixed effect regression analysis and random effect analysis has been performed, the

Hausman test used to see whether the fixed effect model or random model is

suitable. The findings of this study are beneficial for policymaker, manager,

economic agents to control on risk factors. The results of this study show the size of

bank (SOB), liquid assets ratio (LAR), capital adequacy ratio (CAR) has a negative

and statistically significant effect on liquidity ratio. However, Leverage (LEV) has a

positive and statistically significant effect on liquidity risk meaning that increase in

leverage increase the liquidity risk but Non-performing loans (NPLs) has a negative

and statistically insignificant relationship with liquidity risk.

Key words: liquidity, liquidity risk, factor of liquidity risk, size of bank, leverage, capital

adequacy ratio, liquid assets ratio, Non-performing loans.

INTRODUCTION

This study is about the determinants of liquidity risk of the banking sector of Pakistan. The term

“Risk” is a multifaceted and broader concept. The risk is considered as an important aspect in

the financial decision and it can be expressed quantitatively as the degree of unfavorable

outcomes in banking system (Ashlatti, 2015).

The application and mobilization of funds is the function of banks that make the risk in the

banking system. Banks perform the financial intermediation function, for example, a financial

institution manager concern with the question like; whether a customer renews the loan or

not? What happened in financial institutions income due to fluctuation in interest rate and what

is the growth rate of deposits or any other source? The risk is an important element in the

investment decision, to achieve the success in banking business a bank must have the ability to

manage its risk effectively otherwise the failure of manage the risk may decline the growth of

an economy and destabilize the whole financial system (Rose & Hudguis, 2010).

The risk in the financial system broadly classified in at least three aspects: Financial risk,

Business risk, Operational risk. All types of risk are correlated with each other change in one

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Archives of Business Research (ABR) Vol. 9, Issue 4, April-2021

Services for Science and Education – United Kingdom

type of risk influence the others. If there is an inconsistency between due dates of assets of the

bank and liabilities of the bank as well as internal operations of banks liquidity risk happen.

Banks should aware and predict the factors affecting any type of risk. Banking operations are

affected by economic and non-economic environment. The credit crunch of banks 2007-2008

has expanded the research into liquidity risk and its management. Most of the researcher gives

the secondary importance to liquidity risk in banking literature before the credit crunch of

banks (Matz & Neu, 2006). Furthermore, due to the failures of financial institution liquidity risk

considered as a most important and a lot of discussions exists on this topic. The nature of banks

activities brings about liquidity crisis (Chaplin, Emblow, & Michael, 2000).

The main function of banks is to collect funds and gives the loans to others. So, the banks have

to maintain estimated liquidity to perform the daily activities and obligations like fulfill the

demand of customer withdrawals of depositors, maintain the provision for credit amenities for

borrowers (FSC, 2010). If the banks are able to increase the assets and sure about enough funds

then banks convert the short time liquid liabilities into long period illiquid assets. This process

gives the protection to the customers from liquidity issue but harmful if bank face liquidity risk,

in this bad situation banks unable to run their operations soundly. Liquidity is difficult to define

and easy to identify.

The management of liquidity is considered most important and success factor for the banks. If

there is a divergence in maturities, conversion of shortened deposits into perpetual loans is the

basic function of the banks which becomes apparent the liquidity risk. A bank is unable without

any loss to increase the funds or assets and fails to meet the liabilities as they become due. The

capacity of the banks to raise the assets and without bearing the loss and extra cost to fulfill the

unforeseen obligations and unpredicted cash consider as liquidity. The failure of the banks to

pay on maturity without negatively affecting the financial position of the banks is known as

liquidity risk. If the management system is effective, it will lead to control the chances of

unfavorable events and help to ensure that a bank will pay dues on time.

Commercial banks must have to preserve the statutory requirement of the central bank with

the use of proper liquidity management function. Banks keep the appropriate portion of

deposits to liquid assets and deposits to loans and advances. If the bank manages the liquidity

risk then the chances of liquidation reduce. To create and uphold the confidence of the financial

market and depositor is possible if banks hold enough stock of liquid assets. The drawback of a

bank must face in case of illiquid, banks buy the funds at a premium if the financial condition of

the bank disclosed in financial market. Banks should have to handle the liquidity supply and

demand (Ismal, 2010).

Economic stability is essential for improving liquidity management (Reason, 2008). There is a

lack of liquidity in the financial market in case of economic stress. In this situation, banks sell

assets on lesser than the par value of these assets because banks need the cash on an urgent

basis. Banks hold more stock of assets to avail the benefit of investing as a new business against

the buying of assets of another business at a low rate that automatically leads toward future

profit. In the case of economic crisis, banks have an opportunity to grow the new business when

banks stock more liquidity (Acharya, Hynun, & Tanju, 2009).

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Naseem, H. I. (2021). Determinants of Liquidity Risk: A Study of Commercial Banks In Pakistan. Archives of Business Research, 9(4). 01-14.

URL: http://dx.doi.org/10.14738/abr.94.9948

SBP supervise and control also regulates the banking sector in Pakistan under the prudential

regulation. The excellent management of SBP led to growth in the Pakistan’s sector of bank

which ultimately results in the growth of the economy of the country (Tahir, Shah, & Afridi,

2016). The State Bank of Pakistan perform the function as a last resort but cannot handle the

liquidity risk on roots (Nikolaou, 2009).

In Pakistan commercial banks lead the financial sector. Deficiency in liquidity of commercial

banks has an enormous inference on the economic progress of Pakistan. Listed banks in

Pakistan Securities Exchange can take the advantage of quick entrée in capital markets where

liquidity gap can be reduced with the issue of securities. Through the financial services

provision, banks are connected to economic development. For economic development, their

mediation role is assumed to be a catalytic agent (Ongore & Kausa, 2013).

The largest and essential part of the country’s economy is the banking sector of the country. It

supports to control the monetary victims in the country. It assists in control the finance in a

country. To perk up the financial performance and monetary position banking sector should

have to manage the liquidity risk (Ahmad, Ahmad, & Usman, 2011). It is proclaimed that when

any businessman or investor take the high risk, he will take the high return. Although, the

organizations must be continue on attractive high return. The banking sector is the higher risk

taker financial institute. Organizations should have to take defensive measurements to cope the

risk. Organizations should have to administer in such a manner that they save the business from

unfavorable results after taking the risk.

In Pakistan, liquidity risk has been of major concern over the years. To mitigate liquidity risk

the SBP requires banks management to develop and implement adequate liquidity risk policies.

The requirements for the commercial bank are to uphold at least thirty percent of liquidity ratio

(SBP, 2017). The actual liquidity ratio hence liquidity risk differs among banks. Kamau, Erick,

and Muriithi (2013) found that the credit rating, monetary policies, and the government

expenditure and the status of payment of balance affected the liquidity of commercial banks.

Makka (2013) found that the profitability of banks and liquidity risk had an insignificant

relationship.

Liquidity risk can harm the financial position of the bank. So, the administrator of the bank have

the priorities to ensure the availability of the funds at a reasonable cost for fulfill the

unanticipated demand of borrower and investors. The performance and reputation of the bank

are affected by liquidity risk (Ahmad & Jan, 2017). Accountholder maybe fails to keep the

confidence on banks when the bank does not supply the amount on time. The bank should have

to pay the penalties as per the regulation entail. High liquidity risks deter the Banks ability to

meet its liabilities, which in term affects the creditworthiness of the banks, banks lose their

customers and start defaulting, and hence it exacerbates the financial crisis of the bank

(Comptroller of the Currency, 2001).

A number of studies (Zaghdoudi and Hakimi, 2017; Ebenezer, 2016; Vazquez and Federico,

2015; Leykun, 2016) have been conducted to evaluate the determinants of liquidity risk in

developed markets. Fredrick, Jeremiah, and Onsomu (2018) point out that the capital adequacy,

capitalization, and size significant positive relationship with liquidity risk. Ebenezer (2016)

established that bank size had positively influence on liquidity risk while the ratio of