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THE IMPACT of LIQUIDITY on PROFITABILITY an Explanatory Study of the Banking Sector Between 2008 and 2017

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THE IMPACT of LIQUIDITY on PROFITABILITY an Explanatory Study of the Banking Sector Between 2008 and 2017 THE IMPACT OF LIQUIDITY ON PROFITABILITY An explanatory study of the banking sector between 2008 and 2017 Chembe Rodney Bwacha & Jing Xi Department of Business Administration Master's Program in Finance Master's Thesis in Business Administration I, 15 Credits, Spring 2018 Supervisor: Henrik Höglund Acknowledgements We would like to extend our sincere gratitude to our supervisor Henrik Höglund, associate professor at Hanken School of Economics. Without his insight and wise counsel this research would not have been a success. We also wish to extend our gratitude to our families and friends for their unending encouragement and support throughout the breadth of our studies. Chembe Rodney Bwacha & Jing Xi i | P a g e Abstract The 2007/08 global financial crisis led to significant changes in the financial world especially the banking sector. It led to regulators and governments tightening regulations in banking sector in order to mitigate the aftermath effects of the global crisis as well as prevent a repeat of the mistakes that initially led to the kick-off of the crisis. One area that received major attention in the post-crisis period is liquidity management and led regulators, governments and international committees such as the Basel Committee to come up with supervisory and regulatory standards aimed at ensuring that banks were liquid enough to avoid bank runs and ensure business continuity. Therefore, this research was bent towards analysing the nature of the impact of liquidity on profitability in the banking sector. This led us to the research question of what the impact of liquidity on profitability in the banking sector is. The current literature pertaining to the subject of liquidity and profitability has produced mixed results. Some studies have concluded that liquidity does not impact profitability while others have found that liquidity does impact profitability. It is also worth noting that most of these studies were conducted within the context of a country, solely focused on the financial crisis and not in the ordinary course of business or analysed the impact within a short-term time horizon. It is for this reason that our study was directed at specifying the impact of liquidity on profitability; in the ordinary course of business, in a multi-geographical setting and in a mid-long-term time horizon. A quantitative study was conducted on a research sample comprising 50 banks which happen to be the part of the 100 largest banks in the world by asset size and these are domiciled in 3 geographical regions – Asia, Europe and North America. The period of consideration was 10 years i.e. between 2008 and 2017. The quantitative data for these banks was collated to provide a measure of our variables: loan to deposit ratio (LDR), deposit to asset ratio (DAR) and cash and cash equivalents to deposit ratio (CDR) as liquidity proxies while return on equity (ROE) and return on assets (ROA) were the profitability proxies. Based on these 5 variables, 6 hypotheses were developed and used in determining the impact of liquidity on profitability. The findings of this study indicate that only DAR significantly impacts profitability computed as ROE while all the other hypotheses proved insignificant. DAR was not found to significantly impact ROA due to the high liquid assets holdings by banks in the post-crisis period. Both LDR and CDR were found not to significantly impact ROE and ROA owing to the high interest payable on deposits, high liquid assets holdings and high lending rates. Hence, it was concluded that generally liquidity does not significantly affect profitability in the banking sector. ii | P a g e Acronyms CCC Cash & due From Banks to Total Assets CCE Cash & Due from Banks to Total Deposits CDDEP Cash Conversion Cycle CDR Cash Conversion Efficiency CDTA Cash Deposit Ratio CR Current Ratio DAR Daily Sales Outstanding DIH Days Inventory Held DPO Days Payment Outstanding DSO Deposit Asset Ratio INVSDEP Investment to Total Assets INVSTA Investment to Total Deposits LCR Liquidity Coverage Ratio LDR Loan to Deposit Ratio NIM Net Interest Margin NPM Net Profit Margin NSFR Net Stable Funding Ratio ROA Return on Assets ROD Return on Deposits ROE Return on Equity WCM Working Capital Management iii | P a g e Table of Contents 1.0 INTRODUCTION ...................................................................................................... 1 1.1 SUBJECT CHOICE ............................................................................................... 1 1.2 PROBLEM BACKGROUND ................................................................................ 1 1.3 THEORETICAL GAP ............................................................................................ 2 1.4 RESEARCH QUESTION ...................................................................................... 3 1.5 RESEARCH PURPOSE ......................................................................................... 3 1.6 RESEARCH LIMITATIONS ................................................................................ 4 2.0 SCIENTIFIC METHOD............................................................................................. 5 2.1 ONTOLOGY .......................................................................................................... 5 2.2 EPISTEMOLOGY ................................................................................................. 5 2.3 RESEARCH APPROACH ..................................................................................... 6 2.4 RESEARCH DESIGN ............................................................................................ 6 2.5 LITERATURE SEARCH ....................................................................................... 7 2.6 CHOICE OF THEORIES AND CONCEPTS ........................................................ 7 3.0 THEORETICAL FRAMEWORK .............................................................................. 8 3.1 LIQUIDITY ............................................................................................................ 8 3.1.1 CONCEPT OF LIQUIDITY ........................................................................... 8 3.1.2 THEORY OF LIQUIDITY ............................................................................. 9 3.1.3 LIQUIDITY RISK ........................................................................................... 9 3.1.4 MEASUREMENT OF LIQUIDITY ............................................................. 11 3.1.5 LIQUIDITY REGULATION ........................................................................ 14 3.2 PROFITABILITY ................................................................................................ 15 3.2.1 CONCEPT OF PROFITABILITY ................................................................ 15 3.2.2 MEASUREMENTS OF PROFITABILITY .................................................. 16 3.3 RESEARCH ABOUT LIQUIDITY AND PROFITABILITY ............................. 16 3.3.1 THEORY ABOUT RELATIONSHIP BETWEEN LIQUIDITY AND PROFITABILITY .................................................................................................. 16 3.3.2 EMPIRICAL RESEARCHES ABOUT LIQUIDITY AND PROFITABILITY .................................................................................................. 18 3.4 SUMMARIES AND PROPOSITIONS ............................................................... 21 4.0 PRACTICAL METHOD .......................................................................................... 23 4.1 DATA COLLECTION ......................................................................................... 23 4.1.1 QUANTITATIVE DATA COLLECTION ................................................... 23 4.1.2 SAMPLING ................................................................................................... 24 4.2 MEASURES ......................................................................................................... 24 iv | P a g e 4.3 QUANTITATIVE DATA ANALYSIS ............................................................... 25 4.3.1 DESCRIPTIVE STATISTICS ...................................................................... 25 4.3.2 CORRELATIONS ......................................................................................... 26 4.3.3 MULTIPLE REGRESSION ANALYSIS ..................................................... 26 4.4 ETHICAL CONSIDERATIONS ......................................................................... 27 5.0 EMPIRICAL FINDINGS ......................................................................................... 28 5.1 SEGMENTATION ............................................................................................... 28 5.2 DESCRIPTIVE STATISTICS ............................................................................. 29 5.3 CORRELATIONS ................................................................................................ 30 5.4 REGRESSION ANALYSIS 1: ROE AND LIQUIDITY PROXIES ................... 32 5.5 REGRESSION ANALYSIS 2: ROA AND LIQUIDITY PROXIES .................. 33 5.6 REVISED CONCEPTUAL MODEL ................................................................... 35 6.0 ANALYSIS AND DISCUSSION ............................................................................ 37 6.1 DESCRIPTIVE STATISTICS ANALYSIS ......................................................... 37 6.2 HYPOTHESES ANALYSIS ................................................................................ 38 6.2.1 LIQUIDITY PROXY - LDR AND PROFITABILITY PROXIES
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