The Effect of Liquidity on Banks Profitability for Commercial Banks in Ethiopia

Abstract

Banks role in the economy of any country is very significant. Liquidity can be defined as the ability of a financial institution to meet all legitimate demands for funds (Yeager and Seitz 1989). The different financial crisis over the world at different times had illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and individual institutions. Liquidity of banks can be affected by bank specific as well as macroeconomic factors and government/central bank regulations. Thus it is important to study effect of liquidity on banks profitability. However, as to the knowledge of the researcher, there are few studies made generally on this study. Therefore, to examine the effect of liquidity on commercial banks profitability is important. An explanatory research design was employed to examine the relationship of the dependent and independent variables by using quantitative research approach used to see the banks' profitability that has been measured by Return on Assets (ROA) and liquidity explanatory for the independent variables and the unbalanced random effect panel regression was used for the data of all commercial banks in the sample covered the period from 2005 to 2015. Five liquidity explanatory’s that are affecting banks profitability were selected and analyzed. The results of panel data regression analysis showed that cash deposit ratio and capital ratio had statistically significant effect on banks profitability. Liquidity ratio, deposit asset ratio and loan deposit ratio had statistically insignificant effect on banks profitability. Among the statistically significant factors affecting banks profitability cash deposit ratio had positive effect on profitability of commercial banks whereas, capital ratio had negative effect on profitability of commercial banks. Deposit asset ratio and loan deposit ratio had positive but statistically insignificant effect on financial performance but Liquidity ratio had negative but statistically insignificant effect on financial performance. Therefore, banks should maintain adequate liquidity to enhance profitability by financing to creditors and also should have enough capital to absorb shocks which emanate from liquidity and credit risks.