An Evaluation of the Determinants of Bank Liquidity a Case Study of Commercial Banks in Sri Lanka

Abstract

Being liquidity creators, banks confront illiquidity with high liquidity demands of customers, which could increase the bank's vulnerability to liquidity risk not only at the bank-level, but also at the market level. In this context, the study investigates the factors that impact the liquidity of licensed commercial banks (LCBs) in Sri Lanka. Considering the sample of eleven commercial banks from 2008 to 2018, the study investigates bank-specific and macro-economic variables against the liquidity ratios of the liquid assets to total assets, total loans to total deposits, and short-term borrowings using fixed effects panel data regression model to explore the relationships among them. Results confirmed that bank-specific and macro-economic variables are differently related to bank liquidity. From bank-specific variables, capital adequacy ratio is negative and statistically significant, while profitability and funding cost is positive and statistically significant with bank liquidity. Results revealed that bank size negatively impacts liquidity, affirming too big-to-fail status of commercial banks. Further, comparative analysis between total deposits ratio and fixed deposits ratio with bank liquidity shows that an increase in both total deposit ratio and fixed deposits ratio will decrease bank liquidity. However, asset quality measured by impaired loans has no explanatory power over the liquidity. In the case of macro-economic variables, bank liquidity varies negatively with real Gross Domestic Production (GDP) and the inflation rate, and positively with unemployment rate. The findings of the study have important implications for regulators and policy makers to design better policies for the current liquidity framework. Regulators should monitor the capital adequacy ratio to prevent the deterioration of bank liquidity, and policy makers should consider the bank size when preparing the liquidity framework.