CHAPTER   ONE

INTRODUCTION

1.1 Background Of The Study.

The financial system in both US and the Western Europe was on the brink of collapse in September and October 2008, in the wake of the Lehman bankruptcy. Government intervention using taxpayer funds, which in many countries extended to a blanket guarantee of financial institutions complete liabilities, prevented the collapse from taking place.

The financial sector as a whole has experienced some drastic changes in recent years, as technology and globalization continue to create both opportunities for growth and challenges for financial managers to remain profitable in their increasing competitive environment. In their role as financial intermediary they make efficiency and effectiveness as essential requirement towards ensuring stability and growth. They engaged in economic activities to ensure more profitability on the asset side of the balance sheet.

Financial Institutions ensure the smooth flow of funds by lending to deficit spending unit while increasing liquidity to savers on the liability side in facilitating trade through the provision of payment and settlement system, ensuring the productive investment of capital and the profitability of other varied functions according to Jenkison (2008), expose to a larger number of risks which include liquidity risk, credit risk, market risk and among others. Every MFI involves the mobilization of funds from excess or surplus units of the economy and giving out to deficit units as loans, this is called financial intermediation.

 

The performance of these functions by MFIsis open to several risks and amongst these risks is liquidity risk. Risk is a natural element of business and community life; it is the condition thatrises of losses/gains and the uncertain potential events which could manipulate the success of MFIs.  There is a great relationship between liquidity and profitability because every profits depends on the viability of the liquidity, and if the institution is facing liquidity risk it reduces the profits and hence a negative relation but if there is a strong liquidity viability, the institution will experience a positive growth.

Liquidity risk is the risk of loss to MFIs resulting from their inability to meet its needs for cash. The liquidity of MFIs is its ability to fund all contractual obligations as they fall due. These may include lending and investment commitments and deposit withdrawals and liability maturates, in the normal course of business.in the world in Cameroon.

Profitability greatly depends on Liquidity in other to increase the equity and more profits to MFIs, the entire financial intuitions in the world depends on adequate liquidity and if a Financial Institution is facing liquidity risk it affects the profitability of the Institution and hence limiting operations and bringing down the financial line because the financial world is interlined to one another and the collapse of one might affect the others. .

EveryMFI is required to keep certain percentage of their deposit as reserve with a commercial bank and the league which is CamCCul and it is being used when the institution goes short of funds. Reserve ratio is very important for MFIs to keep as stipulated by COBAC with a percentage of 40% and according to Gay (2011), MFIs keep reserve for liquidity management.

Profitability is the ability of MFIs to generate revenue in excess of cost. Strong profitability aids MFIs to withstand negative shock and contribute to the firmness of their financial system. Profitability of MFIs can be expresses as a function of internal and external factors. The internal factors can also be called micro factors and can be seen as a financial statement variable such as loan composition and the external factor can be seen as market growth and market share in ownership.

The MFIs in Cameroon over the years witnessed various changes ranging from technological change and their aim is focused on how to maximize profit but most times are faces with dilemma like certain risk that can lead to them winding up like some cases mentioned below. Following the collapse of COFINEST   in 2010, it affects customers and members negatively and in 2011 the government of Cameroon issued the closure and since then, there has been a high regulatory system to control the activities of MFIs. MFIs are made up of three categories which are category 1, 2 and 3 and all lies on liquidity to make profit.

Because liquidity is an important aspect in MFIs and thus serves as a foundation and it is liquidity that keeps the MFIs in action and gives great capacity for growth. It is through this liquidity that MFIs can be chattered and increases its performance on profitability which is an objective and a focus to maximize profit and also meeting customer’s obligations in granting out of loans.

Liquidity risk is the risk at which MFIs is unable to meet its customer’s obligation through granting of loans or deposit withdrawal and when MFIs is facing liquidity risk, it affects it negatively and the performance on profit reduces drastically. A great portion of the economy of CEMAC is finance to a great extent by MFIs because they help to develop countries and boost entrepreneurship amongst low income earners (George et la ,2000 ) MFIs are hook wires of every economy and the health of the MFIs sector is actually the health of an economy because healthy MFIs system leads to healthy economy .

A Survey was carried out in 2013 as to why Muyenge Cooperative Credit Union in Kumba shut her doors and went out of business and the result was that ,the cooperative went through series of financial challenges to an extend that they were unable to meet customer’s demand and also unable to pay workers due to inadequate cash and no  profit was generated due to the fact that no sufficient cash was make available for loan and they were forced to shut their doors due to liquidity risk.

In this study we are going to analyze the effect of liquidity risk on profitability ofMFIs and also implying solutions which are recommendations on how to reduce or erase this risk so that the profits of MFIs can stand at it maximum.

Liquidity risk is a great threat to MFIs and they will stand at the negative in terms of profit margin and thus reducing performance as the inflow will drop and thus creating setbacks to a MFIs and the coming of this study will help combat this plaque and thus MFIs profitability will increase. Here our population will be the south west Region of Cameroon and the target population will come from Kumba and the random sampling will come from the financial institutions like MFIs and to be precisely category 1 micro finance institutions, how to resolve this plaque in other to have a healthy profitability index in our banking world.

Liquidity risk is a major risk that has makes many MFIs like credit unions to be liquidated and thus liquidity risk should not be undermined since most small income earners depend on this institution for loans and banks depend on the loans given out to make maximum profit.

1.2   Statement Of The Problem.

The impact of liquidity position in management of financial institution and other economic unit have remained fascinating, though very elusive in the process of investment analysis through portfolio management. Liquidity refers to the to the speed and certainty with which an asset can be converted to cash whenever the asset holder desires, cash is the most liquid asset to all liquidity management seeks to ensure attainment of the short term objectives.

A liquid financial institution is one that stores liquid asset and cash together with the ability to raise funds quickly from other source to enable it meet its payment obligation and financial commitment in due time. Liquidity is considered as the success of financial institutions therefore any ineffectiveness in its management can encounter a huge problem that affects the affairs of the financial institution.

The financial sector as a whole has experienced some drastic changes in recent years, as technology and globalization continue to create both opportunities for growth and challenges for financial managers to remain profitable in their increasing competitive environment. The failures of most financial institutions in the world have been due to the inefficiencies in the management of the liquidity which in one way or the other had something to do with either liquidity inadequacy in their management of liquidity incompetence.

The determinants of profitability of financial institutions are an important matter which helps in the appreciation of the contemporary conditions of the financial system to be considered in policy formulation for profitability and growth. In the Basel committee (1988) had set out regulatory standards and Basel II Accord, regulatory standard for liquidity risk was mentioned.

It is important for a financial institution to understand the effect of each of the liquidity components on the firm’s profitability and also seek measures to maximize its liquidity level. High liquidity risk can lead to reduction of profit in all MFIs because liquidity is a crucial factor that impacts MFIs viability and soundness and one of the major impacts it does is in profitability. High liquidity risk occurs when their shortage of fund in MFIs and are not able to meet their obligations in due time.

When there is no fund, MFIs cannot give out loans and thus cannot earn profits as the above cited case of Muyenge Cooperative Credit Union Kumba that shut her doors and went out of function in 2013. Overall statistics have proven that many MFIs suffer liquidity risk because they don’t abide in regulatory rules to keep 40% as reserve and also they didn’t keep asset near cash that is liquid asset.

Muyenge cooperative Credit Union Kumba increases her interest rate and despite the increase, the rate of deposit amount did not increase and MFIs depends mostly also on customers’ deposit in other to make loan available and at the end makes profit. Profit cannot be gotten without liquidity because increase in profit and sufficient cash will be making available for loans which in turn will yield or maximize profits.

MFIs objective is to make profit and profit cannot be make without sufficient cash and liquidity risk have forced many MFIs to close down or liquidated and that destabilizes its activities and thus reduce profits, MFIs depend on liquidity and low level of liquidity  might lead to low profitability One of MFIs objective is profit maximization and this can happen only through giving out of loans and if they can’t meet up due to liquidity risk  the performance of profit reduces and MFIs cannot survive without liquidity and if face by liquidity risk, the profit margin drops greatly that is it leads to low profit.

Profit increases as the customer will pay both principal and the interest of the loan. Liquidity risk is one of the major problems that limit MFIs activities as customers will not have loan and most of MFIs profit comes from loan and if MFIs can’t make out loan, their performance drops thus profit is affected.

Also its been observe that customers who applied for loan and could not gain access to it, closes their account from MFIs and thus our interest on this study is to implement solutions in reducing the risk and making liquidity always available to meet the objective for profitability bringing out solutions in other to benefit both MFIs and their customers, thus we wish to analyze the effect of liquidity risk on the profitability of MFIs.

1.3 Research Questions

Based on the above problem, we were able to bring out 3 questions from the problem we discovered and the questions go thus;

1. What is the effect of liquidity risk on the profitability of MFIs?
2. Is there any relationship between liquidity risk and profitability?
3. What can be done to solve or reduce liquidity risk problems?

1.4. Research Hypothesis.

This research statistically tests the following null hypothesis;

H0: Liquidity risk has no significant effect on the profitability of MFIs

1.5 Research Objectives.

The main goal of this study is to analyze the effect of liquidity risk on profitability.

The specific objectives include;

1. To analyze the effect of liquidity risk on the profitability of MFIs..
2. To analyze the relationship between liquidity risk and profitability
3. To evaluate measures or ways in solving liquidity problems.