CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Liquidity management is a concept that is gaining attraction around the world, particularly in light of present financial circumstances and the health of the global economy. Business owners and managers throughout the world are concerned about devising a strategy for managing their day-to-day operations in order to satisfy their obligations as they become due while also increasing profitability and shareholder value (Don, 2020).

Liquidity management is a critical goal for financial organizations, not only because it keeps banks from running out of cash, but also because it influences their earnings. In managing its assets and liabilities in the wake of uncertainties in cash flows, cost of funds, and return on investments, a bank must ascertain its trade-off between risk, return and liquidity (Mashok (Placeholder1)o, 2020). Indeed, studies in other countries across the globe have attributed bank failures to poor liquidity management.

This is so because scholars argue that one of the major contributors to the Global Financial crisis of 2007-2008 was poor liquidity management (Adalsteinsson, 2014). This was large as a result of the collapse of Lehman Brothers, a leading Investment Bank which ended up spreading across the globe through the “contagion effect”. According to Choudhry (2011), liquidity management refers to the funding of deficits and investment of surpluses, managing and growing the balance sheet, as well as ensuring that the bank operates within regulatory and stipulated limits. Ideal bank management is an uninterrupted endeavour of assuring that a balance exists between  liquidity,  profitability,  and  risk  (Banks,  2014).  Banks  indeed  require

 

liquidity since such a large proportion of their liabilities are payable on demand (deposits) but typically the more liquid an asset is, the less it yields.

Hence, the decision to choose a particular combination of assets over another, taking into consideration the liability side of a bank, would have a massive effect on bank liquidity management, profitability, and risk (Choudhry, 2012). In managing its assets and liabilities in the wake of uncertainties in cash flows, cost of funds, and return on investments, a bank must ascertain its trade-off between risk, return and liquidity (Landskroner & Paroush ,2011).

Sound liquidity management is an important objective of commercial banks, not only because it prevents banks from running into liquidity shortages but also because it determines their profits. Munyambonera (2010), Olweny & Ongore, and Kusa (2013), as cited in Lukorito et al (2014) have not only identified profitability as the primary objective pursued by commercial banks, but have also recognized that profits are a necessity for successful banking in this era of stiff competition in financial markets, and financial managers are committed to meeting that objective.

The liquidity of banks allows them to grant credits and consequently stimulate investment and growth. To Civelek & Al-Alami (1991), since commercial banks are the primary suppliers of funds to firms, the availability of bank credit at affordable rates is of crucial importance to firm investments, and consequently, to the health of the economy. During the 2007-2009 global financial crises several banks experienced some difficulties because they failed to manage liquidity in a prudent manner. Thus, the crisis emphasized the importance of liquidity to the proper functioning of financial markets and the banking sector (Marozva, 2015).

According to Pradhan and Shrestha (2016), the liquidity risk of banks arises from the funding of long-term assets by short-term liabilities, thereby making the

liabilities subject to rollover or refinancing risk. Further, the liquidity risk is usually of an individual nature, but in certain situations may compromise the liquidity of the financial system as well (Pradhan and Shrestha, 2016). Though liquidity management has always been a priority in most banks, the aftermath of the global financial crisis and lessons learned from it have renewed concerns on bank’s liquidity issues. In a state of turmoil in banking markets, customers can withdraw their deposits at any time and this can lead to bank runs that can lead to costly liquidation of assets.

Liquidity management, therefore, involves the strategic supply or withdrawal from the market or circulation of the amount of liquidity consistent with the desired level of short-term reserve money without distorting the profit-making ability and operations of the bank. It relies on the daily assessment of the liquidity conditions in the banking system, so as to determine its liquidity needs and thus the volume of liquidity to allot or withdraw from the market. The liquidity needs of the banking system are usually defined by the sum of reserve requirements imposed on banks by a monetary authority (Njimanted et al., 2017). The relationship between liquidity and performance is critical to banks. It is generally understood that efficiently monitored liquidity levels lead to good financial results. Effective liquidity management creates good public confidence in the financial system of a country and consequently in the liquidity state of banks.

This can lead to a better return on the bank’s assets (Onyekwelu, Chukwuani & Onyeka, 2018). Ibrahim and Aqeel (2017) underscored the need to make optimum use of liquid funds for investments to enhance profitability, keeping aside adequate funds for meeting operational commitments. Excessive levels of liquid funds will negatively affect profitability, while low levels of liquidity can adversely affect the smooth functioning of banks (Ware, 2015). This means that banks should make trade between liquidity and profitability in order to boost business profit (Bagh, Razzaq, Azad, Liaqat & Khan, 2017).

According to Nwankwo (2004), adequate liquidity enables a bank to meet three risks. First is the funding risk – the ability to replace net outflows either through withdrawals of retail deposits or nonrenewal of wholesale funds. Secondly, adequate liquidity is needed to enable the bank to compensate for the non-receipt of the inflow of funds if the borrower or borrowers fail to meet their commitments.

The third risk arises from calls to honor maturity obligations or from requests for funds from important customers. Adequate liquidity enables the bank to find new funds to honour the maturity obligations such as a sudden upsurge in borrowing under atomic or agreed lines of credit or to be able to undertake new lending when desirable. For instance, a request from a highly valued customer. Adequate liquidity is also needed to avoid forced sale of asset at unfavourable market conditions and a heavy loss.

According to (Ibbih 2018) adequate liquidity serves as a vehicle for profitable operations especially to sustain the confidence of depositors in meeting short-run obligations. Finally, adequate liquidity guides against involuntary or non-voluntary borrowing from the regulatory authorities where there is a serious liquidity crisis, the bank is placed at the mercy of the Central Bank, and hence the control of its destiny may be handed over. The importance of liquidity management as it affects corporate profitability in today’s business cannot be overemphasise. The crucial part in managing working capital is required to maintain its liquidity in day-to-day operation to ensure its smooth running and meets its obligation. Liquidity plays a significant role in the successful functioning of a business firm.

A firm should ensure that it does not suffer from lack-of or excess liquidity to meet its short-term compulsions. A study of liquidity is of major importance to both internal and external analysts because of its close relationship with the day-to-day operations of a business (Musaed, 2020). The dilemma in liquidity management is to achieve the desired tradeoff between liquidity and profitability (Raheman, 2007). The liquidity requirement of a firm depends on the peculiar nature of the firm and there is no specific rule on determining the optimal level of liquidity that a firm can maintain in order to ensure a positive impact on its profitability.

The Financial institution sector in Cameroon is still in its infancy and is dominated by the proliferation of foreign banks. By December 2009, there were twelve financial institutions operating in Cameroon, with only three names, National Financial Credit, Afriland First Bank, and financial institution of Cameroon as indigenous banks. This makes up about 75% of foreign dominance. The financial landscape of Cameroon has however experienced some evolution over the past decades, particularly in the financial institution’s sector, where many microfinance institutions have surfaced. According to Njimanted et al (2017) From 400 to about 652 microfinance establishments in the country at the end of 2008, a progress of 10% compared to 2007 of this number, the Cameroon Cooperative Credit Union League (CamCCUL) occupies a relatively large proportion; 177 credit unions.

However, by 2015, there were 418 accredited microfinance institutions in the country (Ministry of Finance (MINFI), 2015). Financial institution activities have equally increased in coverage and depth with the number of banks increasing from 9 in 1999 to 12 by January 2010 and to 14 in 2016 with branches all over the urban centers in the country. Capital market development has in addition increased the intermediation role of banks within the financial landscape of Cameroon although, with only two companies quoted in the capital market, financial institutions in Cameroon are gradually getting involved in the process of enabling companies to go public through  the  Initial  Public Offering  (IPO). Historically,  banks  must face a certain degree or type of risk which may have a severe impact on the economy or financial system and economic system as a whole. This is why banks, governmental entities, and private industries have tried to understand liquidity management and implement public policy, regulations, and risk assessment policies to mitigate this risk of liquidity.

1.2 Statement of the Problem

The financial performance of commercial banks is a critical aspect of the banking industry, as it directly impacts their ability to meet their financial obligations, invest in growth opportunities, and provide valuable services to their customers. One of the key factors that can influence the financial performance of commercial banks is their liquidity management. Effective liquidity management is essential for ensuring that banks have sufficient liquid assets to meet their short-term obligations, while also optimizing the allocation of these assets to generate returns on capital employed (ROCE) (Sufian & Habibullah, 2009).

The relationship between liquidity management and the financial performance of commercial banks is a complex and multifaceted topic that warrants further investigation. This study aims to examine the specific impact of three key liquidity management variables on the ROCE of NFC Buea, a commercial bank in Cameroon: (1) the liquidity asset to total asset ratio, (2) the cash ratio, and (3) the debt ratio.

The liquidity asset to total asset ratio is a critical measure of a bank’s liquidity position, as it indicates the proportion of a bank’s total assets that are held in liquid form. This objective will investigate how the liquidity asset to total asset ratio influences the ROCE of NFC Buea, providing insights into the tradeoffs between maintaining a strong liquidity position and generating higher returns on capital. The cash ratio is another important measure of a bank’s liquidity, as it reflects the bank’s ability to meet its short-term obligations using its most liquid assets. This objective will explore the relationship between the cash ratio and the ROCE of NFC Buea, helping to understand how the management of a bank’s cash and cash equivalents can impact its financial performance.

The debt ratio is a measure of a bank’s financial leverage, indicating the proportion of its assets that are financed by debt. This objective will investigate the influence of the debt ratio on the ROCE of NFC Buea, providing insights into the tradeoffs between debt financing and the generation of returns on capital. There is need to investigate whether this liquidity management is viable to the banks. This study therefore seeks to investigate the effect of liquidity management on the performance of commercial Banks.

1.3 Research Questions

The research questions for this study are as follows;

1.3.1 Main Research Question

What are the effects of Liquidity management on the financial performance of commercial banks?

1.3.2 Specific Research Questions

1. How does the liquid asset to total asset ratio affect a commercial bank’s return on capital employed (ROCE)?
2. How does the cash ratio affect a commercial bank’s return on capital employed (ROCE)?
3. What is the effect of debt ratio on the return on capital employed (ROCE) of commercial banks?

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