• INTRODUCTION:
A commercial bank is a business entity that deals with banking with a view to making a profit. Every commercial bank aims to make a profit in such a way that it does not compromise its liquidity objective, which is vital for its own safety and security.
• Meaning:
Since a commercial bank has to make a profit in such a way that its liquidity remains intact, it diversifies its funds across various assets. A well-diversified and balanced portfolio of assets ensures its strong and successful operation. Several factors play an important role in determining the profitability and liquidity of commercial banks. These factors are taken into account when creating the banks’ asset portfolio.
• EXPLANATION:
A) FACTORS AFFECTING THE PROFITABILITY OF COMMERCIAL BANKS:
1) Amount of working funds:
The funds deployed by a bank in earning assets are the working funds of the bank. The profitability of a business is directly proportional to the amount of working funds deployed by the bank.
2) Cost of Funds:
Cost of funds are the expenses incurred in raising funds from various sources in the form of equity capital, reserves, deposits, and loans. Therefore, it generally refers to interest expense. The lower the cost of funds, the higher the return.
3) Performance of funds;
The funds raised by the bank through various sources are deployed in various assets. These assets generate income in the form of interest. Therefore, the higher the interest, the higher the return.
4) Propagation:
Margin is defined as the difference between interest received (interest income) and interest paid (interest expense). A higher margin indicates a more efficient financial intermediary and a higher net income. Therefore, a higher margin leads to higher profitability.
5) Operating costs:
Operating costs are the expenses incurred in running the bank. Excluding cost of funds, all other expenses are operating costs. Lower operating costs lead to higher profitability for banks.
6) Cost of risk:
This cost is associated with the probable annual loss on the assets. They include provisions for bad debts and doubtful collection. Lower risk costs increase the profitability of banks.
7) Non-financial income:
They are the income derived from non-financial assets and services. Includes commissions and brokerage on payment facilities, locker rental, subscription fees and financial guarantees, etc. These revenues add to the profitability of the banks.
8) Technology level:
The use of improved technology typically leads to lower operating costs for banks. This improves the profitability of banks.
9) Level of non-performing assets (NPA):
A bank’s profitability is inversely related to the level of non-performing assets. Therefore, over the years, the NPAs of commercial banks have decreased considerably.
10) Level of competition:
Increased competition generally leads to higher operating costs. This leads to lower profitability.
B) FACTORS THAT DETERMINE THE LIQUIDITY OF COMMERCIAL BANKS:
1) LEGAL REQUIREMENTS:
The extent of liquid reserves held by banks depends on the legal requirements of the Central Bank (ie the RBI). According to the RBI, commercial banks have to maintain a certain CRR (cash reserve ratio) and SLR ( legal liquidity ratio) Higher CRR and SLR result in lower liquidity.
2) People’s banking habits:
The nature of the economy has an impact on people’s banking habits. In developing countries, every transaction is limited to business. People are more dependent on cash transactions. Therefore, the need for liquidity is comparatively higher.
3) Monetary transactions:
The number and magnitude of monetary transactions determine the liquidity of banks. Higher currency transactions lead to higher liquidity.
4) Nature of the money market:
In the case of fully developed money markets, banks easily buy and sell securities. Therefore, the liquidity requirement is lower.
5) Structure of the banking system:
The branch banking system requires less liquidity as cash reserves can be centralized at the head office. Unit Banking System requires a higher degree of liquidity.
6) Number and size of Deposits:
The number and size of deposits influences the liquidity of banks. The increase in the number and size of deposits will require greater liquidity.
7) Nature of Deposits:
Commercial deposits with banks are of various types, such as time deposits, demand deposits, short-term deposits, etc. larger demand deposits/short-term deposits need higher liquidity
8) Liquidity Policies of other banks:
Several banks may operate in the same area. Therefore, the liquidity policies of other banks also have an impact on a bank’s liquidity to build goodwill among depositors.
• CONCLUSION:
THUS, several factors determine the liquidity and profitability of commercial banks. Therefore, these factors are taken into account when creating the asset portfolio of commercial banks. These factors influence the reconciliation of profitability and liquidity that leads to a strong and successful banking system.
