Which factors determine the profitability and liquidity of banks?

Published: 17th March 2011
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A commercial bank is a business entity that deals in banking with a view to make profits.

Every commercial bank aims to make profits in such a way that it does not compromise on its objective of liquidity, which is vital for its own security and safety.

Meaning :

Since a commercial bank has to make profits in such a way that its liquidity remains intact, it diversifies its funds into various assets.

A well diversified and balanced asset portfolio ensures its sound and successful working.

Various factors play an important role in determining the profitability and liquidity of commercial banks.

These factors are taken into consideration while creating the asset portfolio of the banks.



1) Amount of working funds :

Funds deployed by a bank in profitable assets are the working funds of the bank.

Profitability of a business is directly proportionate to the amount of working funds deployed by the bank.

2) Cost of funds :

Cost of funds are the expenses incurred on obtaining funds from various sources in the form of share capital, reserves, deposits, and borrowings.

Thus, it generally refers to interest expenses .

Lower the cost of funds, higher the profitability.

3) Yield on funds ;

The funds raised by the bank through various sources are deployed in various assets.

These assets yield income in the form of interest.

So, higher the interest, greater the profitability.

4) Spread :

Spread is defined as the difference between the interest received (interest income ) and the interest paid (interest expense ).

Higher spread indicates more efficient financial intermediation and higher net income.

Thus, higher spread leads to higher profitability.

5) Operating Costs :

Operating costs are the expenses incurred in the functioning of the bank

Excluding cost of funds, all other expenses are operating costs.

Lower operating costs give rise to greater profitability of the banks.

6) Risk cost :

This cost is associated to the probable annual loss on assets.

They include provisions made towards bad debts and doubtful debts.

Lower risk costs increase the profitability of banks.

7) Non interest income :

It is the income derived from non financial assets and services

It includes commission & brokerage on rencittance facility, rent of locker facility, fees for underwriting and financial guarantees, etc.

This income adds to the profitability of banks.

8) Level of technology :

Use of upgraded technology normally leads to decline in the operating costs of banks.

This improves the profitability of banks.

9) Level of Non performing assets (NPAs):

The profitability of a bank is inversely related to the level of NPAs.

Hence, over the years, the NPAs of commercial banks have greatly declined.

10) Level of competition :

Increase in competition generally leads to higher operating costs.

This leads to lower profitability.



The extent of liquid reserves held by banks depends on the statutory requirements of the Central Bank (i.e. the RBI)

According to RBI, commercial banks have to maintain a certain CRR(cash Reserve Ratio ) and SLR (statutory liquid ratio)

Higher CRR and SLR result in lower liquidity.

2) Banking Habits of the people :

The nature of the economy has an impact on the banking habits of the people.

In developing countries, cheque transactions are confined to business. Individuals depend more on cash transactions

Hence, the need for liquidity is comparatively higher.

3) Monetary transactions :

The number and magnitude of monetary transactions determine the liquidity of banks.

Higher monetary transaction lead to higher liquidity.

4) Nature of Money market :

In case of fully developed money markets, banks buy and sell securities easily.

Therefore, liquidity requirement is lower.

5) Structure of Banking system :

Branch banking system requires lower liquidity since cash reserves can be centralized in the head office.

Unit Banking System requires higher degree of liquidity.

6) Number and size of Deposits :

The number and sized of deposits influence the liquidity of banks.

Increase in the number & size of deposits will require higher liquidity.

7) Nature of Deposits :

Deposits trade with the banks are of various types like time deposits, demand deposits, short term deposits, etc. larger demand deposits /short term deposits need higher liquidity

8) Liquidity Policies of other banks :

Various banks may function in the same area

So, liquidity policies of other banks also have an impact on the liquidity of a bank to build goodwill among depositors.


THUS, various factors determine the liquidity and profitability of commercial banks.

So, these factors are taken into consideration while creating the asset portfolio of commercial banks.

These factors influence the reconciliation of profitability and liquidity that leads to a sound and successful banking system.

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