Why Banks Must Strike a Balance Between Profitability and Liquidity

Profitability and Liquidity are two basic concepts that attract the attention of all banks. Given the position of banks as catalyst to economic development, they cannot afford to fail their customers nor the public in any of these two issues.Banks want to make profits but at the same time they are concerned about liquidity and safety. Banks have to earn profits because if they don’t, they would not work at all, as the shareholders would withdraw their invested capital in the business if proper and adequate dividends are not earned. Hence they have to earn profits for their shareholders and at the same time satisfy the withdrawal needs of its customer

A commercial bank should be liquid enough to meet the daily cash need for customers. Even at that, the keeping of idle raw cash in a bank’s strong room is unproductive and creates great loss to a bank. Apart from the inherent risk of keeping cash, there is the cost of insurance on a daily basis. There is also the need not to exceed the cash on premises (COP) limit approval for the branch, which default has a penalty attached to it . Since idle cash in the branches earn no interest, banks deposit this cash with CBN and earn interest or better still sale the cash to other banks that may need them. They trade the cash with other banks through their treasury departments as ''call money", "placement", "treasury bills", "treasury certificate", or other near liquids,  which they can easily convert when needed.

A prudent bank tries to make some profit from every One Naira(#1.00)  deposit made into account by a customer. And mindful of the cost of these deposits (interest paid to the customers or lenders), a bank must turn these liabilities to assets that can earn enough to take care of running cost. In the bid to make more profits a bank may trade on very risky ventures. However the regulatory  authorities through rules and policies may prohibit a bank from over trading or creating excess credits.

To avoid ugly "cash run’’, banks must be adequately liquid. They may resort to withdrawing cash from cash from their accounts with CBN; or even from some windows like the Special Drawing Fund (SDF), provided by the apex bank. It is worth noting that banks are required statutorily to keep certain percentages (legal reserve ratio) of their deposit liabilities with CBN, and other special deposits as control and confidence building measures.

However, profitability is a key word in commercial banking. And to remain profitable in business, banks must give out loans facilities from their deposit liabilities, at a reasonable interest charges. Banks therefore make the buck of their declared profits through financial intermediation. The proper use of liquidity brings about profitability. A bank must be socially responsible in the pursuit of profit to create goodwill for itself, hence repeat purchases of its products by confident customers and prospects alike. There must therefore be a balancing of profitability with customer satisfaction through excellent services delivery strategies.


In order to make the best out of these conflicting corporate objectives, there is need to strike a balance between profitability and liquidity is through ALM

ALM (Asset - Liability Management) is  the process of planning, organizing,and controlling asset and liability volumes,
maturities, rates, and yields in order to balance interest rate risk and maintain acceptable profit and liquidity levels.

One of the main ways in which this is
done is by adjusting the interest rates on loans and deposits in line with their respective maturities in an aim to reduce interest rate risk and maximise profitability. Banks also achieve this by placing guidelines on the types of loans and deposits the sales and marketing departments have to sell at a moment in time.

Apart from ALM, liquidity buffer which describes minimal levels of cash that are deposited within central banks (i.e. Central Bank of Nigeria, Bank of England for UK, Federal Reserve for
U.S.A. etc.) could aid bank's liquidity. This buffer is required to ensure that a bank’s liquidity remains at a sufficient level to protect the bank if a run on the bank were to occur.

Also, Loan-Deposit Ratio (LTD) which is utilised to assess the liquidity and profit earning potential of a bank at any instant and is given by the formula:

if the ratio is greater than 1, the bank does not have enough deposits to fund its outgoing loans. This is a risky position to be in. If a run on the bank were to occur in these circumstances, the bank would not have enough money in stock to cover the deposits made by its customers. The bank would therefore have to rely on wholesale markets that may or may not be prepared to help the bank at its time of need.

If, on the other hand, the ratio is less
than 1, the bank is utilising its own
customer’s deposits to finance its
loans. This is a better position to be
in as there is a surplus of customer
deposits which in turn would be held
in liquid Central Bank of Nigeria deposits.

All in all, striking a balance between the two corporate objectives, gives a win win situation for all parties as shareholders interest will be protected by earning returns on invested funds which add up to profit to be declared at the end of the year  and customers (most especially demand deposit customers, ) will have access to their deposit at any time.