The Relationship between Liquidity and Profitability: An Empirical Study on the Listed Commercial Banks in Pakistan

Abstract

The dilemma of the bank liquidity-profitability relationship is well documented in the existing literature. However, the previous studies have employed the traditional ratios of banks' liquid assets to total assets or deposits for measuring bank liquidity. These measures focus on liquid assets exclusively and do not account for a bank's liabilities, equity, and off-balance sheet
activities, which equally contribute to the bank liquidity creation. Consequently, the studies failed to provide conclusive findings on the liquidity-profitability relationship. This study aims to provide new insight into this relationship by using normalized liquidity creation as an inverse measure of bank liquidity. Both accounting-based and market-based measures are applied to quantify bank
profitability. The study investigates the 22 Pakistani commercial banks listed on Pakistan Stock Exchange during 2012-2016. After controlling for the bank size, the results indicate a significant negative impact of bank liquidity on both accounting-based and market-based measures of profitability. The study's findings suggest that the Pakistani banks should redesign their liquidity
management strategies to distribute the excess liquidity to the society rather than holding with them. This will result in bank higher profitability and will be a tremendous economic service for the society.