CHAPTER ONE

INTRODUCTION

1.1 Background of the studies

In today’s world, MFIs play an important role in the economic development of every country it acts as one of the actors helping the economy to effectively use idle capital, and providing many modern banking services. In the process of implementing their financial intermediary function, MFIs have to face many risks, because they provide short, medium and long-term credit, but must also ensure liquidity at all times.  Researching on the causes of the banking system crisis, the Basel Committee on banking supervision (2004) pointed out one of the important causes of the crisis of MFIs, which is liquidity problem. A bank with good liquidity will generate prestige and trust from customers, thereby promoting its business activities such as raising capital, lending, and other activities (Gambacorta & Mistrulli, 2004). Conversely, a bank having liquidity problems can weaken the bank’s capital as well as its assets (Diamond & Rajan, 2001).

Liquidity is a vital condition for any business. The failure to meet payment obligations on time can trigger bankruptcy and gives creditors the right to take possession of the organization’s assets. Liquidity is even more crucial for financial institutions because they are particularly vulnerable to unexpected and immediate payment demands. This is the nature of the loan making and deposit taking business. To stay in business, the institution must be able to pay out legitimate withdrawals and credit requests instantly. 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 obligations. Dilemma in liquidity management is to achieve desired trade-off between liquidity and profitability. 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 positive impact on its profitability (Raheman and Nasr, 2007).

In the US, after the Global Financial Crisis (GFC) commercial banks were exposed to Asset & Liability mismatch on both Balance Sheet and Off-Balance Sheet activities (Brunnermeier, 2009). The result was catastrophic. Several banks went under, with the effect being felt worldwide as the “global recession”. This shows that liquidity of MFIs is fundamental to both the local economy and the world at large. This is aggravated by the roles played by banks in the economy apart from credit extension. They form the nerve center of the economy hence the study of liquidity determination is of focus by academics, practitioners and regulators.  Studies on the determination of bank liquidity are still very few save for studies such as; Valla et al (2006), Vodova (2011), Moore (2009), Raunch (2010), Fadare (2011), Tseganesh (2012) and Chagwiza (2014).

Due to the great importance of the banking sector in the global economy, some authors seek to research which banking policies are being well implemented and create value, and which need to be restructured to contribute more and better to the economic health of institutions, as well as to the economic development of these countries. According to the financial literature (Athanasoglou et al.2008; Dietrich and Wanzenried 2011; Defung et al .(2016), banking performance, measured through profitability and /or by both internal determinants and bank external factors. In fact, according to Trujillo-Ponce (2013); Ding et al., (2017) or Sufian &Kamarudin (2015), the determinants of the bank’s performance can be divided. First, there is a group of bank-specific determinants directly resulting from management decisions, such as asset composition, bank capitalization, operational efficiency, or bank size, among others. The second group of determinants includes the macroeconomic environment or the sector specificity, such as state participation, economic growth, and public debt, among others.

The trade-off between liquidity and profitability has been a burning issue in the field of banking sector. Theoretically, both liquidity and profitability are affected by the working capital decisions of any company. Excess of investment in working capital may result in low profitability and lower investment may result in poor liquidity. Therefore, the management needs to tradeoff between liquidity and profitability to maximize shareholders’ wealth. Every organization, whether profit-oriented or not, irrespective of size and nature of business, requires necessary amount of working capital. Working capital is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business (Mukhopadhyay, 2004).

It is observed that if a firm wants to take a bigger risk for profits, it minimizes the dimension of its working capital in relation to the revenues it generates. If it intends to improve its liquidity, that in turn raises the level of its working capital. Nonetheless, this technique might tend to reduce the sales volume and consequently, it would affect the profitability. Thus, a company needs to have a striking balance between liquidity and profitability. In order to maintain high profitability levels, companies might need to forfeit their solvency by maintaining relatively low levels of current assets. As soon as the companies start doing so, their profitability would improve as less amount of money is fastened up to the idle current assets and their solvency would be in danger. Therefore, excessive levels of current assets may have a negative effect on the firm’s profitability, whereas a low level of current assets may lead to lower level of liquidity and stock outs, resulting in difficulties in maintaining smooth operations. (Van & Wachowicz, 2004).

Liquidity management is highly important for not only banks but also for the total system since the consequences of liquidity insufficiency can be extremely felt on both scales from the bank to the full system. Therefore, banks are responsible for sound management of liquidity risk, which focuses on conserving enough level of liquidity, moreover being ready to face a range of pressure situations, probable losses, or weakness of funding sources (Sviatlana & Lara, 2017).The failure to meet payment obligations on time can trigger bankruptcy and gives creditors the right to take possession of the organization’s assets. Liquidity is even more crucial for financial institutions because they are particularly vulnerable to unexpected and immediate payment demands.  This is the nature of the loan making and deposit taking business. To stay in business, the institution must be able to pay out legitimate withdrawals and credit requests instantly.  Liquidity plays a significant role in the successful functioning of a business firm 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 positive impact on its profitability (Raheman & Nasr, 2007) a study by investigated the impact of credit risk management practices on the financial performance of microfinance institutions in Kenya. The findings suggested that effective credit risk management significantly influenced the financial performance of these institutions Muriithi et al. (2020).

But both the terms are contradictory in nature. If banks maintain more liquidity, their profitability decreases, and if they increase their profitability, they will have to reduce their liquidity. Liquidity of bank refers to reserves of cash, securities, bank’s ability to convert an asset into cash, and unused bank lines of credit. Liquidity must be adequate to meet all maturing unsecured debt obligations due within a one-year time horizon. Despite different approaches that can be used to analyze bank’s liquidity, the following are the key ratios that can be used to examine bank’s liquidity: Cash-Deposit Ratio (CDR), Credit-Deposit Ratio (CRDR) and Investment-Deposit Ratio (IDR) and whether they could be converted quickly to cover redemptions. On the other hand, profitability of the bank determines its ability to increase capital (through retained earnings), support the future growth of assets, absorb loan losses and provide return to investors. The key financial ratios that are used in assessing the profitability of a bank include: Return on Assets (ROA), Return on Equity (ROE), Net Interest Margin to Total Assets, and Operating Profit to Total Assets. Keeping this in mind, banks have to do a balancing act between liquidity and profitability, Badola & Verma R (2006)

1.2 Statement of the Problem

In 2019, the banking sector has shown good financial performance, although there has been a decline in profits, which has increased the risk of profitability. In terms of banking liquidity, the decline in liquidity risk compared to the same period of other years came as a result of increased liquid assets, in the form of deposits and assets held in the CBK. The increase in the risk of solvency is attributed to the decrease in the level of maximization, but it is still significantly higher than the minimum required by the CBK regulations. (CBK – Financial Stability Report, 2019). Up to now, there have been many studies on liquidity and factors affecting the liquidity and profitability of MFIs. However, most studies were done for the entire Cameroon MFIs and commercial banking system, there are no studies focusing specifically on MFIs in Bamenda or particular banks. Moreover, previous studies on factors affecting liquidity only examine the impact of each individual factor on liquidity, but not the interaction between banks liquidity and profitability.

The problem then becomes how to select or identify the optimum point or the level at which a MFIs can maintain its assets in order to optimize these two objectives since each of the liquidity has a different effect on the level of profitability. This problem becomes more pronounced as good numbers of MFIs are engrossed with profit maximization and as such, they tend to neglect the importance of liquidity management. However, the profit maximization becomes a myth as the resulted liquidity can lead to both technical and legal insolvency with the consequence of low patronage, deposit flight, erosion of asset base. This research seeks to investigate other problems such as excess liquidity and the problem of establishing the proportion of the deposits that will be demanded by the depositors at any particular time. There is also the problem of satisfying the two publics of the MFIs simultaneously. Based on the above problems the research work intends to find out the effect of liquidity on the profitability of MFIs in Bamenda.

1.3 Research Questions

1.3.1 Main Research question

What is the effect of liquidity on the profitability of MFIs?

1.3.2 Specific Research Questions

The following research questions were developed following the topic

• What is the effect of Current Ratio on the profitability of MFIs in Bamenda?
• What is the effect of Quick Ratio on the profitability of MFIs in Bamenda?
• What is the effect of Cash Ratio on the profitability of MFI Bamenda?

1.4 Research Objective

1.4.1 Main Research Objective

To investigate the effect of liquidity on the profitability of MFIs in Bamenda 

1.4.2 Specific Research objectives

 The following depicts the specific research questions

• To determine the effect of Current Ratio on the profitability MFIs in Bamenda.
• To examine the effect of Quick Ratio on the profitability of MFIs in Bamenda.
• To assess the impact of Cash Ratio on the profitability of MFIs in Bamenda.