The performance of banking system and liquidity risk impact: (A case study of Pakistani Banks)

Introduction: The strength of the banking system is an essential requirement to ensure the economic stability and growth (Halling and Hayden, 2006). Banks are the main part of the nancial sector in any economy, performing valuable activities on both sides of the balance sheet. On the asset side, they enhance the ow of funds by lending to the cash starved users of funds, whereas they provide liquidity to savers on the liability side (Diamond and Rajan, 2001). Banks also facilitate the payments and settlement systems and support the smooth transfer of goods and services. They ensure productive investment of capital to stimulate the economic growth.They help to develop new industries, there by increasing the employment and facilitating the growth. The varied nature of functions performed by the banks exposes them to liquidity risk the risk that a bank may not meet its obligations (Jenkinson, 2008) as the depositors may call their funds at an inconvenient time, causing re sale of assets (Diamond and Rajan, 2001), negatively affecting protability of the bank (Chaplin et al., 2000). Overthepastfewyears,bankmanagersdidnotpaytherequiredattentiontothisvital element of liquidity risk (Committee of European Banking Supervisors (CEBS, 2008)). Lately, it has obtained a signicant attention from the researchers, regulators and nancial institutions after various economic and banking crises across the globe. There hasbeenanimminentfeelingthatliquidityriskhasnotbeensufcientlycoveredwiththe prevailing risk management practices(Crowe,2009).It is said to be the assassin ofbanks (Ali,2004).Thisclaimndssupportfromthefailureofmanybanksintherecentpast.The banks and regulators are now having deep insight into the liquidity position of banks. Liquidity risk not only affects the performance of a bank but also its reputation (Jenkinson, 2008). A bank may lose the condence of its depositors if funds are not timely provided to them. The banks reputation may become at stake in this situation. In addition to this, a poor liquidity position may cause penalties from the regulator. Therefore, it becomes imperative for a bank to keep a sound liquidity arrangement. Liquidity risk has become a serious concern and challenge for the modern era banks (Comptroller of the Currency, 2001). High competition for consumer deposits, a wide array of funding products in wholesale and capital markets with technological advancements have changed the funding and risk management structure (Akhtar, 2007).

A bank having good asset quality, strong earnings and sufcient capital may fail if it is not maintaining adequate liquidity (Crowe, 2009). Banks should be equipped to deal with the changing monetary policy that shapes the overall liquidity trends and the banks own transactional requirements and repayment of short term borrowing (Akhtar, 2007). There are a number of other risks faced by banks such as credit risk, operational risk and interest rate risk, which may culminate in the form of liquidity risk (Brunnermeier and Yogo, 2009). Banking Sector in Pakistan

Radical changes have been observed in banking sector of Pakistan over a phase of 62 years. Originally it undergoes lack of capital and indecision due to established political and socioeconomic calamity. Ensuing amendments were made to amount the power and function of SBP from side to side State Bank of Pakistan Act 1956 which motivated the private sector to set up financial institutions and banks. In addition privatization developments of banking sector which begin in 1992 provoked local investors and motivated foreign banks (Ahmad, Malik, & Humayoun, 2010). Network of banking system in Pakistan amounted to Rs. 638 billion in 20082009, which was Rs. 131 billion in 2003-2004. While total assets for the banking sector amounted to Rs. 5595 billion in 2008-2009, which were Rs. 3003 billion in 2003-20043. At present 5 Islamic banks and 24 conventional banks are participating in extremely competitive atmosphere4. Pakistani banking system Pakistans banking system is a key engine of growth and main lender to public and private sectors, similar to other regional countries banking systems of India, BangladeshandSriLanka(Pereraetal.,2006).State Bank of Pakistan(SBP)regulate sall the banks and development nancial institutions (DFIs) in Pakistan, under the Banking Companies Ordinance, 1962. Some major amendments in banking laws were made during the year 1997. Resultantly, SBP became an autonomous body for banking supervision. It is the responsibility of SBP, under section 40(A) of the said Ordinance, to monitor the performance of every bank to ensure its conformity with the dened criteria, rules and regulations. SBP has the power to take remedial steps in case of any noncompliance by the banking companies. According to quarterly performance review of the banking system by SBP (September 2010), the Pakistani banking system consists of 40 banks, excluding DFIs and non-banking nance companies. Structurally, SBP has divided these banks into four categories namely; public sector commercial banks (4), local private banks (25), foreign banks (7) and specialized banks (4). Liquidity risk Liquidity risk is a risk arising from a banks inability to meet its obligations when they come due without incurring unacceptable losses (Comptroller of the Currency, 2001). This risk can adversely affect both banks earnings and the capital. Therefore, it becomes the top priority of a banks management to ensure the availability of sufcient funds to meet future demands of providers and borrowers, at reasonable costs. Role of SBP: Liquidity risk is the potential for loss to an institution, arising from either its inability to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable cost or losses. In easier terms, liquidity risk can be dened as the risk of being unable to liquidate a position timely at a reasonable price (Muranaga and Ohsawa, 2002). There are two key dimensions of liquidity risk cited in this denition: (1) liquidating the assets as and when required; and (2) at a fair market value. Banks face liquidity risk if they are not liquidating their assets at a reasonable price. The price fetching remains precarious due to frazzled sales conditions, while liquidating any of the banks assets urgently. This may result in losses and a signicant reduction in earnings. Large-scale withdrawal of deposits may create a liquidity trap for banks (Jeanne and Svensson, 2007; Kumar, 2008), but this may not be always the primary source of liquidity risk (Diamond and Rajan, 2005; Holmstrom and Tirole, 2000). There are various other factors creating massive liquidity problems for the banks. For example, the extensive commitment based, and long-term lending may create serious liquidity issues (Kashyap et al., 2002). Banks having large commitments are bound to honour them when they become due. Moreover, banks having a large exposure in long-term lending may face problems of liquidating the same during times of immense liquidity pressure.

Review of Literature Diamond (1999) has a mechanisms that commit the lender to collecting the loans create liquidity. A bank is structured to be such a mechanism. If the lender finances using demand deposits, she cannot hold up depositors and instead has to pay them the promised amount. Intuitively the sequential service constraint creates a collective action problem among depositors, which makes them run on the bank whenever they think their claim is in danger. When the bank has the right quantity of deposits outstanding, any attempt by the banker to extort a rent from depositors by threatening to withhold her specific collection abilities will be met by a run, which disinter mediates the banker and 39 drives her rents to zero. Thus the banker will not attempt to extort rents, and can commit her human capital to collecting the loans. An important contribution of this paper is to tie the notion of illiquidity of financial assets to the specific skills a lender may have. These skills may have to do with the knowledge the lender acquires about a particular borrower or with expertise acquired by repeated interaction with a certain class of borrower or with a certain type of contract. If these skills are not widely available the lender's financial assets are illiquid with attendant consequences to the borrower. Ghafoor (2000) Islamic Banking system is under evolution and as an alternative solution to many existing banking systems worldwide, it is required to be institutionalized in such a way that it can be acceptable internationally. Therefore, in this regard International Islamic Financial Market. Banking system to international financial markets. IIFM also works as facilitator for Islamic Banks of its member countries to make their reach possible to international secondary markets, where they can trade holding Islamic financial instruments. This has increased the cross-border acceptability of Islamic financial instruments and helped out in intensification of cooperation among different Muslim countries. The IIFM head office is located in Bahrain, and in April, 2002 it had started its complete operations. In present day scenario, Islamic banks are still facing too much liquidity problems and are using very costly techniques such as term commodity mudarabah and other practices for liquidity management, but LMC is working on process development for interest free inter-bank money market to help Islamic Financial Services Institutions (IFSIs) in an effective management of assets liability difference. This will enable Islamic banks to become generators of funds at the same time users of funds and LMC will work as market maker for them in such kind of situation.

Rob (2001) liquidity risk is the assassin of institutions. If an institution leaves itself vulnerable, a cycle of market concerns and credit downgrades, followed by short-term demands for cash and rising funding costs, can put a substantially healthy concern in its grave almost overnight. Liquidity risk is not just a concern for insurers. Its a risk that has helped to cripple all manner of companies from banks to fund managers to manufacturers, and has this year played a key role in the fall in for-tunes of energy risk management giant Enron. Yet it has proved problematic to define and measure, and the best practices associated with managing liquidity are in a state of flux. One area of confusion is that while a liquidity problem is simple enough to define the inability of an institution to meet demands for cash the risk of this transpiring can arrive from a number of different directions. The most obvious threat is that a company will make a straightforward error in its judgment of the timing of the cash flows into or out of an institution. Managing this maturity gap risk has always been a key skill of financial institutions, and notably of banks, whose role is sometimes defined as the provision of liquidity between short-term depositors and longer-term borrowers. But getting cash flow timing right has always involved an important element of judgment in estimating the likelihood of funds being drawn down by customers. Acharya (2006) In this article, we have attempted to provide a conceptual link between liquidity

risk and correlation risk, and the implications of this link for risk management at financial institutions. At the heart of our ideas has been the notion that large negative asset shocks lower the net worth of financial intermediaries and bring them closer to capital or collateral constraints they face. These constraints arise in equilibrium as a market response to more fundamental adverse selection and moral hazard problems, or simply due to regulatory requirements. Understanding the micro-foundations of liquidity risk and correlation risk thus necessarily requires a closer scrutiny of the specific institutions that give rise to these constraints. Another important consideration is what prevents outside capital (e.g. pension funds, insurance funds, etc.) from entering a market when there is an illiquidity discount in this market.

Akhtar (2007) have worked in the Paradigm in the banking sector of the Pakistan. As this sector is relatively more robust, market based and highly profitable than it was ever before. He has discuss the overall risks Pakistani banks face as a result of the changing economic and banking paradigm, he has identify the role bank regulations and supervision play in risk management, and shares perspective on the key risks facing Pakistani banks and briefly touch on the emerging trends and he highlight Central bank and banking industrys initiatives to strengthen the banks and system wide risk management Harner (2008) as he commentators have observed, the 2008 recession was a wake-up call for risk management. Many firms not only were surprised by developments during the recession but also had no effective means to communicate or respond to the changing financial landscape. The subprime-mortgage crisis and subsequent events paralyzed their operations. Better riskmanagement practices would not have averted the 2008 recession, but they might have shortened the duration and eased the severity of the financial turmoil. As policymakers and firms reflect on the recession, they should consider how risk-management improvements can help firms operate more efficiently and be better prepared for the next round of operational or economic surprises. Fusibility Study Report(2008) The far-reaching transformations taking place in nancial markets over the past decade have changed the contour of liquidity. Nowadays, a signicantly part of market liquidity creation lies outside the banking system. Alongside the traditional bankmediated liquidity, there is a second and growing component which depends on the amount of credit that financial intermediaries are willing to extend to each other. As a consequence, market participants are more dependent on market liquidity; there is a close interaction between liquidity and valuation; new contagion channels have appeared; and, finally, uncertainty has a bigger impact than before on market and funding liquidity.

Hart (2008) have highlighted the liquidity risk management. He says that the liquidity and solvency are heavily twins of banking, frequently indistinguishable, An illiquid bank can rapidly become insolvent, and an insolvent bank illiquid. As Tim Condon noted in 1950s liquid asserts were typically 30 percent of British Clearing banks total asserts and these largely consisted on treasury bills and short dated government debt. It is worth noting that many through not all of the aspects of this present crisis were foreseen by financial regulators. They just did not have the instruments or perhaps the will to do anything about it. Moreover these two elements of a banks liquidity management are themselves inter-twined.

Ismal (2010) analyze and evaluate the present liquidity management in the Indonesian Islamic Banking industry. He has proposed an integrated and comprehensive program of liquidity risk management which capture and assimilates the whole aspects of the issue and brings the industry into a better way of managing liquidity risk based on Sharia Principles. The program appoints the institutional Deeping , restricting the liquidity management on asserts side and liability sides and revitalizing the usage of Islamic liquid instruments. The purpose of the program is to lead the Indonesian Islamic banking industry into a better way of managing liquidity risk. JWGs Analysis Report(2010) have explain Risk Management that it is not a new concept; it is the bedrock of the financial service industry. However following the renewed political drive to protest against economic socks, global regulatory bodies have targeted new, prescriptive measures and stringent controls which build on legacy principals to fix risk management. This analysis have viewed thirty thousand pages of global risk regulations have created a significant operational challenge. The new initiatives are giving rise to a shifting landscape that is gradually gaining momentum. Over next two years firms will faced the rethink the way they manage their risk. new perspectives, which challenge legacy practices and required the right result.

Akhtar (2011) had worked on the Liquidity Risk and they found that Liquidity Risk arise from the diverse operations as they have fully liable to make able. There additional efforts are required by Islamic Banks as they have unique characteristics and conform with the Sharia Rules. They also look forward towards the liquidity as this risk have direct connection with the solvency of the financial institutions. These Researchers investigates the role of size of the firm, Networking Capital, return on Equity, Capital Adequacy and Return on Asserts. They have found positive but significant relationship of size of the bank and the networking capital to net asserts with liquidity risk. Asim and Khan (2011) have a significant work on the Liquidity Risk Management, as they have work on the Domestic and Foreign banks of Pakistan in the period of 2001 to 2010. These Researchers have used the Augmented Dickey Fuller test and Johanssons Co-integration for the long run. Linear regression model with OLS techniques is used for analysis. They have found that relationship of bank size with liquidity risk is negative and significant in domestic banks and negative and insignificant in foreign banks. They concluded that liquidity risk may be minimized by enhancing Domestic banks size and minimizing debt to equity ratio. Akhtar(2011) he analyze that the topical financial crunch, tagged as the nastiest crisis ever since the Great Depression, has emphasized the fact that a profitable and lucrative banking sector is best capable to soak up negative distress and adds to the steadiness of the financial system. In that esteem, the study endeavors to shed light on the indicators of profitability for the banking system of Pakistan by taking into consideration bank-specific and macroeconomic factors. This study reveals an efficient image of the profitability on banking sector of Pakistan for the period 2006-2009.On the micro independent variables front, profitability seems to have been positively affected by size, operating efficiency, portfolio composition, asset management and negatively by capital and credit risk in case profitability is measured by return on assets (ROA).

Research Methodology:

Sources of data: The preliminary data were gathered from various secondary sources utilizing journals, books, and annual reports of the banks. Unstructured interviews were also conducted from risk managers of different banks. The purpose of these interviews was to have a general understanding of the liquidity risk management in the Pakistani banking system. Nature of data: The data for analysis have been taken from the annual reports of banks in Pakistan. This study focuses only on conventional banks as Islamic banks and thrifts have a different risk management structure. The data have been collected for a set of 15 banks for the period 2004-2009. The availability of data dictated the choice of 15 banks that account for the majority of the total assets of the Pakistani banking system. The nature of data is panel data; a combination of time series and cross-sectional data. Because of the small size of the sample period (2008-2011) and a small number of degrees of freedom, the researchers have transformed the cross section (15 banks) and time series (2008-2011) data into panel data yielding 132 observations thus overcoming the degrees of freedom problems.

Sample characteristics The Pakistani banking system is divided into four categories: (1) public commercial bank; (2) local private banks; (3) foreign banks; and (4) specialized banks. This study focuses on the rst two categories being the major pie in the overall banking system. There are total 29 banks in the two selected categories, including ve Islamic banks, which have been excluded from the sample as they have a different risk management system being involved in the non-interest based business operations. Two

more banks have been excluded from the sample, as these banks are in the transition Phase (acquisition). They are experiencing losses for the past few years. The banks included are commercial banks, including both the consumer and the corporate banks. Procedure A representative sample of private and public sector banks is taken to evaluate the impact of liquidity risk on the performance of banks. The balance sheets, income statements and their notes have been studied to get the data for the variables mentioned in the developed model. All the taken values for selected variables are in Pak rupees (PKR).

The dimensions of these variables are as follows. Return on Asserts Return on Equity Capital Adequacy Liquidity Risk Results an Discussions Multiple regressions are applied to test the model. ANOVAs explain the analysis of variances of dependent variable (LR) and the independent variable (CAR, ROE, ROA). The below table is significant because the P value is more then .05. Descriptive statistics were obtained to contra the normality of the data and the ADF test was run to satisfy the requirements of regression. Table I shows the descriptive statistics. The mean value of protability is signicantly positive, showing that the overall Pakistani banking system is enjoying a healthy protability, whereas the mean value of the liquidity gap is signicantly negative. In my research I found that 46% explanatory power of on dependent variable ( CAR, ROA, ROE) for the LR that is our dependent variable, as per the statistics value of R is .46 and standard error of the estimate which is 2e indicator of the model fitness. Rest of the a/c 53.9% may be is due to some other aspects of CAR, ROA, ROE, which may not incorporate in this study. ANOVAs test result values on the base of predictor and the dependent variable, So we can conclude that model is significant because t-value more than 1.96 and pvalue is less then .05 at 95% confidence. Residual value of mean square is 2.7 at 3 degree of freedom. Statistically t-value of individual variable are +.310, 0.557 and -.406. just one of them are in negative and p-value are .04 , .034 and 0.693.just two of them are less than 0.05. These figure are indicator of significant of model and show that ROA, ROE, these two variables are explanatory power towards LR.

Mean value Sum of Squares Regression 8.380 1 Residual 174.229 Total 182.609 b. Dependent Variable: LR Model df 3 11 14 Mean Square 2.793 15.839 F .176 Sig. .478a

The beta is .478 this shows that it is a significant result of 2008. This give us a positive sign to the collection of data in the same periods the number of entered data is of 15 banks the person correlation of the variables is .902, .234, .127 with respect to the ROA, and .902, .395, .168 with respect to the ROE, .234, .395, -.022 with respect to the CAR and .127, .168, .-022 with respect to the LR. The correlation is significant at the level 0.01 as 1-tailed test is applied. Table no 2 For the year 2009 Mean & beta calculation Sum of Mean df Squares Square 50.508 3 16.836 51.045 11 4.640 101.553 14

Model 1 Regression Residual Total

F 3.628

Sig. .049a

The year 2009 has the beta .049 which also express the value is quite significant to the data entered. In this year as the global recession this give the impact on the profitability of the banks who invest in foreign markets. The profitability is low in this period. Most of the banks have negative profitability and also no profits for the year 2009.

Table no 3 for the year 2010 Mean calculation Sum of Mean df Squares Square 11.276 3 3.759 106.450 11 9.677 117.726 14

Model 1 Regression Residual Total

F .388

Sig. .374a

And the calculation of the next year is the .374 its beta, the regression df is 3 this is the positive sign to analyze the quality and performance of the banking system. Most of the analyst argue that the banks liquidity the in the period when there is no profibility is high.

Table no 4 for the year 2011 Mean Value Model 1 Regression Residual Total Sum of Squares 19.159 114.043 133.202 df 3 11 14 Mean Square 6.386 10.368 F .616 Sig. .261a

2011 the year where the beta is .261 its much lower then the previous year this is the identification of the financial year a positive residual value to the bank liquidity. The person indicator with ROA is .872, .870 and .227. with respect to the ROE is .872, .789, .269, an of the CAR .870, .789, .132. and with the LR is .227, .269, .132. Here the correlation is significant at the .01 level with the 1-tailed test. The number of bank is 15 due to the limited time duration and the limited data available.

Conclusion Liquidity problems may adversely affect a given banks earnings and capital. Under extreme circumstances, it may cause the collapse of an otherwise solvent bank. A bank having liquidity problems may experience difficulties in meeting the demands of depositors. However, this liquidity risk may be mitigated by maintaining sufficient cash reserves, raising deposit base, decreasing the liquidity gap and NPLs. Adequate cash reserves will decrease the banks reliance on the repo market. This will reduce the cost associated with over the night borrowing. Moreover, it will also help the banks to avoid fire sale risk. It is imperative for the banks management to be aware of its liquidity position in different buckets. This will help them in enhancing their investment portfolio and providing a competitive edge in the market. It is the utmost priority of a banks management to pay the required attention to the liquidity problems. These problems should be promptly addressed, and immediate remedial measures should be taken to avoid the consequences of illiquidity. This study paves the way for more detailed studies into controlling the liquidity risk and to extending the proposed model to incorporate other causes of liquidity risk.

Further, the current study has focused primarily on earning of the bank as measure of the performance of bank. Further research may take a broader view of the performance and can also include economic factors. References Akhtar, S. (2007), Pakistan: changing risk management paradigm perspective of the regulator, ACCA Conference CFOs: The Opportunities and Challenges Ahead, Karachi ,p.8. Diamond, D.W. and Rajan, R.G. (2001), Liquidity risk, liquidity creation, and financial fragility:a theory of banking, The Journal of Political Economy, Vol. 109 No. 2, pp. 287-327. Environment: SBPs Financial Stability Review , State Bank of Pakistan, Islamabad. Goodhart, C. (2008), Liquidity risk management, Financial Stability Review, Vol. 11 No. 6. Gabbi, G. (2004). "Measuring Liquidity Risk in a Banking Management Framework". Managerial Finance, 30, Ghafoor . Banking System Liquidity: Developments and Issues, Financial Stability Review, December 2000 Ismal, R. (2010). "Assessment of liquidity management in Islamic banking industry". International Journal of Islamic and Middle Eastern Finance and Management , 147-167. Ismal, R. (2010). "Strengthening and improving the liquidity management in Islamic banking". Humanomics , 18-35. Jameson. Whos Afraid of Liquidity Risk? ERisk, December 2001 Jenkinson, N. (2008), Strengthening regimes for controlling liquidity risk, Euro Money Conference on Liquidity and Funding Risk Management , Bank of England, London, p. 9. Kumar, V. (2008), Why liquidity is important for banks, available at: www.gtnews.com/article/7362.cfm#request.location# (accessed May 9, 2010). Kashyap, A.K., Rajan, R. and Stein, J.C. (2002), Banks as liquidity providers: an explanation for the coexistence of lending and deposit-taking, The Journal of Finance , Vol. 57 No. 1,pp. 33-73

Makki, M.A.M. (2010). Impact of Corporate Governance on Intellectual Capital Efficiency and Financial Performance,42-47. SBP (2008), Pakistans Banking Sector Remarkably Resilient Despite Challenging Economic SBP (2010), The State of Pakistans Economy, Central Board of State Bank of Pakistan. State Bank of Pakistan, Islamabad.

Further reading Honohan, P. and Laeven, L. (2005), Systemic Financial Crises: Containment and Resolution ,

Cambridge University Press, New York, NY. SBP (2005), Risk Management: Guidelines for Commercial Banks & DFIs , State Bank of Pakistan, Karachi.