ST.

MARY’S UNIVERSITY
SCHOOL OF POST GRADUATE STUDIES
A Thesis Proposal
On
Effect of liquidity on profitability of Ethiopian Commercial Banks
By
Zebiba Awel Ahimed

Presented in Partial Fulfillment of the Requirements for the Degree of

Masters of Accounting and Finance
Principal Advisor: Ass. Prof. Assmamaw Gete

December, 2018
ADDIS ABABA, ETHIOPIA

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CHAPTER ONE..............................................................................................................................1

INTRODUCTION...........................................................................................................................1

1.1. Background of the Study...................................................................................................1

1.2. Statement of the Problem..................................................................................................2

1.3. Research Questions...........................................................................................................4

1.4. Objectives of the study......................................................................................................4

1.4.1. General Objectives.....................................................................................................4

1.4.2. Specific Objectives....................................................................................................4

1.5. Significance of the Study..................................................................................................4

1.6. Scope of the Study............................................................................................................5

1.7. Organization of the Research Report................................................................................5

CHAPTER TWO.............................................................................................................................6

LITERATURE REVIEW................................................................................................................6

2.1. Introduction.......................................................................................................................6

2.2. Theoretical Review...........................................................................................................6

2.2.1. Liquidity: an overview..................................................................................................6

2.2.2. Theories of Liquidity Management...............................................................................7

2.2.2.1. The Shift-Ability Theory...........................................................................................7

2.2.2.2. The Anticipated Income Theory................................................................................7

2.2.2.3. The Liabilities Management Theory.........................................................................8

2.2.3. Liquidity Risk and Liquidity Risk Management.........................................................10

2.2.4. The Concept of Profitability in Banks.........................................................................11

2.2.5. Factors Influencing on Bank Profitability...................................................................12

2.2.5.1. Liquidity..................................................................................................................13

2.2.5.2. Non-performing Loans............................................................................................13

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 2.2.5.3. Capital Adequacy.....................................................................................................14

2.2.5.4. Bank Size.................................................................................................................15

2.2.5.5. Loan Growth Rate....................................................................................................15

2.3. Empirical Literatures.......................................................................................................16

2.4. Conceptual Framework...................................................................................................18

CHAPTER THREE.......................................................................................................................19

RESEARCH DESIGN AND METHODOLOGY.........................................................................19

3.1. Introduction.....................................................................................................................19

3.2. Research Design..............................................................................................................19

3.3. Population of the study...................................................................................................19

3.4. Sampling and sampling procedure..................................................................................20

3.5. Data Sources...................................................................................................................21

3.6. Data Collection Method..................................................................................................21

3.7. Description and Measurement of Variables....................................................................21

3.7.1. Dependent Variable.....................................................................................................21

3.7.2. Independent Variable..................................................................................................22

3.8. Model Specification........................................................................................................23

3.9. Method of Data Analysis................................................................................................24

3.10. Ethical Consideration..................................................................................................24

Reference.......................................................................................................................................25

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 CHAPTER ONE
INTRODUCTION

1.1.Background of the Study

Bank performance gets an immense consideration in the financial literature taking into account
that banks serve a fundamental role in the country economy. As noted in (Olweny, 2011) the
recent global financial crisis of 2007/2008 also demonstrated the importance of bank
performance both in national and international economy and the need to keep it under
surveillance at all times very important. The success of commercial banks is very important for
the smooth operation of the financial system of a country. Business risk arises when while we are
not able to foresee the future, we can determine the probability of possible future situations in the
business entity’s environment. It is necessary to understand that various results of a specific
undertaking are possible on the basis of specific circumstances; this means that nothing is
impossible and nothing is absolutely certain. In the real world determining the probability of the
influences of various circumstances is often connected with difficulties.

Liquidity risk arises when current assets and cash inflows are insufficient to cover cash outflows.
The inability of an institution to raise cash to fund its business activities is known as funding
liquidity risk (Rosen, 2006). Market/trading liquidity risk, on the other hand, is the risk that it
would be costly, or perhaps even impossible, to liquidate certain asset types or establish new
positions to hedge existing exposures when such needs arise. While market risk generally affect
the present value of assets and liabilities, and the management of market risk is evaluated in the
context of the expected value of assets and/or liabilities over all future periods, liquidity risk has
to do with cash flows per period, and the ability (or inability) to meet cash flow needs as they
occur in time.

Management should estimate whether business activities of the company are in accordance with
its strategic goals set, and how risk management is connected with investing and decisions on
growth. The management should have a general overview of risk threats in order to avoid
surprises. Once the strategic (target) composition of the portfolio has been established, reserves
management staff are responsible for the tactical management of the fund on a daily basis to
keep the portfolio on target. Liquidity is very important for functioning of financial market and

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banking sector and as shown during financial crisis (Vodva, 2012). Wuryandani (2012) used
GMM Model and indicated that credit; saving and deposit affect precautionary liquidity, while
financial system and macroeconomic conditions have an effect on involuntary liquidity.

The banking sector around the world is always in search of finding solutions to sustain and
increase the efficiency of their businesses. In many developing countries, particularly those in
Sub-Saharan Africa country like Ethiopia after the financial sector reforms bringing about
significant economic benefits through a more effective mobilization of domestic savings and a
more allocation of resources. Ethiopia one of the oldest civilizations in Africa and the economy
has been state controlled through a series of industrial development plans. The post 1991
government led a transition to a more market-based system, and subsequent governments have
introduced further reforms. One of this reform measures undertaken by the Ethiopian
government start the year 1992 was “liberalizing” the financial sector. Currently, eighteen
commercial banks and two of them are publicly owned banks which are operating in Ethiopia.

Bearing that in mind, the real impact of the study subject matter this paper is very important in
multiple ways, especially as it will open more questions for the liquidity conditions and
appropriate liquidity management. The rationale behind focusing on such bank specific variables
is due to less accessibility and highly protected Ethiopian banking environment so that this study
crucially important for all stake holders, such as the owners, the investors, the debtors, the
creditors and depositors, the managers of banks, the regulators and the government.

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1.2. Statement of the Problem

The liquidity profile of a bank is a function of its assets and liabilities (Chorafaa, 2007).
Depositors and creditors must have confidence in the value of their bank’s assets in order to trust
the bank with their funds. Holding sufficient liquidity is necessary to ensure against liquidity risk
(Diamond and Dybvig, 1983, Diamond and Rajan, 2001). Therefore, viability and efficiency of a
bank is greatly influenced by the availability of liquidity in sufficient amount at all times. Banks
must meet their due obligations and execute payments on the exact day they are due, otherwise,
the banks stand the risk of being declared illiquid (Crocket, 2008). Effective management of
liquidity in the banking system is therefore an important element in maintaining a well-
functioning banking system. Thus measuring and managing liquidity needs are vital activities of
commercial banks.

Banks are vulnerable to sudden and unexpected demand for funds by their customers. Inability to
honor those demands due to liquidity problems may have serious and negative implications for
the whole financial system. To keep away from this kind of scenario, banks operating in Ethiopia
shall maintain liquid assets of not less than 25% of its total current liabilities. For the purpose of
meeting the liquidity requirement, each bank shall maintain at least 20% of the current liabilities
in the form of primary reserve assets and 5% of the current liabilities in the form of secondary
reserve assets (directive No SBB/44/2008). As part of its responsibilities, the National Bank of
Ethiopia has active role in managing the liquidity of the banking system however in return the
liquidity requirement directive affects the performance of all commercial banks (both private and
public ones).

It is obvious that the Ethiopia financial sector is shallow and underdeveloped (African Economic
Outlook, 2012) and the coverage of financial service in Ethiopia is very low. The banking sector
is one of the major sources of financing the economy by providing loan to individuals, firms and
the government. Enhancing domestic resource mobilization (saving, demand and time deposit) in
the country to finance in recent years increased significantly. However, most private banks face
liquidity problems to provide loans to their customers, because of shortage of funds. Liquidity
deficit or liquidity surplus situations both are not desirable for banks. Even without adequate
liquidity, banks are not able to perform some of their core functions like settlement of their inter-
bank obligations (transactions occurring between banks). Besides, movements in exchange rate

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and mismatched currency position exposing banks to settlement risk. In this regard, locally,
some studies have been conducted on the area of banks liquidity. However, even if such studies
have a great contribution as a means of the way out for such problem but most of the studies is
deficient in empirical evidences and the question on the consequence of determinant factors of
liquidity and profitability is still open. So that it’s possible to see the existence of knowledge gap
especially in the context of Ethiopian banking industry. So the study will determine internal
factors to examine the liquidity position of commercial banks and investigate the liquidity risk
management practices and overall impacts on the profitability of commercial banks.

1.3.Research Questions

According to these issues, the main problem of the research is formulated in the following
questions:
1. What is the impact of bank specific bank liquidity factors on profitability of commercial
banks in Ethiopia?
2. How does a bank specific liquidity factor assist to enhance profitability?
3. What is the relationship between bank specific liquidity factors and profitability of
banks?

1.4.Objectives of the study

1.4.1. General Objectives

The general objective of this study is to examine the effect of liquidity on profitability of
commercial banks of Ethiopia.

1.4.2. Specific Objectives

In addition the general objectives this research also have the following specific objectives:

1. To find out the impact of bank specific liquidity factors on profitability of commercial
banks of Ethiopia.
2. To investigate how bank specific liquidity factor assist to enhance banks profitability.

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 3. To identify the relationship between bank specific liquidity factors and profitability of
banks in Ethiopia.

1.5. Significance of the Study

The success of commercial banks is very important for the smooth operation of the financial
system of a country. In Ethiopia, even though the financial sector is regulated as all of other
countries financial sector, it is contributing a lion share for the healthiness of the country’s
financial system. Therefore, the sector’s success is of the main concern for those who are
responsible for policy makers and working inside it. Therefore, the result of the study is
significant for:-
 It assesses determinants of liquidity on financial performance and gives important insight
to supervisors as well as managers of Commercial banks in Ethiopia.
 Help in identifying possible gaps on liquidity and financial performance management
practice of commercial banks in Ethiopia.
 Provide useful information for stakeholders to make better investment decisions and to help
banks to reconsider their performance based on the performance determinant factors used
in the study.
 It would help management bodies of Commercial Banks of Ethiopia at every level to take
actions to fill the gaps.
 Contribute new knowledge to the existing literature and also invite other researchers to
conduct further research concerning this topic.

1.6. Scope of the Study

The scope of the study is limited to commercial banks established in Ethiopia. The Study will
use financial reports of the banks for the period ranging from 2008 to 2017. Hence, due to time
and financial constraints, the study will includes only commercial banks established prior to
2008 because the banks established after 2008 do not meet ten years data that is required for the
use of the analysis.

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1.7. Organization of the Research Report

The study will be structured in five chapters. Chapter one includes background of the study,
statement of the problem, research questions, objectives of the study, significance of the study,
scope of the study, and limitation of the study. Chapter two will covers literatures which are
relevant to the subject matter under study. In chapter three, the methodology part of the study
will describe in detail. The findings of the study will present, analyzed and discussed in chapter
four. Finally, in chapter five summaries of findings, conclusions, and recommendations will
present based on the study result.

CHAPTER TWO
LITERATURE REVIEW

2.1. Introduction

In this chapter, the researcher has primarily focused on three main important issues such as,
theoretical, empirical and the conceptual framework of liquidity and profitability of commercial
banks in detail that guides the study are briefly highlighted.

2.2. Theoretical Review

2.2.1. Liquidity: an overview

Liquidity is an entity’s capacity to finance increases in its volume of assets and to comply with

its payment obligations on maturity, without incurring unacceptable losses (Basel, 2008).
According to Pandey (2010) liquidity is current assets which should be managed efficiently to
safeguard the firm against the risk of illiquid. Lack of liquidity in extreme situations can lead to
the firm’s insolvency. He further state that conflict exists between liquidity and profitability. If
the firm does not invest sufficient fund in current assets, it may become illiquid which is risky. It
may lose profitability if some idle current assets do not earn anything. Liquidity risk refers to the
risk that a financial agent will be unable to meet obligations at a reasonable cost as they come

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due. In other words, it reflects the probability that the agent will become funding illiquid during a
given time period. Banks manage the liquidity risk inherent in their balance sheets by
maintaining a buffer of market-liquid assets - such as cash or government securities which
anticipates their depositors‟ liquidity demands within the relevant timeframe (Shumet, 2016).

Liquidity was an influential factor during the current financial crisis. As uncertainty led funding
sources to evaporate, many banks quickly found themselves short on cash to cover their
obligations as they came due. In extreme cases, banks in some countries failed or were forced
into mergers. As a result, in the interest of broader financial stability, substantial amounts of
liquidity were provided by authorities in many countries, including Canada and the United States
(Longworth 2010; Bernanke 2008). Fund management practices ensure an institution is able to
maintain a level of liquidity sufficient to meet its financial obligations in a timely manner; and
capable of quickly liquidating assets with minimal loss. So that the purpose of liquidity
management is to ensure that every bank is able to meet fully its contractual commitments.
Sound liquidity management can reduce the probability of serious problems. The liquidity gap
approach adapts the variation between assets and liabilities both current and future period. A
positive liquidity gap means for deficit, requiring for liabilities to be increased (Bassis, 2009).
Hence, insufficient liquidity is one of the major reasons of bank failure. Liquidity is necessary to
enable banks providing funds on demand and credits needed by customers which are associated
with the default risk.

2.2.2. Theories of Liquidity Management

The following points highlight the top three theories of liquidity management. The theories are:
The Shift-Ability Theory, the Anticipated Income Theory and the Liabilities Management
Theory.

2.2.2.1.The Shift-Ability Theory

The shift-ability theory of bank liquidity was propounded by H.G. Moulton who asserted that if
the commercial banks maintain a substantial amount of assets that can be shifted on to the other
banks for cash without material loss in case of necessity, then there is no need to rely on
maturities. According to this view, an asset to be perfectly shift-able must be immediately
transferable without capital loss when the need for liquidity arises. This is particularly applicable

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to short term market investments, such as treasury bills and bills of exchange which can be
immediately sold whenever it is necessary to raise funds by banks. But in a general crisis when
all banks are in need of liquidity, the shift-ability theory requires that all banks should possess
such assets which can be shifted on to the central bank which is the lender of the last resort. This
theory has certain elements of truth. Banks now accept sound assets which can be shifted on to
other banks. Shares and debentures of large companies are accepted as liquid assets along with
treasury bills and bills of exchange. This has encouraged term lending by banks.

2.2.2.2.The Anticipated Income Theory

The anticipated income theory was developed by H.V. Prochanow in 1944 on the basis of the
practice of extending term loans by the US commercial banks. According to this theory,
regardless of the nature and character of a borrower’s business, the bank plans the liquidation of
the term-loan from the anticipated income of the borrower. A term-loan is for a period exceeding
one year and extending to less than five years. It is granted against the hypothecation of
machinery, stock and even immovable property. The bank puts restrictions on the financial
activities of the borrower while granting this loan. At the time of granting a loan, the bank takes
into consideration not only the security but the anticipated earnings of the borrower. Thus a loan
by the bank gets repaid out of the future income of the borrower in installments, instead of in a
lump sum at the maturity of the loan.
This theory is superior to the real bills doctrine and the shift ability theory because it fulfills the
three objectives of liquidity, safety and profitability. Liquidity is assured to the bank when the
borrower saves and repays the loan regularly in installments. It satisfies the safety principle
because the bank grants a loan not only on the basis of a good security but also on the ability of
the borrower to repay the loan. According to Nzotta (1997) the theory emphasizes the earning
potential and the credit worthiness of a borrower as the ultimate guarantee for ensuring adequate
liquidity. The bank can utilize its excess reserves in granting term-loan and is assured of a
regular income. Lastly, the term-loan is highly beneficial for the business community which gets
funds for medium-terms.

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2.2.2.3.The Liabilities Management Theory

This theory was developed in the 1960s. According to this theory, there is no need for banks to
grant self- liquidating loans and keep liquid assets because they can borrow reserve money in the
money market in case of need. As cited on Guthua (2012), (Koch and McDonald, 2003) stated
that today banks use both assets and liabilities to meet liquidity needs. Available sources of
liquidity are identified and compared to expected needs by a bank’s Asset and liability
management committee (ALCO). Key considerations include maintaining high asset quality and
a strong capital base that both reduces liquidity needs and improves a bank’s access to funds at
low cost. There is a short run trade-off between liquidity and profitability. In the long-run, if
management is successful in managing liquidity, then, long-term earnings will exceed other
banks earnings, as will the capital and overall liquidity. A bank can acquire reserves by creating
additional liabilities against it from different sources. These sources include the issuing of time
certificates of deposit, borrowing from other commercial banks, borrowing from the central
banks, rising of capital funds by issuing shares, and by ploughing back of profits. We discuss
these sources of bank funds briefly.
 Time Certificates of Deposits: These are the principle source of reserve money for a
commercial bank in the USA. Time certificates of deposits are of different maturities ranging
from 90 days to less than 12 months. They are negotiable in the money market. So a bank can
have access to liquidity by selling them in the money market. But there are two limitations.
First, if during a boom, the interest rate structure in the money market is higher than the
ceiling rate set by the central bank, time deposit certificates cannot be sold in the market.
Second, they are not a dependable source of funds for the commercial banks. Bigger
commercial banks are at an advantage in selling these certificates because they have large
certificates which they can afford to sell at even low interest rates. So the smaller banks are at
a disadvantage in this respect.
 Borrowing from other Commercial Banks: A bank may create additional liabilities by
borrowing from other banks having excess reserves. But such borrowings are only for a very
short duration, for a day or week at the most. The interest rate of such borrowings depends
upon the prevailing rate in the money market. But borrowings from other banks are only
possible during normal economic conditions. In abnormal times, no bank can afford to lend
to others.

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 Borrowing from the Central Bank: Banks also create liabilities on themselves by
borrowing from the central bank of the country. They borrow to meet their liquidity needs for
short term and by discounting bills from the central bank. But such borrowings are relatively
costlier than borrowings from other sources.
 Raising Capital Funds: Commercial banks acquire funds by issuing fresh shares or
debentures. But the availability of funds through this source depends on the amount of
dividend or interest rate which the bank is prepared to pay. Usually the banks are not in a
position to pay rates higher than paid by manufacturing and trading companies. So they are
not able to get sufficient funds from this source.
 Ploughing Back Profits: Another source of liquid funds for a commercial bank is the
ploughing back of its profits. But how much it can get from this source will depend upon its
rate of profit and its dividend policy. It is the larger banks that can depend on this source
rather than the smaller banks.

2.2.3. Liquidity Risk and Liquidity Risk Management

The liquidity risk of banks arises from funding of long-term assets by short-term liabilities,
thereby making the liabilities subject to rollover or refinancing risk. Liquidity risk is usually of
an individual nature, but in certain situations may compromise the liquidity of the financial
system. As in overall terms it is about a situation that is very dependent on the individual
characteristics of each financial institution, defining the liquidity policy is the primary
responsibility of each bank, in terms of the way it operates and its specialization. Liquidity risk
can be sub-divided into funding liquidity risk and asset liquidity risk. Asset liquidity risk
designates the exposure to loss consequent upon being unable to effect a transaction at current
market prices due to either relative position size or a temporary drying up of markets. Having to
sell in such circumstances can result in significant losses (Yadav, 2013).

According to the theory of financial intermediation, an important role of banks in the economy is
to provide liquidity by funding long term, illiquid assets with short term, liquid liabilities (Wang,
2002). Through this function of liquidity providers, banks create liquidity as they hold illiquid
assets and provide cash and demand deposits to the rest of the economy. It is very tough but
indispensable for the banks to reconcile the twin objective of bringing the profitability factor and

10
liquidity factor go hand in hand (Sufian, 2011). Achieving the optimum level of liquidity is
extremely dependent on various properties such as: size, characteristics, nature and level of

complexity of activities of a bank. Greuning and Bratonovic, (2004) explains the management of
liquidity as the bank has to follow a decisional structure for managing liquidity risk; an
appropriate strategy of funding, the exposure limits and a set of rules for arranging liquidities in
case of need.

In the past liquidity risk was not the main focus of banking regulators. Now, there is wide
agreement that insufficient liquidity buffers were a root cause of this crisis and the on-going
disruptions of the world financial system, making the improvement of liquidity risk analysis and
supervision a key issue for the years to come (Brunnermeier, 2009 and BCBS, 2008). The
liquidity condition of the commercial banks was also reliable in all cases, thought some measures
should be made by the individual banks respective to their matter as per (Habtamu, 2004).

According to Drehmann & Nikolaou theory (2010),liquidity risk is money related hazard that for
a specific time frame a given monetary resource, security or ware cannot be exchanged rapidly
enough in the market without affecting the market cost. Subsidizing liquidity chance is the
hazard that a money related establishment, although very much promoted or dissolvable, would
not have the capacity to keep up a consistent harmony between its money inflows and Out
pouring or would have the capacity to do as such just at unreasonable cost over a brief

timeframe. Liquidity risk is managed through controlling concentrations and relative market
sizes of portfolios in the case of asset liquidity risk, and through diversification, securing credit
lines or other back-up funding, and limiting cash flow gaps in the case of funding liquidity risk.

2.2.4. The Concept of Profitability in Banks

Banking sector is an important and unquestionable determinant of the economic development as

it directs the flow of the funds from surplus economic units of the economy towards deficit
economic units (Khan, 2006, p. 11). Banking industry being an important pillar of financial
sector of an economy, its performance measurement cannot be neglected. Khrawish (2011)
scrutinized Jordanian commercial bank profitability from 2000 through 2010, and categorized
the factors affecting profitability into internal and external factors. Better bank performance
increases the reputation and image from public or market point of view. Profitability is an

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indicator of the bank’s competitive position in banking markets and of the quality of its
management, ensuring the health of the banking system. Profitability is also considered as a
bank’s first line of defense against unexpected losses, as it strengthens its capital position and
improves future potentials through the investment of retained earnings (ECB, 2010). Profitability
is the efficiency of banks at generating earnings which will be measured by profitability ratios
and banks, therefore, earn profit by acquiring funds at a cost from severs and lending those funds
to borrowers by charging customers for providing various services (Hubbard, 2002).

The key driver of banks’ performance remains earnings, efficiency, risk-taking and leverage
(ECB, 2010). Bank profitability is influenced by internal efficiencies. It posits that banks earn
high profits because they are more efficient than others (Olweny and Shipho, 2011). The
portfolio theory largely assumes that bank performance is influence by internal efficiencies and
managerial decisions (Olweny and Shipho, 2011). As noted in Tregenna (2009) applied in
banking the market power hypothesis posits that the performance of bank is influenced by the
market structure of the industry. There are two distinct approaches within the market power
theory; the Structure-Conduct Performance (SCP) and the Relative Market Power (RMP)
hypotheses. Unlike the SCP, the RMP hypothesis posits that bank profitability is influenced by
market share. It assumes that only large banks with differentiated products can influence prices
and increase profits. They are able to exercise market power and earn non-competitive profits
(Tregenna 2009).

According to the Structure-Conduct Performance (SCP) approach, the level of concentration in

the banking market gives rise to potential market power by banks, which may raise their
profitability. According to the efficiency approach, more efficient firms are more profitable
because of their lower costs. Such firms tend to gain larger market shares, which may manifest in
higher levels on market concentration, but without any causal relationship from concentration to
profitability (Athanasoglou et al. 2006). The balance sheet structure could also influence banks‟
profitability; in this context, the equity-to-asset ratio is an important balance sheet ratio that
received much attention. For this ratio, theoretical explanations assume different signs of the
relationship with profitability. According to the Modigliani & Miller theorem there exists no
relationship between the capital structure (debt or equity financing) and the market value of a

12
bank (Modigliani & Miller 1958). In this context, there is no relationship that exists between the
equity-to-asset ratio and funding costs or profitability.

2.2.5. Factors Influencing on Bank Profitability

In the banking literature there is various liquidity factors that determine the profitability of
commercial banks. Commercial banks profitability could be affected by a number of determining
factors. In most literatures bank profitability usually expressed as a function of internal and
external determinants. Bourke (1989) also indicated that the determinants of commercial bank
profitability can be divided into two main categories namely the internal determinants which are
management controllable and the external determinants which are beyond the control of
management. We can see these factors also by divided into three categories such as specific
banking factors, factors on the level of the banking sector and macroeconomic factors. The
following discussion reviews some of the most important internal determinants which are bank
specific factors and this study attempted to examine the impact of these internal determinants on
bank profitability.

2.2.5.1.Liquidity

It means ensuring that the institution maintains sufficient cash and liquid assets to satisfy client
demand for loans and savings withdrawals, and to pay the institution’s expenses. Liquidity
management involves a daily analysis and detailed estimation of the size and timing of cash
inflows and outflows over the coming days and weeks to minimize the risk that savers will be
unable to access their deposits in the moments they demand them. The National Bank of Ethiopia
has set the minimum liquid asset of the Bank not to be less that 15% of the Bank’s net current
liability. Out of this the directive obliged banks to hold 5% of them in primary reserve assets
(NBE Directive No.SBB/9/95). The management of the bank should consider seriously the
liquidity management because liquidity always goes to profitability, high liquid asset indicate
that a less risky and less profitability because more liquid asset indicate increase the facility to
raise cash but it reduce the management decision to commit credibly to an investment approach
which means the firms capacity to raise external finance will decrease. So the Profitability of
banks will decrease (Anjili 2014).

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The liquidity ratio is varying from bank to bank and from time to time within individual bank but
in this study the ratio of loan to deposit ratio had adopted in order to compute liquidity ratio.
Loan to deposit ratio are the most important indicators of banks performance in the bank
financial statements because they reflect the bank's primary activity. Assumed, other variables
constant, the higher the rate of transforming deposits into loans, the higher the profitability will
be. For that, a positive relationship between loan deposit ratio and banks profitability is expected.
On the other hand, if increasing loans leads to higher funding requirements, a negative impact of
the loan ratio on the banks profitability may accrue (Alexiou & Sofoklis, 2009; Ana et al., 2011).

2.2.5.2.Non-performing Loans

It means loans & advances whose credit quality has deteriorated such that full collection of
principal and/or interest in accordance with the contractual repayment term of the loan or
advance is in question (NBE directive No SBB/43/2008). Loans and advances are financial
instruments originated by the bank by providing money to the debtors. Loans & advances are the
major portion of bank’s asset, when they become non-performing, it will affect both profitability
and liquidity of the bank. Habtamu (2012) argued that the principal profit- making activity of
commercial banks is making loans to its customers. Lending represents the heart of the industry.
Loan is a major asset, income source for banks, and risky area of the industry.

Non- performing means loans or advances past due 90 days or more days. In most commercial
banks loan is the most common problem of defaults which banks usually take care of and exert
possible efforts to protect from it through proper business viability assessment analysis,
supervisions, and loan reviewing made before and after the loan provision. Most major banking
problems have been either explicitly or indirectly caused by weaknesses in credit management.
In supervisors’ experience, certain key problems tend to persist. Severe credit losses in a banking
system usually reflect simultaneous problems in several areas, such as concentrations, failures of
due diligence and inadequate monitoring (Mirach, 2010). Low nonperforming loans to total loans
shows that the good health of the portfolio a bank. The lower the ratio the better the bank
performing (Sangmi & Tabassum, 2010).

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2.2.5.3.Capital Adequacy

Capital is one of the bank specific factors that influence the bank profitability. Capital is the
amount of own fund available to support the bank's business and act as a buffer in case of
adverse situation (Athanasoglou et al., 2005). Capital refers to the amount of equity to absorb
any loss that the bank may experience it is the major component of financial sector to meet their
short and long term obligation, (Kosmidou, 2009). Capital adequacy is a reflection of the internal
strength of a bank, which would stand it in good stead during the times of crisis.

Capital adequacy may have a bearing on the overall performance of a bank, like opening of new
branches, fresh lending in high risk but profitable areas, manpower recruitment and
diversification of business through subsidiaries or through specially designated branches, as the
Commercial banks could think these operational dimensions to bank's capital adequacy
achievement (Shankar, 1997). The NBE has set specific measure of the capital adequacy position
of Banks, which is the ratio the Capital Adequacy Ratio (CAR) (NBE, 1995). The NBE
directives No.SBB/9/95 clearly set out the computation mechanism and the conversion factors
for both on and off-balance sheet items and strictly set for all banks not to maintain their capital
level below 8% of their risk weighted assets.

2.2.5.4.Bank Size

The bank's total asset is another bank specific variable that affects the profitability of a bank.
Bank size measures its general capacity to undertake its intermediary function. Banks
effectiveness and efficiency represented by profitability also has been argued that profitability is
strongly related to total assets. Banks have good reasons to believe profitability and size are
related. Larger banks have the advantage of more access to additional financing sources, but
dealing with liquidity problems and diversifying risk is another issue. This is probably due to the
fact that larger banks benefit from fail policy plans and are believed to be more likely to survive
than smaller banks. The first view is the “too big to fail” hypothesis which considers negative
relationship between bank size and liquidity whereas; the second view considers there is a
positive relationship between bank size and liquidity. In this study, bank size is measured by the
natural logarithm of total asset of the bank and it is expected positive relationship between bank
size and profitability. Increasing bank size can increase bank profitability by allowing banks to

15
realize economies of scale. For example, increasing size allows banks to spread fixed costs over
a greater asset base, thereby reducing their average costs. Increasing banks’ asset size can also
reduce risk by diversifying operations across product lines, sectors, and regions (Mester 2010).

2.2.5.5.Loan Growth Rate

According to National Bank of Ethiopia (NBE), directive No.SBB/43/2008, loans & advances
means any financial asset of a bank arising from a direct or indirect advances fund by a bank to a
person that is conditioned on the obligation of the person to repay the fund on a specified date or
on demand with interest. Loans & advances are the major earning asset of the bank. Loans &
advances are granted to customer from the amount collected from depositors of the bank. In this
regard, when banks transform short term deposits to long term loans, which have a maturity
mismatch, they will be vulnerable to liquidity problem. Therefore, the increase in loan means
increase in illiquid assets and decrease in short term/liquid assets. As it was discussed in the
literature review part, it is expected that, there is a negative relationship between bank loan
growth and liquidity. For this study loan growth is measured by the annual growth rate of
outstanding gross loans & advances of the bank (Yimer, 2016).

2.3. Empirical Literatures

Banking study has considerable interest at the macroeconomic and microeconomic levels. From
the macroeconomic point of view banking one of the financial intermediation types plays special
role in the movement and distribution of country financial resources in market conditions. Hence
banking inefficiency leads to borrowers’ financial resources shortage when population’s
financial resources excess and, consequently, low rates of economic growth and the common
weal deterioration, for services consumers it means overpriced banking services and their
unavailability (Buriak, 2014).

The study on the determinants of bank profitability began as early as 1979. Many researchers
have studied the determinants of bank profitability. For example, Goddard et al. (2004) find that
a bank’s size could be a determinant of bank profitability. Berger et al. (1994) find that there is a
positive relationship between capital ratio and bank profitability, while Hoffmanm et al. (2011)
find the opposite results. Furthermore, Heslem et al. (1969) collect the balance sheets and
income statements information of all the member banks of the Federal Reserve System. Their
16
study indicates that most of the financial ratios are strongly linked to bank profitability,
especially capital ratio, bank size, loans-to-assets ratio and interest expense. According to
Goddard, a bank’s profitability initially increases with size due to the scale economy but declines
if the size exceeds a threshold level the exhaustion of the scale economy and bureaucratic
managerial style could lead to performance inefficiency. Berger (1994) and Humphrey (1997)
find that, in general, large banks perform better than small banks, but it is less clear whether
large banks benefit from the scale economy. They state that better practice in terms of
technology and management structure is more important than the scale efficiency.

Previous studies usually find a positive relationship between loans and ROA. Banks issue more
loans to generate more interest income and high profit (e.g., Abreu and Mendes, 2002). This is
despite the operational costs related to the lending activities. A high loans-to-assets ratio
indicates that a bank is issuing more loans and generating more income. Conversely, a low loans-
to-assets ratio means that the bank makes less income, which indicates that the bank is not using
its assets to generate income. However, a high loan to assets ratio puts the bank at high liquidity
risk. With respect to the asset structure, Naceur (2003) finds that interest margin and bank loans
have a positive impact on bank profitability, while Husni (2011) argues that it is the high deposit
level rather than loan ratio that improves bank profitability.

Studies discover that the quality of assets on the balance sheet directly affects bank profitability.
Banks are highly vulnerable to credit risk. Issuing high-risk loans can lead to an increase in
doubtful assets on the balance sheet, the return on which cannot be guaranteed (Bourke, 1989).
More deposits make bank more flexible in financial decisions and less exposed to bankruptcy
risk. Moreover, deposits are more stable and less expensive compared with borrowed funds.
Therefore, we conjecture that more deposits from customers mean high bank profitability
(Rasiah 2010). Abdus (2004) has examined empirically the performance of Bahrain's commercial
banks with respect to credit (loan), liquidity and profitability during the period 1994-2001. Nine
financial ratios (Return on Asset, Return on Equity, Cost to Revenue, Net Loans to Total Asset,
Net Loans to Deposit, Liquid Asset to Deposit, Equity to Asset, Equity to Loan and Non-
performing loans to Gross Loan) were selected for measuring credit, liquidity and profitability
performances. By applying these financial measures, this paper found that commercial banks'
liquidity performance was not at par with the Bahrain banking industry. Commercial banks are

17
relatively less profitable and less liquid and, are exposed to risk as compared to banking industry.
With regard to asset quality or credit performance, this paper found no conclusive result.

Damena (2011) examined the determinants of Ethiopian commercial banks profitability. The
study applied the balanced panel data of seven Ethiopian commercial banks that covers the
period 2001- 2010. The paper used Ordinary Least Square (OLS) technique to investigate the
impact of some internal as well as external variables on major profitability indicator i.e., ROA.
Habtamu Berhanu (2013) investigates the financial performance of the Ethiopian Banking sector
using the panel data set for the period 2004/05 – 2009/10. The study took an in depth evaluation
of the performances of the commercial banks based on the selected financial ratios among others.
The result of the study indicates the Ethiopian banking sector in general, as measured by volume
of deposits, granting of loan and possession of assets has also shown a persistent increase
throughout the study periods. Moreover, the profitability of the banks during the study periods in
particular, and the sector in general presented a tremendous improvement.

2.4. Conceptual Framework

The conceptual representation of the relationship between the dependent variable (ROA) and
independent (bank specific) variables is depicted here below:

Figure-1: Conceptual schema of the relationship between the variables

Independent Variables Dependent Variables

Liquidity (LDR)

Asset Quality
Bank Liquidity

Bank Profitability
 ROA
Capital Adequacy

Bank Size 18
 Loan Growth

CHAPTER THREE
RESEARCH DESIGN AND METHODOLOGY

3.1. Introduction

Chapter three outlines the research design, the research method, the population under study, the sampling
procedure, and the method that was used to collect data. The reliability and validity of the research
instrument are addressed. Ethical considerations pertaining to the research are also discussed.

3.2. Research Design

A research design is the set of methods and procedures used in collecting and analyzing
measures of the variables specified in the research problem. A research design is the conceptual
structure within which research is conducted. According to cooper & schindler (2003), a research
design is the arrangement of condition for collecting and analysis of data in a manner that aims
to combine relevance to the research purpose with economy in procedure. Designing a study
helps the researcher to plan and implement the study in a way that will help the researcher to
obtain intended results, thus increasing the chances of obtaining information that could be
associated with the real situation (Burns & Grove 2001:223). It is a framework that has been
created to find answers to research questions. So that by considering the acknowledged research
problem together with the objective of this research, a quantitative research approach will be
found appropriate. The study adopted a quantitative research approach based on secondary data
gathered from the monthly financial statements. So that, an explanatory research design was
adopted to investigate the reason, to answer the question, to meet the objectives of the study and

19
to examine the relationship between variables. This is the type of research design most
commonly used in scientific research to explain the current status of a variable or phenomenon.

3.3. Population of the study

According to Polit and Hungler (1999:37) the population is an aggregate or totality of all the
objects, subjects or members that conform to a set of specification. In generally speaking
population is a study of a group of individuals taken from the general population who share a
common characteristic. It represents a specified segment of the real world with common definite
specified characteristics relating to a particular phenomenon of interest to the researcher.
According to data from National Bank of Ethiopia, there are 17 commercial banks (one
government owned and sixteen private banks) registered and operate in the country. Therefore,
the target populations for the study will be all commercial banks in Ethiopia which are owned by
state and domestic investors. However, the population size reduced to eleven because the newly
established private banks after 2008 do meet ten years data that is required for the use of the
analysis.

3.4. Sampling and sampling procedure

The process of selecting a portion of the population to represent the entire population is known
as sampling (LoBiondo-Wood & Haber 1998:250; Polit & Hungler 1999:95). The sample size
used in a study is determined based on the need to have sufficient statistical power. A sample
with the smallest sampling error will always be considered a good representative of the
population. The study was taken generally a subjective judgment as the research proceeds
determining adequate sample size. In addition a qualitative research is ultimately needs a matter
of judgment and experience in evaluating the quality of the information collected against the uses
to which it will be put (Sandelowski, 1995). So that, for this particular research the researcher
employed purposeful sampling strategy to select the sample element by bearing in mind the
research product intended. Purposive sampling, also known as judgmental, selective or
subjective sampling, reflects a group of sampling techniques that rely on the judgment of the
researcher when it comes to selecting the units that are to be studied (Department of Physical
Education, Lovely Professional University,Phagwara, Punjab, India , 2017). Commercial banks
registered by National bank of Ethiopia and currently under operation in the country are

20
seventeen in number. One government and sixteen privately owned commercial banks are
operating throughout the country. Out of the total sixteen private commercial banks, only eleven
senior private commercial banks that had been in operation for 10 or more years were selected
for the purpose of the study. In other words, the bank selection is done following the historical
time formation of banks. As a result of this the sample size of the study reduced intentionally to
eleven because of the recently established private commercial banks does not meet ten years data
that is required for the purpose of the analysis.

3.5. Data Sources

This study will examines the determinants of financial performance of a commercial bank in
Ethiopia, by considering the research objectives, the type of data for the study used more of a
quantitative so that it could be measured and ranked. In other words, to be more efficient to
address the short comings being observed in all process, the quantitative method will be much
helpful when we speak about performance measures. The data from the sample banks were
gathered from published financial statements of the respective commercial banks & respective
websites of the banks to be investigated, and different bulletins and publications of the NBE. The
coverage of data for this particular study is from 2008-2017. In line with the afore-stated fact,
various documents mainly from secondary sources like Books, Journals, Magazines, Reports and
Internet were reviewed to demonstrate familiarity gaps.

3.6. Data Collection Method

The study will use both primary and secondary data sources in gathering data for analysis. The
primary data was collected by questioner type interview. Interviews were conducted with the
representative of the respective banks’, the target respondents were selected from risk, internal
audit and finance departments in the respective banks & an official at the National Bank of
Ethiopia (NBE-Banking Supervision Directorate). The required secondary data will collect either
from national bank of Ethiopia (NBE) or financial statements of the respective banks.

3.7. Description and Measurement of Variables

3.7.1. Dependent Variable

A profitability measures which is included in the study are;

21
A. Return on Asset (ROA): it reflects the ability of a bank’s management to generate profits
from the bank’s assets. It shows the profits earned per birr of assets and indicates how
effectively the bank’s assets are managed to generate revenues, although it might be biased
due to off-balance-sheet activities. Average assets were used in this study, in order to capture
any differences that occurred in assets during the fiscal year.

ROA can be calculated as: Net Profit After Tax

Total Asset

3.7.2. Independent Variable

A. Liquidity: is ability to meet customers demand and provide advances in the forms of loans
and overdrafts. Liquidity can be measured by two main methods: liquidity gap and liquidity
ratios. The liquidity gap is the difference between assets and liabilities at both present and
future dates. But in this study the ratio of loan to deposit ratio had adopted in order to
compute liquidity ratio.

Loan to deposit Ratio (LDR): the ratio of credit to deposits may give indications of the
ability of the bank to mobilize deposits to meet credit demand. This indicates the degree to
which a bank can support its core lending business through its deposits.

LDR = Loans and Advance

Total Deposit
B. Asset Quality (AQ): the quality of assets is an important parameter to examine the
degree of financial strength. Thus, total non-performing loans to gross loans ratio is
considered. NPLs are loans that a customer fails his contractual obligations on either
principal or interest payments exceeding 90 days. It is expected that there is negative
relationship between profitability and the amount of non-performing loans.
AQ = Non-Performing Loans
Total loan
C. Capital Adequacy (CA): Capital Adequacy reflects the overall financial condition of the
banks. It also indicates whether the bank has enough capital to absorb unexpected losses.

22
 Capital Adequacy ratio acts as an indicator of bank leverage. The study use gross capital to
total asset ratio.
CAR = Gross Capital
Total Asset
D. Bank Size (BS): It measures its general capacity to undertake its intermediary function.
This variable is included to capture the economies or diseconomies of scale. If financial
organizations become too complex to manage, diseconomies of scale arise. The proxy for
bank size was the natural logarithm of total assets.
E. Loan Growth (LG): Lending is the principal business activity for most commercial banks
and loan is one of the greatest sources of risk to a banks safety and soundness. The proxy
for loan growth was annual growth rate of gross loans and advances to customers.
LG (t) = (Year t−1) - (Year t−2)
(Year t−2)

3.8. Model Specification

The performance indicator utilized for this particular study is Return on Assets (ROA) and
Return on Equity (ROE) and the major determinants (independent variables) considered were
Capital Adequacy, Non performing loan, Bank Size, Loan Growth and Bank Liquidity. Hence,
the econometric model utilized for regression analysis is depicted here below:

πit = α0 + α1 LDRit + α2 AQit + α3 CARit + α4 BSit + α5 LGit + εit… … …… (1)

Where:

πit = Performance of Bank i at time t as expressed by ROA

α0 = Intercept.

LDR it = Loan to deposit ratio of bank i at time t

AQ it = Asset quality of bank i at time t

CAR it = Capital adequacy Ratio of bank I at time t

23
BS it = Bank size of Bank i at time t

LG it = Loan growth Rate of Bank i at time t

α1 – α5 = Coefficients parameters

εit = Error term where i is cross sectional and t time identifier

Model Assumptions:

As noted in Brooks (2008) there are basic assumptions required to show that the estimation
technique the following diagnostic tests will be carried in order to ensure the data is in
conformity with the basic assumptions of classical linear regression model.

 Normality test: (To check for normality, i.e., kurtosis and skewness of the distribution of
the data will be examined) descriptive statistics will use.
 Multi-co linearity (To check whether there is a strong correlation among the independent
variables exists or not)
 Autocorrelation ( To check whether there exists a serial relationship in the error terms)
 Heteroscedasticity (To detect the problem of heteroscedasticity of disturbance terms)

3.9. Method of Data Analysis

With regard to data analysis, the study will be carried out using descriptive statistical analysis,
correlation and multiple regression analysis. Correlation coefficients will use to show the
relationship between bank specific determinants and bank performance. On the other hand,
multiple regression analysis will carried out to measure the impact of bank specific determinants
and bank performance. In general Data collected will be analyzed using both descriptive and
inferential analysis. The Statistical Package for Social Scientists (SPSS) 20.0 versions or EVIWS
software will use for data analysis.

3.10. Ethical Consideration

The researcher will maintain scientific objectivity throughout the study, recognizing the
limitations of his competence. Every person involved in the study will be entitled to the right of
privacy and dignity of treatment, and no personal harm will be caused to subjects in the research.

24
Information obtained will be held in strict confidentiality by the researcher. All assistance,
collaboration of others and sources from which information will drawn is acknowledged.

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