Liquidity Management and Bank Profitability: Empirical Evidence from Sri Lanka's Commercial Banking Sector

Abstract

This study employs panel data econometric methodology to examine the nexus between liquidity risk determinants and financial performance within Sri Lanka's licensed commercial banking sector between 2013 and 2022, utilizing a comprehensive dataset encompassing twelve banking institutions. The analytical framework operationalizes liquidity risk through three theoretically-grounded constructs—loan-to-deposit ratio, statutory liquid asset ratio, and non-performing loans ratio—while measuring institutional performance via dual metrics comprising return on assets and return on equity to capture heterogeneous stakeholder perspectives. Multiple linear regression analyses reveal differential performance impacts across measurement dimensions using 120 bank-year observations, with asset-based performance measures demonstrating superior responsiveness to liquidity management practices relative to equity-based measures. The findings establish statistically significant positive associations Received: 05/08/2024 Revised: 03/10/2024 between loan-to-deposit ratios and return on assets and statutory liquid asset raAccepted: 10/10/2024 Published: 12/12/2024 tios and return on assets, corroborating banking intermediation theory while simultaneously challenging conventional liquidity-profitability trade-off paradigms. Notably, the counterintuitive positive statutory liquid asset ratio-return on assets relationship constitutes a substantial theoretical contribution, indicating that prudential liquidity maintenance generates positive externalities through enhanced institutional credibility, regulatory compliance premiums, and crisis resilience capabilities. Non-performing loans demonstrate robust negative impacts on return on equity, underscoring credit quality deterioration's amplified effects through leverage mechanisms. These empirical contributions advance banking literature while informing evidence-based policy formulation and managerial decision-making within emerging market financial systems, demonstrating economically significant performance enhancement potential exceeding 30-40 basis points annually through optimal liquidity management strategies.