How do commercial banks strike a balance between their liquidity and profitability?

How do commercial banks strike a balance between their liquidity and profitability

?

ANS. TRADE OFF BETWEEN LIQUIDITY AND PROFITABILITY

INTRODUCTION

A commercial bank deals in the business of banking with a view to make profits.

In order to earn profits, the asset portfolio of a bank is of utmost importance.

It also gives a picture of the soundness of a commercial bank.

MEANING:

The manner in which a bank applies the various sources of funds on different types of assets reflects the soundness of the bank .

Every bank has two important objectives :

Profitability

Since these two objectives are contradictory in nature, a good banker aims to reconcile both these objectives by creating diversified and balanced asset portfolio.

EXPLANATION :

The two most important objectives of a commercial bank are :

PROFITABILITY :

Every bank aims to earn optimum profit for its shareholders

Hence, it invests in those assets that give them maximum returns

Such assets are of long term in nature and so,

They cannot be easily converted into cash .

So, these assets are less liquid in nature and so cannot be used to meet the withdrawal demands of the customers (depositors)

Such assets include :

Cash credit and overdraft

Term loans

Investment in stocks, shares, bonds, debentures, mutual funds

Loans and advances (long term)

LIQUIDITY :

Liquidity is the second most important objective of a commercial bank as it ensures the bank's own safety and security.

Hence a bank should invest in those assets that can be easily converted into cash.

It readily meets the withdrawal needs of the depositors and helps to build their confidence and trust in the bank.

However, the more liquid the asset is, the less profit it yields.

These assets include :

Cash balances

Money at call and short notice

Bills of exchange.

Investment in Government securities.

Thus these twin-conflicting objectives of liquidity and profitability can be achieved to their optimum level by wisely allocating the funds to various assets.

These assets are shown in the balance sheet in ascending order of profitability and descending order of liquidity.

A well diversified and balance asset portfolio helps in creating a trade off' or a reconciliation between liquidity and profitability.

CONCLUSION :

There fore, a commercial bank has to strike a balance between the contradictory objectives a liquidity and profitability.

This can be achieved with an optimum mix of assets that lead to a sound and successful banking system.

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