Dynamic Research Journals (DRJ)

Journal of Economics and Finance (DRJ-JEF)

Volume 2 ~ Issue 4 (April, 2017) pp: 55-61
ISSN (Online); 2520-7490
www.dynamicresearchjournals.org

Liquidity and Deposit Money Banks Performance in Nigeria

1Agu Nkechi Christiana & 2Dr. Emeka Nnamani
1
Department of Banking and Finance, Enugu State University of Science and Technology (ESUT), Email: nkechiucheagu@gmail.com.
2
Department of Business Administration, Enugu State University of Science and Technology (ESUT), Email: emekannamani98@yahoo.com .

Abstract: The study investigated the relationship between liquidity and performance of Deposit Money Banks in
Nigeria. Specifically, the study investigated the effect of loan-to-deposit ratio and interest rate on return on equity of
DMBs in Nigeria. Loan-to-deposit ratio and interest rate served as the explanatory variables. On the other hand,
return on equity served as the dependent variable and served as a measure of performance in the DMBs. The study
covered the period 2005 to 2015 and data were collected from the Annual reports of First Bank Plc and Fidelity
Bank Plc. The study employed the Pooled (Panel) Least Squares (PLS) technique in order to investigate the
aggregate effect of liquidity on the selected Deposit Money Banks (DMBs) in Nigeria. Findings showed that
liquidity has a negative and insignificant relationship with DMBs performance in Nigeria while interest rate has a
positive and significant effect on DMBs performance in Nigeria. The study recommends that policy makers should
formulate and implement policies that would curb unnecessary risk taking in the banking industry so as to prevent
the banks from overshooting that threshold at which the loan-to-deposit ratio increases rather than decrease banks
performance.
Keywords: Loan-to-deposit ratio, Deposit Money Banks, Liquidity and Return on equity

I. Introduction
Most often than not, the influence of liquidity on the performance of banks is undermined. This stems from the
notion held by the traditional asset pricing models which asserts that the financial market is without frictions and
therefore liquidity is assumed not play any roles at all (Adler, 2012). In the context of the traditional asset pricing
model, the financial intermediaries were assumed to be stable because they had access to readily available funds and
they obtain these funds at low cost. This notion was popular among financial analysts prior to the outbreak of the
Global Financial Crisis (GFC). However, the importance of liquidity in the banking industry came to the fore with
the happenings since the outbreak of the global financial crisis of 2008/2009. The banks became endangered species
as they were faced with huge distress simply because they undermined the importance of liquidity to the system and
therefore did not manage it efficiently (Tarraf & Majeske, 2014). It cannot go without noticing that the rapid
downward trend in market conditions helped to explain how quickly liquidity can disappear. More shocking, as
evidenced by the Global Financial Crisis, is the fact that illiquidity can drain already earned profits. This is because
the financial institutions are either forced to sell accumulated assets below their market value or they are forced to
borrow at interest rates that are well above their return on assets (performance). By and large, what began as credit
challenges for the United States sub-prime market alone virally exploded into challenges in global credit markets
with huge losses (Shen, Chen, Kao and Yeh, 2009). As a result of volatility experienced in the global credit markets,
financial market players became increasingly risk-averse and became unwilling to invest in any market other than
the ones where their returns are guaranteed. Their actions led to reduced levels of liquidity in the global financial
markets and adversely affected the banks performances (SARB, 2009).
Back home in Nigeria, the then Nigerian Governor of Central Bank assured Nigerians that the Nigerian banks
would not be affected even as liquidity challenges ravage other world financial institutions. His assurances came on
the heels of the robustness of Nigerian banks which he hinged on the much touted bank consolidation
(recapitalization) exercise of year 2005. Is the performance of Nigerian banks actually not affected by liquidity
challenges? This is the pertinent question that motivated the study.

1.1 Statement of the Problem

Given that financial intermediation by the banks (through loan disbursement and deposit mobilization) increases
economic activities and enhances economic growth thereby increasing banks performance, the challenge remains
where the banks will strike a balance as to the threshold which their loans shall not exceed. This is against the

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 Liquidity and Deposit Money Banks Performance in Nigeria

backdrop that at a certain threshold the higher the loan-to-deposit ratio the higher the performance of the banks but
beyond this threshold high loan-to-deposit ratio adversely affects liquidity thereby undermining bank performance.

1.2 Research Objectives

The broad objective of the study was to examine the relationship between liquidity and Deposit Money Banks
performance in Nigeria. Specifically, the study did the following:
(i) Investigated impact of loan-to-deposit ratio on return on equity of Deposit Money Banks (DMBs) in
Nigeria.
(ii) Investigated the impact of interest rate on return on equity of Deposit Money Banks (DMBs) in
Nigeria.

1.3 Research Questions

In line with the specific objectives, the following questions sought to be answered by the study:
(i) To what extent does loan-to-deposit ratio affect return on equity of Deposit Money Banks (DMBs) in
Nigeria?
(ii) To what extent does interest rate affect return on equity of Deposit Money Banks (DMBs) in Nigeria?

1.4 Research Hypotheses

Two hypotheses were tested in the study and they are:
(i) H0: Loan-to-deposit ratio does not have significant effect on return on equity of Deposit Money Banks
(DMBs) in Nigeria.
(ii) H0: Interest rate does not have significant effect on return on equity of Deposit Money Banks (DMBs)
in Nigeria.

II. Empirical Literature

Kosmidou, Tanna and Pasiouras (2005) investigated the relationship between liquidity and bank performance in
United Kingdom for the period 1995-2002. The study adopted return on assets as the measure for banks
performance while ratio of liquid assets to customer and short term borrowings served as the measure for liquidity.
Findings revealed that ratio of liquid assets to customer and short term borrowings have a positive and significant
effect on banks performance in Greece. Similarly, Kosmidou (2008) in an independent study investigated the
determinants of bank performance in Greece using a sample of 23 Greek banks. This study adopted data from 1990
to 2002 and employed the Pooled Ordinary Least Squares (POLS) as the analytical tool. Findings revealed that a
liquidity was a major determinant of bank performance in Greece and that liquidity has a negative relationship with
performance of Greece banks as less liquid banks have lower return on assets (proxy for performance). Naceur and
Kandil (2009) examined the effect of capital requirements on banks cost of intermediation and performance in
Egypt. The study employed capital-to-assets ratio, management efficiency, and increase in liquidity and inflation
rate as the independent variables while both return on assets and return on equity served as the dependent variables.
Findings revealed that liquidity does not have any significant effect on both return on assets and return on equity.
Chen, Shen, Kao and Yeh (2010) investigated the effect of liquidity on bank performance. The study employed
net interest margin as the dependent variable while liquidity risk served as the independent variable. Their findings
revealed that a positive and significant relationship exists between liquidity risk and the performance of banks
suggesting that banks with higher levels of illiquid assets achieve higher interest incomes. The study further revealed
that liquidity risk has a negative significant relationship with return on average assets and return on average equity
in a market-based financial system. However, the study revealed that there is no significant relationship between
liquidity risk and bank performance in a bank-based financial system since the banks play a key role in providing
financing. Thus, they are not affected by liquidity risk in a bank-based financial system. Marozva (2015) analyzed
the relationship between liquidity and bank performance in South Africa for the period 1998 to 2014. The study
employed the autoregressive distributed lag (ARDL) model and the Ordinary Least Squares (OLS) model as the
analytical tools. Unit root and cointegration pre-testing were conducted first to determine the stationarity and
existence of long run equilibrium relationship among the variables. The study categorized market liquidity risk,
funding liquidity risk and credit liquidity risk and used them as the key measures for liquidity while net interest
margin served as the measure for performance. Findings showed that there exists a negative significant relationship
between net interest margin and funding liquidity risk but an insignificant relationship exists between market
liquidity risk and credit liquidity risk; and net interest margin (performance) in South African Banks.

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 Liquidity and Deposit Money Banks Performance in Nigeria

Sujeewa (2015) investigated the impact of credit risk management on the performance of commercial banks in
Sri Lanka. The study employed both descriptive and empirical tools as analytical methodologies. Specifically, the
study employed the Panel data analysis making use of data from 2009 to 2013. Return on assets served as the
measure of performance as well as the dependent variable while non-performing loans to total loans ratio, loan
provision to non-performing loan ratio, loan provision to total assets ratio and loan provision to total loans ratio
served as the measures of credit risk as well as the independent variables. Findings revealed that non-performing
loans and provisions have an adverse effect on commercial banks performance in Sri Lanka. Dhanuskodi (2014)
analyzed the effect of loan deposit ratio on profitability of banks in Malaysia. The study adopted data from 2009 to
2013 and employed a Panel data approach to empirically investigate the effect of loan-to-deposit ratio on return on
assets. The study revealed that there exist a positive and insignificant relationship between loan-to-deposit ratio and
profitability of commercial banks in Malaysia. Olarewaju and Adeyemi investigated the relationship between
liquidity and profitability of Nigeria Deposit Money Banks. The study employed the causality test and findings
showed that there exists a unidirectional relationship between liquidity and profitability in the DMBs with the flow
of direction of influence going from liquidity to profitability. The implication of this finding is that liquidity is a
strong determinant of the profitability of the DMBs in Nigeria.

2.1 Theoretical Framework

Some theories of liquidity commercial banks nexus were reviewed in the study. Among them are:

2.1.1 Commercial Loan Theory

This theory is also referred to as traditional theory of liquidity and it was popularized by Onoh (2002). This
theory postulates that lending by the banks should mainly be on short term basis since most bank deposits are also in
short term. Hence, the theory emphasizes the need to march short term deposits with short term loans in order for the
banks to be more efficient in liquidity management.

2.1.2 Anticipated Loan Theory

This theory was postulated by Herbert Prochnow in 1949 and emphasizes that the earning power and credit
worthiness of the borrower should be the top consideration of the banks when granting loans as it was the major
source of bank liquidity. Hence, it becomes imperative for the banks to critically examine the reputation of the
borrower, his ability and willingness to repay the borrowed funds as and when due. If the borrowers have the ability
to service and /or pay back as required, the profitability (performance) of the banks would be enhanced. This theory
favours this study as emphasis is on the approach to adopt so as to eliminate the rising incidence of non-performing
loans.

2.1.3 Liquid Asset Theory

This theory was popularized by Anyanwu (1993) and postulates that banks should maintain large pool of
short term assets. With efficient primary and secondary markets, such short term assets would be able to facilitate
the banks abilities to meet its short term obligations as the fall due.

III. Model Specification

The study anchored on the anticipated loan theory which emphasizes on the need for the banks to identify
credible and willing borrowers so as to reduce the incidences of non-performing loans and enhance performance of
the DMBs. In line with Marozva (2015) with modifications, the model for the study is specified as:
ROE = (LDR, INTR) (1)
Transforming equation (1) into its linear econometric form yields
ROE = 0 + 1LDR + 2INTR + (2)
Where; ROE = Return on equity (proxy for DMBs performance), LDR = Loan-to-deposit ratio (proxy for
funding liquidity), INTR = Interest rate (used as a control variable), 0 = Constant term, 1 and 2 = Coefficient
parameters of the explanatory variables, = Stochastic error term. By a priori, 0 > 0, 1 < 0, and 2 < 0

3.1 Description of Variables

(i) Dependent variable

Return on Equity (ROE); Return on equity measures the performance of the DMBs. Return on equity is described
in the study as: ROE = Profit after Tax divided by Shareholders equity

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(ii) Independent Variables

Loan-to-deposit ratio (LDR); Loan-to-deposit ratio is used as a measure for liquidity in the DMBs. It is measured
as the ratio of total loans to total deposits. Loan-to-deposit ratio is described in the study as: TL/TD = Total loans
divided by total deposits.

Interest rate (INTR); Interest rate is used as a measure for monetary policy effect. It is captured as monetary policy
rate as stipulated by the Central Bank of Nigeria and used merely as a control variable in the study. It is described in
the study as: INTR = Monetary Policy rate (MPR)

IV. Data Analysis and Discussion of Findings

Table 1: Data on Return on equity (ROE), Loan-to-deposit ratio (LDR) and Interest rate (INTR)
YEAR BANK ROE LDR INTR
2005 FIRSTBANK 27.3 55.59 15
2006 FIRSTBANK 27.2 44.94 13
2007 FIRSTBANK 23.7 37.67 12.25
2008 FIRSTBANK 9 66.17 8.75
2009 FIRSTBANK 0.4 63.83 9.81
2010 FIRSTBANK 7.9 76.45 7.44
2011 FIRSTBANK 17.6 74.45 6.13
2012 FIRSTBANK 17.9 75.13 12
2013 FIRSTBANK 16.9 71.35 12
2014 FIRSTBANK 18.8 79.25 12.25
2015 FIRSTBANK 18.9 65.09 14
2005 FIDELITY 12.72 76.2 15
2006 FIDELITY 12.35 58.99 13
2007 FIDELITY 13.98 43.58 12.25
2008 FIDELITY 9.56 63.12 8.75
2009 FIDELITY 1.78 60.4 9.81
2010 FIDELITY 4.33 62.03 7.44
2011 FIDELITY 0.81 47.45 6.13
2012 FIDELITY 11.1 48.2 12
2013 FIDELITY 4.72 52.84 12
2014 FIDELITY 7.97 66.06 12.25
2015 FIDELITY 7.58 75.13 14
Source: Authors compilation from selected banks annual reports and Central Bank of
Nigeria (CBN) Statistical Bulletin.

4.1.1 Return on equity

Table 1 above shows that there are different levels of performance attached to different banks at different
times (periods). For instance, the performance of First Bank Plc stood at 27.3 percent in 2005 and this decreased to
7.9 percent in 2010. However, it resumed its upward trajectory reaching 18.9 percent in 2015. On the other hand,
the performance of Fidelity stood at 12.72 percent and continued to increase reaching 13.98 percent in 2007.
Thereafter, the performance of Fidelity bank was characterized by rapid increases and decreases in the remaining
years. Therefore, it is pertinent to re-emphasize that the selected banks have different levels of performance for the
years under review. This may be a pointer to the fact that the banks may be differently affected by liquidity. In order
to bring to the fore the sum-effect of liquidity on the banks, the study employed the Pooled Ordinary Least Squares
technique.

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 Liquidity and Deposit Money Banks Performance in Nigeria

4.1.2 Loan-to-deposit ratio (LDR)

The effect of liquidity risk on the performance of the DMBs was captured using the loan-to-deposit ratio.
From table 1 above, one can see that the loan-to-deposit ratio differs among the banks at different periods. For
instance, in 2005, the loan-to-deposit ratio of First bank Plc stood at 55.59 percent while that of Fidelity bank Plc
stood at 76.2 percent. In year 2010, the loan-to-deposit ratio of First bank Plc increased to 76.45 percent while that
of Fidelity bank Plc decreased to 62.03 percent. These dynamics in the loan-to-deposit ratio in the banks continued
to play out thereby indicating that the banks undertake different levels of risk in terms of what the loan out in
relation to the bank deposits.

4.1.3 Interest rate (INTR)

Interest rate was adopted as a control variable in the study. It represented the external environment in which
the banks operate in and to that extent it is assumed that its effect is central to the banks. For instance, in 2005, the
monetary policy rate (interest rate) stood at 15 percent and this decreased to 7.44 percent in 2010 but increased again
to 14 percent in 2015. Being that the effect is central; the effect on the banks is expected to be the same.
Table 2: Pooled Ordinary Least Squares (POLS) Result
Method: Panel Least Squares
Date: 03/01/17 Time: 06:04
Sample: 2005 2015
Periods included: 11
Cross-sections included: 2
Total panel (balanced) observations: 22

Variable Coefficient Std. Error t-Statistic Prob.

C -0.510211 10.64673 -0.047922 0.9623

LDR -0.060680 0.128475 -0.472313 0.6421
INTR 1.494283 0.577748 2.586393 0.0181

R-squared 0.571557 Mean dependent var 12.38636

Adjusted R-squared 0.494878 S.D. dependent var 7.963398
S.E. of regression 7.145443 Akaike info criterion 6.896951
Sum squared resid 970.0898 Schwarz criterion 7.045729
Log likelihood -72.86646 Hannan-Quinn criter. 6.931998
F-statistic 3.541508 Durbin-Watson stat 1.817524
Prob(F-statistic) 0.049290

Critical values:
(a) t statistic, t0.05 = 1.721
(b) F-statistic, F0.05 (2, 19) = 3.47
Source: Authors computation using E-views 8.0 software
The result in table 2 above can be summarized as:
ROE = -0.51 0.06LDR + 1.49INTR
t-statistic (-0.05) (-0.47) (2.59)
R-squared = 0.57
F-statistic = 3.54
DW-statistic = 1.82

The result summarized above is analyzed in line with the economic, statistical and econometric criteria.
First, the result shows that there is a negative and insignificant relationship between loan-to-deposit (proxy for
liquidity) and return on equity (proxy for performance) in DMBs in Nigeria. This result conforms to economic a
priori expectation and shows that one unit increase in the loan-to-deposit ratio (liquidity risk) leads to 0.06 unit fall
in the return on equity of Deposit Money Banks in Nigeria. The computed t-statistic for loan-to-deposit ratio (0.45)
in absolute terms is less than the critical t-statistic (1.72) at five percent level of significance. As a confirmation, the

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 Liquidity and Deposit Money Banks Performance in Nigeria

probability value of loan-to-deposit ratio (0.6421) is greater than the test significant level (i.e. P > 0.05). We
conclude that loan-to-deposit ratio (liquidity risk) does not have significant effect on the performance of DMBs in
Nigeria. This finding conforms to economic theoretical expectation to the extent that as banks increase their loan-to-
deposit ratio, the riskier their operations become and if the credit risk management is not effective their performance
would be affected. Perhaps, this result is attributed to the increasing appetite of the banks to take uncertain risks
which have resulted in rising incidence of non-performing loans in the Nigerian banking industry. As the non-
performing loans increase, the performance of the banks reduces. As non-performing loans rise, liquidity squeeze
increases and the banks become unable to obtain sufficient fund either by increasing liabilities or converting its
assets promptly at a reasonable cost. All these ultimately undermine the performance of the bank. Despite the fact
that an increasing loan-to-deposit to a certain threshold may enhance the performance of banks, but beyond that
threshold an increase in loan-to-deposit ratio reduces the performance of the banks. This finding corroborates
Naceur and Kandil (2009) which established a negative and insignificant relationship between liquidity and financial
performance of banks.
Second, the result reveals that there is a negative and significant relationship between interest rate and
return on equity of Deposit Money Banks in Nigeria. By sign, this result conforms to economic a priori expectation
because an increase in interest rate charged on loans leads to a discouragement among borrowers thereby reducing
the performance of the banks. From the result, one unit rise in interest rate leads to 1.49 unit fall in the return on
equity (performance) of the Deposit Money Banks in Nigeria. However, the computed t-statistic for interest rate
(2.59) is less than the critical (tabulated) t-statistic (1.72) at five percent level of significance. As a confirmation, the
probability value of interest rate (0.0181) is less than the test significant level (i.e. P < 0.05). Hence, we conclude
that interest rate has an insignificant effect on the performance of Deposit Money Banks (DMBs) in Nigeria. This
relationship is not in line with economic expectation because it is expected that as interest rate increases, the cost of
borrowing increases leading to many borrowers becoming discouraged from borrowing. With a reduction in the
number of borrowers, the returns those transactions would have brought to the banks are reduced thereby reducing
the performance of the banks. This finding concurs with the findings of Okoye and Eze (2013) which argued that a
positive and significant relationship exists between monetary policy rate and performance of DMBs in Nigeria.
Perhaps, this outcome may be attributed to dearth of borrowing alternatives in Nigeria which makes the borrowers to
still approach the banks irrespective of the unfavourable interest rate regimes of the banks. As this trend continues
despite the high interest rate, the banks rake in more profits and their level of performance increases.
The coefficient of determination (Rsquared) shows that 57 percent of the variations in Deposit Money
Banks performance in Nigeria are due to changes in loan-to-deposit ratio and interest rate. Therefore, the remaining
43 percent are caused by changes in other factors not included in the model. The computed F-statistic (3.54) exceeds
the tabulated F-statistic (3.47) and this shows that the model adopted for the study is significant as well as reliable.
The Durbin Watson statistic (1.82) lies within the permissible region and indicates that there is no autocorrelation.
Interestingly, the Durbin Watson statistic is greater than the R squared and this confirms that the regression
result is not spurious.

V. Summary of Findings
The findings of the study are summarized below:
(i) There exists a negative relationship between loan-to-deposit ratio and performance of Deposit Money
Banks in Nigeria.
(ii) Loan-to-deposit ratio has an insignificant effect on the performance of Deposit Money Banks in
Nigeria.
(iii) There exists a positive relationship between interest rate and performance of Deposit Money Banks in
Nigeria.
(iv) Interest rate has a significant effect on the performance of Deposit Money Banks in Nigeria.

5.2 Conclusion
The study undertook to examine the relationship between liquidity and Deposit Money Banks performance in
Nigeria. To break the broad objectives into manageable specific objectives, the study investigated the effect of loan-
to-deposit ratio and interest rate on the return on equity. Loan-to-deposit ratio was used as a proxy for liquidity and
interest rate was adopted merely as a control variable and both of them served as the independent variables. On the
other hand, return on equity was used to measure performance of the DMBs and served as the dependent variable.
Findings in the study showed that loan-to-deposit reduces the performance of DMBs in Nigeria but its effect on the
banks is insignificant. Surprisingly, the study revealed that interest rate increases the performance of DMBs in
Nigeria and has a significant effect on DMBs performance in Nigeria. In conclusion, the study asserts that although

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 Liquidity and Deposit Money Banks Performance in Nigeria

liquidity reduces the performance of the DMBs but it does not have significant effect on their performance in
Nigeria.

5.3 Recommendations
The study recommends the following based on its findings:
(i) Policy makers in the banking industry should formulate and implement policies that would discourage
unnecessary risk-taking by the banks in order not to overshoot that threshold at which loan-to-deposit
ratio starts to have diminishing returns.
(ii) Deposit Money Banks in Nigeria should sustain programmes and packages that would further attract
borrowers such that even if the interest rate remains high it would not undermine their performance.

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