The impact of liquidity management on capital adequacy

ABSTRACT

This study examined liquidity management and banks capital adequacy in Cameroon. The major aims of the study were to find empirical evidence of the degree to which effective liquidity management affects capital adequacy in commercial banks and how commercial banks can enhance their liquidity and capital adequacy positions. Considering the nature of the survey, quantitative methods of research were applied. In attempt to achieve the objectives of the study, several findings were made through the analysis of both the structured and unstructured questionnaire on the management of banks and the financial reports of the sampled banks. The data obtained from the Primary and Secondary sources were analyzed through collection, sorting and grouping of the data in tables of percentages and frequency distribution. We formulated a hypothesis, which were statistically tested through Pearson correlation data analysis. Findings from the testing of this hypothesis indicate that there is significant relationship between liquidity and capital adequacy. That means capital adequacy in commercial banks is significantly influenced by liquidity and vice versa. The study concluded that for the success of operations and survival, commercial banks should not compromise efficient and effective liquidity management and that both illiquidity and excess liquidity are “financial diseases” that can easily erode the profit base of a bank as they affect bank’s attempt to attain high capital adequacy-level.

CHAPTER ONE

BACKGROUND OF STUDY

1.1       INTRODUCTION

In every system, there are major components that feature paramount for the survival of the system. This is also applicable to the financial system. The banking institution had contributed significantly to the effectiveness of the entire financial system as they offer an efficient institutional mechanism through which resources can be mobilized and directed from less essential uses to more productive investments (Wilner, 2000).

In the performance of this financial inter-mediation role, the financial institutions have proved to be an effective channel between savers and borrowers. Among the financial institutions that make themselves available for this all-important role are merchant banks, savings banks, the Central bank, development banks and commercial banks. Commercial banks have overtime become very important institutions in the financial system as they function as retail banking units facilitating the transfer of financial assets that are well desired from some part of the public (Fund Lenders) into other financial assets which are more widely preferred by greater part of the public (fund seekers). In view of this role and of the fact that the activities of the commercial banks affect the greater part of the society, commercial banks are selected as the main focus of this study.

Financial inter-mediation role of the commercial banks hence becomes the bed-rock of the two major functions of commercial banks namely deposit mobilization and credit extension. An adequate financial intermediation requires the purposeful attention of the bank management to capital adequacy and liquidity, which are two conflicting goals of the commercial banks. These goals are parallel in the sense that an attempt for a bank to achieve higher capital adequacy will certainly erode its liquidity and solvency positions and vice versa.

Practically, capital adequacy and liquidity are effective indicators of the corporate health and performance of not only the commercial banks (Eljelly,2004), but all profit-oriented ventures. These performance indicators are very important to the shareholders and depositors who are major publics of a bank. As the shareholders are interested in the capital adequacy level, the depositors are concerned with liquidity position which determines a bank’s ability to respond to the withdrawal needs which are normally on demand or on a short notice as the case may be.

Liquidity management is an important aspect of monetary policy implementation, while the other integral component of monetary policy, i.e. economic management, involves promoting sustainable economic growth over the long term by keeping monetary and credit expansion in step with an economy’s noninflationary output potential, liquidity or reserve management as a shorter time horizon. In order to maintain relative macro-economic stability, reliance is placed on liquidity management to even out the swings in liquidity growth in the banking system.

An important step towards market oriented policy procedures takes place when the Central bank assumes responsibility for evening out swings in demand relative to demand on its own initiative, rather than waiting passively for individual banks to come to it. Once it begins to supply or absorb liquidity through market intervention, the discount window plays an important, but subordinate safety valve role by providing the short-run reserve needs of the banking system for purposes of meeting short term liquidity obligations.

In the financial intermediation process, a bank collects money on deposit from one group (the surplus unit) and grants it out to another group (the deficit unit). These roles involve bringing together people who have money and those who need money.

Apart from the technical aspects of the CBN’s responsibility discussed above, it is important in this section to highlight certain critical factors that are required to facilitate liquidity management in the context of autonomy. These include a stable macroeconomic environment, a sound and competitive financial system, adequate regulatory and supervisory framework, and capacity build up. Stable Macroeconomic Environment to enhance liquidity management and ensure macroeconomic stability, there is the compelling need to insulate monetary policy from the pressure of financing the government fiscal deficit. Also, the monetary authorities should have freedom in the management of interest rate in order to sufficiently influence transactions in the intervention securities and enhance the effectiveness of instruments for liquidity management. Uncontrolled financing of the deficit by the CBN, either through ways and means advances or the absorption of unsubscribed government debt issues, increase bank liquidity thereby constraining the effectiveness of instruments for liquidity management (Amarachukwu Ona,2003)

Under the new dispensation, sustaining monetary stability will be achieved through greater coordination between the CBN and the Federal Ministry of Finance, in order to limit government borrowing from the bank to the level stipulated by law.

• HISTORICAL BACKGROUND OF NFC BANK

NFC (National Financial Credit Company) bank is a dynamic, innovative and customer-oriented bank that offers a full range of banking services to its customers. Since its creation in 1990, NFC bank has been owned by several local and foreign investors. The Bank’s mission is to be the leading financial institution in Cameroon and the Central Sub-Region of Africa by providing qualitative and customized banking solutions to clients.  NFC bank operates in a niche market which is made up of large companies with complex financial needs as well as medium size companies with high growth potential. The Bank provides strategic support to its clients through a highly qualified team with expertise in commercial banking, project financing, trade finance and treasury.  NFC bank was incorporated on Thursday 26th April 1990 under the Cameroon Companies Code 1990 with registration number: RC BAFOUSSAM 518 B1 under the name Nde Financial Services Limited. Nde Financial Services Limited (NFC) is a limited liability company duly registered in Cameroon under Registration No: RcBafoussam518B1 as a Finance Company offering diversified financial services.

1.2       STATEMENT OF THE PROBLEM

Through the financial inter-mediation role, the commercial banks reactivate the idle funds borrowed from the lenders by investing such funds in different classes of portfolios. Such business activity of the bank is not without problems since the deposits from these fund savers which have been invested by the banks for profit maximization, can be recalled or demanded when the later is not in position to meet their financial obligations. Considering the public loss of confidence as a result of bank distress which has bedeviled the financial sector in the last decade; and the intensity of competition in the banking sector due to the emergence of large number of new banks, every commercial bank should ensure that it operates on profit and at the same time meets the financial demands of its depositors by maintaining adequate liquidity.

The problem then becomes how to select or identify the optimum point or the level at which a commercial bank can maintain its assets in order to optimize these two objectives since each of the liquidity has a different effect on the level of capital adequacy. This problem becomes more pronounced as good numbers of commercial banks are engrossed with profit maximization and as such they tend to neglect the importance of liquidity management. However, the profit maximization becomes a myth as the resulted liquidity can lead to both technical and legal insolvency with the consequence of low patronage, deposit flight, erosion of asset base.

This research seeks to investigate other problems such as excess liquidity and the problem of establishing the proportion of the deposits that will be demanded by the depositors at any particular time.

There is also the problem of satisfying the two publics of the commercial banks simultaneously. While the accurate selection of the factors that influence the level of bank liquidity also poses some problems. All these problems are what the study intends to consider, find solutions and make recommendations where necessary.

1.3       OBJECTIVES OF THE STUDY

The competitive environment of the financial institutions is so tense that any commercial bank that aims to survive must be fully aware of the consequences of its liquidity and capital adequacy obligations as both variables can make or destroy its future. This study is largely centered on liquidity management which enables the bank to determine its liquidity requirement and ensures its ability to meet up the depositors demand or its financial obligations, thereby maximizing its value.  Due to the fact that the value of the new deposit does not synchronize or correspond with the customers’ withdrawal needs at any particular time, there are uncertainties in the asset management of the commercial banks. These uncertainties become complex as depositors make their withdrawals on demand or at short notice. Consequently, this study will disclose how liquidity management will handle these uncertainties and determine their effects on capital adequacy. The study is aimed at discovering the specific factors that are useful in enhancing the capital adequacy and liquidity position of the commercial banks. It will attempt to identify the basic causes of liquidity problems in Cameroon commercial banks and to recommend appropriate measures to solve such problems.