A commercial bank is a business entity that deals in banking with a view to make profits. Every commercial bank aims to make profits in such a way that it does not compromise on its objective of liquidity, which is vital for its own security and safety.
Since a commercial bank has to make profits in such a way that its liquidity remains intact, it diversifies its funds into various assets. A well – diversified and balanced asset portfolio ensures its sound and successful working. Various factors play an important role in determining the profitability and liquidity of commercial banks. These factors are taken into consideration while creating the asset portfolio of the banks.
A) FACTORS AFFECTING THE PROFITABILITY OF COMMERCIAL BANKS:
1) Amount of working funds:
Funds deployed by a bank in profitable assets are the working funds of the bank. Profitability of a business is directly proportionate to the amount of working funds deployed by the bank.
2) Cost of funds:
Cost of funds are the expenses incurred on obtaining funds from various sources in the form of share capital, reserves, deposits, and borrowings. Thus, it generally refers to interest expenses. Lower the cost of funds, higher the profitability.
3) Yield on funds;
The funds raised by the bank through various sources are deployed in various assets. These assets yield income in the form of interest. So, higher the interest, greater the profitability.
Spread is defined as the difference between the interest received (interest income ) and the interest paid (interest expense ). Higher spread indicates more efficient financial intermediate and higher net income. Thus, higher spread leads to higher profitability.
5) Operating Costs:
Operating costs are the expenses incurred in the functioning of the bank Excluding cost of funds, all other expenses are operating costs. Lower operating costs give rise to greater profitability of the banks.
6) Risk cost:
This cost is associated to the probable annual loss on assets. They include provisions made towards bad debts and doubtful debts. Lower risk costs increase the profitability of banks.
7) Non – interest income:
It is the income derived from non – financial assets and services It includes commission & brokerage on rencittance facility, rent of locker facility, fees for underwriting and financial guarantees, etc. This income adds to the profitability of banks.
8) Level of technology:
Use of upgraded technology normally leads to decline in the operating costs of banks. This improves the profitability of banks.
9) Level of Non – performing assets (NPAs):
The profitability of a bank is inversely related to the level of NPAs. Hence, over the years, the NPAs of commercial banks have greatly declined.
10) Level of competition:
Increase in competition generally leads to higher operating costs. This leads to lower profitability.
B ) FACTORS DETERMINING THE LIQUIDITY OF COMMERCIAL BANKS:
1) STATUTORY REQUIREMENTS:
The extent of liquid reserves held by banks depends on the statutory requirements of the Central Bank (i.e. the RBI) …