The Impact of Liquidity Risk on the Financial Performance of Licensed Commercial Banks in Sri Lanka

The importance of liquidity risk management prompted the global financial crisis in 2007 as it highlighted the significance of ensuring adequate liquidity to withstand adverse issues in the financial system. The funding pressures in 2007, underlined the deficiencies in the liquidity risk management practices in the financial system and thereby the Basel Committee introduced Basel accord III emphasizing the importance of liquidity risk management. As liquidity and profitability are prerequisite factors of the sustainability of the financial system, it is vital to analyze the impact of liquidity risk on financial performance. Thus, the main objective of this paper is to investigate the impact of liquidity risk factors and their significance on the performance of domestic Licensed Commercial Banks (LCBs) in Sri Lanka by analyzing data from twelve domestic LCBs from 2011-2021 using panel data regression analysis. The performance was measured using Return on Equity (ROE) and Return on Assets (ROA) where liquidity risk was measured using Non-Performing Loan Ratio (NPLR), Capital Adequacy Ratio (CAR), Loan to Deposit Ratio (LDR), Current Ratio (CR), Loan to Asset Ratio (LAR), Value of deposits (Deposits) & Liquidity Gap (LG). As per the findings, Deposits and NPLR had a negative significant impact while CAR had significant positive impact on bank performance. This study suggests that it is important to strengthen liquidity risk management to preserve the profitability of the banks in Sri Lanka and recommends that bank management need to take multiple actions such as creating a steady liquidity risk management framework, setting and reviewing risk limits regularly, implementing a strong Management Information System, conducting stress testing and creating and implementing a Contingency Funding Plan to mitigate liquidity risks.