Liquid Asset Holdings and Banking Profitability: Evidence from South Asia

Abstract

Abstract Ensuring liquidity is critical for the functioning of banks. This study investigates the functional form of bank profitability and liquid asset holdings. We test for an inverted Kuznets curve-shaped quadratic polynomial relationship using generalized least square regression on an unbalanced quarterly dataset of Islamic and conventional banks of South Asia from 2016 to 2021. The study finds that profitability and liquid asset holdings have a concave nonlinear relationship suggesting a profit-maximizing level of liquidity. However, Islamic banks are less nonlinear than conventional banks, suggesting that their profitability is less responsive to changes in liquid asset holdings and needs more liquid assets to maximize profitability. Additionally, we find that the optimal level of liquidity to maximize profitability fell during Covid-19 as the relationship became more nonlinear. The study provides evidence of unique liquid management requirements for different types of banks based on how bank profitability response differs across different types of banks. The development of a one-fit-all liquidity management framework as in the case of the Basel III liquidity risk framework may not be appropriate. From a policy standpoint, the Basel III liquidity risk framework needs to be tailored especially in the context of Islamic banks.