The impact of liquidity regulation on financial performance of banking industry

Abstract

Liquidity and profitability are contemporary issues in the banking sector of emerging countries. We examine how Basel III liquidity regulation, as reflected in the liquidity coverage ratio (LCR) and non-performing assets (NPAs), affects banks’ financial performance using balanced panel data from 25 banks’ annual reports from 2018 to 2024. By applying the collapse instrument technique in a two-step system generalized method of moments (GMM) estimator, the study found a significant and strong positive relationship between LCR and return on assets (ROA). This finding is in line with the liquidity–profitability trade-off theory (Modern Risk–Adjusted Version) and financial intermediation theory. A novel finding is that LCR exerts a negative effect on net interest income (NII). Another result reveals that higher liquidity (LCR) has a statistically significant inverse relation with NPAs, indicating that higher liquidity reduces bad loans (NPAs). The result suggests that Basel III has successfully set liquidity requirements to mitigate the industry–wide liquidity crisis. Our results remain robust when using alternative methods. The results provide guidance for financial institutions to maintain liquidity and profitability better. The study’s contribution is meaningful for banks, national and international regulators, and policymakers in making strategic decisions to support financial stability and long-term growth in the banking industry.