The negative relationship between classified loans and profitability has been a major concern for the policymakers in the banking industry of Bangladesh, according to a study conducted by the central bank.
The study recommended that the authorities of commercial banks should adopt proper policy to improve the efficiency of liquidity management.
"The negative relationship between non-performing loans (NPLs) and return on assets (ROA) has been a major concern for the policymakers in the banking industry of Bangladesh since NPLs in the banking sector have increased in the last three years during the post-2011 period," the Bangladesh Bank (BB) said in the study report.
The Research Department of the central bank prepared the working paper styled 'Nexus between Bank's Liquidity and Profitability in Bangladesh: An Empirical Overview' and released it Thursday.
The main objective of the paper is to investigate the relationship between banks' liquidity and profitability and the impact of liquidity on bank's profitability.
The paper applied the 'ordinary least square (OLS) method' during the sample period between 1997 and 2014 to examine the impact of liquidity on banks' profitability.
The paper has also found that the advance deposit ratio positively impacts banks' profitability while profitability is defined as ROA.
Call money rates, NPLs, and excess liquidity impact banks' profitability in a negative fashion, according to the study.
It also said excess liquidity ratio has a negative impact on banks' profitability.
The call money rates vary negatively with banks' profit which indicates that banks meet their liquidity deficit with higher cost.
As a result, the higher cost of funds impacts banks' profit inversely.
Accordingly, the estimated result shows a negative relationship between NPLs and profitability, it added.
"So, commercial banks need to be careful while giving loans and reduce NPLs to increase profitability," the paper noted.
The recent rise in NPLs is a concern for overall banking stability because high NPLs of banks reduce loanable funds by stopping recycling and banks cannot earn profit from classified loans, it explained.
Besides, the banks need to put a portion of their income as loan loss reserve to make up for bad debt. It is found that the percentage share of NPLs to total loans reduced dramatically from 1997 to 2011.
The gross NPLs ratio for all banks declined to 6.20 per cent in 2011 from highest 37.5 per cent in 1997.
The ratio again increased during the previous two years due to sharp increase in NPLs of state-owned commercial banks (SoCBs), according to the report.
On the other hand, the volume of NPLs increased by 2.42 per cent to Tk 513.71 billion as of December 31 last from Tk 501.66 billion a year ago, the BB data showed.
Such rising trend of NPLs continued until June 30 last despite close monitoring by the central bank.
The amount of classified loans increased by more than 23 per cent or Tk 120 billion to Tk 633.65 billion as of June 30 last from Tk 513.71 billion as of December 2015.