Liquidity coverage ratio and profitability: an inverted U-shaped pattern

The aim of this paper is to investigate the relationship between the Liquidity Coverage Ratio (LCR) and profitability in the banking sector of Vietnam, focusing on determining how LCR impacts profitability while identifying the optimal level of LCR that balances liquidity management and profitability. The study uses a sample of 20 banks from Q1 2015 to Q4 2022. Profitability is measured through Return on Assets (ROA) and Net Interest Margin (NIM). Employing a system GMM estimator to explore the quadratic effect of LCR on profitability, the results demonstrate an inverted U-shaped relationship. Initially, increases in LCR enhance profitability, reflecting better liquidity management. However, beyond optimal points (approximately 5.89 for ROA and 7.47 for NIM), further increases in LCR lead to diminishing returns, indicating that excessively high liquidity buffers impose opportunity costs and reduce profitability. These findings underscore the importance of balancing liquidity and profitability in banking operations. This study is novel in its use of the system GMM estimator to investigate the quadratic relationship between LCR and profitability in the Vietnamese banking sector, offering new insights into how banks can optimize liquidity management to enhance profitability. Unlike previous studies, this paper identifies specific optimal LCR thresholds for ROA and NIM, providing actionable benchmarks for banking operations. This study contributes valuable insights into the relationship between the Liquidity Coverage Ratio (LCR) and profitability within the Vietnamese banking sector. By identifying a specific optimal LCR threshold for Vietnamese banks, the research offers actionable benchmarks that enable financial institutions to balance liquidity and profitability more effectively. These findings underscore an inverted U-shaped relationship between LCR and profitability, wherein initial increases in LCR enhance bank performance through better liquidity management. However, profitability diminishes as LCR exceeds optimal levels, highlighting the potential opportunity costs associated with maintaining excessive liquidity. This study's application of a dynamic two-step Generalized Method of Moments (GMM) estimator further provides a rigorous and robust analysis, addressing endogeneity concerns often present in banking studies. Ultimately, these insights equip Vietnamese banks and regulatory bodies with practical tools to enhance financial stability and operational efficiency in a dynamic economic landscape.