The impact of funding sources on bank profitability and the role of risk as an intermediary in the relationship: A critical study of commercial banks

Abstract

This research paper aims to theoretically evaluate sources of bank funding and their impact on profitability, highlighting the role of risk as a key factor in this relationship. It seeks to shed light on the complex interplay between funding, risk, and bank profitability within Libya's unique economic context. To achieve this objective, the paper employs a theoretical evaluation methodology based on studies that have modeled the relationships between funding sources, risk, and profitability. It reviews the findings of previous research on these topics, particularly within the context of Libyan commercial banks and their counterparts in other countries. Several studies that utilized methodologies such as Ordinary Least Squares Regression (OLS), path analysis, and dynamic panel data models to analyze credit risk management and profitability are cited. The paper summarizes several key findings, noting that commercial banks in Libya rely on customer deposits as a stable and cost-effective source of funding. These deposits enable banks to offer competitive loan rates and invest in high-yield assets, thereby increasing net interest income. Effective asset and liability management is crucial for profitability when relying on deposits. Previous studies have indicated that banks heavily reliant on customer deposits tend to enjoy strong liquidity and financial stability, which indirectly enhances profitability.

Studies applied to Libyan banks also indicate that those heavily reliant on customer deposits tend to enjoy strong liquidity and financial stability, which indirectly enhances profitability. In the same vein, the research paper found that interbank lending is more flexible than customer deposits in terms of access to large sums, but it is also more costly and volatile. It was also observed that equity capital enhances a bank's lending capacity, covers losses, and is essential for financial stability and profitability. Furthermore, risk plays a crucial mediating role between funding sources and profitability. Banks manage numerous risks, including credit, liquidity, operational, and regulatory risks. The analysis also revealed that low-cost financing can incentivize banks to relax lending standards and increase loan volumes, but this is likely to lead to more non-performing loans (NPLs), which directly reduce profitability through loan loss provisions. Increased exposure to credit risk leads to lower profits and reduced financial stability. Risk mediates the relationship between funding sources and bank profitability. The analysis also revealed some variations in the direction of the direct relationship between funding sources and profitability due to differences in methodology and the specific contextual circumstances of each bank.