Q.Why is there a conflict between liquidity and profitability for a commercial bank, and how does the bank resolve it?

Liquidity and profitability pull in opposite directions because liquid assets earn little and high-earning assets are not liquid. …

The nature of the conflict. A commercial bank must at all times be able to repay depositors on demand — this needs liquidity, that is, cash and assets easily turned into cash. But cash earns nothing, and near-cash assets earn very little, so a bank that holds too much liquidity earns too little profit. On the other hand, the assets that earn the most — loans and advances — are the least liquid, because they are locked up until the borrower repays, and the most risky. Thus the drive for profitability pushes the bank towards illiquid, higher-earning assets, while the need for liquidity pushes it towards low-earning cash and near-cash. The two objectives therefore pull in opposite directions.

How the bank resolves it. The bank does not choose one objective over the other; it strikes a balance by holding a graded range of assets:

• enough cash and balances with the central bank to meet day-to-day withdrawals and legal reserve requirements;
• a layer of money at call and short-notice and bills that are almost as liquid but earn a little;
• a body of government and other securities that are safe, earn a steady return, and can be sold when cash is needed;
• and the remainder in loans and advances, the most profitable use, spread across many borrowers and industries to limit risk. …

Avoid concluding that a bank should simply 'hold lots of cash to be safe' — that would destroy its profitability. The correct answer is balance throug …