Impact of Prudential Banking Regulations on Bank Profitability and Liquidity: Evidence from Ethiopian Commercial Banks

Abstract

This study investigates how prudential regulatory instruments introduced by the National Bank of Ethiopia (NBE) influence the profitability and liquidity of private commercial banks in Ethiopia. Using balanced panel data from seven private commercial banks covering the period 2014–2023, the study employs fixed-effects and random-effects regression models to examine the relationship between regulatory measures—including legal reserve requirements, capital adequacy, capital requirements, equity investment limitations, and NBE bill purchase requirements—and bank performance. The findings indicate that prudential regulations affect different dimensions of bank performance in varying ways. Specifically, the legal reserve requirement has a positive and statistically significant effect on bank liquidity, suggesting that higher reserve holdings improve banks’ ability to meet short-term obligations. However, it is associated with a weak negative effect on profitability, highlighting the potential trade-off between maintaining liquidity and generating income. The results also show that higher capital adequacy significantly reduces return on equity, indicating that stronger capital buffers may limit shareholders’ returns. Among bank-specific factors, managerial efficiency is found to be an important driver of profitability, whereas greater dependence on deposit funding is associated with lower profitability. In contrast, capital requirements, equity investment limitations, and NBE bill purchase requirements do not exhibit statistically significant short-run effects on bank profitability or liquidity. Overall, the findings suggest that Ethiopia’s prudential regulatory framework has contributed more strongly to strengthening liquidity and financial stability than to improving bank profitability. The study underscores the need for regulators to maintain an appropriate balance between financial stability objectives and banks’ operational efficiency and profitability in emerging banking systems.