AQA Specification focus:
‘Potential conflicts between these objectives.’
Introduction
Banks must balance liquidity, profitability, and security, but these aims often clash. Understanding these conflicts is essential for analysing commercial bank behaviour in financial markets.
The Three Core Objectives of a Commercial Bank
Liquidity
Liquidity refers to the ease with which assets can be converted into cash without significant loss of value.
Banks need sufficient liquidity to meet customer withdrawals and short-term obligations.
Profitability
Profitability is the ability of a bank to generate returns from its operations.
Banks achieve profitability mainly through lending at interest rates higher than their cost of borrowing, and by investing in financial assets.
Security
Security concerns the safety of depositors’ funds.
Banks must ensure that loans and investments are carefully managed to avoid default risk and maintain the overall stability of the institution.
Why Conflicts Arise
Although banks aim to achieve all three objectives simultaneously, in practice, trade-offs are unavoidable:
Liquidity vs Profitability
Highly liquid assets, such as cash, generate little or no return.
Lending long-term or investing in illiquid assets is more profitable, but reduces liquidity.
Maintaining too much liquidity protects against bank runs but lowers profits.
Profitability vs Security
Riskier loans or investments typically yield higher returns.
However, increased exposure to default risk threatens the security of depositors’ funds.
Pursuing maximum profit can undermine financial stability.
Liquidity vs Security
Holding highly liquid assets increases security against sudden withdrawals.
Yet banks must also balance this with investing in safe, longer-term assets, which may reduce liquidity in the short run.
Over-emphasis on either side can expose the bank to operational risks.
Detailed Exploration of Conflicts
Conflict 1: Liquidity vs Profitability
Banks must decide how much of their resources to keep as liquid reserves.
If reserves are too high, funds sit idle with little return.
If reserves are too low, banks risk being unable to meet withdrawal demands.
This conflict became clear during the 2007–2008 financial crisis, when liquidity shortages led to bank collapses despite high profit-seeking behaviour.
Conflict 2: Profitability vs Security
To maximise profits, banks often seek higher-yielding investments such as corporate loans or mortgage-backed securities.
These carry higher risk compared to government bonds or prime lending.
If defaults rise, security is compromised.
This conflict highlights the need for prudent credit risk assessment.
Conflict 3: Liquidity vs Security
A bank holding mainly liquid assets may appear safe, but excessive reliance on short-term funds exposes it to maturity mismatch risk.
Borrowing short term while lending long term can leave a bank vulnerable to sudden funding pressures.
Prioritising liquidity alone may weaken the balance sheet’s security.
Managing Conflicts
Regulatory Influence
Banks face strict regulation designed to limit excessive risk-taking.
Liquidity coverage ratios ensure banks hold sufficient liquid assets.
Capital adequacy ratios force banks to maintain security through stronger capital buffers.
These rules compel banks to strike a balance rather than chase profitability at the expense of stability.
Internal Policies
Banks employ risk management strategies, such as:
Diversifying loan portfolios.
Setting lending limits by sector or borrower.
Using stress testing to predict responses to adverse economic conditions.
Central Bank Oversight
The central bank acts as lender of last resort, supporting liquidity during crises.
This reduces the danger of liquidity shortages, but may encourage banks to prioritise profitability over caution, a problem known as moral hazard.
Broader Economic Implications
Conflicts between bank objectives are not only internal matters; they affect the wider economy:
Excessive pursuit of profitability can cause financial instability, as seen during global crises.
Overemphasis on liquidity may restrict lending, reducing credit available to households and firms, which dampens aggregate demand.
Stronger security measures promote stability but may reduce the bank’s willingness to lend, constraining economic growth.
Key Points Recap
Liquidity ensures banks meet withdrawals but reduces profit potential.
Profitability drives returns but can compromise security if risk is excessive.
Security protects depositors but may limit both liquidity and profit.
Conflicts are managed through regulation, risk management, and central bank support.
FAQ
When banks prioritise profitability, they often take on higher-yield but riskier investments such as subprime loans or speculative assets.
If many banks follow this pattern, the risks accumulate across the system. Defaults or downturns then spread quickly, creating systemic instability rather than isolated failures.
Banks often borrow short-term (e.g. customer deposits) but lend long-term (e.g. mortgages).
This improves profitability since long-term lending usually pays higher interest.
However, it creates liquidity risks if depositors withdraw funds suddenly.
It can also threaten security if the bank struggles to refinance short-term liabilities.
Regulators intervene to prevent banks from tilting excessively towards profitability at the expense of liquidity and security.
They may impose:
Minimum liquidity requirements.
Capital adequacy ratios.
Limits on risky lending practices.
This ensures stability in the wider financial system.
Yes. If banks hoard liquidity to stay secure, they reduce lending to households and firms. This cuts off credit supply, weakening investment and consumption.
On the other hand, if they chase profits through excessive lending, defaults and instability may follow, damaging confidence and growth.
Banks use internal risk management policies such as:
Diversifying loan portfolios across industries.
Setting strict lending criteria to balance risk and return.
Holding a buffer of high-quality liquid assets.
These measures help balance profitability with liquidity and security.
Practice Questions
Define liquidity in the context of a commercial bank. (2 marks)
1 mark for recognising liquidity refers to the ease with which assets can be converted into cash.
1 mark for mentioning that this allows banks to meet customer withdrawals or short-term obligations.
Explain why conflicts may arise between a commercial bank’s objectives of profitability and security. (6 marks)
Up to 2 marks for defining or outlining profitability (earning returns from lending or investments) and security (safeguarding depositors’ funds and reducing risk of default).
1–2 marks for identifying that higher profitability often involves riskier loans or investments.
1–2 marks for explaining that this increases the chance of loan defaults or financial instability, which undermines security.
1 mark for linking to real-world context, e.g. financial crises or risky mortgage lending increasing bank vulnerability.
