Bank Profitability and the Business Cycle

Even before the contributions of McKinnon and Shaw [1] , many economists have focused on the role of the financial sector in the economic development process. For many of them, economic and financial developments are intimately linked. Moreover, the existence of a financial sector, even rudimentary, is for them the necessary condition for economic takeoff, and for ensuring a sound and healthy economy in concordance with key economic player’s aspirations.

Efficient financial system should show profitability improvements, increasing volume of funds flowing from savers to borrowers, better quality services for consumers and better earnings for direct shareholders. Profitable banks contribute also to the economic growth and to the creation of wealth [2] . Moreover, a sound and profitable banking sector is better able to withstand negative shocks and contribute to the stability of the financial system. In fact, the global credit crisis has reminded us that a close connection exist between nation’s financial sector and its economic prosperity.

Conversely, banks constitutes also a risk for the economy from the time when repressed financial sector will retard the economic growth when its savings vehicles are not well developed; when financial intermediaries that collect savings do not allocate them efficiently among competing uses; or/and when firms are discouraged from investing because of financial policies repression that reduce the returns to investment or make them uncertain.

Thus, banks fit into the economic cycle, means some of the banking industry’s key decisions have an impact on the economy. Conversely, households and businesses’ decisions resound directly on banks. This assumption was largely debated and several studies have proved a positive correlation between financial market development and economic growth both in short and long term (see Levine. 1997, Arestis et al., 2001 Fase, 2001)

However, from another side, understanding and monitoring the impact of a deteriorating economy on the health of the banking industry is also a particularly important challenge for bank regulators and policy makers. In fact, economic activities experiences over long period of time recurring fluctuations occurring at irregular intervals because of disturbances and imperfections in the economy of one sort or another. Those fluctuations last for varying lengths of time and compose what economic community commonly calls the “Business cycle”. Every recession in which the economy is involuntarily driven results in a loss of output that cannot be regained. Thus, cycles are costly, difficult times and unpleasant experience for most economic agents.

Financial market in general and banking sector in particular were not spared of the impacts of business cycles. Their health’s nowadays is a tangible proof for this assumption. In fact, Economic slowdown is the second wave to hit the financial systems since August 2007 following the disruption in global financial markets. This serious downturn in the economy is wrecking a majority of banks in the world when the turmoil in financial markets continues. It affects equity but also banks’ profits. Moreover, the scope and the severity of its impacts are difficult to predict.

Literature review: BPD

Bank profitability is sensitive to macroeconomic conditions. Neely and Wheelock, 1997, Van den Heuvel, 2003 among others assume that business cycle fluctuations affect substantially profitability of banking institutions as well as consumption, investment and aggregate demand. While few empirical papers deal with this issue. Investigations were generally limited to study the relationship between bank profitability and macroeconomic variables in developed countries with an objective of knowing if they are determinative in explaining the profitability level of the bank. (See (Berger, (1995), Bourke, (1989), Saunders and Schumacher (2000), Athanasoglou et al (2006), Kosmidou et al (2007)…etc.). Beside that, less developed countries were rarely concerned with such an investigation. There was more interest to compare the power of macroeconomic indicators to explain profitability between private and state owned banks or between domestic and foreign banks rather than seeing if these effects stay stable or change when economy switch to a recessionary regime.

Particularly, Ben Naceur and Goaied (2001, 2003 and 2008), Ben Naceur (2003) and Ben Khediri et al (2005) focused on Tunisian bank’s performances and show that private banks are relatively more profitable than their state owned counterparts and individual bank characteristics explain a substantial part of the within-country variation in bank interest margins and net profitability. However, macro-economic indicators such inflation and growth rates have no significant impact.

The interest to bank profitability determinants was also felts in the works of Bashir (2000), and Hassan and Bachir (2003), in the cases of Islamic bank’s. Their outcomes are ones again in concordance with the literature; they revealed that foreign banks profitability is higher than the average profitability of the domestic banks, that profitability increase with high capital and liquidity ratios and with efficient management. Surprisingly, the results indicate a strong positive correlation between profitability and overhead costs [3] . Among the macro-indicators, high interest ratio was associated with low bank profitability, inflation was found to have a positive effect on bank performance and implicit and explicit taxes affect the bank performance measures negatively.

Chantapong (2005) studies the question of banks profitability in relation with crisis in the case of Thailand and justify that banks reduces their credit exposure during crisis and gradually improved their profitability during post crisis years

Kobeissi ( 2004) explores the ownership details of 249 banks in 20 MENA countries, with a total of 567 observations during the 2000-2002 sample years. She sheds some light on the association and impact of ownership structure affecting bank performance. Overall, her results show that private banks, especially foreign ones are significantly better performer than all sample groups. State-owned banks are lagging behind other banks; they are performing the worst among the sample banks. Banks involved in the stock exchanges and foreign banks with majority ownership within the Middle East and North Africa (MENA) region seem to have significant affect on performance in most estimation. Importantly, the extent of foreign bank presence in the country is associated with better performance by the sample banks.

Ben Naceur and Omran (2008) examine the influence of bank regulations, concentration, financial and institutional development on MENA countries commercial banks margin and profitability during the period 1989–2005. They find that bank specific characteristics, in particular bank capitalization and credit risk, have positive and significant impact on banks’ net interest margin, cost efficiency, and profitability. On the other hand, macroeconomic and financial development indicators have no significant impact on bank performance.

Add some comments showing limits off those works mainly the absence of considering business cycle fluctuations

are the same or not whereas their financial market are more sensitive to economic fluctuations because they are less organized and less capitalized.

In this paper, we are interested to assess empirically which are the main factors behind the profitability of MENA banks taking into consideration business cycle fluctuations. The main novelty of this work is , in addition to our interest to emerging financial market, that we consider bank specific determinants We aim to contribute to enhancement of countries with a particular attention to the effect of business cycle

Bank spreads, more particularly loan spread [4] and deposit spread [5] are a key determinant of bank profitability , however , previous studies have the limitation of considering only the volatility of short-term interest rates, bank market power in loan and deposit markets, bank risk aversion, and default risk on bank loans among factors affecting bank spreads and consequently the profit, however, they did not attempt to link these factors to business cycle fluctuations and they did not consider the countercyclical effect of bank spreads [6] . Whereas, this baseline hypothesis is supported and justified Bernanke et al. (1996) and Kiyotaki and Moore (1997) who, based the financial accelerator theory, show that business cycles are exacerbated by the cyclical behavior of bank lending rates because borrowers’ net worth (or collateral) deteriorates during recessions.

Moreover, recessions are proved to be accompanied by interest rate volatility witch induce systematically higher bank spreads and profit since banks generally transfer the higher risk to customers ( Fernadez de Guevara, 2004)

Research question

Motivation

Objectives

Methodology

Paper structure:

Through the process of taking deposits and making loans, banks help the economy allocate funds from savers to borrowers in a more efficient manner. The reward earned by the banking sector during this process depends largely on the average interest margin, which is commonly defined as interest revenue minus interest expense, per dollar/Dinar of assets. The net interest margin (NIM), one of the main measures for a bank’s lending profitability, refers to the difference between interest income generated by the bank and the amount of interest paid out. NIM is given by the bank net interest margin income as a share of total assets. Among banks in similar lines of business, higher margins can be a sign of great management. But, it could the result of riskier lending policies. Narrower margins can suggest trouble on the deposit side and a higher cost of funds. Or, it could mean more conservative lending practices. Higher values of NIM indicate a higher spread in deposit and lending rates and therefore lower efficiency.

Literature review

Two types of causality for the relationship between bank’s profit and macroeconomics have been studied. We are interested to the second direction of causality showing the effects of economic development on bank’s performance. [7]

– Demirguc-Kunt and Huizinga (2000) and Bikker and Hu (2002) attempted to identify possible cyclical movements in bank profitability – the extent to which bank profits are correlated with the business cycle. Their findings suggest that such correlation exists, although the variables used were not direct measures of the business cycle.

– Arpa et al. (2001) do focus more on the influence of macroeconomic developments in explaining (components of) bank incomes and provisions for future credit losses over 1990-1999. They demonstrate that Austrian banks make more provisions for credit risk as Gross Domestic Product (GDP) growth figures decline (with a procyclical effect) and as net income rises (with a countercyclical effect).

– Moreover, it is crucial for regulators to fully comprehend the nexus between banks’ profitability and different business cycle regimes in order to be able to detect any upcoming financial crisis and to explain the importance of capital adequacy hypothesis for banking sector (Demirguc-Kunt and Detragiache (1999); Kaminsky(1999), Logan (2000), Borio, (2003), Albertazzi and Gambacorta (2006).

– Marcucci, and Quagliariello (2008) focused on the relation between credit risk and the business cycle and succeed to proof the presence of asymmetric effects. They examine this relation both at the aggregate and the bank level exploiting a dataset on Italian banks’ borrowers’ default rates. They employ threshold regression models that allow to endogenously establishing different regimes identified by the thresholds over/below which credit risk is more/less cyclical. They find that not only are the effects of the business cycle on credit risk more pronounced during downturns but cyclicality is also higher for those banks with riskier portfolios.

– Bikker and . Metzemakers (2005) investigates how bank provisioning behavior is related to the business cycle. They used 8000 bank-year observations from 29 OECD countries over the past decade and find that provisioning turns out to be substantially higher when GDP growth is lower, reflecting increased riskiness of the credit portfolio when the business cycle turns downwards, which also increases the risk of a credit crunch. However, they stipulate that this effect is mitigated somewhat as provisions rise in times when earnings are higher, suggesting income smoothing, and loan growth is higher, indicating increased riskiness.

РApergis (2007) identify whether bank profitability in Greece is affected to a larger (or smaller) extent by recessionary (expansionary) conditions. He used a methodology based on panel threshold models with an objective of identifying endogenously the thresholds at which the system switches from one regime to the other. Business cycle regimes were defined through GDP Growth over the period 1990-2006 and classified intro expansion and recession phases. Results of the author are in favor of a display that there exists a positive relationship between bank profitability and the business cycle and this positive cyclicality remains robust in either phase of the business cycle. Ĭ ok

– Gasha and Morales (2004) apply a self-exciting threshold autoregressive (SETAR) model to country-level data and show that GDP growth affects nonperforming loans only below a certain threshold in a group of Latin American countries.

– A direct measure of the business cycle, namely cyclical output, was used by Athanasoglou et al. (2005) for the Greek banking industry.

– cavello and Majnoni (2002)???

However, the abovementioned studies have not explored the possibility of asymmetric effects, for which the impact of macroeconomic conditions on banks’ portfolio riskiness is dissimilar in different phases of the business cycle. This is very important since bank supervisors are inherently more concerned about downturns rather than expansions. Also, assuming linear relationships may hinder some important characteristics of banks’ riskiness.

In principle, many banking variables are potentially able to convey signals about the evolution of banks’ health over the business cycle

the macroeconomic environment may also influence bank profitability through many different channels. Economic growth, inflation and the level of real interest rates, for example, influence credit risk, as they affect the borrower’s repayment ability and the value of collateral.

Bank characteristics over business cycle regimes

The profitability of a credit institution is its ability to get sufficient earnings from its operating activities, after deducting all necessary costs. Profitability comes from the transformation processes implemented by credit institutions under their intermediation function such as compensation, interest rates, currencies or maturities.

Several studies have tried to seek for the mostly associated determinants with bank profitability. Some of those studies have focused on a particular banking system and some others make comparisons into a panel of countries. The well-known works were interested to American and European banking performance, whereas, fewer studies have looked at bank performance in developing economies.

Profitability determinants in US banking sectors have gained great interest from many authors since 1980 (see (Berger, 1995), (Neeley and Wheelock, 1997), (Angbazo, 1997), and more recently (De Young and Rice, 2004), (Stiroh and Rumble, 2006) and (Gelos , 2006) . Results are converging and classify bank profitability determinants into internal determinants such as capital, non interest income, default risk , the opportunity cost of non-interest bearing reserves, leverage, and management efficiency, and external determinants such as market conditions, technological change, macroeconomic risk represented by interest rates.

Similar results were also extracted for Canadian, Japanese or UK banks with Short (1979), and Kosmidou et al. 2007’s work and for European countries with several works like Saunders and Schumacher (2000) , Molyneux and Thornton (1992), Abreu and Mendes (2002), Yao, Jean-Marie, (2005) Athanasoglou, et al (2006 and 2008), Pasiouras and Kosmidou (2007) and many others. Results validate also the ownership status, and the growth rate of individual bank’s assets among specific determinants, insisting to their strong relation with profitability mainly for commercial banks’. Moreover they conclude on the important trade-off between ensuring bank solvency and lowering the cost of financial services to consumers, which also affect the bank profitability. The latter also is found to be higher with reducing expected bankruptcy costs with well capitalized banks. Conversely the picture regarding the macroeconomic determinants is mixed since the effect of financial market structure and macroeconomic conditions on bank profitability differ for domestic and foreign banks and for governments owned banks and private owned banks. We notice at the end that unemployment rate and the inflation rate were found to be relevant in explaining bank profitability insisting that macroeconomic conditions.

The main novelties in those papers is that

Works who adds also. Results support also the view that greater concentration leads to higher profit rates.

En plus

• Their results suggest that macroeconomic volatility and regulations affect significantly the bank interest rate margin and consequently its profitability.
• They conclude that interest rate level, bank concentration and government ownership affect positively the return on equity, which is the proxy of bank profitability.
• Although with a negative sign in all regressions, the unemployment rate and the inflation rate are relevant in explaining bank profitability.
• report that European banking sector reacts differently to the variation of certain determinants.
• – the negative relationship between banking reform and profitability was not identified, and the picture regarding the macroeconomic determinants is mixed.
• financial market structure and macroeconomic conditions and bank profitability, their impacts differ for domestic and foreign banks.

In the case of Greek banks over the period 1985–2001, Athanasoglou, et al. (2008) ƒ¨ find that that the market structure is not perfectly competitive, the profitability of banks is shaped by bank-specific factors and macroeconomic control variables. Industry structure does not seem to significantly affect profitability in this case ( Greece) .

New Zealand To and Tripe, 2002

ƒ¨ reviews factors affecting the performance of foreign-owned banks in where over a period of 10 years from 1991 to 2000.The study has developed and investigated a number of hypotheses relating to the impact of various advantages on the performance of foreign banks. Among the seven explanatory variables examined, the two variables with consistent positive impacts on the size and profitability of foreign banks are whether a bank has been in New Zealand for a long time and its parent bank’s return on assets. This suggests that the parent bank’s ownership-specific advantages, especially knowledge of and experience in the host market and general managerial expertise, are the most important factors determining the foreign banks’ performance.

Williams (2003) develops and tests a model that integrates the existing multinational bank literature with the domestic bank profits literature. Using data for Australia, this paper demonstrates that an integrated model results in a small increase in explanatory power when compared to models drawn solely from the multinational banking literature. The paper finds that profits are a negative function of competitor market share and bank license status, and a positive function of Australian size and home GDP growth. It is argued that there is incomplete integration between the market segments of domestic and multinational banks due to the first mover advantages of incumbent banks.

Fadzlan and Habibullah (2009) focuses in the determinants of the profitability in the case of Chinese banking sector during the post-reform period of 2000–2005. They find that the determinants variables have statistically significant impact on Chinese banks profitability. However, the impacts are not uniform across bank types.

Albertazzi and Gambacorta, (2009), studies the link between banking profitability and the business cycle in concordance with institutional and structural characteristics. They focus on a sample of balance sheet and income statements items for banks in the 10 industrialized countries over the period 1981-2003 in order to evaluate of macroeconomic and financial shocks on banks profitability. They conclude that the convergence process towards the third stage on EMU has declined the dispersion of bank profitability among euro-area countries. The authors argue also that bank profits pro-cyclicality derives from the effect that the economic cycle exerts on net interest income and loan loss provisions. However, Noninterest income is not significantly influenced by GDP changes suggesting that, contrary to previous findings, revenue diversification could contribute to the stabilization of bank profitability. Financial deepness stimulates banks profitability.

Banking performance is analyzed through a set of ratios that make use of information taken from financial statements and other reports allowing the surveyor to asses for the viability, stability and profitability the bank activities.

Capital Adequacy Ratio: = equity / total assets

Definition:

The Capital adequacy ratio measures bank’s ability to maintain capital commensurate with the bank’s risk. It determines the capacity of the bank in terms of meeting the time liabilities and other risks such as credit risk, operational risk, etc. In the simplest formulation, a bank’s capital is the “cushion” for potential losses, which protects the bank’s depositors or other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.

Links with the business cycle

The stylized facts suggest that, at the beginning of an expansionary phase in the economy, firms’ profits tend to increase, asset prices rise and customers’ expectations are optimistic.

– Expansion of aggregate demand leads to a remarkable, often more than proportional, growth in bank lending and in economy’s indebtedness.

– During the boom, banks may underestimate their risk exposures, relaxing credit standards and reducing provisions for future losses.

After the peak of the cyclical upturn, customers’ profitability worsens, borrower’s creditworthiness deteriorates and non-performing assets are revealed, thus causing losses in banks’ balance sheets (cyclicality). This may be associated with a fall of asset prices that, in turn, further affects customers’ financial wealth and depresses the value of collaterals.

Besides, the possible rise of unemployment reduces households’ disposable income and their ability to repay their debts. Banks’ risk exposure increases, thus requiring larger provisions and higher levels of capital, exactly when it is more expensive or simply not available. Intermediaries may react by reducing lending, especially if they have thin capital buffers above the minimum capital requirement, thus exacerbating the effects of the economic downturn (procyclicality).

In principle, many banking variables are potentially able to convey signals about the evolution of banks’ health over the business cycle; however, loan loss provisions and bad debts have been generally considered the “transmission channels” of the macroeconomic shocks to banks’ balance sheets.

Banks make loan loss provisions against profits when they believe that borrowers will default; this is the tool they can use for adjusting the (historical) value of loans to reflect their true value. Provisions affect both banks’ profitability, since they represent a cost for the intermediary, and capital, since they reduce the book value of the assets. In practice, loan loss provisions are often backward-looking, as banks tend to underestimate future losses in periods of economic expansion because of disaster myopia (Guttentag et al., 1986), herding behaviour (Rajan, 1994) or because higher provisions are interpreted by stakeholders as a signal of lower quality portfolios (Ahmed et al., 1996).

Banks tend to provision against actual rather than expected losses also because of accounting and fiscal rules that allow specific provisions only against impaired debts and do not permit tax deductibility for general provisions, since they cannot be documented and can potentially be exploited by banks to reduce their fiscal burden. Sub-standard loans are also considered as a good proxy for asset quality and a reliable leading indicator for bank fragility. In fact, there is clear evidence that the proportion of non-performing loans dramatically increases before and during banking crises (Demirguc-Kunt and Detragiache, 1998; Gonzales-Hermosillo, 1999). The stock of the outstanding bad debts is however a rough measure of credit quality, in fact it can decrease just because some of the credits are written off. For this reason, the flow of new bad debts, i.e. the amount of loans classified as bad debts for the first time in the reference period, can be considered to be a more precise indicator of the banks’ portfolio riskiness.

Since credit risk is still the main source of instability for most banks, the dependent variable is very often a measure of loan quality.

For instance, Salas and Saurina (2002) analyse the relation between problem loans and the economic cycle in Spain, over the period 1985-1997. They observe that, during economic booms, banks tend to expand lending activity to increase their market share; this result is often reached by lending to borrowers of lower credit quality. They report that bad loans increase in recessionary phases and that the contemporary impact is remarkably higher than the delayed one, concluding that macroeconomic shocks are quickly transmitted to banks’ balance sheets.

Assets Quality = Loan Loss Prov / Net Int Rev

Asset quality reflects the amount of credit risk with the loan and investment portfolios

Management Quality: Cost to Income Ratio

This ratio reflects management’s ability to identify, measure, monitor, and control risks

Earnings = profits

Reflects the quantity, trend, and quality of earnings

Liquidity = Liquid Assets / Cust & ST Funding

Reflects the sources of liquidity and funds management practices

Sensitivity to market risk

Reflects the degree to which changes in market prices and rates adversely affect earnings and capital