Literature Review on Bank Profitability

In the literature, bank profitability is usually expressed as a function of internal and external determinants. The internal determinants originate from bank accounts (balance sheets and/or profit and loss accounts) and therefore could be termed micro or bank-specific determinants of profitability. The external determinants are variables that are not related to bank management but reflect the economic and legal environment that affects the operation and performance of financial institutions. A number of explanatory variables have been proposed for both categories, according to the nature and purpose of each study. The main conclusion emerging from these studies is that internal factors explain a large proportion of banks profitability; nevertheless external factors have also had an impact on their performance. Some recent studies also focus on the impact of regulations on banks performance and profitability (e.g. Barth et al., 2003, 2004), and report only weak evidence to support that bank supervisory structure and regulations affect bank profits.

Empirical studies on the bank profitability literature have focused mainly on a specific country, including the US (Berger, 1995; Angbazo, 1997), Greece (Mamatzakis and Remoundos, 2003; Kosmidou, 2006), Australia (Pasiouras et al. 2006), Malaysia (Guru et al., 1999), Colombia (Barajas et al., 1999), Brazil (Afanasieff et al., 2002) and Tunisia (Ben Naceur, 2003). Molyneux and Thorton (1992) were the first to investigate a multi-country setting by examining the determinants of bank profitability for a panel of European countries, followed by Abreu and Mendes (2001), Staikouras and Wood (2003), and Pasiouras and Kosmidou (2006). Other multi-country studies include Hassan and Bashir (2003), who examine profitability for a sample of Islamic banks from 21 countries; and Demirguc-Kunt and Huizinga (1999) who consider a comprehensive set of bank specific characteristics, as well as macroeconomic conditions, taxation, regulations, financial structure and legal indicators to examine the determinants of bank net interest margins in over 80 countries. This group of studies also includes Haslem (1968), Short (1979), Bourke (1989). A more recent study in this group is Bikker and Hu (2002), though it is different in scope; its emphasis is on the bank profitability-business cycle relationship. Studies in the first group mainly concern the banking system in the US (e.g. Berger et al., 1987 and Neely and Wheelock, 1997) or the emerging market economies (e.g. Barajas et al., 1999). All of the above studies examine combinations of internal and external determinants of bank profitability. The empirical results vary significantly, since both datasets and environments differ. There exist, however, some common elements that allow a further categorization of the determinants.

The literature concentrating on regulatory framework suggests that the emerging economies have significantly increased the attractiveness of its banking system for foreign investors. Foreign ownership may have an impact on bank profitability due to a number of reasons. First, the capital brought in by foreign investors decrease fiscal cost of banks’ restructuring (Tang et al., 2000). Second, foreign banks may bring expertise in risk management and a better culture of corporate governance, rendering banks more efficient (Bonin et al., 2005). Third, foreign bank presence increases competition, driving domestic banks to cut costs and improve efficiency (Claessens et al., 2001). Finally, domestic banks have benefitted from technological spillovers brought about by their foreign competitors. The literature on effect of deregulation on bank performance lacks formal verification. However, the contestable market theory and regulation theory in general, point out the importance of entry barriers in enhancing profitability, while some other regulatory interventions may have an opposite effect. Mamatzaky et al. (2005) provide evidence that a non-collusive behavior among banks is in operation in banking industry, suggesting the existence of a contestable market. In contrast, other studies on transition countries have highlighted the fact that the financial reform process positively affect banks’ profitability and that banking sector reform is a necessary condition for the development and deepening of the sector (Fries and Taci, 2002).

Internal Determinants of Profitability

Studies dealing with internal determinants employ variables such as size, capital, risk management and expenses management. Size is introduced to account for existing economies or diseconomies of scale in the market. Akhavein et al. (1997) and Smirlock (1985) find a positive and significant relationship between size and bank profitability. Demirguc-Kunt and Maksimovic (1998) suggest that the extent to which various financial, legal and other factors (e.g. corruption) affect bank profitability is closely linked to firm size. In addition, as Short (1979) argues, size is closely related to the capital adequacy of a bank since relatively large banks tend to raise less expensive capital and, hence, appear more profitable. Using similar arguments, Haslem (1968), Short (1979), Bourke (1989), Molyneux and Thornton (1992) Bikker which and Hu (2002) and Goddard et al. (2004), all link bank size to capital ratios, they claim to be positively related to size, meaning that as size increases – especially in the case of small to medium-sized banks – profitability rises. However, many other researchers suggest that little cost saving can be achieved by increasing the size of a banking firm (Berger et al., 1987), which suggests that eventually very large banks could face scale inefficiencies. The need for risk management in the banking sector is inherent in the nature of the banking business. Poor asset quality and low levels of liquidity are the two major causes of bank failures. During periods of increased uncertainty, financial institutions may decide to diversify their portfolios and/or raise their liquid holdings in order to reduce their risk. In this respect, risk can be divided into credit and liquidity risk. Molyneux and Thornton (1992), among others, find a negative and significant relationship between the level of liquidity and profitability. In contrast, Bourke (1989) reports an opposite result; while the effect of credit risk on profitability appears clearly negative (Miller and Noulas, 1997). This result may be explained by taking into account the fact that the more financial institutions are exposed to high-risk loans, the higher is the accumulation of unpaid loans, implying that these loan losses have produced lower returns to many commercial banks. Bank expenses are also a very important determinant of profitability, closely related to the notion of efficient management. There has been an extensive literature based on the idea that an expenses-related variable should be included in the cost part of a standard microeconomic profit function. For example, Bourke (1989) and Molyneux and Thornton (1992) find a positive relationship between better-quality management and profitability.

External determinants of profitability

Turning to the external determinants of bank profitability, it should be noted that we can further distinguish between control variables that describe the macroeconomic environment, such as inflation, interest rates and cyclical output, and variables that represent market characteristics. The latter refer to market concentration, industry size and ownership status. A whole new trend about structural effects on bank profitability started with the application of the Market-Power (MP) and the Efficient-Structure (ES) hypotheses. The MP hypothesis, which is sometimes also referred to as the Structure-Conduct-Performance (SCP) hypothesis, asserts that increased market power yields monopoly profits. A special case of the MP hypothesis is the Relative-Market-Power (RMP) hypothesis, which suggests that only firms with large market shares and well-differentiated products are able to exercise market power and earn non-competitive profits (see Berger, 1995a). Likewise, the X-efficiency version of the ES (ESX) hypothesis suggests that increased managerial and scale efficiency leads to higher concentration and, hence, higher profits.

Interest rate & profitability

Interest rate fluctuations play a huge role in the profitability of a bank. Loan rates can be separated into two major components – the interest rate paid to depositors and the rate added on by banks. That difference between the deposit rate and the loan rate is commonly referred to as the spread. The size of banking spreads serves as an indicator of efficiency in the financial sector because it reflects the costs of intermediation that banks incur (including normal profits). Some of these costs and are imposed by the macroeconomic, regulatory and institutional environment in which banks operate while others are attributable to the internal characteristics of the banks themselves. Cost management efficiency is the single most important indicator in bank profitability. Therefore, banks can improve their profitability indicators by paying more attention on interest rates.

As financial intermediaries, banks play a crucial role in the operation of most economies. The primary reason why interest rates are important is because they are a source of banks’ interest rate risk exposure. Changes in interest rates may “narrow the interest spread between assets and liabilities” because due to differences in the maturity of banks’ instruments (banks borrow short term (long term) to fund long-term (short-term) assets) there are mismatches in the re-pricing of bank assets, liabilities, and off-balance sheet instruments (Wright and Houpt 1996, 115). Research, as surveyed by Levine (1996), has shown that the efficacy of financial intermediation can also affect economic growth. Crucially, financial intermediation affects the net return to savings, and the gross return for investment. The spread between these two returns mirrors the bank interest margins, in addition to transaction costs and taxes borne directly by savers and investors. This suggests that bank interest spreads can be interpreted as an indicator of the efficiency of the banking system.

An increase in market interest rates means an increase in the price of banking products, which automatically leads to an increase in costs for businesses outside of the banking sector and is a source of inflation (Brockway 1989, 53). The increase in the costs of running business potentially increases default risks of borrowers. This is an important example of how interest rates indirectly affect “default risk of loans, securities, and real estate holdings” (Madura and Zarruk 1995, 5).

Interest rate is an important macroeconomic determinant of bank performance. A comprehensive review of determinants of interest spreads is offered by Hansonand Rocha (1986). That paper summarizes the role that implicit and explicit taxes play in raising spreads and goes on to discuss some of the determinants of bank cost and profits, such as inflation, scale economies, and market structure. Using aggregate interest data for29 countries in the years 1975-1983, the authors find a positive correlation between interest margins and inflation. Recently, several studies have examined the impact of international differences in bank regulation using cross-country data. Analyzing interest rates in 13 OECD countries in the years 1985-1990, Bartholdy, Boyle, and Stover (1997) find that the existence of explicit deposit insurance lowers the deposit interest rate by 25 basis points. Using data from 19 developed countries in 1993, Barth, Nolle and Rice (1997) further examine the impact of banking powers on bank return on equity -controlling for a variety of bank and market characteristics. Variation in banking powers, bank concentration and the existence of explicit deposit insurance do not significantly affect the return on bank equity.

Ogunleye (2001: 61) argues that when interest rates rise or fall, it exerts an impact on banks’ profits through adjustment to revenues; and this comes about in two ways. First, an increase in market rates raises the amount of income a bank can earn on new assets it acquires. However, the speed with which revenues adjust to new market conditions depends on how long it takes for the average asset’s interest rate to adjust to current market rates (Flannery, 1980). Secondly, the effect could come through impact on the bank’s decisions about which loans and securities to purchase and how much to hold in cash reserves (apart from regulatory requirement). In time of rising rates, rates on loans are usually higher than rates on marketable securities; hence banks are likely to book more loans to earn higher incomes than buying securities. In the same vein, banks’ holdings of cash reserves and non-earning assets would be at the lowest level, since these groups of assets yield little or nothing. Therefore, total income during periods of rising rates increase even more than the proportion of increase in rates. Empirical evidence from Molyneux and Thornton (1992) and Demirgüç-Kunt and Huizinga (1999) indicate that high interest rate is significantly associated with higher bank profitability, i.e. a significant positive relationship. Demirgüç-Kunt and Huizinga (1999) emphasize that this relationship is more so in developing countries. But, conversely, Naceur (2003) highlights a negative relationship between interest rates and bank profitability. The contradiction between these researchers generates a need for further empirical analyses of the relationship between interest rates and bank profitability.

Among other macro-factors that could influence banks’ performance, Beckmann (2007, 9) highlighted the ambiguous effect of real interest rates on performance of banking organizations due to the initial “dampening effect of a rise in real interest rates on credit demand and accompanying deterioration in credit quality” that could contribute to negative association of interest rates with ROA. Beckmann (2007) also found a very strong impact of real interest rate on the return on assets.

Performance tends to be influenced by interest rates, which influence composition of banks’ portfolio, in the following way. According to Brechling and Clayton (1965), an increase in interest rates tends to induce FIs to restructure portfolios through decrease in the amount of liquid assets (cash, money at call, Treasury bills) and corresponding increase in the amount of investments into interest-bearing securities and advances, This strategy leads to changes in the relative earning power of various assets in the portfolio. In particular, it leads to an increase in the earning power of interest-bearing securities.

In essence, changes in interest rates should not significantly affect short-term assets and liabilities as they are re-priced more frequently than long-term ones. The latter are more sensitive to changes in interest rates (Ghazanfari, Rogers, and Sarmas 2007, 349-350), which may result in squeezing of interest margins and, as a result, in a decrease in banks’ profitability.

Yap and Kader (2008) assessed the impact of changes in interest rates on performance of conventional and Islamic banking organizations running in parallel in Malaysia (where Islamic banking was introduced in 1983) over the period of 1999-2007, which was characterized by falling interest rates in Malaysia. They found that depositors at Islamic banks did not react to changes in interest rates suggesting that “there is no shifting effect between the Islamic and conventional deposits in response to changes in conventional interest rates,” which could be explained by moving rates of return on deposits in Islamic banks very closely with interest rates offered by conventional banks during time period under investigation (Yap and Kader 2008, 129-130). In terms of financing, the authors concluded that customers of Islamic banks are profit oriented and suggested that during a decrease in discount rates/basis rates BBA (bai bathamin ajil – fixed rate asset) financing offered by Islamic banks (fixed rate assets financing is collateralized) is less popular than getting loans from conventional banks due to the fixed rate of BBA financing and vice verse if there is a reverse situation. They noted that, in essence, divergence of rates (on deposits or loans) between Islamic and conventional banks due to changes in market interest rates would lead to switching banks by customers. In this respect, one must bear in mind that profitability of banks in dual banking systems will be influenced not only by micro and environmental factors (the impact of latter is going to be assessed in this study), but also by type of bank (Islamic or conventional).

Despite significant regulatory concern paid to the interest-rate risk that banks face (OCC [2004]; Basel Committee on Banking Supervision [2004]), research on a key component of earnings that may be most sensitive to interest shocks—namely, bank net interest margins—has been limited thus far, particularly for U.S. banks. With a few exceptions discussed in this section, there has been little published research on the effects of interest-rate risk on bank performance since the late 1980s.

Al-Haschimi (2007) studies the determinants of bank net interest rate margins in 10 SSA countries. He finds that credit risk and operating inefficiencies (which signal market power) explain most of the variation in net interest margins across the region. Macroeconomic risk has only limited effects on net interest margins in the study. Using bank level data for 80 countries in the 1988–95 period, Demirgüç-Kunt and Huizinga (1998) analyze how bank characteristics and the overall banking environment affect both interest rate margins and bank returns. In considering both measures, this study provides a decomposition of the income effects of a number of determinants that affect depositor and borrower behavior, as opposed to that of shareholders. Results suggest that macroeconomic and regulatory conditions have a pronounced impact on margins and profitability. Lower market concentration ratios lead to lower margins and profits, while the effect of foreign ownership varies between industrialized and developing countries. In particular, foreign banks have higher margins and profits compared to domestic banks in developing countries, while the opposite holds in developed countries. Gelos (2006) studies the determinants of bank interest margins in Latin America using bank and country level data. He finds that spreads are large because of relatively high interest rates (which in the study is a proxy for high macroeconomic risk, including from inflation), less efficient banks, and higher reserve requirements. In a study of United States banks for the period 1989–93, Angbazo (1997) finds that net interest margins reflect primarily credit and macroeconomic risk premia. In addition, there is evidence that net interest margins are positively related to core capital, non-interest bearing reserves, and management quality, but negatively related to liquidity risk. Saunders and Schumacher (2000) apply the model of Ho and Saunders (1981) to analyze the determinants of interest margins in six countries of the European Union and the US during the period 1988–95. They find that macroeconomic volatility and regulations have a significant impact on bank interest rate margins. Their results also suggest an important trade-off between ensuring bank solvency, as defined by high capital to asset ratios, and lowering the cost of financial services to consumers, as measured by low interest rate margins.

Theoretical models of net interest margins have typically derived an optimal margin for a bank, given the uncertainty, the competitive structure of the market in which it operates, and the degree of its management’s risk aversion. The fundamental assumption of bank behavior in these models is that the net interest margin is an objective to be maximized. In the dealer model developed by Ho and Saunders (1981), bank uncertainty results from an asynchronous and random arrival of loans and deposits. A banking firm that maximizes the utility of shareholder wealth selects an optimal markup (markdown) for loans (deposits) that minimizes the risks of surplus in the demand for deposits or in the supply of loans. Ho and Saunders control for idiosyncratic factors that influence the net interest margins of an individual bank, and derive a “pure interest margin,” which is assumed to be universal across banks. They find that this “pure interest margin” depends on the degree of management risk aversion, the size of bank transactions, the banking market structure, and interest-rate volatility, with the rate volatility dominating the change in the pure interest margin over time.

Allen (1988) extends the single-product model of Ho and Saunders to include heterogeneous loans and deposits, and posits that pure interest spreads may be reduced as a result of product diversification. Saunders and Schumacher (2000) apply the dealer model to six European countries and the United States, using data for 614 banks for the period from 1988 to 1995, and find that regulatory requirements and interest-rate volatility have significant effects on bank interest-rate margins across these countries. Angbazo (1997) develops an empirical model, using Call Report data for different size classes of banks for the period between 1989 and 1993, incorporating credit risk into the basic NIM model, and finds that the net interest margins of commercial banks reflect both default and interest-rate risk premia and that banks of different sizes are sensitive to different types of risk. Angbazo finds that among commercial banks with assets greater than $1 billion, net interest margins of money-center banks are sensitive to credit risk but not to interest-rate risk, whereas the NIM of regional banks are sensitive to interest-rate risk but not to credit risk. In addition, Angbazo finds that off-balance-sheet items do affect net interest margins for all bank types except regional banks. Individual off-balance-sheet items such as loan commitments, letters of credit, and net securities lent, net acceptances acquired, swaps, and options have varying degrees of statistical significance across bank types.

Zarruk (1989) presents an alternative theoretical model of net interest margins for a banking firm that maximizes an expected utility of profits that relies on the “cost of goods sold” approach. Uncertainty is introduced to the model through the deposit supply function that contains a random element. Zarruk posits that under a reasonable assumption of decreasing absolute risk aversion, the bank’s spread increases with the amount of equity capital and decreases with deposit variability. Risk-averse firms lower the risk of profit variability by increasing the deposit rate. Zarruk and Madura (1992) show that when uncertainty arises from loan losses, deposit insurance, and capital regulations, a higher uncertainty of loan losses will have a negative effect on net interest margins. Madura and Zarruk (1995) find that bank interest-rate risk varies among countries, a finding that supports the need to capture interest-rate risk

However, Wong (1997) introduces multiple differentials in the risk-based capital requirements. sources of uncertainty to the model and finds that size-preserving increases in the bank’s market power, an increase in the marginal administrative cost of loans, and mean-preserving increases in credit risk and interest-rate risk have positive effects on the bank spread.

Both the dealer and cost-of-goods models of net interest margins have two important limitations. First, these models are single-horizon, static models in which homogenous assets and liabilities are priced at prevailing loan and deposit rates on the basis of the same reference rate. In reality, bank portfolios are characterized by heterogeneous assets and liabilities that have different security, maturity, and repricing structures that often extend far beyond a single horizon. As a result, assuming that bankers do not have perfect foresight, decisions regarding loans and deposits made in one period affect net interest margins in subsequent periods as banks face changes in interest-rate volatility, the yield curve, and credit risk. Banks’ ability to respond to these shocks in the period t is constrained by the ex ante composition of their assets and liabilities and their capacity to price changes in risks effectively. In addition, the credit cycle and the strength of new loan demand determine the magnitude of the effect of interest-rate shocks on banks’ earnings. In this regard, Hasan and Sarkar (2002) show that banks with a larger lending slack, or a greater amount of “loans-in-process,” are less vulnerable to interest-rate risk than banks with a smaller amount of loans in process. Empirical evidence, using aggregate bank loan and time deposit (CD) data from 1985 to 1996, indicates that low-slack banks indeed have significantly more interest-rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability that were not empirically tested with aggregate data. The second important limitation of both the dealer and cost-of-goods models of net interest margins is that they treat the banking industry either as being homogenous or as having limited heterogeneous traits based only on their asset size. However, banks with distinct production-line specializations usually differ in terms of their business models, pricing power, to these shocks in the period t is constrained by the ex ante composition of their assets and liabilities and their capacity to price changes in risks effectively. In addition, the credit cycle and the strength of new loan demand determine the magnitude of the effect of interest-rate shocks on banks’ earnings. In this regard, Hasan and Sarkar (2002) show that banks with a larger lending slack, or a greater amount of “loans-in-process,” are less vulnerable to interest-rate risk than banks with a smaller amount of loans in process. Empirical evidence, using aggregate bank loan and time deposit (CD) data from 1985 to 1996, indicates that low-slack banks indeed have significantly more interest-rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability that were not empirically tested with aggregate data. The second important limitation of both the dealer and cost-of-goods models of net interest margins is that they treat the banking industry either as being homogenous or as having limited heterogeneous traits based only on their asset size. However, banks with distinct production-line specializations usually differ in terms of their business models, pricing power, their assets and liabilities, and they are therefore more likely to be sensitive to changes in the yield curve.

Exchange rate & profitability

Exchange rates represent the number of units of a given currency of one country that can be exchanged for unit of another currency (Van Horne, 1986). Today foreign exchange has been the talk of the town, and this is because foreign exchange plays a very crucial role in the overall performance of the national economy. The practice of managing foreign exchange resources has therefore evolved broadly in line with the globalization and liberalization of economies and financial market. This has planed over such areas as risk management and active portfolio management. Broadly speaking foreign exchange is held and managed to facilitate international transactions. (Anifowoshe, 1997).

If there were a single international currency there would be no need for a foreign exchange market. The purpose of foreign exchange market is to enhance transfer of purchasing power dominated in one currency for another currency. The foreign exchange market is not a physical place rather it is an electronically linked network of banks, foreign exchange brokers and dealers whose function is to bring together buyers and sellers of foreign exchange. So, Bank profitability could be affected by the nature of a country’s exchange rate regime. Ogunleye (1995: 56) has asserted that bank profitability is largely constrained by a fixed exchange rate regime; whereas, in a regime of partial / outright liberalization of the foreign exchange (forex) market, banks are given enough latitude to trade in forex and hence improve the overall profitability.

Due to very intensive involvement of banking organizations in foreign currency trading activities, the issue of risks associated with it deserves some attention. In the literature, a large number of empirical works have been carried out to examine the foreign exchange exposure of banks. However, past studies mainly focused on banking markets which are well developed, including the US (Grammatikos et al. (1986), Choi et al. (1992), Choi and Elyasiani (1997), and Martin and Mauer (2003, 2005)), Japan (Chamberlain et al. (1997)), Canada (Atindéhou and Gueyie (2001)), and Australia (Chi et al. (2007)), or large banking institutions (Martin (2000)). By comparison, studies focusing on less developed banking markets are relatively scant.

Grammatikos, Saunders, and Swary (1986, 671) stated that there are two types of risk related to foreign currency trading activities, namely exchange rate risk, which comes from unexpected change in exchange rates in the presence of “a positive (or negative) net asset position [in terms of size] in a particular foreign currency”, and foreign interest risk, which occurs from changes in interest rates in the presence of mismatched maturities of banks’ “foreign currency assets and liabilities.”

If foreign currency assets are greater (smaller) than liabilities, an appreciation (depreciation) in the foreign currency vis-à-vis the dollar generates capital gains (losses) either on paper or realized. …. If the average duration of its foreign currency assets is greater (smaller) than its liabilities, then an unexpected upward parallel shift in the term structure of foreign interest rates will reduce (increase) the bank’s net interest earnings (Grammatikos, Saunders, and Swary 1986, 671).

The authors analyzed the overall performance and risks of banks associated with foreign currency trading activities in the US from December, 1975 to November, 1981, and noted that there is a possibility that “diversification by the bank into many currencies” might “reduce the overall risk exposure” even in the presence of mismatch in the maturities (durations) of its foreign currency assets and liabilities (Grammatikos, Saunders, and Swary 1986, 675).

As emerging markets become more integrated into global capital markets, the choice of exchange rate arrangement by those countries is receiving more attention because it is regarded as one of the sources of main economic crises like “the Mexican peso crisis in 1994–95, and the Asian crisis in 1997–98” as a result of which the “hollowing-out hypothesis” or the “bipolar view” is becoming more popular, even though it is still not well-accepted. This hypothesis explains that

…in a world of increasing international capital mobility, only the two extreme exchange rate regimes are likely to be sustainable – either a permanently fixed exchange rate regime (i.e., a “hard fix”) such as a currency board or monetary union, or a freely floating exchange rate regime (Bailliu and Murray 2003, 17).

As shown by Chamberlain et al. (1997), to the extent that banks’ direct exposure generally provides a significant explanation for banks’ foreign exchange exposure, it only measures banks’ foreign exchange risk partially. Using a bank’s loan to an exporter as an example, Chamberlain et al. (1997) demonstrate that banks that perfectly hedge their accounting exposure could still be exposed to significant foreign exchange risk if exchange rate movements affect cash flows, competitiveness, and credit risk of banks’ customers significantly (i.e. indirect or econom