Factors Affecting Profitability of Commercial Banks

Profitability Factors of Commercial Banks

Determinant factors of bank profitability are separated to both internal factors which is controlled by bank management and external factors outside the control of management and under the condition of massive environment. The basic goal of any business and economic bank is profitability. Banks use all of their efforts to achieve the objectives and meet the economic needs of the community they serve and they are considered as one of the main tools of monetary policy in each country's economic system for on one hand gather small savings and wandering funds in the hands of the people and on the other hand in line with the implementation of economic policies and credit which has been set, direct the financial resources to steering the wheel of manufacturing and industrial sectors.

Over the past few years of the establishment of commercial banks, in addition to financial services for different activities it has been effort for increasing the profitability and less relied on government resources.

Bank Specific Variables

The bank-specific variables are selected by using some key drivers of profitability like earnings, efficiency, risk taking and leverage. Profitability is driven by the ability of a bank in generating sufficient earnings or in lowering operational cost, implying being more efficient. Furthermore, due to the special nature of banks, risk taking and leverage are also very important drivers for profitability. Theoretical academic literature suggests that there is a risk-return trade off, higher risks is associated with higher profits. Risk taking could relate to the quality of assets, liquidity of assets and to the capital structure of a bank. Hence, the following part of this particular section clearly presents the bank-specific variables that are used in this particular study.

 

The Profitability Factors

• Capital strength: The equity-to-asset ratio measures how much of bank’s assets are funded with owner’s funds and is a proxy for the capital adequacy of a bank by estimating the ability to absorb losses.
• Operational efficiency: Cost to income ratio shows the overheads or costs of running the bank, including staff salaries and benefits, occupancy expenses and other expenses such as office supplies, as percentage of income.
• Income diversification: The concept of revenue diversifications follows the concept of portfolio theory which states that banks can reduce firm-specific risk by diversifying their portfolios. Moreover, the decline in interest margins during the last decade has changed the traditional role of banks and forced them to search for new sources of revenue.
• Liquidity risk: Liquidity risk is one of the types of risk for banks; when banks hold a lower amount of liquid assets they are more vulnerable to large deposit withdrawals. Therefore, liquidity risk is estimated by the ratio of liquid assets to total assets.
• Size: There is consensus in academic literature that economies of scale and synergies arise up to a certain level of size. Beyond that level, financial organizations become too complex to manage and diseconomies of scale arise. The effect of size could therefore be nonlinear; meaning that profitability is likely to increase up to a certain level by achieving economies of scale and decline from a certain level in which banks become too complex and bureaucratic. Hence, the expected sign of the coefficient of bank size is unpredictable based on academic literature.
• Asset Quality: There appears to be a consensus that bank profitability is directly related to the quality of the assets on its balance sheet; that is, poor credit quality has a negative effect on bank profitability and vice versa. This relationship exists because an increase in the doubtful assets, which do not accrue income, requires a bank to allocate a significant portion of its gross margin to provisions to cover expected credit losses; thus, profitability will be lower. This was in line with the theory that increased exposure to credit risk is normally associated with decreased firm profitability. Indicating that banks would improve profitability by improving screening and monitoring of credit risk.

Industry-specific variables

This subsection discusses the industry concentration variable separately from bank-specific variables as far as this variable is to some extent external. That means managers cannot change the variable immediately like that of bank-specific variables.

Industry Concentration Level 

The SCP hypothesis states that a more concentrated sector favors bank profitability motivated by the benefits of greater market power. The efficiency theory explains the positive relationship between concentration and profitability as an indirect consequence of efficiency.

 

Macroeconomic variables

The macroeconomic control variables are external for banks‟ managers and uncontrollable. The growth of real gross domestic product and the inflation rate are selected as possible macro-economic variables that can affect bank profitability in this study.

• Real GDP growth: Poor economic conditions can worsen the quality of the loan portfolio, generating credit losses and increasing the provisions that banks need to hold, thereby reducing bank profitability.
• Inflation: Another important macro-economic condition which may affect both the costs and revenues of banks is the inflation rate (INFL).

This study examines the bank-specific, industry-specific and macro-economic factors affecting bank profitability.