Banking Profitability

By John Dudovskiy

Banking Profitability Banking profitability. One of the fundamental functions of any bank is its profitability. There is no doubt that recent global financial crisis negatively affected on the profitability of many banks around the globe. Some of them are starting to recover due to efficient measures from bank management and help from their governments. However, many European banks are still struggling to regain strong position in marketplace which they used to hold only a few years ago. And many of them are still not too far from the verge of bankruptcy.

The problem of assessing the profit efficiency of banking industry is of paramount importance for local governments and economic theorists. Therefore, the important point is if government is striving to assist for the performance of banks to be improved, it is crucial to know how far a bank is able to increase its profit by increasing its efficiency, not using new resources for the purpose.

The study on profitability of banks is especially important at this point of time. As in summer of 2012, the lowest point of global economic crises is past; however the banks and financial system in many countries and in many industries are still vulnerable to various shocks. The main important point is that problems within banking system are going to affect all other businesses as well. Because businesses have a close relationship with banks and most of them are financed by banks. This fact makes it necessary to study all the causes of the recent economic crisis in detail, giving extra attention to its affect to banks and to work on making banks less vulnerable to such external shocks.


Studies into banking profitability

Kumbhakar and KnoxLovell (2000, p.8) inform that Christensen, Jorgensen and Lau were the first researchers to estimate a flexible profit function in 1970. However, when estimating flexible profit function they used “squares techniques, or variants of least square techniques, in which error terms were assumed to be symmetrically distributed with zero means” (Kumbhakar and KnoxLovell, 2000, p.8).

However, it can be said that the validity of their research is compromised by the assumption that was made about the distribution of the error terms. Later, it was found that stochastic approach method provided more valuable results for types of studies that related to the profitability function.

Ramlall (2009, p.2) states that the studies on the determinants of the banking profitability can be divided into two groups:

  1. The studies focusing on a specific country. Major works on this type of studies belong to Berger et al (1987), Berger (1995b), Barajas et al. (1999), Naceur and Goalied (2001), Naceur (2003) and others.
  2. The studies focusing on specific factors within a range of countries. The works of Haslem (1968), Short (1979), Bourke (1989), Molyneux and Thornton (1992), Demirguc-Kunt and Huizinga (1999), Demirguc-Kunt and Huizinga (2001), Bashir (2000), Abreu and Mendes (2002) and other can be classified under this category.

Athanasoglou et al (2005, p.7) divide studies on increasing banking profitability into several groups:

1.         The first group of studies include Haslem (1968), Short (1979), Bourke (1989), Molyneux and Thornton (1992), Demirguc-Kunt and Huizinga (2000), and Bikker and Hu (2002). All of the works in this group have focused on the bank profitability business cycle relationship.

2.         The focus of the second group was mainly the banking system in the US ( Berger et al (1987), and Neely and Wheelock (1997)), or emerging markets (Barajas et al.,(1999)).

These classifications above are highly subjective and were undertaken by relevant researchers for their own study only. Nevertheless, the classifications can be used for present study in order to research the topic of banking profit efficiency in several levels.

X-efficiency of financial institutions has been researched by many authors over the past decades. A survey undertaken by Berger and Humphrey (1997) studied 130 works on efficiency, obtaining the data from twenty-one countries, within different time periods, from various types of financial institutions including banks, savings institutions, and insurance companies. They also used different efficiency concepts and measurement techniques. The result of the survey at that time indicated the range of average banking inefficiency between 20-25 per cent of total costs. However, many economic, geopolitical and other circumstances have changed since that period which had a direct effect on baking efficiency. Therefore, the findings of this dissertation will reveal the scale of change in banking efficiency from 1997 to 2008 (the year the profit efficiency calculations are based on).

Numerous studies have focused on the determinants of banks’ profits and margins within the scope of a specific country. Both internal and external factors of profitability have been studied when analysing either a single country or a number of countries at the same time. In such cases bank’s specific characteristic are considered to be internal factors, and external factors are financial industry and economic environment of the country the bank in question is situated in.

Works on determining banking profitability within a single country include the works of Berger (1995), and Angbazo (1997) which studies banking in the United States;  Mamatzakis and Remoundos (2003), Kosmidou and Pasiouras (2005) studied banking profitability in Greece; Pasiouras et al (2005), analysed the profitability of banks in Australia; Guru et al (1999), focused their work to study the profitability of Malaysian banks, etc.

Researches that have focused on studying the profitability within a single country easier to undertake in many levels compared to researches that compares the profitability of banks of several countries. Yet, they provide valuable methodological framework and tools that can be used for profitability studies of many forms.

Studies analysing bank profitability involving several banks at the same time provide more detailed background for the present research. Among such studies the most notable ones are the works of Molyneux and Thorton (1992), Abreu and Mendes (2001), Staikouras and Wood (2003) and others. Also, Hassan and Bashir examined the profitability of Islamic banks involving data from 21 countries. These researches provide a valuable material for the current research due to the fact that that they study the same issues. However, the findings of these researches are outdated compared to the dissertation, and at the same time they do not specifically cover US, European and Japan banks, as the present dissertation does.

The study of banking profitability involving a range of bank which is the biggest in scale belong to Demirguc-Kunt and Huizinga (1999). Their paper considered such banking characteristics as legal indicators, macroeconomic conditions, financial structure, size, taxation and regulation and others to study the determinants of bank profitability in more than eighty countries. The only shortcoming the above research has is that it does not study the characteristics of the factors affecting profitability of banks deep enough in order to establish the ways of how the profitability changes when those factors change.

Two main concepts – parametric and non-parametric approaches are mainly used to study topics dealing with efficiency.

When used by individuals with sufficient knowledge, frontier analysis allows Harker and Zenios (2000) describe frontier analysis as an essentially sophisticated way to “benchmark” the relative performance of production units which has two main advantages:

  1. Frontier analysis allows individuals with little knowledge and/or experience to select best performers within industry or company and assign numerical efficiency values, broadly identify areas of attention and prepare relevant reports.
  2. This approach allows management to identify areas of best practice within even complex service operations.

Harker and Zenios (2000) inform that at least five different types of evaluating the efficiency of financial institutions have been employed and all these methods differ from each other in terms of:

a)      The functional form of the best-practice frontier (a more restrictive parametric functional form vs. a less restrictive non-parametric form;

b)      If the account is taken of random error which may temporarily give some production units, inputs, costs or profit

c)      Whether there is a random error, the probability distribution assumed for the inefficiencies (e.g., half-normal, truncated normal) which are used to disentangle the inefficiencies from the random error;



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Category: Finance