Measures to Increase Banking Profitability Function

By John Dudovskiy

banking profitability

Banking profitability. Ramlall (2009, p.2) divides the determinant factors of banking profitability into two groups:

1.  External factors. They can be divided into further two categories: macroeconomic environment and market/industry characteristics.

2.  Internal factors that is characteristics which are bank-specific.

Dividing banking profitability in such groups is an efficient way of studying the issue, because it differentiates the factors affecting it according to its characteristics.

According to Anthanasoglu (2005) studies dealing with internal profitability determinants employ such variables as size, capital, risk management and expenses management. However, the authors fail to mention external profitability determinants in greater details as compared to the internal factors, despite the fact that external factors are important as well.


1. Mergers as a Measure to Increase Banking Profitability 

A study undertaken by Akhvein et al (1997) was focused on examining the efficiency and price effects of mergers by the use of frontier profit function. The result of their study indicated that merged banks enjoyed an average of 16 per cent increase on profit efficiency compared to other banks due to the range of factors including shifting outputs from securities to loans and improvements on higher value product range.

While examining the effect on banking profitability and rate of return on capital on changes in interest rates, Hancock (1985), made three assumptions:

1. Banking profitability depend on interest rates for asset and liability items, which is not the same for one market interest rate.

2. Banking profitability depend on the user costs of all financial items, and user costs depend on service charges, service premium costs and deposit insurance premiums, as well as on interest rates.

3. The relative price changes between financial and non-financial items is taken into account.

Berg et al. (1993) concluded Swedish banks being generally more efficient than Norwegian and Finnish banks.


2. Size and its Impact on Banking Profitability 

Berger, Hancock, and Humphrey (1993) conducted a research on efficiency taking into account the size factor of the banks and concluded that larger banks are more efficient. However, they also acknowledged that size alone cannot be an indicator of efficiency, and the way these banks are managed is more important in identifying their efficiency.

Sheldon (1999) used Data Envelopment Analysis to examine cost and profit efficiency of 1783 commercial and savings banks in the European Union, Norway and Switzerland. The study covered the period of 1993-97. They study found the more cost and profit efficiency of retail banks, large banks and specialized banks compared to wholesale banks, small banks and diversified banks respectively. The results of average frontier efficiency were found to be 45% cost efficiency and 65% profit efficiency. Also their results indicated the highest average efficiency of Denmark, France, Luxembourg and Sweden banks and Greece, Italy, Portugal, Spain, and United Kingdom had the lowest average efficiency.

Authors like Akavein et al (1997), Demirguc-Kunt and Maksimovic (1998) believe in the positive relationship between the bank size and banking profitability and stress that the extent to which a range of financial, legal and other factors affect banking profitability is closely related to its size. Short (1979) relates the bank size also to the capital adequacy justifying his stand by the argument that large banks usually raise less expensive capital and therefore may appear more profitable.

Multicriteria approach was implemented by Kosmidou et al (2003) to assess the banking profitability over a range of time period given. The results indicated that small UK banks had higher overall performance compared to larger banks within the time period of 1998-2002.


3. Integration and its Role in Banking Profitability 

A study on country specific efficiency and banking profitability covering 194 banks in 15 countries was conducted by Allen and Rai (1996) which identified substantial banking inefficiency and banking profitability in countries that prohibit integration of commercial and investment banking for the period of 1988-1992 compared to nonspecialised bank groups. Studying X-efficiency in relation to economies of scale and scope Benston (1994) concluded that universal banks are more efficient specialised banks.


4.  Managerial Efficiency as a Measure to Increase Banking Profitability

A range of authors point to the managerial efficiency as an important determinant of banking profitability. Notably according to Berger (1995) managerial efficiency not only raises profits, but also assists in increased concentration and greater market share gains.

Moreover, in recent years the focus has been on customer perceived quality, especially when dealing with service operations as it is seen one of the main drivers of retail banking and increasing banking profitability. The role of relationship managers increased over the last ten years in banking sector as service quality is considered by many as the key to gaining competitive advantage, and its importance for the Banking Industry has been pointed out by many authors.


5.  Inflation Rate as an Important Factor Affecting Banking Profitability 

Another set of factors influencing banking profitability are the macroeconomic control variables, which include inflation rate, interest rate, the amount of money supply and others. Studies by Bourke (1989), Molyneux and Thornton (1992) and others indicated to a positive relationship between banking profitability and the rate of inflation. A research by Revell (1979) on the issue of inter-relationship of banking profitability and inflation produced a result concluding that if banks’ wages and other operating expenses increased faster than inflation than inflation affected bank profitability. Perry (1992) states that the extend of inflation affecting banking profitability depends on forecast of inflation expectations made by bank. Because in case of inflation rate is in the same rate as forecasted by bank, then the bank is able to adjust the interest rate appropriately which will result in increase in revenues.


6.  Conglomerates and Banking Profitability 

Vennet (2002) conducted a work analysing cost and banking profitability of European conglomerates and universal banks and found conglomerates to be more revenue efficient than specialised competitors, and in terms of cost and profit efficiency universal banks were found to be more efficient than non-universal banks, concluding in the support of de-specialisation of banks.

According to Benston (1994) and Sauders and Walter (1994) static and dynamic efficiency of financial services sector would increase, not causing to financial system stability if the tendency towards universal banking to be continued. However there are no many examples in the real business world to support their argument.

According to Canal (1993), banking profitability has been improved many times in recent times due to the revenues obtained from the new business units. But the author fails to justify his argument by mentioning statistical data related to the performance of banks.

The banking profitability was also increased by mutual fund activities, and the combination of banking insurance and securities activities as found by Gallo et al (1996). This research was undertaken with smaller sample size of banks and this fact compromises the validity of these findings.

A distinction between transactional and relationship banks is made by Allen and Gale (1995), specifying that relationship banks such as German, Dutch, and Swiss main banks provide both debt and equity to companies, as well as establishing long-term relationships with them, serving on corporate boards and remaining committed to customers in times of financial difficulties.


7.  Liquidity and Its Impact on Banking Profitability 

A positive relationship between bank’s liquidity and banking profitability have been found by Bourke (1989) and Kosmidou and Pasiouras (2005). However, contradictory results were obtained by Molyneux and Thorton (1992) and Guru et al. (1999), which stated a negative relationship between banking profitability and liquidity.

A rather interesting reason of increased banking profitability was revealed by the empirical studies of Naceur (2003). It starts with the possibility of the stock market enlargement as a source of a wider scope of information. The abundance of information, in its turn, allows the possibility of more efficient processes of client identification and monitoring.

Athanasoglu et al (2005) confirms that that interest on the factors affecting bank profitability was raised due to the fact that business researchers and practitioners understood the importance of the profitability of bank itself.


8. Level of deposit accounts

Naceur and Goalited (2001) state that banks which maintain a high level of deposits accounts compared to their assets have higher profitability. It can be explained in a way that if the total deposits to total assets ration increases, it will result in an increase in funds which the bank can use to increase its revenues by investing them or lending them.

Rhoades and Rutz (1982) confirm that revenues are generated through interest on loans which increases the profitability of banks, therefore, large credit portfolio can allow banks to lend more money that will generate more revenue, and ultimately more profit for the bank.


9. Interest Rate Policy and Banking Profitability 

The idea that the profitability of a bank is influenced by the bank’s interest rate policy is forwarded by Bobakova (2003), who also argues that the profitability can be increased by appropriately adjusting bank’s interest rate policy. Accordingly, European banks should be able to assign their interest rate for asset deals in a way that it should cover costs of funds and the operating costs of the bank and also it has to ensure the required rate of profitability


10. Labour productivity

Positive and tremendous effect of labour productivity on the banking profitability is noted by Athanasoglou et al (2005). Increased labour productivity contributes to greater revenues and in this way the overall productivity of banks will be increased. Labour productivity can be achieved by keeping the work force steady, hiring the most talented workforce among candidates and investing in new technologies to assist on some job functions undertaken by the staff.


11. Information technology

Another factor which has been noted by only a few authors to increase banking profitability is the state of information technology at banks. Porter and Millar (1985) argue about the importance of IT in reducing the operating costs of banks which will lead to increased bank income, and eventually to increased profitability.

An empirical study regarding the effects of investment on bank IT in UK to the banking profitability was undertaken by Holden and El-Bannany (2006) for the time period between 1976-1996. The results indicated to a positive relationship between the level of investment on bank IT system and the bank’s profitability. Other researches have also found that investments from banks to have more ATM’s contributed to the profitability of banks, since staff hours were reduced due to the fact that ATM’s performed some of the functions which is usually performed by staff.

Internet has also great potential to be used to increase the banking profitability. According to a survey by Daniel and Storey (1997) the unit transaction cost of a non-cash payment was £1.08 if done in a branch, it was 54p if it was done through telephone banking, and only 13p through internet banking. This survey was done 13 years ago and since then the internet banking has developed to a new level and obviously plays more important part in the banking profitability than ever before.


12.  Risk taking policy as a Determinant of Banking Profitability 

The importance of effect of bank’s risk taking policy and practice to its profitability cannot be argued and has been noted by Koehn and Santomero (1980), Kim and Santomero (1988) and other authors. According to Bobakova (2003) profitability does not only include ability to foresee, monitor or avoid risks, it also includes the banks’ ability to cover the losses which have been caused by the risks the bank has taken.


13. Ownership and its Role in Banking Profitability 

Some literatures on the topic specify the ownership of banks as a determinant of its profitability. For example, researchers like Vennet (1996), Bashir (2000), and Micco et al (2004) inform foreign owned banks to be more profitable compared to domestic banksin developing countries; but the statement is opposite in industrial countries. The possible explanation is that developing countries sometimes offer tax breaks and other benefits for foreign business, including banks to be set up within the country, which can not be seen in industrial countries.

Also, Sapienza (2004), Barth et al (2004), and Short (1979) stress the profitability of privately owned banks compared to the profitability of public banks. The possible explanation is offered by some researchers in the form of social expectations public banks have to respond to instead of purely focusing on profitability, which not always true with private banks.

Ownership concentration does affect the banking profitability as well as it was revealed by some literature. A study undertaken by Claessens et al (1997) researched more than 700 companies based in Czech Republic which were listed on the Prague Stock Exchange and obtained results indicated that companies with ownership concentration were more profitable due to the incentives it gives to better monitor the performance of companies and make the changes needed to increase the efficiency. Also a study by Mitton (2002) indicated improved stock market performance of companies with concentrated ownership.


14. Other factors Affecting Banking Profitability 

Anthanasoglu et al. (2005) also link the banking profitability to their age as well. Apparently, banks are not profitable during the first year of their operation due to the fact that at that period they usually focus more on increasing their market share rather than increasing their profitability.

Restructuring is another factor which has been reported by Claessens et al (1997) to have an effect on the banking profitability. Restructuring may involve de-layering the management of banks, adopting new standards and policies, increasing operational efficiency and other similar activities which increase the overall efficiency of performance and profitability of bank.

A study undertaken by Klein and Saidenberg (1997) produced results according to which it can be said that diversified banks were less profitable in general. Contradictorily, Hughes et al (1999) claim that geographic diversification increased the efficiency of banks, and the bank risk can be reduced through product and geographic diversification.

Stocholtens (2000) did a research on European banks covering the time period of 1988-98 which revealed that small banks grew faster compared to larger banks, which contradicts the finds of Williams (2003) which was focused on the banks in Australia. Therefore, it can be said that the banking profitability do not affect all banks in the same manner, and local specifications play important role as well.

A suggestion by Nicols (1967) and O’Hara (1981) is made about increased efficiency of US mutual firms compared to the firms in private sector. Their conclusion is supported by Mester (1993) who also confirms the efficiency of mutual firms. However, Chebenoyan et al (1993) do not agree with this statement, because there the study undertaken by them found no difference between.



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