Banking Development in Financial Structure by Harry Huizinga - Article Example

Running Head: Critique Critical Review of a Journal Article --------------------------- ------------------- Critical Review of a Journal Article Introduction This paper has chosen to critically review the journal article Financial Structure and Bank Profitability written by Asl1 Demirguc-Kunt and Harry Huizinga of the Development Research Group, The World Bank, and Department of Economics, Tilburg University, CEPR, respectively. The chosen article is in the area of finance and economics with a direct focuses on banking. The article is written in the overall milieu of the financial development and development of financial structure and their concomitant and possible impact on bank performance as measured by the chosen indicator(s). The following paragraphs critically appraise the article in its various perspectives. Topic Selection and Rationale of the Article The topic selected by the authors is Financial Structure and Bank Profitability and the selected issue is vital from two points of view.One, the issue encompasses not only financial structure but also financial development as the paper goes on to elaborate at the beginning.Two, the concept of economic development and growth has taken a new meaning with the advent of globalization. Globalization has meant lowering of borders and freer movements of goods, services and capital across the borders. Thus now economic growth has a distinct contribution from the rest of the world interface of the domestic economy. Banks which were playing the role of conduits in channeling domestic investible resources to investment channels domestically now have to widen their horizons and acquire international hue in order to cater to growing internationalization of the domestic economy. Authors of the article have, however, taken a snap shot view of the phenomenon of financial development, financial structure and bank performance from domestic operations of the banks without emphasizing or building in the international dimension. Authors suggest that economic development fosters financial development. As nations grow richer the financial development and financial markets grow and develop. As a proxy of this financial development the authors cite the relative importance of bank finance versus market finance. They state that the bank finance can be set in comparison to stock market operations. In case bank lending is more in relation to stock market then the economy can be considered to be bank finance based economy and market finance based if the stock market operations are more than the bank lending. They state that the economies of Germany and Japan can be reckoned as bank finance based as bank finance predominates over any other form of market financing.Similary in UK and USA the market financing predominates and hence these economies are to be reckoned as market finance based economies. Though the topic does not explicitly include the new globalization dimension; it talks about domestic financial development, financial structure and bank profitability. Here the financial development is said to take place in the financial system of an economy. Financial system is defined to include various financial institutions, i.e. banks and other financial intermediaries and stock markets. Financial structure is primarily seen as the ratio between bank finance and market finance .In this paper we focus on the performance of the banking sector itself across different financial systems. It was observed that the chief purpose of the chosen article comprised in two tasks. First, was to analyse the possible impact of the level of financial development on bank profits and margins. Second, was to hold the level of financial development as constant and unchanged, and then examine if the evolving concept of financial structure had an independent impact on level of bank performance. It was only logical for the authors to conclude if banks operating in different financial structures exhibited marked differences in performance (particularly bank margins), and then this had important implications for economic growth. On the converse if the differences in the financial structure did not result in differences in the cost of bank financing for firms, then the conclusion would be that financial structure is not an important determinant of economic growth. (Kunt & Huizinga, Financial) Literature Review Authors have taken up a rather limited literature review of other research efforts connected to the topic of the article. First tranche of literature review is primarily used to investigate the concept of the financial system or structure .In this respect the authors cited the work of Demirguc-Kunt and Levine (1999) who constructed the indices of the organization of the financial system, or financial structure, for a large set of developing and developed countries. In this cited work the researchers had measured the relative importance of bank versus market finance by the relative size of stock aggregates, by relative trading or transaction volumes, and by indicators of relative efficiency. This work could have been cited more particularly in relation to relative efficiency indicators as the present paper also used same efficiency indicators to establish impact or otherwise of financial structure on banks' profitability. The cited work had concluded that the developing countries were shown to have less developed banks and stock markets in general. Second tranche' of literature support has been drawn by authors to substantiate the argument that both banking sector development and stock market development may lead to higher growth at the firm, industry and country level. In this respect authors have cited several studies touching on various aspects of the relationship between economic development and banking sector and stock market growth. The cited research includes King and Levine (1993) and Levine and Zervos (1998) on evidence regarding financial development and economic growth; Rajan and Zingales (1998) to show that industries that rely more heavily on external finance grow faster in countries with better-developed financial systems; Demirguc-Kunt and Maksimovic (1998) to show that firms in countries with an active stock market and large banking sector grow faster than predicted by individual firm characteristics. The last and final tranche of literature support drawn by authors relates to focusing on those studies that correlate financial structure-the relative importance of banks vs. markets -with firm performance and long-run economic growth. The authors use Stulz (1999), Demirguc-Kunt and Maksimovic (2000) and Levine (2000) to report analysis of the impact of financial structure on firm performance and economic growth, respectively. (Kunt & Huizinga, Financial) However the gists of findings of the research studies have not been dealt with appropriately. For instance the causality leading to the link between financial structure-in its various variants- to both firm performance and economic growth in each of these studies would have supplanted literature review to make it more holistic and relevant to the issue addressed by the present article. Methodology The methodology adopted is empirical, quantitative and based on historical data covering the period 1990-97.The data pertains to a large number of developed and developing countries and is used to investigate if there is any relationship between measures of bank performance on the one hand, and levels of bank and stock market development, and financial structure on the other. The data covers almost ninety percent of the global banking industry assets. Authors consider two measures of bank performance: bank profitability (measured as profits divided by assets), and bank interest margins (measured as net interest income divided by assets). Bank profitability and bank interest margins are reckoned as indicators of the (in) efficiency of the banking system, as the two ratios separate out the interest rate received by savers on their deposits and the interest paid by lenders on their loans. In causality these variables would affect the cost of bank finance for firms and bankable investment projects thus affecting impact economic growth. Authors combine bank level data with cross country data on financial structure to derive their conclusions. Through simple means testing the authors have stated some relationships between financial development and bank profitability, on the one hand, and between financial structure and bank profitability on the other. The authors state that, " we find that financial development has a very important impact on bank performance. Simple means tests show that countries with underdeveloped financial systems have significantly higher levels of bank profits and margins. Once we control for the level of financial development, however, there is no significant difference in bank profits or margins between bank-based and market-based systems". ( Kunt & Huizinga, Financial,p4). Thereafter the methodology primarily comprises of confirming the above relationship by means of running a regression equation on the above historical data. While empirical approach was an appropriate methodology to adopt, however within this approach the authors have not built in an important aspect of financial structure indicators. The emphasis has already been initiated above with discussions on globalization. There has been an increasing trend with globalization for the banks to diversify and turn into universal banks offering a bouquet of services apart from traditional banking products. This includes important interfaces with stock markets in form of brokers, investors and even speculators apart from other high non interest fee based activities like underwriting, mergers and amalgamations, consultancy, project financing etc . Such diversification has resulted in non interest income registering substantial growth in some markets- particularly developed markets and in some developing markets as well. Thus the increase in non interest income to total profits ratio would have indicated an increasing role of banks as universal banks and thus served as an indicator of rapidly altering financial structure as well as hastening level of financial development. This would have yielded much better regression results on conclusions regarding financial structure and development. The authors have instead used the balance sheet based ratio of non-interest earning assets/total assets in relating bank profitability with financial structure. ( Kunt & Huizinga, Financial).However, due to short term, seasonal and even notional nature of non -interest earning assets the former and suggested ratio would have been better in regressing financial structure with bank profitability. Methods As indicated above the method adopted is a regression equation which is to be tested for apriority mean based causal generalizations. This critical appraisal would now examine the specific regression equation being put to empirical test by the authors. The regression equation is as under: I i,j = + B i + X j + S j + i,j (1) where ,as the authors define, I i,j is the independent variable (either Profit/total asset or Net Margin/total asset) for bank i in country j; B i,t are bank variables for bank i; X j are country variables for country j; S j are financial development and structure variables for country j; and ei,j is an error term. ( Kunt & Huizinga, Financial). Authors go on to estimate that the versions of (1) are estimated with either bank-level data or country-level data. The bank level specifications use bank mean values over the sample period for each bank. The bank level data is derived from bank balance sheets and income statements, as available from the BankScope data base compiled by Fitch IBCA. Bank-level variables are used in the empirical work for each country separately. First is a Profit/total asset and is computed as pre-tax profits divided by total assets. Second is Net Margin/total asset and is defined as net interest income divided by total assets. However, Net Margin/ total asset is an ex post interest margin which differs from the ex ante interest margin (simply the loan interest rate minus the deposit interest rate) so as to account for possible loan defaults. Thus the variable Net Margin/ total asset adjusts for the fact that banks that charge high interest rates may experience equally high loan default rates. ( Kunt & Huizinga, Financial). In assessing impact of financial structure on bank profitability and margins the authors use some balance sheet based ratios that are direct indicators of the earning power and the cost side of banks and hence, are useful in empirical work relating bank profitability and interest margins to financial structure variables. These ratios are essentially viewed as controls ratios. Equity/ total asset is defined as book equity divided by total assets. International variation in Equity/ total asset reflects differences in capital adequacy as well as different definitions of book equity. Loan/ total asset is defined as total loans divided by total assets, while Non-Interest Earning Assets/ total asset is defined as cash, real estate and other non-interest earning assets divided by total assets. This is subject to the comments carried in methodology section above. Finally, Customer & Short Term Funding/ total asset is deposits and other short-term funding divided by total assets.( Kunt & Huizinga, Financial). Country level specifications instead use country mean values for bank and other variables. Authors first take up three ratios which are indicative of the size and extent of the financial system. The first of these ratios is the Bank/GDP ratio and gives the ratio of the total domestic assets of deposit money banks divided by GDP, providing a measure of the overall size of the banking sector. Next, is the Central bank/GDP ratio and is defined as the total assets of the central bank divided by GDP and third is the Mcap/GDP ratio which gives out the stock market capitalization divided by GDP.Then the authors define two variables which cover the volume of activity of the banking system and stock markets respectively. Bank credit/GDP is the credit to the private sector by deposit money banks divided by GDP. Hence, this variable proxies for the credit activity of the banking system. Next, Tvt/ GDP is the total value of stocks traded divided by GDP, as an indicator of stock market activity.( Kunt & Huizinga, Financial). The authors also examined empirically as to how the performance of the banking sector (in terms of profits and the net interest margin) is related to the relative development of the banks and stock markets of bank and stock markets. To capture whether a financial system is bank-based or market-based, authors used an index of financial structure constructed by Demirguc-Kunt and Levine (1999). Specifically, this Structure index was the means-removed average of relative size, relative activity and relative efficiency measures. Relative size was calculated as the ratio of the stock market capitalization to total assets of deposit money banks; relative activity was defined as the total value of stocks traded divided by bank credit to the private sector; relative efficiency, finally, was given by the product of total value traded and average overhead costs of banks in the country. (Kunt & Huizinga, Financial).Authors regress along (1) above with the help of above independent variables to assess impact on both profit and net margins. By using combinations of variables authors regress financial development, financial structure with bank profits and bank margins. Particularly interesting is authors' approach to regressing financial structure approaching it once through structure index, as cited above, and trying it again through a market dummy variable. The various regressions are termed as specifications by the authors. As measure of consistent results authors calculate and report White's heteroskedasticity-consistent standard errors. Authors were also clear about the regression methods used in the article to derive conclusions. Again authors presented the regression results under different specification in tabular form to make for easy reference and understanding. The conclusion was well drafted to cover almost all regression specifications which were ,though. elaborately discussed with their implications ahead of the conclusion itself. Data The article, however, had very well defined empirical analysis. The data used in the empirical analysis was delineated explicitly. All of the dependent and independent variables were defined in clarity leaving no ambiguity. The authors also took pains to point out historical data outliers, the reasons for their being outliers, particularly for country wide bank indicators. However authors did not specifically point out if such outlier data impacted their findings and if so how and to what extent. In addition authors interpreted and defined the directional implications of most independent variables (ratios used in the regression). In fact data used in the empirical analysis was summarized in tabular forms at appendices which made for a quick and understandable reference. Conclusion The article concluded that financial development leads to closer and narrower bank profitability ratios and margins across the industry; however financial system structure does not independently affect bank profitability or margins. A predominance of market over banks may still result in higher bank profits and the converse may be true as well provided one is traveling in one stage or level of financial development. This gist would have helped establish a consistent argument from external literature to the findings of this article. The authors concluded as follows: " The empirical evidence of this paper suggests that banks have higher profits and margins in underdeveloped financial systems. Once we control for the level of financial development, financial structure, i.e. the relative development of banks versus markets, does not have an independent effect on bank profitability or margins. In developed financial systems, bank profits and margins are indeed not statistically different across bank-based systems and market-based systems. Regression results indicate that greater bank development lowers bank profits and margins. Underdeveloped banking markets tend to be rife with resource-costly inefficiencies and less-than-competitive pricing behavior, as also suggested by their relatively high profitability and net interest margins. Thus greater bank development brings about tougher competition, higher efficiency and lower profits. ( Kunt & Huizinga, Financial,p 14). Works Cited Kunt Asl1 Demirguc, & Harry Huizinga .Financial Structure and Bank Profitability.JEL. Read More