The Level of Profitability of Gulf Cooperation Council Banks - Case Study Example

Table of Contents Background and Justification of the study Aims and Objectives of the Study Summary of the Study 2 Methodology of Study 6 Conclusion 7 Refrences 9 BACKGROUND AND JUSTIFICATION OF THE STUDY It is widely held that the banking sector is a key factor underpinning the success of any economy. Banking institutions have always aimed to channel funds collected from savings towards investments in projects and other productive ventures, lending credence to the findings of past researches that established a significant relationship between economic advances and financial growth. The operating environment of banking industry is constantly developing and evolving, with macro as well as micro factors playing a significant part in the overall structure and performance of some global financial institutions of which banks are an integral part. For a bank to be profitable, it needs to achieve optimal operating level that as far as possible maximizes opportunities in the micro and macro environments. In its internal micro environment, revenue maximization and cost minimization are very important for the firm to attain profitability and competently prosper. On the other hand, at a macro level, the financial health and viability of each banking institution collectively strengthens the foundations of the entire banking sector. Such stability is crucial for survival during times of financial uncertainties and global recessions. As a consequence, previous studies have thoroughly addressed the determinants of bank performance (Athanasoglou et al., 2005). This paper will examine the level of profitability of Gulf Cooperation Council (GCC) banks. The relevance of this study lies in the careful examination of the profitability factor and how it is determined in the banks of the GCC, which consists of Saudi Arabia, the United Arab Emirates (UAE), Oman, Bahrain, Qatar, and Kuwait. AIMS AND OBJECTIVES OF THE STUDY There are various factors that materially determine a bank’s profitability. Accordingly, this paper sheds light on the different internal and external factors on which the GCC profitability is dependent. In order to determine these factors, it is important to look at the degree of banking profitability in relation to market structure and macro characteristics of banking institutions. As such, the main question which needs to be addressed is as follows: What are the crucial determinants of profitability in banks belonging to the GCC community? For an in-depth approach to the main research question, some attention needs to be paid to other sub-questions which are relevant to the topic. The first question relates to the structure of the GCC banking system and how it is associated with bank profitability; the second examines the external determinants affecting profitability; finally, the third looks at the internal determinants impacting on profitability. The methodology in this study follows the same procedure as that employed by Athanasoglou et al. (2005) and Kosmidou et al. (2005). Among the internal factors under consideration are bank size, capital strength, liquidity, operating cost and credit risk. As for external factors, government ownership, economic growth, concentration, inflation and stock market development are the variables considered. SUMMARY OF THE STUDY Profitability represents an underlying factor in any company’s success story and banks are no different. Similar to any other business, bank profitability is the result of a mathematical function of both earnings and expenses. To determine profits, a simple calculation can be carried out by subtracting expenses like interest, operational and non interest costs out of the total generated revenues. Gross revenues are primarily realized from the main business activity, based on the spreads between the interest charged on loans and that paid out on deposits, as well as from fees and charges imposed on other banking services. It has been suggested that the Return on Equity (ROE), which shows the earnings that are gained against the shareholders’ investment, is among the best indicators in deciding profitability in the eyes of many investors (Andersen, 1993). In addition, the ROE, when viewed in relation to other financial ratios, could provide insights into other facets of the business such as the robustness of business activity and the degree of financial leverage of the firm. The ROE model, also known as Dupont model, is illustrated by Humple and Simonson (1999) who claimed that the ROE in this model is decomposed into different ratios that would provide the analyst a comprehensive perspective for business improvement. To start with, expressing ROE can be firstly done in relation to the Return on Assets (ROA) and Leverage multiplier (LM) in the following equation: ROE= ROA × LM (1) A concise definition of ROA can be: the ratio of net income over total assets. The main aim of this ratio is to point out the ability of employing both financial and non financial resources in income generation. It has been argued by many researchers that the ROA is to be considered as an important ratio for determining the efficiency of banking institutions. In contrast, LM is defined as the ratio of assets over equity, indicating what proportion of total resources (assets) of the business is financed by ownership (equity). Secondly, the ROA can then be expressed in terms of the Profit Margin (PM) and Asset Utilisation as shown in the equation below: ROA= PM × AU (2) To perform the PM calculation, net income is divided by total revenue. This ratio shows the proportion of total revenue that remains after all expenses have been deducted, leaving net profit. This is an indicator of the cost efficiency of the firm. In terms of the AU, the ratio calculation of this value is done by dividing total revenue over total assets. This is a measure of activity of the firm, the level of revenues generated by each unit of asset the firm owns. A low AU may signify that the firm is not fully utilizing its resources to generate income, or that some assets it carries are unproductive and may best be disposed. The combination of both equations 1 and 2 results in: ROE= PM × AU × LM (3) Thus, DuPont analysis, in decomposing the ROE into its component ratios, links insights into the firm’s profitability (profit margin) with its efficiency (asset utilization) and level of financial risk (leverage). Banking institutions rely on the notion of no risk, no return. Profit can only be realized with the assumption of risk, and that financial risk has, under regular circumstances and within reasonable limits, been positively related to bank returns. The greater the risk, the higher the anticipated return; in this way, banking activities can be split into two categories. The first category seeks profit maximisation, while the second strives to minimise and control risks. With the assistance of ROE and Risk and based on the same framework, Sinkey (2002) created a risk return model in which the overall performance of a bank is indicated. According to Hefferman (2005), credit risk entails loans that cannot be recovered under some circumstances, which includes the probability of completely defaulting on a loan agreement or partially by an unexpected non-payment due to delay. It is also believed that as the returns go up for a medium loan quality, then, so does the risk (Hampel and Simonson, 1999). On the other hand, return are similarly expected to fall when banks aim for less risky loans. Therefore, it is a normal practice that banks are frequently diverse when it comes to the level of risk associated with their financial services such as loans so as to improve their returns. In addition, some arguments have been raised as with Sinkey (2002), which states that care should be taken in the process of monitoring borrowers by banks. Rather than being confined to the common formal procedures known as the 5C’s; namely, Capital, Conditions, Collateral, Character, and Capacity, banks are increasingly advised to carry out additional screening and evaluating procedures to alleviate most risks resulting from submitting false information and moral hazards. Another risk is liquidity, which is simply defined as the inability to have sufficient funds to meet short-term obligations. Developing countries, for example, commonly suffer from this risk since they first invest in illiquid assets, and secondly because their funds are locked away in long term securities. Therefore, this issue is likely to become critical if a large volume of deposit is unexpectedly withdrawn by the banks’ depositrs, which may force banks to opt for the undesirable decision to seek funds at the existing interest rates. Furthermore, the lack of liquid assets is considered as one of the main reasons for banks to fail. Even when management seeks to address this lack of liquid assets by the mobilization of bank reserves, the situation tends to erode depositors’ confidence in the bank, thereby compromising future revenues. One suggestion is that a gap should be present between maturities where deposits on a short term basis are taken and loans for the long term are made, therefore applying the saying “funding short and lending long” (Hefferman, 2005). Note: This appears to be reversed. A bank will be better off with long-term and time deposits, while loaning out short-term. When short-term deposits mature before the long-term loans, withdrawal by the depositor will force the bank to cover for funds still out on loan, resulting in pressure towards shortage of liquidity. Generally, any party involved in lending or borrowing, as is the case here with banks, are exposed to the risks associated with interest rates. Simply defined, interest rate refers to the cost of holding money. Essentially, the principal business action of most banks revolves around taking money from depositors and lending it to investors. As a result, any interest rates’ changes will have either positive or negative impacts on the profitability of most banking institutions. In addition, Hefferman (2005) asserts that interest rates are the main factor driving most of the assets and liabilities. Not surprisingly, banks may be hugely affected by the fluctuating rates. To stand any chance of benefiting from any advantages, banks must pro-actively anticipate any potential developments in the movement of interest rates. Therefore, it is important to have a metric by which to monitor the risk, such as the sensitivity ratio equation where the value of interest sensitive assets is divided by the value of interest sensitive liabilities. Moreover, it is claimed that in order to reduce the interest rate risks, a bank must attempt at maintaining a sensitivity ratio as close to one as is possible (Hempel and Simonson, 1999). According to Hempel and Simonson (1999), capital risk can be defined as the level where depositors’ position is at risk as a result of declining assets. This type of risk is also known as the leverage risk. In general, banks tend to have a high level of leverage when compared to other businesses because of the safety factor that depositors feel when depositing their funds. However, Hefferman (2005) believes that the banking system as a whole can be regarded as stable with only minor fluctuations taking place in the borrowing or depositing operations. Still, this is not to be taken for granted given the fact that financial stability can be doubtful for unforeseen circumstances. For any institution, profitability is prized for being the ultimate and most sought after objectives especially for the banking sectors. However, gaining profit is a lengthy and absorbing process which involves clear planning and implementation as indicated by Chorafas (1989) who also states that profitability depends entirely on earnings and expenses. Therefore, for a bank to incur a profit, it is recommended that its financial operations involve several services and products and which are diverse and enhanced to eventually achieve better net interest margins. In addition, there are three main factors in banking institutions which are required in the establishment of a financially profitable business, as is the case with other organisation. These factors include the kind of service and products at the disposal of customers, customers targeted for these services and products, and finally the endeavours both individual and collective dedicated to ensure that both services and products have reached the right customer. In the course of studying the profitability principle, two major research directions have emerged. Whilst the first group has approached single countries such as Barajas et al (1999), Neely and Wheelock (1997), Naceur (2003) and Berger (1995), the other group who included Molyneux and Thornton (1992), Demirguc- Kunt and Huizinga (1999), Bourke (1989) and Haslem (1968) has selected a wider scope aiming for more than one country or a group of countries. As has already been stated, there are several factors influencing bank profitability. These major influential factors affecting profitability both internally and externally have also been supported by studies performed by Short (1979), Molyneux & Thornton (1992). As for internal factors, they are those existing within the organisation’s control at the local level including bank size, liquidity, capital strength, credit risk, and operating cost; whereas external factors are those associated with the macro environment or the external world which are out of the organisation’s control of which stock market development, government ownership, inflation, economic growth, and concentration are but a few examples. METHODOLOGY OF STUDY This study takes the nature of a historical-descriptive inquiry, dealing with a social phenomenon that has implications on the management and conduct of business. The research design shall entail the gathering of both quantitative and qualitative information, and integrally analysing such data to arrive at a cogent and rational interpretation. The analysis shall be founded on secondary data, since the study pertains to past performance of banks and the implications of surrounding conditions on the banks’ profitability. Secondary quantitative data will be sourced from the financial statements of the banks for the micro economic factors, and the economic indicators of the countries of location of the banks for the macro economic factors. The study shall also apply both cross-sectional and longitudinal time frames, obtaining data that shall span eight years where available, and across the major banks in the industry located within the GCC region. For the best results when measuring bank profitability, data both within the bank along with macroeconomic data are gathered from multiple databases. On a micro level, specific bank data variables are obtained from Bankscope. As for the macroeconomic data such as GDP growth rates and inflation rates, such will be sourced from the databases of three different economic organisations; namely, the International Monetary Fund’s (IMF), Arab Monetary Fund’s (AMF), and the World Economic Outlook Databases. In terms of time scope, the study will cover the years spanning from the year 2000 until 2007. However, data for Stock Market Capitalization is not currently available for some locations, for which reason the variable Stock Market Development has not been considered for the analysis. On the other hand, the number of banks in the GCC area has multiplied over the years starting with 58 banks in 2000 to reach a total number of 97 banks within 7 years. Used as an estimation procedure, multiple regression analyses have been applied in most studies of bank profitability. The purpose of the regression analysis is to seek establishing the type of relationship and the level of significance in terms of dependent and independent variables. Within a multiple regression model, the coefficient also reveals the one explanatorily variable partial effect on the value of the independent variable mean, yet the other explanatory variables that are in the model are still constant. To better discuss the impact of both internal and external variables on the GCC’s banking profitability, it is worth considering the following model, which is similar to that employed by Kosmidou et al., (2005) and Pasiouras and Kosmidou (2007). ZIt = boit + bmitYmit + bdjtYdit + ε Where, i is the reference to an particular bank, t is the reference to the year, j is the reference to the operating bank’s country, z refers to the dependent variable for either the return on average assets (ROAA), the net interest margin (NIM), or Return on average equity (ROAE), Ym refers to a vector captured from the internal factors of a bank and Yd is refers to a vector captured from the external factors of a bank,  refers to the error term. To support the interpretation of the quantitative data, qualitative secondary information shall be sourced from reports and documents from reputed credible and authoritative sources available in the public domain. The document search may include annual reports of the banks under study, industry analyses, reports published and released by economic fora, investment analyses and advisories by certified financial institutions, articles in noted academic and professional journals, and economic and financial news in major broadsheet publications. Conceptual Framework In the course of analysing the various internal and external variables and relating them to the banking institution’s performance, there must be a construct by which the logical relationships of these explanatory variables (financial ratios and macroeconomic indicators) may be related to the dependent variable (profitability). For this purpose, the following framework shall be utilised as the paradigm for the investigation. The Bank Profitability Analysis Framework is a structured analysis method used in accounting theory to trace the sources and comparative levels of revenues and expenses that ultimately determine profitability. The terminology is slanted towards the even of decreasing profitability, in order to establish the directionality of the various components of revenues and expenses. The framework takes the form of a tree diagram, and the various component accounts are decomposed into their subcomponents in order to determine the ultimate source of inefficiency in the bank’s operations that adversely affects its profitability. The model may, naturally, be used to depict the event of increasing profitability, with the indicated directions for each component or sub-component merely reversed. BANK PROFITABILITY ANALYSIS FRAMEWORK Source: http://www.ruf.rice.edu/~jgsmcc/Accounting_Frameworks.pdf In this study, the respective financial or economic indicator shall be assessed as to its impact on the above tree diagram; that is, the component or subcomponent affected by the indicator shall be identified and the direction towards which it is influenced is determined. Through this method, the rational link between the bank’s profitability and the significantly-related variable may be established, as well as the nature of the relationship, whether favourable or adverse. CONCLUSION To conclude, any type of financial institutions such as banks needs to be successful both at the macro as well as the micro levels. At the micro level, profitability is essential as it assists the bank to thrive and compete confidently in a highly competitive market. The process of channelling funds from depositors to investors has also been addressed as well as paying particular attention to making the company profitable in terms of predicting and assessing risk as well as profiting from interest fluctuations. This paper attempts to outline different internal and external factors responsible for the eventual profitability in the GCC banking environment. So as to better determine those factors, the paper has examined a number of bank characteristics, market structure in relation to macro characteristics of bank profitability such as the state of the market, inflation and other important factors. As with previous academic literature on the subject, this study highlights the existence of various factors influencing commercial bank profitability. For example, empirical literature has categorised most factors into internal and external denominators. The first category is internal determinants which are factors regarded to be under firm grasp by the bank as they are the firm’s internal activities. On the other hand, external factors or determinants are those influenced from the outside or the macro factor on which the business has no control. There have been single-country studies carried out, one of which is a study that focused on the Greek banking system, while others have chosen to select mainly the states from Europe. Furthermore, in determining profitability, ROA has always been used in earlier studies, as have ROE, and NIM. In ROA, the efficiency with which the firm operates its resources is measured; while ROE can be seen as a measurement of profitability from a shareholder’s perspective. On the other hand, NIM calculates the profit accrued from assets based on interest. As for information, it has been indicated that data was collected from Bankscope; however, with regards to country specific data, information was collected from higher financial establishments such as the International Monetary Fund (IMF), Arab Monetary Fund (AMF), and the World Economic Outlook Database. Finally, it is worth mentioning that for best results, effects of different internal and external variables on bank profitability in the GCC have been examined using regression analysis selected as the preferred methodology. In addition, a description of both dependent and independent variables and their impacts in this study have been provided in this chapter. References Andersen & Andersen Consulting, (1993), ‘European Banking and capital market: a strategic forecast’, The Economist Intelligence Unit, London. Athanasoglou, P.P., Brissmis, S.N., & Delis, M.D. (2005), ‘Bank-Specidfic, Industry- Specific and Macroeconomic Determinants of Bank Profitability’, Journal of International Financial Markets, Institutions and money, Bank of Greece Working Paper, No. 25. Barajas, A., Steiner, R., Salazar, N., (1999). ‘Interest spreads in banking in Colombia’. 1974-96. IMF Staff Papers 46, 196-224. Berger, A.N., (1995). 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