Determinants of Indian Commercial Bank Profitability - Research Paper Example

Introduction The last two decades have been very important for banking sector through out the whole world. During this period the banking industry has gone through a lot of transformation in a number of countries including India. In India reform in banking sector started in the year of 1991 with the initiation of economic reform. The major transformation has taken place in the operating areas of the commercial banks. It is true that there have been a rising trend towards bank disintermediation in a large number of countries, but the role of banks still remains central to finance related economic activities of the countries. A profitable banking system is able to cope up with different kind of negative shocks that an economy may get from different directions. It also brings a greater account of stability in the financial system of the economy. The determinants of profitability of banks, particularly commercial banks, have now therefore been drawing interest of academic research to an increasing extent. (Leeladhar, 2005; Ram Mohan; 2002) Indian banking sector is one of the largest industrial sectors in the country. Prior to 1990, Indian banking industry was operating in the country in a very comfortable environment. The degree of competition was not very high. However, with the initiation of economic reform, which banking reform was a part of, the whole banking system of the country had been pushed into the pool of extreme competition. Particularly after the starting of new millennium, the banking industry of the country started to face more and more challenges. In the present time the activity of banking can be characterized as the activity operating in a vast horizon together with high risk factor and intense competition. (Pandey, 2002; Rishi and Saxena, 2004; Ram Mohan; 2002) Therefore, profitability of the banks is a very vital factor for any bank, private or public, to ensure efficient performance and for survival. Hence the determinants of the profitability are also of great importance to the management as well as the researchers who are interested in doing research in the banking area. The present research seeks to look at the different determinants of profitability of the Indian commercial banks and to examine to what extent different determinants affect the profitability. Purpose and contribution of the study: In the international sphere, most of the researches on the bank profitability, like the works of Molyneux and Thornton (1992), Goddard et al (2004), Short (1979), etc. basically used some linear model of regression to find out the effect of different factors that are expected to be important determinants of the profitability of the banks. These researches show the possibility of conducting meaningful study of bank profitability. There, however, exist some problems with these researches. These works either left out a number of issues important to the issue of profitability or did not deal with them in adequate way. These studies mainly took into account the profitability determinants at the bank or industry level by adopting the selection process of the variables which sometimes lacked internal consistency. Sometimes, there was also not sufficient amount of investigation of the impact of macroeconomic variables on bank profitability. In a number of cases, the methodology applied to study the impact of different factors on bank’s profitability was also not very clearly stated. The present research will focus on the Indian banking industry which is considered to be a very strong and stable compared to banking industries of other countries. The proposed study will make an effort to study the profitability of Indian commercial banks and its determinants along with the extent each determinant affect profitability. The study will also seek to provide a comparative analysis of profitability and its determinants for public, private and foreign banks. The study will consider the period of 2001-2007 for its analysis. The paper will take under its consideration important bank specific, industry specific as well as macroeconomic variables that are supposed to affect the profitability if banks. Literature review: There exists a vast amount of literature relating to banking industry. A large number of studies also exist on Indian banking industry. It is found that once the banks got nationalized, one of the prime motives of the public sector banks of India was to provide its services to all sectors of the country. The nationalized banks had been ascribed the duty to spread its branches all over the country, even in the far-flung remote places so that the people living in those places could get an access to banking services. Making profit was not the prime objective of the public sector banks. They were actually ascribed the duty to act on behalf of the government to fulfill economic needs of the mass. The private and foreign banks however, did not make such moves and their prime objective was profit making. With the initiation of economic reform in 1991, the Reserve Bank of India (RBI) also undertook several reform measures for the banking sector of India. The reform measures were undertaken following the recommendation made by the Narasimhan Committee. One of the major aims of the implementation of reform was to make the banking system more profitable and more efficient so that they can survive in the face of the intense competition during the age of globalisation. The reform opened the banking sector of the country largely to the private players. India’s domestic private sector banks can be divided into two types – first, the old private banks which existed along with the public sector banks prior to 1991 also, and second, the new private banks which came into existence after 1991. (Sathye, 2005; Sarkar, 1999) Once the new set of private sector banks started their operation, the inefficiencies of the public sector banks got exposed. In terms of rate of growth the new set of private sector bank outpaced the public sector banks. The interesting thing was that although in the whole banking system the business share of private sector banks was not very high, their share in the net profit of the whole banking sector was very high. There is no doubt in the fact that higher profit means, greater stimulus to the management to expand and improve the services of the bank. It’s true that profit maximization is a secondary objective of the public sector banks, but for these type of banks too adequate amount of profit is required to make them survive and having a healthy and efficient operation. (Pitre, 2003; Bisht, Mishra, and Belwal, 2001; Sarkar and Das, 1997; R.B.I., 2002; Shanmugam, and Das, 2004) Hence, profitability of the banks is a very vital factor for any bank, private or public, to ensure efficient performance and for survival. There exist some important research works which deal with the issue of bank’s profitability. In the existing literature, it can be found that profitability of a bank in any country can be expressed as a function of internal as well as external factors. These are the internal factors which can be termed as bank specific determinants of profitability. It is the balance sheet of bank or account of profit or loss of the bank which give rise to internal determinants of bank profitability. The bank specific factors can also be termed as the micro determinants of profitability. The external determinants, on the other hand, are those which are not related to the management of the bank. External factors actually reflect those economic as well as legal factors that influence the performance of the bank. The existing studies have taken into account a number of explanatory variables under each of these categories of profitability determinants in accordance with the nature and purpose of the study. Some of the existing studies undertook analysis of profitability of cross-country, while some other studies concentrated on individual country analysis. Research works of Haslem (1968), Short (1979), Molyneux and Thornton (1992) etc. focused on cross country analysis of profitability. The second group of studies include the work of Berger et al. (1987), Barajas et al. (1999) etc.. all of these studies concentrated on analyzing bank profitability by combining internal and external determinants of profitability. (Verma and Verma, 1999; Molyneux and Thornton, 1992; Berger., 1995(a), Berger, 1995(b), Barajas, et al. 1999, Berger et al. 1987; Haslem, 1968; Short 1979) The internal determinants that the existing studies employed included variables like the size of the bank, capital, risk management capability, ability of managing expenses etc.. Size was introduced as a bank specific variable to take into account for the extent of economies of diseconomies of scale of operation that exists in the market. There is a work of Akhavein et al. which found that size is significantly related to the profitability of the banks. Another work (Demirguc-Kunt and Maksimovic, 1998) has found that the degree of affecting profitability by several financial, legal and some other factors, like corruption, is closely associated with firm size. Adding to these, in his study Short (1979) claimed that bank’s capital adequacy is also closely related to the level firm size as there have been a tendency for the large sized banks to raise expensive capital in lesser amount compared to small banks , and therefore, they appear to be more profitable. A number of other works also shows a positive link between size of the bank and capital ratios. Therefore it has been argued that as the firm size rises profitability also goes on increasing. However, some other researchers argue that very often increasing firm size actually results in very little cost saving and therefore large bank could face scale inefficiencies. Risk management is another important factor in the banking system. Total risk of a bank can be divided into credit and liquidity risk. It has been found that while in some study the level of liquidity is found to be negatively associated with profitability in a significant way, in other studies credit risk is associated with profitability in a negative way. As far as expense management is considered, it has been found that better expense management is positively related with profitability. (Akhavein, et al. 1997; Bikker, 2005; Bikker, and Haaf, 2002; Demirguc-Kunt and Maksimovic, 1998, Goddard, et al. 2004) Coming now to the external variables, one can distinguish between industry specific variables and macroeconomic variables. Industry specific variables include market concentration, size of the industry, ownership status etc., while macroeconomic variables include inflation, rate of interest, cyclical output. Studies have obtained varied results regarding these variables. (Sarkar, Sarkar, and Bhaumik, 1998; Bourke, 1989) Research design: The present study will analyze the effect of these internal and external factors on the profitability of bank in Indian context and particularly after the entry into new millennium. However, before finding out the which factors work as major determinant of profit in Indian banking system, the present study will first look into the trend of profitability of Indian banks since 1990s.Here the study will make an effort to compare the performance of the public, private and foreign banks in terms of profitability. To measure profitability, the study will take into account two alternative measures. These two measures are Return to asset (ROA) and Returns to equity (ROE). ROA actually shows the bank’s capacity in generating profit from its asset, while ROE reflects the return to shareholder on their equity. Next, the present study will conduct a regression analysis to find out what internal and external factor discussed above actually play vital roles in determining banks’ profit in India. Among the bank specific variable, the present research will consider capital, credit risk, productivity, expenses management, and the size of the banks. To measure capital equity to asset ration will be taken under consideration as a proxy variable for the capital. The ratio of loan-loss provisions to loans will be taken as the proxy variable of credit risk. Rate of change in labor productivity will be used to measure productivity of the bank. Including expenses management as a variable, the ratio of operating expenses to total asset will be taken under consideration as it is only the operating expenses that reflect the performance of bank management. To measure size the study will consider value of total real asset of the bank. Under industry specific variable only the ownership and concentration factors will be taken under consideration. The study will incorporate dummy variable to find out the effect of ownership on the profitability. Concentration will be measured by using Herfindahl-Hirschman index. Under macroeconomic variables the study will incorporate inflation rate and cyclical output. This research will conduct a single equation regression in the following format- J ∏it = a + ∑j=1 bj Xitk + uit Where, ∏it is profitability of bank i at the year t with i= 1,….., N; and t = 1,……, T; a is costant, bj is the sensitivity of profitability to jth explanatory variable; Xitk is kth explanatory variable of ith bank at the year of t; and uit is the error. (Das, 1999; Anderson, and Hsiao, 1982; Arellano and Bond, 1991; Arellano and Bover, 1995; Baltagi, 2001; Sampling Design and data collection method: For finding out the important determinants of profitability of Indian commercial banks, the present study will take into account 75 commercial banks. The period for which the analysis will be done is 2002-2007. The study will follow the method of stratified sampling to ensure that all the three categories of banks do get included into the analysis. But one thing the sampling method should take into account that only those banks will be considered for purpose of study which had the existence during the period of 2001-2007. The study will make a panel data after selection of the banks. The profitability of 75 banks will be analysed over a period of 7 years. For data, the study will use secondary source of data. The study will use those data which are published by R.B.I (Reserve Bank of India) yearly. 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Determinants of profitability of SBI Group, Other Nationalized & Foreign Banks in India. In Banking & Financial Sector Reforms in India, ed Amlesh Banerjee & S. K. Singh, 1999, New Delhi :Deep & Deep. Read More