Determinants Of Firm Profitability

Contents

TOC o “1-3” h z u HYPERLINK l “_Toc376111657” Models of Firm Profitability PAGEREF _Toc376111657 h 3

HYPERLINK l “_Toc376111658” Factors Determining Profitability of Commercial Banks PAGEREF _Toc376111658 h 5

HYPERLINK l “_Toc376111659” Internal Determinants of Bank Profitability PAGEREF _Toc376111659 h 5

HYPERLINK l “_Toc376111660” Financial Statement Variables PAGEREF _Toc376111660 h 6

HYPERLINK l “_Toc376111661” Composition of Loans and Cost Measurements PAGEREF _Toc376111661 h 7

HYPERLINK l “_Toc376111662” Measure of Profitability PAGEREF _Toc376111662 h 12

HYPERLINK l “_Toc376111663” Internal Factors that Determine of Profits of Banks PAGEREF _Toc376111663 h 12

HYPERLINK l “_Toc376111664” Macroeconomic Determinants PAGEREF _Toc376111664 h 13

HYPERLINK l “_Toc376111665” Structural Determinants PAGEREF _Toc376111665 h 13

Executive Summary

Companies operate in a dynamic environment that is full of many challenges. Although most industries are characterized by free entry and exit, the level of competition and changing consumer tastes and preferences demand that firms should establish competitive advantages in order to remain in business. As studies have reported, the motive of companies is to maximize profits. This study will analyze factors that determine the profit realized by companies. The study will use the structure conduct model and the effect model has on profitability of companies. Using unbalanced panel data collected from the Bank of England and HSBC, the survey concluded that the internal variables such as efficiency and bank deposits and the economic growth affect the profitability of banks positively. Other variables such as concentration could affect the profits negatively.

Introduction

The objective of the paper is to establish the factors that determine the profits realized by different organization. Profits are important because they determine the going concern of organizations. The structure conduct model and the effect models will be analyzed with regard to their effect on profitability of companies. The SCP model argues that the profits realized by commercial banks are determined by the level of concentration in the industry, which in turn determines the behavior exhibited by competitors. On its part, the effect model argues that features of the firm such the level of efficiency, the structure of an organization and the management style depicted by an organization determine the differences in profitability exhibited among different companies. Other studies conducted on the issue revealed that profitability of commercial banks could be determined by several factors some of which are internal, within the organization while others originate from the external environment of the organization. Commercial banks operate in the financial industry and in the service sector where efficiency of the provided services is of significance with regard to the revenue generated by the bank. This study will analyze factors that determine profitability of commercial banks operating in different countries in Europe.

Objective: The study has the objective of investigating and analyzing the factors that determine the profits of commercial banks in Europe. In relation to this, the paper will seek to answer the question: what are the determinants of profitability among commercial banks in European countries?

Review of Literature

This section reviews the previous studies on the factors that determine the profits realized by different companies in different industries. According to Slade (294), companies aim at maximizing their income by minimizing the costs incurred in production. Minimizing the costs is determined by several factors some of which include application of the relevant strategies and making efficient decisions regarding cost minimization (Stiewald 6). Therefore, the strategies require application of good decisions by the management of firms. On the contrary, the decisions made by companies are based on the resolution made by competitors in similar industries. For instance, a decision to reduce the price of a commodity by a competitor could negatively affect the substitute products of an organization (Coelli 67). Therefore, it may be forced to reduce the price or base its products on its quality and other competitive advantages.

Models of Firm ProfitabilityTwo common models of profitability applied by different corporation operating in different industries are the effect model and the structure-conduct performance (SCP). According to Coelli, the SCP model postulates that the behavior of companies with regard to their operations and other aspects in the industry determines the profits realized by such companies. On the contrary, the firm effect model argues that the structure depicted by companies is an outcome of firm distribution in an industry and the profits realized by the companies. The neoclassical theory asserts that organizations that operate in industries that are highly concentrated are more profitable than organizations operating in industries that are not concentrated. The reason for the profitability of such firms is that high industry concentration enables companies to exert market power as could be seen in pricing strategies of monopolies. Companies can collude in an industry and impose higher mark-up on products that have lower elasticity of demand without losing demand to other competitors in the industry.

An increase in the prices allows companies to earn profit that are higher than their competitors. A study conducted by Coelli established that sub-optimal levels of welfare are associated with concentration of industries and high profits because the quantity of products supplied is restricted.

The firm effect model assumes that organizations operating in the industry are heterogeneous. Similarly, the superior firm hypothesis distinguishes organizations based on their costs incurred in production or productivity efficiency. Therefore, organizations that merge profitable have competitive advantage over their competitors in the industry. Low costs of production could be used to ensure that firms attain cost efficiency. This could also be an outcome of applying economies of scale or using high quality products. Demesetz model postulates that an organization is likely to maintain a superior performance in terms of profitability due to the character of the organization, complex organizational structure, heterogeneity of resources, mobility of factors of production and uncertainty in company investments. A study conducted by Coelli stated that only companies that are competitive survive by staying longer in the market (34). They could also grow and increase their market shares. Consequently, such organizations realize more profits as compared to non-efficient competitors.

A study conducted by Marin (60) established that markets with high concentration characterized by high market shares and high profits of companies occur simultaneously. These factors are responsible for differences in productivity of companies. The competitiveness in the market is one of the features of markets. Under such circumstances, no collusion among companies can restrict supply or enable organizations to increase the prices charged above marginal costs. Therefore, high profits realized by companies are not necessarily associated with losses in welfare arising from the effect models. Evidence of empirical research reveals that the SCP and the effect models are plausible. Therefore, effects such as concentration and barriers to entry, differences in productivity, and strategic management are significant in determination of firm profitability. Similarly, Marin (56) notes that firm level and industry specific factors named above are dominant in determination of profits realized by organizations.

Factors Determining Profitability of Commercial BanksCommercial banks operate in the financial sector and the factors that determine their profitability could be divided into two categories. According to Marin (59), profitability of commercial banks is determined by internal and external factors. Internal factors relate to the internal organization and operations within the firm. The management of the bank controls such activities and factors and they could include variables that relate to financial statements and non-financial statement variables. On their part, external determinants of bank profitability are beyond the direct control of the administration of the bank and they include financial deregulation, impact of competitive forces in the market, concentration, market share, ownership and scarcity of capital and inflation.

Internal Determinants of Bank ProfitabilityAccording to Marin (63), internal factors determining profitability of banks are controllable by the management of commercial banks. Such factors account for inter-firm differences in profits realized by commercial banks. The broad categories are variables related to financial reports and those that are not related to the financial statements of the companies. Internal factors relate to decisions made by the management of the banks in relation to items on the balance sheet and income reports.

Financial Statement VariablesBourke et al. (1990) posit that these variables affecting the profits of the companies relate to the balance sheet of the bank and the statement of income. Given that the balance sheet is related to the assets and liabilities of commercial banks, their management is significant to the profits realized by commercial banks. Management of assets in banks is related to making portfolio-related decisions that attempt to maximize the income realized on portfolios thereby enhancing the liquidity of banks. Coelli (71) noted that the liability of managing bank assets is concerned with making decisions that are related to the deposit mix, borrowing and significant capital that meets the objectives of the minimizing costs of funding while attaining the aspired fund stability. Therefore, the decision regarding the liability of assets would definitely affect the profits realized by commercial banks.

Coelli studied profitability factors among different organizations in Korea and reported that the profit and loss of companies is closely related management of incomes and expenses, hence the management of costs in companies. Coelli reports that managing the sensitivity of interest rates and the margins, and allocation of expenses safely determines the level of profitability realized by commercial banks. A study conducted by Coelli (77) on profitability of banks measured the existing relationship between items contained on the balance and the profit and loss of 300 different banks in the United States. After using the net current operating income and net profit realized before taxation, they found out that changes that were realized on the portfolios of assets and liabilities had positively affected earnings realized by banks. Assets resulted in a positive effect while liability items that included demand, time, and deposit savings made contrary effects.

Differences in the management depicted by a bank could also affect the profits realized by the bank. Slade (104) affirms that banks differ in terms of management objectives, policies, decisions made and actions undertaken by the bank. These features differentiate the operating relationship and profits realized by banks. The operating relationship could be determined by operating ratios that cover the overall profitability of the banks fund-source measures, measures of fund-use and measures of expenses.

Marin (76) studied the profits in relation to the ability to manage expenses. He established that improvement of profits by banks requires effective management of expenses, fund-sources uses of funds within the bank. In order to manage these aspects effectively, bank managers manage gross returns on loans, securities, analyze capital ratios, the interest that is paid on time savings and deposits and the proportion of loans among other factors. The costs incurred by banks in relation to operations are related to utility of physical factors and services. The ability to control the expenses makes the measure an internal measure that determines the profits of companies. Although the studies stipulate these masseurs as effective in determining profitability, Stiewald (78) criticized them by arguing that they failed to include a theoretical construct that relates the expenses of banks and the earnings realized by banks.

Composition of Loans and Cost MeasurementsJensen and Meckling note that the composition of loans comprises of four different ratios, those of commercial and industrial loans, real estate loans, consumer loans and loans from the agricultural sector. Initial research on the performance of commercial banks was initially focused on the structure of banks and the level of competition as the determinants of their performance. However, studies kept on advancing in their variables and included efficiency of commercial banks. Today, researchers compare between banks as well as countries with regard to the performance of commercial banks. Among earlier researcher on bank profitability were Short and Bourke. They noted that survival of banks depends on the profit generated, thereby meaning that profit serves a significant role for existence of commercial banks. Existing literature on the factors affecting profits of commercial banks have delved on internal and external factors. Internal factors include the factors that are under the control of the administration of the bank while external factors are embedded in the macroeconomic environment.

Guru et al. (24) and Hassan and Bashir (56) studied the profitability of commercial banks and found out that bank specific factors, financial structure and macroeconomic variables are responsible for the profits realized by banks. Ali et al. (75) examined the profit indicators in public and private banks in Pakistan and reported that the profits of commercial banks was affected by the size of the bank, the operating efficiency of the bank and the ability to manage the assets effectively. They also reported that the profit realized by commercial banks is negatively related to capital and credit risks. Using return on assets and the GDP as an external factor, they concluded that constructive relationship between the profits of the bank and the variables exists. On the contrary, they reported existence of a negative relationship between inflation and return on assets of banks.

Wasiuzzaman and Tarmizi (23) also conducted a study on the effect of bank-specific factors and macroeconomic determinants in the performance of commercial Islamic banks especially with regard to their profits. Their study was conducted in Malaysia between 2005 and 2008. Their findings affirm that the quality of capital and assets of banks have an inverse relationship with the profit of banks. Moreover, liquidity and operational efficiency of commercial banks positively affect commercial banks’ profits. The findings of their study were similar to those of earlier studies that noted that the performance of the economy in terms of the GDP positively affects the profits of commercial banks. A related study was conducted by El Biesi (72) to establish the impacts of selected macroeconomic factors, the macroeconomic environment and specific internal factors on the profits realized by foreign banks in Middle East and North African countries. Their data set comprised of 71 foreign banks. They outcomes concluded that the significant factors that affect the profit realized by banks at the bank level are the capital, income levels and liquidity levels. At the industry level, the study found out that capitalization of the stock market and income per capita are significant determinants of the profits of commercial banks. The study further revealed that the concentration level of the industry and the volumes of stock traded in the stock market are insignificant in relation to the profit of commercial banks. According to Sufian (103) who investigated the level of efficiency in 15 Malaysian banks, domestic Islamic banks higher technical efficiency as compared to other foreign commercial banks. However, it is clear that foreign Islamic Banks were more effective in establishing their costs.

Some previous studies focused on the differences in profitability between domestic and foreign banks. Elyor (43) who compared the profits of domestic and foreign banks that operated in Malaysia conducted one such study. Study reported although foreign banks have a strong capital, domestic banks are more profitable. However, Alyor’s study did not examine the differences in the determinants of profitability between domestic and foreign banks. Another study that was conducted on a similar issue of profits differences between domestic and foreign banks reported contrary findings. They study that was conducted by Azam and Siddiqu (86) reported that foreign banks realized higher profits than domestic banks. Similarly, the study reported that determinants of profitability among domestic and foreign banks have some slight differences. The findings indicated that some factors determining profits in domestic banks do not matter for foreign banks.

Fotios and Kyriak (102) studied the 584 commercial and domestic banks in 15 European countries regarding the impacts that bank specific, macroeconomic conditions and financial structure affected profitability. The study was conducted between 1995 and 2001. The findings indicated that liquidity of the bank is important and therefore positively related to the profit realized by domestic banks. However, the study reported that liquidity was negatively related to the profitability of foreign banks. The results indicate differences in the existing association between the level of concentration in the banking industry and realized profits for domestic and foreign banks. Further results pointed to the correlation between the GDP and inflation rate and the profits of domestic commercial banks. On the contrary, the two variables show negative impacts on profitability of foreign banks. Another study by Awdeh (89) in Lebanon established that foreign banks realized higher profit levels than all domestic banks although they operated in the same market. The researchers concluded that macroeconomic factors have a small impact on foreign banks as compared to domestic banks.

Research Methods

The data for bank specific variables were collected from the bank of England and the HSBC bank operating in the United Kingdom. The data was collected from online databases on macroeconomic variable in UK. The study uses unbalanced panel for a period of five years beginning the first 2008 – 2012. The data was regressed using E-views. The generalized least squares technique with the unbalanced panel data has been applied in analyzing the cross sectional data on the variables. Two estimation models will be used with the first model indicating the relationship between the profit of banks and external factors while the second depicts internal factors.

Model 1

ROE = α0 + β1 OHTA + β2 LOTA + β3 DTA + β4 GDPGR + β5 GDPPC + β6CONC + ε

Where: ROE represents the dependent variable that indicates the profitability of the banks, OHTA represents the overhead expenditure over total assets, and LOTA represents the Loans (financing) over Total Assets. DTA represents the Deposits over Total Assets, GDPGR represents the Gross Domestic Product of the UK economy, GDPPC represents the Gross Domestic Product Per Capita of UK

CONC represents the Concentration Ratio in the banking industry

α is intercept, β is regression coefficient and, ε is an error term.

Model 2

ROE = α0 + β1 CRTA + β2 LATA + β3 TE + β4 INF + β5 LOGTA+β6 LOGAGE + Β7 GFC + ε

Where:

ROE represents the dependent variable that indicates the profits realized by banks.

Independent variables include CRTA, which is Capital and Reserves over Total Assets, LATA, the Liquid over Total Assets, technical Efficiency (TE), Annual Inflation Rate (INF), Bank Size (LOGTA), Bank Age (LOGAGE) and Global Financial Crisis (GFC). α is intercept, β is regression coefficient and, ε is an error term.

Measure of ProfitabilityThe profit of commercial banks involves the use of many ratios such as the return on equity, deposits, the interest margin and the profit margin. Given the measures used in previous studies, this study will also use ROE as the measure for profitability. The return on equity does not only determine the profit realized by banks, but it also determines the level of efficiency and effectiveness in managing the investments made by investors. The study calculates the ROE as net income realized after tax and divided by the equity of shareholders.

Internal Factors that Determine of Profits of BanksCapital and reserves is one of the internal factors that can be manipulated by the bank. Capital reserves to total losses were included in the model because it identifies the capitalization and the capability of the bank to overcome its losses using the funds from shareholders. Overhead expenses have been included in the model because it involves expenses necessary to the continued functioning of the banks. Indicated in the model as OHTA, it is obtained through the division of personnel and overhead expenses using total assets. Based on literature, reduction of expenses improves the profit of the bank as it raises profits, hence the existence of a negative relationship with profits. The loans ratio represented in the model as LOAT is used to establish the component of income that is attributed to the quality of management in the bank. It is computed as total loans over total assets. It is expected that the loans given out by banks would generate profits, hence implying correlation between the two variables.

Deposits made by customers are considered the significant funding source for banks and it helps banks generate income. The liquidity ratio (LATA) estimates the extent that banks are able to fund their operations using current assets especially to meet the withdrawal demand. A high liquidity ratio indicates excess liquidity for banks hence low profits. The technical efficiency indicates the ability of the commercial banks to reduce their input given targeted output. Technical efficiency is measured using data envelopment analysis that was developed by Alper and Anbar (145).

Macroeconomic DeterminantsInflation is one of the common external factors and is defined general increase in prices of commodities in an economy. High inflation increases living costs. Its negative effect on profitability could be realized if wages increase faster than inflation. The GDP measures the level of economic growth thereby reflecting the economic conditions in the country. Economic growth means a good economic climate for commercial banks. Therefore, economic growth results in improved economic conditions hence profits of commercial banks.

Structural Determinants

Bank size (LOGTA) is a significant determinant of profits of banks because of the industrial economic theory that postulates that large firms in an industry realize economies of scale that end up minimizing costs and increasing profits. The age of the bank (LOGAGE) indicates the period the bank has been in business. The variable is included in order to determine the relationship between age and bank profit. The level of concentration was included because the structure conduct model postulates that high levels of concentration in an industry minimizes the chances of collusion between firms hence resulting to higher profits. GFC is another external factor that is included as a dummy.

Results

Regression Results are indicated in table 1 in the appendix.

Findings

The regression output in table 1 in the appendix indicates that total assets negatively affects ROE hence profitability of the Bank of England and HSBC bank. This means that the profitability of a bank increases if the bank is able to manage its costs. Therefore, total assets significantly determine the profits of commercial banks as supported by Ramadan et al. (78). The loans ratio as used in the model has a statistically significant positive effect on the return on equity of the bank of England and HSBC. This implies that banks play a significant intermediary role between borrowers and lenders thereby emphasizing the fact that it is possible to transform more deposits into loans, which eventually increases the profits of banks. Awdeh supports these findings as he reported a positive relationship between loans of the bank and deposits (76). The deposits ratio has a significant effect on the profitability of banks because more deposits improve ROE.

Regression results on macroeconomic variables indicate that the GDP has a significant positive effect on the ROE and profit realized by banks. Another macroeconomic factor is the per capita income that was established to have a significantly unconstructive association with ROE of the Bank of England. Therefore, the variable has a negative effect on the profits realized by commercial banks. Results on structural variables indicate that the level of concentration in the banking industry has no impact on the ROE of the banks. This means that the results are not in line with the structure-conduct-performance model. Therefore, the level of concentration in the banking industry positively affects the profits of commercial banks. Choong et al. (121) who established that concentration positively affects the performance of Malaysian commercial banks supported the findings.

Total assets have a negative and significant impact on ROE. Liquidity has an insignificant relationship with profitability of banks indicated by ROE. These results are against the expected findings and could be explained by the financial crisis that affected many banks during the period. Technical efficiency on its part is statistically significant and improves the profits realized by commercial banks. Higher efficiency of banks is consistent with high profits realized by banks. Therefore, efficiency of commercial banks realized in effective management of bank operations positively affects the bank revenue and therefore the profit realized. Other macroeconomic variables such as inflation and the bank size negatively and positively affect bank profits respectively. On a similar note, the age of the bank and the economic conditions such as a financial crisis negatively affect the profits realized by commercial banks.

Conclusion

This study examined the factors that affect profitability of commercial banks. The study analyzed both external and internal factors affecting profits of the Bank of England and HSBC. Using unbalanced panel data and regression analysis of two models, the study established that different factors affect the profits of commercial banks in different ways. While some factors such as deposits, efficiency of bank assets and the economic growth positively affected the profitability of banks, other factors such as inflation, concentration, and age of the bank negatively affects the profit realized by the bank.

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