Report on Theories of bank profitability- One of the crucial components of the financial systems

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Theories of bank profitability

One of the crucial components of the financial systems and the economy are the commercial banks. In the recent years, commercial banks have contributed to a great extent in the financial development of the economy of the region. Banks are responsible for allocation of funds to the organizations and individuals who need them. They deposit the funds of the organizations and individuals who have them in excess. Hence, they are responsible for mobilization of funds. Financial performance of the banks affects the capital allocation, expansion of the firms, economic growth of the industries and development of the economy. Profitability of the banks affects not only the commercial banks but it has its impact on the macroeconomic level. In presence of the current environment the profits fetched by the banks reflect their financial performance. Banks come in stable state and they fetch high profits in case of maintainence of the profitability index of the commercial banks (Goddard et al., 2004). Hence, profitability becomes the important part of the performance of the banks which affects many sectors. Hence, factors influencing the performance of the banks in financial sector have grabbed the attention of the many research scholars, bank supervisors and financial markets. Scholars began conducting research on the performance of the banks between 1970 and 1980. They applied two models named as efficient structure theory and market power theory (Athanasoglou et al., 2006).

Another theory which is known as balanced portfolio theory helps in determining profits fetched by banks. It has also been used in the study of the profitability of banks.(Nzongang and Atemnkeng, 2006). The performance of the banks is affected by the market structure of the industry stated by market power theory which was given by Tregenna (2009). The SCP and the RMP theoram are the two different approaches of the market power theory. SCP approach states that banks in high concentration market have more potential to raise profits than firms in low concentration market as banks have the chance to get deposits at lower interest rates and allocate loans at higher interest rates due to the presence of monopolistic environment (Tregenna, 2009). The RMP approach states that profits fetched by the banks are affected by their shares in market. This approach makes an assumption that the banks which have differentiated products can be price makers and experience more power in the market (Tregenna, 2009).

Another theory which is known as efficiency theory states that banks are more efficient than other hence, they earn more profits. This theory also possesses two different approaches named as Scale efficiency hypothesis and X efficiency. X efficiency states that efficient firms have lower cost hence, they are more profitable than others. On the other hand, approach of Scale efficiency focuses on high scale production and ignores any differences in management and technology of production. Large firms have benefit of economies of scale which leads to low per unit cost of product and high profits for the firms. Hence, they have high market share which leads to higher profits (Athanasoglou et al., 2006). Balanced portfolio theory also plays a vital role in the study of performance of the banks. (Nzongang and Atemnkeng,2006).This theory states that decisions regarding the policy affect the optimal presence of each asset in the investment of shareholder. These decisions are affected by a number of factors such as rate of return, size of the portfolio and risks associated with the holding of each asset. High profits can be achieved by possible set of liabilities and assets which are recognized by management and expenses incurred by banks.. The performance of the banks is also affected by signaling, balance sheet ratio, bankruptcy costs and risk return trade off. Hence, equity to asset ratio also plays a important function in determining the performance of the banks.

Modigliani & Miller (1958) theory states that capital structure of the bank is not affected by the market value of the bank. According to financing theory, high levels of debt and low value of equity to asset ratio results in high risk which results in high rates of return. This also explains the risk return trade off theory (Van Ommeren, 2011). Some scholars have also explained that higher profits can be fetched by high equity to asset ratio. According to Berger, these explanations are consequence of application of signaling and bankruptcy costs hypothesis. Market value of the bank increases with high equity ratio according to signaling hypothesis (Berger, 1995). On the other hand, bankruptcy cost hypothesis states that banks hold high equity as a result of unexpectedly high bankruptcy costs to avoid financial debt (Berger, 1995).

2.1.2 Factors affecting profitability of bank


The factors influencing the profits of banks can be divided into two parts named as the internal determinants and external determinants. Investment in stocks, liquidity, overhead expenditure and loans are the factors internal to firm which can be controlled by the management of the firm. Total capital, savings, current account deposits, capital reserves, supply of money and current account savings also influence the profits of the banks. The external factors affecting the profitability like interest rate, market share,market growth and inflation rate are beyond the control of management.

Capital adequacy (CA)

Financial strength of the bank can be measured by the availability of capital in it. Banks can manage unforeseen losses if they have adequate capital available with them. Adequacy of capital determines the financial soundness of the bank and lowers the chances of failure of the bank (Kumar and Thamilselvan, 2014). Bandara (2015) had conducted a study in Sri Lanka and discovered that there exists a direct relation between the adequacy of capital ratio and return on average equity but there is no relation between adequacy of capital ratio and return  fetched on assets. According to Swarnapali (2014) capital adequacy ratio negatively affects the profitability of bank. There exists a direct relation between the adequacy of capital ratio and profits of the commercial banks of Sri Lanka according to the studies carries out in other countries (Rao and Lakew (2012), Obamuyi (2013), Flamini. (2009), Nouaili (2015).

Bank size (BS)

Generally, size of a firm is measured using its total assets.

Amount of total assets held by a firm determines its size. According to Yong and Floros, (2012) and Staikouras and Wood, (2003) size of the firm affects its profitability in a negative manner. Ayanda et al., (2013) conducted a study in Nigeria and discovered that size of the firm plays a crucial role in determining its profitability. Weerasinghe and Perera (2013), Madhushani and wellappuli (2016), Sufian and Chong (2008) and Deger and Adem (2011) stated that there  is a direct relation between the size of the firm and amount of profits earned by it. Alice Gatete (2015) conducted a study in Kenya and revealed that size of the firm affect its profits to a great extent.

Nonperforming Loans (NPL)


Non-performing loans are the type of loans in which borrower does not pay any interest or principal for more than 90 days. Akter and Roy (2017), Kaaya and Pastory (2013) and Kirui (2014) stated that non-performing loans puts a negative effect on the profits of the bank. They lower the amount of profits fetched by the banks. Rathnasiri (2016) conducted a study on relation to non-performing loans and profits of banks at Sri Lanka. He discovered that higher the proportion of non-performing loans in commercial bank, lower will be its profitability. Sujeewa (2015) also conducted a study in Sri Lanka to find the relation between profits and non-performing loans and discovered that non-performing loans adversely affects the profitability of banks in a negative way.

Managerial efficiency (ME)

Efficiency of managers is reflected by the amount of deposits incurred by the bank from its customers. Higher the amount of deposits, higher is the managerial efficiency. If there is improve in the efficiency of the managers then, it will result in higher amount of profits and lower amount of costs for the bank. The efficiency of the employees of the bank can be measured by the ratio of average cost incurred and profits fetched from employee. There should be lower cost incurrence on employee and higher profits should be generated from the employee in order to enhance profits. Some researchers stated that managerial efficiency should be considered as one of the internal factors for the banks. Senarath (2015) also conducted a study in Sri Lanka and discovered that there is a direct relation between the managerial efficiency and profits of the banks.

Assets quality (AQ)


Amount of credit risk with loan and investment portfolio is known as asset quality. Asset quality of the bank and loan risk management helps in effective supervision of the banks. (Abata,2014). Adhikary (2006) stated that bankruptcy can occur in banks if asset quality of the bank is low. This also leads to slowdown of the economy. Abata (2014), Bace (2016), Ozurumba (2016), Ongore and Kusa (2013) and Duraj and Moci (2015) surmised that poor asset quality lowers the profitability of bank and put impact on financial performance of the bank.

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