DETERMINANTS OF PROFITABILITY OF SRI LANKAN COMMERCIAL BANKS

Transcription

1 DETERMINANTS OF PROFITABILITY OF SRI LANKAN COMMERCIAL BANKS mov I WW.Ilo ii 1 F."10v luv ii :I J7I THESIS SUBMITTED TO THE UNIVERSITY OF SRI JAYAWARDANAPURA IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN MANAGEMENT (FINANCE) ON

2 The work described in this thesis was carried out by me under the supervision of Professor Y.K. Weerakoon Banda and a report on this has not been submitted in whole or in part to any university or any other institution for another Degree/Diploma. PADhand' kabandar.

3 I certify that the above statement made by the candidate is true and that this thesis is suitable for submission to the University for the purpose of evaluation. Professor Y.K. Weerakoon Banda!. ). 7kv1 Date

4 Table of Contents Page No Chapter 1: Introduction Background Research Problem Objectives of the study Significance of the study Limitations Chapterisation 05 Chapter 2: Literature review Introduction Bank Specific and Macroeconomic variables Bank specific determinant Cost to Income Ratio Capital Adequacy Credit risk management Bank size 20

5 Liquidity Macroeconomic Indicator variables Inflation Growth in GDP Growth in Money Supply Variable selected for the current study 30 Chapter 3: Analytical Frame work Introduction Sample and Data Statistical Model used in the study Dependent Variables Return on average assets Return on average equity Net interest margin Independent variables used in the study Cost to Income Ratio Size of Bank Loan Loss Provision 37 ii

6 3.5.4 Loans to Deposit Ratio Capital Adequacy Ratio Macroeconomic variables Inflation Growth in money supply Growth in Gross Domestic products Research Hypothesis Variables and their hypothecated relationship 41 Chapter 4: Analysis of Data Introduction Descriptive Statistic Correlation Analysis Results of Correlation Analysis Results of Regression Analysis ROAE Model 49 4,4.2 NIM Model ROAA Model 53

7 Chapter 5: Conclusion Introduction Conclusion Suggestion for Further research 60 References 61

8 List of Tables Page Variables and their hypothecated relationship 41 Descriptive statistics 44 Correlation Analysis 45 Regression result- ROAE model 49 Regression result- NIM model 51 Regression result - ROAA model 53 V

9 Acknowledgements I wish to place my heartfelt gratitude to Professor Y.K. Weerakoon Banda for his unstinted guidance, assistance and courage given to me throughout the preparation of the thesis. And also I fail in my duty if I do not mention the guidance provided by Dr. P.J.Kumarasinghe. vi

10 LIST OF ABBREVIATIONS LLP Loan Loss Provision LDR Loan to Deposit Ratio CIR Cost to Income Ratio CAR Capital Adequacy Ratio GDP Gross Domestic Production MS Money Supply INF Inflation CBSL Central Bank of Sri Lanka NIM Net Interest Margin ROAA Return On Average Assets ROAE Return On Average Equity VII

11 Determinants of profitability of Sri Lanka Commercial Banks By P.A. Dhammika Bandara ABSTRACT This paper investigates the magnitude of the impact of the bank specific determinants and macroeconomic indicators, on the profitability of Sri Lankan commercial banks. Financial data from eight commercial banks have been taken into in carrying out the study, representing both private sector and state sector. The period involved in the study is from 2001 to Three profitability measures namely return on average assets, return on average equity and net interest margin are included to make results more comprehensive. The independent variables employed are cost to income ratio, capital adequacy ratio, loan to deposit ratio, loan loss provision and size of the bank which are bank specific determinants. Other independent variables are year to year growth in gross domestic product, inflation and growth in money supply which cannot be controlled by the banks. Cross sectional regression analysis has been used to find out the independent variables which are statistically significant in explaining the three profitability measures. Statistical models have been designed to test the bank specific determinants separately as a first step and bank specific determinants under the influence of three macroeconomic indicators as the second step. Cost to income ratio was found to be significant in explaining the profitability or the banks. Loan loss provision and growth of money supply have also been proved to be significant in explaining the profitability of banks.

12 CHAPTER 1 INTRODUCTION 1.1.Background Financial industry is the backbone of any country's economy. Sri Lanka being country with large number small and mediuni industries (SMIs) financial intermediation is more significant. With the liberalized economic policies, private sectors' involvement in the economy was made more prominent. Mostly the new breed of entrepreneurs found it difficult to raise capital on their own. Surge in the economy created a sound demand for lending.consequent to the economic reforms in late nineteen seventies more players entered the financial industry hitherto dominated by the two state commercial banks. As a result of the upward revision of interest rates on deposits more funds flowed into commercial banks, making them strengthening in lending. With the entry of new commercial banks including foreign banks, market share of dominant players were dwindling, affecting their degree of profitability. Globally banking as an industry has been very competitive and innovative. As a result, the banking industry underwent tremendous technological advancement. Sri Lankan banking industry has been in the forefront among their Southeast Asian counterparts, in adopting these innovations. Performance of the banking industry got more prominent to face the growing level of competition. 1

13 In the light of increased global trend of disintermediation, and its influence on the banking Industry in Sri Lanka, profitability has attracted the interest of academics, management of banks and regulators. Regulator's role has also earned more prominence both locally and globally in light of negative shocks experienced by banks. The regulatory framework itself has introduced the Integrated Risk Approach assisting the sustainability of profitability of commercial banks. The directions given by the regulator will ensure to keep the pace of economy of the country at a sound level by making commercial banks more strengthened. This paper is leveled at the investigation of determinants of profitability of commercial banks. 1.2 Research Problem Profitability of the commercial banks is imperative for the very existence and to progress. Any commercial bank's strength will rest on the pillars of the deposits of the customers and funds of the shareholders or debenture holders. Raising money from all these sources will depend on the confidence of all stakeholders placed on the bank. Profit is the most basic economic indicator which will drive the investors. Academics around the world have carried out plenty of studies on the determinants of profitability of commercial banks. Very little focus has been shed on the determinants of profitability and the magnitude of its impact in Sri Lanka. The available literature on the determinants of profitability of banks in Sri Lanka has only tested return on assets (ROA) in FA

14 assessing the profitability. Current study aims to add two more profitability measures in addition to ROA, the one and only tested by another study, in view of deeper analysis of profitability. Profitability measures both return on average equity (ROAE) and net interest margin (NIM) are. tested in the current study. Focus on NIM is vital in the banking industry, since it isolate the performance of its core business of accepting deposits and lending. Therefore the current study intends to expand the available knowledge on the financial industry in Sri Lanka particularly in the context of the core business of commercial banking. In view of the above factors our object is to find out the determinants of the profitability of commercial banks which will fill the gap in the existing literature and improve the understanding of the determinants of bank profitability. 1.3 Objective of the study Objective of the study is to measure the magnitude of the effect of bank specific and selected macroeconomic indicators on the profitability of commercial banks in Sri Lanka. Bank specific determinants comprise cost to income ratio, capital adequacy, loan to deposits ratio, loan loss provision and the size of the bank. Macroeconomic indicators included are inflation, growth in gross domestic production, money supply. 3

15 1.4 Significance of the study Commercial banks of Sri Lanka collectively account for 48.9% of financial assets of the financial industry. Out of the balance assets Central bank of Sri Lanka holds 12.1%. The balance 39% is held jointly by all other financial institutions1. The niagnitude of the Commercial banking sector involvement in the country's economy is clear with the Central Bank published data. This investigation is aimed to appraise the applicability of profitability measure, net interest margin (NIM) in particular, which is vital to banking industry. The outcome of the investigation may assist the investors, regulator, and bank management in making their decisions. Virtual economic growth in the country is expected by a sound commercial banking sector which will augur well for the growth in gross domestic product of the country. 1.5 Limitations Branches of twelve foreign banks have been excluded from the study. Local commercial banks have also been excluded due to non availability of data during the whole period under consideration. Central Bank of Sri Lanka Annual Report 2014,page 178 4

16 1.6 Chapterisation The research is organized in the following structure. Chapter two reviews literature pertaining to profitability of commercial banking. Majority of articles are studies on banks abroad. Some of the studies are based on banks in a single country and some studies are cross country studies. Chapter three deals with analytical framework, of the investigation. This chapter includes selecting the variables, defining them, developing logical arguments and deriving hypothesis. Finally the justification of hypothesis undertaken and a rational model is developed. Chapter four is on regression analysis. Results of the regression for all six models are analyzed to find out the significance of the independent variables in explaining the dependent variables. Last chapter is conclusion. 5

17 CHAPTER 2 LITERITURE REVIEW 2.1 Introduction The literature review has assisted to ascertain the historical developments and the current trends of the profitability of the banking industry in the academic viewpoint. These facts have laid the foundation for the current research undertaken by the author. Most of the studies carried out have been based on banks in the developed countries. 1-lowever substantial amount of literature on the Asian region have also been reviewed in the study. The studies can be categorized into two groups. The first one is researches conducted on banks domiciled in a particular countly and the second one is banks in various regions of the world. 2.2 Bank specific and macroeconomic variables Reading through the researches on the determinants of commercial bank profitability, it is evident that the determinants of the bank profitability can be broadly categorized into two streams; the bank specific determinants and macroeconomic indicators. The bank specific variables are the areas that individual banks have control over to optimize the return on investment. The external determinants are the macro economic conditions under which the banks are compelled to operate. N.

18 2.2.1 Bank specific determinants Cost to income ratio Cost to income ratio is the total operational expenses as a percentage of the net income. The cost referred here excludes the interest cost incurred in respect of payment of interest to the depositors of money. And the provision charged on the profit on account for doubtful debts identified is also excluded in the expenses. Major element in the cost structure is the salaries of the employees. Weerasinghe and Perera(20 13) analyzed the determinants of profitability of Sri Lankan commercial banks. Efficiency ratio employed for the study had been the operational cost ratio. Basically the administrative cost and the personnel cost as a percentage of total assets had been taken into account. Operation cost had been statistically significant in explaining the determinants of profitability. David (1997) states cost to income ratio is superior to cost to assets ratio. The study is based on the cost to income ratio of Australian banking sector. David(] 997 ) further elaborates on the comparison of two ratios and argues that cost to income ratio shows less variation than cost to assets ratio. The author further justifies his argument, on the basis of the relationship between cost to income ratio and bank profitability. David further states that profitability by definition is the difference between income and cost, and a ratio that includes both of these must lead to a focus on profitability 7

19 On the basis of David's argument cost to income ratio has been considered for the Current study as the variable for efficiency. Kosmidou (2008) research on banks in Greece high ROAA was found to be associated with banks which have lower cost to income ratio. It was further evidenced that personnel expenses in the Greek banks are comparatively high when banks in other European countries were considered. It has been concluded that Greek banking system at the time of research to be overstaffed. Kosmidou(2008) further goes on explaining that the relationship between profits and expenditure is straight forward implying that higher expenses means lower profits and the opposite may not be always same. The reason being higher amount of expenses may be associated with higher volume and therefore higher revenues. In accordance with Kosmidou's thinking it is more appropriate to measure the efficiency in expense management relative to income. Badola and Verma (2007) based their study on the profitability of commercial banks in the public sector of India, subsequent to reforms in the banking industry. The period covered was 1991 to This period has specially been selected since India resorted to speedy reforms and liberalization in the early nineties. Efficiency level in this study is denoted by operating expenses (OE) and, business per employee (BPE). It was found that operating expenses have a significant relationship which is negative in explaining the profitability. Business per employee and profit per employee was Ihund to have a low explanatory power. The authors have further stressed the importance of maximizing the business per employee and per branch in the public sector banks in India. In this study operating expenses have E:I

20 been considered as a single number. Operating expenses in comparison with the income derived would have been a more realistic indicator. Because more expenses are encountered to enhance the turnover whereby a higher income is earned. Yong and Floros (2012) examined the profitability of banks in china which comprised five state owned banks, 12 joint stock commercial banks, and 84 city commercial banks. The period under consideration extended from 2003 to This period is said to be the final round of reform which focused on banking modernization and partial privatization. The cost efficiency in this study was proxied by the ratio of overhead expenses over total assets. Cost efficiency was significantly related to profitability in accordance with study. Total assets ratio includes non performing assets, so it will not give the exact value relevant to the year under review. Because some of the non performing assets, belong to a previous year. Tahir et al., (2012) researched on the cost inefficiency in ASEAN banking. Panel dataset of 625 banks in the ASEAN countries for the period from 2003 to 2008 have been used for the analysis. Panel data set consisted, commercial banks from 6 ASEAN countries, namely Indonesia. Malaysia, Singapore, Thailand and Vietnam. Banks in Singapore have the highest efficiency among all and stands at 80% followed by banks in Philippines (79%), Indonesia (73%) and closely by Thailand (72%), Vietnam (60%) and lastly Malaysia (45%). Further investigations have shown that banking industry in ASEAN was considered efficient after 2004, but the global economic crisis in 2008 has resulted in higher inefliciency score. The empirical results indicated that cost inefficiency is positively correlated with economic growth, indicating that economic growth contributes to lower cost efficiency. The

21 explanation is, when economic growth increases, the demand for bank loans from businesses and households increases, to finance investment and consumption, banks will have to raise more capital to fulfill this demand. Although the new capital is likely to be more costly during a period of high economic growth, banks can afford these costs because the cost can be easily offset by increasing revenue from the loans. In short, the bank behaviour drives the cost and increases the bank cost inefficiency. Berger and Mester (1997) focused their attention to study the difference in the efficiencies of financial institutions. The paper examined differences in the efficiency concept used, differences in measurements methods used to estimate efficiency within the context of these concepts and potential correlates of efficiency. The authors have employed three distinct economic efficiency concepts: cost, standard profit and alternative profit efficiencies. Consistent with the authors' expectation, they have found that measurement of each of the efficiency concepts does add some independent informational value. Further they have found the measures of profit efficiency were not positively correlated with cost efficiency. Kosmidou (2008) has found that the poor expense management of Greek banks has contributed for poor profitability performance. Study has further revealed that Greek banks operating expenses account for significantly higher percentage of their total assets than in other EU countries. Based on the Bank of Greece reports of 1998 and 1999, the author states that the reason for higher expenses percentage has been the inelastic nature of administrative 10

22 and personnel expenses. High ROAA was found be associated with lower cost to income ratio. Almost all the authors ofjournals mentioned under cost to income ratio have a similar view. That is, higher level of cost efficiency is desired for growth of banks. A reduction in the cost for certain amount of revenue leads to higher profitability. Over the years academics have focused their attention to find out efficiency of financial institutions. Inefficiency in the banking industry, lead to higher pricing of banking services.the pricing of a product is one of the main attraction in choice of buying. The more inefficient a financial institution, there is more likelihood to pass on the cost of inefficiency to the end user, the consumer. In a monopolist market the latter situation may exist in the long run. But in a competitive market, the inefficient banks will be out of business. The inefficiency can cost more than 20% of the total cost of financial institution in accordance with Berger and Mester(1997). Efficiency will affect the productivity, and without sound productivity, return on any investment will not be substantial. Productivity is how much output generated from the given input. Here efficiency should be treated as a comparative concept Capital adequacy Capital adequacy ratio (CAR) refers to the relationship between capital and risk weighted assets as defined in the framework developed by the Bank for International Settlements (B IS) and as modified by the Central Bank of Sri Lanka to suit local requirement. Capital act as a buffer for any bank against external shocks which are abundance in the global sphere of banking. 11

23 Ayanda et al., (2013) research has been conducted on the Nigerian banking industry using first Bank of Nigeria as a case study. Capital adequacy has been represented by the independent variable, equity as a ratio of total assets (EQTY/ TA). Profitability measures employed by the study comprised ROA and ROE. Capital adequacy has been significant in explaining ROE and NIM at 5% and 10% respectively. So the findings of the study revealed that capital adequacy is significantly related to profitability with a negative relationship. Vong and Chan (2009) study was focused on the determinants of bank profitability in Macau. The data set involved, covered a 15 year period from 1993 to 2007, with a sample of five different banks which account for about 75% of the total assets and a similar percentage of loans in the banking sector as at end of Capital adequacy was proxied by total equity divided by total assets (EQTA). EQTA variable showed a positive and significant impact in explaining the ROA. The author further states that equity capital is perceived to have more safety and such advantage could be translated into higher profitability. Shrimal et al., (2013) investigated the bank specific and other determinants of commercial bank profitability in selected South Asian countries (Bangaladesh, India. Pakistan and Sri Lanka) the sample comprised 119 domestic commercial banks over the period of 1992 to 2007 with 1539 bank-year observations. The ratio of equity to total assets has been used as the proxy for bank's capital strength (EQ). The equity capital level (EQ) was found to be significantly and positively associated with bank profitability. These results according to the authors substantiate the fact that well capitalized banks can source deposits and other funding at low cost and thereby increase their profits. 12

24 Athanasoglou et al., (2005) study has been based on a panel of Greek banks covering the period from A low level of liquidity has been stated in the study as one cause of bank failure. Equity to assets ratio (EA) has been used as proxy to capital. The capital refers to the amount of own funds available to support a bank's business and therefore bank's capital act as a safety net in case of adverse developments. Capital has been found significantly related to profitability which has a positive association. Staikouras and Wood (2003) have focused their research on profitability of European banks. In the study equity to assets ratio (EA) is included as a measure of the overall capital strength. The ratio is a measure of capital adequacy and should capture the general average safety and soundness of the financial institution. Further the study goes on to say a deterioration of the equity to assets ratio indicates either an increase in debt financing of bank's total assets(while holding total assets constant), or a decline in bank's total assets(while holding total equity constant), or both over time and space. This development is an increase in bank's risk and potentially, in bank's cost to capital. Equity to assets ratio has been found significant and has a positive relationship suggesting that banks with a greater level of equity are relatively more profitable. iavaid et al., (2011) analysis was to determine the internal factor analysis of profitability of top ten banks of Pakistan from 2004 to The capital ratio which is measured by total equity over total assets (TE/TA) reveals the capital adequacy and should capture the general safety and soundness of financial institution. It indicates the ability of a bank to absorb losses and handle risk exposure in accordance with the study. The results of the study 13

25 showed a significant impact by TE/TA on the ROA. In other words well capitalized banks have a higher return. Kosmidou (2008) investigated on prolits of banks in Greece during the period of European Union financial integration, it has been revealed that the ratio, equity to assets to have a significantly positive relationship with the banks performance. High ROAA was found to be associated with well capitalized banks. However it is not certain that the assets have been risk weighted in line with the BIS guidelines. Yong and Floros (2012) study evaluated the determinants of bank profitability in china. It examined the effects of inflation on bank profitability, while controlling for comprehensive bank specific and industry specific variables. The performance measurements employed were ROA and NIM. Higher liquidity of Chinese banks was found to be significant in explaining NIM. Liquidity in the study was denoted by loans to assets ratio. All the studies showed a positive relationship of capital adequacy have with profitability. Capital adequacy is a very stringent measure which is being closely monitored by the regulator, in the Sri Lankan context. The articles reviewed on the subject have shown the strength of the equity a bank acquires. For the purpose of the capital adequacy, even the debt can be raised by a bank, a predetermined rate of interest have to be paid to debt holders and the face value of the debt should be paid back on maturity. Equity raised by a bank is not subject to any interest; depending on the profitability level board of directors can declare a dividend. This proves the superiority of equity to debt. 14

26 Credit risk management Credit risk is basically borrower not honouring the contractual obligation on the due date. The lender may lose the capital amount lend, interest and unnecessary cost involved in recovery process. Mitigating the risk involved in lending is the management of credit risk. Chaudhry et al., (1995) investigation was on U.S. commercial banks in the 1970s and 1980s. Credit risk has been proxied by provision for loan losses as a ratio of total assets. The banks have been categorized to three difterent groups depending on their asset sizes. Provision for loan losses was found to be highly significant and generally proportional in all three categories. Authors have noted that the time period under consideration caught the banking industry in a major loan loss situations attributed to the heavy loan loss provision on, among other categories, third world debt. Suf Ian and Chong (2008) examined the determinants of profitability of banks in Philippines during the period 1990 to Loan loss provision divided by total loans (LLP/TL) signified the credit risk variable. LLP/TL was found to be statistically significant at I % and a negative relationship has been witnessed. The results have suggested that Philippine's banks with higher credit risk tend to exhibit lower profit levels. The empirical findings imply that Philippine's banks should focus more attention on credit risk management, which have proven to be problematic in the recent past. Serious banking issues have arisen from the failure of financial institutions to recognize impaired assets and create reserves for writing off these assets. The author further states that efforts to smooth these anomalies would be significantly aided by improving the transparency of financial system, which in 15

27 turn would assist financial institutions to evaluate the credit risk more effectively and to avoid issues associated with hazardous exposure. Khizer Ali et al., (2011) study was on the commercial banks both private and state in Pakistan. According to the author radical changes of banking have been observed in the banking sector of Pakistan over a phase of 62 years. Originally Pakistan banking sector underwent lack of capital and indecision due to established political and socio economic calamity, states the author. Ensuing amendments were made empowering state bank of Pakistan in 1956 which motivated private sector to set up financial institutions. From the year 1992 Pakistan has witnessed sweeping changes in the banking industry. The period covered under the study was 2006 to Credit risk has been significant and negative in explaining both ROA and ROE. Yong and Floros (2012) investigation was on banks in China and they found that credit risk is negatively related to ROA, but positively related to NIM. The coefficient of credit risk was statistically significant and had a negative relationship with profitability. Banks whose loans carry high risk will naturally have a more percentage of nonperforming assets. As a result a statutory provision is made for the latter bad doubtful debts which are charged to the profit and loss account. On the other hand high risk lending is priced high and will contribute more to net interest income (NIM). Kolapo et al., (2012) have examined the quantitative effect of credit risk on the performance of commercial banks in Nigeria over the period of 11 years ( ). Five commercial banks have been selected on cross sectional basis. The results showed that the 16

28 credit risk on bank performance measured by the Return on Assets of banks is cross sectional invariant. The effect was similar across banks in Nigeria, though the degree to which individual banks and are affected, was not captured by the method of analysis employed in the study. A 100 percent increase in non-performing loan reduces profitability (ROA) by about 6.2 percent, a 100 percent increase in loan loss provision also reduces profitability by about 0.65 percent, while a 100 percent increase in total loan and advances increase profitability by about 9.6 percent the author states. Based on the findings, it was recommended that banks in Nigeria should enhance their capacity in credit analysis and loan administration while the regulatory authority should pay more attention on banks' compliance to relevant prudential guidelines. Dong et al., (2012) paper reviewed and analyzed the Chinese loan loss provision system, then studied the relations of commercial bank loan loss provision and earning management through empirical study. This paper selected 14 domestic commercial banks from year 2001 to 2009 as data sample. The authors have concluded the study stating that the loan loss provision is charged to profit and loss account in years that will have excess profits and postponed charging the loan loss provision years with lesser amount of profits. Further the authors state that loan loss provision used as a tool of manipulating profits, so that uniform level of profitability is maintained right through years. In the Sri Lankan context the regulator is very particular on provisioning for bad and doubtful debts. During the annual supervision rounds, CBSL ensures the proper procedure is followed by all the banks. CBSL keep a tab on all the facilities which are about to be 17

29 classified as nonperforming. Figures used for the current study can be assumed as accurate since the regulator has a good control over all the commercial banks. Syeda and Rana (2012) aimed their investigation to find out the relationship of internal and external factors that affect the profitability of banks in Pakistan. A panel data of five years from 2005 to 2009 have been taken on quarterly basis for 11 banks in Pakistan. Credit risk was found to be positively related with profitability and was significant. Vong and Chan (2009) study based on the banks in Macau have appraised the asset quality as an independent variable in explaining the profitability. Asset quality for the purpose of this study has been defined as loan loss provision over total loans. Authors view that if a bank operates in more risky environment and lack expertise to control their lending operation, it would probably result in a higher loan loss provision. Hence loan loss provision to total loan ratio was expected to have a negative relationship with profitability. The results of the regression have showed a significant negative impact on banks' return on assets (ROA). The authors states that even though banks tend to be more profitable when they are able to undertake more lending activities, yet due to credit quality of lending portfolios and general practice in Macau, a higher level of provision is needed. Even for performing loans a I % provision is warranted by the regulator in addition to the provision for non-performing assets. So a high level of provision against the total loans in fact depresses banks' return on assets (ROA) significantly. 18

30 Jana Erina and Natalija Lace (2013) focused their study on the profitability of Latvian commercial banks. The Latvian banking system has evolved rapidly after regaining independence. During the first four years from 1991 until 1994 license were sought by 67 banks. Assets of the banking sector grew three fold from 1992 to As of the fourth quarter of 2011 banking services were provided by 22 banks and branches of 9 foreign banks. The period covered by the research was from 2006 to On the basis of obtained results authors concluded that credit risk has a negative effect on both ROA and ROE. Apart from the Seyda and Rana (2012) findings others agree with the concept of negative relationship credit risk has with profitability. Seyda and Rana (2012) argument is when the advances or credit risk is increased, the profitability of banks also increases. In accordance with Dong et al.,(2012) finding on Chinese banks the loan loss provision is used as a tool of manipulating profits, so that uniform level of profitability is maintained right through years. In the Sri Lankan context the regulator is very particular on provisioning for bad and doubtful debts. During the annual supervision rounds, CBSL ensures the proper procedure is followed by all the banks. CBSL keep a tab on all slow moving credit facilities. Figures used for the current study can be assumed as accurate since the regulator has a good control over all the commercial banks. One of the fundamental tasks involved in lending is the evaluation of the borrower or credit analysis. Depending on the banks risk appetite, it may decide whether to lend or not, 19

31 depending on the degree of risk involved. If it decides to lend, pricing would be set to compensate the risk undergone. Following up of the project or business is one of the integral duties of the lender. Any guidance relating to the financial matters of the business should also be addressed by the bank in minimizing their credit risk. Thirdly warning signal of any sickness of the company should also be monitored through the account or any other sources and immediate corrective measures should be taken. For the purpose of the current study we have measured credit risk, by loan loss provision as a percentage of total loans. For more accuracy and to protect the influence exerted during a particular year, only the provision charged to the current year has been taken for the ratio. In other words I have not taken the cumulative figure of loan loss provision Bank Size For the put-pose of this study total asset of individual bank has been taken as size of the bank. Sultan and Chong (2008) study was on Philippine banking industry over the period of 1990 to Bank size was found to be negatively related to profitability during the study. So it has been decided that negative coefficient indicates lower profits for asset wise larger banks. This finding support the view that economies of scope and scale for smaller banks and diseconomies of scale for larger banks. Ayanda et al., (2013) study on the Nigerian banking industry has found that the size of the bank does not have significant relationship with profitability. Authors further states that the

32 number of branches was inversely and insignificantly related to ROA, ROE and NIM. This indicates that banks in Nigeria have neither benefited from economies of scale or diseconomies of scale arising as a result of ownership of large assets and increasing branch network in the long run. Athanasoglou et al., (2005) investigation on banking industry of Greece for the period of 1985 to 2001 also have got results in line with the two previous studies of Ayanda et al., (2013) and Sufian and Chong (2008). Athanasolu et al., (2005) has found that bank size on profitability is not important. As the explanation authors say that small sized banks usually try to grow faster, even at the expense of their profitability. In addition, newly established banks are not profitable in their first few years of operation, as they place greater emphasis on increasing their market share, rather than on improving profitability. Authors further states that even if the size variable is removed from the estimations, the rest of the coefficients are not affected, which implies that the non-stationarity of this variable does not affect the performance model. Deger and Adem (2011) aimed their study on, the profitability of commercial banks during 2002 to 2010 in Turkey. Bank size showed a positive and significant relationship with profitability. It suggested that the larger banks have higher ROA and ROE. Also the positive and significant coefficient of asset size variable provided evidence for economies of scale theory. 21

33 Mirzaei (2011) investigation was on market power on stability and performance of Islamic banks in 12 Middle Eastern countries. Data from 175 banks have been included in the study. Results showed a significant and negative relationship between size and the profitability. Masood and Ashraf (2012) investigation was undertaken to find out whether bank specific and macroeconomic determinants influence Islamic banks' profitability in the selected countries of different regions. Based on the empirical results it was found that the size of the bank has a positive and significant impact on the profitability. Yong and Floros ( 2012) study on Chinese banks have revealed that there was a negative relationship, between the profitability and size of the bank. However the size variable is statistically significant in describing only the dependent variable NIM. The authors further say that the negative effect of bank size, on profitability would have been due to bureaucratic reasons when bank becomes extremely large. Naceur (2003) analysis was on profitability of Tunisian banking industry from 1980 to The results have found that the size of the bank has mostly negative and significant coefficient on the net interest margin. The author further elaborates the results suggesting that larger banks tend to lower margins and is consistent with models that emphasize the negative role of size arising from scale inefficiencies. In accordance with Staikouras and Wood (2003) findings the size variable has negative effect on large banks profitability. This results give support the diseconomies of scale 22

34 concept that exist when a bank size is grown beyond a particular point, found in majorities of the researches on the subject. Husain and Abdullah (2008) analyzed the determinants of the profitability of Kuwaiti banks. Independent variable, the size of the bank was proved to bring scale economies to Kuwaiti banks during 1993 to The relationship of size to ROA has been significant and positive. Syed et al., (2013) found a negative relationship of size variable with profitability. The authors further describe the results of the study and states that 1% increase in bank size will decrease the profitability by 0.008%. The reason for decrease of profitability given is when bank increase assets by way of debts, for servicing debt, bank has to set aside a specified sum of money out of its profits. Kosmidou (2008) study on the determinants of banks' profits in Greece revealed that the effect of the size is insignificant for ROAA when only the bank specific characteristics are regressed and become significant with the introduction of macroeconomic indicators. Weerasinghe and Perera (2013) investigated on the profitability of Sri Lankan commercial banks. SIZE had been significant in explaining the profitability at 5% confidence level. Apart from the studies of Deger and Adem (2011), Masood and Ashraff (2012), Husain & Abdullah (2008) and Weerasighe and Perera(2013) all the others agreed on the diseconornies of scale with the growth of size. 23

35 Liquidity Liquidity is required for a bank to meet its financial obligations as they become due. Bank lending, finances investments in relatively illiquid assets, but it funds its loans with mostly short term liabilities, thus one of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions. Liquidity risk arises from the inability of a bank to accommodate decreases in liabilities or to fund increases of assets. Banks with liquidity issues may not he able to raise liabilities or convert assets at a reasonable cost, thereby severely affecting their profitability. More than any other business, liquidity is an important ingredient of banking industry. Confidence level of the depositors and the general public should be with any given financial institution. The moment the confidence is lost all the depositors will demand their money. No financial institution can survive without lending money and most of the lending is for medium to long term. If majority of the depositors demand their money at the same time, imagine the state of the financial institution. This situation is called a run on the bank' and virtually the financial institution will collapse if they cannot meet the demand from their clients. 1-lusain and Abdul lab (2008) investigation has been performed on banks in Kuwait. Only the bank specific determinants on bank profitability have been focused. Annual data of seven national commercial banks over the period of 1993 to 2005 were used for the regression analysis. According to the authors banking plays a vital role in Kuwaiti economy second only to oil sector. Liquidity is proxied by liquid assets (non interest earning assets) as a 24

36 fraction of total assets. The results indicate interest earning assets to total asset ratio as negative in relationship with profitability. A higher amount of liquidity reduces the ability of the bank to generate income. Kosrnidou (2008) study on the bank profitability of Greek banks has revealed that the high ratio of bank loans to customers over short term funding (LODEPO) denote lower liquidity. And the results imply that less liquid banks have lower ROAA. When the macro economic and financial structure variables enter the equation, liquidity become positive and insignificant in explaining ROAA. Ayanda et al., (2013) focused their study on the profitability of Nigerian banks. In this study the liquidity has been represented by total loans to total assets (TL/TA) and total loans to total bank deposits (TL/TBD). Statistical analysis has shown a negative relationship of total loans to total assets with ROA, ROE and NIM. Total loans to total bank deposit (TL/TBD) have shown a negative relationship with the ROA, ROE and NIM. Anyway these results have proved to be statistically insignificant in determining profitability in the long run for the period of study. An explanation provided by author was, most banks in Nigeria do not prefer to hold long term funds, as holding long term funds only tends to constitute idle cash, thereby having absolutely no effects on the profits. Badola and Verma (2006) investigated the profitability of banks in India. The liquidity was denoted by credit to deposit ratio (C/D). Credit to deposit ratio was found to be with a low explanatory power in explaining the profitability of public sector banks in India for years 1991 to 1992 and2003 to

37 Yong and Christos (2012) study, evaluated the determinants of bank profitability in china. It examined the effects of inflation on bank profitability, while controlling for comprehensive bank specific and industry specific variables. The performance measurements employed were ROA and NIM. Higher liquidity of Chinese banks was found to be significant in explaining NIM. Weerasinghe and Perera(2013) findings on the profitability on Sri Lankan commercial banks during 2001 to 2011 have found a negative relationship between profitability and liquidity. The relationship is at 5% confidence level. Liquidity in the study has been defined by total liquid assets as a percent of total assets. Weerasinghe and Perera (2013) Husain and Abdullah (2008) have a common view of the inverse relationship of liquidity and profitability. Liquidity in the current study was denoted by loans to assets ratio Macroeconomic Indicator variables Inflation Inflation in a country is a measurement of percentage of increase in prices of goods and services on an annual basis.. Athanasoglou et al., (2005) study on the banks in Greece has found that inflation has positively and significantly affected profitability: possibly due to the ability of Greek banks' 26

38 management to satisfactorily, though not accurately, ftrecast future inflation, which in turn implies that interest rates have been appropriately adjusted to achieve higher profits. Derger and Adeni (2011) study was conducted on commercial banks profitability in Turkey. 10 banks' financial statements have been analyzed for the period 2002 to Results of the analysis have shown that inflation is not significant in explaining the profitability. Jamal Ct al., (2012) analyzed the ROA of Malaysian banks during 2004 to The results have showed a positive and significant relationship of inflations' effect on profitability. This fact signifies that the banks involved have been highly inflation anticipated. During the period of the study bank managements have predicted the inflation and adjusted the rates accordingly and made profits. Ghazali (2008) investigated on the profitability of Islamic banking. Data from 18 countries over the period of were used for the study. The inflation has been proxied by consumer price index (CPI). Inflation was found to have a positive relationship with all profitability measures ROA, ROE and NIM. Inflation has been anticipated by the banks concerned, as in the previous researches stated under inflation. Masood and Ashraf (2012) Study on profitability of Islamic banks have found that there is a positive relationship of inflation to the ROE which is insignificant. Syed et al., (2013) investigated on the profitability of Pakistan banking industry. The results of the study have proved that the inflation is positively and significantly related to profitability. According to the authors 1% increase in inflation causes increase in 27

39 profitability by 0.057%. The reason behind is the anticipation of inflation by banks and adjusting their interest accordingly. Kosmidou (2008) on his investigation on the profitability of banks in Greece revealed a negative impact of inflation on the profitability of banks. Kosmidou (2008) results for inflation were contradictoi-y with all other investigations which had the argument of positive relationship of inflation to profits. Yong and Floros(2012) examined the banking sector profitability in china, in accordance with the study positive relationship was found between the profitability and inflation. The authors further elaborate this result as the Chinese banks anticipatory nature on the inflation and subsequent adjustment of rate of interest. Based on the results of the literature review as far as the banks are concerned the inflation is anticipated, and they get geared up adjusting their rates of interest accordingly Growth in GDP GDP growth is defined as an increase of production of goods and service, in a country and as a measure of total economic activity in a country. Ghazali (2008) has found that the growth in GDP is significantly related to ROA and ROE and the relationship has been positive. A similar result has been found in the findings of Kosmidou (2008): a significant and positive relationship between growth in GDP and ROAA. 28

40 Staikouras and Wood (2003) study on the EU banking industry has found that there exists a significant negative relationship between growth in GDP and profitability. Dietrich and Wanzenried (2009) investigation was on the determinants of profitability of commercial banks in Switzerland. The period covered was from 1999 to Sample included 1919 observations from 453 banks. In accordance with the study, GDP growth rate have a positive relationship with the profitability of commercial banks in Switzerland. Ghazali (2008) Kosmidou (2008), Dietrich and Wanzenried (2009) all found to have a positive relationship between GDPG and profitability Growth in Money Supply Money supply is stock of money held by people. Central Bank basically announce two money supply figures. They are narrow money (M1 ) and broad money (M2). Narrow money is defined by the Central Bank as the sum of currency held by the public and demand deposit held by public. Broad money supply is defined as the narrow money supply plus time and savings deposits held by the commercial banks. Ayanda et al.,(2013) study on determinants of profitability is based on the Nigerian banking sector using First Bank of Nigeria Plc as a case study. Growth in broad money supply was found to be a significant driver in explaining the profitability. There existed a positive relationship between growth in money supply and profitability. 29

41 Sufian and Chong (2008) examined the determinants of profitability of Philippines banking sector during 1990 to The results have shown that the growth in money supply has not been significant in explaining profitability. 2.3 Variables selected for the current study Reading through the above researches it is evident that the determinants of the bank profitability can be broadly categorized into two sections. That is internal determinant, and external determinants. Internal Determinants are banks specific, where bank concern has a control over. In other words the internal determinants can be driven in such way to derive higher degree of profitability. Profitability is measured by Return on Average Assets (ROAA), Return on Equity (ROE) or Net Interest Margin (NIM). Internal determinants are size of the bank (SIZE), Cost to Income Ratio (CIR), Loan Loss Reserves to Gross Loans (LLP) Capital Adequacy Ratio (CAR), and Loan to Deposits Ratio (LDR). Customer perception of the individual bank plays a vital role in determining which bank to bank with. This fact is not measureable and is in the minds of the clientele due to brand loyalty. So we have omitted this variable for the study. Size of the bank is a measure of the asset base. Capital base of a bank has a distinctive position in the asset base of a bank. Sound level of capital is an excellent buffer for any unforeseen losses. Regulators around the world are very much vigilant of the CAR (Capital Adequacy) of the financial institutions under their purview. One school of thought is when 30