The determinants of Finance Companies' profitability in Sri Lanka VIA MAHADE VAN SUTHAKAR

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1 DOI: /fmscmst The determinants of Finance Companies' profitability in Sri Lanka VIA MAHADE VAN SUTHAKAR A research submitted to the University of Sri Jayewardenepura in partial fulfillment of the requirements for the Degree of Master of Business Administration (Finance)

2 The work described in this research was carried out by me under the supervision of Prof. W.M.A.Bandara and a report on this has not been submitted in whole or in part to any university or any other institution for another Degree or Diploma...(5 M.Suthakar Date

3 I certify that the above statement made by the candidate is true and that this research is suitable for submission to the University for the purpose of evaluation. IDN Prof. W.M.A.Bandara Date

4 Table of Contents Page CHAPTER - ONE 1. INTRODUCTION Overview of Sri Lankan financial institutions Overview of Sri Lankan finance companies Recent developments in the finance company sector Introduction to the Finance Business Act No. 42 of Introduction to Deposit insurance scheme Compulsory listing in CSE Enhancement of minimum Core Capital Corporate governance to LFCs Appointment of External Auditors Recent recovery and growth of the sector Future outlook of the sector Research problem Objectives of the research Problem Justification Significance of the research Limitations of the study Outline CHAPTER - TWO 2 LITERATURE REVIEW Introduction Internal I firm specific determinants...15

5 2.2.1 Capital Asset quality Firm size Expense Management Liquidity Activity diversification Public deposits External determinants Inflation Economic Growth Interest Rate Impact of Management Quality, Corporate Governance and Risk Managementon Profitability Empirical Evidence Introduction Greece Philippines Malaysia Indonesia Korea Kenya United States Bangladesh Pakistan Turkey

6 Sub-Saharan Africa Europe Summary CHAPTER - THREE 3 METHODOLOGY Introduction Response variable Explanatory variables Firm specific variables Capital Asset quality Size Expense management Asset Composition Liquidity Public Deposits Non-interest income External / Macroeconomic variables Interest rate Economic Growth Inflation Conceptual framework Operationalization List of Hypotheses ff

7 3.7 Research Design and Data Data and data source Population and sample Econometric model Summary CHAPTER - FOUR 4 DATA ANALYSIS Introduction Descriptive statistics Correlation analysis Explanatory analysis Fixed effects model Random effects model Hausman test Heteroskedasticity Multicollinearity Empirical Findings Results Trend Analysis of LFC sector profitability and other factors Summary CHAPTER - FIVE 5 DISCUSSION Introduction... 89

8 5.2 Capital Assets quality Size Loans and advances Non-interest income GDP growth Summary CHAPTER - SIX 6 SUMMARY AND CONCLUSION Introduction conclusion Recommendations for future research REFERENCES APPENDICES V

9 List of Tables Page Table 1.1: List of Licensed Finance Companies listed in the CSE...4 Table 1.2: List of Finance Companies not listed in the CSE... 5 Table 3.1: Definition, notation and expected effects of explanatory variables Table 3.2: List of Hypotheses...57 Table 4.1: Descriptive statistics Table 4.2: Table 4.3: Correlation matrix...67 Results of the Fixed Effects model...70 Table 4.4: Results of the Random Effects Model...71 Table 4.5: Table 4.6: Table 4.7: Table 4.8: Results of the Hausman Test...73 Results of Random effects with Robust error term...74 Variance Inflation factor Results under random effects model (all explanatory variables).77 Table 4.9: Results under random effects model (firm specific variables)...78 Table 4.10: Results under random effects model (firm specific variables), under ROE as a proxy for profitability...79 vi

10 List of figures Page 1. Figure 1.1: Movement of NIM, ROA and NFL of the LFC Sector Figure 1.2: Assets, Public Deposits and Capital growth of LFC sector Figure 3.1: Conceptual model Figure 3.2: Population and sample of the research Figure 3.3: Size of the LFCs included in the sample Figure 4.1: ROA, ROE and NIM movement based on research sample Figure 4.2: ROA and NIM movements based on Macroeconomic factorsvolatility Figure 4.3: NFL Movements of LFCs based on Macroeconomic factor's volatility Figure 4.4: Movements of composition of funding Figure 4.5: Movements of composition of Loans and Advances vii

11 ACKNOWLEDGEMENTS Pursuing a Master Research in Finance is both an interesting and pleasurable experience. The experiences during the research period are hardships, encouragements and confidence gained from great people's support. My first sincere thanks go to my Professor K.D.Gunawardene, who initiated me to search for a research topic while emphasising the importance of the research work for the MBA degree program. Secondly my special thanks go to my advisor Professor W.M.A.Bandara, who accepted me without any hesitation as his student. His experiences in academic life and industry exposure assisted me throughout my research period. His encouragement and assistance even with his busy schedule, made me feel confident to achieve my objectives. Next I appreciate the advice of Dr. M.H.A. Sisira Kumara, who extended his full support to form the econometric model and to arrive at the outcome of my analysis. I made use of his expert knowledge in econometrics and his art of teaching for a layman. Further I am thankful to the former coordinator Dr. P.D. Nimal, and present coordinator Dr. P.J.Kumarasinghe, both of whom always encourage and guide students to meet with deadlines. I must thank the non academic staffs of the Postgraduate unit for their support during the tenure of my research. Special thanks go out to my family, relatives and friends who supported me during the study by arranging reference lists, formatting, editing and proof reading. My sincere thanks also go to all who supported me in different capacities. Moreover, it is my hope that this research contributes a practical knowledge to the determinants of finance companies' profitability. Mahadevan S uthakar Colombo, February viii

12 The determinants of Finance Companies' profitability in Sri Lanka Mahadevan Suthakar MBA Finance (Student) Faculty of Graduates Studies, University of Sri Jayewardenepura. ABSTRACT In this study, balanced panel data sets of Sri Lankan Finance Companies were used to investigate the firm specific (endogenous) and macroeconomic (exogenous) determinants of profitability of Finance Companies using the random effects model. For this purpose 130 observations of 26 Finance Companies (out of 43) over the period were included. Return on Assets was considered as a measure for profitability of Finance Companies and Return on Equity was considered as an alternative measure. Capital, Assets Quality, Size, Overhead expenses Management, Composition of loans and advances, Liquidity, Public Deposits and Noninterest income are considered as endogenous factors whereas Interest rate, GDP growth rate and Inflation rate are considered as exogenous factors. The result shows that Capital, Size, Composition of loans and advances, Noninterest income have a positive and significant impact on finance company profitability. However Non performing loans (proxy for asset quality) have a negative and significant impact on profitability. With regard to exogenous variables, GDP growth has significant positive influences on profitability. Based on these findings, this study recommends maintaining healthy capital ratios, concentration on asset quality, improving size with diversified branch networks, investing more on loans and advances and involvement of fee based activities that will enhance the profitability positively. ix

13 Further research on impact of Finance Companies' profitability with Management Quality, Corporate Governance and Risk Management will not only add value to explaining profitability of Finance Companies but also add value to the academic literature. Keywords: Financial institutions, Sri Lankan Finance companies' profitability, firm specific factors, macroeconomic factors, panel data x

14 ABBREVIATIONS ASPI BCBS CAR CBSL CCPJ CEO COIN CSE DETA DIS EQTA EVA GDP GMM ICASL IMF INF INT IPO LATA LCB LFC All Share Price Index Basel Committee on Bank Supervision Capital Adequacy Ratio Central Bank of Sri Lanka Colombo Consumer Price Index Chief Executive Officer Cost to Income Ratio Colombo Stock Exchange Deposits to Total Assets Sri Lanka Deposit Insurance Scheme Equity to Total Assets Economic Value Added Gross Domestic Product Generalized Method of Moments Institute of Chartered Accountants of Sri Lanka International Monetary Fund Inflation Rate Interest Rate Initial Public Offer Loans and Advances to Total Assets Licensed Commercial Bank Licensed Finance Company xi

15 LSB NBFI NCBFJ NIITA NIM NPL OLS Licensed Specialized Banks Non Bank Financial Institutions Non Commercial Bank Financial Institutions Non Interest Income to Total Assets Net Interest Margin Non Performing Loans Ordinary Least Squares RAROC Risk Adjusted Return on Capital RFC ROA ROE SEC SLC VAT VIF Registered Finance Company (Now known as LFC) Return on Assets Return on Equity Securities and Exchange Commission of Sri Lanka Specialized Leasing Company Value Added Tax Variance Inflation Factor xii

16 CHAPTER - ONE INTRODUCTION The licensed finance company (LFC) sector represents a small proportion in the financial sector of the country representing 5.8% in terms of the total deposit base and 4.6% in terms of the total assets base. However, it plays a key role in developing the small and medium enterprises and the micro finance sector. The core business of LFCs is financing of vehicles through hire purchase and lease. LFCs offer other products as well which include mortgage and other credit facilities, pawning advances, real estate and property development. They are also authorised to accept deposits except demand deposits. LFC complement the role of commercial banks by filling the financial intermediation gap through offering a wide range of financial products. Generally the LFC sector's asset quality is weaker than banks' due to the high risk level of their target customer base and its support to offer higher interest rates than banks. Since the banks are risk averse to a certain extent, the importance of the LFC sector towards economic development has been identified in the recent past. The importance of the profitability of the sector is also highlighted in order to ensure depositor safety and to maintain system stability. 1.1 Overview of Sri Lankan financial institutions Financial institutions function to bridge the gap between savers and borrowers, and to provide financial intermediation by converting deposits to productive investments (Akbas, 2012). The financial institutions of Sri Lanka can mainly be classified into two

17 major categories, i.e. Banks and Non bank financial institutions. Banking institutions represent licensed commercial banks (LCBs) and licensed specialized banks (LSBs) that hold a major share which is 85% of total financial institution's assets. Licensed finance companies (LFCs) and specialized leasing companies (SLCs) are classified under non bank financial institutions and hold 10% of the asset base. These institutions were incorporated under the Companies Act and regulated by the Central Bank of Sri Lanka (CBSL) under the Banking Act No. 30 of 1988, Finance Business Act No. 41 of 2011 and Finance Leasing Act No. 56 of Co-operative rural banks, Co-operative societies, primary dealers, stock broking companies and unit trust management companies including underwriters, margin providers and investment managers may be classified under specialized financial institutions and hold a minor share of 5% assets. 1.2 Overview of Sri Lankan finance companies The history of the Finance Company begins way back on 30th May, 1940 when 'The Finance Company' was registered with the registrar of companies as the 7th public company. During the 1960s The Finance Company listed its ordinary shares in the Colombo Brokers Association. The first legislation to govern finance companies (specially deposit accepting companies) was introduced in 1979 by introducing the Control of Finance Companies Act No. 27 of 1979 where CBSL's Bank Supervision Department was empowered to issue directions, guidelines and examine books of accounts to ensure and safeguard depositors' funds. During the period 1977 to 1985 numerous players entered into the sector and some had to face bankruptcy due to corruption, malpractice and mismanagement (RAM Ratings 2

18 Lanka, 2009). With the experience of collapse, CBSL decided to intervene by tightening regulatory controls by implementing new legislation (Finance Companies Act No. 78 of 1988). With the implementation of the Finance Companies Act, LFCs come under the direction of the Department of Supervision of Non Bank Financial Institutions (NBFI) of CBSL. Even after the introduction of the Finance Companies act, the sector experienced collapse in 2008 resulting from the collapse of un-registered and un-regulated financial institutions such as Go1den Key' and 'The Finance and Guarantee Co. Ltd' who accepted deposits from the public and found it difficult to repay when customers demanded. This extended to many other finance companies and the sector to an extent faced liquidity problems resulting from loss of public confidence and panic withdrawals. Since the finance company industry runs with assets and liabilities mismatch, most of the companies faced severe liquidity crunches, especially due to high deposit withdrawals. Companies that maintained high investment in real estate and property development faced further difficulties to convert it into cash. To maintain the stability of the financial system, the stability of these companies and to safeguard public deposits, the regulator imposed different strategies such as bailout plans, imposing new management agents to manage the companies, introducing new capital, converting some public deposits to shares etc. But still some finance companies find it difficult to stabilize themselves. With the experience of the recent fall of finance companies, the government introduced a new act known as 'The Finance Business Act No. 42 of 2011' and it came into force 3

19 on 9th November, 2011 repealing and replacing the Finance Companies act No. 78 of The new act bestowed powers to the regulator not only to regulate the LFCs but also to prohibit the functioning of unregistered deposit taking institutions. As at the end of May 2012, the following finance companies were registered with the Monitory Board of CBSL and listed in the Colombo Stock Exchange (CSE). Table 1.1: List of Licensed Finance Companies listed in the CSE 01. Abans Finance PLC 16. Lanka ORIX Finance PLC Aliance Finance PLC 17. Mercantile Investment PLC 03, AMW Capital Leasing PLC 18. Multi Finance PLC Arpico Finance Company PLC 19. Nanda Investment and Finance PLC Asia Asset Finance PLC 20. Nation Lanka Finance PLC Associated Motor Finance Company PLC 21. Peoples Finance PLC Bartleet Finance PLC Bimputh Lanka Investment & Finance PLC Capital Alliance Finance PLC Central Finance PLC Central Investment & Finance PLC Chilaw Finance PLC Citizen Development Business Finance PLC Commercial Credit PLC L B Finance PLC Peoples Merchant Finance PLC Senkadagala Finance PLC Singer Finance (Lanka) PLC Sinhaputhra Finance PLC Softlogic Finance PLC Swarnamahal Financial Services PLC The Finance Company PLC Trade Finance and Investment PLC 0. Vallibel Finance PLC (Source: CBSL) 4

20 As at the end of May 2012, the following licensed finance companies were not listed with the CSE. Table 1.2: List of licensed finance companies not listed in the CSE 1. Asian Finance Ltd Meista Regal Finance Ltd City Finance Corporation Ltd Merchant Credit of Sri Lanka Ltd D3. Commercial Leasing & Finance Ltd. I 10. Prime Grameen Micro Finance Ltd, Divasa Finance Ltd ETI Finance Ltd 96. Ideal Finance Ltd The Finance & Guarantee Co. Ltd The Standard Credit Lanka Ltd TKS Finance Ltd 117. Kanrich Finance Ltd (Source: CBSL) 1.3 Recent developments in the finance company sector With the recent experience of collapse and the crisis in the sector the regulator has started implementing stringent regulations in order to maintain stability and safeguard depositor funds. The following are the recent developments, Introduction to the Finance Business Act No. 42 of 2011 The new act, the Finance Business Act No. 42 of 2011 was introduced, to empower the regulator with enhanced examination and supervisory powers over LFCs and further make effective legal provision to curtail unauthorised deposit taking institutions. To 5

21 ensure good governance of finance companies, disqualification criteria have been specified for directors and key management personnel of LFCs. The new act defines deposit' clearly and it also includes several other features as well. To identify the licensed finance company by its name, using the words 'finance' or financing' or 'financial' as part of its name is made mandatory and it is prohibited to use the above words by others. The act also prohibits the use of the name, and abbreviated name or acronym of a licensed finance company by any other companies. Advertising soliciting deposits without regulatory authority is treated as an offence and media institutions are required to verify the authority to accept deposits. Employees of licensed banks and finance companies are required to inform the Director NBFI, of any person whom they have reasonable suspicion of accepting deposits from the public without authority. Carrying on finance business without due authority is made an offence and made punishable on conviction after a trial before the High Court with an imprisoimient not exceeding 5 years and / or fine not exceeding Rs. 5 million Introduction to Deposit insurance scheme A voluntary deposit insurance scheme was established in 1987 for banks and cooperative societies, in terms of the Monetary Law Act but due to its voluntary nature most institutions did not contribute. CBSL introduced a new scheme 'Sri Lanka Deposit Insurance Scheme (DIS)' with effect from 01" October, All LCBs, LSBs and LFCs are members of the DIS and deposits up to Rs. 200,000 are insured and payment with effect from 01st of January, 2012 within six months upon cancellation of license. Deposits of shareholders, directors, key management personnel, related parties, 6

22 Government and Government institutions and deposits held as collateral against any advances will be excluded under this scheme Compulsory listing in CSE. Listing in CSE is made mandatory for LFCs. Listing will further enhance the transparency and accountability, and listed finance companies need to comply with regulations imposed by CSE and the Securities and Exchange Commission (SEC) of Sri Lanka. Presently, 30 LFCs are listed while 13 have not complied with the requirements (as at May, 2012) Enhancement of minimum Core Capital. The industry was made to realize the importance of capital adequacy and with the listing requirements some companies raised capital through initial public offers and rights issues. CBSL increased the core capital requirement for LFCs from Rs. 200 Mn. to Rs. 400 Mn. with transactional provisions. Accordingly LFCs were needed to increase their core capital to Rs. 300 Mn. by end of 2013 and to Rs. 400 Mn. by end of Corporate governance to LFCs. CBSL issued a direction on corporate governance to the LFC sector and listed LFCs additionally need to comply with a code of best practice on corporate governance, issued jointly by SEC and the Institute of Chartered Accountants of Sri Lanka (ICASL). These directions were guidelines for better management practices and good governance VA

23 which includes responsibilities of the Board of Directors, meetings of the board, composition of the board (composition of executive, non executive and independent non executive directors), segregation of duties of CEO and Chairperson. Board sub committees such as audit, risk management and remuneration committees, transactions with related parties and disclosure requirements were further requirements Appointment of External Auditors To ensure the accountability of LFCs' CBSL appointed a panel of external auditors and LFCs were compelled to use auditors from this panel. This is to direct the LFCs to practice better auditing and accounting standards and to comply with regulations. The panel of external auditors was based on the strength of the audit firms to handle the volumes of accounts and financial transactions and their experience in the field. 1.4 Recent recovery and growth of the sector LFC sector had recovered with the favorable economic climate, mainly tax reduction, in early 2011 and with a low interest rate regime. Excluding a few distressed finance companies, this sector had shown satisfactory performance during the last two years. The sector has strengthened its liquidity levels, curtailed non performing advances and the industry's margins widened, largely supported by lower funding costs aimed at the faster downward repricing of deposits; this has highly supported to the industry to return to profitability after the previous years' unfavourable performances. Figure 1.1 shows the profitability movements over the period of five years in terms of NIM & ROA, and NPL movements for the same period. 8

24 Figure 1.1: Movement of Nilvi, ROA and NPL of the LFC Sector 9% 8% 7% 6% 5% 4% 3% 2% 1%- 0% - -- NIM MM, ROA and NPL of LFC Sector March 2008 March 2009 March 2010 March 2011 ROA 2.82% NPL 5.19% December % 5.85% % 7.91% 8.46% 0.85% 0.07% 2.82% 6.08% 6.46% 7.90% 7.60% 4.70% (Source: CBSL as citied by RAM Ratings Lanka, 2012) During the last year the sector's asset base and deposit base grew substantially and it supported profitability growth. Even so the deposit growth was identified as insufficient to support advances in growth and the sector's funding composition had altered marginally by bringing in more capital and borrowings. Figure 1.2 shows the growth of Assets, Deposits and Capital over the last five years. Figure 1.2: Assets, Public Deposits and Capital growth of LFC sector Assets, Deposits and Capital of LFC Sector - 400, ,000 n 300, , , , ,000 50,000 n Assets (Rs Mn.) Deposits (Rs Mn.) Capital (Rs Mn.) Ii March March March March Decemb er , , , , , , , , , , , , , , , (Source: CBSL as citied by RAM Ratings Lanka, 2012)

25 1.5 Future outlook of the sector. The latter half of the financial year 20 11/2012 was a turning point for the sector with the turn in economic variables such as interest rates, exchange rate movements and high import taxes on vehicles. With this backdrop, advances are likely to grow at a decelerated level than in previous years and the sector will face a further mismatch in interest rates due to the quick re-price of liabilities over assets, which will impact the net interest margin. The new high tax structure for the import of brand new and reconditioned vehicles will directly curtail the leasing and hire purchase advances. Also the sector maintains a higher yield on three-wheelers and motor bikes, which contributed a major portion in the sector's portfolio and may be expected to decline in the coming years. 1.6 Research problem This research attempts to examine the determinants of profitability of Finance Companies in the Sri Lankan context. The problem is given in question form below. What are the important determinants of profitability of Finance Companies in Sri Lanka? 1.7 Objectives of the research The objectives of the study are; To identity the determinants of profitability of the LFCs in the Sri Lankan context, To assess the level of intensity of these factors in the profit determination of LFCs and finally, To make suggestions to address the identified problems of LFCs profitability. 10

26 1.8 Problem justification Unlike the banking industry the LFC sector is less stable and has a high number of small players. Further each and every firm is not systematically important to the economy even though the sector as a whole is important. A high systemic risk nature is associated with the firms and the fall of one player will highly impact on the entire sector. This has been experienced from time to times and in the recent past. While analyzing the reasons for collapse, poor performance has also been identified as a major factor since it may erode capital. Hence this study examines the factors influencing the profitability, which may be helpful to the decision makers to enhance profitability. Further, addressing profitability of the sector will support to improve its stability and safety of depositors' funds. 1.9 Significance of the research Many empirical studies have been done on determinants of Bank profitability and such determinants are well documented in many other countries such as Nigeria, Greece, Malaysia, Philippines, Kuwait, US, Pakistan, Indonesia, Jordan, India, etc. However, comprehensive studies to assess the determinants of Finance Company profitability are still in their infancy and not much is available in the Sri Lankan context, Therefore, this research may fill the knowledge gap with regard to this aspect. The findings of this study will go a long way in educating finance executives, regulators, policy makers and government on planning their activities by identifying the 11

27 actual factors affecting the profit of LFCs in Sri Lanka. This can assist them to make their necessary moves with respect to the behaviors of the variables determining profits and enabling better guidelines to their financial planning, implementation and to have better risk management strategies. Further, this may be a stepping stone for future studies to other researchers Limitations of the study Even though this research finds some important relationships between several factors of LFCs' profitability, there are some limitations. The research uses only the unconsolidated (separate) financial statements of LFCs and ignored the consolidated financial statements. Further restatements of financial statements during the following year also are a concern due to some of the LFCs restating their financial statements in the following year. Scarcity of literature on the Finance Companies (or NBFIs) sector's profitability is also identified as a concern. Another major limitation is insufficiency of available data on the published accounts. Especially some LFCs are not disclosing the NPL details in their audited accounts, as they are a major source of information to identif' asset quality. The researcher used the data from rating agencies reports to quantify the amount of NPLs. 12

28 1.11 Outline The reminder of this research is structured as follows. The following literature review chapter introduces the theoretical background and previous empirical findings in relation to the problem concerned. Subsequently chapter three selects the variables which determine finance companies' profitability and hypotheses with the expected relationships. It also describes the sample and the econometric model. Chapter four presents the data collection, analysis and presents the findings. The next chapter discusses the findings with the available literature. Chapter six concludes with the summary and conclusion of the research while answering the research problem. 13

29 CHAPTER TWO LITERATURE REVIEW 2.1 Introduction As discussed earlier, financial institutions play a crucial role in the economic development of a country. Al-Omar and Al-Mutairi (2008, p. 20) state 'the stability, efficiency and consequently profitability of the banking sector are of vital importance for the stability and growth on the whole economy'. Hence understanding the factors influencing profitability is also essential to manage financial institutions efficiently. This chapter widely reviews the factors influencing the profitability of the financial institutions based on existing empirical research. Subsequently a broad overview of important findings of studies in different countries is also discussed to provide an understanding of factors influencing profitability of financial institutions in different countries. In the recent literature, the determinants of profitability of financial institutions are expressed as internal determinants and external determinants (Alper & Anbar, 2011; Kosmidou, 2008; Sufian & Chong, 2008; Sastrosuwito & Suzuki, 2012). Internal determinants are firm specific factors, which are influenced by the firm's management decisions and policy objectives (Sufian & Chong, 2008). The external determinants of profitability include the factors which are not influenced by a firm's decisions but by events that occur externally. These external factors reflect the volatility in the economic indicators such as interest rate, exchange rate, inflation and economic growth. Further, quality management can handle all the above factors effectively to reduce risk of the 14

30 financial institutions. Staikouras & Wood (2011) argue that quality management is an attribute of superior bank performance. Hence management quality also influences the profitability of financial institutions. Guru et al. (2002), stress that bank which enjoy specific competitive advantages with their corporate image or customer relationship influence profitability, but which may not be easy to quantify. Tandelilin et al. (2007) affirm that banks can increase performance and reduce risk when they implement good corporate governance. Growth in the market and the entry barriers may also have significant influence on profitability. In Sri Lanka, the number of finance companies had continuously increased and at the end of May 2012 is stood at 43. With the extended high competition in the sector new participants may find it more difficult to compete. 2.2 Internal / firm specific determinants Firm specific determinants mostly reflect the different management policies and practices and the decisions are mainly with regard to sources and utilization of funds, capital, liquidity and expense management (Guru et al., 2002). Firm specific factors can be evaluated by analysing the financial statements of the Finance Companies. Capital, assets quality, size, cost management, activity diversification, liquidity and public deposits are examples of internal determinants of profitability. Some of the recent research uses the CAMEL model to evaluate factors influencing profitability (Olweny & Shipho, 2011). CAMEL is a widely used framework to evaluate bank profitability and it stands for Capital adequacy, Asset quality, Management efficiency, Earnings performance and Liquidity. Further the Base! Committee on Bank Supervision and IMF recommends the CAMEL framework to evaluate performance (Baral, 2005 as cited by Olweny & Shipho, 2011). 15

31 2.2.1 Capital The level of capital is essential to run a finance business to absorb any shocks that financial institutions may experience. Generally capital is highly regulated and a compulsory restriction in any country. Koch (1995) as cited by Olweny and Shipho (2011) who argue that regulators are willing to fix higher minimum capital requirements to diminish failures, whilst bankers argue that it is expensive and difficult to obtain additional capital and higher requirements restrict their competitiveness. The Basel Committee also introduces several regulations on capital with the objective of maintaining a more resilient banking sector. Hoffrnann (2011, p. 255) states, 'Regulators and supervisory entities that set minimums for equity capital, and establish other types of regulations in order to deter excessive risk taking, can affect the bank's capital structure decisions, and hence its earnings.' In the Sri Lankan context, the CBSL has introduced 3 main restrictions for the LFC sector. The first is minimum core capital limit is Rs. 400 Mn. with effect from The second is Capital Adequacy Ratio (CAR) based on risk weight of the assets and capital base. The CAR is identified at two stages, core capital ratio, total risk weighted capital ratio and minimum requirements standing at 5% and 10% respectively. The CAR ensures the strength and stability of LFCs. The third is Capital funds to total deposits ratio and this is introduced to safeguard the deposits. Presently the requirement stands at 10% and further an LFC is required to transfer part of its profits to a capital reserve which will ensure a certain percentage of internal rate of capital generation. These regulations were introduced to maintain strong and adequate capital that may be kept as a cushion for any losses, which may result from risk of any assets in the Balance Sheet. RAM Ratings Lanka (2010) points out that Net NPL to Shareholders' fund ratio 16

32 deteriorated from 19.24% as at 2009 March to 26.69% as at March 2010 due to capital erosion through losses of a few troubled LFCs. While commenting on capital of LFC, RAM Ratings Lanka (2009, p. 7) highlights the following, 'the RFC industry's capital adequacy remains well above the statutory requirement imposed by the Central Bank. Nevertheless, we observe that the Basel I Capital-adequacy architecture - currently in operation - fails to capture the myriad risks that RFCs are exposed to.' Further RAM Ratings Lanka (2010) state LFCs are still using the Base! I framework for capital adequacy calculations which counts only the risk arising from credit and it does not capture the market risks and operational risks as addressed in Base! II. On the other hand improvement of profitability will enhance the capitalization of LFCs supported with higher internal rate of capital generation. The relationship of capital with profitability is expected at positive and most of the empirical findings support a positive relationship. Athanasog!ou et at. (2005) stressed that sound capital pursues more opportunities, more effectively, offers more time and flexibility to handle unexpected losses, and hence supported increased profitability. Bourke (1989) as cited by Hoffmann (2011) agrees that capital is positively related to profits with the assumption that well capitalized banks may enjoy cheaper and less risky funds. However a negative relationship is also evident in the literature. A number of studies suggest that a well capitalized bank tend to reduce the risk of equity and accordingly lowers the expected return on equity (Staikouras & Wood, 2011; Flamini et at., 2009; Hoffmann, 2011). Beckmann (2007) as cited by Olweny and Shipho (2011) highlight that high capital tends to lower profitability since high capital tends to have risk-averse behaviour and they may ignore risky investment opportunities. Hoffmann 17

33 (2011) agrees that excessively high equity could operate conservatively and may disregard potential profitable investment. While justifying the negative relationship between profitability and capital Hoffmann (2011, p. 256) stresses the following, 'An increase in equity by substituting additional equity for debt reduces the risk of both securities, and therefore lowers the market's required rate of return by both, as long as investors are risk averse and cannot completely diversify away the bank's risk. So, in this situation we can expect a negative relationship between the bank's profitability and capital ratio.' Further, higher equity reduces the profit after tax by reducing the tax shield provided by the deductibility of interest payments on borrowed funds. Olweny and Shipho (2011) point out that banks which depend more on borrowed funds may experience more volatile earnings and it may affect credit creation and liquidity. Hoffmann (2011) explains a non-monotonic relationship between capital and profitability in United States banks and which can be explained using a quadratic form. Further Hoffmann (2011) explains two frameworks of capital such as, the efficiency-risk hypothesis and franchise-value hypothesis. The efficiency-risk hypothesis explains that efficient firms have a tendency to select low capital ratio, as greater returns from the higher profit efficiency is replaced with equity capital to a certain extent, and will secure the institution against distress, default and liquidity risks. The franchise-value hypothesis explains that more efficient firms are likely to prefer reasonably high equity ratios to guard the future income derived from high profit efficiency. More than the profitability, capital should be viewed from the point of view of stability of the institution. Strong capital is essential for banks in developing countries during unstable macroeconomic conditions to provide strength to survive during financial crises and to safeguard depositors (Sufian, 2011; Sufian & Chong, 2008). Sufian and 18

34 Chong (2008) also highlights that lower equity levels imply higher leverage and risk, which may lead to higher borrowing costs. Thus it is clear that capital is one of the major determinants of profitability for financial institutions Asset quality Asset quality is directly related with the lending function of the financial institution and it can be identified as Credit Risk. Hoffmann (2011) highlights that financial institution as a whole are more vulnerable to high credit risk than other institutions. Credit risk also refers to default risk and is the risk that creditors of business fail to pay their dues in full on time. Once the loan is defaulted or close to being in default, such loans can be called Non Performing Loans. For LFCs, CBSL defines that once the capital and I or interest in arrears exceeded six months or more, it can be classified as NPL and LFCs are required to make provision for possible losses (RAM Ratings, 2009). Possible losses on NPLs depend on the loan-to-value ratio of the advances, and a better credit risk management system always recommends a low ratio. But competition among the industry may lead to lend with high exposure which may have an effect on the profits when financial institutions try to foreclose the collateral to recover the dues. On a study on 'Macroeconomic and bank- specific determinants of non-performing loans in Greece' Louzis et al. (2010) identified macroeconomic variables such as GDP growth rate, unemployment rate and lending rate to have a strong effect on asset quality and they further identified that, quality of the management also impacts on NPLs positively. Therefore, it is evident that asset quality is closely related with macroeconomic factors and companies which are implementing better credit orientation standards and efficient 19

35 recovery approaches will improve on asset quality and hence profitability. RAM Ratings Lanka (2009) identified the deterioration of asset quality of LFCs during due to the effect of the economic downturn. RAM Ratings Lanka (2009, p. 3) further stressed, 'Although asset quality varies significantly among the different industry players, RAM Ratings Lanka also notes that many RFCs have improved their creditorigination standards and monitoring procedures, aside from strengthening their recovery efforts in a bid to maintain asset quality.' Olweny and shipho (2011) highlights, poor monitoring on loans and advances tend to be less profitable to those pay special attention to asset quality. According to Abruime (2008) as cited by Olweny and Shipho (2011) profitability of a bank depends on its ability to foresee, avoid and monitor risks, possibly to cover losses brought about by risks arisen. Athariasoglou et al. (2005) also highlights that the bank can improve profitability by improving screening and monitoring of credit risk and such policies involve the forecasting of future levels of risk. Further research on bank failures explaining the causes and found that a major proportion of assets were kept under non performing loans before failures (Sufian & Parman, 2009). Waweru and Kalani (2009) stress (as cited by Olweny and Shipho, 2011), many financial institutions in Kenya collapsed in 1986 due to NPLs and most of the larger bank failures involved extensive related party lending and often to politicians. In Sri Lanka too one of the main reasons for distress of Ceylinco group finance companies is due to high exposure to related parties even without collateral. In the banking literature many researchers argue that the institution with high loan growth often faces more losses as credit appraisals and analysis procedures are less rigorous, but it may allow the institution to charge high margin representing risk return trade-off. 20

36 2.2.3 Firm size In general one may argue that the size is related to the market power which helps larger institutions to borrow funds at lower cost and they may price their loan products high. It is further noted that, when demand for advances is high for large institutions they can implement better risk management practises in making lending decisions. Further Short (1979) as cited by Hoffmann (2011) argues that size positively influences the capital adequacy of banks, since large banks can raise capital less expensively, resulting in high profitability. Hoffmann (2011, p. 257) states, 'profitability is more likely to improve by emulating industry best practice in terms of technology and management structure than by increasing the size'. Alternatively the larger institutions can enjoy economics of scale through allocation of fixed expenses such as advertising, marketing, risk management, etc., over a high volume of services. Sufian and Parman (2009) suggest that size can be used to capture potential economics or diseconomics of scale in the banking industry. Economics of scale lead to positive correlation with profitability while diseconomies of scale lead to lower profitability. According to Eichengreen and Gibson (2001) as cited by Sufian and Chong (2008) the impact of growing bank size on profitability may be positive up to a certain extent and beyond that limit it could be negative due to bureaucratic and other factors. Athanasoglou et al. (2005) rationalized that, small sized institutions try to grow faster even at the expense of profitability. Accordingly recently incorporated institutions put more emphasis on increasing their market share rather than improving profitability. Demirguc-Kunt and Maksimovic (1998) (as cited by Hoffmann, 2011) suggest that the 21

37 extent to which various financial and legal factors influence profitability is closely linked to the firm's size. Sufian (2011, p. 62) notes the following, it could be argued that the large banks with extensive branch networks across the nation may have an advantage over smaller bank counterparts as they may attract more deposits and loan transactions, and in the process command larger interest rate spreads and subsequently higher levels of profitability'. In Sri Lanka, CBSL identified that LFCs with strong balance sheets (Above 10 Billion size) manage to record relatively high net interest margins of 9.2% when comparing with small LFCs (Less than 10 Billion size) which record 7.9% (Silva, 2013). Sufian and Chong (2008) highlight that in the literature profitability and size found mixed relationships, while in some cases a U-shaped relationship is identified. Hence the size of the financial institution and its profitability may be expected to be a non linear relationship Expense Management High overhead expenses are often discussed in the literature since it directly impact profitability. But financial institutions need to incur at least a certain amount of expenses to offer quality services to its customers. The compensation to its employees and other administrative expenses contribute a considerable volume in the overhead expenses. Some may argue that quality management may incur high compensation which will enhance the profitability through timely and quality decisions. A number of researchers highlight the relationship between profitability and expenses appear to have a straightforward negative relationship, this may not always be the case (Kosmidou, 2008; Olweny & Shipho, 2011). This is because a higher degree of expenses may be 22

38 associated with higher volumes of activities and enhance the revenues. Further this explains the 'expenses preference behaviour hypotheses', where a higher level of operational expenses exhibits higher profitability. The negative impact on expenses management expressed the lack of passing part of the increased expenses to its customers, and high competition might not allow the management to overcharge (Athanasoglou et al., 2005). Flamini et al., (2009) also pointed out that, high operating expenses erode profits except banks that manage to pass on their costs to depositors and lenders. LFCs in Sri Lanka used to pass the expenses incurred in marketing, sales promotion expenses and others to its borrowers while charging documentation charges, service or processing charges, etc. Staikouras and Wood (2011, p. 58) note 'Expenses management offers a major and consistent opportunity for profitability improvement' Liquidity The relationship between profitability and liquidity are often discussed in banking literature. Financial institutions are engaged in the maturity transformation process, where short term deposits will be converted to long term advances. This process would constantly involve the risk associated with maturity mismatches (Guru et al., 2002). CBSL identified the short term mismatches (up to one year) of assets and liabilities of LFCs and this is mainly due to a lack of stable long term funds. In order to manage the depositors' requirement, financial institutions hold a small portion of investment in liquid assets and the liquid assets are often associated with less return. Kamau (2009) as cited by Olweny and Shipho (2011) highlights that holding of more liquid assets, is at the opportunity cost of other investments with high returns. But liquidity is important 23

39 for the stability more than the profitability. LFCs need to safeguard vigilantly against liquidity risk (the risk arising due to insufficient liquid assets such as cash and treasury securities to fulfill the current obligations of depositors) mainly during times of an economic stress scenario. Hence it is rational to mention that inadquate liquidity make the firms go for quick borrowings to face liquidity requirements. This may impact additional costs or higher rates and finally impact negatively on profitability. Bourke (1989), as cited by Al-Omar and Al-Mutairi (2008) point out a positive relationship between profitability and liquidity. This is because a high level of liquidity reduces transaction costs and absorbs obligations without incurring unacceptable losses. Literature on financial institutions' profitability often identifies poor asset quality as well as low level of liquidity to be major causes of failures (Athanasoglou et al., 2005; Olweny & Shipho, 2011). They further expressed that during an increased uncertainty time diversifying the portfolios and raising liquid holdings will reduce the risks. Sufian and Parman (2009, p. 116) state, 'Liquidity risk arising from the possible inability of a bank to accommodate decerase in liabilities or to fund increases on the assets' side of the balance sheet, is considered an important determinant of bank profitability'. To balance liquidity and profitability, financial institutions are expected to hold a certain percentage of liquid assets and it is called as 'statutory liquid assets ratio'. The statutory liquid assets ratio for the LFC sector changed in 2009 from 15% to 10% for fixed deposit liabilities and 20% to 15% for savings deposits liabilities considering the liquidity stress scenario caused by the Ceylinco debacle. Further CBSL has introduced weekly online reporting systems to capture the liquidity position of the finance companies on a daily basis. 24

40 2.2.6 Activity diversification In the recent past financial institutions enhanced alternative sources of revenues by diversifying the lending activities into trading activities. These non-interest incomes were mainly from off balance sheet activities, specially trading dealing securities, investment in properties, real estate business, property developments and other commissions. Olweny and Shipho (2011) notes revenue diversifications are based on the portfolio theory which states that individuals can reduce firm-specific risk by diversifying their portfolio. RAM Ratings Lanka (2009) highlights LFCs' investment in real-estate spiked up 8.6% of the industry assets base, as at the end of March RAM Ratings Lanka (2009, p. 5) further stress, 'Increasing exposure to real estate is deemed risky because of the current slump in the property market and the inability to dispose of assets in the short term, thereby exposing RFCs to liquidity risk.' Choi and Kotrozo (2006) as cited by Olweny and Shipho (2011) highlight that activity diversification or product mix provides a stable and less volatile income, economics of scope, scale and the ability to leverage managerial efficiency across products. But recent experience signifies the high concentration on real-estate exposes, the high risk due to non / slow movement of the stock. Especially Ceylinco related finance companies invested in real estate and property development activities by using the short term deposits funds, which raised a major impact on liquidity. Some of the finance companies over exposed in the equity investments and earned considerable amounts of income with the rise in ASPI up to 2011 but subsequently faced losses when mark to market the value. RAM Ratings Lanka (2012, p. 8) stress, 25