Determinant of Bank Profitability free essay sample

The estimation results show that profitability persists in some extent, implies that the indicator of the existance of relatively fairly competitive market in Ethiopian commercial banking environment, especially competition between private banks. Regarging the explanatory variables, all bank-specific determinants, with the exception of bank size, expense management and credit risk, affect bank profitability significantly and positively in the anticipated way. However, bank size, expense management and credit risk affect the commercial banks profitability significantly and negatively. In addition to this, no evidence is found in support of the presence of market concentration. Finally, from macro economic determinants GDP has positive and significant effect on both asset return and interest margin of the bank. But interest rate policy has significant and positive effect only on interest margin. The commercial banks of Ethiopia policy makers and managers should give high concern to the credit risk management, expense management and large bank size management inorder to reduce the hindrance of the profitability of the banks. iii 3 ACKNOWLEDGEMENT My deepest and warmest thank goes to the Almighty God and his mother Sanity Marry, who help me in all aspect of my life including the achievement of this masters program. Along with, I would like to express my sincere gratitude to Abebe yitayew (Ass. professor) who is Instructor of Department of Accounting and Finance at Addis Ababa University and my advisor, for his expert guidance, helpful criticism, valuable suggestions and encouragement at every stage during the completion of this work. It was pleasant and inspiring experience for me to work under his guidance. I am also grateful, to NBE change management directors and bank supervision department staffs, for their assistance by giving twelve year audited financial reports. It is my pleasure to thank, the financial officers of all sampled banks, specially thank forwarded to Awash International Bank, Construction and Business Bank and Abiyssina Bank financial officers, those help me by answering the questionnaire. I add a special note of admiration and gratitude to my families and friends, for their moral support, to done and to go through this piece of work. DB Dashen Bank ESH Efficiency Structure Hypothesis iiix 8 EVA Economic Value Added GDP Gross Domestic Product HHI Herfindahl-Hirschman Index IMF International Montary Fund ISBN International Standared Book Number LIB Lion International Bank MoFED Ministry of Finance and Economic Development NBE National Bank of Ethiopia NIB Nib International Bank NIM Net Interest Margin OBS Off Balance Sheet OIB Orromian International Bank OLS Ordinary Least Squares PER Profit Earning Ratio RAROC Risk-Adjusted Return on Capital RMP Relative-Market-Power 9 x ROA Return on Assets ROE Return on Equity SCP Structure-Conduct Performance SSA Sub Sahara African UB United Bank WB Wegagen Bank ZB Zemen Bank 10 xi 11 Chapter One Introduction 1. 1 Background of the Study The Banking sector acts as the life blood of modern trade and economic development to provide them with a major source of finance. The concept of profitability is more important both for the non-financial and financial institutions and banks are the part of them. Banks largely depend on competitive marketing strategy that determines their success and growth. Bank performance has been one of the main concerns of management experts, investors, and economic analysts. This concern closely relates to the significant impact of the profitability of financial organizations in general, and commercial banks in particular, on the potential growth of the economy as a whole. Due to this, the protocols of the banking business have changed a lot in the new millennium compared to the way they used to be in the years by gone (Hussain and Bhatti, 2010). Bank performance gets a great deal of attention in the finance literature considering that banks serve a pivotal role in the economy. The performance of banks is expressed in various terms, such as competition, concentration, efficiency, productivity, and profitability. Firms with better performance are better able to resist negative shocks and contribute to the stability of the financial system (Athanasoglou et al. , 2008). The profitability of the banking system has been one of the hot issues in financial environment. Since the bank industry play a major role in the financial system of the country and it supports the compititiveness of the financial institution. Given the relation between the well-being of the banking sector and the growth of the economy 1 Levine, 1998), knowledge of the underlying factors that influence the financial sectors profitability is therefore essential not only for the managers of the banks, but also for numerous stakeholders such as the central banks, bankers associations, governments, and other financial authorities. Knowledge of these factors would be useful in helping the regulatory authorities and bank managers formulate future policies aimed at improving the profitability of the banking sector. Many researchers in different countries have made investigation on this area by considering the importance and the hot issue of profitability in banking sector. For instance research conducted by Goddard, et al, (2004) by using panel data and dynamic panel etimation to investigate the determinants of profitability in six selected Europian counrties banking sectors: Denmark, France, Germany, Italy, Spain, and the UK, for the period 1992-98. The result suggested that among modeled determinants of profitability incorporate: size, capital asset ratio, credit risk and ownership, by measuring profitability in term of Return On Equity (ROE), checked that bank- specific determinants and profitability relation ship is very strong. Finally they checked that there is little evidence of a systematic relationship between industry – specific determinants(i. e ownership) type and profitability. In the case of Sub Sahara African (SSA) countries banking sector, the profitability of the commercial banks industries are affacted by different internal and external factors. For instance research conducted by Flamini et al. (2009) used a sample of 389 banks in 41 SSA countries to study the determinants of bank profitability measured by the ratio of after tax profits to total assets ( ROA). The results revealed that the bank – specific, industry – specific and macroeconomic determinants affacted 2 the bank return or bank profitability in strong manner. And finally they conclude that Bank profits are high in Sub-Saharan Africa (SSA) as compared to other regions. In Ethiopia, commerial banks play important primary role as financial intermediaries in the economic growth process, channeling funds from savers to borrowers for investment. As financial intermediaries, banks play an important role in the operation of an economy. In such away, commercial banks are key providers of funds and their stability is of paramount importance to the financial system. As such, an understanding of determinants of their profitability and the drivers of bank profitability for that matter is essential and crucial to the stability of the economy. However, substantial amount of studies have not conducted to investigate the status of bank profitability as well as the determinants of profitability of the Ethiopian banking system. This research examined the effects of bank-specific, industry-specific and microeconomic determinants on profitability of industry from the period 2000-2011. Ethiopiann commercial banks 1. 2 Statement of the Problem A lot of studies conducted in the area of commercial banking profitability and its determinant by considering the importance of the area at international level. They veriefied that there is a direct association between profitability of commercial banking industries and its both internal and external deteminants(eg. Rajan Zingales, 1998; Eichengreen Gibson, 2001; Bourke, 1989). Even though, all these and other researchers conducted study on this area, the determinants of profitability have been debated for many years and still unsolved issues in the corporate finance literature. Indeed what makes the profit deteminants debate exciting is the determinants of profit 3 is dynamic through time to time and differ with the nature of operating of the firm from place to place (Flamini et al. , 2009). To sum up, there is no universally accepted findings to the determinants of profitability of the banking sector. Because countries differ each other by their economic systems, financial systems, political systems and operating environments. Thus in this study, the researcher examined some bank-specific, industry-specific and microeconomic determinants of profitability of Ethiopian commercial banks, and a variety of variables (capital adequacy, deposit liability, credit risk, liquidity risk, loan and advance, expenses management, efficiency and productivity, non-interest income, market concentration, economic growth and interest rate policy) that are potentially responsible for determining profitability of banks have been selected based on the selacted theoretical literatures and privious emperical workes. Although, numbers of earlier studies have made to add their own contribution to the theory of profitability and stated their own policy implication, they were inclined towards to the developed economy, and less developed countries including Ethiopia received litle attation in various literature on this issue. Consequently the conclusion and finding of the study in one country may not serve to another. Specifically in Ethiopia the banking sector is unstudied area, though, few studies have been conducted on financial performance of Ethiopian commercial banks. For instance, study conducted on financial performance and ownership structure of Ethiopian commercial banks (Deepak and Abebaw, 2011, pp. 1 8) indicated that, even if, after 1994 financial liberalization the numbers of banks in the industry (particularly private banks) are increased and the performance progress of the sector is better than the past. However, Ethiopia’s financial sector remains closed and is much 4 less developed than its neighbors. In addition to this, other study conducted by Belayneh (2011) examined the determinants of profitability at internal and external level. By employed the variables like; capital, bank size, loan and advance, saving deposit, fixed deposit, non interest income, non- interest expenses and credit risk as bank–specific; market concentration as industry – specific variable and economic growth, saving interest rate and inflation as macroeconomic variable. This researcher also conclude that, Ethiopian commercial banks profitability affected by other additional factors. Even though, those two studies conducted on this area, The researchers not included non financial variables and qualitative information from their studie. As a result, this area is not effectively studied. Because, these variables are the most important factors to determaine the profitability of the commercial banks. Among these determinants the most commenly known variables are employee efficiency and productivity and management quality (Athanasoglou et al. , 2005; Haron, 2004 ). As per the result of those researchers, the variables are highly significant and explanatory of profitability of the commercial banks. Because of this, the current researcher was included these non-financial variables and other financial determinants in addition to the previous study with additional qualitative information. So, the theme of this research was emperically examined the main determinants of Ethiopian commercial banks industry profitability( bank-specific, industry-specific and macroeconomic) during the period of 2000 2011 by adding non financial variables and other determinants of profitability which are not included in previous study. It is an important research area that need to be investigated by benchmarking 5 the same researches under taken in other countries to know the past decade of profitability and its determinants of Ethiopian commercial banks. The time period of 2000 – 2011 was selacted because, following 1994 financial liberalization of Ethiopia, large numbers of private banks established from the period 1994 – 1999 continuouslly and the period has significant structural change in profitability increment in Ethiopia banking sector after financial libralization. This is the basic reason to start the investigation of this research from 2000 year. 1. 3 Objective of the Study In commercial banking industry of Ethiopia no sufficient study was conducted on the both internal and external determinants of commercial banks profitability. Because of this, the Ethiopian commercial banks managers and policy makers have not clearly identified and understand the determinants of banks profitability at bankspecific, indistry-specific and macroeconomic level during the decad operation time. So, the objective of this paper can be stated as follows. 1. 3. 1 General Objective The aim of this study is to examine the effect of bank-specific, industry-specific and macroeconomic determinants on Ethiopian commercial banking industry profitability over the period 2000 – 2011 and to identify the significant determinants of profitability. 6 . 3. 2 Specific Objective The study has the following specific objectives: ? To assess and analyse the extent of bank-specific (internal) determinants effect on profitability of Ethiopian commercial banking industry. ? To check the effects of external ( both industry-specific and macroeconomic ) determinants on profitability of Ethiopian commercial banks. ? To identify the behaviour of market structure of Ethiopian commercial banking sector over the past decade. ? To know the significant determinants of profitability across the state owned and private commercial banks over the last decade. . 4 Hypothesis In oder to acheive the objective of the study, a number of hypotheses was tested regarding the determinants of profitability in Ethiopia commercial banks based on different emperical research and theoretical reviewed made. There are three general testable hypothesis with their sub hypothesis. These testable hypotheses could be formulated as follows. Hypothesis A: Bank specific determinants have significant effect on banks profitability. Hypotheses A1: There is direct positive relationship between capital adequacy and profitability Hypotheses A2: There is direct negative relation between credit risk and profitability. Hypotheses A3: There is direct positive relation between deposit liability and profitabilty. Hypotheses A4: There is direct positive relation between liqui dity risk and profitability. Hypotheses A5: There is direct positive relation between loan and advance and profitability. Hypotheses A6: There is direct negative relation between management and profitability. expense Hypotheses A7: Efficiency and productivity has positive direct relation with profitability. Hypotheses A8: There is positive direct relation between bank size and profitability. Hypotheses A9: Non-interest income has positive direct relation with profitability. Hypotheses B: There is direct positive relation between industry-specific determinant(i. e market concentration) and profitability. Hypotheses C: Macroeconomic determinants have significant effect and relation on banks profitability 8 Hypotheses C1: Economic growth has direct positve relation with profitability. Hypotheses C2: There is direct positive relation between interest rate policy and profitability . 5 Significant of the Study This study has ultimate significance to show the degree of the bank-specific, industry specific and maacroeconoomic determinants in what extent it affected the profitability of the commercial banks, by idetifying and showing the main determinants of profitability and to suggest policy implications after critical examination of the profitability determinants of the commercial banking ind ustry of Ethiopia. To this end, Particulary this study has importance for the following body. ? It enables policy makers and management body of the commercial banks to adjust the bank management system and mechanisms. ? It will help the management to hedge against adverse factors, like uncertainty, and capitalize on other, like strong demand and cost complementarities that improve performance. ? Moreover, it will help investors to measure the performance of their portfolios and proceed with readjustments as required. ? It will help research biginners who are interested to conduct their research in this area. ? It will provide a road map for managers and the shareholders to evaluate there bank performance in term of profitability with respact to the internal and external determinants. 9 ? It will give direction for economic policy makers to measure the impact of the bank industry performance on the economy and its implications on the issues of policy. 1. 6 Delimitation and Limitation of the Study 1. 6. 1 Delimitation of the Study There are fouteen commercial banks in Ethiopia both public and private which is fully engaged in commercial banking activity at least more than five years. But to make the study more manageable, the scope of the study was delaminated on eight of the main office in Addis Ababa city which is fully operated from the year 2000-2011. And the research is concentrated on the bank-specific, industry-specific and and macroeconomic measurable determinants only. In addition to this the study measure the more of financial performance of the banks. 1. 6. 2 Limitation of the Study The study is more of financial related variables was considered that of non financial measure variables may have a little influnce and might need a further investigation. Financial reports within twelve years may affacted by different non modaled variables in the state of the economy. This might fail to measure the actual effects of the internal and external determinants on profitability of the bank. 1. 7 Organization of the Paper This paper consists of five chapters with different sections and sub-sections and it was stucture as follows. Chapter one presents the introduction for the main part of the paper. Chapter Two reviews the most significant theortical and emperical studies 10 including Ethiopian bankink business enivronment. Chapter three focuses to presents methodology of the study. Chapter four also provide the interpretation and analysis of econometric model outcomes. Chapter five as usual gives conclusion and recommendation with policy implication and further research direction. 11 Chapter Two Literature Review Various determinants influence banks’ profitability, recognizing the main concepts of the banking sector profitability and its determinants are essential in order to provide evidence to support the practical result by the theoretical and emperical view. Hence, this chapter serves as a base for this study by describing factors that could influence banks’ profitability. Sub topics which build on this chapter are described here below. First, this chapter explains some theoretical frameworks that are helpful in assessing the relationship between macroeconomic, industry-specific, bank-specific factors and banks’ profitability, and the, emperical review was discusses. Next, the commercial banking industry of Ethiopia were reviewed. Finally, conceptual frame work and conclusion and knowledge gap was conducted. 2. Theoretical Framework There is no general theory of profitability that provides a unifying framework for the study of financial performance determinant of the commercial banking industry. Because of this, this study tries to view some theories which is nearer to the concept of profitability and its determinants. The theoretical frame work upon which this study is based on structural approaches to investigate behavior of the banking market regarding to profitability. A structural approach was mainly focuses on the structure-conduct performance (SCP) paradigm and on the efficient structure paradigm. Structural approach has investigated how the market 12 concentration weakens the market competition by fostering collusive behavior among firms (Panzar, J. C. and J. N. Rosse, 1987) as cited by Lalith (2010). 2. 1. 1 Market Structure Theories and Bank Profitability The traditional theory of the firm was assumed that a firm’s objective is simply to maximize profits. In practice this theory is not applicable because of most modern industries , involvement in providing a variety of products/services, and faced with much more complex decisions to be taken in dynamic and uncertain environment Devinaga (2010) . Due to this most resaercher prefer market structure theoreis rather than the traditional theory to analyze the profitability of the industry in term of industry structure. Like other authors the this researcher was used market structure theories to analyse market structure of the firm ( industry-specific determinant). The central assumption of this theory is, the industry str ucture (measured by market concentration interm of market share ratio ) has impact on profitability of banks. The literature on the measurement of market structure (structural approach) divided into two mainstreams, called the structure–conduct–performance (SCP) paradigm and the efficiency structure hypothesis (ESH). Market structure theory suggested two alternative policy drives inorder to increase profit of the bank industry and for rationalizing market structure in banking industry (Byeongyong et al 2005). The first one lies in limiting the number of banking units in the market through encouraging mergers among existing banks. This is help to increase the bank size for pursuing scale of economics. The second strategy is the sharing common facilities such as ATM with other banks in the industry. Both strategies may be useful in enhancing the competition in the market and improving 13 the overall profitability and efficiency of the market. As explained in the efficient structure hypothesis (ESH), there is no need to encourage mergers, since the efficient entities can improve their market share by providing banking services, which is more economical in the market. Therefore, ESH suggests instead of encouraging bank mergers, the ESH supports policies that may encourage sharing common facilities to avoid duplication of capital cost. 2. 1. 1. 1 Structure Conduct Performance (SCP) Hypothesis In formulation of theoretical framworke for studying determinants of commercial banks profitability (industry –specific determinants), market structure conduct performance hypothesis provided usefull prototype. Market structure conduct and performance (SCP) framework derived from the neo-classical analysis of markets. It first formalized by Mason in 1939 as a method of analyzing markets and firms (Worthington et al. , 2001) . The SCP was the central opinion of the Harvard school of thought and popularized during 1940-60 with its empirical work involving the identification of correlations between industry structure and profitability. Most early research explanation for the relationship between the market concentration and profitability based on the structure-conduct performance (SCP) hypothesis, and focused on the interpretation of a positive empirical relationship between concentration and profitability Goddard et al. 2004). The SCP paradigm asserts that there is a relationship between the degree of market concentration and the degree of competition among firms. This hypothesis assumes that firms behave or rivalry in the market determined by market structure conditions, especially the number and size distribution of firms in the industry and the conditions 14 of entry. This rivalry leads to unique levels of prices, profits and other aspects of market performance (Berger et al. , 1989). The Structure-Conduct-Performance (SCP) hypothesis, which also sometimes referred to as the MP hypothesis, asserts that increased market power yields monopoly profits. A special case of the SCP hypothesis is the Relative-Market-Power (RMP) hypothesis, which suggests that only firms with large market shares and well-differentiated products are able to exercise market power and earn non-competitive profits (Berger, 1995). The assumption of SCP hypotheses have been applied in different research by various researcher and supported positive relationship between market concentration measured by concentration ratio) and performance (measured by profits) exists. Furthermore, SCP recognized the competitiveness of small market share banks with large market share is weak as a result the positive relationship between market concentration and performance (profitability) of high market share banks exist (Berger and Hannan, 1989). As explained in the SCP, the market concentration encourages collusi on among large firms in the industry, which subsequently leads to higher profits. Hence, SCP pointed out those changes in market concentration may have a direct influence on a firm’s financial performance. Firms in more concentrated industries can earn higher profit than firms operating in less concentrated industries earn, irrespective of their efficiency (Goldberg et al. , 1996). The relative market power hypothesis (RMPH) which is a special case of SCP posited that only banks with large market shares and well differentiated service lines are able to exercise market power to gain superior profit on non-competitive price setting behavior ( in this case service charge) Berger (1995). Studies, such as those by Smirlock (1985) and Berger and Hannan (1989), investigated the profit-structure 15 elationship in banking, providing tests of the RMP hypotheses. To some extent, the RMP hypothesis verified that superior management and increased market share (especially in the case of small-to medium-sized banks) raise profits. SCP, in general, provides two main benefits to studies, which investigate the banks profit behavior. First, it shows the way to the banks profits are operating. Thus, it ex plains different forces that restrict or expand the scope of banks’ operations in the market. Especially with profitability studies, SCP helps to interpret different sources of productivity and efficiency gains or losses. Second, SCP provides a rational basis for analyzing the market behavior. 2. 1. 1. 2 The Efficient Structure Hypothesis (ESH) The second formulation of theoretical framworke for studying determinants of commercial banks profitability is the efficient structure hypothesis. According to the ‘efficiency’ hypothesis, a positive concentration– profitability relationship may reflect a positive relationship between size and efficiency. It states that efficient banks in the market lead to increase in the firms’ size and market share due to the aggressive behavior. This behavior of the efficient banks allowed such firms to concentrate and earn higher profits with further enhancing their market share. Those firms can maximize profits either by maintaining the present level of product price or service charge and firms’ size or by reducing the service charge and expanding the firm size Smirlock (1985). Finally, the ESH stated that the positive relationship between profit and concentration results from the lower cost achieved through superior management and efficient production process (Goldberg et al. , 1996). In contrast to SCP hypothesis, the ESH 16 ncertain whether the high profits of large banks are a consequence of concentrated market structures and collusion. As explained by Berger and Hannan (1989), ESH and SPC stand on similar observation on the relationship between concentration and performance (profitability). However, the difference in two theories consisted mainly in ways of interpretation of the relationship. 2. 2 Emperical Rev iew A number of studies have examined the determinants of banks’ profitability in many countries around the world. Most of the studies consider internal factors (i. e. , banks’ specific) and external factors (i. . , industry-specific and economic environment) and examine either a particular country or a number of countries. Many emperical literatures conducted on banks profit determinants belong to developed countries economies. Mainly focused on the U. S. banking system ( e. g Berger, 1995; De young and Rice, 2004; Stiroh and Rumble, 2006 etc. ) and the banking systems in the western developed countries for instance, Europian countries (Ommeren, 2011; staikouras and wood, 2004 etc. ), south-east Europ (Athanasoglou et al. , 2008), Korea (Sufian (2011)) and Greeke ( kasmidou et al. 2007; Athanasoglou et al. , 2008; Kasmidou and Zopounidis, 2008 etc. ). By contrast few studies have looked bank performance in developing economies (e. g Mthuva,2002 in Kenya; Flamini et al . , (2009) in SSA countries, Belayneh, 2011 in Ethiopia etc. ). Both studies usually expressed bank profitability, as a function of internal and external determinants. A number of explanatory variables have been proposed for both categories, according to the nature and purpose of each study. The finding of each studies depending on the operational environment of their banks, the economic and 17 egal environment and the empirical results vary significantly, since both datasets and environments differ. The internal determinants originate from bank accounts (balance sheets and/or profit and loss accounts) and therefore could be termed micro or bank-specific determinants of profitability. Internal determinants of bank profitability can defined as those factors that are influence by the banks’ management decisions and policy objectives. Management effects are the results of differences in bank management objectives, policies, decisions, and actions reflected in differences in bank operating results, including profitability. Essentially, company-level determinants of bank profitability comprise characteristics of individual bank companies that affect their profitability. Shareholder and managerial decisions and activities can directly influence these characteristics; hence, they also differ from company to company. (Athanasoglou et al. , 2006; kasmidou, 2008 and Sufian, 2011). In this study such internal profitability determinants are includes: capital adequacy, credit risk, deposit liability, the level of liquidity, loan and aadvance, expense management, efficiency and productivity, bank size and non-interst income. The literature suggests that, the environment in which banks operate influences them, like any firm; from this, the external environment is the commen and the uncontrole one. The external determinants are variables that not related to bank management but reflect the industry-related and macroeconomic environment that affects the operation and performance of commercial banks. External determinants of bank profitability are concerned with those factors, which are not influence by specific bank’s decisions and policies, but by events outside the influence of the bank. Several external determinants are included in the performance examination of commercial banks 18 profitability: the financial market structure; the economic condition of the country, the legal and political environment all may influence the performance of the banks (Athanasoglou et al. , 2006; kasmidou, 2008 and Sufian, 2011). From this study including market concentration as industry-specific determinants and economic growth and interest rates policy as macroeconomic determinants. 2. 2. 1 Bank-specific Determinants 2. 2. 1. Capital Adequacy It is measureing by the ratio of equity capital to total risk weighted assets. It is sometimes mention as Capital structure by great deal of literatures. Bank equity capital can see in two dimensions as stated by Aburime (2008). That are the amount contributed by the owners of a bank (paid-up share capital) that gives them the right to enjoy all the future earnings and the amount of owners’ funds available to support a bank’s busine ss which includes reserves, and is also termed as total share holders’ funds. Bank’s capital is widely used as one of the determinants of bank profitability since it indicates the financial strength of the bank (Athanasoglo et al. , 2005: p. 14). Aburime (2008) suggested that the bank level of safety achieved through the high capital requirements which generated positive net benefits. The degree of security exceeded the level maximizing net benefits. Capital adequacy requirements generally aim to increase the stability of a national banking system by decreasing the likelihood of a bank failure and a number of negative externalities exist in banking that cause risk to systematically under price. 9 Studies dealing about the capital adequacy are stated and concluded as follows. Athanasoglou et al. (2005) study on the effects of bank specific, industry – specific and macroeconomic determinants ofprofitability on Greek bank from the period 1985 – 2001, based on the emperical fram worke that incorporates the traditional structure – condu ct – performance (SCP) hypothesis. Applying General Movment Method (GMM) used apanel data, the investigation demonstrated that the existence of Positive correlation between returns and capital. An other research conducted by Flamini et al. (2009) on the determinants of commercial banks profitability in Sub – Saharan Africa by taking 389 sample banks in 41 SSA countries, they measuring profitability by return on asset indicators. They founded that capital adequacy has positive and significant effect on profitability. Other reseacher Berger (1995) found that capital adequacy ratio affected ROA of USA banks positively in 1983-1989 and negatively in 1989-1992. Based on these results, Berger argued that the relationship between capital adequacy ratio and profitability depending on the specific circumstances of the time period observed. According to the results of the study, a high capital adequacy ratio positively affects profitability when financial situation of banks is perceived as risky and it negatively affects profitability in normal situations due to alternative cost of capital. The main problem in benefiting from this result is the difficulty of determining an optimal level for the capital adequacy ratio. Similar studies conducted on developing countries founed and concluded that, capital adequacy is significant company level determinants of profitability. According to Naceur and Goaied (2001) investigation the impact of bank- specific, industryspecific and macroeconomic determinants of banks’ net interest margins and return 20 on asset in the Tunisian banking industry for the 1980-2000 period. The result shows that high net interest margin and return on asset (profitability) tend to be associated with banks that hold a relatively high amount of capital. As determained by Aburime (2008) company level determinants of bank profitability evidence from Nigeria. Using apanal data set consist of 91 observation of of 33 banks over the 2000 – 2004 period. Regresion desired outcomes revaled that capital size is one of significant company level determinants of profitability. Though the results indicate that capital size is a significant determinant of bank profitability in Nigeria, only the size of the reserves component of bank capital has a significant relationship with bank profitability. But the shares component of bank capital does not have a significant relationship. In case of Ethiopian commercial banks, the single research conducted by Belayneh (2011 ) on the determinants of commercial banks profitability during the period 2001 – 2010 by used Ordinary Least Square (OLS ) and balanced panel data of seven Ethiopian commercial banks. The result from estimation show that, capital can significantly affect commercial banks profitability in Ethiopia. Following this, he concluded that there is positive relationship between banks capital and profitability. And also the higher the capital level brings higher profitability for Ethiopian commercial banks since by having more capital; a bank can easily adhere to regulatory capital standards and the excess capital also can be provided as loans. Generally, there is the presence of positive relationship between profitability and capital has been supported by Athanasoglou et al. (2005); Flamini et al. (2009); Naceur and Goaied (2001) and Belayneh (2011). Therefore, researchers widely posit that the more capital a bank has, the more resistant it will be to failure. 1 2. 2. 1. 2 Credit Risk Credit risk is one of the key drivers of banks’ profitability because of this; the research examines credit risk as the main determinants of profitability. The asset quality of the loan portfolio used as proxy for credit risk, measured by the ratio of loan loss provisions over total loans and advances. The loan loss provisions are report on a bank’s profit and loss account. This research does no t use the ratio of loan loss reserve to gross loans similar to Athanasoglou et al. 2008) and Dietrich and Wanzenried (2011) as cited by Ommeren (2011) because many data is missing for this variable. Athanasoglou et al. (2005) suggest that bank risk taking has irrational effects on bank profits and safety. similarly Bobakova (2003) asserts that the profitability of a bank depends on its ability to foresee, avoid and monitor risks, possibly to cover losses brought about by risks arisen. Hence, in making decisions on the allocation of resources to asset deals, a bank must take into account the level of risk to the assets. According to Flamini et al. (2009) the main source of bank-specific risk is credit risk. Poor enforcement of creditor rights and obligation, weak legal environment, and insufficient information about the borrowers expose banks to high credit risk. At the macroeconomic level, weak economic growth adds to risk as it promotes the deterioration of credit quality, and increases the probability of loan defaults. Higher anticipated non-repayment of the loans, measured by the loan loss provisions, reflects a lower credit quality of the loans. Over a longer period, a lower credit quality could negatively influence the profitability since the actual impairment costs of nonrepayment are likely to be higher for banks with a lower asset quality than for banks with higher asset quality. In contrary to the risk-return hypothesis, a lower asset 22 quality expected to negatively, influence banks’ profitability. Most literatures suggest that increased exposure to credit risk is obviously associated with decreased firm profitability Ommeren (2011). The study examined a negative and strongly significant impact of credit risk on Ethiopian commercial banks profitability. This is occure due to weak inspection techniques of identifying potential borrowers. Credit risk trend may bring a series collapse against the sector as well as the nation economy Belayneh (2011). 2. 2. 1. 3 Deposit Liability The amount of interest income Commercial banks earn mainly depend on the amount and quality of the fund deposited with them by the public. There are three major sources of deposit funds for the commercial banks; namely: current or demand deposits, fixed or time deposits / term deposits and Savings deposits. On current or demand deposits, the bank no pays practically interest. The depositor can be withdrawn in part or in full at any time by issuing cheques. Fixed / Time / Term deposits are so- called for commercial banks because they are left with the bank for a certain fixed period before the expiry of which they cannot be withdrawn except after giving due notice. On such deposits, the bank pays higher interest. Savings deposits can withdraw any time subject to certain limitations regarding the amount withdrawn or the frequency of withdrawals. In fact, only a small percentage of savings are withdraw at any particular time. Since, withdrawals can and do take place, the commercial bank has to keep a certain proportion of its assets in liquid form Rasiah (2010). 23 As we know the primery function of the commercial banks are collecting deposits and giving loan to the public from this deposits. The competitiveness and the profitability of the bank is depend on the degree of well performing of this activity. About this, Rasiah (2010) stated like: Commercial banks, accepts cash and hold on to as much of it as possible because the more it has and can retain the more funds it can lend to the public. That is, the more cash a commercial bank has the greater is its capacity to make profits. Moreover, the commercial bank always utilizes its funds to the full in lending funds; the greater is the commercial banks’ profitability. Hence, the competition for deposits is really a competition for profits. Commercial banks compete for deposits in order to become larger and thus to be able to supply more funds to the public. However, such financial growth is profitable only if the commercial bank does not incur additional expenses to obtain and retain cash. Most studies from the literature agreed that, liability portfolio Management especially deposit liablity may influence the profitability of commercial banks positively, among this (Moin, 2008) found. In contrary other researchers conclude that Since, time and savings, deposits represent a relatively higher cost source of funds, the more a commercial bank is committed to time and saving deposit, the higher would be the funding cost and hence the lower the profits (Ommeren, 2011). In the case of Ethiopian commercial banks business environment regarding the impact of deposits on profitability research conducted by (Belayeneh, 2011) concluded that, even though, deposit is the main source of funds for banks, the number one expense item for a banking sector is interest payment on saving and fixed deposits. Because of this, 24 study revealed fixed deposit has a negative and significant impact on Ethiopian commercial banks profitability. In addition to this, the result show that the impact of saving deposit on banks profitability is unstable and insignificant. . 2. 1. 4 Liquidity Risk Liquidity risk is another type of risk for banks; when banks hold a lower amount of liquid assets they are more vulnerable to large deposit withdrawals. In other word liquidity risk, arising from the possible inability of a bank to decreases accommodate liabilities or to fund increases on the assets’ side of the balance sheet. Following Saunders and Cornett (2008), liquidity ris k refers to the risk that an asset cannot convert into cash or that the conversion is costly. Furthermore, they state that price risk refers to the risk that the sale price will be lower than the purchase price of an asset. It is considered an important determinant of bank profitability Athanasoglou (2006). Therefore, liquidity risk estimated by the ratio of liquid assets to customer deposits and other short term funding. Insufficient liquidity is one of the major reasons of bank failures Ommeren (2011). Liquidity is the quality of an asset that makes it easily convertible into cash with little or no risk of loss. A bank considered liquid when it has sufficient cash and other liquid assets, together with the ability to raise funds quickly from other sources, to enable it to meet its payment obligation and financial commitments in a timely manner. In addition to the maintenance of cash reserve with the Central Bank, the commercial banks are also required to maintain a minimum level of liquid assets. While the primary reason behind the imposition of minimum liquidity ratio is to ensure that the commercial banks have at all times, a reservoir of liquidity, which can be tapped to 25 eet unusual deposit withdrawals, the ratio can also be used as a means of influencing the monetary situation in these countries. When total demand for liquidity exceeds its total supply, the commercial banks will face with liquidity deficit. In such a situation, these institutions will force to raise additional liquid funds by borrowings or disposing some of their liquid assets. Usually, short-term borrowings are costl y and the loss of income from the sale of liquid assets will tend to have an adverse effect on profitability. On the other hand, idle funds and the lower returns on liquid assets may also adversely affect the profitability of those institutions with surplus liquidity. Thus, liquidity management represents yet another important determinant of commercial bank profitability Rasiah (2010). Based on the risk-return hypothesis, more liquidity risk is associated with higher expected returns. Otherwise stated more cash and other liquid non-earning assets result in a lower expected return because these assets do not generate any return. Following prior research of Ommeren, (2011) and Rasiah (2010) a negative relationship between profitability and large liquid assets to customer deposits and short term funding ratio is hypothesize. On the other hand researchers expacted a positive relationship between liquidity risk and profitability and concluded that the fewer the funds tied up in liquid assets the higher expected profitability to be (Eichengreen and Gibson, 2001) . 2. 2. 1. 5 Loans and Advances It is needless to emphasize that extending loans is one of the most important role of banks. The interest raised from the loans is the most important source of the banks’ income. However, inherent with bank’s loan is liquidity risk as well as credit risk. In 26 this respect, in extending loans, banks should properly manage such risks. In general, it is expected that the more loans, the more interest income, and the more profitable the bank Sastrosuwito and Suzuki (2011). Loans are the most important indicators of banks performance in the bank financial statements because they reflect the banks primary activity. Assumed, other variables constant, the higher the rate of transforming deposits into loans, the higher the profitability will be. For that, a positive relation between the loans and banks profitability are expected. On the other hand, if increasing loans leads to higher funding requirements, a negative impact of the loan ratio on the banks profitability may accrue. In their study, Moin (2008) found a significant positive relation between asset composition and profitability. In Ethiopian banking business tangible condition as proved by Belayneh (2011) this variable has positive and highly significant impact on profitability. In contrast, Staikouras and Wood (2004) documented a negatively significant relation with the profitability. Related to this the researcher conclude that a high volume of loans alone is not a guarantee for high interest income. If the borrowers default, then the interest income will not earn and this will certainly affect the profitability of the bank adversely. One of the principal activities of commercial banks is to grant loans to borrowers. Because loans are among the highest yielding assets a bank can add to its balance sheet, and they provide the largest portion of operating revenue. In this respect, the banks are face with liquidity risk since; loans advanced from funds deposited by customers. Following the raising of loan by the bank to generat large interest income, the liquidity risk problem face the bank. Regarding to this Rasiah (2010) describe as follows: 27 However, the higher the volume of loans extended the higher the interest income and hence the profit potentials for the commercial banks. At this point, it is also worth noting that banks with a high volume of loans will also face with higher liquidity risk. Thus, the commercial banks need to strike a balance between liquidity and profitability. In addition to the volume of the loans, the quality of the loans would also contribute towards higher profitability. To this extent, it is worth nothing that the non-performing loans can used as an indicator of the loans quality. Hence, the non-performing loans must take into account as a factor. Because this may affect a bank’s interest income and profitability. Furthermore, it must also be noted that higher interest income are not merely a function of higher volume of loans but are in fact also dependent on the lending rates and the interest rate elasticity of loans as well. The interest rate elasticity of loans will depend on the national affluence or national income Moin (2008). Loan and advance is the ratio of loans to total assets. It measuring what percent of total assets is comprise by loans and it gauges the percentage of total assets the bank has invested in loans (or financings). It is also another important ratio that measures the liquidity condition of the bank in terms of its total assets Moin (2008). 2. 2. 1. 6 Expense Management It is measured by the ratio of operating expense to total assets ( e. g Aburime, 2008) and it is a proxy to management quality. Clearly, efficient cost management is a prerequisite for improved profitability of banks. There is evidence that superior management raise profits and market shares (Berger, 1995 and Athanasoglou et al. , 28 2005). According to Athanasoglou et al. (2005) investigation on Greek banks during the period 1985 – 2001 observed that Operating expenses appear to be an important determinant of profitability. There is direct negative connection between Operating expenses and profitability of banks; means that there is immediate negative relation between lack of efficiency in expenses management and profitability of banks. In other words there is direct positive relation between efficient expense management ( i. management quality ) and profitability. Since banks pass part of increased cost to customers and the remaining part to profits. In a study of United States banks for the period 1989–93, Angbazo (1997) finds that there is evidence that net interest margins are positively related management quality. Guru et al. (2002) attempt to identify the determinants of succe ssful deposit banks in Malaysia. The findings of this study revealed that efficient expenses management was one of the most significant in explaining high bank profitability. On the other hand, Montinola and Moreno (2001: 6) as cited by Aburime, (2008) argue that about effective cost management or quality of management as follows: Where management quality is low and managerial monitoring is imperfect, some workers will not exert full effort, thereby â€Å"free riding† on good workers. Observing that a poor worker next to him is shirking, a good worker may reduce his own effort; so over time average effort falls to that of the poorest worker. From time to time, good workers may be hired, but their effort will eventually drop down to the preexisting level. At other times, workers who are lazier than existing employees may hire, dragging down the performance of current workers. Since only hires that cause workers to shirk 29 more have an impact, the equilibrium is for efficiency to fall over time and the profitability of the firm is adversely affected. The total cost of a bank (net of interest payments) can separated into operating cost and other expenses (including taxes, depreciation etc. ). From various literatures, only operating expenses can viewed as the outcome of bank management. The ratio of these expenses to total assets expected to negatively, relate to profitability, since improved management of these expenses will increase efficiency and therefore raise profits. The operating expenses to operating income ratio shows the overheads or costs of running the bank, including staff salaries and benefits, occupancy expenses and other expenses such as office supplies, as percentage of income. It used as an indicator of management’s ability to control costs and is expected to have a negative relation with profits, since improved management of these expenses will increase efficiency and therefore raise profits Guru et al. 2002). 2. 2. 1. 7 Efficiency and Productivity In the literature on bank performance, the single ratios such as net interest income over totoal assets, operating expense to operating income, operating expense to total assets and gross income to the numbers of employees hade been used to assess manager’s and employee’s efficienc y in banks. Especialy the last ratio is almost the best measurment of employee’s efficiency and productivity. The former considers the proportion of every birr of income spent on the average by a bank as a measure of the efficiency of the banks management. The higher this ratio indicats better managerial efficiency of the bank. The latter ratio relates the expenditure of the bank 30 (as an input) to its asset base (as a measure of its output). According to Aburime (2008) Clear sudggestion, the single ratio measures of efficiency can hardly serve as proxy for the technical efficiency measures. The single ratio measures are too simplistic and are devoid of sufficient information to capture the input-output relationship and characteristics of a typical bank in view of their highly aggregated nature. Higher the efficiency levels of a bank, higher its profits level. Hence, a positive relationship posited between efficiency and profitability of banks. Empirical evidence from Athanasoglou et al. (2005) shows that labor productivity growth has a positive and significant effect on bank profitability. This suggests that higher productivity growth generates income that partly channeled to bank profits. The commercial banks can target high levels of efficiency and productivity growth both by keeping the labor force steady and by increasing overall output. Ramlall (2009) said the higher the efficiency level of a bank, the higher the profits level. In this research efficiency and productivity will measure by the ratio of gross inacom to total employees. 2. 2. 1. 8 Bank Size Sudies conducted on determinants of bank proftability took bank size variable, as considered to an important determinants of bank performance Kosmidou (2008). If the relative size of a firm expands its market power and profits increases, this is the Market-Power (MP) hypothesis. The hypothesis also referred to as the StructureConduct-Performance (SCP) hypothesis (Athanasoglou et al. , 2005). One of the most important questions underlying bank policy is which size optimizes bank profitability? Because there is no clear cut points which indicates the relation of 31 appropriat bank size and its profitability. The effect of a growing size on profitability has proved positive to a certain extent. However, for banks that become extremely large, the effect of size could be negative due to bureaucratic and other reasons Athanasoglou et al. (2005). The different studies regarding bank size concluded mixed emperical results. Some studies found economies of scale for large banks (e. g. Athanasoglou, 2006 South Eastern European banks and Kosmidou, 2008 on Greece banks, ) and others oncluded that disecomies scale for large banks due to possible bureaucratic bottlenecks and managerial inefficiencies or economics of scale for small banks ( e. g. Athanasoglou et al. , 2005 on Greece banks, Aburime, 2008 on Nigeria banks and Ngo, 2006 Australian bank ). As extensive researchers pointed out the expected sign of bank size is ambiguous. Hence, the size-profitability relationship may expect t o be non-linear. The researcher use the natural logarithm of total assets as a proxy for bank size, while the square of the natural logarithm of total assets is included to capture any non linearity’s in the size-profit relationship. Accourding to Belayneh (2011 ) research conducted on the determinants of commercial banks profitability during the period 2001 – 2010 concluded that the size of all Ethiopian commercial banks which is measured by log of total asset is increased for the last 10 years. In case of Ethiopian commercial banks, as the result implies that larger banks enjoy the higher profit than smaller banks in Ethiopia banking sector because they are exploiting the benefit of economies of scale. In the literature, asset and/or deposit base of banks have adopted as proxy for their size. At times, their market shares of assets and/or deposit have also used. The second 32 set of measures, however, follows from the first. According Aburime (2008) investigation on Nigeria banking industry on the area of bank performance and supervision by adopted the data envelopment analysis approach founded that, the profitability of the bigger banks is significantly higher than that of the smaller banks. 2. 2. 1. 9 Non-Interest Income Non-interest income is other alternative means of income other than earning from loans. It includes fees earned from offering unit trust services, service charge on deposit account, standard fees, and charges for other bank services. With increasing globalization and financial liberalization, the bank business has been undergoing a gradual transformation away from the traditional business of financial intermediation and towards provision of other financial services including mutual fund, insurance etc. Thus, non-interest income would represent a key source of bank revenue at present and in the future Rasiah (2010). By more aggressively selling services other than loans such as brokerage, insurance and trust services, bankers have found a promising channel for boosting the income statement by diversifying their income sources, and for insulating their banks more adequately from fluctuations in interest rates and loan default risk. Further more, higher diversification regarding banks’ income sources towards derivative instrunments and other fee-based activities shows apositive effect on banks profitability on the Korean banking sector Sufian (2011). In this study, the income which generate from the non interest sources was measured by non-interest income to total income ratio. The importances of fee-based services of commercial banks are to increase the non-interest income. As the result activity of fee-based services and their product diversification is captured by non-interest income 33 to total income ratio. Although, In the case of commercial banks the majority income generate from interest income, commercial banks profitability highly affected by interest fluctuation and loan default risk. But Banks those income are highly depend on non-interest income can protact the profit from decline during this situation. Since, this income never affected by interest fluctuation and loan default risk. In the banking industry of Ethiopia as check by (Belayneh, 2011) there is apositive relation between non-interest income and profitability. 2. 2. 2 Industry-Specific Determinants 2. 2. 2. 1 Market Concentration The previous researcher like Ommeren (2011) and Athanasoglou et al. (2005) measured concentration using the Herfindahl-Hirschman (H-H) index. In this study also measured market concentration like the previous researcher by using the Herfindahl-Hirschman (H-H) index, which is the sum of the squares of market share of the sample banks included in this particular study. It is the number, size, and distribution of banks in a particular market or country. An HH-index of 10,000 indicates that there is only one bank in the country while if the number of banks goes to infinite the HH-index will return almost to zero Athanasoglou et al. (2005). The high concentration ratio in the market creates greater than average efficiency in these markets yielding a positive profit concentration relationship (Berger et al. , 1989). They pointed out four sources of anti-competitive behaviors may be arisen as a consequence of high market concentration: first, if a firm is enjoying a large share of market and it is able to set the prices in excess of competitive levels with a lesser pressure on managers for maintaining operation costs at or near their competitive 34 evel. Second Managers’ self-interest behavior may lead to making more risky financing decisions (which are above the shareholders’ expectation) to reduce the variation in earnings to protect their positions. Third increase in the political cost associated with obtaining and depending on the existing market power. And the fourth the retention of inefficient managers or the maintenance of inefficient practices allowing managers to live a quiet life to pursue other o bjectives or maintain market power gains. A positive relationship between bank concentration and profitability was found by Short (1979) in a study which was based on a sample of banks from Canada, Western Europe and Japan. How ever Some contemporary studies have challenged the acceptability of the positive relationship predicted between market concentration and profitability. Smirlock (1985) posited that there is no relationship between concentration and profitability but between profitability and market share. His study, which used 2,700 unit-banks in state, found no evidence for the relationship between concentration and profitability. However, he found strong evidence for the relationship between market shares (which are use as proxy for the firm’s profitability). He showed that market concentration is not a signal of collusive behavior but rather the superior efficiency of the leading firms. The SCP hypotheses have been applied in different rsearch by various researcher and supported positive relationship between market concentration (measured by concentration ratio) and performance (measured by profits) exists. Furthermore, SCP recognized the competitiveness of small market