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Literature Review on Bank Profitability

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In the literature, bank profitability is usually expressed as a function of internal and external determinants. 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. The external determinants are variables that are not related to bank management but reflect the economic and legal environment that affects the operation and performance of financial institutions. A number of explanatory variables have been proposed for both categories, according to the nature and purpose of each study. The main conclusion emerging from these studies is that internal factors explain a large proportion of banks profitability; nevertheless external factors have also had an impact on their performance. Some recent studies also focus on the impact of regulations on banks performance and profitability (e.g. Barth et al., 2003, 2004), and report only weak evidence to support that bank supervisory structure and regulations affect bank profits.

Empirical studies on the bank profitability literature have focused mainly on a specific country, including the US (Berger, 1995; Angbazo, 1997), Greece (Mamatzakis and Remoundos, 2003; Kosmidou, 2006), Australia (Pasiouras et al. 2006), Malaysia (Guru et al., 1999), Colombia (Barajas et al., 1999), Brazil (Afanasieff et al., 2002) and Tunisia (Ben Naceur, 2003). Molyneux and Thorton (1992) were the first to investigate a multi-country setting by examining the determinants of bank profitability for a panel of European countries, followed by Abreu and Mendes (2001), Staikouras and Wood (2003), and Pasiouras and Kosmidou (2006). Other multi-country studies include Hassan and Bashir (2003), who examine profitability for a sample of Islamic banks from 21 countries; and Demirguc-Kunt and Huizinga (1999) who consider a comprehensive set of bank specific characteristics, as well as macroeconomic conditions, taxation, regulations, financial structure and legal indicators to examine the determinants of bank net interest margins in over 80 countries. This group of studies also includes Haslem (1968), Short (1979), Bourke (1989). A more recent study in this group is Bikker and Hu (2002), though it is different in scope; its emphasis is on the bank profitability-business cycle relationship. Studies in the first group mainly concern the banking system in the US (e.g. Berger et al., 1987 and Neely and Wheelock, 1997) or the emerging market economies (e.g. Barajas et al., 1999). All of the above studies examine combinations of internal and external determinants of bank profitability. The empirical results vary significantly, since both datasets and environments differ. There exist, however, some common elements that allow a further categorization of the determinants.

The literature concentrating on regulatory framework suggests that the emerging economies have significantly increased the attractiveness of its banking system for foreign investors. Foreign ownership may have an impact on bank profitability due to a number of reasons. First, the capital brought in by foreign investors decrease fiscal cost of banks' restructuring (Tang et al., 2000). Second, foreign banks may bring expertise in risk management and a better culture of corporate governance, rendering banks more efficient (Bonin et al., 2005). Third, foreign bank presence increases competition, driving domestic banks to cut costs and improve efficiency (Claessens et al., 2001). Finally, domestic banks have benefitted from technological spillovers brought about by their foreign competitors. The literature on effect of deregulation on bank performance lacks formal verification. However, the contestable market theory and regulation theory in general, point out the importance of entry barriers in enhancing profitability, while some other regulatory interventions may have an opposite effect. Mamatzaky et al. (2005) provide evidence that a non-collusive behavior among banks is in operation in banking industry, suggesting the existence of a contestable market. In contrast, other studies on transition countries have highlighted the fact that the financial reform process positively affect banks' profitability and that banking sector reform is a necessary condition for the development and deepening of the sector (Fries and Taci, 2002).

Internal Determinants of Profitability

Studies dealing with internal determinants employ variables such as size, capital, risk management and expenses management. Size is introduced to account for existing economies or diseconomies of scale in the market. Akhavein et al. (1997) and Smirlock (1985) find a positive and significant relationship between size and bank profitability. Demirguc-Kunt and Maksimovic (1998) suggest that the extent to which various financial, legal and other factors (e.g. corruption) affect bank profitability is closely linked to firm size. In addition, as Short (1979) argues, size is closely related to the capital adequacy of a bank since relatively large banks tend to raise less expensive capital and, hence, appear more profitable. Using similar arguments, Haslem (1968), Short (1979), Bourke (1989), Molyneux and Thornton (1992) Bikker which and Hu (2002) and Goddard et al. (2004), all link bank size to capital ratios, they claim to be positively related to size, meaning that as size increases – especially in the case of small to medium-sized banks – profitability rises. However, many other researchers suggest that little cost saving can be achieved by increasing the size of a banking firm (Berger et al., 1987), which suggests that eventually very large banks could face scale inefficiencies. The need for risk management in the banking sector is inherent in the nature of the banking business. Poor asset quality and low levels of liquidity are the two major causes of bank failures. During periods of increased uncertainty, financial institutions may decide to diversify their portfolios and/or raise their liquid holdings in order to reduce their risk. In this respect, risk can be divided into credit and liquidity risk. Molyneux and Thornton (1992), among others, find a negative and significant relationship between the level of liquidity and profitability. In contrast, Bourke (1989) reports an opposite result; while the effect of credit risk on profitability appears clearly negative (Miller and Noulas, 1997). This result may be explained by taking into account the fact that the more financial institutions are exposed to high-risk loans, the higher is the accumulation of unpaid loans, implying that these loan losses have produced lower returns to many commercial banks. Bank expenses are also a very important determinant of profitability, closely related to the notion of efficient management. There has been an extensive literature based on the idea that an expenses-related variable should be included in the cost part of a standard microeconomic profit function. For example, Bourke (1989) and Molyneux and Thornton (1992) find a positive relationship between better-quality management and profitability.

External determinants of profitability

Turning to the external determinants of bank profitability, it should be noted that we can further distinguish between control variables that describe the macroeconomic environment, such as inflation, interest rates and cyclical output, and variables that represent market characteristics. The latter refer to market concentration, industry size and ownership status. A whole new trend about structural effects on bank profitability started with the application of the Market-Power (MP) and the Efficient-Structure (ES) hypotheses. The MP hypothesis, which is sometimes also referred to as the Structure-Conduct-Performance (SCP) hypothesis, asserts that increased market power yields monopoly profits. A special case of the MP 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 (see Berger, 1995a). Likewise, the X-efficiency version of the ES (ESX) hypothesis suggests that increased managerial and scale efficiency leads to higher concentration and, hence, higher profits.

Interest rate & profitability

Interest rate fluctuations play a huge role in the profitability of a bank. Loan rates can be separated into two major components – the interest rate paid to depositors and the rate added on by banks. That difference between the deposit rate and the loan rate is commonly referred to as the spread. The size of banking spreads serves as an indicator of efficiency in the financial sector because it reflects the costs of intermediation that banks incur (including normal profits). Some of these costs and are imposed by the macroeconomic, regulatory and institutional environment in which banks operate while others are attributable to the internal characteristics of the banks themselves. Cost management efficiency is the single most important indicator in bank profitability. Therefore, banks can improve their profitability indicators by paying more attention on interest rates.

As financial intermediaries, banks play a crucial role in the operation of most economies. The primary reason why interest rates are important is because they are a source of banks' interest rate risk exposure. Changes in interest rates may “narrow the interest spread between assets and liabilities” because due to differences in the maturity of banks' instruments (banks borrow short term (long term) to fund long-term (short-term) assets) there are mismatches in the re-pricing of bank assets, liabilities, and off-balance sheet instruments (Wright and Houpt 1996, 115). Research, as surveyed by Levine (1996), has shown that the efficacy of financial intermediation can also affect economic growth. Crucially, financial intermediation affects the net return to savings, and the gross return for investment. The spread between these two returns mirrors the bank interest margins, in addition to transaction costs and taxes borne directly by savers and investors. This suggests that bank interest spreads can be interpreted as an indicator of the efficiency of the banking system.

An increase in market interest rates means an increase in the price of banking products, which automatically leads to an increase in costs for businesses outside of the banking sector and is a source of inflation (Brockway 1989, 53). The increase in the costs of running business potentially increases default risks of borrowers. This is an important example of how interest rates indirectly affect “default risk of loans, securities, and real estate holdings” (Madura and Zarruk 1995, 5).

Interest rate is an important macroeconomic determinant of bank performance. A comprehensive review of determinants of interest spreads is offered by Hansonand Rocha (1986). That paper summarizes the role that implicit and explicit taxes play in raising spreads and goes on to discuss some of the determinants of bank cost and profits, such as inflation, scale economies, and market structure. Using aggregate interest data for29 countries in the years 1975-1983, the authors find a positive correlation between interest margins and inflation. Recently, several studies have examined the impact of international differences in bank regulation using cross-country data. Analyzing interest rates in 13 OECD countries in the years 1985-1990, Bartholdy, Boyle, and Stover (1997) find that the existence of explicit deposit insurance lowers the deposit interest rate by 25 basis points. Using data from 19 developed countries in 1993, Barth, Nolle and Rice (1997) further examine the impact of banking powers on bank return on equity -controlling for a variety of bank and market characteristics. Variation in banking powers, bank concentration and the existence of explicit deposit insurance do not significantly affect the return on bank equity.

Ogunleye (2001: 61) argues that when interest rates rise or fall, it exerts an impact on banks' profits through adjustment to revenues; and this comes about in two ways. First, an increase in market rates raises the amount of income a bank can earn on new assets it acquires. However, the speed with which revenues adjust to new market conditions depends on how long it takes for the average asset's interest rate to adjust to current market rates (Flannery, 1980). Secondly, the effect could come through impact on the bank's decisions about which loans and securities to purchase and how much to hold in cash reserves (apart from regulatory requirement). In time of rising rates, rates on loans are usually higher than rates on marketable securities; hence banks are likely to book more loans to earn higher incomes than buying securities. In the same vein, banks' holdings of cash reserves and non-earning assets would be at the lowest level, since these groups of assets yield little or nothing. Therefore, total income during periods of rising rates increase even more than the proportion of increase in rates. Empirical evidence from Molyneux and Thornton (1992) and Demirgüç-Kunt and Huizinga (1999) indicate that high interest rate is significantly associated with higher bank profitability, i.e. a significant positive relationship. Demirgüç-Kunt and Huizinga (1999) emphasize that this relationship is more so in developing countries. But, conversely, Naceur (2003) highlights a negative relationship between interest rates and bank profitability. The contradiction between these researchers generates a need for further empirical analyses of the relationship between interest rates and bank profitability.

Among other macro-factors that could influence banks' performance, Beckmann (2007, 9) highlighted the ambiguous effect of real interest rates on performance of banking organizations due to the initial “dampening effect of a rise in real interest rates on credit demand and accompanying deterioration in credit quality” that could contribute to negative association of interest rates with ROA. Beckmann (2007) also found a very strong impact of real interest rate on the return on assets.

Performance tends to be influenced by interest rates, which influence composition of banks' portfolio, in the following way. According to Brechling and Clayton (1965), an increase in interest rates tends to induce FIs to restructure portfolios through decrease in the amount of liquid assets (cash, money at call, Treasury bills) and corresponding increase in the amount of investments into interest-bearing securities and advances, This strategy leads to changes in the relative earning power of various assets in the portfolio. In particular, it leads to an increase in the earning power of interest-bearing securities.

In essence, changes in interest rates should not significantly affect short-term assets and liabilities as they are re-priced more frequently than long-term ones. The latter are more sensitive to changes in interest rates (Ghazanfari, Rogers, and Sarmas 2007, 349-350), which may result in squeezing of interest margins and, as a result, in a decrease in banks' profitability.

Yap and Kader (2008) assessed the impact of changes in interest rates on performance of conventional and Islamic banking organizations running in parallel in Malaysia (where Islamic banking was introduced in 1983) over the period of 1999-2007, which was characterized by falling interest rates in Malaysia. They found that depositors at Islamic banks did not react to changes in interest rates suggesting that “there is no shifting effect between the Islamic and conventional deposits in response to changes in conventional interest rates,” which could be explained by moving rates of return on deposits in Islamic banks very closely with interest rates offered by conventional banks during time period under investigation (Yap and Kader 2008, 129-130). In terms of financing, the authors concluded that customers of Islamic banks are profit oriented and suggested that during a decrease in discount rates/basis rates BBA (bai bathamin ajil – fixed rate asset) financing offered by Islamic banks (fixed rate assets financing is collateralized) is less popular than getting loans from conventional banks due to the fixed rate of BBA financing and vice verse if there is a reverse situation. They noted that, in essence, divergence of rates (on deposits or loans) between Islamic and conventional banks due to changes in market interest rates would lead to switching banks by customers. In this respect, one must bear in mind that profitability of banks in dual banking systems will be influenced not only by micro and environmental factors (the impact of latter is going to be assessed in this study), but also by type of bank (Islamic or conventional).

Despite significant regulatory concern paid to the interest-rate risk that banks face (OCC [2004]; Basel Committee on Banking Supervision [2004]), research on a key component of earnings that may be most sensitive to interest shocks—namely, bank net interest margins—has been limited thus far, particularly for U.S. banks. With a few exceptions discussed in this section, there has been little published research on the effects of interest-rate risk on bank performance since the late 1980s.

Al-Haschimi (2007) studies the determinants of bank net interest rate margins in 10 SSA countries. He finds that credit risk and operating inefficiencies (which signal market power) explain most of the variation in net interest margins across the region. Macroeconomic risk has only limited effects on net interest margins in the study. Using bank level data for 80 countries in the 1988–95 period, Demirgüç-Kunt and Huizinga (1998) analyze how bank characteristics and the overall banking environment affect both interest rate margins and bank returns. In considering both measures, this study provides a decomposition of the income effects of a number of determinants that affect depositor and borrower behavior, as opposed to that of shareholders. Results suggest that macroeconomic and regulatory conditions have a pronounced impact on margins and profitability. Lower market concentration ratios lead to lower margins and profits, while the effect of foreign ownership varies between industrialized and developing countries. In particular, foreign banks have higher margins and profits compared to domestic banks in developing countries, while the opposite holds in developed countries. Gelos (2006) studies the determinants of bank interest margins in Latin America using bank and country level data. He finds that spreads are large because of relatively high interest rates (which in the study is a proxy for high macroeconomic risk, including from inflation), less efficient banks, and higher reserve requirements. In a study of United States banks for the period 1989–93, Angbazo (1997) finds that net interest margins reflect primarily credit and macroeconomic risk premia. In addition, there is evidence that net interest margins are positively related to core capital, non-interest bearing reserves, and management quality, but negatively related to liquidity risk. Saunders and Schumacher (2000) apply the model of Ho and Saunders (1981) to analyze the determinants of interest margins in six countries of the European Union and the US during the period 1988–95. They find that macroeconomic volatility and regulations have a significant impact on bank interest rate margins. Their results also suggest an important trade-off between ensuring bank solvency, as defined by high capital to asset ratios, and lowering the cost of financial services to consumers, as measured by low interest rate margins.

Theoretical models of net interest margins have typically derived an optimal margin for a bank, given the uncertainty, the competitive structure of the market in which it operates, and the degree of its management's risk aversion. The fundamental assumption of bank behavior in these models is that the net interest margin is an objective to be maximized. In the dealer model developed by Ho and Saunders (1981), bank uncertainty results from an asynchronous and random arrival of loans and deposits. A banking firm that maximizes the utility of shareholder wealth selects an optimal markup (markdown) for loans (deposits) that minimizes the risks of surplus in the demand for deposits or in the supply of loans. Ho and Saunders control for idiosyncratic factors that influence the net interest margins of an individual bank, and derive a “pure interest margin,” which is assumed to be universal across banks. They find that this “pure interest margin” depends on the degree of management risk aversion, the size of bank transactions, the banking market structure, and interest-rate volatility, with the rate volatility dominating the change in the pure interest margin over time.

Allen (1988) extends the single-product model of Ho and Saunders to include heterogeneous loans and deposits, and posits that pure interest spreads may be reduced as a result of product diversification. Saunders and Schumacher (2000) apply the dealer model to six European countries and the United States, using data for 614 banks for the period from 1988 to 1995, and find that regulatory requirements and interest-rate volatility have significant effects on bank interest-rate margins across these countries. Angbazo (1997) develops an empirical model, using Call Report data for different size classes of banks for the period between 1989 and 1993, incorporating credit risk into the basic NIM model, and finds that the net interest margins of commercial banks reflect both default and interest-rate risk premia and that banks of different sizes are sensitive to different types of risk. Angbazo finds that among commercial banks with assets greater than $1 billion, net interest margins of money-center banks are sensitive to credit risk but not to interest-rate risk, whereas the NIM of regional banks are sensitive to interest-rate risk but not to credit risk. In addition, Angbazo finds that off-balance-sheet items do affect net interest margins for all bank types except regional banks. Individual off-balance-sheet items such as loan commitments, letters of credit, and net securities lent, net acceptances acquired, swaps, and options have varying degrees of statistical significance across bank types.

Zarruk (1989) presents an alternative theoretical model of net interest margins for a banking firm that maximizes an expected utility of profits that relies on the “cost of goods sold” approach. Uncertainty is introduced to the model through the deposit supply function that contains a random element. Zarruk posits that under a reasonable assumption of decreasing absolute risk aversion, the bank's spread increases with the amount of equity capital and decreases with deposit variability. Risk-averse firms lower the risk of profit variability by increasing the deposit rate. Zarruk and Madura (1992) show that when uncertainty arises from loan losses, deposit insurance, and capital regulations, a higher uncertainty of loan losses will have a negative effect on net interest margins. Madura and Zarruk (1995) find that bank interest-rate risk varies among countries, a finding that supports the need to capture interest-rate risk

However, Wong (1997) introduces multiple differentials in the risk-based capital requirements. sources of uncertainty to the model and finds that size-preserving increases in the bank's market power, an increase in the marginal administrative cost of loans, and mean-preserving increases in credit risk and interest-rate risk have positive effects on the bank spread.

Both the dealer and cost-of-goods models of net interest margins have two important limitations. First, these models are single-horizon, static models in which homogenous assets and liabilities are priced at prevailing loan and deposit rates on the basis of the same reference rate. In reality, bank portfolios are characterized by heterogeneous assets and liabilities that have different security, maturity, and repricing structures that often extend far beyond a single horizon. As a result, assuming that bankers do not have perfect foresight, decisions regarding loans and deposits made in one period affect net interest margins in subsequent periods as banks face changes in interest-rate volatility, the yield curve, and credit risk. Banks' ability to respond to these shocks in the period t is constrained by the ex ante composition of their assets and liabilities and their capacity to price changes in risks effectively. In addition, the credit cycle and the strength of new loan demand determine the magnitude of the effect of interest-rate shocks on banks' earnings. In this regard, Hasan and Sarkar (2002) show that banks with a larger lending slack, or a greater amount of “loans-in-process,” are less vulnerable to interest-rate risk than banks with a smaller amount of loans in process. Empirical evidence, using aggregate bank loan and time deposit (CD) data from 1985 to 1996, indicates that low-slack banks indeed have significantly more interest-rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability that were not empirically tested with aggregate data. The second important limitation of both the dealer and cost-of-goods models of net interest margins is that they treat the banking industry either as being homogenous or as having limited heterogeneous traits based only on their asset size. However, banks with distinct production-line specializations usually differ in terms of their business models, pricing power, to these shocks in the period t is constrained by the ex ante composition of their assets and liabilities and their capacity to price changes in risks effectively. In addition, the credit cycle and the strength of new loan demand determine the magnitude of the effect of interest-rate shocks on banks' earnings. In this regard, Hasan and Sarkar (2002) show that banks with a larger lending slack, or a greater amount of “loans-in-process,” are less vulnerable to interest-rate risk than banks with a smaller amount of loans in process. Empirical evidence, using aggregate bank loan and time deposit (CD) data from 1985 to 1996, indicates that low-slack banks indeed have significantly more interest-rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability that were not empirically tested with aggregate data. The second important limitation of both the dealer and cost-of-goods models of net interest margins is that they treat the banking industry either as being homogenous or as having limited heterogeneous traits based only on their asset size. However, banks with distinct production-line specializations usually differ in terms of their business models, pricing power, their assets and liabilities, and they are therefore more likely to be sensitive to changes in the yield curve.

Exchange rate & profitability

Exchange rates represent the number of units of a given currency of one country that can be exchanged for unit of another currency (Van Horne, 1986). Today foreign exchange has been the talk of the town, and this is because foreign exchange plays a very crucial role in the overall performance of the national economy. The practice of managing foreign exchange resources has therefore evolved broadly in line with the globalization and liberalization of economies and financial market. This has planed over such areas as risk management and active portfolio management. Broadly speaking foreign exchange is held and managed to facilitate international transactions. (Anifowoshe, 1997).

If there were a single international currency there would be no need for a foreign exchange market. The purpose of foreign exchange market is to enhance transfer of purchasing power dominated in one currency for another currency. The foreign exchange market is not a physical place rather it is an electronically linked network of banks, foreign exchange brokers and dealers whose function is to bring together buyers and sellers of foreign exchange. So, Bank profitability could be affected by the nature of a country's exchange rate regime. Ogunleye (1995: 56) has asserted that bank profitability is largely constrained by a fixed exchange rate regime; whereas, in a regime of partial / outright liberalization of the foreign exchange (forex) market, banks are given enough latitude to trade in forex and hence improve the overall profitability.

Due to very intensive involvement of banking organizations in foreign currency trading activities, the issue of risks associated with it deserves some attention. In the literature, a large number of empirical works have been carried out to examine the foreign exchange exposure of banks. However, past studies mainly focused on banking markets which are well developed, including the US (Grammatikos et al. (1986), Choi et al. (1992), Choi and Elyasiani (1997), and Martin and Mauer (2003, 2005)), Japan (Chamberlain et al. (1997)), Canada (Atindéhou and Gueyie (2001)), and Australia (Chi et al. (2007)), or large banking institutions (Martin (2000)). By comparison, studies focusing on less developed banking markets are relatively scant.

Grammatikos, Saunders, and Swary (1986, 671) stated that there are two types of risk related to foreign currency trading activities, namely exchange rate risk, which comes from unexpected change in exchange rates in the presence of “a positive (or negative) net asset position [in terms of size] in a particular foreign currency”, and foreign interest risk, which occurs from changes in interest rates in the presence of mismatched maturities of banks' “foreign currency assets and liabilities.”

If foreign currency assets are greater (smaller) than liabilities, an appreciation (depreciation) in the foreign currency vis-à-vis the dollar generates capital gains (losses) either on paper or realized. …. If the average duration of its foreign currency assets is greater (smaller) than its liabilities, then an unexpected upward parallel shift in the term structure of foreign interest rates will reduce (increase) the bank's net interest earnings (Grammatikos, Saunders, and Swary 1986, 671).

The authors analyzed the overall performance and risks of banks associated with foreign currency trading activities in the US from December, 1975 to November, 1981, and noted that there is a possibility that “diversification by the bank into many currencies” might “reduce the overall risk exposure” even in the presence of mismatch in the maturities (durations) of its foreign currency assets and liabilities (Grammatikos, Saunders, and Swary 1986, 675).

As emerging markets become more integrated into global capital markets, the choice of exchange rate arrangement by those countries is receiving more attention because it is regarded as one of the sources of main economic crises like “the Mexican peso crisis in 1994–95, and the Asian crisis in 1997–98” as a result of which the “hollowing-out hypothesis” or the “bipolar view” is becoming more popular, even though it is still not well-accepted. This hypothesis explains that

…in a world of increasing international capital mobility, only the two extreme exchange rate regimes are likely to be sustainable - either a permanently fixed exchange rate regime (i.e., a “hard fix”) such as a currency board or monetary union, or a freely floating exchange rate regime (Bailliu and Murray 2003, 17).

As shown by Chamberlain et al. (1997), to the extent that banks' direct exposure generally provides a significant explanation for banks' foreign exchange exposure, it only measures banks' foreign exchange risk partially. Using a bank's loan to an exporter as an example, Chamberlain et al. (1997) demonstrate that banks that perfectly hedge their accounting exposure could still be exposed to significant foreign exchange risk if exchange rate movements affect cash flows, competitiveness, and credit risk of banks' customers significantly (i.e. indirect or economic exposures).This indicates that the sources of foreign exchange risk of banks are far more than just their holdings of net foreign assets.

The bankers business has been and continues to be that of taking risks; which he does through maturity transformation – borrowing short and lending long. One can infer that the basis for doing this is the probability that he will not be called upon at any one time to redeem all his obligations provided he managed his affairs prudently. This implies having adequate capital and earnings and adequate liquidity to honor his obligation as and when they fall due. In congruous, it also means avoiding excessive risks. Risks that are taken must be compatible with profitability, liquidity are prudence (Nwankwo, 1991). Thus if profitability is the foundation of banking then confidence is its cornerstone. If confidence collapses or is shattered, the whole edifice collapses and so will the bankers business. Managing risks, just like managing capital and liquidity is therefore a core function of banking and this has been increasingly so in the banking business for decades. The risk inherent in foreign exchange transactions is part of the risks a banker faces, in the 1950's attention was focused on techniques for the management of bank assets, while the 1960's and 1970's emphasized liability management. However, banking in the 1980's and 1990's shifted attention to risk, how to measure risk and how to control it for the betterment of the industry and its customers (Yahaya, 1997). Essentially the over-riding consideration of bank management is the necessity to minimize risks and maximize returns, consistent with the prudential constraints and regulations. In reality the cardinal objective of a risk manager is to ensure that at the end of the day, he tries as much as possible to minimize his loss and maximize profit through efficient and effective management. Nwankwo (1991) posits that foreign exchange risk is probably the most involved of the banking risks. The risks involved are frequently not limited to losses due to unanticipated exchange rate changes. As each bank has to be in a position to meet its own foreign currency demand on time, there are liquidity risks and there are also interest rate risks; for dealings in the forward foreign exchange market. Since exchange rate movements correlate with movements in relative interest rate, a mismatched currency position and a mismatched inherent position may frequently not be independent. Accordingly, most of the instruments and techniques for addressing these other risks particularly the interest rate risk are frequently used for managing foreign currency exposure risks (CBN Review, 1991). With the expansion of treasurer's business activities, the need to adequately manage the associated exposure is becoming increasingly important. Some treasury functions today have introduced and others are planning to introduce an overall exposure monitoring and management system, able to integrate balance sheet and off- balance sheet business activities. This is done by consolidating all information elements relevant to risk and exposure offering a comprehensive view that facilitates control.

Inflation & Profitability

The importance of inflation on the performance of banks was heavily discussed in the literature, primarily due to the influence of inflation on the sources and users of banks' financial resources. In particular, inflation affects companies' pricing behavior. The effect of inflation on bank profitability was first discussed by Revell (1980). He believed that inflation could be a factor in the variations in a bank's profitability. He notes that the effect of inflation on bank profitability depends on whether banks' wages and other operating expenses increase at a faster rate than inflation. The question is how mature an economy is so that future inflation can be accurately forecasted and thus banks can accordingly manage their operating costs. In this vein, Perry (1992) states that the extent to which inflation affects bank profitability depends on whether inflation expectations are fully anticipated. An inflation rate fully anticipated by the bank's management implies that banks can appropriately adjust interest rates in order to increase their revenues faster than their costs and thus acquire higher economic profits. If companies expect general inflation to be higher in the future, they may believe that they can increase their prices without suffering a drop in demand for their output. (Driver and Windram 2007, 209). In this scenario, upon the condition that expected inflation will be equal to actual inflation, there will be no decrease in business activities and no negative effect on banks' performance. Most studies (including those by Bourke (1989) and Molyneux and Thornton (1992)) have shown a positive relationship between either inflation or long-term interest rate and profitability. Some of these studies used consumer price index (CPI) as a proxy for inflation. Although the first empirical testing on inflation was done by Bourke (1989), Heggested (1977) in his study had tried to measure the effect of inflation on profitability indirectly. He used per capita income as an independent variable instead of using the CPI. Heggested's finding, however, did not indicate any relationship between per capita income and a bank's profitability.

Empirical evidence from cross-country studies by Demirgüç-Kunt and Huizinga (1999) and Demirgüç-Kunt and Huizinga (2001) suggest that inflation enhances bank profitability. They opine that the positive relationship between inflation and bank profitability implies that bank income increases more with inflation than bank costs. High inflation rates are also generally associated with high loan interest rates, and therefore, high incomes. Banks also obtain higher earnings from float or delays in crediting customer accounts in an inflationary environment. However, if inflation is unanticipated and banks are sluggish in adjusting their interest rates, then there is a possibility that bank costs may increase faster than bank revenues and hence adversely affect bank profitability. Reporting the results of Demirgüc-Kunt and Huizinga's 1999 study, Beckmann (2007, 6) also noted a significant positive effect of inflation on profitability of banks expressed as ROA. Adopting a non-empirical negative stance on the relationship between inflation and bank profitability, Uche (1996) and Ogowewo and Uche (2006: 164-165) argue that, by their nature, banks are seriously constrained by high inflation. Under high inflation regimes, banks are extremely vulnerable and this has been a major cause of distress in these financial institutions. To them, it is trite that high inflation leads to macro-economic instability; and the absence of a stable macro-economic environment materially increases banks' risks, lessening banks' profits. The empirical evidence from Naceur (2003) contradicts all the aforementioned evidences and arguments by indicating that inflation has no significant impact on bank profitability specifically in Tunisia. The evidence suggests that banks in Tunisia neither significantly profit nor significantly lose due to inflation. This contradiction of the win or lose stances adopted by other researchers generates a need for further empirical analyses of the relationship between inflation and bank profitability.

Boyd and Champ & Abreu and Mendes (2002) contradicted with the view that inflation has a positive relationship with the profit of banks. Abreu and Mendes (2002), studied data from Portugal, Germany, Spain and France for the 1986-1999 period and concluded that inflation and unemployment rates affect both profitability ratios negatively. According to Boyd and Champ, inflation has a dramatic negative impact on the profitability of banks. Various measures of bank profitability—net interest margins, net profits, rate of return on equity, and value added by the banking sector—all decline in real terms as inflation rises, after controlling for other variables. They argued that, countries with high inflation rates have inefficiently small banking sectors and equity markets. This effect suggests that inflation reduces bank lending to the private sector, which is consistent with the view that a sufficiently high rate of inflation induces banks to ration credit.

Boyd and Champ (2006, 1) stated that the real rate of return on assets can be decreased with inflation which will result in depressing savings and pushing borrowings while new borrowers are “likely to be of lesser quality and are more likely to default on their loans” which together with decreased real rate of return on assets may force banks to ration the credit especially if banks fail to distinguish borrowers of good and bad quality. They stressed that the situation can be worsened by imposing higher nominal interest rates because banks can lose good quality but risk averse borrowers. However, regardless of the underlying reasons, putting limitations on the amount of credit to be given to the private and corporate sector will lead to a decrease in investments to be brought into the economy leading to a lowering of real economic activity.

In regard to the direct effect of inflation on financial sector, Boyd and Champ (2006, 1-2) stressed that there is some inflation threshold below which there will be no credit rationing and “higher inflation might actually lead to increased real economic activity,” contingent upon low nominal interest rates because in economies with increasing inflation, but beneath some threshold, and low interest rates, banking organizations can raise nominal interest rate so that the “real return on loans dominates the return on currency, encouraging banks to lend more” which in turn stimulates investments and economic growth.

Boyd and Champ (2006) tested whether an increase in inflation beyond some threshold would result in a decrease in bank lending and found, surprisingly, that even small increase in inflation negatively affects bank lending, suggesting that size of the banking sector is negatively associated with inflation. Furthermore, they found a very negative impact of inflation on profitability of banks. This is in line with previous findings of Boyd, Levine, and Smith (2000, 17), which suggested a negative relationship between inflation and financial sector performance regardless of the “time period considered, the empirical procedure employed … inclusion or exclusion of countries that have experienced extraordinarily high rates of inflation.”

The most interesting issue put forward by Boyd and Champ (2006, 3) is “the question of the exact rate at which inflation becomes destructive” while their findings suggest that “the critical point lies at a fairly modest inflation rate, somewhere around 5 percent.”

Alhadeff (1976, 14) stressed that, depending on inflationary expectations, banks can think of various “ways of managing their affairs,” implying that more investments should be made directed at the development of financial intermediaries. In particular, Alhadeff (1976, 14-15) pointed out that inflationary expectations can lead to changes in the competitiveness of banks in different fund markets, primarily due to pressure on interest rates. In turn, this may result in high pressure on the liability side of banking organizations which eventually serves as a trigger factor in occurrence of liquidity problems. The lack of public confidence in the banking system under inflation is jeopardized due to high uncertainty, which can accentuate liquidity problems of banks in such environments.

Analyzing the impact of inflation on the performance of English commercial banks (expressed as return on assets and return on capital) from 1920 to 1968, Capie and Billings (2001, 385-386) noted that if capital is not subject to continuous revaluation due to inflation, returns on capital have a tendency to be inflated (as a result of inflation) by lifting profits relative to capital. They emphasized that returns on assets, in turn, are not affected by inflation in the same way as returns on capital because returns and assets capture the effect of changes in prices caused by changes in inflation. Because of this, return on assets could be considered as “a more straightforward measure” of banking organizations' profitability.

With respect to effect of inflation on return on capital, however, “while inflation distorts comparisons over time, comparisons between banks in the same time period are not invalidated” (Capie and Billings 2001, 386).

Profitability Determinant of Bangladeshi Banks

There has been a little study on the profitability determinants of Bangladeshi Banks. To the best of our knowledge, only a single study has been conducted to determine the profitability determinants of Bangladeshi Banking industry. In their study Jahangir, Shubhankar & Alamin investigated Bank's Return on Equity, Market Size, Market Concentration Index, and Bank Risk Measure. They concluded that, Loans are the riskiest asset of a bank, but these loans play a pivotal role in banks' profitability. The analysis finds that market concentration and bank's risk do little to explain bank's return on equity, whereas bank's market size is the only variable providing an explanation for banks return on equity in the context of Bangladesh.

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