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Literature Review On Profitability Performance And Macroeconomic Factors

CHAPTER 2

Financial performance of a commercial bank can be measured by profitability. Based on Codjia (2010), financial performance will look at the statement of an accounting summary that details a business organization's revenues, expenses and net income. A corporation may prepare a statement of financial performance on a monthly, quarterly or annual basis (Codjia, 2010). Bank profitability and bank interest margins can be seen as indicators of the (in) efficiency of the banking system, as they drive a wedge between the interest rate received by savers on their deposits and the interest paid by lenders on their loans (Kunt et al., 2001). Profitability measure is important to the investors of MBB. This measure of profitability is the most important for stockholders of a bank since it reflects what the bank is earning on their investments (Rasiah, 2010).

The profitability performance can be measured using ROA. The higher the ROA ratio, the better bank profits (Rasiah, 2010). As stated by Berger and Humphrey (1997), studies of frontier efficiency rely on accounting measures of costs, outputs, inputs, revenues, profits, etc. to impute efficiency relative to the best practice within the available sample. In this research paper, the profitability performance will be measured using the Return on Asset (ROA) of MBB. Besides that, there are many ways to measure the profitability performance. According to Rushdi and Tennant (2003), profitability can be measured in a number of ways including return on assets, return on equity (ROE) or profit margins. Other than that, getting on top of the financial measures of the bank performance is an important part of running a growing business, especially in the current economic climate. In addition, ROA and Return on Asset (ROE) are the indicators of measuring managerial efficiency (Hassan, 1999; Samad, 1998). In ROA, the bank will know the efficiency and capability to convert the assets into net income. ROA is the ratio of operating profit to average total assets (Rushdi et al., 2003). In principle, ROA reflects the ability of a bank’s management to generate profits from the bank’s assets though it may be biased due to off-balance sheet activities (Athanasoglou et al., 2005). ROA and ROE can be used to view the bank’s performance in terms of profitability. In analyzing how well any given bank is performing, it is often useful to contemplate on the return on assets (ROA) and the return on equity (ROE) (Rasiah, 2010). We have chosen ROA as the key proxy for bank profitability instead of the alternative return on equity (ROE) because an analysis of ROE disregards financial leverage and the risks associated with it (Flamini, McDonald & Schumacher, 2009). Moreover, according to Landajo, Andrés and Lorca (2008) company performance is usually measured by profitability, which may itself be proxies by using the return-on-assets (ROA) ratio. In addition, according to the author, ROA also can be defined as the quotient of net profit after taxes to total assets.

The advantage of using profitability ratios is that they are inflation invariant; that is they are not affected by changes in price levels (Rasiah, 2010). Besides that, the ROA is a helpful measurement when comparing the profitability of one company to another, either for those within the same industry or those from a different industry. Therefore, the ROA is a valuable measure when comparing the profitability of one bank with another or with the commercial banking system as a whole (Rasiah, 2010).

2.1 RELATIONSHIP BETWEEN PROFITABILITY PERFORMANCE AND MACROECONOMIC FACTORS

In terms of the macroeconomic condition, the researchers use the external factors which are beyond the control or uncontrollable by the bank or the company’s management. The external determinants are variables that are not related to the bank’s management but reflect the economic and legal environment that affects the operation and performance of financial institutions (Athanasoglou, et al., 2005). There are so many external determinants, but in this research paper the focus is only on inflation, interest rate and money supply which will give an impact toward the bank profitability. Commercial banks will make operating plans to react to changes of the macroeconomic factors, for example the banks will give a higher or lower interest rate according to the economic condition in that year. Bank returns are affected by macroeconomic variables, suggesting that macroeconomic policies that promote low inflation and stable output growth do boost credit expansion (Flamini et al., 2009).

Besides that, there are too many types of external variables such as inflation, money supply and others. External variables are those factors that are considered to be beyond the control of the management of a bank. Among the widely discussed external variables are competition, regulation, concentration, market share, ownership, scarcity of capital, money supply, inflation and size (Sudin, 2004). In terms of the macroeconomic condition, the researchers used the external factors which are beyond the control or uncontrollable by the bank or the company’s management. The external determinants are variables that are not related to the bank’s management but reflect the economic and legal environment that affects the operation and performance of financial institutions (Athanasoglou, et al., 2005). There are so many external determinants, but in this research paper the focus is only on inflation, interest rate and money supply as all these will have an impact on bank profitability. Commercial banks will make operating plans to react to changes in the macroeconomic factors. As an example, the banks will give a higher or lower interest rate according to the economic condition of that year. Bank returns are affected by macroeconomic variables, suggesting that macroeconomic policies that promote low inflation and stable output growth do boost credit expansion (Flamini et al., 2009).

Besides that, there are too many types of external variables such as inflation, money supply and others. External variables are those factors that are considered to be beyond the control of the management of a bank. Among the widely discussed external variables are competition, regulation, concentration, market share, ownership, scarcity of capital, money supply, inflation and size (Sudin, 2004).

2.1.1 Profitability and Inflation

Inflation is one of macroeconomic conditions that will affect the profitability performance of the commercial bank. Besides that, the profitability of a business will be affected if there is inflation especially towards the revenue and cost of the bank. Rasidah (2011) explained the three external measures which reflect the macroeconomic conditions of the sample countries are inflation, GDP growth and interest rates. She further explained that inflation may affect costs and thus revenues of any businesses. Thus, for this study, we have considered these three external variables as they reflect the macroeconomic conditions of the country.

When there is inflation, the interest rate of the bank will increase. Therefore, the operating expenses of the bank will increase giving impact on bank loss. When the interest rate increases, customers will prefer to save in the banks to earn profits but banks will experience losses. Revell (1979) pointed out that the effect of inflation, however, depends on whether the banks’ earnings and other operating expenses increase at a faster rate than inflation.

There is less research being done on the issues of inflation in earlier studies of bank profitability. According to Rasiah (2010), inflation has been one of the least researched issues in earlier bank profitability studies. Nevertheless, inflation is one of the factors that influence the commercial bank’s profitability. As stated by Flamini et al. (2009), they expect a positive effect of commodity prices on bank profitability, in which the effect of inflation on bank profitability depends on whether future movements in inflation are fully anticipated and in turn, this depends on the ability of firms to accurately forecast future movements in the relevant control variables. An inflation rate that is fully anticipated raises profits as banks can appropriately adjust interest rates in order to increase revenues, while an unexpected change could raise costs due to imperfect interest rate adjustment (Flamini et al., 2009). As stated by Rasiah (2010) inflation may also affect commercial banks’ profitability by diminishing the real value of the banks’ assets and liabilities.

Other than that, the profits of commercial banks would depend to a large extent on the effect of inflation on their revenues and costs. However, since our Malaysia’s economy is blessed with low inflation and sustained economic growth as a whole, we can expect a positive relationship between inflation and bank profitability (Rasiah, 2010). Economic growth or recession determines a financial institution’s profitability performance. The different economic conditions from time to time will affect bank’s profitability. According to Guru, Staunton and Shanmugam (1997) the varying economic conditions from one year to another can also be expected to have an impact on the profitability of these institutions. Besides that, the profitability can be explained by internal and external factors, but in this research the focus is only on the external factors which are the macroeconomic factors. According to Mamatzakis and Remoundas (2003), this approach assumes that profitability is explained by internal factors, like management policy decisions (i.e. size, capital adequacy, ownership, cost structure, business risk) and by external factors, like the economic environment (i.e. market structure, inflation, money supply growth). The relationship between expected inflation and long-term interest rate, which incorporates inflation expectations and profitability, is ambiguous (Athanasoglou et al., 2005).

Various studies have utilized CPI as a proxy for inflation in their studies. As stated by Haron (2004), the consumer price index (CPI) when used as a proxy for inflation and studies have shown that inflation has a significant relationship with profit. In addition, Cheng et al. (2002) in their study have also used CPI as the proxy to measure inflation. In their study, CPI is a composite index weighted by the regional expenditure weights of Peninsular Malaysia, Sabah and Sarawak‘s consumer price indices measured separately (Cheng et al., 2002). Izhar and Asutay (2007) also utilize CPI as a proxy for inflation in their study. Furthermore, Haron & Azmi (2005) have also employed CPI as a proxy for inflation in their research paper.

Inflation also depends on whether it is anticipated or unanticipated. For the anticipated inflation, a bank can change its interest rates so that it can increase its revenue more than its cost. According to Perry (1992), the effect of inflation on a bank’s performance depends on whether the inflation is anticipated or unanticipated. Anticipated inflation rate implies that banks can appropriately adjust their interest rates in order to increase their revenues faster than their costs and thus this produces a positive impact on bank profitability.

For the unanticipated inflation, the cost will increase faster than the revenue. In contrast to anticipated inflation, unanticipated inflation could lead to improper adjustment of interest rates and hence the possibility that costs could increase faster than revenues (Anthanasoglou et. al. 2006). Consequently, there is a negative impact on bank profitability.

2.1.2 Profitability and Interest Rate

The other macroeconomic factor that will affect bank profitability is the interest rate. In view of this, interest rates have also been considered as determinants of bank profitability in most bank research (Rasiah, 2010). A number of studies have examined the determinants of banks’ interest margin and profitability in many countries around the world (Bennaceur and Goaied, 2008). Macroeconomic factors such as inflation, interest rate and others do affect banks’ profitability performance. The set of variables includes several factors accounting for bank characteristics, macroeconomic conditions, taxation, regulations, financial structure and legal indicators (Bennaceur et al., 2008). As stated by Kunt et al. (2000), if banks operating in different financial structures show differences in performance especially bank margins, this could have important implications for economic growth. The appropriate proxy for interest rate is Base Lending Rate (BLR). In view of the above-suggested problems, the base-lending rate (BLR) appears to be the ideal candidate to proxy for market interest rate (Rasiah, 2010). Other than that, Haron et al. (2005) have used BLR as a proxy for market interest in their research paper.

There are two types of interest that will influence the profitability of a bank which are interest expenses and interest income. According to Rasiah (2010), interest expenses and interest income affect net interest income and hence bank profitability. Besides that, supply and demand can also affect the interest rate. Furthermore, since local monetary policies as well as supply and demand conditions affect interest rates, it has been included as an external profitability determinant in these research studies (Rasiah, 2010). When the interest expenses are reduced, it will result in profits for the bank. For the most part, the literature argues that reduced expenses improve the efficiency and hence raise the profitability of a financial institution, implying a negative relationship between the operating expenses ratio and profitability (Bourke, 1989).

Rasiah (2010) states that since 1991 the commercial banks have been allowed to freely quote their own BLR based on a standardized formula, which takes the funding cost into account. Loan is the bank asset while the deposit is the bank liabilities. According to Bennaceur et al. (2008), bank loans (BLOAN) are expected to be the main source of income and are expected to have a positive impact on bank performance. The increase in the supply of long-term loans can promote economic growth (Du et al., 2011). Bank deposit and bank loan have an impact on bank profitability. For instance, the market for deposits and loans may be affected by an economic slowdown and this would certainly have an impact on profitability (Guru et al., 1997).

2.1.3 Profitability and Money Supply

Other than that, money supply also influences bank profitability. The best way to measure money supply is the annual growth in the M3 of money supply. Based on Rasiah (2010), the annual growth in money supply will also be considered as a proxy for market growth in this study. In addition, Haron et al. (2005) also used M3 as a proxy for money supply in their research paper. Money supply or M3 is one of the tools used by the government in managing its monetary policy (Haron et al., 2005). Since the banks’ asset portfolios are dependent on their liability portfolio for financing purposes, the market growth is proxies by growth in the M3 component of money supply, which, in Malaysia is defined aggregate of currency in circulation and savings and fixed deposits, net issues of NCD and REPO transactions of commercial banks, finance companies, merchant banks, and discount houses (Guru et al., 1997).

In addition, Rasiah (2010) explains that the M3 measure of money supply is in turn defined as M2 plus the savings deposits, fixed deposits, net issues of NCD and repo transactions of finance companies, discount houses and Islamic banks. Money supply influences the condition directly as explained by Haron et al. (2005) who state that changes in money supply can have a major impact on economic conditions.

Table 2.1: Summary of the dependent variable in this study

Dependent Variable

Variable

Proxies

Profitability Performance

Based on quarterly basis of return on asset

Return on Asset (ROA)

Table 2.1 shows the summary of the dependent variable used in this study. The return on asset (ROA) was chosen as the proxy to measure profitability performance. In addition, these studies also used the quarterly basis to analyze the relationship between the independent variables and dependent variable.

Table 2.2: Summary of the independent variables in this study

Macroeconomic Factors

Variable

Proxies

Inflation Rate

Annual percentage change in the Malaysian Consumer Price Index

Consumer Price Index(CPI)

Market Interest

Average annual BLR of all commercial banks

Base Lending Rate (BLR)

Market Growth

Annual growth in the M3 measure of money supply

Money Supply (M3)

Table 2.2 summarizes the independent variables used in this study. The inflation rate used CPI as proxy while for market interest, BLR was chosen as the proxy. Other than that, for market growth was used as the proxy in this study. The variable that was used for inflation rate is the annual percentage change in the Malaysian Consumer Price Index. In addition, for market interest, the average annual BLR of all commercial banks was used as a variable. Instead of using M1 or M2 as the variable for market growth, in this study we have chosen annual growth in the M3 measure of money supply as the variable.

In summary, this chapter has presented a short literature review of the key concepts and relevant studies related to this present research. The following chapter describes the methodology to be employed in this research encompassing sections on the data collection method, sources of data, variables and measurement, the theoretical framework and the research design.

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