Determinants of Bank Profitability in the South Eastern Europe

¶ … govern the profitability of banks in the South Easter part of Europe. The banking profitability in question is evaluated in terms of the rate of Return on Assets (ROA) and the rate of Return on Equity (ROE) .These two measures are expressed in terms of various other determinants. This paper therefore makes use of a series of raw data collected from South Eastern Europe credit institutions over a five-year period (2003-2007).The determinant used in this study are bank-specific and are also industry related. Macroeconomic determinant are also utilized in the examination of the banks' profitability. The study revealed that apart from liquidity alone, all the other remaining bank specific determinants greatly affects a bank's profitability in a predictable manner. The structure conduct performance hypothesis is proven true by the positive results of concentration that is obtained. However, it is worth noting that the efficient structure proposition's applicability can not be ruled out. This paper also seeks to examine the effect of banking reforms to the bank's profitability amid the various macroeconomic determinants. This paper presents the findings obtained while giving recommendations on the applicability of the necessary reforms that are intrinsic to the profitability realization for SEE banks.

Introduction

The banking sector plays a very integral role in the South Eastern European (SEE) economies. The financial system in the SEE is heavily reliant on the banks and therefore important milestones in the banking system have a direct and palpable effect on the SEE economies. It is worth noting that the illiquidity ration of the Capital Market portion of the SEE financial dynamics is however very high. This is coupled with immaturity in the part of the other non-bank segment of the financial system. The banking sector reform that have been hugely accepted and implemented has been on of the major driving forces in the sustainability and profitability of the SEE banks. This is because of the necessary and closely regulated aspects of the baking industry that it has introduced. The reforms have made baking safer, more efficient and more successful due to the streamlining of the necessary institutional and legal frameworks that have been put in place to safe guide the interest of the SEE banking sector. The reforms have in fact motivated even foreign banks to venture into the SEE market. This is largely due to the friendly and safe guidelines that were considered in the drafting of the SEE banking reforms.

It is the objective of this research paper to critically highlight the effects of certain bank-specific variables on the profitability of the South-Eastern banking sector. The variables are also related to specific industries. The countries under our study include the following;( Albania, Serbia, Fyrom, Bulgaria, Romania, Turkey, Croatia and Moldova).The study focuses on the period of 5 years in the period of 2003-2007.This paper considers two main point of study. The initial proposition is based on the examination of the effects of both the internal and the external determinants that affect the banking profitability in the SEE countries. The second proposition however examines the direct and indirect influence of the banking sector reforms in the profitability gap of the SEE countries. This is based on the efficient structure proposition. The macroeconomic environment for profitability is also examined.

This paper is arranged into various sections. The first section discusses the reform process that has happened in the SEE banking sector in the last couple of years. The second section is concerned with the literature review regarding this subject area. The content under this section concern the elements of a bank profitability and its subsequent driving force (determinants).The third section gives a full description of the SEE banking data sources and the methodology involved in the collection and analysis. It focuses on the econometric determination the SEE banking sector profitability.

The final conclusions and the special policies that are drawn from the study

Conclusions and some policy are then. The final section gives a presentation and the critical analysis of the obtained empirical information.

The SEE countries Banking Reforms

The formation of sound and viable banking system in the financial circles of the Southeastern European (SEE) countries was one of the most important quantum leaps in their economies. This has necessitated the transition of their economy to a market oriented type of economy which in tern has offered more profitability due to a wider market and more streamlined regulatory, supervisory and operationaldynamics.However the process of achieving such a transition was never easy.

Several studies have proven than the onset of the financial system transition process was indeed very weak, shallow and mainly underdeveloped. This happened somewhere in the 1990s.The forces that impeded the growth and ease of operation of the financial systems was mainly due to either internal causes or several other external setbacks. The system has however over the last decade been transformed into a better one even though it still experiences some problems. Despite the challenges that affect the system, it is worth noting that there has been improved economic performance coupled with a more improved macroeconomic stability and a projected long-term growth all of which are a function of the level of improvement in the operation and regulation of the financial institution's operations and the market dynamics that all form part of the more improved financial infrastructure.

The reforms of the financial system were not as a result of an academic research findings but rather were due to real lessons that were experienced and a call of action was prompted in the process. Through the assistance of the major global financial institutions, the government of these countries embarked on a journey that would see their financial institutions being fine tuned to fit into appropriate level. This was as a result of adopting the necessary reforms that would revolutionize their financial processes and their capital markets' operations. Their collaboration was aimed at creating a coming up with a financial system that was better in more ways. The system would be institutionally stable, with better administrative functions and more sensitive to the demands of their emerging markets.

During the final years of the transition, there were various changes in the banking and financial market systems that were spearheaded by the combined action of the World Bank and the International Monetary Funds. These changes mainly centered on the legal, institutional, regulatory and supervisory framework of the financial system. Over the years however, these prescribed guideline have been continuously improved. The foundation of the contemporary banking system was therefore laid down by the World Bank using a model developed from the experience gathered from the various ways and means that the system had earlier operated.

The reforms in the banking sector have been actualized through the adoption of various programs. The main programs at the center of the change were economic adjustment programs and stability programs. Surveillance programs were also instituted in order to provide constant reports on the changes to the system. The process of restructuring was country-specific and industry related. The promotion and implementation of the policies that revolutionized the banking sector had been made possible through the adoption of appropriate monetary policy management programs. The processes of their implementation were also fuelled by the timely management programs that were offered by the various visiting missions and the domestic advisors of the specific countries.

The process of financial restructuring has been supported by various other international financial institutions. Such institutions include OECD, EBRD, EIB, ECB and BIS. The bilateral processes between the European Union and the SEE countries have also fuelled the rate of change in the reform process.

It is worth noting that due to the variation in the banking system from country to country; all the initiatives and efforts of the international financial organizations to streamline the financial systems still face serious challenges. Such challenges include elements of weaknesses in the system together with localized fragmentation and fragility. The problem of undercapitalization is always eminent. All these challenges have continued to emerge despite the various efforts that are put in place by the reports generated through the process of academic studies and assessments.

Several new reform measures have been instituted by the international financial institutions. These measures are concentrated around the major indicators of financial systems stability in the SEE countries. The measures mainly target the various indicators of market growth. These changes are aimed at recapitalizing the banking sector; this is achieved through the process of liquidation whereby insolvent institutions are reliquidated.Mergers and acquisitions are also done in order to consolidate the banking industry into strong and consolidated financial units. There is also an adoption of improved administrative efficiency techniques and improved capacity of the banking sector. There have been recent changes in the system that mainly targeted the deposit insurance scheme policies and loan collateral policy guidelines.

A quick review of the banking sector progress has shown that in many ways than one, the process of development of the guidelines that govern the institutions and the accompanying fundamental principles has overtaken the demand of the real economy and the process of restructuring itself. This is evident in the various achievements in several areas of the banking sector. The introduction of the BIC principles coupled with the legislation of the central bank's independence and the introduction of transparency and accountability mechanisms into the financial framework have all added up in the list of achievements.

The level of success of the financial sector reform in the SEE countries will be determined by the level of commitment of the authorities together with the willingness of the masses to support market driven reforms in the various sectors of the economy.

Several drawbacks facing the financial sector of the SEE countries can be traced to the following root causes.

1. Problematic and incomplete privatization bids.

2. The eminent lack of ethical mechanism to monitor the level of transparency and accountability in both the public and the private financial dealings.

3. The high level of accumulation of loans (non-performing) in the state owned banking institutions

4. The lack of an appropriate corporate governance infrastructure

5. The eminent lack of confidence by the public to the public institutions.

More concerns are raised by the apparent level of increase in the number of insolvency cases in the public institutions domain. There is also a worrying increase in the level of case of improper lending. This is coupled with poor deposit taking practices.

It is important that the government of the SEE countries continue to support the initiatives and processes that would systematically lead to the elimination of the many problems that are inherent in their banking system. Their basic driving mantra would be to strive to come up with a fully consolidate financial system that would be able to absorb all the shocks (both internal and otherwise) while at the same time effectively be sensitive to react to the various changes affecting the demands, risks and challenges that go hand in hand with highly competitive financial environment. The system's applicability should be both at the national and regional levels. This would therefore help in coming up with a more accommodative European convergence at the institutional level. Such desirable regional convergence would lead to more stable macroeconomics and better social cohesion; the basic requisites for better investment in a region for improved and continued sustainability in financial growth.

It is worth noting that the restructuring of the banking system in the SEE countries has had a considerable amount of positive changes in the last decade. This however has never been satisfactory enough to earn it the rank that has been achieved in the developed markets. More work still needs to be done for the system to reach the same level as the highly evolved and developed market economies. A basic comparison of the fundamental financial systems growth indicators such as the ratio of lending to the private sector to the GDP in consideration to the Capital market size-measure by the level of capitalization expressed as a percentage to the GDP, reveal that bank intermediation is necessary. This is further reinforced by the relatively high importance that the banking system provides to the SEE country economies.

Even though faster economic growth ere experienced in the second quarter of the 1990s, the stability of the financial and the microeconomic variables of the SEE markets were still dwindling. There was the lack of the requisite high level of standard regarding the level of service provision as compared to the European Union Market and the other developed markets on the globe. This was as a result of poor macroeconomic frameworks that were applied at that time in the region. The corresponding market inefficiencies of the proceeding decades resulted in a crisis in the region. This resulted in the increase on the average private sector loan (became an eighth of the total credit given out by the European banking sector) while the level of domestic credit soared to over 120% of the Gross Domestic Product (2002).(ECB,2004).

This therefore meant that the banking system of the SEE countries still had be improved in order to support the rapidly expanding demands and need of the economic and investment growth in the region. That would be possible through the expansion of the macroeconomic framework coupled with a corresponding stability in the banking system institutions

This implies that the banking sector in the SEE countries, in spite of the recent expansion, has still ample field for further financing the economies' investment and growth needs, if macroeconomic and financial system's institutions are enhanced.

The collaboration between the governments of the SEE countries with the major international financial institutions have come up with better reforms that have reshaped the banking institutions together with the SEE markets. The adopted institutional framework had elements that restructured, rehabilitated and privatized the banks that were owned by the state. Apart from the earlier mentioned techniques that were improved, better methods of risk evaluation and the improved asset and liability management were also adopted in the system. The inclusion of foreign investors in the financial system also marked a turning point the SEE financial framework.

A time ordered account of the major regulatory practices that were adopted by the SEE governments and their corresponding banking legislations are shown in the Table 1.These legislations have improved the transparency in the SEE banking system and has also made it have a definite framework for foreign investment portfolios. The overall effect has been the increase in both the local and foreign confidence in the system which in turn has lead to a rapid expansion in the volume of financial capital base. The existence of Deposit Insurance schemes has also stabilized the financial system. This is due to their corresponding effect of increasing the level of confidence and risk reduction that are integral to the level of deposit base.

The various microeconomic factors that include all the fiscal and monetary aspects, the sow but systematic reduction of interest rates and insurance premiums, the rise in disposable income level in the SEE region and the ever expanding demand for currency have all contributed to a positive improvement in the financial market sector. The results of these factors have included the intermediation among the countries in the SEE region. Therefore this led to a subsequent paradigm shift as the banking system of the region is concerned. The shift was accompanied by a corresponding economic stimulation that has led to better. The second table shows the decline in the total number of financial institutions in the region. The reduction is more notable in Serbia. There was however a, general reduction in the aggregate number of credit providing institutions. In 2002, the process of consolidating financial institutions began. All these ere as a result of tight regulatory capitalization requirements as prescribed by the new policy which sort to match the SEE's capital adequacy and liquidity rations closer to the ones of the EU countries.

Literature Review

This literature review provides viable insight on the methods used in the determination of a bank's profitability. It is worth noting that the factors that influence a bank's profitability are usually bank specific and industry specific. This means that different banks in different parts of the world possess different unique operating conditions and it is therefore necessary for different factors to be considered while evaluating the profitability of the bank.

The measures that are used in the evaluation of a bank's profitability include the ROA and the ROE. Profitability is often expressed as a function of several determinants. The determinants in this case can either be internal or external. The internal determinants are those policies that are affected from a ban's management board. They include factors such as the liquidity level, adequacy of capital, policy regarding provision, management of expenses and the size of the bank. External determinants of a bank's profitability however include factors that are related to industry and the macroeconomic variable which together gives a picture of the economic and legal operating environment in which the financial institutions operate.

The risks associated with liquidity index usual come out of a particular bank's lack of ability to take care of the decrease in the level of liabilities. It can also arise due to the increase of funds on the side of assets if the balance sheet is considered. This forms a pivotal role in the determination of bank's profitability. The risk associated with the loan market to households and various companies is particularly high. However such loans also hold higher expected return as when compared to the lower returns that are realized against government securities. This therefore draws out an interestingly good correlation between profitability and liquidity levels (Bourke, 1989).Usually the scenarios is that the lesser the amount of funds held in liquid investments, the greater the expected profitability index (Gibson, 2001).

The level of changes in the risk associated with credit portrays the subsequent changes in a bank's loan portfolio. This could have great effects in the performance of the baking institution (McLaughlin, 1990).McLaughlin concluded that the changes in the profitability of a bank are mostly due to the fluctuations in the credit risk. This is because continue exposure to risks associated with credit is usually a precursor for low profitability. This in turn initiates a debate that is centered on the volume of loans and the quality of the loans given out. Miller (1997) suggested that the higher the rate at which banking institutions are subjected to high-risk loans, the greater the rate of accumulation of bad loans and hence a reduction in profitability.

It has however been demonstrated that the overall level of capitalization is fundamental in the explanation of a banks performance. It is also worth noting that the impact of leverage is somewhat ambiguous. This is because low rations of capitalization usually denote a risk; therefore one would expect a negative coefficient on this determinant (Berger, 1995).

A decrease in the cost of capital can be initiated by an n increase in the equality levels. This would have a desirable effect on the profitability index (Moleneux, 1993).

The level of expected income may also be increased by an increase in the capital. This is achieved through the reduction of distress that related to finance. Such stresses include bankruptcy.

Several studies employ the method of capital ratios in the determination of the level of profitability. Example of such studies includes the works of Burke (1989), Goddard (2004) and Molyneux in 2005.All of them identified a positive correlation. Eventually in 2005, Athanasoglou suggested that the modeling of capital is better achieved if it is considered as an external determinant of the profitability of a bank. This is because higher rates of profitability would result in a corresponding increase in the capital achieved (Berger, 1995).

A reduction in the level of expenses goes along way in the improvement of the efficiency and therefore the increase in the profitability of the banking institutions. This shows a negative correlation between the ratio of operating expenses and the level of profitability. This is as outline by Bourke in 1989.It is worth noting that both Molyneux and Thornton pointed out in 1992 that there exists a positive correlation and hence suggesting that increase earnings by companied may as well be used in the payment of higher salaries paid to amore productive workforce. Such a case would therefore be desirable in the identification of the dominant outcomes in very specialized and transitional financial systems as observed in the SEE.

The size of a bank can be utilized in the capture of prime economies of scale in the financial sector. The effect would also be employed in the diseconomy of scale too. This variation controls in the difference of cost and the diversification of the product risk as a function of the credit institutions might. The initial factors can result in a positive correlation between the size of a bank and its subsequent profitability. This is possible under the influence of supporting economies of scale (Akhavein,1997, Bourke, 1989, Goddard,2004).Increased level of diversification has been identified to cause a reduction in the credit risk and hence a corresponding reduction in the profitability. The work of other analysts concludes that there could be savings realized by the increase in the size of a financial institution. This is mostly true as the market expands (Berger, 1987; Boyd and Runkle, 1993, Athanasoglou, 2005).Earlier on in 2001.two researchers, Eichengreen and Gibson suggested that the there could be a positive effect to a banks profitability caused by an increase in a bank's size. However this could only be true to certain limit. Going beyond that particular limit could result in a reduction in profitability as the expected relationship is non-linear.

Earlier on, we outlined that the introduced new system of regulatory framework that govern the SEE banking sector has lead to higher efficiency and liking in the financial system. This has in turn stimulated foreign investors to join the SEE financial market stream.However, during this period that we are considering there was still not very much remarkable foreign investment penetration into the financial market. Very few foreign markets were interested in forming mergers and acquisitions with the traditional SEE banks. Several importances are attached to the profitability element of foreign ownership. The impact on profitability could arise due to the following reasons:

The very first point regarding the effect of foreign ownership's effect on a bank's profitability is tied to the fact that a lot of foreign capital would be attracted to the bank. This would have a desirable effects since the foreign capital would reduce the costs (fiscal) that are required in the bank's restructure process (Tang,2002).The second reason would be that there would be a corresponding influx of foreign expatriates who are well trained to handle risk management. The expatriates would also help in instilling a better corporate governance culture and thereby resulting to an increase in the bank's efficiency (Bonin, 2005).The third reason is tied to the fact that the physical presence of the foreign bank would drive competition uphill and hence motivating the local banks to reduce their costs and interest rates and hence leading to a rise in efficiency (Claessens, 2001).The last reason would be the overall increase in the use of technology from the foreign countries. The foreign competitors would bring about competition through the use of better and more efficient technologies.

The study analyzing the relationship between competition and the overall performance of a financial institution has been structured to include two approaches. The first approach relates to the structural component while the second approach uses a non-structural approach (Berger, 2004).In the structural approach, the Structure-Conduct-Performance (SCP) proposition is utilized. Also utilized in this approach is the Efficient-Structure proposition. Both propositions are geared towards finding out there is an effect of collectivity in behavior that is associated with operating in a highly concentrated market. They also seek to expose the level of efficiency that can be achieved by large banks in order to improve their performance. The non-structural approach however, got its origin from the advancement of the new empirical industrial organization (NEIO).This approach explores the aspect of competition by utilizing market power. This in turn points out the effects of non-structural dynamics on competition.

The SCP proposition which enjoys the support of certain aspects of NEIO elements as advanced by Bikker (2005), point out clearly that financial institutions are capable of withdraw monopolistic advantages in a saturated markets using their power to give lower deposit levels and to demand higher loan rates. This comes about as a result of several factors such as collusion or other manifestations of noncompetitive techniques. The higher the level of concentration of a market, the lower is the level of competition in the market. A more concentrated structure in the market is achieved through the existence of several smaller firms. This increases the chances of the market achieving a joint price output configuration that nears the monopoly breakthrough. This results in firms in more concentrated markets achieving higher profits as a result of either collusive or maybe monopolistic reasons. This gives them an advantage over firms operating in less concentrated regions, their efficiency notwithstanding. The EFS proposition however still shows and suggests that concentration may be a sign of industry-specific efficiencies.(Berger,1995). One would expect more efficient companies to command a higher market share, however the means of differentiating the market power and the efficiency of a structured or non-structured theory can be shown by the profitability equation as postulated and Eichengreen and Gibson (2002).Concentration and market share are heavily significant in the theory. However the SCP is used if the concentration becomes insignificant.

There is however very little or no verification regarding the effects of deregulation on the profitability levels of a bank. As expected some banks would have to undergo the process of restructuring and hence bring in the need of deregulation. Some analysts such as Edwards (1977) suggested that deregulation would result in the reduction in the number of credit facilitating institutions. The impact of such an effect however cannot be clearly shown. Therefore it becomes almost impossible to evaluate the effects of changes in the regulatory intensity on the power of an institutions' performance.

The application of the market theory together with the regulatory theory clearly outlines the necessity of entry hurdles in improving the profitability while at the same time providing some negative effects. It was pointed out by Mamazaki (2005) that certain non-collusive behaviors are in action in the SEE banking sector. It is however argued out that entry level requirements are necessary in order to prevent unnecessary and harmful banking practices. This however is opposed by the premise that is shown through study. It shows that the process of financial reforms has desirable effect in the profitability of banks in transition economies (Fries, 2002).

The profitability of banks is therefore shown to be very sensitive to the macroeconomic dynamics regardless of the physical location of the financial institutions. It has however been shown that exponential economic growth stimulates financial institutions to lend out more money. It also allows them the ability to offer.

The most widely used derivative in the measure of macroeconomic factors that influence profitability is inflation. This concept was introduced by Revell (1979).He noted that rate of inflation.