Studies in Economics and Finance

Emerald Article: Specialization and other determinants of non-commercial bank financial institutions' profitability: Empirical evidence from Malaysia Fadzlan Sufian, Suarddy Parman

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To cite this document: Fadzlan Sufian, Suarddy Parman, (2009),"Specialization and other determinants of non-commercial bank financial institutions' profitability: Empirical evidence from Malaysia", Studies in Economics and Finance, Vol. 26 Iss: 2 pp. 113 - 128 Permanent link to this document: http://dx.doi.org/10.1108/10867370910963046 Downloaded on: 21-10-2012 References: This document contains references to 43 other documents To copy this document: permissions@emeraldinsight.com

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Specialization and other determinants of non-commercial bank nancial institutions protability

Empirical evidence from Malaysia
Fadzlan Suan
Khazanah Research and Investment Strategy, Khazanah Nasional Berhad, Kuala Lumpur, Malaysia and Department of Economics, Faculty of Economics and Management, Universiti Putra Malaysia, Selangor, Malaysia, and

Bank nancial institutions protability 113

Suarddy Parman
Department of Applied Statistics, Faculty of Economics and Administration, University of Malaya, Kuala Lumpur, Malaysia
Abstract
Purpose The purpose of the present study is to provide empirical evidence on the factors that inuence non-commercial bank nancial institutions (NCBFIs) protability in a developing economy. Design/methodology/approach The least squares methods of random effects, xed effects, and ordinary least square models are employed to examine the NCBFIs specic and macroeconomic determinants of NCBFI protability. Findings The ndings indicate that NCBFI with a high loans intensity and credit risk tend to exhibit lower protability level. On the other hand, large and more diversied NCBFI with high operational expenses and level of capitalization tend to exhibit higher protability level. Research limitations/implications Further analysis into the investigation of Malaysian NCBFIs performance is to examine the efciency changes over time by employing the non-parametric data envelopment analysis and/or the parametric Stochastic Frontier Analysis methods. Investigations into productivity changes over time, as a result of a technical change or technological progress or regress by employing the Malmquist productivity index could yet be another extension to the paper. Originality/value The paper aims to ll a demanding gap in the literature by providing empirical evidence on the determinants of the protability of non-commercial banks nancial institutions. Keywords Banks, Financial institutions, Prot, Malaysia Paper type Research paper

1. Introduction Non-Commercial Bank Financial Institutions (NCBFIs) play an important dual role in a nancial system. Traditionally NCBFIs comprise of a mixed bag of institutions that
The authors would like to thank an anonymous referee for the constructive comments and suggestions, which have signicantly improved the contents of the paper. The remaining errors are our own responsibility. The analyses, opinions, and ndings in this paper represent the views of the authors; they are not necessarily those of Khazanah Nasional Berhad.
Studies in Economics and Finance Vol. 26 No. 2, 2009 pp. 113-128 q Emerald Group Publishing Limited 1086-7376 DOI 10.1108/10867370910963046

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includes all nancial institutions, which are not classied as commercial banks. They complement the role of commercial banks, lling in nancial intermediation gaps by offering a range of products and services that they offered. Nevertheless, they also compete with commercial banks, forcing the latter to be more efcient and responsive to their customers needs. Most NCBFIs are also actively involved in the securities markets and in the mobilization and allocation of long-term nancial resources. The state of development of NCBFIs is usually a good indicator to the state of development of a countrys nancial system as a whole. The importance to investigate Malaysian NCBFIs performance could be best justied by the fact that in Malaysia, the NCBFIs play important roles in complementing the facilities offered by the commercial banks and are the key players in the development of the capital markets. The existence of Banking Financial Institutions (BFIs) and NCBFIs, supported by efcient money and capital markets, keeps the nancial sector complete, while enhancing the overall growth of the economy. Although Malaysia is moving towards a full market-based economy, its capital markets are still at its infancy. As a sophisticated and well-developed capital markets are considered as the hallmark for a market-based economy worldwide, study of this nature is particularly important as the health and development of the capital market rely largely on the performance of the NCBFIs. Hence, efcient and productive NCBFIs are expected to enhance the Malaysian capital markets in its pursuit to move towards a full market-based economy. The main motivation for this study is the Malaysias Financial Sector Master Plan (FSMP), a long-term development plan charting the future direction of the nancial services industry in Malaysia to achieve a more competitive, resilient, and efcient nancial system (see Bank Negara Malaysia, 2001). Among the measures outlined in the plan is further liberalization of the banking sector, ahead of the opening of the nancial sector to foreign competitions in 2007. However, despite the progress in nancial liberalization that was pursued during the 1990, which saw the banking sector expanding at a rapid pace, studies that attempt to investigate the performance of nancial institutions in Malaysia are relatively scarce. Furthermore, while there have been extensive literature examining the protability of banking industries in various countries, empirical works on NCBFIs protability are still at its infancy. This paper unfolds as follows. The second section will provide a brief overview of the Malaysian nancial system. Section 3 provides an overview of the related studies in the literature, followed by a section that outlines the econometric framework. Section 5 reports the empirical ndings. Finally, Section 6 concludes and offers avenues for future research. 2. Brief overview of the Malaysian nancial system The Malaysian nancial system can broadly be divided into the banking system and the non-bank nancial intermediaries. These two banking institutions are different with respect to their activities. For a well-functioning nancial market along with the BFIs, NCBFIs have an important role to uplift the economic activity. These two nancial sectors can simultaneously build up and strengthen the nancial system of the country. The banking system is the largest component, accounting for approximately 70 per cent of the total assets of the nancial system. The banking

system can be further divided into three main groups namely the commercial banks, nance companies, and the merchant banks[1]. The commercial banks are the main players in the banking system. They are the largest and most signicant providers of funds in the banking system. As at end-2004, there were ten domestically incorporated and 13 locally incorporated foreign commercial banks in Malaysia. Legally, Malaysian commercial banks enjoy the widest scope of permissible activities and are able to engage in a full range of banking services. Traditionally, Malaysian commercial banks main functions include retail-banking services, trade nancing facilities, treasury services, cross-border payment services and custody services. Apart from the more traditional activities, Malaysian commercial banks are also allowed to engage in foreign exchange activities, i.e. to buy, sell, and lend foreign currencies and the only nancial institutions allowed to provide current account facilities. Finance companies formed the second largest group of deposit taking institutions in Malaysia. There were ten domestically incorporated nance companies in Malaysia as at end-2004. Traditionally, nance companies specialize in consumption credit, comprising mainly of hire purchase nancing, leasing, housing loans, block discounting, and secured personal loans. The nance companies are allowed to accept savings and xed deposits from the public, but are prohibited from providing current account facilities. They are also not allowed to engage in foreign exchange transactions compared to their commercial bank counterparts. During the later part of the last decade, the nance companies began to expand its traditional role in retail nancing to include wholesale banking as well. Merchant banks emerged in the Malaysian banking scene in 1970, marking an important milestone in the development of the nancial system alongside of the corporate development of the country. As the countrys small businesses prospered and grew into large corporations, the banking needs of the nation became larger and more sophisticated, requiring more bulk nancing and complex banking services. Merchant banks lled the need for such services by complementing the facilities offered by commercial banks, which were at times more focused on providing short-term credit for working capital and trade nancing. They play active role in the short-term money market and capital raising activities such as nancing, syndicating, corporate nancing, providing management advisory services, arranging for the issue and listing of shares as well as managing investment portfolio. As at end-2004, there were ten merchant banks in Malaysia and all were domestically controlled institutions (Table I). The Malaysian nancial systems assets and liabilities continued to be highly concentrated at the commercial banking sector with total assets and liabilities amounting to RM761,254.8 billion or 3.05 times the national gross domestic product (GDP) as at end-2004. Prior to the Asian nancial crisis in 1997/98, the nance companies assets and liabilities were seen increasing from only RM531 million or 0.05 times of the national GDP in 1970 to reach a high of RM152.4 billion or 0.77 times in 1997. The ratio, however, gradually declined to RM123.6 billion or 0.60 times in 1998 to RM109,409.8 billion or 0.52 times GDP in 2000, before increasing again in year 2001, to reach a post-crisis high of RM141,911.0 billion or 0.61 times of the national GDP in 2003.

Bank nancial institutions protability 115

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Year 1960 1970 1980 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Commercial banks Percentage RM million of GDP 1,231.9 4,460.2 32,186.1 129,284.9 295,460.0 360,126.8 480,248.1 453,492.0 482,738.3 512,714.7 529,735.5 563,254.1 629,975.3 761,254.8 0.21 0.38 0.63 1.23 1.77 1.98 2.46 2.52 2.50 2.44 2.51 2.56 2.71 3.05

Finance companies Percentage RM million of GDP N.A. 531.0 5,635.4 39,448.0 91,892.0 119,768.8 152,386.8 123,596.9 116,438.0 109,409.8 121,811.1 130,520.0 141,911.0 68,421.1 N.A. 0.05 0.13 0.50 0.55 0.65 0.77 0.68 0.60 0.52 0.58 0.59 0.61 0.27

Merchant banks Percentage RM million of GDP N.A. 19.6a 2,228.7 11,063.2 27,062.0 34,072.8 44,300.0 39,227.8 39,184.0 36,876.0 41,025.2 41,415.5 44,103.6 42,691.0 N.A. 0.002 0.05 0.14 0.16 0.19 0.23 0.22 0.20 0.18 0.19 0.19 0.19 0.17

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Table I. Assets of the nancial system 1960-2004

Note: aAs at end-1971 Source: Bank Negara Malaysia

Due to further consolidation in the Malaysian nancial sector, the nance companies assets as a ratio of the national GDP declined again to reach a low of 0.27 times in 2004. As for the merchant banks, a similar trend is observed where its assets and liabilities as a ratio of the national GDP have been increasing since 1971 to reach a peak of RM44.3 billion or 0.23 times GDP in 1997, i.e. before the Asian nancial crisis. During the post-crisis period, the merchant banks assets and liabilities continued to remain stable at 0.17-0.22 times of the national GDP. A combination of both the nance companies and merchant banks total assets reveal that the non-commercial bank nancial sector command approximately 22.8 per cent of the banking systems total assets and liabilities[2]. 3. Related studies In the literature, bank protability, typically measured by the return on assets (ROA) and/or the return on equity, is usually expressed as a function of internal and external determinants. Internal determinants are factors that are mainly inuenced by a banks management decisions and policy objectives. Such protability determinants are the level of liquidity, provisioning policy, capital adequacy, expenses management, and bank size. On the other hand, the external determinants, both industry and macroeconomic related, are variables that reect the economic and legal environments where the nancial institution operates. Liquidity risk, arising from the possible inability of a bank to accommodate decreases in liabilities or to fund increases on the assets side of the balance sheet, is considered an important determinant of bank protability. The loans market, especially credit to households and rms, is risky and has a greater expected return than other bank assets, such as government securities. Thus, one would expect a positive relationship between liquidity and protability (Bourke, 1989). It could be the case, however, that the fewer the funds tide up in liquid investments the higher we might expect protability to be (Eichengreen and Gibson, 2001).

Changes in credit risk may reect changes in the health of a banks loan portfolio (Cooper et al., 2003), which may affect the performance of the institution. Duca and McLaughlin (1990), among others, conclude that variations in bank protability are largely attributable to variations in credit risk, since increased exposure to credit risk is normally associated with decreased rm protability. This triggers discussions concerning not the volume but the quality of loans made. In this direction, Miller and Noulas (1997) suggest that the more nancial institutions are exposed to high risk loans, the higher the accumulation of unpaid loans and the lower the protability. Even though leverage (capitalization) has been demonstrated to be important in explaining the performance of nancial institutions, its impact on bank protability is ambiguous. As lower capital ratios suggest a relatively risky position, one might expect a negative coefcient on this variable (Berger, 1995). However, it could be the case that higher levels of equity would decrease the cost of capital, leading to a positive impact on bank protability (Molyneux, 1993). Moreover, an increase in capital may raise expected earnings by reducing the expected costs of nancial distress, including bankruptcy (Berger, 1995). For the most part, the literature argues that reduced expenses improve the efciency and hence raise the protability of a nancial institution, implying a negative relationship between operating expenses ratio and protability (Bourke, 1989). However, Molyneux and Thornton (1992) observed a positive relationship, suggesting that high prots earned by rms may be appropriated in the form of higher payroll expenditures paid to more productive human capital[3]. In any case, it should be appealing to identify the dominant effect, in a developing banking environment like Malaysia. Bank size is generally used to capture potential economies or diseconomies of scale in the banking sector. This variable controls for cost differences and product and risk diversication according to the size of the nancial institution. The rst factor could lead to a positive relationship between size and bank protability, if there are signicant economies of scale (Akhavein et al., 1997; Bourke, 1989; Molyneux and Thornton, 1992; Bikker and Hu, 2002; Goddard et al., 2004), while the second to a negative one, if increased diversication leads to lower credit risk and thus lower returns. Other researchers, however, conclude that marginal cost savings can be achieved by increasing the size of the banking rm, especially as markets develop (Berger et al., 1987; Boyd and Runkle, 1993; Miller and Noulas, 1997; Athanasoglou et al., 2008). Eichengreen and Gibson (2001) suggest that the effect of a growing banks size on protability may be positive up to a certain limit. Beyond this point, the effect of size could be negative due to bureaucratic and other reasons. Hence, the size-protability relationship may be expected to be non-linear. Bank protability is sensitive to macroeconomic conditions despite the trend in the industry towards greater geographic diversication and larger use of nancial engineering techniques to manage risk associated with business cycle forecasting. Generally, higher economic growth encourages bank to lend more and permits them to charge higher margins, as well as improving the quality of their assets. Neely and Wheelock (1997) use per capita income and suggest that this variable exerts a strong positive effect on bank earnings. Dermiguc Kunt and Huizinga (2000) and Bikker and Hu (2002) attempted to identify possible cyclical movements in bank protability, i.e. the extent to which bank prots are correlated with the business cycle[4].

Bank nancial institutions protability 117

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Their ndings suggest that such correlation exists, although the variables used were not direct measures of the business cycle. 4. Data and methodology We use annual non-commercial bank level and macroeconomic data of all Malaysian non-commercial bank nancial institutions over the period 2000-2004. The non-commercial bank variables are obtained from published balance sheet information in annual reports of each individual institution, while the macroeconomic variable is sourced from various issues of Bank Negara Malaysia annual reports. The dataset is unbalanced. It was reviewed for any inconsistencies and covers the whole gamut of the industrys total assets. The nal sample consists of 18 non-commercial banks in 2000, 19 non-commercial banks in 2001, 2002 and 2003, and 18 non-commercial banks in 2004 yielding a total of 93 NCBFI-year observations. Appendix lists the non-commercial banks that are included in the study. The independent variables used to explain the NCBFIs protability are grouped under two main characteristics. The rst represent NCBFI-specic attributes, while the second encompass economic conditions during the period examined. The NCBFI-specic variables included in the regressions are, total loans divided by total assets (LOANS/TA), log of total assets (LNTA), loans loss provisions divided by total loans (LLP/TL), non-interest income divided by total assets (NII/TA), total overhead expenses divided by total assets (NIE/TA) and book value of stockholders equity as a fraction of total assets (EQASS). To measure the relationship between economic conditions and NCBFIs protability, a proxy measure of economic conditions, the growth rate of the countrys GDP is used. LOANS/TA as a proxy of loans intensity is expected to affect NCBFIs protability positively, if loans are the main source of revenue. However, the loan-performance relationship depends signicantly on the expected change of the economy. During a strong economy, only a small percentage of loans will default, and the NCBFIs prot will rise. On the other hand, the NCBFIs could adversely be affected during a weak economy, because borrowers are likely to default on their loans. Ideally, NCBFIs should capitalize on favorable economic conditions and insulate themselves during adverse conditions. The LNTA variable is included in the regression as a proxy of size to capture the possible cost advantages associated with size (economies of scale). In the literature, mixed relationships are found between size and protability, while in some cases, a U-shaped relationship is observed. LNTA is also used to control for cost differences related to NCBFIs size and for the greater ability of larger NCBFIs to diversify. In essence, LNTA may lead to positive effects on NCBFIs protability if there are signicant economies of scale. On the other hand, if increased diversication leads to higher risks, the variable may have negative effects. Following Havrylchyk (2006), Sathye (2001), and Isik and Hassan (2003), the ratio of LLP/TL is incorporated as an independent variable in the regression analysis as a proxy of credit risk. The coefcient of LLP/TL is expected to be negative because bad loans are expected to reduce protability. In this direction, Miller and Noulas (1997) suggest that the greater the exposure of the nancial institutions to high risk loans, the higher would be the accumulation of unpaid loans and protability would be lower.

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To recognize that nancial institutions in recent years have increasingly been generating income from off-balance sheet business and fee income generally, the ratio of NII/TA is entered in the regression analysis as a proxy to non-traditional activities. Non-interest income consist of commission, service charges, and fees, guarantee fees, net prot from sale of investment securities, and foreign exchange prot. The ratio is also included in the regression model as a proxy measure of NCBFIs diversication into non-traditional activities. The variable is expected to exhibit positive relationship with NCBFIs protability. The ratio NIE/TA is used to provide information on the variations of NCBFIs operating costs. The variable represents total amount of wages and salaries, as well as the costs of running branch ofce facilities. The relationship between the NIE/TA variable and protability levels may be negative, because NCBFIs that are more productive and efcient should be keeping their operating costs low. Furthermore, the usage of new electronic technology, like ATMs and other automated means of delivering services, may have caused expenses on wages to fall (as capital is substituted for labor). EQASS variable is included in the regressions to examine the relationship between protability and NCBFIs capitalization. Strong capital structure is essential for nancial institutions in developing economies, since it provides additional strength to withstand nancial crises and increased safety for depositors during unstable macroeconomic conditions. Furthermore, lower capital ratios in banking imply higher leverage and risk, and therefore greater borrowing costs. Thus, the protability level should be higher for the better capitalized NCBFIs. The variable LNGDP is included in the regression models capture developments in the regulatory environment and in the marketplace, which may have changed the underlying production technology and the associated production functions. Furthermore, different nancial institution forms could demonstrate different reactions to environmental changes. Hence, the change in the nancial landscape and structure, etc. may vary across banking groups (Saunders et al., 1990; Button and Weyman-Jones, 1992; Berger et al., 1995). We do not have a priori expectation on the LNGDP variable sign. The variable may have positive or negative relationship with NCBFIs protability levels. Favorable economic conditions are expected to result in higher demand and supply of banking services, and would possibly improve NCBFIs protability. On the other hand, during economic downturns, NCBFIs protability levels could adversely be affected, resulting in a negative relationship. 4.1 Econometric specication To test the relationship between NCBFI protability and the NCBFIs specic and macroeconomic determinants described above, we estimate a linear regression model in the following form: Pjt f b0 b1 SNCBFI_characteristicsjt b2 SEconomic_conditionst b3 SSpecializationjt 1jt ; 1jt vjt ujt 1

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where Pjt is the protability of NCBFI j at time t; b1, b2, and b3 represent the coefcients of the explanatory variables to be estimated (grouped into NCBFI-specic, macroeconomic determinants, and specialization, respectively), and 1jt is the disturbance term, with vj capturing the unobserved NBCFI-specic effect and ujt is

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the idiosyncratic error and is independently identically distributed, eit~N 0; s 2 . The preference for a random effects model (REM) over xed effects model was based on the use of Hausman and Lagrange multiplier tests (Baltagi, 2001). We apply the least square method of REM, where the standard errors are calculated by using Whites (1980) transformation to control for cross-section heteroscedasticity. As a robustness check, we have also computed the regressions based on the xed-effects (FE) and ordinary least squares (OLS) models. Before proceeding with the multivariate analysis, we perform a series of parametric (t-test) and non-parametric (Kruskall-Wallis test) tests to verify the difference between the merchant banks and the nance companies characteristics. The results are presented in Table II. During the period of study, it is apparent that the nance companies have generated a higher amount of loans (mean 0.73990 . 0.66791) and are statistically signicant in the non-parametric Kruskall-Wallis test. It is also clear from Table II that the nance companies were also larger (mean 8.99430 . 7.64323, p-value 6.534) and is statistically signicant at the 1 per cent level in both the parametric and non-parametric tests. The nance companies also seem to be saddled with a higher amount of bad loans (mean 0.1573 . 0.00824). The merchant banks on the other hand, seem to have generated signicant amount of their income from non-tradition activities (mean 0.04093 . 0.00284, p-value 2 2.191) and is statistically signicant at the 5 per cent and 1 per cent levels in the case of the parametric t-test and non-parametric Kruskall-Wallis test, respectively. Similarly, the results indicate that the merchant banks were highly capitalized (mean 0.24538 . 0.09067, p-value 2 1.756) and are signicant at the 10 and 1 per cent levels in the case of the parametric t-test and non-parametric Kruskall-Wallis test, respectively. Interestingly, despite being smaller compared to their nance companies counterparts, the merchant banks
Kruskall-Wallis equality of populations test Mean rank x 2 (Prob . x 2) 52.57a 41.55b 68.65a 25.81b 62.02a 32.30b 44.28a 49.66b 25.72a 67.83b 55.52a 38.66b 35.61a 58.15b 3.870 * * 58.576 * * * 28.194 * * * 0.923 56.593 * * * 9.073 * * * 16.213 * * *

Variables ROA LOANS/TA LNTA LLP/TL NII/TA NIE/TA EQASS Table II. Summary of parametric and non-parametric tests on equality of means and equality of populations

Obs 46 47 46 47 46 47 46 47 46 47 46 47 46 47

t-test Mean 0.01516 0.01730b 0.73990a 0.66791b 8.99430a 7.64323b 0.01573a 0.00824b 0.00284a 0.04093b 0.01523a 0.02065b 0.09067a 0.24538b
a

t (Prob . t) 2 0.234 0.207 6.534 * * * 0.376 2 2.191 * * 2 0.710 2 1.756 *

Notes: Signicant at the *10, * *5 and * * *1 percent levels; aindicates nance companies; bindicates merchant banks; t (Prob . t) represents the p-values of t-test on equality of means between merchant banks and nance companies; cx 2(Prob . x 2) represents the p-values of Kruskall-Wallis test on equality of populations between merchant banks and nance companies

seem to have incurred a higher amount of operating expenses (mean 0.02065 . 0.01523) and are statistically signicant at the 1 per cent level in the case of the non-parametric Kruskal-Wallis test. And, nally, the merchant banks were also seem to be more protable compared to their nance companies peers (0.01730 . 0.01516) and is statistically signicant at the 5 per cent level in the case of the Kruskal-Wallis test. 5. Empirical ndings The regression results focusing on the relationship between NCBFI protability and the explanatory variables are presented in Table III. The equations are based on 93 NCBFI year observations during the 2000-2004 period. To conserve space, the full regression results, which include both NCBFIs and time-specic xed and RE, are not reported in the paper. Several general comments regarding the test results are warranted. The model performs reasonably well in at least two respects. First, results for most variables remain stable across the various regressions tested. Second, the R 2 s are reasonably high ranging from 86 to 89 per cent. The ndings suggest that in most cases the explanatory variables have the expected signs. LOANS/TA reveals negative relationship with Malaysian NCBFIs protability although is not statistically signicant at any conventional levels. On the other hand, LNTA exhibits positive coefcient and is statistically signicant at the 5 per cent level implying that the larger NCBFIs tend to be more protable. Hauner (2005) offers two potential explanations for which size could have a positive impact of bank efciency. First, if it relates to market power, large banks should pay less for their inputs. Second, there may be increasing returns to scale through the allocation of xed costs (e.g. research or risk management) over a higher volume of services or from efciency gains from a specialized workforce. Thus, assuming that the average cost curve for Malaysian NCBFIs is U-shaped, the recent growth policies of the small and medium Malaysian NCBFIs seem to be consistent with the drive to minimize costs. As expected, LLP/TL shows a negative relationship with bank protability and is statistically signicant at the 1 per cent level, indicating that NCBFIs with higher proportion of riskier loans tend to exhibit lower protability levels. The nding is consistent with earlier studies by among others, Kwan and Eisenbeis (1995), Resti (1997), and Barr et al. (2002) which have found negative relationship between problem loans and bank efciency. Furthermore, most research conducted on explaining the causes of bank or thrift industry failures have found a large proportion of non-performing loans at failing institutions prior to failure (Dermiguc-Kunt, 1989; Whalen, 1991; Barr and Siems, 1994). Berger and Humphrey (1992), Barr and Siems (1994), and Wheelock and Wilson (1995) suggest that banks approaching failure tend to have low cost efciency and experiencing high ratios of problem loans and that failing banks tend to be located far from the best practice frontiers. The results imply that the Malaysian NCBFIs should focus more on credit risk management, which has been proven to be problematic in the recent past. Serious banking problems have arisen from the failure of nancial institutions to recognize impaired assets and create reserves for writing off these assets. An immense help towards smoothing these anomalies would be provided by improving the transparency of the nancial systems, which in turn will assist nancial institutions to evaluate credit risk more effectively and avoid problems associated with hazardous exposure.

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Constant NCBFI characteristics LOANS/TA LNTA LLP/TL NII/TA NIE/TA EQASS Specialization DUMSPEC Economic conditions LNGDP R2 Adjusted R 2 Durbin-Watson statistic F-statistic Prob (F-statistic) x2 Prob (x 2) No. of observations (2.949486) 20.001175 (20.329530) 0.006958 * * (2.234479) 20.119433 * * * (2 5.582954) 20.002618 (2 0.011902) 0.673593 * * * (3.789132) 0.041992 * * * (3.402516) 0.0000424 20.055209 * * * (2 2.979728) 0.857080 0.845447 1.563381 73.67674 0.000000 (2 1.831303) 93 93 2 0.082161 * 0.894290 0.853269 2.047030 21.80045 0.000000 2 0.000124 (20.012759) 0.021462 (1.337079) 2 0.115158 * * * (27.893061) 2 0.197960 (20.741294) 0.689076 * * * (5.478860) 0.051166 (0.875913) (2.976306) (1.972425) 93

Notes: Signicant at the *10, * *5 and * * *1 per cent levels; values in parentheses are t-statistics

Table III. Multivariate OLS and GLS regressions results (1) REM 0.620188 * * * (3.523082) 20.002290 (2 0.422292) 0.006996 * * (2.172065) 20.112527 * * * (2 3.943025) 20.051151 (2 0.234606) 0.680511 * * * (3.694244) 0.045785 * * * (4.089493) (0.015699) 0.621477 * * * 0.832730 * 0.645168 * * * (2) OLS (3) FEM (4) REM 20.057113 * * * (2 3.527048) 0.855875 0.842149 1.540884 62.35338 0.000000

20.000877 (2 0.245423) 0.006956 * * (2.143850) 20.119318 * * * (2 5.628593) 20.007684 (2 0.034969) 0.662623 * * * (3.728389) 0.041795 * * * (3.226644)

20.055096 * * * (2 2.942578) 0.856711 0.845048 1.582953 73.45523 0.000000 28.349050 0.0769 93

The results suggest that NII/TA possess negative relationship with NCBFIs protability level. The results imply that NCBFIs tend to become less protable as they increase their income emanating from non-interest or off-balance sheet sources. The empirical nding is consistent with earlier ndings by among others Stiroh (2004) and Stiroh and Rumble (2006). Stiroh (2004) suggests that greater reliance on non-interest income, particularly trading revenue, is associated with lower risk-adjusted prots and higher risk, while Stiroh and Rumble (2006) nd that diversication benets of the US nancial holding companies are offset by the increased exposure to non-interest activities, which are much more volatile but not necessarily more protable than interest generating activities. Interestingly, the ndings seem to suggest that expense preference behaviour measured by NIE/TA exhibit positive relationship and is statistically signicant at the 1 per cent level to Malaysian NCBFIs protability. There are a few plausible explanations. First, as suggested by Sathye (2001), the more highly qualied and professional management may require higher remuneration packages and thus a highly signicant positive relationship with protability measure is natural. Second, as suggested by Claessens et al. (2001), although overstafng may lead to the deterioration of bank protability levels in the middle-income countries, the same could not be hold true for banks operating in the middle and high income countries. As expected, the empirical ndings suggest that EQASS exhibits positive relationship with Malaysian NCBFIs protability and is statistically signicant at the 1 per cent level. The result is consistent with the ndings of previous studies (e.g. Isik and Hassan, 2003). The ndings seem to suggest that the more protable NCBFIs, ceteris paribus, uses less leverage (more equity) compared to their peers. Nevertheless, strong capital structure is essential for nancial institutions in emerging economies since it provides additional strength to withstand nancial crises and increased safety for depositors during unstable macroeconomic conditions. It is also apparent from column 1 of Table III that LNGDP exhibits negative relationship with NCBFIs protability levels and is statistically signicant at the 1 per cent level. 5.1 Robustness checks: different specications methods As a robustness check, we have performed similar regression models by using the OLS and FE methods. The results are presented in columns 2 and 3 of Table III, respectively. The results seem to suggest that all the explanatory variables continued to remain robust in terms of directions, while the coefcients of LNTA and EQASS loses its explanatory power in the FE regression model. 5.2 The impact of specialization on NCBFIs protability NCBFIs with different specialization may react differently to the same protability determinants. Thus, in the preceding analysis we control for the effect of NCBFIs specialization by adding the DUMSPEC (dummy variable that takes a value of 1 for merchant banks, 0 otherwise) to equation (1). The regression results are presented in column 4 of Table III. It is observed from column 4 of Table III that the coefcient of the variable DUMSPEC entered the regression model with a negative sign. However, the coefcient of the variable is not statistically signicant at any conventional level, suggesting that there is no relationship between NCBFIs specialization and protability levels.

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6. Concluding remarks and directions for future research In this paper, we examine the factors that inuence the protability of the non-commercial bank nancial institutions in a developing economy. Specically working within the Malaysian banking sector, the analysis is conned to the universe of merchant banks and nance companies that have been operating in the Malaysian nancial sector during the period 2000-2004. During the period of study, the empirical ndings seem to suggest that all NCBFIs determinants affect their protability in the anticipated way. The ndings indicate that Malaysian NCBFI with a high loans intensity and credit risk tend to exhibit lower protability level. On the other hand, the large NCBFI with high operational expenses and level of capitalization tend to exhibit higher protability level. The continued success of the Malaysian nancial sector depends on its efciency, protability, and competitiveness. Further, in view of the increasing competition resulting from the more liberalized banking sector, bank managements as well as the policymakers will be more incline to nd ways to obtain the optimal utilization of capacities as well as making the best use of their resources, so that these resources are not wasted during the production of banking products and services. Moreover, the ability to maximize risk-adjusted returns on investment and sustaining stable and competitive returns is an important element in ensuring the competitiveness of the banking system. Thus, from the regulatory perspective, the performance of the banking institutions will be based on their efciency and protability. The policy direction will be directed towards enhancing the resilience and efciency of the nancial institutions with the aim of intensifying the robustness and stability of the nancial system (Bank Negara Malaysia, 2001). The ndings of this study have considerable policy relevance. Within the context of the Malaysian banking sector, it could be argued that the more productive nancial institutions will be able to offer more new products and services with relatively attractive risk-adjusted returns on investment. To this end, the role of technology advancement is particularly important given that a nancial institution with relatively more advanced technologies may have added advantage over its peers. Due to its limitations the paper could be extended in a variety of ways. It is suggested that further analysis into the investigation of Malaysian NCBFIs performance to examine the changes in the efciency changes over time by employing the non-parametric data envelopment analysis and/or the parametric Stochastic Frontier Analysis methods. Investigations into productivity changes over time, as a result of a technical change or technological progress or regress by employing the Malmquist productivity index could yet be another extension to the paper. This should testify to the robustness of the results against alternative estimation methods. Despite these limitations, the ndings of this study could have provided useful insights to the policymakers, industry leaders, as well as bank managers with regard to attaining optimal utilization of capacities, improvement in managerial expertise, efcient allocation of scarce resources, and most productive scale of operation of the Malaysian NCBFIs industry. From the policymakers point of view, the ndings of this study may help them facilitate future directions for sustainable and competitive banking operations in Malaysia. The ndings may also help bank managements to gure out on ways to further improve their bottom line.

Notes 1. The merchant banks and nance companies are not considered as banks under the Banking and Finance Institutions Act (BAFIA), 1989. Under BAFIA, the business of banking is dened as the business of: receiving deposits; paying or collecting cheques; provision of nance; and such other business as Bank Negara Malaysia (BNM) with the approval of the Minister may prescribe. While the nance companies are allowed to take deposits from the Malaysian public, and thus t into the rst criteria, they are not allowed to provide current account facilities and thus are not t into the second criteria as a bank. Likewise, the merchant banks are not allowed to collect deposits from the Malaysian public (retail deposits), and are also not allowed to provide current account facilities, and thus does not t into the criteria of a bank. 2. The gure is at end-2003, prior to the consolidation of nance companies into their respective commercial banking parents. 3. A guess would be that such relationship is observed in developed banking systems, which hire high quality and therefore, high cost staff. Hence, providing that the high quality staff is sufciently productive, such banks will not be disadvantaged from a relative point of view. 4. In a contestable market active rms are vulnerable to hit and run entry. For its existence, sunk costs must be largely absent. In the banking industry, some argue that most of the costs are xed but not sunk, making it contestable (Whalen, 1988).

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Sathye, M. (2001), X-efciency in Australian banking: an empirical investigation, Journal of Banking & Finance, Vol. 25 No. 3, pp. 613-30. Saunders, A., Strock, E. and Travlos, N.G. (1990), Ownership structure, deregulation, and bank risk taking, Journal of Finance, Vol. 45 No. 2, pp. 643-54. Stiroh, K.J. (2004), Diversication in banking: is non-interest income the answer?, Journal of Money, Credit and Banking, Vol. 36 No. 5, pp. 853-82. Stiroh, K.J. and Rumble, A. (2006), The dark side of diversication: the case of US nancial holding companies, Journal of Banking & Finance, Vol. 30 No. 8, pp. 2131-42. Whalen, G. (1988), Actual competition, potential competition and bank protability in rural markets, Federal Reserve Bank of Cleveland Economic Review, Vol. 3, pp. 14-21. Whalen, G. (1991), A proportional hazards model of bank failure: an examination of its usefulness as an early warning tool, Federal Reserve Bank of Cleveland Economic Review, Vol. 27 No. 1, pp. 21-31. Wheelock, D.C. and Wilson, P.W. (1995), Explaining bank failures: deposit insurance regulation and efciency, Review of Economics and Statistics, Vol. 77 No. 4, pp. 689-700. White, H.J. (1980), A Heteroskedasticity-consistent Covariance matrix estimator and a direct test for Heteroskedasticity, Econometrica, Vol. 48, pp. 817-38. Further reading Berger, A.N. and Mester, L.J. (1997), Inside the black box: what determine differences in the efciency of nancial institutions?, Journal of Banking & Finance, Vol. 21 No. 7, pp. 895-947. Hassan, M.K. and Bashir, A.H.M. (2003), Determinants of Islamic banking protability, paper presented at the 10th ERF Annual Conference, 16-18 December, Morocco. International Monetary Fund (2002), Financial soundness indicators: analytical aspects and country practices, Occasional Paper 212, International Monetary Fund, Washington DC. Rivard, R.J. and Thomas, C.R. (1997), The effect of interstate banking on large bank holding company protability and risk, Journal of Economics and Business, Vol. 49, pp. 61-76. Rosly, S.A. and Abu Bakar, M.A. (2003), Performance of Islamic and mainstream banks in Malaysia, International Journal of Social Economics, Vol. 30 No. 12, pp. 1249-65. (The Appendix follows overleaf.)

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Appendix
NCBFI Afn Merchant Bank Afn-ACF Finance Alliance Finance Alliance Merchant Bank Arab-Malaysian Finance Arab-Malaysian Merchant Bank Aseambankers Bumiputra-Commerce Finance Commerce International Merchant Bankers EON Finance Hong Leong Finance Malaysian International Merchant Bankers Mayban Finance Public Finance Public Merchant Bank RHB Delta Finance RHB Sakura Merchant Bankers Southern Finance Southern Investment Bank Utama Merchant Bank Number of Observations Type MB FC FC MB FC MB MB FC MB FC FC MB FC FC MB FC MB FC MB MB N 2000 p p p p p p p p p p p p p p p p p p 18 2001 p p p p p p p p p p p p p p p p p p p 19 2002 p p p p p p p p p p p p p p p p p p p 19 2003 p p p p p p p p p p p p p p p p p p p 19 2004 p p p p p p p p p p p p p p p p p p 18

128

Table AI. Summary of the sample used in the study

Notes: MB, merchant bank; FC, nance company

Corresponding author Fadzlan Suan can be contacted at: fadzlan.suan@khazanah.com.my; fsuan@gmail.com

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