INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS Key Discriminators of Bank Profitability

Sathya Swaroop Debasish P.G. Department of Business Management, Fakir Mohan University Balasore, Orissa 756019, India Nikhil Chandra Shil Department of Business Administration, East West University 43, Mohakhali C/A, Dhaka 1212, Bangladesh

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Abstract The precise analysis and measurement of bank profitability has long been a concern of researchers, bankers and analysts. However, the number of parameters on profitability abounds that gave the analysis a critical look. There is therefore, an urgent need to identify the key determinants of bank profitability which may provide a scientific and empirically tested framework of measurement. The objective is pursued with the help of data on selected independent variables applied on the data of 93 commercial banks for a period stretching about 8 years from 2001 to 2009. The technique of multiple discriminant analysis (MDA) is used as an important methodology to identify the most critical profitability ratios and a model is proposed which may be effectively used for financial decision-making relating to bank profitability. Key Words: Bank, profitability, multiple discriminant analysis 1. Introduction Banking occupies a crucial place in undertaking the development effort and acts as a vehicle for socio-economic transformation as well as catalyst to economic growth. Banking is the kingpin of the chariot of economic progress. As such its role in expanding economy of a country like India can neither be underestimated nor overlooked (Bhaba, 1956). One of the major concerns in the Indian Financial Sector is the low profits churned by the commercial banking industry. The performance of a bank can be measured by a number of indicators. Profitability is the most important and reliable indicator as it gives a broad indication of the capability of a bank to increase its earnings (Verghese, 1983). Profitability assumes greater importance in the changing scenario of autonomy and
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financial reforms. The viability of banks depends largely on the adequacy of profits and profitability. Profits, is banking terms refers to the excess of interest spread over burden, whereas profitability is a ratio of net earnings to the total funds used. Profitability has been an important criterion to evaluate the overall efficiency of a firm s operations. Being a relative measure, it is devoid of the pitfalls associated with interpretation of the term profit . The concept of profitability is used and interpreted in a bank similarly as for other business firm. Bank s profitability has assumed greater importance in the changing scenario of autonomy to banks and financial reforms. Profitability in banking parlance denotes the efficiency with which a bank deploys its total resources to optimize its profit and thus serves an index of asset utilization and managerial effectiveness. The present paper attempts to explore the relationship between bank profitability and its determinants. Since there are many variables affecting profitability, a model giving the most critical variables has been developed by using multiple discriminant analysis. 2. Objective and Schema of Presentation In this study, bank profitability is measured by the net returns generated out of the total resources deployed. This is given by Return on Assets (ROA) i.e. net profit as a percentage of total assets. This paper is an attempt to identify the most critical profitability ratios using a multivariate analysis technique called discriminant analysis. Discriminant analysis derives the linear combination of two (or more) independent variables that will discriminate between the prior defined groups (Aaker et al., 1998). The objective of the study is to develop a discriminant function for bank profitability using the most significant parameters and also to measure the direction and extent to which each of such parameters influence bank profitability. The factors that define bank profitability are many in number and no study could possibly be exhaustive to include all. For the purpose of the analysis, few representative determinants of profitability are selected. The paper is organized as follows. Next section presents a review of the past studies on measuring performance of banking in India followed by a discussion on the major determinants of bank profitability that are considered as independent variables in this
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analysis. Then, the scope and design of the study is outlined. The process of discriminant analysis in detailed in the next section with the development of the discriminant function explaining bank profitability. Finally, the discriminant function as developed has been validated; the limitations of the study are highlighted with the identification of the scope of further research and the concluding remarks are presented for making it comprehendible. 3. Literature Review Studies dealing with bank profitability are enormous though the objectives of those studies vary to a greater extent. However, some references of past researches are presented here that are very close to the current research objective to make the research more meaningful and interesting. Verghese (1983) conducted an in depth study on profits and profitability of commercial banks during the 70s (1970-79). The major issues covered were: (i) have there actually been a declining trend in the profits and profitability of Indian commercial banks in the seventies? (ii) what are the main determinants of profits and profitability of the Indian banks during the study period? Raut and Mohanty (1985) attempted to analyze the reasons for declining profitability of a co-operative central bank. The study concluded that the declining trend of profitability could be arrested by increasing the ratio of time deposits in total deposits. Mishra (1992) analyzed the profitability of scheduled commercial banks in India taking into account the interest and non interest income, interest expenditure, manpower expenses and other expenses. This study concluded that the growing preemption of funds in the form of Statutory Liquidity Reserve (SLR), Cash Reserve Requirements (CRR), faster increase of expenses as compared to the interest income, advances, total investment and few more have contributed to the declining profitability of commercial banks. Aggrawal (1992) , Malhotra and Kaur (1992) and Elvia and Bansal (1993) have adopted the regression model and empirically stated that reserve requirements, bank rate, lending to priority sector at a lower rate of interest, unprofitable expansion of bank branches in rural areas are the major determinants of profits and profitability of public sector banks in India. In a study on profitability of commercial banks, Amandeep (1993) has attempted to examine the trends in profits and profitability of twenty nationalized commercial banks. Using the
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multivariate analysis, the study concluded that it is the efficient management of the burden (as against the widely believed interest spread element) which plays a major role in determining the profitability of commercial banks. Parasuraman (2001) attempts to measure the performance of major banks in India for the year 1998-99 based on Economic Value Added (EVA). The study found that ranking of banks under ROA assumes close resemblance to the ranking under EVA, whereas the ranking under other criteria like total income, interest, as percentage of total assets, spread, and net profits do not match with the ranking under EVA. Das (2002) has studied the interrelationships among capital, non-performing loans and productivity using data on public sector banks for the period 1995-96 through 2000-2001 and finds the three parameters to be intertwined, with each reinforcing and to a degree, competing the other. 4. Determinants of Bank Profitability Indian banking has the distinction of being driven by the dual forces of Government interventions in the form of Reserve Bank of India (RBI) stipulations, and the efficiency of internal bank management. This is in addition to investment behavior of the consumers and the trend of public savings in the economy. Two of the major RBI interventions that effect profitability are: CRR and priority lending norms. Higher CRR restricts the banks from lending extravaganza and higher priority lending

(Pr iority Advances / Net Advances)

shrinks the bottom line of these individual banks

because the return on the advances is relatively less. The efficiency of banks can be judged on four broad parameters. They are as follows: 4.1 Liquidity (L) The financial ratios (measured in percentages) measuring liquidity in banks are Credit/Deposit ratio (C / D) , Investment /Total Deposits Ratio (I / TD ) and Long term Deposits / Total Deposits (LD / TD ) ratio. Higher C / D ratio and I / TD ratio results in less liquidity, while lower LD / TD ratio increases the liquidity of the bank. 4.2 Return Performance (RP) Three basic parameters that measure returns generated by banks are: Interest Income, Non-interest income and Net interest Spread, all divided by total assets. Net interest

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spread is the difference between interest income and interest expenditure. Higher the net spread, higher the profitability. The other return ratio is Return on Investments (ROI), made out of the deposits mobilized by the bank. 4. 3 Expense Parameters Three ratios are used under this category. They are wage bill/ total expenses, cost of deposits and cost of borrowings. All these normally have negative effects on profitability. 4.4 Operational Efficiency (OE) Non-performing assets (as percentage of net advances) and intermediation cost (divided by total assets) are usually the prime measure of operational efficiency. Higher figures in any one may erode long term profitability of the bank concerned. The dependent variable, ROA is given by the following functional relationship:

ROA = f (RBI, L, RP, EP, EE) , where, RBI denotes the interventions of Reserve Bank.
Only one parameter (Pr iority Advances / Net Advances) is studied under this variable. The Total number of independent variables (profitability determinants) studied is thirteen. 5. Scope and Design of the Study The study is confined to the major scheduled commercial banks in India. The sample consists of 93 banks (Appendix I) - 27 public sector banks (PSB), 30 private banks (PVT) and 36 foreign banks (FB). The data relates to the post banking sector reforms period (2001-2009). The source of data is the official website of Reserve Bank of India (www.rbi.org). The data on selected independent variables (Table-1) has been pooled together for each of the commercial bank for the periods of time 2001-2009. The basic idea underlying the pooling of the data is to make the data more representative. In the case of developmental indicators, it is quite possible that some irregular fluctuations or erratic behavior which is not normal do creep in the data. Therefore, it is desirable to mitigate the effect of such fluctuations by having more information, spread over 7-8 years. Moreover, pooling has been done to have more observations, which is required to avoid any problem associated with lesser degrees of freedom.

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Table 1 below shows the mean, standard deviation (S. D.) and t-values of the thirteen selected independent variable and the dependent variable (ROA) for Group I and Group II for the period from 2001 to 2009.
Group Variable s Title of Variables (Higher Profitability ) MEAN Y X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 X11 X12 X13 Net Profit / Total Assets Credit/Deposit Investment/ Deposit Term Deposits/ Total Deposits Priority Advances Interest Income/ Total Assets Net interest Spread/ Total Assets Non-interest income / Total Assets Intermediation Cost / Total Assets Wage Bills/ Total Expenses Cost of Deposits Cost of Borrowings Return on Investments Net NPA/ Net Advances Sector Advance / Net 1.32 67.08 47.52 57.89 33.53 9.45 2.08 2.84 15.19 57.45 8.17 6.59 4.55 8.79 S.D. 0.11 3.96 5.21 4.83 5.85 8.01 0.34 4.11 8.59 11.22 15.11 17.33 1.02 4.13 I Group (Lower Profitability) MEAN 0.74 65.78 38.29 53.10 34.53 12.89 2.10 1.71 25.03 65.12 10.15 8.03 3.12 11.33 S.D. 0.32 4.92 4.15 2.41 5.75 2.15 0.29 3.15 11.11 2.01 4.15 6.79 5.45 2.13 2.88* 0.95 1.32 3.86* 2.12* 2.98* 1.61 2.07* 1.15 2.56* 1.04 1.52 1.55 2.11* II tValues

Table 1: Comparison of selected variable for Group I versus Group II during 2001-2009 * Significant at 5 percent level.

As discussed in the previous section, all the above 13 ratios fall in one of the five groupsRBI interventions (X4); Liquidity (X1, X2, X3); Return Performance (X5, X6, X7, X12); Expense Parameters (X9, X10, X11) and Operational Efficiency ( X8, X13). Total numbers of observations are 93 banks multiplied by 8 years, i.e., 744 observations. Out of this, 216 (27 banks multiplied by 8 ) are for public sector banks, 240 for private banks ( 30 banks multiplied by 8 ) and remaining 288 for Foreign banks in India.
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The dependent variable Y (ROA) has been viewed as position or status in qualitative term, and hence measured on non-metric scale. The mean ROA of the 93 commercial banks over period 2001-2009 was found to be 0.85 percent. Accordingly, banks have been categorized into two groups, one consisting of those banks which showed average ROA of above 0.85 % & have been priori assigned into high profitable group (with categorical value of 1) ,and those with average ROA less than or equal to 0.85 % are grouped as low profitable banks with categorical value 0. In this way in Group I (Profitability higher than 0.85 %) there are 524 observation (out of 744 i.e., 93 banks for 8 years) and Group II (profitability lower or equal to 0.85 %) has 220 observations. The technique used for developing the Discriminant function of bank profitability is Stepwise Discriminant Analysis. Discriminant Analysis has the objectives of determining linear combinations of predictor variables to separate the groups, testing whether significant differences exist between the groups based on group centroids and identifying the variables which count most in explaining the inter-group differences (Green et al., 1988). Out of the various measures (say for example, smallest F ratio, Roa s V Variable , Wilk s Lamda , Mahalanobis Distance), the study employs Wilk s Lamda with minimum value (required for entry) as 3.84 and maximum value (for removal of the independent variable) as 2.71. At each step, the variable that minimizes the overall Wilk s Lambda is entered. The computation ends when any further entry of variables fails to minimize the Wilk s Lambda. 6. Analysis and Findings The multiple discriminant analysis was carried out using SPSS software package (version-10) and the process involved 7 steps with the final Wilk s Lambda of 0.873. The first step featured the selection of X13 (net NPA / net advances), followed by X9 (Wage bills/ total expenses) in next step. One variable entered at each of next three steps, i.e., X6 (Net interest Spread/ Total Assets) in step 3; X7 (Non-interest income / Total Assets) in step 4 and X4 (Priority Sector Advance / Net Advances) in step 5. In step 6, X13 is removed and in next step, X5 is entered. After step 7, no other variable was found to have the tolerance level (F value) more than the minimum value and hence the process was stopped.
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Thus, discriminant analysis identified only five variables (X4, X5, X6, X7 and X9) among the 13 variables as the significant discriminators of bank profitability (ROA- the dependent variable).The relative importance of these 5 independent variables in terms of their standardized canonical coefficient and Discriminant loading are given in Table-2.

Variable Titles

Standardized Weights

Discriminant Loadings

Priority Sector Advance / Net Advances -.598 (X4) Interest Income/ Total Assets (X5) Net interest Spread/ Total Assets (X6) Non-interest income / Total Assets (X7) Wage Bills/ Total Expenses (X9) .790 .970 .673 -1.112

-.066

-.018 .355 .370 -.403

Table-2: Standardized Co-efficient and Discriminant Loadings for Commercial banks during 2001-2009

Thus, the discriminant function arrived at is: Z = - 0.598 (X4) + 0.790 (X5) + 0.970 (X6) + 0.673 (X7) All the five variables are in the standardized form. The canonical correlation of the Discriminant function is 0.953 which indicates a fairly strong relationship between the groups and the Discriminant function. The centroids of the two groups are: 0.517 for Group I and 0.921 for Group II. Thus the Cut off score is determined as: {[524(0.921) +220(0.571)]/ 744} which is equal 0.8175. Out of the five variables, X6 (net interest spread /Total Assets) and X9 (wage bills/ Total expenses) have already been the most acknowledged variables influencing profitability in banks and the discriminant function confirms the same. Although X4 (interest income/total assets) was found to have negative discriminant coefficient, but the effect is 1.112 (X9)

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nullified by positive coefficients of other two income parameters (X6 and X7). Priority sector advances as percentage of total assets has positive coefficient of 0.790. In the overall analysis, the study finds that one RBI factor (X4), three Return Parameters (X5, X6, X7) and one expense ratio (X9) effected profitability in banks. Liquidity factors (X1, X2, X3) did not figure in the discriminant function and neither in any of the steps. The operational Parameter (X13) although entered step 1 was removed in step 6. 7. Validation of the Model, Limitations and Concluding Remarks From the empirical analysis of Table-3, it can be examined how far the multivariate data confirms the prior categorization of commercial banks into the priori assigned two groups. It clearly follows that during 2001-2009, the percent of correct classification of banks into Group I (higher Profitability) was 90.83% and that for Group II (lower Profitability) was 83.63%, and both are quite large enough to validate the discriminant model obtained.

Actual Group I II Table

Categorical Value 1 0

Number of Cases Predicted Group Membership (Observations) 524 220 Group I 476 ( 90.83 % ) 36 ( 16.37 % ) Group II 48 ( 9.17 % )

184 ( 83.63 % )

3: Classification of Banks on the basis of Discriminant Analysis

Note: The figures in parenthesis represent the percentage of each predicted group to total cases for the specified group. Percent of Group cases correctly classified: 88.70 % The validity of the model (Discriminant function) is assessed by calculating the analysis sample (93 banks). The hit ratio for analysis sample was 88.70 % (i.e., summation of 90.83 % of 524 and 83.63% of 220). Cross-sectional analysis of the commercial banks reveal that the classification accuracy was 85.34% in Foreign banking sector, 82.11% in private banking and the maximum 87.45% in Public Sector commercial banks. The basic
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limitation relates to that of the technique (Multiple Discriminant analysis) and financial ratios. It is to be kept in mind that the analysis pertains to the period Post- Banking sector reforms, and any general conclusions has to be a qualified one. The paper paves a path for future research measuring bank profitability. The Discriminant model developed and the reduced set of five key variables provide an empirical tested framework for financial decision-making in the Indian banks. References Aaker, D. A., Kumar, V. and Day, G. S. (1998). Marketing Research, John Wiley & Sons Inc., p. 561. Aggrawal. (1992). Analysis of profitability of public sector banks: A case for financial sector reforms. Journal of Income and Wealth. Amandeep. (1993). Profits and profitability in commercial Banks. Deep & Deep Publications, New Delhi. Bhaba, C. H. (1956). Better Climate for expansion of Indian Banking Needs. Commerce, Annual Number, p. 50. Bhatia, S. and Verma, S. (1999). Factors Determining profitability of public sector banks in India: An application of multiple regression model. Prajnana, Vol. 26, No. 4, pp. 433-445. Das, A. (2002). Risk and Productivity Changes of Public Sector Banks. Economic and Political weekly, February 2, 2002, pp. 437-448. Elavia and Bansal. (1993). Economies of scale in the Indian banking industry: a profit function approach. Journal of Indian Institute of Bankers. January March, 1993.

Klecka, W. R. (1976). Discriminant Analysis, Sage University series on Quantitative Applications in the social Science, Sage University Press, Beverly Hill & London. Malhotra and Kaur. (1992). Impact of monetary policy on the profitability of commercial banks in India. Artha Vijnana.

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Mishra, M. N. (1992). Analysis of profitability of Commercial Banks. Indian Journal of Banking & Finance, Vol. 5. Parasuraman, N. R. (2001). Economic Valued Added- Its Computation and Impact on Select Banking Companies. The ICFAI Journal of APPLIED FINANCE, Vol.6, No.4, pp. 14-30. Green, P. E., Tull, D. and Albaum, G. (1998). Research for Marketing Decisions. Engelwood Cliffs, N. J., Prentice Hall. Raut and Mohanty. (1985). Determinants of Profitability: A Case Study of A central Cooperative Bank. The Rainbow, Orissa Co-operative Union, Bhubaneshwar. Verghese, S. K. (1983). Profits and Profitability of Indian Commercial Banks in the Seventies. National Institute of Bank Management, Bombay. Appendix I List of Sample Commercial Banks Public Sector Bank 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Allahabad Bank Andhra Bank Bank of Baroda Bank of India Bank of Maharashtra Canara Bank Central Bank of India Corporation Bank Dena Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Punjab & Sind Bank Punjab National Bank 107

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15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. Syndicate Bank UCO Bank Union Bank of India United Bank of India Vijaya Bank State Bank of India State Bank of Hyderabad State Bank of Indore State Bank of Mysore State Bank of Patiala State Bank of Saurashtra State Bank of Trancore State Bank of Bikaner & Jaipur

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Private Sector Banks 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. Bharat Overseas Bank Ltd. City Union Bank Ltd. Development Credit Bank Ltd. Lord Krishna Bank Ltd. SBI Coml. and Intl. Bank Ltd. Tamiland Mercantile Bank Ltd. The Bank of Rajasthan Ltd. The Catholic Syrian Bank Ltd. The Dhanalakhsmi Bank Ltd. The Federal Bank Ltd. The Ganesh Bank of Kurundwad Ltd. The Jammu & Kashmir Bank Ltd. The Karnataka Bank Ltd. The Karur Vysya Bank Ltd. The Lakshmi Vilas Bank Ltd. The Nainital Bank Lt.D 108

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44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. The Nedungadi Bank Ltd. The Ratankar Bank Ltd. The Sangli Bank Ltd. The South Indian Bank Ltd. The United Western Bank Ltd. The Vysysa Bank Ltd. Ban Of Punjab Ltd. Centurian Bank Ltd. Global Trust Bank Ltd. HDFC Bank Ltd. ICICI Bank Ltd. IDBI Bank Ltd. IndusInd Bank Lt.d UTI Bank Ltd.

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Foreign Banks 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. ABN-Amero Bank N.V. Bank Internasional Indonesia Bank Muscat SAOG Ban of America NA Bank of Bahrain and Kuwait BSC Bank of Ceylon Barclays Bank PLC BNP Paribas Chinatrust Commercial Bank Chohung Bank Citibank N.A. Commerzbank AG Credit Agricole Indosuez Credit Lyonnais Deustsche Bank AG 109

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73. 74. 75. 76. 77. 78. 79. 80. 81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. Dresdner Bank AG Ing Bank JP Morgan Chase Bank KBC Bank N.V. Krung Thai Bank Public Company Ltd. MashreqBank psb MIZUHO Corporate Bank Ltd. Oman International Bank Ltd. Oversea-Chinese Banking Corporation Ltd. Science Generale Sonali Bank Standard Chartered Bank Standard Chartered Grindlays Bank Ltd. State Bank of Mauritius Ltd. Sumitomo Mitsui Banking Corporation The Bank of Nova Scotia The Bank of Tokyo Mitsubishi Ltd.

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The Development Bank of Singapore Ltd. The Hongkong & Shanghai Bkg. Corp. Ltd. The Saim Commercial bank PCL The Toronto Dominion Bank

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