The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2044-1398.htm
CFRI
8,2
216
Received 21 October 2016
Revised 6 November 2017
Accepted 9 November 2017
China Finance Review
International
Vol. 8 No. 2, 2018
pp. 216-231
© Emerald Publishing Limited
2044-1398
DOI 10.1108/CFRI-10-2016-0118
Determinants of bank’s
profitability: role of poor asset
quality in Asia
Nimesh Salike
International Business School Suzhou, Xi’an Jiaotong-Liverpool University,
Suzhou, China, and
Biao Ao
KPMG Huazhen LLP, Shanghai, China
Abstract
Purpose – The purpose of this paper is to study the determinants of Asian banks’ profitability with
particular focus on the role of asset quality. This concern has been particularly important as the Basel III
imposed more stringent requirements in banking regulation.
Design/methodology/approach – The paper uses fixed effect estimation for the panel data of the sample
that consists of 947 banks from 12 Asian economies over the period of 2001-2015.
Findings – The authors find that poor asset quality (measured as impaired loans over gross loans) has a
significant negative impact on banks’ profitability. Other bank-specific variables – capital adequacy, income
diversification and operating inefficiency – are also important determinants. With regard to macroeconomic
factors – real gross domestic product growth has most significant influence on the performance of banks.
Research limitations/implications – The authors also find that the banks operating in
non-advanced economies enjoy higher profit margin than banks operating in advanced economies.
Practical implications – Although the average asset quality in Asian banks improved over the years,
governments could promote more competition, particularly in non-advanced economies. Banks in the region
are recommended to diversify their income by avoiding over reliance on interest income.
Originality/value – Although there are prior studies that looked into asset quality, in particular with
regard to the European and US experience, to the best of the authors’ knowledge there is no such study that
explores cross-country Asian countries. In addition, the other primary determinants of Asian banks’
profitability are investigated. Further, the authors also looked in depth at the performance of the banks in
advanced and non-advanced Asian economies.
Keywords Asia, Bank’s profitability, Panel data, Asset quality, Impaired loan
Paper type Research paper
1. Introduction
Bank’s primary function as a financial intermediary is to pool the funds from lenders and allocate
them to borrowers, thereby making profits from the interest spread. This supposedly enhances
efficient allocation of capital by channeling fund to those who have a shortage of funds from those
who have a surplus. The bank loans entered into the financial statements reflect the value of the
asset and measure how much financial resource is effectively transferred from banks to users.
Allen and Carletti (2010) stated that the price reflects the fundamentals of assets and can be
trusted in an efficient market. However, if the price fails to do so, it may understate or
overstate the fundamentals of assets and become difficult for banks to determine the value of
assets. Banking is a profit-seeking industry and all the inputs and outputs need to be
quantified. Hence, the price of assets held by banks can be used to measure their ability to
generate future cash flow. Conventionally, one of the measures of poor asset quality is
JEL Classification — G21, G32, C33, E44
The authors would like to thank Yilin Jolene Tan for her able research assistance and
Shafeena Taylor-Cross for proof reading. The authors are also grateful to two anonymous referees and the
editors for their valuable and insightful comments, which improved the quality of the paper.
expressed as the ratio of non-performing loans or impaired loans to gross loans. While banks Determinants
are able to decide the amount of loans they lend to qualified borrowers, the proportions of of bank’s
recoverable loans are not within the control of the management. Moreover, the recoverable profitability
loans depend on the clients’ ability to repay the principal and interest. During economic
downturns, the clients’ ability to repay the principal and interest becomes weak and the
pricing mechanism of an asset does not function well. In such a situation, the asset price
cannot accurately reflect asset quality. Therefore, assessing the role of asset quality in 217
the profitability of the banking sector has attracted much interest in academic research works.
Besides, regulations related to banking operations have been a point of debate among
policy makers particularly after the advent of the global financial crisis (GFC) of 2007-2009.
This has led to the upgrading of the Basel accord, resulting in its third installment, Basel III,
to respond to the inadequacies in financial regulation revealed by the crisis. It is intended to
strengthen global capital and liquidity rules with the goal of promoting a more resilient
banking sector in order to improve the sector’s ability to absorb sudden shocks in the
market. It also anticipates improving risk management and strengthening banks’
transparency and disclosures (BIS, 2011). In the process, it introduced several stringent
regulations in both aspects of capital and liquidity requirements. For example, the minimum
capital requirement was raised to 4.5 percent of risk-weighted assets and Tier 1 capital to
6 percent, the expectation for banks to have a capital conservation buffer of 2.5 percent and
to maintain a leverage ratio in excess of 3 percent. Similarly, the minimum requirement for
liquidity coverage ratio was increased to 100 percent and net stable funding ratio was also
introduced. Following these, there are concerns how these regulations would impact lending
behavior and profitability of the banks (e.g. see Ozili, 2015; Pasiouras et al., 2009).
Banks in Asia are structurally sound and appear to have stronger financial positions
than the banks in Europe, the UK and Australia on all aspects of capital adequacy,
liquidity and risk exposure. Nevertheless, the stringent capital and liquidity requirements
have an impact on leveraging of banks that would trigger unintended reallocation of
funds (Sheng, 2013). The Asian financial market is typical bank-based financial system
with banking sector playing the important role of intermediary. The profitability of the
banking sector was consistently positive until the GFC of 2007-2009. As can be seen in
Figure 1, both the measures of profitability (return on average assets (ROAA) and return

0.7 7
ROAA (left axis) ROAE (right axis)
0.6 6

0.5 5

0.4 4

0.3 3

0.2 2

0.1 1

0.0 0

–0.1 –1
Figure 1.
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Profitability of
Asian banks (average
Notes: ROAA, return on average assets; ROAE, return on average equity ROAA and ROAE)
Source: Orbis Bank Focus database
CFRI on average equity (ROAE)) were positive for Asian banks until 2007. However, these
8,2 banks were quick to recover after 2009, even surpassing the pre-crisis level.
The country-specific profit distribution of the Asian banks is presented in Figure 2
for four different years. These countries have enjoyed a relatively healthy ROAA except for
Japan and Malaysia over the years. Japanese banks suffered the most in the advent of
the GFC. The profitability is healthy in most recent times particularly for Singapore,
218 South Korea and Hong Kong.
Figure 3 shows the general picture of asset quality among the Asian banks, measured as
average ratio of impaired loans over gross loans and average ratio of loss reserves over
gross loans. It can be seen that over the years Asian banks have been effective in controlling
the bad loans; in particular, the impaired loans have seen a major drop during the first half
of the 2000s. The figure is stable and consistent even during the period of GFC. This shows
the robust nature of the Asian banking industry.

2.0

2007 2008 2014 2015

1.5

1.0

0.5

0.0
China

Hong Kong

India

Indonesia

Japan

Malaysia

Philippines

Singapore

South korea

Taiwan

Thailand

Vietnam
Figure 2.
Return on average
assets of individual –0.5
Asian economies
Source: Orbis Bank Focus database

12.00

10.00

8.00

6.00

4.00

2.00
Ratio of impaired loans over gross loans (%)

Figure 3. Ratio of loan loss reserves over gross loans (%)

0.00
Asset quality 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
of Asian banks
Source: Orbis Bank Focus database
Studies on the determinants of bank’s profitability in Asia have been undertaken to some Determinants
extent in previous research works; however, there is no study that focused specially of bank’s
on asset quality. Further, given the heightened attention on banking regulations put profitability
forward by Basel III, it has been imperative to see if these stringent asset quality
requirements have had an impact on bank’s profitability. This paper delves into such an
issue by assessing the role of asset quality on profitability of Asian banks from
12 economies using the sample period of 2001-2015 that included the financial crisis years. 219
Although there are prior studies that looked into asset quality, in particular with regard to
the European and US experience, to the best of our knowledge there is no such study
that explores cross-country Asian countries. In addition, the other primary determinants
of Asian banks’ profitability are investigated. Further, we also looked in depth at the
performance of the banks in advanced and non-advanced Asian economies.
In one such study that focused on the Chinese experience, Boateng et al. (2015) examined
the effect of asset quality using 111 Chinese commercial banks over the period of 2002-2012.
The authors found that lower financial leverage is positively associated with overall bank
performance. Among other results, they also found that foreign banks appear to have better
asset quality and overall performance compared to domestic banks.
In the next section, we review the existing studies that looked into the determinants of
the bank’s profitability across the world. In Section 3, we present data and the research
model followed by discussions of the results in Section 4. Section 5 concludes.

2. Literature review
Previous studies on determinants of bank’s profitability have identified two set of
variables: internal and external determinants from the perspective of management
controllability. Internal factors are identified as capital adequacy, bank size, liquidity,
market power, bank ownership and importantly, asset quality. External factors
include market potential, macroeconomic condition and interest rates. While we review
all the potential determinants, we pay particular attention to the role of asset quality.

2.1 Internal factors

Bank management consists of asset management, liquidity management, liability management,
capital adequacy management and risk management. One of the most important determinants
for bank’s profitability and the main interest of this paper is the asset quality, which is a critical
variable in determining the overall condition of a bank. The quality of bank assets depends
primarily on its portfolio of loans and internal credit administration mechanisms. Poor asset
quality, also known as poor loan quality and normally represented by non-performing loans or
impaired loans, is an important consideration in asset management and is an indicator of
potential banking profitability. The theoretical consideration is that as the loans granted out by
commercial banks appear in the asset side of the balance sheet, their quality would determine
the credit risk for the banks. Loans are generally the most sizeable item in a bank’s assets and
carry the largest potential risk to the bank’s capital account. Exposure to such risk is associated
with decreased profitability (Athanasoglou et al., 2008). The excessively high level of
non-performing loans could indicate poor corporate practices, lax credit administration
processes and the absence of credit risk management practices. Therefore, reduction of such
non- performing loans is beneficial to economic growth, eliminating the uncertainty over the
banks true capital position. This would also increase the propensity to lend out more.
Berger et at. (2009) and Berger et at. (2008) concluded that asset quality is associated with bank
size with larger banks carrying significantly less non-performing loans, and therefore they have
a better loan portfolio quality than smaller banks. In addition to bank size, the ratio of
non-performing loans depends on other variables such as the borrowers’ ability to repay, the
market for trading the problem assets, regulations for the resolution of non-performing loans,
CFRI etc. Beck et al. (2010) used loan loss provision to proxy asset quality and concluded that there
8,2 was weak evidence to show that asset quality was associated with a higher spread for private
domestic banks. Kosmidou et al. (2008) found that there was no clear-cut establishment of a
negative association between loans loss reserves and profitability. Nevertheless, poor asset
quality is an important determinant of bank’s profitability, especially in times of recession. Bock
and Demyanets (2012) found that banks’ poor asset quality is significantly linked with
220 macroeconomic aggregates, specifically, the reduction of credit growth and worsening loan
quality that could stem from lower economic growth, exchange rate depreciation, weaker terms
of trade and a fall in debt-creating capital inflows. For the banks in Portugal, Garcia and
Guerreiro (2016) found evidence that poor asset quality, when measured as loan loss provisions
over total loans as a proxy for credit risk, has significant negative impact on profitability.
Among other internal determinants, capital adequacy, generally measured by the ratio
of equity to assets, is a significant contributor to bank’s profitability. Kosmidou et al.
(2008) found that well-capitalized banks (higher equity over assets ratio) had a lower risk
of bankruptcy. The higher the ratio of equity over assets, the smaller the risk of
insolvency that banks might face. Liquidity is the ratio of liquid assets to liquid liabilities
and is a proxy for banks’ ability to repay their clients’ shot-term deposits and other funds
at maturity. Kosmidou (2008) stated that a high ROAA was found to be associated with
well-capitalized banks and lower cost to income ratios. In the study on the impact of
liquidity on the bank’s profitability, Bordeleau and Graham (2010) concluded from the
quarterly observations from 55 American bank holding companies and 10 Canadian
banks from 1997 to 2009, that there is an inflection point that divides the impact of
liquidity on bank’s profitability. Holding liquid assets within reasonable levels could
improve bank’s profitability, but beyond the inflection point the holding of additional
liquid assets diminishes banks’ financial performance. Hence, the impact of liquidity on
bank’s profitability could also be ambiguous. Allen and Carletti (2010) stated that the high
cost of holding liquidity may result in bank failures since the holding of liquidity increases
operating costs and erodes profits whereas higher returns could have been generated by
loaning out. Similar results were observed in the Indian banking sector by Sufian and
Noor (2012) and Garcia and Guerreiro (2016) for Portuguese banks.
For conventional commercial banks, their income mainly consists of interest income and
non-interest income. Banks make profits from the interest income that is realized through
the supply of funds to private businesses. The evidence from the banking sector in
Switzerland, by Dietrich and Wanzenried (2011), indicates that the share of interest income
has a significant impact on profitability. Specifically, banks that are heavily dependent on
interest income are not as profitable as banks whose income is more diversified. Likewise,
there is a significant positive relationship between non-interest income and risk-adjusted
return on assets (ROA), found by Nguyen (2012) who used data of commercial banks from
28 financially liberalized countries for the period 1997-2004.
Operating inefficiency would capture the relative inefficiencies of banks in terms of their
costs and reduction of non-productive costs can result in higher profits. Dietrich and
Wanzenried (2011) noted that efficient banks are more profitable than non-efficient ones.
The authors examined the impact of the GFC of 2007-2009 on the profitability of commercial
banks in Switzerland and concluded that the main determinants of banks’ profitability
were operational efficiency, the growth of total loans, funding costs and interest income
share. Moreover, loan loss provisions increased significantly during the GFC and had a
negative impact on banks’ profitability.
Bank size in the form of sizeable assets is not only able to take advantage of economies of
scale and earn higher incomes during prosperous periods, but is also able to soften the
negative shocks during recession periods. Moreover, Haron (2004) found that the size of
banks significantly influences profits based on the evidence from Islamic banks.
However, Goddard et al. (2004) suggested that there was no convincing evidence to support Determinants
the systematic relationship between size and operational performance although larger of bank’s
banks tended to further improve growth performance. This was further supported by profitability
Kosmidou (2008) who did not find a significant effect of size.

2.2 External factors

Unlike the internal factors, macroeconomic variables are the factors that are not within the 221
control of the banks’ management. One of the frequently used variables as a measure of
market potential is the growth rate of gross domestic product (GDP). Kosmidou (2008)
found that GDP growth plays a substantially positive role in determining banks’ financial
performance. Demand for banking services will be high during the time of upward
sentiments, thereby increasing the aggregate demand. Jiang et al. (2003) found a positive
relationship between real GDP growth and bank’s profitability based on a sample of
banks from Hong Kong. During the economic slowdown period, uncertain global economic
conditions were reflected in lower investments and export growth, which could have
seriously hampered the recovery process. Therefore, higher growth rates of real GDP
would result in more loans and thereby higher profitability, whereas the converse would
result to lower growth.
Inflation indicates the macroeconomic condition of an economy and banks operating in
countries with high inflation exhibit very high margins and cost ratios (e.g. Vittas, 1991;
Flamini et al., 2009; Sastrosuwito and Suzuki, 2012). Banking activities tend to be high
resulting in higher profitability during times when macroeconomic conditions are favorable.
Sufian and Chong (2008) concluded that inflation has a negative impact on bank’s
profitability based on empirical evidence from the Philippines from 1990 to 2005.
However, Buckley (2011) argued that the net effect of inflation on bank’s profitability seems
to be more complicated and ambiguous.
Interest spread, the difference between the lending interest rate and the deposit interest
rate, is the nominal interest income that is generated by banks after paying depositors
(Liu et al., 2010). Banks in countries with higher interest spreads tend to face lower default
risks. This is because when interest spread widens, banks, as the suppliers of funds, hold
assets that now have more purchasing power. Haron (2004) found that the income of Islamic
banks is influenced positively by interest rates. Demirguc-Kunt and Huizinga (1999)
found that higher real interest rates are associated with higher interest margins and
profitability especially in developing countries. This may be because in developing
countries, demand deposits frequently pay lower market interest rates.

3. Data and methodology

This study covers bank-level unbalanced panel data including 1,455 banks of 12 Asian
economies from 2001 to 2015. The bank-specific variables were extracted from Orbis Bank
Focus database (https://orbisbanks.bvdinfo.com/). The economies are China, Hong Kong, India,
Indonesia, Japan, Malaysia, Philippines, Singapore, South Korea, Taiwan, Thailand and
Vietnam. These economies were further categorized as advanced and non-advanced based on
the International Monetary Fund (IMF) classification (refer to Appendix 1). The other
macroeconomic variables, including growth rate of real GDP, growth rate of the CPI and
interest spread, were derived from the Asian Development Bank (ADB) database.
Another consideration for the sampling of banks is the type of banks comprised
in the data. The banks used in this study include: commercial banks, saving banks,
cooperative banks, real estate and mortgage banks, investment banks and Islamic banks.
The other categories were excluded because of less significance of these types of banks in
the Asian context.
CFRI In principle, there were supposed to be 21,825 (1,455 banks ×15 years) observations but
8,2 some were eliminated because of the unavailability and insufficiency of data. Several
filtering processes were implemented. Specifically, those observations were excluded when
banks had missing ROAA, our dependent variable. Also, observations with only one year of
data as well as outliers were excluded[1]. As a consequence, the final data set contained
10,434 observations from 947 banks (refer to Appendices 1 and 4).
222 For estimation purposes, the following panel relationship between the dependent
variable and independent variables is generated:

Y it ¼ aþbX sit1 þ    þeit1 (1)

Yit is the dependent variable for entity i and time t; Xs represent the vector of independent
variables; and ε is the error. The dependent variable in our model is bank’s profitability
measured as ROAA and the main variable of interest in vector of independent variables is
ratio of impaired loans over gross loans (ASSQ).
Further, to look into the performance of banks operating in advanced economies vs
non-advanced economics, a dummy variable, D, is added to Equation (1):

Y it ¼ aþbX sit1 þ    þg1 D þeit1 (2)

The dummy variable, D, would take the value of 1 if the banks are operating in
non-advanced economies, 0 otherwise.
Given that the model is panel in nature, the ordinary least square may suffer from
estimation bias. Therefore, we test between the use of the random and/or the fixed effects
model. Under the fixed effects model, entity (bank) fixed effects and time (year) fixed
effects are considered. Moreover, we suspect possible endogeneity arising from the
simultaneity effect of profitability and key independent variables including asset quality.
In order to deal with this, we lag the independent variables with one period.
ROAA is used as the dependent variable as a measure of bank’s profitability as it shows
how efficiently the bank has utilized its assets in comparison to other banks. Our main
variable of interest is asset quality (ASSQ), measured as impaired loans/gross loans.
Following the discussions made in the literature review, the internal determinants used for
this study are capital adequacy (CAPS) measured as equity/total assets; liquidity ratio
(LIQD) measured as liquid assets/deposits and short-term borrowing; income diversification
(DIV ) measured as net interest revenue/average assets; and operating inefficiency (IEF)
measured as cost to income ratio. Among the external determinants, we use rate of real GDP
growth (GDP) to measure the market potential; inflation rate (CPI) to access the
macroeconomic stability of the economy; and net interest margin (INTS) to measure the
interest spread. Other variables used are ROAE and loan loss reserves/gross loans (ASSQ2)
for robustness purposes.
A dummy variable (DNAD) is used to indicate non-advanced economies in the sample.
Generally, in advanced and mature markets, competition among banks is intense and it is
difficult for them to realize higher margins and profits (Demirguc-Kunt and Huizinga, 2000).
Therefore, we hypothesize that banks in advanced economies will experience lower profit
margins than banks operating in non-advanced economies. According to the IMF
classification, the economies included in this study are divided into these two groups.
The advanced economic entities include: Hong Kong, Japan, Singapore, South Korea and
Taiwan; while the non-advanced group includes: China, India, Indonesia, Malaysia,
Philippines, Thailand and Vietnam. The brief explanation of the variables, their descriptions
and expected signs are provided in Table I.
 Expected
Determinants
Variable Description Notation sign of bank’s
profitability
Dependent variable Bank’s profitability Return on average assets ROAA
Internal determinants Poor asset quality Impaired loans/Gross loans ASSQ −
Capital adequacy Equity/Total assets CAPS +/−
Liquidity ratio Liquid assets/Deposits and LIQD +/−
short-term borrowing 223
Income diversification Net interest revenue/Average assets DIV −
Inefficiency Cost/Income IEF −
External determinants Market potential Growth rate of real GDP GDP +
Macroeconomic condition Growth rate of CPI CPI +/−
Interest spread Net interest margin INTS +
Country group Dummy variable: 1 ¼ non-advanced DNAD +
countries; 0 ¼ advanced countries Table I.
Notes: Refer Appendix 2 for descriptive statistics of the variables. All variables are in percentage except for Variable definition
the dummy variable and notation

4. Empirical results and discussion

4.1 Fixed effects estimation
The Hausman test was conducted to determine the choice between the fixed effects or
random effects model. The fixed effects model explores the relationship between predictor
or independent variables and outcome variables within an entity with each entity having its
own individual characteristics. Unlike the fixed effects model, the random effects model
assumes that variation across entities is random and uncorrelated with predictors included
in the model. The null hypothesis of the Hausman test is that the difference in coefficients is
not systematic (i.e. the preferred model is random) against the alternative hypothesis
that fixed effects model is preferable. The test result is shown in Table II (Note 1).
The probability is 0.000 and is far smaller than 0.05, therefore, the null hypothesis is rejected
and the fixed effects model is preferred.

Dependent variable: return on

average assets (1) (2) (3) (4)

Poor asset quality −0.007*** (−2.92) −0.008*** (−3.18) −0.009*** (−3.37) −0.013*** (−6.31)
Capital adequacy 0.028*** (3.88) 0.027*** (3.83) 0.025*** (5.31)
Liquidity ratio 0.003** (2.35) 0.003** (2.37) 0.002** (2.25)
Income diversification 0.021*** (2.81) 0.024*** (3.03) 0.024*** (3.20)
Inefficiency −0.004*** (−5.83) −0.004*** (−5.10) −0.006*** (−8.35)
Growth rate of real GDP 0.012*** (6.08) 0.011*** (5.4)
Growth rate of CPI −0.004 (−1.04) −0.004 (−1.19)
Interest spread −0.016 (−1.08) −0.014 (−0.97)
Dummy for non-advanced country 0.378*** (3.83)
Constant 0.409*** (25.61) 0.412*** (4.91) 0.397*** (4.51) 0.575*** (6.96)
No. of observations 8,934 8,563 8,563 8,563
F-test 0.00 0.00 0.00 0.00
Fixed effects Yes Yes Yes No
Clustered SE Yes Yes Yes Yes
Notes: 1. Hausman test results; H0: difference in coefficients is not systematic; χ2 ¼ 260.5; Prob W χ2 ¼ 0.0000
2. Breusch-Pagan/Cook-Weisberg test for heteroskedasticity; H0: constant variance; χ2 ¼ 723.91; Prob Wχ2 ¼ 0.0000
3. Standard errors clustered at bank level Table II.
4. Economy dummy variables are also used for random effects model in column 4 Panel regression
Numbers in parentheses indicate t-statistics. **,***Statistically significant at 5 and 1 percent levels, respectively with fixed effects
CFRI Further, the estimated coefficients are obtained by using clustered standard errors because
8,2 of the statistical significance of the result of the Breusch-Pagan/Cook-Weisberg test
(null hypothesis of constant variance) as shown in Table II (Note 2). The lower probability
0.00 indicates the presence of heteroskedasticity and the null hypothesis should be rejected.
Table II presents the results of regression for the different specifications.
Firstly, our main variable of interest, poor asset quality (ASSQ) is taken as the single
224 determinant of bank’s profitability and reported in column 1. It has significant negative
impact on banks’ returns although the magnitude is small. As it is defined as the ratio of
impaired loans to gross loans, this result indicates that a 1 percent increase in impaired
loans to gross loans would reduce the ROAA by 0.007 percent. When bank managers decide
to accept a risky policy and lower the requirements needed to obtain a loan, for example, by
providing loans to clients who are unable to afford sufficient charges or provide liquid
assets as collateral, then the probability of default will increase once the customers’ financial
situations worsen. However, if the management implements a conservative credit policy and
attempt to minimize impaired loans through the setting of strict filtering rules and proper
investigation of the customers’ background and capacity to repay, the probability of
non-performing loans could be reduced.
In column 2, other bank-specific variables are considered. The results indicate that the
impact of poor asset quality (ASSQ) on bank’s profitability is still negative and highly
significant. The coefficient of capital adequacy (CAPS) is positive and significant, meaning
banks with strong capital arrangements experience higher returns. Liquidity (LIQD) and
income diversification (DIV ) both have a positive association with banks’ profitability.
Interest income is the bank’s core revenue generation activity and its higher value would
indicate that banks are less diversified. This result is in contrast to our expectation.
A possible explanation for this is that in Asia, as banks operate more in the traditional
model, interest income dominates the total income structure. The banks’ operating
inefficiency (IEF) has an adverse effect on profitability. For a profit-oriented business,
any inefficiency in operation (larger proportion of expenses to total revenue) will erode the
company’s financial performance.
In column 3, we add macroeconomic variables: growth rates of real GDP, growth rates of
consumer price index (CPI) and interest spread (INTS). Poor asset quality still remains
negative and is a highly significant determinant of bank’s profitability.
The growth rate of GDP positively contributes to banks’ financial performance, consistent
with the literature. Both inflation and interest spread are found to be not significant.
In column 4, we report the result by including the dummy variable for non-advanced
economies (DNAD); DNAD equals to 1 if the bank is operating in a non-advanced economy,
0 otherwise. The estimation technique used for this specification is the random effects
estimation[2]. It is clear that the coefficient of the dummy variable is positive and significant.
It reveals the notable difference indicating that banks operating in non-advanced economies
do better than those operating in advanced economies in terms of profitability. This could be
explained due to competition factor. In the advanced economy, the banking industry has been
growing for a long time and customers can freely transfer from their current bank to another
so as to enjoy better banking services. This is because in a mature market, the customers’
transferring cost is lower and they do not need to stay loyal to one bank and sacrifice the
convenience and flexibility that can be provided by another bank. Additionally, the products
and service provided by one bank can be substituted by others in advanced economies; this
threat forces the banks to reduce internal non-productive overheads and external charges.
In all four specifications, our main variable of interest, poor asset quality (ASSQ),
maintained its negative sign and significant at 1 percent. The magnitude is rather small
ranging from 0.007 to 0.013 percent, nevertheless the results indicate the adverse effect of
poor asset quality in the bank’s profitability.
4.2 Entity and year fixed effects estimation Determinants
Assuming that economies might face time invariant effects, we next conduct the regression with of bank’s
entity and time fixed effects. The results are reported in Table III followed by the discussion. profitability
We present the results of the random effects model in column 1 for the purpose of
comparison. The random effects model does not require the specification of individual
characteristics that may influence the predictor variables. In column 2, we replicate
the results of entity fixed effects model (as reported in Table II, column 3), again for the 225
purpose of comparison.
In the last column, we present the results of entity (bank) and time (year) fixed effects.
The assumption made is that the performance of banks is affected not only by
entity-specific factors but also by time invariant factors. Our main variable of interest,
poor asset quality (ASSQ), is still negative and highly significant at 1 percent. There has
been a slight increase in the magnitude to 0.10 after taking time effects into account.
It indicates that if the ratio of impaired loans to gross loans increase by 1 percent, the
ROAA would go down by almost 0.01 percent. The joint test for time dummy variables is
also significant at 1 percent.
With regard to other variables, there are no major changes in both the bank-specific and
macroeconomic variables. All these variables keep the same sign as entity (bank) fixed
effects results and there is also not much difference in magnitude. Interest spread has a
change in sign but is not significant.
Overall, with the above results in hand, we find the evidence that poor asset quality
(ASSQ) plays an important role that has a negative effect on profitability of Asian banks.
The results pertaining to the asset quality variables are consistent over different models,
considering for entity and/or time fixed effects. It shows that with the increase in the loans
that banks fail to collect from the borrowers, termed as impaired loans, there are direct
negative consequences on a bank’s ROA. The absolute impact in this case of Asian banks is
somewhat minimal. In general, 100 percent increment in impaired loans would result in just
1 percent reduction in bank’s profitability. This further shows that Asian banks are
structurally sound. Other bank-specific determinant variables also pose significant effects
whereas GDP is the main macroeconomic variable that produces significant results.

Dependent variable: return on average assets (1) (2) (3)

Poor asset quality −0.013*** (−8.53) −0.009*** (−3.37) −0.010*** (−3.09)

Capital adequacy 0.025*** (9.17) 0.027*** (3.83) 0.028*** (3.76)
Liquidity ratio 0.002*** (3.04) 0.003** (2.37) 0.002* (1.90)
Income diversification 0.024*** (6.15) 0.024*** (3.03) 0.043*** (5.09)
Inefficiency −0.006*** (−15.11) −0.004*** (−5.10) −0.004*** (−5.14)
Growth rate of real GDP 0.011*** (4.48) 0.012*** (6.08) 0.012** (2.57)
Growth rate of CPI −0.004 (−1.41) −0.004 (−1.04) −0.008 (−1.63)
Interest spread −0.014 (−1.27) −0.016 (−1.08) 0.013 (0.67)
Constant 0.952*** (10.61) 0.397*** (4.51) 0.318*** (3.55)
No. of observations 8,563 8,563 8,563
F-test 0.00 0.00
Random effects Yes No No
Bank fixed effects No Yes Yes
Time fixed effects No No Yes
Clustered SE Yes Yes Yes
Notes: 1. Joint test for time dummies: F (13, 911) ¼ 24.62; Prob WF ¼ 0.0000 Table III.
2. Standard errors clustered at bank level Panel regression with
3. Economy dummy variables are also used for random effects model in column 1 entity and year
Numbers in parentheses indicate t-statistics. *,**,***Statistically significant at 10, 5 and 1 percent levels, respectively fixed effects
CFRI 4.3 Robustness test
8,2 We conducted several robustness tests, in particular, to deal with two aspects of analysis.
First, to control the bias on sample due to the large sample size of one particular country,
Japan. Second, to examine the use of the dependent variable and the main variable of
interest. The results are reported in Table IV.
In column 1, we reproduce the fixed effects estimation results of Table II (column 3) to
226 serve as a benchmark comparison with the other results. In our sample, the number of
observations from the banks of Japan outnumbers others and account for about 70 percent
of the total banks (refer to Appendix 4). Hence, we doubt if the results in column 1 are
characterized by one single country. To eliminate this, all the banks operating in Japan
are excluded from the model while all the independent variables and the dependent variable
remain the same, as shown in the column 2. The output indicates that all the bank-specific
variables and macroeconomic variables included in this paper are still important
determinants of banks’ profitability and such a result is consistent with the findings in
column 1. They imply that the previous conclusions about the relationships between
outcome variables and bank-specific and macroeconomic condition-related predictor
variables are robust in nature from the perspective of country composition, particularly with
regard to significant negative influence of poor asset quality.
Next, we examine the relationship between banks’ profitability and poor asset quality
by changing the dependent variable to ROAE. Comparing models in columns 1 and 3, all
determinants are consistent and are still statistically significant except for inflation, which is
now negative and significant. In particular, poor asset quality, our main variable of interest,
is still an important factor to determine Asian banks’ financial performance.
We also examine the relationship between banks’ profitability and poor asset quality by
changing our variable of interest, poor asset quality. The results reported in column 4 use
the banks’ asset quality as loan loss reserves per gross loans (ASSQ2). We find that the new

(1) (2) (3) (4) (5)

Return on Return on Return on Return on Return on
Dependent variable average assets average assets average equity average assets average assets

Poor asset quality −0.009*** (−3.37) −0.012** (−2.17) −0.145** (−2.56) −0.006** (−2.20)
Capital adequacy 0.027*** (3.83) 0.041*** (5.1) 0.230** (2.42) 0.021** (2.51) 0.020*** (2.93)
Liquidity ratio 0.003** (2.37) 0.001 (0.83) 0.057*** (2.62) 0.002* (1.89) 0.003** (2.43)
Income diversification 0.024*** (3.03) 0.024*** (2.88) 0.543*** (5.30) 0.020** (2.45) 0.021*** (2.94)
Inefficiency −0.004*** (−5.10) −0.011*** (−4.79) −0.078*** (−2.83) −0.004*** (−5.06) −0.002** (−2.50)
Growth rate of real GDP 0.012*** (6.08) 0.017*** (3.78) 0.241*** (5.63) 0.010*** (4.72) 0.011*** (5.75)
Growth rate of CPI −0.004 (−1.04) −0.003 (−0.60) −0.151** (−2.26) 0.002 (0.56) −0.005 (−1.37)
Interest spread −0.016 (−1.08) 0.012 (−0.57) −0.367 (−1.54) −0.032** (−2.09) −0.011 (−0.75)
Loss reserves per
gross loans −0.018** (−2.48)
Return on average
assets (lagged) 0.125*** (5.02)
Constant 0.397*** (4.51) 0.938*** (5.72) 10.026*** (4.47) 0.394*** (3.97) 0.246*** (2.88)
No. of observations 8,563 2,267 8,560 8,563 8,563
F-test 0.00 0.00 0.00 0.00 0.00
Fixed effects Yes Yes Yes Yes Yes
Clustered SE Yes Yes Yes Yes Yes
Notes: 1. In column 1, banks from all 12 economies are included
2. In column 2, banks from Japan are excluded from the regression
3. In column 3, the dependent variable is taken as return on average equity (ROAE)
4. In column 4, the banks’ poor asset quality is measured as loan loss reserves/gross loans
Table IV. 5. In column 5, lagged dependent variable is added as one of the independent variables
Panel regressions for 6. Standard errors clustered at bank level
robustness check Numbers in parentheses indicate t-statistics. *,**,***Statistically significant at 10, 5 and 1 percent levels, respectively
measure of asset quality variable is also negative and highly significant thereby confirming Determinants
our main results. Lastly, in column 5, we report results by adding lagged dependent variable of bank’s
as one of the independent variables in the main regression. The assumption that this profitability
year’s profitability is affected by last year’s performance is confirmed by positive
significant results. Moreover, signs and significance of other variables are consistent with
the previous results and expectations.
Overall, we find that poor asset quality is an important determinant that contributes to 227
the banks’ financial performance despite tailoring the sample size through the exclusion of
banks from Japan, the changing of the dependent variable and the use of different
measures of variables. The most encouraging result is that in all the robustness results,
our variable of interest, poor asset quality, appears consistently with a negative sign and
is highly significant. These findings validate the robustness of our original results.

5. Conclusions and recommendations

Profitability of banks is determined by internal and external factors from the perspective of
control of bank management. Among one of the most important internal factors is the
quality of assets. It is expected that the poorer the quality of the asset, the more adverse
effect it will have on profitability.
Furthermore, after the GFC of 2007-2009 and the introduction of stringent requirements
by Basel III, there have been consequences on the lending behavior and profitability of the
banks operating in the region. Policy makers are concerned that the regulations have
resulted in the reallocation of loans to different sectors.
In this paper, we looked into the role of asset quality in the profitability of Asian banks.
We found that poor asset quality is significantly and negatively associated with banks’ financial
performance. This implies that any increase in poor asset quality will indicate a lower return for
the bank because more loans are likely to be provisioned or directly written-off if this ratio gets
bigger. For banks following the prudent principle of the International Financial Reporting
Standards, the assets held by the borrowers in the form of bank loans cannot be overstated in
the statements of financial position. Therefore, the probability of loan recoveries does matter.
When indicators suggest that some loans will not be recovered, banks must record such a loss
and charge it to the income statement. Eventually, such banks suffer from underperformance,
which is reflected as lower returns on the assets or equity employed during that period.
For regulators in non-advanced economies, further efforts are needed to build a well-
functioning capital market where the banking industry plays a crucial role. One of the ways to
develop the banking industry in less advanced economies is to make the domestic banks open
to more competition and to introduce more financial institutions. Temporary protection
regulations may help domestic banks earn higher profits in the short term; however, these
protections are not likely to guarantee success in the long run. Another benefit of having
foreign financial institutions is to bring in more managerial and product skills. Second, there
are other bank-specific variables that are highly likely to contribute to a better financial
performance, in particular, capital adequacy, income diversification and operating inefficiency.
This finding is consistent with earlier research. In addition, all these factors are related to
the banks’ operation, specifically, these determinants are largely within the control of the
management. Hence, any decisions about capital adequacy, liquidity, channels of income
generation and operating efficiency should be made deliberately by the management to
strike a balance between risk and return in the face of asymmetric information. Third, real GDP
is found to be an important macroeconomic factor in the performance of bank’s profitability;
higher GDP growth is associated with higher profits. Compared to the bank-specific factors,
these determinants are not within the control of bank management. Therefore, it is important
for banks to choose feasible strategies under such circumstances.
CFRI Finally, there exists a notable difference in profitability for banks operating in advanced
8,2 vs non-advanced economies. This finding is consistent with the prediction that banks
operating in advanced economies are likely to experience lower profit margins as intensified
competition weakens the interest spread. The banks in Asia may consider diversifying their
income by avoiding over reliance on interest income, in the wake of growing competition.
Furthermore, the threat of new entrant banks forces many existing banks to acquire or
228 merge with others to achieve economies of scale. To survive and remain competitive in the
industry, most banks should choose either cost leadership or to focus on niche markets.

Notes
1. Grubbs test was used to identify the outliers.
2. Since DNAD is a dummy variable, the fixed effects model could not be implemented.

References
Allen, F. and Carletti, E. (2010), “An overview of the crisis: causes, consequences, and solutions”,
International Review of Finance, Vol. 10 No. 1, pp. 1-26.
Athanasoglou, P.P., Brissimis, S.N. and Delis, M.D. (2008), “Bank-specific, industry specific and
macroeconomic determinants of bank profitability”, Journal of International Financial Markets,
Institutions & Money, Vol. 18 No. 2, pp. 121-136.
Beck, T., Cull, R., Fuchs, M., Getenga, J., Gatere, P., Randa, J. and Trandafir, M. (2010), “Banking sector
stability, efficiency, and outreach in Kenya”, Policy Research Working Paper No. 5442, The
World Bank, Washington, DC.
Berger, A.N., Klapper, L.F. and Turk-Ariss, R. (2009), “Bank competition and financial stability”,
Journal of Financial Services Research, Vol. 35 No. 2, pp. 99-118.
Berger, A.N., Young, R.D., Flannery, M.J., Lee, D. and Öztekin, Ö. (2008), “How do large banking
organizations manage their capital ratios”, Journal of Financial Services Research, Vol. 34
Nos 2/3, pp. 123-149.
BIS (2011), Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems,
Basel Committee on Banking Supervision and Bank for International Settlements, Basel.
Boateng, A., Huang, W. and Kufuor, N.K. (2015), “Commercial bank ownership and performance in
China”, Applied Economics, Vol. 47 No. 49, pp. 5320-5336.
Bock, R.D. and Demyanets, A. (2012), “Bank asset quality in emerging markets: determinants and
spillovers”, Working Paper No. Wp/12/71, International Monetary Fund, Washington, DC.
Bordeleau, E. and Graham, C. (2010), “The impact of liquidity on bank profitability”, Bank of Canada
Working Paper No. 2010-38, Ottawa.
Buckley, A. (2011), Financial Crisis: Causes, Context and Consequences, Financial Times Prentice Hall,
Edinburgh.
Demirguc-Kunt, A. and Huizinga, H. (1999), “Determinants of commercial bank interest margins and
profitability: some international evidence”, The World Bank Economic Review, Vol. 13 No. 2,
pp. 379-408.
Demirguc-Kunt, A. and Huizinga, H. (2000), “Financial structure and bank profitability”,
Policy Research Working Paper No. 2430, The World Bank, Washington, DC.
Dietrich, A. and Wanzenried, G. (2011), “Determinants of bank profitability before and during the crisis:
evidence from Switzerland”, Journal of International Financial Markets, Institutions & Money,
Vol. 21 No. 3, pp. 307-327.
Flamini, V., McDonald, C. and Schumacher, L. (2009), “The determinants of commercial bank profitability
in Sub-Saharan Africa”, Working Paper No. WP/09/15, International Monetary Fund,
Washington, DC.
Garcia, M.T.M. and Guerreiro, J.P.S.M. (2016), “Internal and external determinants of banks’ Determinants
profitability: the Portuguese case”, Journal of Economic Studies, Vol. 43 No. 1, pp. 90-107. of bank’s
Goddard, J., Molyneux, P. and Wilson, J.O.S. (2004), “The profitability of European banks: a cross- sectional profitability
and dynamic panel analysis”, The Manchester School, Vol. 72 No. 3, pp. 363-381.
Haron, S. (2004), “Determinants of Islamic bank profitability”, The Global Journal of Finance and
Economics, Vol. 1 No. 1, pp. 11-33.
Jiang, G., Tang, N., Law, E. and Sze, A. (2003), “The profitability of the banking sector in Hong Kong”, 229
Hong Kong Monetary Authority Quarterly Bulletin, Vol. 3 No. 36, pp. 5-14.
Kosmidou, K. (2008), “The determinants of banks’ profits in Greece during the period of EU financial
integration”, Managerial Finance, Vol. 34 No. 3, pp. 146-159.
Kosmidou, K., Tanna, S. and Pasiouras, F. (2008), “Determinants of profitability of domestic UK
commercial banks: panel evidence from the period 1995-2002”, Economics, Finance and
Accounting Applied Research Working Paper Series No. RP08-4, Coventry University, Coventry.
Liu, H., Molyneux, P. and Nguyen, L.H. (2010), “Competition and risk in the South East Asian
commercial banking”, Applied Economics, Vol. 44 No. 28, pp. 3627-3644.
Nguyen, J. (2012), “The relationship between net interest margin and noninterest income using a
system estimation approach”, Journal of Banking & Finance, Vol. 36 No. 9, pp. 2429-2437.
Ozili, P.K. (2015), “Determinants of Bank profitability and Basel capital regulation: empirical evidence
from Nigeria”, Research Journal of Finance and Accounting, Vol. 6 No. 2, pp. 124-131.
Pasiouras, F., Tanna, S. and Zopounidis, C. (2009), “The impact of banking regulations on banks’ cost
and profit efficiency: cross-country evidence”, International Review of Financial Analysis, Vol. 18
No. 5, pp. 294-302.
Sastrosuwito, S. and Suzuki, Y. (2012), “The determinants of post-crisis Indonesian banking system
profitability”, Economics and Finance Review, Vol. 1 No. 11, pp. 48-57.
Sheng, A. (2013), “Basel III and Asia”, Finance working paper, Fung Global Institute, Hong Kong.
Sufian, F. and Chong, R.R. (2008), “Determinants of Bank profitability in a developing economy:
empirical evidence from the Philippines”, Asian Academy of Management of Journal of
Accounting and Finance, Vol. 4 No. 2, pp. 91-112.
Sufian, F. and Noor, M.A.N.M. (2012), “Determinants of Bank performance in a developing economy:
does bank origins matters”, Global Business Review, Vol. 13 No. 1, pp. 1-23.
Vittas, D. (1991), “Measuring commercial Bank efficiency: use and misuse of bank operating ratios”,
Working Paper Series No. 806, The World Bank, Washington, DC.
CFRI Appendix 1
8,2

No. of banks
Country group Before filtering After filtering
230 Advanced economies
Hong Kong 73 23
Japan 689 587
Singapore 40 8
South Korea 50 12
Taiwan 66 35
Non-advanced economies
China 165 101
India 90 55
Indonesia 77 42
Malaysia 74 24
Philippines 49 17
Thailand 34 17
Vietnam 48 26
Table AI. Total 1,455 947
Classification of Notes: Included banks: commercial banks, saving banks, cooperative banks, real estate and mortgage banks,
economies and investment banks and Islamic banks (Source: Orbis Bank Focus database); for the classification of advanced
number of banks economies and non-advanced economies (Source: International Monetary Fund (IMF))

Appendix 2

Variable Observations Mean SD Min. Max.

Return on average assets 10,428 0.37 0.68 −6.51 13.79

Poor asset quality 10,313 6.33 4.94 0.00 37.35
Capital adequacy 10,428 6.51 3.57 −7.77 99.23
Liquidity ratio 10,203 23.22 13.68 0.36 299.82
Income diversification 10,287 2.69 2.45 −2.84 15.95
Inefficiency 10,404 67.48 18.49 3.38 274.14
Interest spread 10,434 2.19 1.87 0.76 10.50
Growth rate of real GDP 10,434 2.42 3.54 −5.53 15.24
Growth rate of CPI 10,434 1.33 2.91 −1.37 23.09
Table AII. Return on average equity 10,421 4.76 11.50 −298.18 67.25
Descriptive statistics Loss reserves 10,317 2.47 2.15 0.00 28.69
Appendix 3 Determinants
of bank’s
profitability
ROAA ASSQ CAPS LIQD DIV IEF INTS GDP CPI ROAE ASSQ2

ROAA 1.00
ASSQ −0.38 1.00
CAPS 0.46 −0.26 1.00
231
LIQD 0.02 0.12 0.15 1.00
DIV 0.48 −0.12 0.27 −0.01 1.00
IEF −0.64 0.34 −0.34 0.09 −0.38 1.00
INTS 0.50 −0.23 0.31 −0.14 0.70 −0.46 1.00
GDP 0.46 −0.26 0.23 −0.02 0.50 −0.48 0.59 1.00
CPI 0.49 −0.30 0.33 0.01 0.68 −0.39 0.70 0.53 1.00 Table AIII.
ROAE 0.82 −0.32 0.20 −0.02 0.34 −0.53 0.36 0.37 0.34 1.00 Correlation coefficient
ASSQ2 −0.09 0.64 0.01 0.16 0.15 0.06 0.06 0.02 0.00 −0.13 1.00 of variables

Appendix 4

Country Frequency Percent Cum.

China 677 6.49 6.49

Hong Kong 222 2.13 8.62
India 596 5.71 14.33
Indonesia 376 3.6 17.93
Japan 7,375 70.68 88.61
Malaysia 207 1.98 90.6
Philippines 155 1.49 92.08
Singapore 62 0.59 92.68
South Korea 59 0.57 93.24
Taiwan 332 3.18 96.43
Thailand 193 1.85 98.27
Vietnam 180 1.73 100 Table AIV.
Total 10,434 100 Frequency of banks

Corresponding author
Nimesh Salike can be contacted at: nimesh.salike@xjtlu.edu.cn

For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
Or contact us for further details: permissions@emeraldinsight.com