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A study of determinants of intellectual capital performance in banks: the UK case

Magdi El-Bannany
Liverpool Business School, Liverpool, UK
Abstract
Purpose The purpose of this paper is to investigate the determinants of intellectual capital performance in the UK banks over the period 1999-2005. Design/methodology/approach Multiple regression analysis is used to test the relationship between the intellectual capital performance as a dependent variable and certain independent variables. Findings Results indicate that the standard variables, bank protability and bank risk, are important. The results also show that investment in information technology (IT) systems, bank efciency, barriers to entry and efciency of investment in intellectual capital variables, which have not been considered in previous studies, have a signicant impact on intellectual capital performance. Research limitations/implications More evidence is needed on the determinants of intellectual capital performance before any generalisation of the results can be made. In addition, the empirical tests were conducted only on the Major British Banks Group over the period 1999-2005 and hence the results of the study cannot be assumed to extend beyond this group of banks or to different study periods. Practical implications The study might help the banking regulators in addressing the factors affecting intellectual capital performance to take actions towards developing their performance and in turn maximise their value creation. Originality/value This paper adds to the literature on the determinants of intellectual capital performance in banks. In particular, it tests the theories that investment in IT systems, bank efciency, barriers to entry and efciency of investment in intellectual capital have impact on intellectual capital performance. Keywords Intellectual capital, Human capital, Systems analysis, Banks, United Kingdom Paper type Research paper

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Introduction Human capital, as an intellectual capital component, is one of the most important resources which companies rely on to improve their efcacy and efciency, and hence gain a competitive advantage as argued by de Pablos (2003). Nielsen et al. (2006) argued that human capital, represented by the companys stock of, e.g. skilled employees, knowledge and management philosophy, helps to improve the companys performance. This makes studying the determinants of intellectual capital performance a key challenge. In addition, the results of this study might help the banking authorities to formulate and implement strategies to develop intellectual capital and guide banks to benchmark themselves in order to improve their value creation as argued by Goh (2005).
The author is grateful to Professor Ken Holden of Lancaster University in the UK for his helpful and valuable comments on earlier drafts of this paper.

Journal of Intellectual Capital Vol. 9 No. 3, 2008 pp. 487-498 q Emerald Group Publishing Limited 1469-1930 DOI 10.1108/14691930810892045

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In 1998, the UK Ministry of Trade and Industry adopted strategies to transfer the economy from an input-driven (relying on the traditional inputs of land, labour, capital and organizing to create value to the economy) to a knowledge driven economy (depending on factors such as creativity and employees skills to create value to the economy) as argued by Goh (2005). So, the UK as a country and the years from 1999 to 2005 as a period are convenient for the present study. World Bank (1999, p. 20) stated that knowledge is our most powerful engine of production. In addition, Usoff et al. (2002, p. 9) stated knowledge has become the key economic resource and the dominant and perhaps even the only source of competitive advantage. Also, World Bank (1998) stated:
[. . .] for countries in the vanguard of the world economy, the balance between knowledge and resources has shifted so far towards the former that knowledge has become perhaps the most important factor determining the standard living [. . .] todays most technologically advanced economies are truly knowledge-based.

Additionally, Public (1998) stated in a knowledge based economy the responsible party for the achieved market results are denitely the employees. So, in a knowledge driven economy such as the UK, skilled. Employees, known as human capital, play a crucial role in creating value through increasing efciency. They gain an advantage which allows them to compete in the market. That is, if the skills of the staff of company (A) are better than the skills of the staff of company (B) which is performing the same services, this will be reected in better performance for company (A) compared to company (B). This is because the staff of company (A) might adopt certain strategies, e.g. new production methods, which might lead to reduction in the production cost of the services and in turn allow this company to offer a lower price and hence make the company more efcient than company (B). This will lead it to gain a competitive advantage in the market which allows maximizing the prot of the company (maximizing the value creation). Production requires both physical and intellectual capital as argued by Goh (2005). In the agricultural and industrial sectors (which rely mainly on the traditional inputs of land and labour), physical rather than intellectual capital is more important in the process of wealth creation. But in other sectors, e.g. banking, (which relies mainly on knowledge), intellectual rather than physical capital is more important in the process of wealth creation. This is the reason for choosing the banking sector rather than other sectors for the present study. Also, Mavridis (2004, p. 93) stated the banking sector in general offers an ideal area of intellectual capital research because the business nature of the banking sector is intellectually intensive. The Major British Banks Group (MBBG) has been chosen as a study sample based on the assumption of the potential role of human capital of these large banks is expected to be clearer than other medium or small sized banks, whereas the proposed cost of obtaining skilled staff who are supposed to have a critical role in improving efciency, is assumed to be high and affordable only by the major banks. The MBBG and its abbreviations are represented as follows: (1) Alliance & Leicester Group (AL): . Alliance & Leicester plc. . Alliance & Leicester Commercial Bank plc.

(2) Abbey Group (AN): . Abbey National plc. . Abbey National Treasury Services plc. . Cater Allen Ltd. (3) Barclays Group (B): . Barclays Bank plc. . Barclays Bank Trust Company Ltd. . Barclays Private Bank Ltd. (4) Bradford & Bingley (BB). (5) HBOS Group (HBOS): . Halifax plc. . Bank of Scotland. . HBOS Treasury Services plc. . Capital Bank plc. (6) HSBC Bank Group (HSBC): . HSBC Bank plc. . HSBC Trust Company (UK) Ltd. (7) Lloyds TSB Group (LT): . Lloyds TSB Bank plc. . AMC Bank Ltd. . Cheltenham & Gloucester plc. . Lloyds TSB Private Banking Ltd. . Lloyds TSB Scotland plc. . Scottish Widows Bank plc. (8) Northern Rock plc (NR). (9) The Royal Bank of Scotland Group (RBS): . The Royal Bank of Scotland plc. . Adam and Company plc. . Coutts & Co. . National Westminster Bank plc. . Tesco Personal Finance Ltd. . Ulster Bank Ltd. . Ulster Bank Ireland Ltd. The remainder of this paper is structured as follows: section B discusses the denition of intellectual capital and its components, section C considers the measurement of intellectual capital, section D formulates the hypotheses, section E covers the research method used, section F presents the empirical results, and section G provides the conclusions.

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Denition of intellectual capital and its components Many denitions in the literature for intellectual capital and some of these are: . An intangible asset with the potential to create value for the enterprise and the society itself as stated by Mavridis (2005, p. 43). . The knowledge, information, intellectual property and experience that can be put to use to create wealth as stated by Martinez and Garcia-Meca (2005, p. 305). . Encompasses intangibles such as patents, intellectual property rights, copyrights and franchises as stated by Brennan (2001, p. 423). . Information, knowledge applied to work to create value as stated by Edvinsson and Malone (1997, p. 3). . Broad organisational knowledge unique to a rm, which allows it constantly to adapt to changing conditions as stated by Mouritsen (1998, p. 462). . Given to the combined intangible assets which enable the company to function as stated by Brooking (1996, p. 12). So, intellectual capital is an intangible asset. It covers the knowledge and experience which skilled staff can use to gain a competitive advantage for the company through applying some creative strategies as discussed above. Several types of intellectual capital components have been addressed in the literature. Of these, human capital is assumed to be the most important component for the present study. Bontis et al. (2000, p. 87) stated that human capital can be dened as the individual knowledge stock of an organisation as represented by its employees. Riahi-Belkaoui (2003, p. 217) stated that human capital generates innovation whether of new products and services or improving business processes. Galunic and Anderson (2000, p. 3) stated that human capital can be dened as the know-how, information, relationships, and general capabilities that individuals bring to bear on behalf of the rm through the employment relation. Chen et al. (2004, p. 201) stated that human capital can be considered as such factors as employees knowledge, skill, capability, and attitudes in relation to fostering performances which customers are willing to pay for and the companys prot comes from. We can conclude that human capital is an important production tool in rising the quality of services provided to customers. In turn, it might lead to a competitive advantage in the market and hence a higher value for the company. Measurement of intellectual capital performance As discussed above, both physical and intellectual capital are important for creating value to the company. In the present study, measuring the intellectual capital performance is based on the assumptions that the existence of the physical capital is essential to allow the human capital to contribute to creating added value. Human capital cannot act without the physical capital (the initial investment to buy the core components of the business) so this part cannot be ignored in constructing an index of intellectual capital performance. That is, assume that business man (A) decides to establish an IT company and recruit two highly skilled IT engineers to run the company. These two engineers will

not be able to show their brilliance without the availability of IT facilities in the company (which will be reected in the initial physical capital for company). So it might be acceptable to consider the physical capital value added (VA) as a part of the VA intellectual coefcient. The value added intellectual capital (VAIC) method explained by Public (1998) will be used to measure the intellectual capital performance because it is more convenient than others in implementing the above theoretical argument as follows: Output Gross income Input Operating expenses Excluding personal costs VA Output 2 Input HC Personal cost Considered as investment CA Physical capital VA of human capital VAHC VA HC VA CA

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VA of physical capital VACA

VA intellectual capital VAIC VAHC VACA Formulation of hypotheses In the banking literature, some factors which can be considered as determinants of intellectual capital performance are: investment in information technology (IT) systems, bank efciency, barriers to entry, efciency of investment in intellectual capital, bank protability and bank risk. Investment in IT systems In general, IT systems can be classied into two groups: (1) IT systems for internal use which can be dened as the IT resources allocated mainly to serve the purposes of the management of the company such as different types of computers and their related software. (2) IT Systems for external use which can be dened as the IT resources allocated to serve customers of the bank such as electronic distribution channels including ATMs and online banking. These two groups of IT systems can be considered as a threat to the employees, specially the unskilled ones and hence, it can be argued that there is a negative impact of investment in IT systems on the employees because it reects the intention of the management to re a number of staff. Holden and El-Bannany (2004) found that investing in ATMs by the MBBG over the period 1976-1996 led to reduction in the number of staff of the bank. The published data on computing cost will be used as a measure of investment in information technology systems.

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The logarithm of the computing cost for bank is in year t (LOGITINVit), will be used to represent the level of bank is investment in IT in year t for the reasons discussed in Section 6. Therefore, the rst hypothesis is: H1. There is a negative relationship between the levels of investment in information technology and intellectual capital performance. Bank efciency Based on the discussion in section B above, it can be argued that human capital plays an important role in lowering the production cost of the bank (giving a cost advantage) and differentiates its products (hence gaining a competitive advantage) which should be reected in increasing the market share of the bank through attracting more customers. This situation might lead in turn to motivate the banks staff (the human capital) to continue in innovating (e.g. new products or services) or improving business processes to keep the increase in the market share. It can be assumed that if bank efciency is associated with human capital, there should be a positive correlation between human capital performance and the market shares of the banks. In the banking literature, two measures of market share are used for bank efciency: in terms of deposits or assets. But it is better to measure bank efciency in terms of the comprehensive measure, total assets, than using a partial measure, because there are different sources for efciency, e.g. intangible assets. Based on the above discussion, the second hypothesis is: H2. There is a positive relationship between banks relative efciency and intellectual capital performance. Barriers to entry It can be argued that rms that are protected from competition in their sector by heavy barriers to entry are much more likely not to encourage and motivate their staff to generate innovation and this situation might have a negative impact on the performance of the staff (human capital). Depoers (2000) argued that there are several ways of measuring obstacles to entry have been considered in the banking literature. Here, the amount of investment necessary to enter the sector, represented by the ratio of xed assets to total assets, appears more appropriate than others in representing the notion of barrier to entry. The ratio of xed assets to total assets for bank i in year t will be used to reect barriers to entry to the market. Based on the above discussion, the third hypothesis is: H3. There is a negative relationship between barriers to entry in a rms sector and intellectual capital performance. Efciency of investment in intellectual capital Kannan and Aulbur (2004, p. 389) stated that human capital can be dened as the accumulated value of investments in employee training, competence, and future. As discussed in Section 2 above, human capital as an investment (represented by the staff cost) is expected to contribute to value creation for the company

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(represented by the ratio of staff cost to total revenues of bank i in year t). As a result, the more efcient investment is, the greater the contribution of that investment to the value creation and this in turn should motivate the banks staff (the human capital) to continue innovating, e.g. new products or services or improving business processes to keep the efciency of the investment in intellectual capital as it is or better. The ratio of staff cost to total revenue for bank i in year t will be used to represent the efciency of investment in human capital. This suggests the fourth hypothesis of this study: H4. There is a positive relationship between the staff costs ratio and intellectual capital performance. Bank protability In general, the nancial results of any company can be classied positive results, which are making prots, and negative results, which is making loss. Losses might require time to be spent by the directors of the company to investigate the reasons for them. Losses can be considered unusual nancial results and hence the directors need to be cautious when dealing with them. If, the directors have to spend time clarifying the reasons for losses they will have less time to undertake useful activities for the company such as encouraging innovation which might lead to increased protability of the company. On the other hand, making prots can be considered as the usual nancial results and leave the directors to undertake other useful activities for the company such as encouraging staff to innovate which might increase prots. Therefore, a positive association between bank protability and human capital performance is expected. The individual bank i annual net prot before taxation divided by shareholders equity in year t will be used to represent the bank protability. Based on the above argument, the fth hypothesis is: H5. There is a positive relationship between bank protability and intellectual capital performance. Bank risk It is well known that there is a positive relationship between the level of risk and rate of return. Patton and Zelenka (1997, p. 611) stated that the percentage of intangible assets is a proxy for the extent to which a rms future performance depends on risky assets. It can be argued that increasing the percentage of intangible assets might give the impression to the human capital (as intangible assets) that they are important in contributing to the success of the company and motivate them to continue in innovating, e.g. new products or services or improving business processes to achieve more benet to the company. Therefore, a positive association between bank risk and human capital performance is expected. Bank risk is measured as the ratio of intangible assets to total assets of bank i in year t. Based on the above argument, the sixth hypothesis is: H6. There is a positive relationship between bank risk and intellectual capital performance.

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Research methods The regression model used in this study is shown as follows: VAICit a0 a1 LOGITINit a2 HASSit a3 FASSit a4 SREVit a5 ROEit a6 ITAGASSit uit where VAICit, the dependent variable VAIC for bank i in year t; measured as explained in Section 3 above. a0 constant. a1,2,3. . ., coefcients of the independent variables, details of the denitions of the independent variables are given in Table I. uit, disturbance term that is the usual error term. Analysis of the results El-Bannany (2006, p. 64) stated that:
[. . .] if the choice of whether the variables should be included in the basic equation in linear form, or in non-linear form such as logarithms or square roots, is not clear from the theory then the approach which can be adopted is to choose the form which best ts the data.

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Hence, after conducting several experiments, I found that log of a positive variable represented by investment in information technology systems (LOGITINit) is the best performing variable and as a result the study variables are as in the regression model shown in Section 5 above. Descriptive statistics Table II reports the descriptive statistics for the intellectual capital performance and independent variables selected in this study. The mean intellectual capital performance for the sample banks throughout the study period varies from 4.52 to 29.77 of the maximum value representing the intellectual capital performance and the mean for the intellectual capital performance is 10.80. The independent variables represented by
Variable and abbreviation Investment in information technology systems (LOGITINit) Measurement Expected sign Actual sign 2 2

Table I. Description of independent variables and expected signs

Natural logarithm of total cost of hardware and software of computing systems for bank i in year t Banks relative efciency (HASSit) The ratio of bank i assets divided by total banking market assets in year t Barriers to entry (FASSit) The ratio of xed assets to total assets for bank i in year t The ratio of staff costs to total Efciency of investment in revenue for bank i in year t intellectual capital (SERVit) Individual bank i annual net prot Bank protability (ROEit) before taxation divided by shareholders equity in year t Bank risk in terms of the ratio of The ratio of intangible assets to intangible assets to total assets total assets for bank i in year t (ITAGASSit) Source: Annual reports

2 2

investment in information technology systems, bank efciency in terms of assets, barriers to entry, efciency of investment in intellectual capital, bank protability and bank risk all vary as well and this should increase the condence level in the results as argued by Naser and Al-Khatib (2000). Test for multicollinearity Multicollinearity exists when independent variables correlate signicantly with each other. Muticollinearity in the data set was investigated by the correlation matrix of the independent variables shown in Table III. The highest correlation coefcient value is between FASSit and ITAGASSit and is less than 0.99 (it is 0.89), which means that the multicollinearity should not be considered a serious problem as argued by El-Bannany (2002). Furthermore, Neter (1985) stated:
[. . .] the fact that some or all independent variables are correlated among themselves does not, in general, inhibit our ability to obtain a good t nor does it tend to affect inferences about mean responses or predictions of new observations, provided these inferences are made within the region of observations.

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Moreover, Neter (1985) stated that deleting some variables to reduce multicollinearity reduces the models explanatory power and may lead to specication errors.
Variable Intellectual capital performance (VAICit) Investment in information technology systems (LOGITINit) Banks relative efciency (HASSit) Barriers to entry (FASSit) Efciency of investment in intellectual capital (SERVit) Bank protability (ROEit) Bank risk in terms of the ratio of intangible assets to total assets (ITAGASSit) Note: N 60 observations Mean 10.80 3.00 0.07 0.02 0.12 0.23 0.01 SD 6.64 0.58 0.05 0.02 0.06 0.10 0.01 Min 4.52 1.69 0.01 0.00 0.03 20.15 0.00 Max 29.77 3.91 0.17 0.06 0.23 0.45 0.04

Table II. Descriptive statistics for the dependent and independent variables

Independent variables LOGITINit HASSit FASSit SERVit ROEit ITAGASSit

LOGITINit

HASSit 0.873 * * 0.000

FASSit 0.710 * * 0.000 0.651 * * 0.000

SERVit 0.695 * * 0.000 0.720 * * 0.000 0.521 * * 0.000

ROEit 20.028 0.831 20.149 0.256 20.113 0.390 20.137 0.297

ITAGASSit 0.690 * * 0.000 0.701 * * 0.000 0.890 * * 0.000 0.599 * * 0.000 2 0.090 0.492

Notes: Correlation is signicant at the *0.05 level (two-tailed); * *0.01 level (two-tailed). The two-tailed signicance level is shown in parentheses

Table III. The correlation coefcient matrix for the independent variables

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So, caution is needed while implementing and interpreting the results for multicollinearity test. Regression results and discussion The results presented in Table IV show that the regression model is signicant and explains 85 per cent of the relationship between the intellectual capital performance and the independent variables and this indicates that the model is well specied. The coefcients of investment in information technology systems, bank efciency, barriers to entry, efciency of investment in intellectual capital, bank protability and bank risk are statistically signicant. Investment in information technology systems is signicant with the expected negative sign. This suggests that investing in IT systems can be considered as a threat because it might reect the intention of the management to re a number of staff and hence affect negatively on the performance of the staff (human capital). Bank efciency is signicant with the expected positive sign. Therefore, the more efcient a bank is, the better the performance of the staff (human capital). Barriers to entry is signicant with the expected negative sign. This suggests that rms that are protected in their sector by heavy barriers to entry are less likely to encourage and motivate their staff to innovate because of the absence of competition and this situation might have a negative impact on the performance of the staff (human capital). Efciency of investment in intellectual capital is signicant with the unexpected negative sign. This might be because the innovative activities which are the main reection of intellectual capital are not only due to human capital. Bank protability is signicant with the expected positive sign. This suggests that at good nancial performance, represented by prots, motivates bank directors to encourage staff to perform better, which will lead in turn to increasing in the nancial return. Bank risk is signicant with the expected positive sign. This suggests that increasing the percentage of intangible assets might give the impression to the human capital (as intangible assets) that they are important in contributing to the success of the company and motivate them to carry on performing innovative activities to achieve more benet to the company. Conclusions This study provides empirical evidence relating to the determinants of intellectual capital performance for the MBBG over the period 1999-2005.
Regressor Intercept LOGITINit HASSit FASSit SERVit ROEit ITAGASSit Coefcient 39.07 27.92 71.09 2114.40 285.77 8.06 181.32 t-Ratio 13.33 25.77 4.49 22.23 29.90 2.31 2.41 Probability 0.000 0.000 0.000 0.030 0.000 0.025 0.020

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Table IV. The regression results: dependent variable VAICit

Notes: R 2 0.86; 0.85; F(6, 59) 55.99; sig. F 0.000; N 60 observations

The regression results show that investment in information technology systems, bank efciency, barriers to entry and efciency of investment in intellectual capital variables, which have not been considered in previous studies of other sectors, have a signicant impact on intellectual capital performance. In addition, the coefcients on bank protability and bank risk are statistically signicant. Access to information about the determinants of intellectual capital performance has provided insight into accounting for the knowledge assets-related parameter. In particular, the paper has found that banks which invest more in information technology systems have a lower human capital performance. That is to say, the results support the expected negative impact of investment in information technology systems on the motivations of human capital to perform better. In contrast, barriers to entry and the efciency of investment in intellectual capital both have a negative impact on human capital performance which from the perspective of the banks directors might reect potentially bad indicators. On the other hand, banks relative efciency, bank protability and bank risk have positive impact on human capital performance which from the perspective of the banks directors might reect potentially good indicators. A number of limitations of this study can be identied. First, more evidence is needed on the determinants of intellectual capital performance before any generalisation of the results can be made. Second: the empirical tests were conducted only on the MBBG over the period 1999-2005 and hence the results of the study cannot be assumed to extend beyond this group of banks or to different study periods.
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