THE SOUTH AFRICAN COMMERCIAL BANKING SECTOR

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CHAPTER 3: EMPIRICAL REVIEW OF LITERATURE ON BANKS’ PROFITABILITY

INTRODUCTION

In the previous chapter, the author examined the definition and importance of capital for an enterprise. The author observed that the composition of capital varies among different countries, as well as in South Africa, depending on the regulatory authorities of the particular country.
In this chapter, the author critically examined the theory of bank capital, regulatory issues, developments within the sphere and its links with bank profitability. Issues, debates and experiences on matters that relate to bank capital were discussed.
The capital of a bank, also known as equity, is the margin by which creditors are covered if the assets of the bank were to be liquidated. A measure of the financial health of the bank is its capital/asset ratio, which is required to be above a prescribed minimum (Hummel, 2002). When a bank creates a deposit to fund a loan, the assets and liabilities of the bank increase equally, with no increase in equity. That causes its capital ratio to drop. Therefore, the capital requirement limits the total amount of credit that a bank may issue. It is important to note that the capital requirement applies to assets while reserve requirement applies to liabilities.
Capital and its adequacy as a subject have been raised at different forums and has been a matter of concern for both banks and regulators from a policy perspective. Despite the immerse amount of work that has been devoted to this issue, there has been little in the way of agreement among the various commentators as to the guiding principles (Pringle, 1975).
There has been debate on whether capital plays a role in curbing excessive risk taking by banks and reducing the probability of bankruptcy. The orthodox argument (Berger, Herring & Szego 1995; Kaufman, 1991; Furlong & Keeley, 1989; Furlong, 1990) is that capital acts as a buffer against failure, and therefore the regulation that forces banks to hold more capital will reduce the likelihood of bankruptcy.
Other authors (Kahane, 1977; Koen & Santomero, 1980; Lam &Chen, 1985) disagree and suggest that capital regulation may indeed lead to increased risk taking by banks.
The current study addresses the importance of capital. The author argued that the relationship between capital and profitability needs to be explored further.
Conventional wisdom suggests that the riskiness of a bank is determined by its ability to absorb unforeseen losses. Given that capital is viewed to act as a buffer against losses, a high capital asset ratio (CAR) tends to be associated with lower profitability.
Berger (1995b) appears to have been the first to have reported and provided a plausible theoretical explanation of the positive relationship between CAR and return on investment (ROE). First, Berger argues that a bank that is maintaining a low CAR relative to the equilibrium value may have relatively high-expected bankruptcy costs, thus an increase in the CAR may lead to an increase in the ROE by lowering insurance costs on uninsured debt. Secondly, Berger suggests that this positive relationship could be the result of a signalling equilibrium. Other authors (Bernaner & Koubi, 2002) suggest that competitive forces may motivate banks to maintain higher capital ratios as a means of covering their borrowing costs. It is worthy to note however that all the theoretical literature analysing banking behaviour assumes that capital requirements are a binding constraint on banking behaviour and therefore do not treat capital as a managerial decision.

OTHER DETERMINANTS OF BANK PERFORMANCE

Capital as measured by the present regulatory framework, though important, is not the only factor that determines profitability of a bank. Much also depends on the quality of the assets of the bank and, importantly, the level of provisioning a bank may be holding outside its capital against assets of doubtful value.
Other than capital, the quality of assets and the level of provisioning, there are also other determinants of bank performance that are worthy of discussion.
In the review of existing literature, this thesis made use of the work of various scholars in the field. Two schools of thought about bank profitability dominate literature: some research has been done in developed countries and other in developing countries. This thesis identified divergent opinions within the literature regarding the contribution of factors such as equity capital, bank size, loans and advances, credit risk, market concentration, inflation, and economic growth in addition to other factors.
Researchers, such as Short (1979), Dermirguc-Kunt and Huizinga (1999, 2000), Bikker and Hu (2002), Davis and Zhu (2005) examined and compared the determinants of profitability across different countries, while authors such as Athanasoglou , Brissimis and Delis (2005, Berger (1995a, 1995b), Goddard, Molyneux, and Wilson, (2004a, 2004b),) focused on the banking sectors of individual countries. However, there is a relatively common list of factors that is advanced in recent literature as the usual determinants of bank profitability.
An observation is made in most of the studies around the topic of capital and profitability that the factors can broadly be grouped into two, internal factors and external factors (Alper & Adbar, 2011).
Gungor (2007) describes internal determinants as being related to bank management and referred to them as micro or bank-specific determinants of profitability. According to Gungor (2007), external determinants are reflective of the economic and legal environment that affects the operation and performance of banks.
Mamatzakis and Remoundos (2003) conclude that the variables that are directly related to the strategic planning of the banks that cover, among others, personnel expenses, loans-to-assets ratio, equity-to-assets ratio are responsible for the profit levels shown in their studies.
The pair also report that economies of scale play a significant role in the market, and has a positive impact on profitability. In their study, Mamatzakis and Remoundos also find that the size of the market, an external variable, defined by the supply of money, significantly influences profitability.
Findings by Afanasieff et al., (2002) who examined the determinants of the interest spreads of banks in Brazil suggested that both macro and micro variables have the most impact on bank interest spread.
Naceur (2003) who investigates the impact of the characteristics of banks, capital structure and macro-economic indicators on the net interest margin and profitability of banks in the Tunisian banking industry for the 1983–2000 period, concludes that high net interest margin and profitability tend to be associated with banks that hold a relatively large amount of capital, and do not have large overheads.
In a research conducted in Switzerland, Dietrich and Wanzenried (2009) find significant differences in profitability between commercial banks and argued that the differences can largely be explained by the factors that they cover in their studies.
These factors revolved around capitalisation and the results support the notion that better capitalised banks are more profitable than other banks. They also touched on the loan volume of the bank and conclude that if the loan volume of a bank is growing at a faster rate than the rest of the market, the impact on bank profitability is positive.
The key variables included in these studies are GDP growth, which they find to affect bank profitability positively, the effective tax rate and the market concentration rate, which both had a significant negative impact on bank profitability in Switzerland.
In the case of Pakistan, Javaid, Anwar, Zaman, and Gafoor, (2011) find that more total assets may not necessarily lead to higher profits due to the diseconomies of scale, and bigger loans contribute towards profitability, but their impact is not significant.
They also conclude that equity and deposits have a significant impact on profitability thus supporting the widely held view that there is a positive relationship between capital and profitability.
There are some studies that are analysing bank profitability in groups of countries, such as Molyneux and Thorton (1992), Demirguc-Kunt and Huizinga (1999, 2001), Abreu and Mendes (2001), Bashir (2000), Hassan and Bashir (2003), Athanasoglou, Delis and Stakouras (2006).
The findings by Molyneux and Thorton (1992) who are the first to investigate a multi-country setting by examining the determinants of bank profitability for a panel of 18 European countries for the 1986–1989 period, suggest a significant and positive association between the return on equity and the level of interest rates in each country.
In the study by Demirguc-Kunt and Huizinga (1998) who examined the determinants of bank profit and net interest margins, using a comprehensive set of bank specific characteristics, as well as macro-economic conditions, taxation, regulations, financial structure and legal indicators for 80 countries, both developed and developing, for the 1988–1995 period find that foreign banks have higher profitability than domestic banks in developing countries, while the opposite holds in developed countries. The summarised position from these studies of clusters of countries is that costs in general are negatively correlated with profits and that larger size of the bank, greater dependence on loans for revenue, higher the market concentration, greater GDP growth and higher proportion of equity capital to assets are generally associated with greater profitability.
In the same vein, banks with higher liquidity ratios, greater provisions for loan losses and who are more reliant on debt capital indicate lower bank profits.

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 Firm/bank size

The empirical evidence regarding size as a possible determinant of profitability/leverage of an institution is mixed. On the one hand, there is support for a positive relationship between firm size and capital structure of relatively small institutions (Sogorb-Mira, 2005); while on the other hand some studies find a negative relationship in the short-run (Chittenden, Hall, & Hutchinson, (1996); Hall, Hutchinson & Michaelas, (2004). These authors argue that small institutions tend to depend mostly on equity, while large firms are most likely to use debt. According to Newman, Gunessee, and Hilton, (2012) research conducted in developing countries also establishes a positive relationship between firm size, profitability and measures of capital structure.
Size is part of the argument in as far as the accounting of any (dis)economies of scale in the market is concerned. According to Akhavein, Berger and Humphrey (1997) and Smirlock (1985) there is a positive and significant relationship between size and profitability.
Size have been supported by other researchers basically to account for existing economies or diseconomies of scale within the banking market (Alper & Ambar, 2011; Miller & Athanasios, 2010; Peiy & Werner, 2005; Spathis, Kosmidov & Doumpus, 2002; Sufian & Habibullah, 2009).
Alper and Ambar (2011:149) examine the bank-specific and macro-economic determinants of bank profitability in Turkey during the period from 2002 to 2010. They find that asset size had a positive and significant effect on profitability.
Bank loans are expected to be the main source of income and to have a positive impact on bank performance. However, with regard to macro-economic variables, only real interest rate is found to have an effect on profitability, as measured by ROE. The remaining bank-specific factors (capital adequacy, liquidity, deposits/assets ratio and net interest margin) and macro-economic factors (real GDP growth rate and inflation rate) do not have any significant effect on bank profitability.
Miller and Athanasios (2010:505) examine large commercial banks to determine what factors affect bank profitability. They find that large banks experience poor performance because of the declining quality of the loan portfolio. However, real estate loans generally have a negative effect on the profitability of large banks, although not at high levels of significance. By contrast, contraction and land development loans have a strong positive effect on the profitability of these banks. In the same vein, Sufian and Habibullah (2009:288) investigate the determinants of profitability in the Chinese banking sector during the period 2000–2005. They find that the Chinese banking sector had undergone significant financial reforms, which had transformed the banking sector largely. However, it is reasonable to assume that these developments pose great challenges to banks in the Chinese banking sector, as the environment in which they operate change rapidly, a fact that consequently have an impact on the determinants of profitability of Chinese banks. Nevertheless, the overall results show that all the determinants have a statistically significant impact. Hussein and Al-Tamimi (2008:46) examine the determinants of the performance of commercial banks in the UAE. They find that the most significant determinants of the performance of the national banks are the size and portfolio composition of the banks.
Spathis, Kosmidou and Doumpos (2002:528) investigated the factors of Greek banks that were induced from their financial statements and were related to their size, for the period 1990–1999. They find that large banks are more efficient than small ones. They classify banks in the correct size in proportion to their differences in efficiency, liquidity, risk, leverage, and capital adequacy. Additionally, the size of a bank is crucial. Both small and large banks have advantages and disadvantages. They report that though small banks seem to be more efficient and vulnerable, large ones have lower operating costs due to the economies of scale and their network. In the same line of arguments, Peiy and Werner (2005:03) analyse a panel of 288 German banks from 1998 to 2002. Their conclusions support the structure-conduct performance hypothesis and the efficiencies-of-scale version of the efficient-structure hypothesis. They find that German banks may improve their profitability by increasing their asset size and or by consolidation. Additionally, they also find that portfolio risk is a key factor in determining the profit-structure relationship. However, some other researchers suggest views that are contrary. In their study Ali, Akhtar and Ahmed (2011:238) find size to be an insignificant factor in the relationship, but the relationship is negatively related to profitability (ROE). Corroborating this position, Athanasoglou et al., (2008:134) posit that the effect of bank size on profitability is not important. The explanation for this according to them may be that small-sized banks usually try to grow faster, even at the expense of their profitability. The empirical results as generated from the models show that size is one of the main variables, which determine the profitability of banks.
Other researchers (Berger, Hanweck &Humphrey (1987); Boyd & Grahame, 1991) indicate that economies of scale in banking tend to be exhausted at relatively small sizes, which suggests that large banks could eventually face scale inefficiencies.
Athanasoglou et al., (2005) suggest that size is closely related to capital and that large banks are able to raise capital relatively cheaply, which consequently makes them appear more profitable. Large banks do possess market power due to established brands, which enable them to attract low cost capital, thus resulting in them appearing more profitable.
It is conversional wisdom that growth in demand is constrained by the size of the market, thus there are limits to the size to which a firm can grow before adversely affecting profitability.
On the other hand, many authors have point out (Berger, 1995b; Goddard et al., 2004b) that a principal source of capital is retained earnings.
As a result, under the current regulatory regime where banks are required to meet certain capital adequacy requirements, profit is an important determinant for the expansion of the portfolio of risk assets of a bank.
Size has been viewed as a determinant of both the profitability and capital structure of a firm. A number of reasons could be listed that justify the inclusion of size indicators to the capital structure of the firm (Cassar, 2004). First, smaller banks find it costly to resolve information asymmetry problems with potential lenders, resulting in limited access to finance or financing only being available at a higher cost (Newman, Gunesse & Hilton, 2013). Consequently, it becomes more efficient for small banks to use internally generated funds than external sources (Barbosa & Moraes, 2004; Myers, 1984). Information costs are lower for large banks than for small banks due to better quality of financial information in terms of accuracy and transparency (Daskalakis & Psillaki, 2009). Secondly, small banks/firms face higher transaction and interest rate charges than large banks/firms that have the advantage of economies of scale for the financial institution (Cassar, 2004). Since transaction costs are fixed, financing costs are inevitably more costly for small institutions than for large ones. Thirdly, small institutions are perceived to possess greater operating risk than larger institutions, resulting in a higher risk premium when raising loans or equity capital (Ortqvist, Masli, Rahman & Selvarajah, 2006). Thus small institutions have far higher risk of bankruptcy as they tend to fail more often than large institutions. At the same time, larger institutions have diversified streams of revenue and established operations, making them more prone to succeed in the long run than small institutions. Therefore, size is expected to be positively related to higher profitability and leverage.

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Age of the firm/bank

According to Abor and Biepke (2007), age is a standard measure of reputation and risk in capital structure models. Age plays a significant role on the ability of the bank/firm to acquire debt. Old ban ks are deemed more stable, and thus more reputable, than new banks due to their ability to survive over a longer period of time (Diamond, 1991). Therefore, the prediction is that old banks/firms tend to have more long-term debt in their capital structures, which has a bearing on profitability due to tax benefits. Empirical work on the relationship between age of a bank/firm and its use of external finance is mixed. Petersen and Rajan (1994:24) find a significant relationship between age and leverage of small banks/ firms. Similarly, Barton, Ned and Sundaram (1989:41) conclude that mature banks/firms experience lower earnings volatility and hence are expected to have higher debt ratios. Hall et al., (2004) find a positive relationship between age and long-term debt, but negatively related to short-term debt. This suggests that the reputational capital held by old firms is sufficient to ensure that the risk of default on the bank credit is minimised. In Ghana, Abor and Biepke (2007) also find that age is positively related to debt, suggesting that age is an important factor influencing access to debt capital of institutions.
Curak, Poposki and Pepur (2011) examine the determinants of profitability within the Macedonian banking sector and find that new banks have a higher cost-to-income ratio, a phenomenon that is consistent with the conventional wisdom, which says that if an institution is new in a market, the institution cannot benefit from economies of scale because it has none. There are no reputational benefits in the early years of operations and the cost of capital is equally expensive.
The well-established banks/firms will thus have a competitive advantage over new banks/firms. As the new banks strive for market share and recognition, their expenses goes up in the early years of their operations. It is expected therefore that newer banks should be at a disadvantage compared to older banks in a market.

Asset quality

The consensus among researchers is that asset quality and structure is directly related to leverage (Bester, 1985). However, due to a conflict of interest between providers and shareholders, lenders face the risk of adverse selection and moral hazard. Therefore, lenders take action to protect themselves by requiring tangible assets. Collateral also provides a means to mitigate the risks of information asymmetry between lenders and borrowers (Besanko & Thakor, 1987) thereby limiting monitoring costs or any extra risk acceptance required by banks/firms with unsecured positions (Newman, et al., 2013). Hence, asset quality and structure is likely to be positively associated with profitability and capital structure of institutions. Furthermore, in the event of bankruptcy, a higher proportion of tangible assets could enhance the salvage value of the assets of a firm (Stiglitz & Weiss, 1981). The lenders of finance are thus willing to advance loans to firms with a high proportion of tangible assets.
In general, empirical studies on small institutions in developed countries are in support of a positive association between asset structure and long-term leverage and a negative relationship between asset structure and short-term leverage (Cassar & Holmes, 2003; Chittenden et al., 1999; Sorgob-Mira, 2005). This emanates from the fact that small institutions use internal sources of finance which do not require fixed assets as collateral in the short-term, while in the long-term, financing is secured against fixed assets (Newman, et al., 2013). Thus, assets function as guarantee in case of default (Harris & Raviv, 1991). Similarly, it has also been argued that collateral reduces adverse selection and moral hazard costs (Forte, Barros & Nakamura, 2013) for small banks with information asymmetry. Empirical evidence discussed so far provides strong support for the positive association between asset structure and leverage predicted by capital structure theorists. This is also evident in developing economies as supported by studies in Ghana (Abor & Biepke, 2007) and in China (Huang & Song, 2006). It can be suggested that the asset structure of a bank/firm influences its use of debt finance. Without tangible assets, the b a n k / firm cannot access bank finance and has to look for alternative sources of finance.

TABLE OF CONTENTS
DECLARATION
ACKNOWLEDGEMENTS
DEDICATION
ABSTRACT
Key Words
LIST OF ACRONYMS
CHAPTER 1: INTRODUCTION AND BACKGROUND
1.1 BACKGROUND
1.2 PROBLEM STATEMENT
1.3 RESEARCH QUESTIONS
1.4 OBJECTIVES OF THE STUDY
1.5 RESEARCH HYPOTHESIS
1.6 EXPECTED OUTPUTS AND BENEFITS
1.7 SCOPE OF THE STUDY
1.8 METHOD OF INVESTIGATION
1.9 DATA AND METHODOLOGY
1.10 DATA SOURCES AND SAMPLE SIZE
1.11 ANTICIPATED PROBLEMS AND RESOLUTION
1.12 THESIS CHAPTER OUTLINES
1.13 CHAPTER SUMMARY
CHAPTER 2: HISTORICAL DEVELOPMENTS ON CAPITAL AND ISSUES OF REGULATION
2.1 INTRODUCTION
2.2 THE DEFINITION OF CAPITAL
2.3 THE THEORY OF CAPITAL STRUCTURE
2.4 CHAPTER SUMMARY
CHAPTER 3: EMPIRICAL REVIEW OF LITERATURE ON BANKS’ PROFITABILITY
3.1 INTRODUCTION
3.2 OTHER DETERMINANTS OF BANK PERFORMANCE
3.3 EQUITY CAPITAL (CAP)
3.4 CHAPTER SUMMARY
CHAPTER 4: THE SOUTH AFRICAN COMMERCIAL BANKING SECTOR: HISTORICAL DEVELOPMENTS, LEGISLATIVE AND REGULATORY STRUCTURES
4.1 INTRODUCTION
4.2 THE SOUTH AFRICAN BANKING SECTOR: AN OVERVIEW
4.3 SOUTH AFRICAN COMMERCIAL BANKING SECTOR: THE APARTHEID ERA
4.4 SOUTH AFRICAN BANKING SECTOR: POST-APARTHEID ERA
4.5 BANKING LEGISLATIVE FRAMEWORK
4.6 THE SOUTH AFRICAN RESERVE BANK
4.7 THE BANKS ACT
4.8 REGISTRATION
4.9 ANNUAL LICENSE
4.10 PRUDENTIAL REQUIREMENTS
4.11 MINIMUM RESERVE BALANCE
4.12 MINIMUM LIQUID ASSETS
4.13 LARGE EXPOSURES: CONCENTRATION OF RISKS
4.14 REPORTING TO THE REGISTRAR
4.15 RESTRICTIONS ON INVESTMENTS AND LOANS
4.16 CONCLUSION
4.17 REGULATORY COMPLIANCE
4.18 FINANCIAL INTELLIGENCE CENTER ACT 38 OF 2001 (FICA)
4.19 Basel ii and Basel iii framework
4.20 CHAPTER SUMMARY
CHAPTER 5: RESEARCH METHODOLOGY
5.1 INTRODUCTION
5.2 THE RESEARCH PROCESS
5.3 RESEARCH APPROACH
5.4 RESEARCH DESIGN
5.5 TIME DIMENSION
5.6 DATA AND SAMPLE
5.7 METHODOLOGY AND DATA SOURCES
5.8 ESTIMATION METHODS
5.9 GMM PROFITABILITY FUNCTIONS
5.10 POOLED IV CAPITAL-TO-ASSET RATIO (CAR) FUNCTIONS
5.11 GMM CAPITAL-TO-ASSET (CAR) FUNCTIONS
5.12 CORRELATIONAL ANALYSIS
5.13 REGRESSION ANALYSIS
5.14 HOMOSCEDASTICITY
5.15 METHODOLOGICAL LIMITATIONS
5.16 ETHICAL CONSIDERATIONS
5.17 INFORMED CONSENT
5.18 CHAPTER SUMMARY
CHAPTER 6: RESULTS AND DATA ANALYSIS
6.1 INTRODUCTION
6.2 CHARACTERISTICS OF THE SAMPLE
6.3 THE RESULTS
6.4 DIAGNOSTIC TESTS
6.5 PANEL TWO-STAGE LEAST SQUARES (2SLS) PROFITABILITY REGRESSIONS
6.6 CHAPTER SUMMARY
CHAPTER 7: DISCUSSION, SYNTHESIS OF RESULTS, SUMMARY OF CONCLUSIONS AND DIRECTION FOR FUTURE RESEARCH
7.1 INTRODUCTION
7.2 RESEARCH OBJECTIVES AND HYPOTHESES REVISITED
7.3 RESULTS AND DISCUSSIONS
7.4 POOLED IV (PANEL 2SLS) PROFITABILITY REGRESSIONS
7.5 GMM PROFITABILITY REGRESSIONS
7.6 POOLED IV (PANEL 2SLS) CAPITAL-TO-ASSET RATIO REGRESSIONS
7.7 GMM CAPITAL-TO-ASSET RATIO REGRESSIONS
7.8 RECOMMENDATIONS
7.9 CONTRIBUTION OF THE STUDY
7.10 LIMITATIONS OF THE STUDY
7.11 SUGGESTIONS FOR FURTHER STUDY
7.12 FINAL CONCLUSION
REFERENCES
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