Bank Profitability and Financial Stability
TL;DR: In this paper, a theoretical model of the relationship between bank profitability and financial stability was developed by exploring the role of non-interest income and retail-oriented business models, and a panel regression analysis was conducted to examine the empirical determinants of bank risks and profitability.
Abstract: We analyze how bank profitability impacts financial stability from both theoretical and empirical perspectives. We first develop a theoretical model of the relationship between bank profitability and financial stability by exploring the role of non-interest income and retail-oriented business models. We then conduct panel regression analysis to examine the empirical determinants of bank risks and profitability, and how the level and the source of bank profitability affect risks for 431 publicly traded banks (U.S., advanced Europe, and GSIBs) from 2004 to 2017. Results reveal that profitability is negatively associated with both a bank’s contribution to systemic risk and its idiosyncratic risk, and an over-reliance on non-interest income, wholesale funding and leverage is associated with higher risks. Low competition is associated with low idiosyncratic risk but a high contribution to systemic risk. Lastly, the problem loans ratio and the cost-to-income ratio are found to be key factors that influence bank profitability. The paper’s findings suggest that policy makers should strive to better understand the source of bank profitability, especially where there is an over-reliance on market-based non-interest income, leverage, and wholesale funding.
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TL;DR: In this article, a dynamic panel estimation has been employed for 1046 firm-year observations of commercial banks operating in one of the fastest-growing emerging markets, India, covering the period 2007 to 2019.
Abstract: The fallout of the Global Financial Crisis demonstrated the importance of bank liquidity creation (LC) for the economies. This study attempts to analyze the implications of LC for promoting the financial stability of banks. To address this question, a dynamic panel estimation has been employed for 1046 firm-year observations of commercial banks operating in one of the fastest-growing emerging markets, India, covering the period 2007 to 2019. The results suggest that LC enhances the financial stability of banks. However, this impact varies according to bank size. Further, private sector banks are found to be more stable than public sector banks. Thus, the study emphasizes the need for LC. It also suggests that ‘one-size-fits-all’ liquidity regulations are not optimal for the stability of banks.
36 citations
TL;DR: In this article, the authors study the transmission of financial shocks across borders through international bank connections using data on cross-border interbank loans among 6,000 banks during 1997-2012, and estimate the effect of asset-side exposures to banks in countries experiencing systemic banking crises on profitability, credit and the performance of borrower firms.
Abstract: We study the transmission of financial shocks across borders through international bank connections. Using data on cross-border interbank loans among 6,000 banks during 1997-2012, we estimate the effect of asset-side exposures to banks in countries experiencing systemic banking crises on profitability, credit, and the performance of borrower firms. Crisis exposures reduce bank returns and tighten credit conditions for borrowers, constraining investment and growth. The effects are larger for foreign borrowers, including in countries not experiencing banking crises. Our results document the extent of cross-border crisis transmission, but also highlight the resilience of financial networks to idiosyncratic shocks.
22 citations
TL;DR: The estimated conditional distributions reveal that for some banks, a determined reduction in NPLs combined with cost efficiency improvements and customized changes to their business models appears to be the most promising strategy for durably raising profitability.
Abstract: This paper explores the determinants of profitability across large euro area banks using an approach based on conditional profitability distributions. The most reliable determinants of bank profitability are real GDP growth and the nonperforming loan (NPL) ratio. The estimated conditional distributions reveal that, while higher growth would raise profits on average, a large swath of banks would most likely continue to struggle even amid a strong economic recovery. Therefore, for some banks, a determined reduction in NPLs combined with cost efficiency improvements and customized changes to their business models appears to be the most promising strategy for durably raising profitability.
18 citations
TL;DR: In this article , a dynamic panel model was used to evaluate the impact of environmental, social and governance (ESG) scores on banks' systemic risk contribution to systemwide distress.
Abstract: ABSTRACT How do changes in Environmental, Social and Governance (ESG) scores influence banks’ systemic risk contribution? Using a dynamic panel model, we document a beneficial impact of the ESG Combined Score and Governance pillar on banks’ contribution to system-wide distress analysing a panel of 367 publicly listed banks from 47 countries over the period 2007–2020. Stakeholder theory and theory relating social performance to expected returns in which enhanced investments in corporate social responsibility mitigate bank-specific risks explain our findings. However, only better corporate governance represents a tool in reducing bank interconnectedness and maintaining financial stability. The results are robust to alternative measures of systemic risk, both contribution and exposure, as well as when estimating a static model. Our findings stress the importance of integrating banks’ ESG disclosure into regulatory authorities’ supervisory mechanisms as qualitative information.
12 citations
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05 Feb 2020Abstract: Stress Testing at the IMF
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TL;DR: In this paper, the authors address the puzzle of why major problems began to arise in the early 1980s and not sooner and propose a hypothesis that increases in competition caused bank charter values to decline, which, in turn, caused banks to increase default risk through increases in asset risk and reductions in capital.
Abstract: A fixed-rate deposit insurance system provides a moral hazard for excessive risk taking and is not viable absent regulation. Although the deposit insurance system appears to have worked remarkably well over most of its 50-year history, major problems began to appear in the early 1980s. This paper addresses the puzzle of why major problems began to arise in the early 1980s and not sooner. ; The hypothesis is that increases in competition caused bank charter values to decline, which, in turn, caused banks to- increase default risk through increases. in asset risk and reductions in capital. This hypothesis is tested using pooled cross section time-series data for the 1970-1986 period for a sample of 85 large bank holding companies.
2,271 citations
"Bank Profitability and Financial St..." refers background or result in this paper
...42 On the one hand, competition destroys bank franchise value and thus incentive for prudence (Keeley 1990; Besanko and Thakor 1993; Matutes and Vives 2000; Repullo 2004)....
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...First, on profitability and risks, some researchers found that higher profitability leads to higher “charter value” (i.e., long-term expected profitability) and therefore less risktaking by banks (Keeley 1990; Berger, Klapper, and Turk-Ariss 2009)....
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...This finding is consistent with that of Keeley (1990) and subsequent papers (e.g., Besanko and Thakor 1993; Matutes and Vives 2000; Repullo 2004) that charter value provides incentive for prudence.19...
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...This mechanism is not our focus, as the empirical evidence is largely in favor of the mechanism that charter value defers risk taking (see, for example, Keeley 1990; and Berger, Klapper, and Turk-Ariss 2009), which is captured in our modeling framework....
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...One potential explanation is that profitable banks have higher charter value and are therefore less willing to engage in risk-taking behavior (e.g., Keeley 1990; Berger, Klapper, and Turk-Ariss 2009)....
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TL;DR: The authors show that existing theoretical analyses of this topic are fragile, since there exist fundamental risk-incentive mechanisms that operate in exactly the opposite direction, causing banks to become more risky as their markets become more concentrated.
Abstract: There is a large body of literature that concludes that—when confronted with increased competition—banks rationally choose more risky portfolios. We argue that this literature has had a significant influence on regulators and central bankers. We review the empirical literature and conclude that the evidence is best described as “mixed.” We then show that existing theoretical analyses of this topic are fragile, since there exist fundamental risk-incentive mechanisms that operate in exactly the opposite direction, causing banks to become more risky as their markets become more concentrated. These mechanisms should be essential ingredients of models of bank competition.
1,836 citations
TL;DR: In this paper, the impact of national bank concentration, bank regulations, and national institutions on the likelihood of a country suffering a systemic banking crisis was studied using data on 69 countries from 1980 to 1997.
Abstract: Motivated by public policy debates about bank consolidation and conflicting theoretical predictions about the relationship between bank concentration, bank competition and banking system fragility, this paper studies the impact of national bank concentration, bank regulations, and national institutions on the likelihood of a country suffering a systemic banking crisis. Using data on 69 countries from 1980 to 1997, we find that crises are less likely in economies with more concentrated banking systems even after controlling for differences in commercial bank regulatory policies, national institutions affecting competition, macroeconomic conditions, and shocks to the economy. Furthermore, the data indicate that regulatory policies and institutions that thwart competition are associated with greater banking system fragility.
1,292 citations
"Bank Profitability and Financial St..." refers background in this paper
...…Ho and Saunders 1981)41, but competition affect risks non-monotonically.42 Empirically, the estimation of competition and market power is challenging, and the impact of banking market structure is ambiguous (Berger, Klapper, and Turk-Ariss 2009; Vives 2010; Beck, Demirgüç-Kunt, and Levine 2006)....
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TL;DR: This article used a pooled time series approach to estimate a linear equation, regressing performance measures against a variety of internal (staff expenses, capital ratios, liquidity ratios) and external (concentration ratios, government ownership, interest rates, market growth and inflation).
Abstract: A recent study by Bourke (1989) on the determinants of international bank profitability, replicated and extended earlier research undertaken by Short (1979), and found support for the view that concentration was positively and moderately related to profitability. The results also provide some evidence for the Edwards-Heggestad-Mingo hypothesis [Edwards and Heggestad (1973) and Heggestad and Mingo (1976)] of risk avoidance by banks with a high degree of market power. Bourke uses a pooled time series approach to estimate a linear equation, regressing performance measures against a variety of internal (staff expenses, capital ratios, liquidity ratios) and external (concentration ratios, government ownership, interest rates, market growth and inflation) determinants of bank profitability. This note replicates Bourke’s methodology in order to evaluate the determinants of European bank profitability. A sample of European banks, 671 for 1986, 1,063 for 1987, 1,371 for 1988 and 1,108 for 1989, are taken across eighteen countries. (The country breakdown is shown in the appendix.) Standardized accounting data for the banks was obtained from International Bank Credit Analysis Ltd (IBCA), a
1,224 citations
"Bank Profitability and Financial St..." refers background in this paper
...A number of studies found that efficiency, typically measured by the cost-to-income ratio, is an important driver of bank profitability (Molyneux and Thornton 1992; Kok, Móré, and Pancaro 2015; IMF 2017)....
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TL;DR: In this paper, market-power and efficient-structure explanations of the profit structure relationship in banking were investigated by including direct measures of X-efficiency and scale efficiency in the analysis.
Abstract: This paper enters the debate between market-power and efficient-structure explanations of the profit-structure relationship in banking by including direct measures of X-efficiency and scale efficiency in the analysis. Structural models of two market-power hypotheses and two efficient-structure hypotheses are expressed in testable reduced form profit equations. This methodology is applied to thirty cross-sections of 1980s banking data. These data are somewhat consistent with one of the market-power and one of the efficient-structure hypotheses. However, none of the hypotheses are overwhelmingly important in explaining bank profits, suggesting that alternative theories be pursued. Copyright 1995 by Ohio State University Press.
1,199 citations
"Bank Profitability and Financial St..." refers background in this paper
...On the one hand, banks with higher capital ratios tend to face lower funding costs owing to lower prospective bankruptcy costs (Berger 1995)....
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