University of Huddersfield Repository
Tan, Aaron Yong, Floros, Christos and Anchor, J.R
The Profitability of Chinese banks: impacts of risk, competition and efficiency
Original Citation
Tan, Aaron Yong, Floros, Christos and Anchor, J.R (2017) The Profitability of Chinese banks:
impacts of risk, competition and efficiency. Review of Accounting and Finance, 16 (1). pp. 86-105.
ISSN 1475-7702
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Review of Accounting and Finance
The Profitability of C
hinese banks: impacts of risk,
competition and efficiency
Journal:
Review of Accounting and Finance
Manuscript ID
RAF-05-2015-0072.R3
Manuscript Type:
Research Paper
Keywords:
profitability, Chinese banking, Lerner index, risk-taking behaviour
Review of Accounting and Finance
Review of Accounting and Finance
1
The Profitability of Chinese banks: impacts of risk, competition and efficiency
Abstract
Purpose- This study aims to test the impacts of risk-taking behaviour, competition and
cost efficiency on bank profitability in China.
Design/methodology/approach- We use a two-step Generalized Method of Moments
(GMM) system estimator to examine the impacts of risk, competition and cost
efficiency on profitability of a sample of Chinese commercial banks over the period
2003-2013.
Findings- We find that credit risk, liquidity risk, capital risk, security risk and
insolvency risk significantly influence the profitability of Chinese commercial banks.
To be more specific, credit risk is significantly and negatively related to bank
profitability; liquidity risk is significantly and positively related to Return on Assets
(ROA) and Net Interest Margin (NIM) but negatively related to Return on Equity
(ROE); capital risk has a significant and negative impact on ROA and Net Interest
Margin (NIM) but positive impact on ROE; there is a significant and negative impact of
security risk on bank profitability (ROA and NIM). It is found that Chinese commercial
banks with higher levels of insolvency risk have higher profitability (ROA and ROE).
Finally, higher competition leads to lower profitability in the Chinese banking industry
and Chinese commercial banks with higher levels of cost efficiency have lower ROA. In
other words, Structure-Conduct-Performance paradigm rather than Efficient-structure
paradigm holds in the Chinese banking industry.
Originality/value- This is the first paper to investigate the impact of different types of
risk, including credit risk, liquidity risk, capital risk, security risk and insolvency risk,
on bank profitability. This is the first study which uses more accurate measurements of
efficiency and competition compared to previous Chinese banking profitability
literature and which tests their impact on bank profitability. Our findings not only
provide a general picture on the risk, efficiency and competition conditions in the
Chinese banking industry, but also give valuable information to the Chinese government
and to the banking regulatory authorities to make relevant policies.
Keywords Risk-taking behaviour, Lerner index, Profitability, Chinese banking
Paper Type: Research paper
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1 Introduction
According to the World Bank, the Chinese economy has undergone significant growth
during the period 2003-2013, with an annual GDP growth rate of more than 7%, while
developed countries such as the United States and the United Kingdom have GDP
growth rates of less than 5%. The banking sector in China plays an important role in the
development of the country’s economy. The World Bank statistics report that the
domestic credit provided by the financial sector in China over the period 2003-2013
accounted for more than 120% of GDP, with the figure reaching a peak in 2013, when
it accounted for more than 150% of GDP.
The efficient functioning of the banking sector in China is attributed to various rounds
of banking reforms. In particular, competition has increased significantly since China
joined the World Trade Organization (WTO) in 2001. Thus, domestic Chinese
commercial banks were required to compete more vigorously with others within the
ownership type. They were also exposed to competition from other countries for the
first time. The traditional structure-conduct-performance (SCP) hypothesis uses
concentration as an indicator of bank competition and argues that in a low competition
environment (with higher concentration), banks tend to collude with each other to
obtain high profits.
There are a number of studies which use concentration to measure competition and test
its impact on bank profitability in China (see Tan and Floros, 2012a; Tan and Floros,
2012b; Garcia-Herrero et al., 2009, among others). They report mixed findings with
regard to the effect of concentration on bank profitability. Most recently, using a sample
of Chinese commercial banks over the period 2003-2013, Tan (2016) uses the Lerner
index as a competition indicator and tests its impact on bank profitability. The findings
show that there is no robust impact of competition on bank profitability in China.
By contrast with the traditional SCP hypothesis, the efficient-structure hypothesis
argues that it is superior efficiency, rather than collusive behaviour, which actually leads
to an improvement in bank profitability. However, the empirical literature has different
findings with regard to the impact of efficiency on bank profitability (Berger, 1995a;
Garcia-Herrero et al., 2009; Gelos, 2006; among others). Our study extends the work by
Garcia-Herrero et al. (2009) in the Chinese banking industry by using the Lerner index
and a three-bank concentration ratio to test further the impact of competition on bank
profitability. Rather than using the accounting ratio to measure cost efficiency (Tan,
2016), the current study uses the stochastic frontier approach (SFA) to evaluate bank
efficiency in China, and further examines its impact on bank profitability.
A significant amount of research has focused on analysing the impact of risk, rather
than competition and efficiency, on bank profitability. In particular, there is a growing
volume of literature examining the effect of risk on profitability in the Chinese banking
industry (see Tan and Floros, 2012a, 2012b, 2012c; Tan and Floros, 2014; Tan, 2015;
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Sufian, 2009; Sufian and Habibullah, 2009, among other). All of them focus on one or
two types of risk such as credit risk, liquidity risk or insolvency risk. However,
commercial banks are exposed to other types of risk as well, such as capital risk and
security risk. In particular, there is no empirical study investigating the impact of
security risk on commercial bank profitability in China. The investigation of the impact
of various types of risk on bank profitability will provide more policy implications to
the Chinese government as well as to the banking regulatory authorities.
Our paper contributes to the empirical literature on the investigation of bank
profitability in China in the following ways: 1) the comprehensive examination of types
of risk, especially the impacts of security risk and capital risk, on bank profitability in
China, provides new and important policy recommendations to the Chinese government
and the banking regulatory authorities; 2) using SFA to measure cost efficiency, the
Lerner index and 3-bank concentration ratio to measure competition, we obtain more
robust results with regard to the impact of efficiency and competition on bank
profitability. Thereby we extend the studies of Garcia-Herrero et al. (2009) and Tan
(2016).
The empirical results suggest that the profitability of Chinese commercial banks is
significantly affected by credit risk, liquidity risk, and insolvency risk; in particular, we
find that security risk has a significant and negative impact on bank profitability (ROA
and NIM); the impact of capital risk on ROA and NIM is significant and negative, while
significant and positive on ROE. Moreover, we find that as competition increases, the
profitability of Chinese commercial banks decreases. The efficiency of Chinese
commercial banks is found to be significantly and negatively related to the Return on
Assets (ROA) of Chinese commercial banks. In other words, Chinese commercial banks
with higher levels of cost efficiency have lower ROA.
The remainder of the paper will be organized as follows: section 2 reviews the literature
on the investigation of profitability in the banking sector; section 3 describes the data
and methodology; section 4 presents the empirical results; while section 5 concludes the
paper.
2 Literature review
There is a large amount of literature investigating the profitability in the US banking
sector as well as the European banking sector. The findings show that bank profitability
is significantly affected by bank size, bank liquidity, bank capitalization, bank credit
risk, bank efficiency, bank diversification, concentration, inflation as well as GDP.
Table 1 provides a summary of the empirical studies focusing on US and Europe.
<<Table 1---about here>>
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