Factors influencing the profitability of domestic and foreign commercial banks in the European Union

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Abstract

Using bank level data this paper examines how bank's specific characteristics and the overall banking environment affect the profitability of commercial domestic and foreign banks operating in the 15 EU countries over the period 1995–2001. The results indicate that profitability of both domestic and foreign banks is affected not only by bank's specific characteristics but also by financial market structure and macroeconomic conditions. All the variables, with the exception of concentration in the case of domestic banks profits, are significant although their impact and relation with profits is not always the same for domestic and foreign banks.

Introduction

Over the last years a number of factors have contributed to the growing competition in the European Union (EU) banking sector. One of the most important factors is deregulation, promoted by the Second European Directive on Banking and Financial services, concerning establishment, operation and supervision of credit institutions. This Directive sets out the principles of banking in the Single European financial market and provides equal competitive conditions for all European banking institutions. As a result banks now compete in previously inaccessible domestic and foreign markets. Furthermore, a number of recent technological advances offered more opportunities for economies of scale and scope while the adoption of euro accelerated the changes in the industry. For instance, income generation from foreign exchange transactions has been lost while the pricing of banking products and services has become more transparent, enhancing competition. Furthermore, the macroeconomic policies that were followed in most countries gradually reduced inflation and interest rates. Finally, in more and more European countries non-financial firms were allowed to offer traditional banking services, leading to further increase in competition. Therefore, banks were forced to generate new products and seek new customers. This is reflected in the continued diversification across geographical areas and business lines. Many banks have been forced to increase in size in order to compete in the enlarged European market and the banking industry experienced an unprecedented level of consolidation through mergers and acquisitions.

It is reasonable to assume that all these changes posed great challenges to banks in the EU as the environment in which they operated changed rapidly, a fact that consequently had an impact on their performance. As Golin (2001) points out adequate earnings are required in order for banks to maintain solvency, to survive, grow and prosper in a suitable environment. Given the relation between the well-being of the banking sector and the growth of the economy (Rajan and Zingales, 1998, Levine, 1997, Levine, 1998), knowledge of the underlying factors that influence banks’ profitability is essential not only for the managers of the banks but for numerous stakeholders such as the Central Banks, Bankers Associations, Governments, and other Financial Authorities. Knowledge of these factors would also be of particular interest to the new EU countries whose economies and banking systems are experiencing fundamental changes during this period.

The aim of this paper is to extent earlier work on the determinants of profitability of banks in the EU and examine to what extent the performance of commercial banks operating in EU markets is influenced by internal factors (i.e. banks’ specific characteristics) and to what extent by external factors (i.e. macroeconomic and financial market structure) in view of the ongoing process of integration and concentration. Although a growing literature uses efficient frontier approaches to examine the profit and cost efficiency of EU banks (e.g., Altunbas et al., 2001, Schure et al., 2004), to our best knowledge, there are only few studies that focus on the determinants of profitability while focusing on the EU as a total1 (e.g., Molyneux and Thorton, 1992, Staikouras and Wood, 2003).

Molyneux and Thorton (1992) were the first that examined the determinants of banks profitability operating in 18 European countries over the period 1986–1989. Most recently the European banking sector was examined by Staikouras and Wood (2003) that considered banks from 13 EU countries over the period 1994–1998. The present study attempts to provide additional and more recent evidence on the determinants of banks profitability in the EU. In order to accomplish this task, our paper differs from the earlier mentioned studies in several aspects. First of all, we include more recent years in the analysis by examining the period 1995–2001. Furthermore, we examine more factors by introducing the influence of additional financial market structure variables such as stock market capitalization to GDP, stock market capitalization to assets of deposits money banks and assets of deposits money banks to GDP, not considered in the above studies. Finally, we are the first that distinguish between foreign and domestic banks. During the last years both developed and developing countries around the world have relaxed restrictions on foreign banking and most of them now allow more foreign banks to undertake more banking-related activities in their domestic banking markets, mainly because of the increasingly importance of international trade in goods and financial services. As Goddard et al. (2001) point out since 1989 the number of foreign banks has increased in every banking market in Europe, which now hold a large proportion of banking assets in the UK (53% of banking sector assets in 1999), Belgium (24% of assets in 1999), Portugal (12% of assets in 1999) and France (12% in 1999). Previous studies that distinguish between domestic and foreign banks focus mostly on differences on profit and cost efficiencies using frontier approaches (e.g., Berger et al., 2000, Sathye, 2001) or financial characteristics that differentiate these two groups of banks (e.g., Kosmidou et al., 2006a) and not on whether the internal and external determinants of profitability among domestic and foreign banks are different.

The rest of the paper is structured as follows: Section 2 provides a literature review of related studies. Section 3 describes the dependent and independent variables while Section 4 presents the data and methodology used in the study. The empirical results are presented in Section 5. Finally, in Section 6, the concluding remarks are discussed.

Section snippets

Literature review

Prior literature related to the present paper can be classified in three broad categories. The first consists of studies that focus on the determinants of banks’ profitability. The second consists of studies that examine the profit and cost efficiency of European banks. The third consists of studies that compare domestic and foreign banks. In the following sections we discuss each one of these categories.

Dependent variable

This study uses return on average assets (ROAA) to evaluate bank's performance. ROAA is the net profits expressed as a percentage of average total assets. It shows the profits earned per euro of assets and indicates how effectively the bank's assets are being managed to generate revenues. Average assets are being used in order to capture any differences that occurred in assets during the fiscal year. As Golin (2001) points out, return on average assets is the key measure of profitability.

Determinants and independent variables

Four

Data

Our sample is a balanced panel dataset of 584 commercial banks operating in the 15 EU countries over the period 1995–2001 consisting of 4088 observations.5

Empirical results

Table 4 reports the empirical estimations of Eq. (2) for banks’ ROAA. The first column presents the results when all the banks (584) are simultaneously considered. Columns two and three present the results when we split the banks according to the country of origin of their owner. We define a bank to be foreign (domestic) when foreigners own more (less) than 50% of its share capital. The sub-samples include 332 domestic banks and 218 foreign banks. About 34 banks were excluded from the analysis

Concluding remarks

In recent years numerous factors contributed to the increase of competition in the EU banking sector and posed great challenges to banks as the environment in which they operate changed rapidly. It is reasonable to assume that all these changes must have had some impact on banks’ performance. As Golin (2001) points out adequate earnings are required in order for banks to maintain solvency and to survive in a suitable environment. The relation between banks’ efficiency and the growth of the

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