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Margarida Abreu
Assistant Professor
Instituto Superior de Economia e Gestão CISEP
R. do Quelhas 6
Ph: 351-21-3925968
Victor Mendes
Associate Professor
Faculdade de Economia do Porto CEMPRE
R. Dr. Roberto Frias
4200 Porto PORTUGAL
Ph: 351-21-3177163
Fax: 351-21-3537077
Preliminary draft
Objectives: The main goal of this paper is to study the determinants of bank interest
margins and profitability for some European countries in the last decade. We use a set
of bank characteristics, macroeconomic and regulatory indicators as well as financial
structure variables in order to explain interest margins and profitability. We intend to
evaluate whether European countries, sharing a common bond (EU membership) also
share the same interest margin and profitability determinants. In particular, we want to
check whether inflation, exchange rates, economic growth, bank size and
capitalisation, bank product mix, among others, could be accepted as explanatory
variables for interest margins and profitability. At the same time, we evaluate the
impact of the EMS crisis of 1992/3/4 on the net interest margin and bank profitability,
as well as the impact of the liberalisation of capital movements (occurred in Portugal
in 1992 and in Spain in 1993) on Portuguese and Spanish banks.
Background: This paper follows in the footsteps of Demirguç-Kunt and Huizinga
(1999), Bartholdy, Boyle and Stover (1997) and Barth, Nolle and Rice (1997), and
several specifications of the equation
(1) ijtjjjtjijti0ijt uCXB+β+β+β+β=Π
will be estimated (with Πijt the net interest margin or ROA/ROE for bank i in country j
at time t, B
ijt represents a vector of characteristics of bank i in country j at time t, X
jt is
a vector of control variables for country j at time t, and C
j is a vector of country
dummy variables).
The focus of the paper will be the investigation of possible influences of a standard set
of bank-specific explanatory variables along with other variables taking account of
cross-country differences in the regulatory environment in which banks do operate on
bank profitability and interest margins. Although in many studies empirical results are
essentially unchanged with respect to the used measure of bank performance, we will
use three different indicators of ex-post bank performance: the robustness of our
results is at stake. The bank specific variables we use are commonly used variables
such as market share, operating costs, capital to asset ratio and loan to asset ratio (to
account for bank-specific risk insofar as the dependent variable is not risk-adjusted).
Among the macroeconomic variables we use the inflation rate, the unemployment
rate, and the nominal effective exchange rate. We will also use dummy variables to
account for the range of permissible activities as well as the existence of crises of the
European Monetary System.
Some authors have claimed that the relationship between the explanatory and
explained variables is not linear and is not stable (v.g. Swamy et all 1996). On the
other hand, it is not easy to design a single model that completely describes bank
performance. Therefore we will test different specifications of the general model (1)
in order to avoid the risk of misspecifying the functional form of the relationship.
Data and Methods: In this paper we will use balance sheet and income statement
data from Datastream for the period 1986-99, as well as from other sources
(Économie Européenne).
Data set:
Banks from four different EU countries (Portugal, Spain, France and Germany).
Number of banks from each country in the data set.
Years Portugal Spain France Germany TOTAL
1986 8 5 0 8 21
1987 8 6 0 8 22
1988 8 7 2 8 25
1989 8 7 2 8 25
1990 8 7 3 8 26
1991 8 7 3 9 27
1992 8 7 14 9 38
1993 8 6 15 9 38
1994 8 7 15 9 39
1995 8 7 17 9 41
1996 8 13 18 10 49
1997 8 14 19 10 51
1998 0 14 19 10 43
1999 0 8 15 9 32
Variable definition:
The dependent variable is a measure of ex-post bank performance. In order to test the
robustness of our results we use four different variables: Interest Margin (IM =
Interest received Interest paid), Return on Assets (ROA) and Return on Equity
(ROE). NIM is alternatively defined as IM/Total Assets or IM/Equity. ROA is Pre-tax
Profit/Total Assets and ROE=Pre-tax Profits/Equity.
The explanatory variables are the following:
1) Labor/Assets = Total Employment Costs/Total Assets. It is a proxy for
operating costs; it is expected that banks with higher operating costs will have
higher net interest margins (in order to survive) and lower ROA and ROE
(everything else constant, banks will have lower pre-tax profits). Differences
in operating costs may also capture differences in business and product mix or
even differences in the range and quality of services offered.
2) Equity/Total Assets. We expect that the higher equity-to-asset ratio, the lower
ne ed to external funding and therefore higher NIM and profits. It is also a sign
that well-capitalized banks face lower costs of going bankrupt and thus their
cost of funding is reduced.
3) Loans/Assets = Total debtors and equivalent/Total Assets. Traditionally, banks
are intermediaries between lenders and borrowers. Other things constant, the
more deposits are transformed into loans, the higher the interest margin and
profits. However, if a bank needs to incur higher risk in order to have a higher
loan-to-asset ratio, then profits may decrease.
4) Bank market share (MS), defined as bank’s Loans/Country’s Domestic Credit.
We were unable to get information on total bank loans at the country level.
Therefore, the denominator is Domestic Credit of the country.
5) Unemployment rate (UR). The Eurostat definition (% of civilian active
6) Inflation rate (INF). The annual % change of the GDP deflator at market
7) Exchange rate (EXR). The nominal effective exchange rate (base 100=1991;
performance vis-à-vis the rest of the 22 industrialized countries).
8) CRIS: Dummy variable, equal to 1 if the year is 1992 or 1993 (all countries),
or 1994 and the country is Portugal.
9) DCFPS: Dummy variable, equal to 1 if the country is Portugal and the year is
1992 and beyond, or the country is Spain and the year is 1993 and beyond.
10) D1: Dummy variable, equal to 1 if the country is Portugal.
11) D2: Dummy variable, equal to 1 if the country is Spain.
12) D3: Dummy variable, equal to 1 if the country is France.
13) YEAR: Time trend.
Accounting data from DATASTREAM is used for banks from Spain, France and
Germany. Accounting data from banks’ annual balance sheet and income statement
for Portuguese banks. As for UR, INF, EXR and Domestic Credit, we use “Économie
Européenne”, nº 70, 2000 (Commission Européenne, Direction Générale ‘Affaires
Économiques et Financières’).
Descriptive statistics of some variables (%)
Mean 2.54 1.06 6.25 1.43 109.45 4.18
Max 8.01 6.29 26.02 3.14 989.36 33.24
Min -1.67 -2.62 0.98 0.11 27.48 0.02
Std. Dev. 1.57 0.95 3.52 0.60 70.60 5.98
LS // Dependent Variable is IM/ASSETS
Sample (adjusted): IF EQUITY>0
Included observations: 477 after adjusting endpoints
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable Coefficient
Std. Error
C -0.799791
LOAN/ASSETS 0.023527
MS 0.008137
UR -0.030525
INF -0.102139
EXR -1.77E-05
CRIS 0.002852
DCFPS -0.013428
D1 0.023207
D2 0.019599
D3 -0.002845
YEAR 0.017382
YEAR*YEAR -9.60E-05
LS // Dependent Variable is ROA
Sample (adjusted): IF EQUITY>0
Included observations: 477 after adjusting endpoints
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable Coefficient
Std. Error
C 0.197540
LOAN/ASSETS 0.007695
MS 0.015280
UR -0.037868
INF -0.043461
EXR 2.00E-06
CRIS 0.000682
DCFPS -0.004374
D1 0.001854
D2 0.012096
D3 -0.003270
YEAR -0.004278
YEAR*YEAR 2.25E-05
LS // Dependent Variable is IM/EQUITY
Sample (adjusted): IF EQUITY>0
Included observations: 477 after adjusting endpoints
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable Coefficient
Std. Error
C -3.366639
LOAN/ASSETS 0.404142
MS 0.154858
UR -0.592039
INF -1.754957
EXR -0.002360
CRIS 0.054085
DCFPS -0.200159
D1 0.419235
D2 0.281686
D3 0.024557
YEAR 0.095506
YEAR*YEAR -0.000591
LS // Dependent Variable is ROE
Sample (adjusted): IF EQUITY>0
Included observations: 477 after adjusting endpoints
White Heteroskedasticity-Consistent Standard Errors & Covariance
Variable Coefficient
Std. Error
C 5.077019
LOAN/ASSETS 0.044995
MS 0.340045
UR -0.862172
INF -1.152596
EXR 0.000456
CRIS 0.001792
DCFPS -0.061173
D1 0.026513
D2 0.210882
D3 -0.042555
YEAR -0.105481
YEAR*YEAR 0.000560
Summary of results
C - ** - + +
LABOR/ASSETS + * + * + +
EQUITY/ASSETS + * - * + * + *
LOAN/ASSETS + * + * + * +
MS + + + * + *
UR - - - *** - *
INF - * - ** - ** - *
EXR - - + +
CRIS + ** + ** + +
DCFPS - * - * - ** - ***
D1 + * + * + +
D2 + * + * + * + *
D3 - *** + - ** - ***
YEAR + ** + - -
YEAR*YEAR - ** - + +
* significant at the 1% level (two-tailed).
** significant at the 5% level (two-tailed).
*** significant at the 10% level (two-tailed).
Some comments on the results:
1. The determinants of NIM and Pre-tax Profits are not the same and this holds true
when we use either total assets or equity on the denominator of the ratios. In
particular, we have found that CRIS and Labor/Assets impact on NIM only, whilst
MS and Ur are relevant for explaining ROA(E).
2. Results do not significantly change when we use Equity (instead of total assets) in
the denominator of the dependent variable, meaning that results are robust.
3. Regarding bank-specific variables, the net interest margin reacts positively to
operating costs, but pre-tax profits do not. This means that less efficient banks
(that is, banks with higher operating costs) charge higher interest rates on loans (or
pay lower rates on deposits), therefore passing those costs onto customers.
However, competition does not allow them to ‘overcharge’ and thus all banks
achieve similar profitability ratios.
4. Well-capitalised banks (ie, banks with higher equity/assets) face lower expected
bankruptcy costs and thus lower funding costs and higher interest margins on
assets. In general, this advantage ‘translates’ into better profitability ratios.
5. The loan-to-asset ratio has a positive impact on interest margins and profitability.
This could mean that in our sample period banks did watch carefully the lending
process. That is, they did not grant credit at all costs (relaxing credit selection and
monitoring), just for the sake of organic growth. Thus, they seem to have been
able to maintain low levels of non-performing loans, thereby increasing profits
and margins.
6. The market share variable is not significant when we explain the Net Interest
Margin. If we consider that MS captures product differentiation as well as market
power, then it appears that banks do not differentiate traditional loan and deposit
products (and do not exert market power in these markets) but rather less
‘conventional’ bank products and services. It also means that market structure is
not relevant in those traditional activities; however, they do exert market power in
some other bank products and services such as off-balance activity.
7. Although with a negative sign in all regressions, the unemployment rate (as a
proxy for the cyclical behavior of the economy) is relevant in the two last
equations only. Results are not better if we use the GDP growth rate instead.
8. The inflation rate is relevant in all models. Inflation brings along higher costs but
also higher income. It seems that bank costs increase more than do bank revenues.
This contradicts findings from other studies (Barth et al 1997, Claessens,
Demirguç-Kunt and Huizinga 1998, Hanson and Rocha 1986, Demirguç-Kunt and
Huizinga 1999, Demirguç-Kunt and Huizinga 2000, Denizer 2000), but goes
along the lines of earlier research (Wallich 1977, Petersen 1986).
9. The nominal effective exchange rate does not have any impact on net interest
margins and profitability.
10. The EMS crisis of 1992/3/4 seems to have had a positive impact on the net interest
margin on assets but not on bank profitability. Under pressure, European
authorities reacted by increasing short-term interest rates and that has had some
impact on median and long-term rates. However, credit rates react generally faster
than do deposit rates and thus the positive impact on the interest margin. At the
same time, exchange rate instability increases risk in cross-border bank activity
and losses could have occurred in foreign exchange transactions. Other bank costs
may have also increased, thus offsetting increased bank revenues.
11. Portuguese and Spanish banks suffered from the liberalisation of capital
movements (occurred in Portugal in 1992 and in Spain in 1993), both in terms of
interest margin and profitability. Given the increased competition brought about
by liberalisation, fund holders did look for more efficient banking systems and
more profitable applications, thus flowing out of these two countries.
12. Banks in Portugal and Spain perform generally better than banks in Germany.
However, French banks at the lower end of the spectrum. We can consider that we
have in these four countries bank-based financial systems. And “after controlling
for the level of financial development, there is some evidence that a more market-
based financial structure would lead to lower levels of bank profits” (Demirguç-
Kunt and Huizinga 2000, p.12). That seems to be the case of Portugal and Spain
vis-à-vis France and Germany. The bank sector in Iberian countries thus
represents for firms a larger source of funds than does the capital market, leading
to superior performances for Portuguese and Spanish banks. As for France and
Germany, 1995 data shows that total bank assets represent 119% of GDP in
Germany (against the 99% in France), whilst stock market capitalization
represents 34% of GDP in France and 24% in Germany (Demirguç-Kunt and
Huizinga 1999, table3). Using the same reasoning, banks in France face more
intense competition from the stock market and therefore show lower interest
margins and profitability.
13. No clear time trend, except for IM/Assets.
Barth, J. R., D. E. Nolle, and T. N. Rice (1997). “Commercial Banking Structure,
Regulation, and Performance: An International Comparison”, Comptroller of the
Currency Economics WP 97-6.
Claessens, S., A. Demirguç-Kunt, and H. Huizinga (1998). “How Does Foreign Entry
Affect the Domestic Banking Market?”,
Demirguç-Kunt, A. and H. Huizinga (1999). “Determinants of Commercial Bank
Interest Margins and Profitability: Some International Evidence”, The World Bank
Economic Review, vol. 13, nº 2, 379-408.
Demirguç-Kunt, A. and H. Huizinga (2000). “Financial Structure and Bank
Profitability”, World Bank Policy Research WP 2430.
Denizer, C. (2000). “Foreign Entry in Turkey’s Banking Sector, 1980-97”, World
Bank Policy Research WP 2462.
Hanson, J. A., and R. R. Rocha (1986). “High Interest Rates, Spreads, and the Cost of
Intermediation: Two Studies”, World Bank Industry and Finance Series 18.
Petersen, W. M. (1986). “The Effects of Inflation on Bank Profitability”, in Recent
Trends in Commercial Bank Profitability A Staff Study, Federal Reserve Bank of
New York, 89-114.
Swamy, P.A.V.B., J. R. Barth, R. Y. Chou and J. S. Jahera Jr. (1996). “Determinants
of US Commercial Bank Performance: Regulatory and Econometric Issues”, Research
in Finance, vol 14, 117-156.
Wallich, H. C. (1977). “Inflation is Destroying Bank Earnings and Capital
Adequacy”, Bankers Magazine, Autumn 1977, 12-16.
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Banking markets are becoming increasingly international through financial liberalization and general economic integration. Using bank-level data for 80 countries for 1988-95, the authors examine the extent of foreign ownership in national banking markets. They compare net interest margins, overhead, taxes paid, and profitability of foreign and domestic banks. The comparative functions of foreign banks and domestic banks is very differentin developing and industrial countries, possibly because of a different customer base, different bank procedures, and different regulatory and tax regimes. In developing countries foreign banks tend to have greater profits, higher interest margins, and higher tax payments than do domestic banks. In industrial countries it is the domestic banks that have greater profits, higher interest margins, and higher tax payments. It is common to read, in the literature on foreign banking, that the entry of foreign banks can make national banking markets more competitive, thereby forcing domestic banks to operate more efficiently. The authors show that increasing the foreign share of bank ownership does indeed reduce profitability and overhead expenses in domestically owned banks - so the general effect of foreign bank entry may be positive. Interestingly, the number of foreign entrants matters more than their market share, suggesting that they affect local bank competition more on entry rather than after gaining a substantial market share. These effects hold even when controlling for the fact that foreign banks may be attracted to markets with certain characteristics, such as low banking costs.
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Using bank-level data for 80 countries in the years 1988-95, this article shows that differences in interest margins and bank profitability reflect a variety of determinants: bank characteristics, macroeconomic conditions, explicit and implicit bank taxation, deposit insurance regulation, overall financial structure, and underlying legal and institutional indicators. A larger ratio of bank assets to gross domestic product and a lower market concentration ratio lead to lower margins and profits, controlling for differences in bank activity, leverage, and the macroeconomic environment. Foreign banks have higher margins and profits than domestic banks in developing countries, while the opposite holds in industrial countries. Also, there is evidence that the corporate tax burden is fully passed onto bank customers, while higher reserve requirements are not, especially in developing countries.
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The purpose of this paper is to identify important determinants of the performance of commercial banks. Two profitability measures and one measure of loss are used as indicators of performance. Each of these measures is related to different types of bank assets and other variables. The choice of these measures and variables is justified by citing several previous studies in the area. Various arguments are also presented to show that these relationships are not linear, have unknown functional forms, and are not stable. To avoid the risk of misspecifying the functional form of the relationships, a wide class of functional forms is employed that may embody the true functional form as a special case even when the specific functional forms considered in previous studies are false. The empirical results obtained from the class approach are compared with those obtained by assuming linear and specific nonlinear relations to study the robustness of the results to departures from specific functional forms. The effects of excluded variables and of errors in measurement are also accounted for in the class approach.
Despite high and volatile inflation, a record number of foreign and local banks entered Turkey's banking sector after the country relaxed rules about bank entry, and generally eliminated controls on interest rates, and financial intermediation in 1980. The country's financial integration with the rest of the world took a big step forward with the opening up of the capital account in 1989. Capital inflows rose significantly, and the financial system became increasingly linked with external markets. The author examines one dimension of liberalization: the impact of foreign banks entering the financial sector. Between 1980 and the end of 1997, 17 foreign banks, and a number of new local banks entered the sector. The author investigates how these banks'entry into the sector affected performance, based on three measures: net interest margin, overhead expenses, and return on assets (all expressed as a percentage of total assets). He finds that: 1) Foreign bank ownership is related to all three performance measures. 2) Foreign bank entry reduced the overhead expenses of domestic commercial banks, strengthening profits. 3) Despite their small scale operations, foreign banks entering the sector had a strong effect on competition. But the market could use more competition. 4) There are strong indications that foreign banks had a positive impact on financial, and operational planning, credit analysis and marketing, and human capital.
Inflation is Destroying Bank Earnings and Capital Adequacy
  • H C Wallich
Wallich, H. C. (1977). "Inflation is Destroying Bank Earnings and Capital Adequacy", Bankers Magazine, Autumn 1977, 12-16.
The Effects of Inflation on Bank Profitability
  • W M Petersen
Petersen, W. M. (1986). "The Effects of Inflation on Bank Profitability", in Recent Trends in Commercial Bank Profitability -A Staff Study, Federal Reserve Bank of New York, 89-114.