Factors that Affect Banks Profitability

Factors that Affect Banks Profitability

In a modern economy, the productivity depends on the soundness of financial institutions. According to Pasiouras & Kosmidou (2012), the health condition of a commercial bank is crucial to economic stability and development. Banks are intermediaries between investors and savers. Specifically, commercial banks are means through which the government (through central bank) implements monetary policies (Demsetz & Strahan, 2012). In light of this, their profitability and performance are of paramount interest to the stakeholders and the economy. Default loan and administrative fee are two of the main factors that affect the profitability of banks.

Default Loan

The effect of default loan was prevalent and clearly visible during 2008 financial crisis. It exposed banks to internal corporate risks on the management of securitized assets’ individual investment portfolios. Resultantly, banks become vulnerable to bankruptcy because of limited finances to operational activities (Kosmidou, 2011). Undeniably, some crises are part of daily challenges encountered by banks. However, when cases of loan default are rampant, the impact is more severe, hence can prompt the financial institution to file for bankruptcy.  A significant percentage of bank profits accrue from interests charged on mortgages and loans (Haron & Ahmad 2014). Therefore, if banks fail to manage loan defaults effectively, they will reflect negatively on the annual profits.

Administration Fee

Operational efficiency in a bank is measured using cost-to-income ratio (Maudos et al., 2012). Administrative fee one of the operating elements as it reflects the cost of running a financial institution. Ideally, a negative relationship between profitability and the cost-to-income ratio is expected because proper management of administration fee and other operating costs increase efficiency (Athanasoglou et al., 2011). As an expenses-related variable, the administration fee is often included in the cost part when analyzing the macroeconomic standard profit function. In retrospect, the higher the administration fee, the lower the profitability of a financial institution.

References

Athanasoglou, P. P., Brissimis, S. N., & Delis, M. D. (2011). Bank-Specific, Industry-Specific and Macroeconomic Determinants of Bank Profitability. Journal of International Financial Markets, Institutions, and Money, 18(2), 121-136.

Demsetz, R. S., & Strahan, P. E. (2012). Diversification, Size, and Risk at Bank Holding Companies. Journal of Money, Credit, and Banking, 300-313.

Haron, S., & Ahmad, N. (2013). The Effects of Conventional Interest Rates and Rate of Profit on Funds Deposited with Islamic Banking System in Malaysia. International Journal of Islamic Financial Services, 1(4), 1-7.

Kosmidou, K. (2011). The Determinants of Banks' Profits in Greece during the Period of EU Financial Integration. Managerial Finance, 34(3), 146-159.

Maudos, J., Pastor, J. M., Perez, F., & Quesada, J. (2012). Cost and Profit Efficiency in European Banks. Journal of International Financial Markets, Institutions, and Money, 12(1), 33-58.

Pasiouras, F., & Kosmidou, K. (2012). Factors Influencing the Profitability of Domestic and Foreign Commercial Banks in the European Union. Research in International Business and Finance, 21(2), 222-237.