MASTER THESIS
Determinants of Bank Profitability
(Return of Equity)
Collins Chigozie Nnakuba
10681787
Master International Finance MSc
University of Amsterdam
August 2016
Abstract
This paper is a practical based analysis conducted for ING Bank. The purpose is to analyze the drivers of profitability particularly return on equity of banks competing with ING. The competitors are banks that offer similar financial products as ING across the globe. This paper examines whether internal factors such as management strategy, assets size, operational efficiency, capitalization, risk management, diversification, business model, ownership and external factors such as inflation, interest rate, supervisory influence and tax regime have an impact on the bank profitability. I observed that internal factors such as the management strategy/decision, bank model, and operational efficiency have an impact on individual bank profitability while external factors have an impact on the overall industry. This paper also investigated whether business model has an impact on the profitability. This business model was derived by clustering the assets composition of the sample (selected banks) into lending, hybrid and investment bank using the percentage of the net loan. Lending banks have net loan above 50%, Hybrid banks have net loan between 50% and 37%, while investment banks have net loan below 37%. The observable outcome is that some lending banks are more profitable than hybrid and investment. Hybrid banks profit from a more diverse income stream specifically fee income whilst investment bank sometimes profits during the downturn economy. Furthermore, I decomposed return on equity into profitability, sanity, risk weight and leverage factor using DuPont analysis to capture the underlying drivers of RoE. The observation with DuPont analysis is that banks with sustainable RoE showed high profitability ratio, good sanity, moderate risk weight and leverage ratio within the regulatory requirement. Finally, an indicative regression analysis using OLS model was conducted to capture the variables that correlate with RoE.
Table of Contents
1. Introduction ... 3
2. Literature Review on bank profitability ... 5
3. Bank business Model (Clustering of Bank model) ... 13
4. Bank Performance (model, income share, and DuPont analysis) ... 26
5. Statistical model and result ... 34
6. Conclusion ... 37
7. Appendices ... 39
1. Introduction
European Banks profitability is heavily under pressure as a result of ever increasing regulations, a slowdown in economic growth (volatility in commodities prices, negative interest rates), new entrants (Fintech) and pressure from shareholders to receive a decent return on investment. Despite the above-mentioned pressure, some banks still posted an impressive result with a decent return on equity (RoE) at year-end 2015.
As part of the project during my short term assignment with ING Wholesale Banking Strategy and Business Management team (WB S&BM), I was given the assignment to analyze ING competitors financial performance. ING competitors are banks that offer similar financial products, operate in the same geography and co-exist in some businesses. This triggered my research as I wanted to understand the core drivers of ING competitors profitability especially the return on equity. The analysis was conducted from the selection of 21 top European banks which include some global systemically important financial institutions (G-SIFIs) and other local banks. The data used for the analysis was last five years result (2011-2015) extracted from Bankscope.
To narrow my research on the determinants of bank profitability, the samples were analyzed on the total level and then clustered into three categories: lending, hybrid, and investment based on the asset composition. By this clustering, I wanted to investigate whether the categories or individual bank strategy plays a major role in determining the bank’s profitability. Furthermore, I decomposed the return of equity of each bank using DuPont analysis; these are Profitability (net income / total income), Sanity (total income / average risk-weighted assets (RWA)), risk weight (average RWA / total assets) and leverage factor (total assets / average common equity). This is geared towards understanding the underlying drivers of RoE of ING competitors.
I hope the outcome of the analysis will add to the empirical studies which suggested that the determinants of bank profitability are banks-specific factors (internal), macroeconomic factors and structural factors by fully concentrating on individual bank RoE driver. I also hope that ING WB S&BM team will use the outcome of the analysis in decision making. The rest of this paper is organized into five sections. The first section analyses the literature review of the empirical studies on determinants of bank profitability. In the second section, I introduced the bank business model, the current model, changes in the business model and the highlight of year-end 2015 performance result of the sample. The third section introduced the mechanism used in clustering the samples, the analysis of the income composition of the sample, the impact on RoE and the decomposition of RoE. In the fourth section, I did an indicative regression analysis using OLS model to capture the variables that significantly impact/correlate with RoE. The last section summarizes the outcome of the analysis and the observations on the drivers of bank profitability.
2. Literature Review on bank profitability
In the literature, bank profitability is commonly expressed as a function of both internal and external determinants. The internal determinants might be called bank-specific determinants of profitability while the external determinants are variables that are not related to bank management but reflect the economic and legal environment that affects the operation and performance of the banks. For the purpose of this paper, Bank profitability is simply what the financial institutions return to the shareholder, which is denoted as Return on Equity (RoE). To get a proper understanding of the variables that could impact the profitability of the bank, I visited both the internal and external factors that have an impact on the profitability. A large body of empirical studies has investigated the role of different factors influencing bank performance. These factors are shown and broadly discussed below;
Figure 1. Factors influencing Bank Profitability
Internal factors Banks size/Assets Efficiency Capitalization Risk management Diversification Business model Ownership External factors Macroeconomics Inflation Interest rate Industry specifics Supervisory influence Tax regime Profitability (RoE)
Bank-specific factors (internal factors)
Bank-specific determinants of profitability include factors that are internally controlled by bank management decision and strategy, namely bank size with respect to balance sheets volume, efficiency, Agile way of working and innovation-minded, risk and prudent costs management, solid capital base and assets diversification.
Bank size
The empirical literature evidence exploring the impact of bank size on profitability is highly unsettled. According to Shehzad and Scholten (2013), the proponents of size benefits argue that larger banks are likely to have a higher degree of product and loan diversification than smaller banks and should benefit from economies of scale and scope, which in turn leads to higher profits. Goddard et al. (2004) findings suggest that size/profitability relationship may be either non-linear. They stated that growth regressions reveal little or no evidence of mean-reversion bank sizes. Banks that maintain a high capital-assets ratio tend to grow slowly, and growth is linked to macroeconomic conditions. Otherwise, there are few systematic influences on bank growth. The persistence of profit appears higher for savings and co-operative banks than for commercial banks. Banks that maintain high capital assets or liquidity ratios tend to record relatively low profitability. Berger and Humphrey (1997) argues that even if large banks are more efficient than small ones, profitability benefits derive from emulating industry best practice in terms of technology, management structure, instead of focusing on increasing the size of the bank. Tregenna (2009) argued that economies of scale only exist for smaller banks and that larger banks suffer from diseconomies of scale owing, for example, to agency costs, overhead costs of bureaucratic processes and other costs related to managing large banks. My view is that the size of the bank plays some role in determining the profitability of
profitability. Management decides how, when, and where to expand the organization. After the crisis of 2007-2009, governments bailed some vulnerable banks on the conditions that they deleverage and become smaller and concentrate on the core banking business. They argue that banks are more manageable and profitable when they are smaller. Adding to above literature on the impact of size on bank profitability, large banks might profit from economies of scale and scope. However, some smaller banks are easily manageable, efficient and profitable. It really depends on the management style, strategy and business model.
Operational Efficiency
Bank expenses are also a very important determinant of profitability, closely comparable to the idea of efficient management. Many empirical studies stated that operational efficiency is an important driver of bank profitability. Most studies find that higher efficiency typically measured by cost to income ratio or risk adjusted cost to income (including risk cost) positively affects bank profitability. Bourke (1989) and Molyneux and Thornton (1992) found a positive relationship between better-quality management and profitability. Lower ratios related to higher efficiency, other factors such as the business model, bank size, and management intent play a measured role in determining profitability.
Bank Capitalization
Bank capitalization is another vital factor influencing profitability, based on various research. This is a number of capital banks are required to hold to withstand shocks/market volatility by the regulators. Existing literature suggests that the impact of bank capital on profitability is unclear, despite that the majority of the studies came out with a positive relationship. Nevertheless, banks with higher capital ratios tend to face lower funding costs owing to lower probability of default. However, higher capitalization could also mean lower risk taking which could negatively impact return and profitability.
Risk Management
Risk management and the level of risk are among the most important bank-specific factors determining performance. Risk management in the banking is essential due to the nature of the business. Poor asset and liquidity management are among the major causes of bank failures. Banks might choose to diversify their portfolio or raise liquidity in a time of uncertainty. Molyneux and Thornton (1992), among others, find a negative and significant relationship between the level of liquidity and profitability. In contrast, Bourke (1989) reports an opposite result, Miller and Noulas (1997) result on the effect of credit risk on profitability appears clearly negative. The inclusiveness in the empirical results and differences on how bank manage risk triggered the implementation of Standard Approach of calculating risk by the regulators instead of the Advance Internal Rating Based traditionally used by banks. In my view, banks profitability partly depend on the willingness and risk appetites of the individual banks. Using the standard approach of calculating the risk-weighted assets will create more visibility and transparency in the banking industry.
Diversification
Recent studies on the impact of diversification on bank performance argue that more diversified banks are more profitable. Other studies identified a “diversification quality”, inferring that banks with more diversified revenue streams are more profitable. According to the study of Stiroh, potential diversification benefits in the U.S. banking industry from the steady shift toward activities that generate fee income, trading revenue, and other types of non-interest income. In the aggregate, declining volatility of net operating revenue reflects reduced volatility of net interest income, not diversification benefits from noninterest income, which is quite volatile and increasingly correlated with net interest income. At the bank level,
risk-adjusted profits and higher risk. I partly support that diversification especially in the income stream contribute to bank profitability but to a certain degree.
Business model
A recent research on the identification of banks business models and the evaluation of banks performance and risk across these business models. According to the result from the study of Gambacorta and van Rixtel (2013), retail (or diversified retail) banks tend to outperform banks with other business models, such as wholesale and investment banks. My view is that banks engage deliberately in different intermediation activities and select the balance sheet structure (model) to fit their business objectives. In a pursuit of growth opportunities in a competitive environment, banks choose a business model that suits the strategy of the organization to leverage their strengths.
Ownership
Some studies explore the relationship between ownership type and bank performance, the results varies according to the geographical region and/or time period of the investigation. Recent evidence for European banks by Iannotta et al (2007) on the performance of the bank and the evaluation of the impact of alternative ownership models, together with the degree of ownership concentration, on their profitability, cost efficiency and risk. Three main results emerge. Firstly, mutual banks and government-owned banks exhibit a lower profitability than privately owned banks, in spite of their lower costs. Secondly, public sector banks have poorer loan quality and higher insolvency risk than other types of banks while mutual banks have better loan quality and lower asset risk than both private and public sector banks. Lastly, while ownership concentration does not significantly affect a bank’s profitability, a higher ownership concentration is associated with better loan quality, lower asset risk, and lower insolvency risk.
Macroeconomic factors (external factors)
A Large number of studies combine the macroeconomic variables into the analysis in order to examine cyclical impact in bank performance and behavior. Albertazzi and Gambacorta (2009) study find that bank profits pro-cyclicality derive from the effect that the economic cycle uses on net interest income (via lending activity) and loan loss provisions (via credit portfolio quality). An increase in economic activity through higher demand for bank intermediation services which includes lending, securities underwriting, advisory services and trading activities will tend to increase banks' net interest income and income generated from fees and commissions. In contrary, downturn economic activity contributes to a worsening of banks asset quality and higher loan loss provisioning, thus demonstrating a negative influence on bank profits. Current negative interest environment is a case whereby most of the traditional lending banks are under margin pressure.
Inflation and Interest rate
Other macroeconomic factors such as inflation and the term structure of interest rates supposed to have an impact on bank profitability. The inflation rate, the long-term interest rate and/or the growth rate of money supply. Revell (1979) introduces the issue of the relationship between bank profitability and inflation. He noted that the effect of inflation on bank profitability depends on whether banks’ wages and other operating expenses increase at a faster rate than inflation. The question is how mature an economy is so that future inflation can be accurately forecasted and thus banks can accordingly manage their operating costs. Perry (1992) indicated that the extent to which inflation affects bank profitability depends on whether inflation expectations are fully anticipated. An inflation rate fully anticipated by the bank’s management implies that banks can appropriately adjust interest rates in order to
studies from Bourke (1989), Molyneux and Thornton (1992) have shown a positive relationship between either inflation or long-term interest rate and profitability.
Structural factors (external factors)
Turning to structural factors affecting bank profitability, Mirzaei et al ( 2013) investigated the effects of market structure on profitability and stability for 1929 banks in 40 emerging and advanced economies over 1999–2008 by incorporating the traditional structure-conduct-performance (SCP) and relative-market-power (RMP) hypotheses. They observed that a greater market share leads to higher bank profitability being biased toward the RMP hypothesis in advanced economies, yet neither of the hypotheses is supported for profitability in emerging economies. The SCP appears to exert a destabilizing effect on advanced banks, suggesting that a more concentrated banking system may be vulnerable to financial instability, however, the RMP seems to perform a stabilizing effect in both economies. Their evidence also highlights that profitability and stability increase with an increased interest-margin revenues in a less competitive environment for emerging markets. By contrast, the “efficient structure” hypothesis states that the positive relationship between profitability and concentration can be driven by efficiency, in that more efficient banks gain market share and improve profitability. Another structural factor that could impact the profitability of the bank is the capital market orientation, the evidence of the impact on bank profitability is inconclusive. Supervisory power is expected to have some impact on bank profitability. However, the empirical evidence is again inconclusive despite the extensive amount of on-going work at the Basel Committee on Banking Supervision (BCSB) and European Banking Authority (EBA) to evaluate the possible impact of regulatory measures to bank business model. A global overview of the potential implications for business models resulting from the collective implementation of the regulatory measures developed since the financial crisis (see appendix VI) for the recent regulatory measures to bank business model.
In summary, bank profitability is commonly expressed as a function of both internal and external determinants. The internal determinants are known as bank-specific determinants of profitability while the external determinants are variables that are not related to bank management but reflect the economic and legal environment that affects the operation and performance of the banks. The empirical studies and literature review on the determinants of profitability are in some case inconclusive. Just like the study of Shehzad and Scholten (2013) which argue that larger banks are likely to have a high degree of product and loan diversification than the smaller bank. Larger banks might profit from diversification but this is not a guarantee for higher profitability. Operational efficiency plays a vital role in the profit maximization just like Bourke (1989) and Molyneux and Thornton (1992) find a positive correlation between quality management and profitability. Empirical research on the impact of risk management, diversification capitalization, and ownership structure is inconclusive. However, risk management is crucial for effective portfolio management. Diversification help in tapping into other source of revenue generation and capitalization could demonstrate that bank will withstand shocks and market volatility. Macroeconomic factors such as inflation and interest rate have shown a positive relationship with profitability based on the studies of Bourke (1989), Molyneux and Thornton (1992).The impact of supervisory power is rather inconclusive. Based on the summary of the literature review some internal and external factors have an either positive or negative relationship with bank profitability. Despite my support for the studies, I am of the opinion that banks profitability should be analyzed on the individual basis and return on equity fully decompose using DuPont analysis, to capture the real determinant of the profitability. This will be the value added of this paper to the study of the bank profitability.
3. Bank business Model (Clustering of Bank model)
According to Porter (1979), The concept of business models originates from the literature concerning strategic groups that basically mean sets of firms that are active in a single sector and use similar strategies. The notion of business strategies in banking, and also the business models originate from a number of strategic variables that reflect the long-term choices of bank management with respect to assets, funding, capitalization, and diversification. Seeing that a strategy is essentially a long-term concept, my conclusion is that individual banks business models will be stable over the years. This means that the differences between banks are more important than changes over time within banks to identify the performance impact of business model choices.
There are many types of banks model namely; private banking & asset management, retail banking/commercial bank and Investment bank. Most of the banks with the exception of American bank operate as universal bank meaning that they offer all products ranging from private banking to investment banking. Seeing that this paper is built around ING competitors, I will focus on the retail/commercial banking model. The identification of retail/commercial bank business models requires a set of variables that determine the possible strategies. With this in mind, the use of balance sheet data seems logical for the composition of bank business model. From the assets composition of the samples, three categories of bank model were derived.
Firstly, the lending banks which are traditional lenders that provide loans to individuals, organizations and other institutions. Banks in this category mostly dependent on interest income and to lesser extend non-interest income as a source of income. Secondly, the hybrid banks which have more diversified asset composition than lending banks. Income source is also well-diversified between interest and non-interest income (notable fee). Lastly, the
investment banks are mostly trading in derivatives and securities. Main income stream revenue are other income, fee income and also interest income.
Giving the introduction of bank business model, the rest of this section will concentrate on the current model, the change in business model and FY 2015 financial performance of the sample (ING competitors analysis).
3.1 Current model
Bank has simply two functions: deposit and lender. This means that bank has two clients namely one that deposits money and one that borrows. The bank intermediates between the borrower and depositor. This means that bank offers lower interest to depositors and lend to borrowers at a higher rate. The spread is the profit margin. This is the basic business model of the bank.
Individuals, businesses, and institutions will have the preference of keeping money in the bank rather than in a safe, cellar or other places. They prefer to deposit the money in the bank and sometimes receive an interest payment. They trust that the bank will safeguard their money and make it available when needed. For the borrowers perspective, they prefer to go the bank to lend money at a slightly higher interest rate.
The customers of the bank (borrowers and depositors) are from Retail and Corporate. Retail clients are individuals, household or private persons whilst Corporates are commercial institutions, businesses, and governments. Banks offer many services to the clients; for retails clients bank offer mortgages, car loans, personal loan and wealth management. To corporate clients, the bank offers different services and intermediation from loans for project, hedging, advisory, structured finance. The key element in lending is the ability to manage client risk
profile. This is to ensure that customer will be able to pay the principal and also the interest. Banks will usually do a risk assessment of customers before lending.
Banks use multiple channels to reach out to their customers. This ranging from operating from branches to physically meet clients to installing ATM in some convenient locations to encourage self-services. Some banks are using direct banking using internet and mobile apps to offer a basic product to customers.
Due to complexities in product offering, packaging, risk management, regulatory requirement, competition and operational excellence, Banks are partnering with technology (FinTech) to create innovative and simplify banking models such as dis-intermediation, multi-channel integration, business intelligence and predictive analysis.
The banking industry is well regulated by many institutions and governmental organizations ranging from local bank authority, European Banking Authority, Basel Committee on Banking Supervision. It is essential that banks are constantly supervised due to the importance of banks to the economy. The supervision is also to protect the taxpayers and depositors. This is the reason why the regulators set the minimum reserves that each bank must hold.
Some basic income streams of the banks are interest income from the lenders, fee income for operations such as trading portfolios, advisory, and other income. Costs line are the channel costs, interest paid to depositors, risk cost from loan loss and other operational costs.
Despite that, most of the banks in the European union/community are labeled universal bank which may offer credit, loans, deposits, asset management, investment advisory, payment processing, securities transactions, underwriting and financial analysis. While a universal banking system allows banks to offer a multitude of services, it does not require them to do so. Banks in a universal system may still choose to specialize in a subset of banking services.
Universal banking combines the services of a commercial bank and an investment bank, providing all services from within one entity. The services can include deposit accounts, a variety of investment services and may even provide insurance services. Deposit accounts within a universal bank may include savings and checking. Under this system, a bank can choose to participate in any or all of the permitted activities. They are expected to comply with all guidelines that govern or direct proper management of assets and transactions. Since not all institutions participate in the same activities, the regulations in play may vary from one institution to another.
3.2 Change in business model
After the financial crisis of 2007-09 as banks were bailed with tax payers money, policymakers, regulators, and supervisors have worked toward improving the safety and soundness of the global financial system through a range of regulatory changes towards banks. Banks are being forced to consider radical changes to the business models that support some of their core banking services. Changes are in various stages of progress, with some already taken place, some just starting, and others still to be determined. Few changes to the banking model after the crisis are discussed below;
Originate to distribute: Traditionally, banks used deposits to fund loans and book it on their balance sheets awaiting maturity. Recently, banking model started to change. Banks started to increase the funding source with alternative products such as bond financing, commercial paper financing, and repurchase agreement (repo) funding. Some Bank even started to replace the traditional originate-to-hold model of lending with another strategic securitization mechanism named originate-to-distribute model. At the earlier stage, banks limited the distribution model to mortgages, credit card credits, and car and student loans, but over time
distribute is that banks will share the risk with other banks, shrink the balance sheet, gain from lower risk-weighted assets, gain from higher fee income via income diversification and possibly increase profitability (RoE).
Regulators influence: The highlight of the regulatory debate has been concentrated on the "too-big-to-fail". International and domestic regulators are identifying SIFIs, the largest and most interconnected firms, for greater scrutiny and additional regulation. The regulators are being given new tools to manage the buildup of credit in the system, including countercyclical capital buffers. The name too big to fail is not well appreciated by the regulator and they simply want to shrink banks either directly through regulation or indirectly through rules that make some businesses less appealing or limit the benefits of scale. Some regulators want SIFIs banks to pay an insurance premium for the risks they represent to society or to limit the potential capital advantage SIFIs may have over smaller banks.
Customer Centric and Clients profitably: Banks are making major changes to the business models of their core services, and the growing cost of delivery requires major investments in information technology. This is to improving customer service as a means to improve the industry’s reputation and create pathways to more loyal, profitable customer and client relationships. Few banks are moving from product driven organization to a more client focus. Activities like know your client (KYC), Net promoter score, new innovations to empower clients and digitalization are a key focus of bank to promote customer services and profitability.
Risk governance: Banks are focusing on their ability to react quickly to stress scenarios so they can be agile as the crises and uncertainties continuously exist within the industry. Banks are constantly working with the regulator to improve regulatory reporting. Even the regulators suggested a shift from Advance Internal Reporting method of calculating risk-weighted asset
to more standardize method. Banks are not in favor of this due to the anticipated increase in risk-weighted assets. This is still to be decided by the regulators in the course of 2016.
Focus on growth and profitability levels: Banks will have to reduce costs radically, deploy capital more dynamically and efficiently, capture growth opportunities in emerging markets, and consider material changes to compensation levels. They must also redesign service delivery and business models while rethinking the fundamental rationale for some existing businesses. Banks are streamlining and moving some activities to a low-cost environment. On the revenue generation, well-diversified income source such as an increase in non-interest income will ultimately contribute to higher profitability/return on equity of the banks.
3.3 Analysis of the bank full year 2015 figures (at a glance)
Looking back, 2015 will be remembered as a year in which the global and domestic economic landscape remained difficult to navigate. Factors like a higher regulatory requirement, volatility in oil and commodity prices, negative in interest rate and economic sentiments weighted heavily on the profitability of banks in 2015. Despite the pressure, few EU bank posted a good result in 2015. As curiosity emerges on the drivers of financial performance and profitability, Table 1. shows the performance of ING competitors financials of FY 2015 and the last reported full years. Key results as income lines (net interest and non-interest income), costs, risk costs, efficiency (cost/income ratio), Net interest margin, Return on equity, total assets, common equity, average risk-weighted assets, loan to asset and loan to customer deposit were analyzed.
Table 1 Full Year 2015 banks key results and performance indicators
Net interest income (NII) is the different between interest earned from loan and interest paid on deposit
Net Interest Income = Interest paid on earning assets - Interest paid on deposits
The net-interest income generated by the selected in FY 2015 is € 291bln compared to FY 2014 € 277bln showing a growth of 5% (see appendix I). One observation is that banks with higher NII growth do not necessary have higher total assets with the exception of BBVA and Santander (appendix I). This could be an evidence that higher interest income growth does not fully correlate with assets growth. Another observation is that traditional lending banks such as ING, Santander, ABN, and Rabo have high NII dependency (see graph A).
FY 2015 key result in EUR bln & % Net interest income Fees & other income Total income Costs Risk costs PBT PAT C/I
ratio NIM RoE
Total assets common equity Average RWA LTA LTD ABN 6.1 2.4 8.5 5.2 0.5 2.7 1.9 61.8% 1.6% 11.9% 390.3 16.2 108.8 66.4% 114.5% Barclays 17.1 17.0 34.1 22.5 2.9 2.8 0.8 66.0% 1.1% 1.0% 1524.5 85.9 502.2 35.6% 96.6% BBVA 16.4 6.8 23.2 12.1 4.2 4.6 3.3 52.2% 2.7% 6.3% 750.1 52.8 376.1 54.3% 112.1% BNPP 23.1 19.8 42.9 29.3 3.6 10.4 7.0 68.2% 1.2% 7.6% 1994.2 93.2 622.0 34.1% 101.7% BPCE 11.3 12.5 23.7 16.2 1.6 6.1 3.8 68.4% 1.1% 6.1% 1166.5 62.1 392.1 50.6% 128.2% Commerz 5.8 3.9 9.7 7.2 0.7 1.8 1.2 74.0% 1.1% 4.1% 532.6 29.1 206.7 38.3% 83.4% Credit Agricole 21.3 10.6 31.8 19.8 2.3 9.4 6.4 62.3% 1.3% 6.9% 1698.9 93.4 247.5 43.3% 114.9% Credit Suisse 8.6 11.7 20.3 18.6 0.3 -2.2 -2.7 91.7% 1.3% -6.6% 759.9 41.3 257.9 33.3% 80.0% Deutsche 15.9 17.2 33.1 31.9 0.9 -6.1 -6.8 96.4% 1.1% -10.0% 1629.1 68.0 397.0 26.3% 76.5% HSBC 30.0 24.0 54.0 36.5 3.3 17.3 13.9 67.7% 1.4% 7.7% 2213.3 180.1 1008.9 38.4% 72.4% ING 12.8 3.7 16.5 9.3 1.3 6.4 4.7 56.3% 1.6% 11.9% 838.5 39.9 307.3 63.9% 106.5% Intesa Sanpaolo 10.3 7.2 17.4 11.0 3.4 4.2 2.8 62.8% 1.7% 6.0% 676.5 47.0 277.1 51.7% 162.7% Lloyds 14.6 8.3 22.9 14.1 0.6 1.9 1.0 61.3% 1.5% 1.6% 1113.3 66.4 307.4 55.7% 109.5% Nordea 5.1 4.9 10.0 4.9 0.5 4.7 3.7 49.4% 0.8% 12.3% 646.9 29.8 144.4 46.6% 165.3% Rabo 9.1 3.5 12.6 8.5 1.1 2.9 2.2 67.1% 1.5% 6.9% 670.4 31.9 212.5 65.4% 132.6% RBS 11.9 5.4 17.3 20.4 -1.2 -3.7 -1.6 117.9% 1.1% -2.2% 1109.9 72.5 393.9 37.5% 91.2% Santander 33.3 12.3 45.5 25.2 10.2 9.5 7.3 55.4% 2.9% 7.5% 1340.3 98.1 585.4 56.6% 128.7% SocGen 10.0 15.3 25.3 17.5 2.4 6.1 4.4 69.2% 0.9% 7.9% 1334.4 55.6 355.0 28.9% 111.5% Standard Chartered 8.7 4.6 13.3 10.3 4.4 -1.4 -2.0 77.0% 1.7% -4.7% 588.3 43.1 279.8 40.2% 73.5% UBS 6.2 21.3 27.5 22.2 0.1 5.0 5.8 80.6% 1.0% 11.5% 873.3 51.1 190.5 33.2% 77.9% Unicredit 12.8 9.3 22.0 15.9 4.8 2.4 2.0 72.1% 1.6% 3.8% 860.4 53.7 399.9 51.8% 123.1% Total 290.5 221.4 511.9 358.6 48.0 84.9 59.4 70.1% 22,712 1,311 7,572 Average 24.4 10.5 24.4 17.1 2.3 4.0 2.8 70.4% 1.4% 4.6% 1,082 62 361 45.3% 107.8% Data compiled March 31, 2016
Graph A: net interest share of the sample
Non-interest income of the bank income derived primarily from fees including deposit, and transaction fees, fees from financial market trading portfolios, advisory fees annual fees, and other alternative income not related to Interest income. From the sample, Investment banks such as UBS, SocGen, Credit Suisse Deutsche generate more non-interest income than lending banks (see graph B).
Graph B: non-interest share of the sample 77% 73% 72% 72% 71% 69% 67% 66%64% 60% 59% 58% 56% 54% 51% 50%48% 48% 42% 40% 23% Net interest income dependency
23%27% 28% 28% 29% 31%33% 34% 36%40% 41% 42% 44% 46%49% 50% 52% 52% 58%60% 77%
Costs are total expenses the business spend during the normal business operations. Costs include rent, payroll, professional services, regulatory costs and other expenditures. One of the key responsibility of the management is to effectively reduce costs without massively affecting the company ability to compete with the peers. From our sample, FY 2015 costs were € 359bln this an increase of 7% compared to FY 2014. Drivers to costs increases were regulatory costs (all banks), impairments of goodwill & intangibles and litigation costs (Deutsche).
Risk cost includes the net impairment charge in relation to the bank's loans and advances as well as off-balance sheet. Risk cost is mostly higher in lending banks an even higher amongst bank that operate in some geography. Santander, Unicredit, Standard Chartered and BBVA reported risk cost of € 10bln, € 5bln, € 4bln and € 4bln respectively. However, overall risk costs from our sample declined by -5% compared to FY 2014.
Efficiency ratio is commonly regarded as the cost to income ratio which the is a measure of total expenses as the percentage of total income.
Cost income ratio = total expenses / total income
Efficiency ratio measures operating expense as a percentage of operating income, it is basically used to evaluate the efficiency and productivity of a corporation. Lower ratios basically show higher efficiency, however, few factors can impact the ratio such as bank business model (asset class), the size of the organization and other unforeseen costs. From our sample, average C/I slightly increased in 2015 mainly observed within the investment banks such as RBS, Deutsche, Credit Suisse, and UBS.
Net interest margin (NIM) is a measure of the difference between the interest income generated by banks (interest received) and interest paid (customer deposit) over total earning assets.
NIM = (interest received-interest paid) / total earning assets
The sample average NIM at 1.4% was at the same level as FY 2014 despite pressure on the interest rate (negative interest rate environment). With the exception of Santander and BBVA which profit with higher interest margin due to high yield bonds in South Americas but also a very risky business, all other banks NIM are under pressure due to ultra-interest rate environment.
Return on Equity (RoE) is a profitability ratio that measures the ability of a firm to generate profits from the shareholder's investments in the organization. It basically shows how much profit each amount invested in the by the shareholder returns. It calculated as:
RoE = Net income / Equity
In this paper, RoE was decomposed using DuPont analysis. This is to properly analyze the underlying drivers of RoE (this will be discussed in the next chapter). From the sample, Nordea, ING, ABN and UBS reported RoE of 12% in 2015 whilst Deutsche, Credit Suisse, Standard Chartered and RBS reported -10%,-7%,-5% and -2% respectively. Deutsche bank lower RoE was mainly due to higher litigation costs, Credit Suisse due to higher costs, Standard Chartered was primarily driven by higher risk costs while RBS was attributable to higher costs base.
Total assets are the total amount of assets owned by an entity. It is basically referred to items of economic value which are used over a period of time to generated profit for the owners.
€-23.3tln). One reason for assets decline might be the balance sheet optimization and deleveraging exercise going on in some banks.
Common equity refers to the amount that all common shareholders have invested in a company. This includes the value of the common shares, retained earnings, and additional paid-in capital. From the sample, common equity increased by 10% compared to 2014. One possible reason for higher common equity is the ability to reinvest the income instead of distribution to shareholders (plow-back).
Risk-weighted asset (RWA) is a bank's assets or off-balance-sheet exposures, weighted according to risk. It is used for the calculation of asset and computing the capital requirement or Capital Adequacy Ratio (CAR) for the banks. Viewing from the sample, average RWA slightly decreased compared to 2014 (0.5%). Few observations are; lending banks such as BBVA and Santander reported higher RWA. Again, lending banks have higher risk weight (average RWA / total assets) compared to investment banks. This means that investment used originate to distribute mechanism to reduce RWA on the book, unlike the originate and hold strategy mostly seen with lending banks.
Loan to assets ratio measures the total net loans as a percentage of total assets. The higher this ratio indicates a bank is loaned up and its liquidity is low. However, there is a strong correlation between higher loan to asset and Net interest margin. Banks with higher LTA tend to show higher NIM.
Graph C: loan to asset of the sample
Loan to customer deposit is a measure loan to deposit ratio is used to calculate a lending institution's ability to cover withdrawals made by its customers.
Loan to deposit = Net loan / deposit
It is also a measure of stable funding. A lending bank that received a deposit and gives loans to the customer must have must have a certain amount of reserve (liquidity) to maintain it normal operation. However, a bank with LTD in the in the range of 100% has stable funding base. If the LTD of a bank is higher than 100% that means that the bank might not have enough liquidity for fund requirement. On the other hand, if LTD is too low, the bank may not be earning enough as expected. From the sample RBS, Barclays, ING, and Lloyds have LTD in the range of 100%, Nordea, Intesa Sanpaolo and Rabo have higher LTD whilst HSBC, Standard Chartered, Deutsche, and UBS reported lower LTD (see graph D).
66% 65% 64% 57% 56% 54% 52% 52% 51% 47% 43% 40% 38% 38% 38% 36% 34% 33% 33% 29% 26% Loan to asset
Graph D: loan to deposit of the sample
In conclusion, Bank chooses a business model that suits the strategy of the organization despite flexibility in the universal banking model. Some bank is more into private banking, some are in retail/commercial banking and some are leverage more in investment banking. Bank business experience slight changes after the financial crises of 2007-2009 ranging from Originate-to-hold model, to originate to distribute model, a more regulatory power to hold more capital, plan to introduce standard approach methodology in calculating risk-weighted asset, customer centric, increase profitability and investment in innovation. These are the strategies implemented by banks to maximizes profitability and regulators to ensure the sustainability of the industry. Comparing the overall financial performance of the ING competitors (sample) in FY 2015 vs. FY 2014, total income increased by 5.2%, total costs increased by 6.6 % mostly due to higher regulatory costs, risk costs decreased by -5.5%, total assets decreased by -2.2% mainly due to deleveraging and balance sheet optimization, shareholders common equity increased by 10.1% and risk-weighted asset decreased by 0.5%. All in all, FY 2015 financial demonstrate that banks are much better shape despite the all the headwinds (see appendix I for delta FY 2015 and FY 2014).
165% 163% 133% 129%128% 123% 115% 114% 112%112%110%107% 102% 97% 91% 83% 80% 78% 76% 74% 72% Loan to deposit
4. Bank Performance (model, income share, and DuPont analysis)
Bank business model is structured based on the vision and strategy of the management of an organization. Bank’s strategy defines the asset class and the business model. To understand the business model of the sample, I constructed an asset composition of the banks using five years (2011-2015) average asset split into loans, derivatives & securities, other earning assets, and non-earning assets. Based on the outcome of asset class, the banks were clustered in lending, hybrid and investment banks (graph E). the reason is to actually see the average assets composition of ING competitors in the 5-years period.
lending banks (LB) with loan asset above 50%
Hybrid banks (HB) with loan asset in the range of 49% - 37%
Investment banks (IB) with loan portfolio below 37%
Graph E: 5-years average asset composition of the sample (ING competitors)
67% 65% 63% 57% 56% 55% 55% 53% 49% 46% 42% 41% 39% 37% 34% 31% 33% 29% 27% 26% 22% 0% 10% 20% 30% 40% 50% 60% 70% 80%
Loans Der & Ser others EA Non-NEA
4.1 Income composition and RoE of the sample
The supporters of diversification often claim that well-diversified income stream improves the overall income and profitability of the bank. However looking at the income diversification of the sample (graph F), there is no much deviation in the income composition of the sample in the last five years. Interest income was in the range 56%-58%, fee income 27%-29% and other income 13%-16%. The conclusion is that banks do not often deviate from chosen strategy. Looking at the RoE trend of the sample in the last five years, the average RoE was highest in 2015 (5.7%) and lowest in 2013 (3.6%). The is an indication that banks are in a better financial shape in 2015.
Graph F: income share and RoE of the sample
Analyzing the income composition of the three categories lending, hybrid, and investment banks:
Lending banks income share was consistency in the last five years. Interest income share was in the range of 65% to 69%, fee income was in the range of 21% to 23% and other income was in the range of 8% to 13%. From the average income composition of the last five years, it is obvious that lending banks do not have a well-diversified income source. Banks operating
58% 56% 56% 58% 58%
28% 27% 28% 29% 29%
13% 16% 16% 13% 13%
2011 2012 2013 2014 2015
Income split sample
Interest Fee Other
4.9 3.5 3.0 5.0 4.6 2011 2012 2013 2014 2015
with this model might experience interest margin pressure in a low/negative interest environment due to high-interest income dependency. Looking at the RoE trend, 2015 was the best year for lending banks with average RoE around 7%. RoE was under pressure in 2011 and 2013 driving by higher risk cost (write-offs) from Intesa Sanpaolo and Unicredit.
Graph G: income share and RoE lending banks
Hybrid banks are BCPE, Nordea, Standard Chartered, Credit Agricole, HSBC, Commerz, and Nordea. These banks have on average lower interest income compared to lending banks but higher fee income. Hybrid banks have better income stream diversification than lending banks but that does not result in higher profitability. Looking at the RoE, there is a declining trend for banks in this cluster. However, looking on the individual bank, Nordea reported RoE above 12% in 2015 due to prudent cost management while Standard chartered reported low RoE due higher costs base and risk cost.
Graph H: income share and RoE hybrid banks
69%
65% 65% 69% 68%
23% 21% 23% 22% 22% 8% 13% 13% 8% 9% 2011 2012 2013 2014 2015
Income split Lending Banks
Interest Fee Other
1.5 4.5 0.6 6.0 7.0 2011 2012 2013 2014 2015
RoE Lending Banks (in %)
60% 60% 61% 59% 58%
28% 27% 29% 30% 30% 12% 13% 11% 12% 12%
2011 2012 2013 2014 2015
Income split Hybrid Banks
Interest Fee Other
7.8 5.5 7.3 6.4 5.4 2011 2012 2013 2014 2015
Investment banks are typically Deutsche, Credit Suisse, UBS, SocGen, Barclays, BNPP, RBS, and SocGen. On average, IB business model on average has low net loan portfolio, high derivatives, and securities. IB tend to have a well-diversified model with interest income dependency in the range of 42% to 47%, fee income 34% to 36% and other income 19%-23% on average over the last five years. RoE is massively under pressure. This might be an evidence which supports the argument that having a well-diversified income composition does not guarantee better profitability. However, looking at the individual banks, UBS, SocGen and BNPP reported RoE of 11.4%, 7.8% and 7.6% respectively in 2015. Deutsche, Credit Suisse, and RBS all showed negative RoE in 2o15 driven by higher costs base.
Graph I: income share and RoE investment banks
4.2 Analyzing Bank Performance of ING competitors (sample) using DuPont analysis
The decomposition of RoE using DuPont analysis is important in defining the drivers of return on equity, especially for a bank. The drivers are Profitability (profit after tax over total income), Sanity (total income over Average RWA), Risk-weight (average RWA over average assets) and leverage factor (average assets over average equity). The multiplication of the outcome of the four variables gives the return on equity.
45% 43% 42% 45% 47% 35% 34% 35% 36% 35%
21% 23% 23% 19% 19%
2011 2012 2013 2014 2015
Income split Investment Banks
Interest Fee Other
6.2
0.5
2.1 2.6
1.3
2011 2012 2013 2014 2015
RoE = Profit after / Average equity
Profitability (P)= Profit after tax / Total revenue
Sanity (efficiency) (S)= Total revenue / Average risk-weighted assets
Risk weight (RW) = Average risk-weighted assets / Average assets
Leverage factor (LR)= Average assets / average equity
RoE for total sample: looking at the average five-year trend of the sample, RoE was in the range of 3%-5%. 2014 and 2011were on the high side with average RoE of 5.0% and 4.9% respectively. Analyzing the average RoE drivers of 4.9% in 2011, profitability ratio was 9%, Sanity was 7%, risk weight was 34% and leverage ratio 4.2% (100/24). The observation is that on average, bank leverage ratio was very low resulting from high debt in 2011. In 2014, the outcome shows that profitability was at 12% and leverage ratio improved to 5.0% (100/20). Examining 2015 average RoE of the sample which ended at 4.6%. I observed that profitability ratio is moderate at 11%, sanity ratio was at the same level as other years, risk weight was stable whilst leverage ratio improved to 5.6% (100/18). This proofs that on average banks are more capitalized than preceding years.
Graph J: RoE drivers and RoE Sample (Profitability, sanity, risk weight in %)
RoE Lending banks: I observed that on average, lending banks RoE was under pressure in 2011 and 2013 (graph K). This was due to higher pressure on profitability driven by high-risk costs and write-off of some bank in this cluster .Some bank operates in risk region like Latin Americas where the interest rate is very high but also risk costs. FY 2015 was a good year for lending banks as profitability ratio surged to 16%, sanity ratio 7%, risk-weight was on the better side at 38% and leverage ratio at 5.5% (100/18). All these drivers pushed RoE of the lending banks to 7% in 2015. Analyzing the drivers of RoE of individual banks within this cluster (see alsoAppendix IILending Banks income split, asset composition, and drivers RoE), I observed the result varies per bank for example, ING and ABN posted the same RoE of 12% in 2015 but the drivers are different (ING 29%, S 5%, RW 37% and LR 4.8% (100/21) whilst ABN P 23%, S 8%, RW 28% and LR 4.2%). This is an evidence that banks use different strategies and mechanism in achieving the return on equity. Another observation was that some bank in this category didn’t perform well due to the nature of the business and geographical presence such as the aforementioned Latin Americas.
9 7 5 12 11 7 7 7 7 7 34 34 36 34 34 24 22 20 20 18 2011 2012 2013 2014 2015
Drivers of RoE sample
Profitability Sanity Risk weight Leverage factor
4.9 3.5 3.0 5.0 4.6 2011 2012 2013 2014 2015
Graph K: RoE drivers and RoE lending banks (Profitability, sanity, risk weight in %)
RoE Hybrid banks: the observation from this cluster is that the bank in this segment profit from a well-diversified income. However, the diversified income stream does not guarantee higher returns. Looking at the RoE drivers, Profitability ratio is in the range of 14%-19% this is best in class compared to lending and investment banks, Sanity is also on a moderate level, risk weight is on moderate side and lower than lending banks. Leverage ratio increased toward 2015 meaning that the best are well capitalized. However one can argue that on average banks in this cluster are a bit conservative and not aggressive in taking a risk. RoE drivers for the bank in this cluster also varies, some banks are very profitable while some are still navigating a stormy water. For the dynamics of RoE driver for the banks in this cluster (see Appendix III – Hybrid Banks income split, asset composition, and drivers RoE)
Graph L: RoE drivers and RoE hybrid banks (Profitability, sanity, risk weight in %) 0 10 -1 14 16 6 6 6 6 7 42 40 42 39 38 20 19 18 19 18 2011 2012 2013 2014 2015
Drivers of RoE Lending Banks
Profitability Sanity Risk weight Leverage factor
1.5 4.5 0.6 6.0 7.0 2011 2012 2013 2014 2015
RoE Lending Banks (in %)
17 14 19 18 16 6 6 6 6 7 37 37 37 34 34 24 21 20 19 17 2011 2012 2013 2014 2015
Drivers of RoE Hybrid Banks
Profitability Sanity Risk weight Leverage factor
7.8 5.5 7.3 6.4 5.4 2011 2012 2013 2014 2015
RoE Investment banks: Bank in this cluster on average are deemed a very risky bank with an exception of BNPP, SocGen, and UBS (see Appendix IV – Investment Banks income split, asset composition, and drivers RoE). Looking at the RoE trend, 2011 was the best year for the banks in this cluster. They performance better than lending banks. This might be an evidence that IB profits in an adverse market scenario.
Graph M: RoE drivers and RoE investment banks (Profitability, sanity, risk weight in %)
In conclusion, using the assets composition of the ING competitors (sample) in clustering the banks into lending, hybrid, and investment banking help in understanding the dynamics, business model and return on equity drivers. Banks profitability highly depend on the decision of the management, the strategy of the organization and the business model. From the decomposition of the RoE, I observed that lending banking which is retail/commercial bank like are on average much profitable than hybrid bank and investment bank. Hybrid banks on average profit from a well-diversified revenue stream such as fee and other income but some of them are well capitalized and practically risk averse. The investment bank is the best in class when it comes to income diversification but higher costs in running IB business have massive pressure on the returns of some bank in this cluster. To maximize profitability and have a decent RoE on equity, a bank should make the right decision, choose a sustainable business model and effectively manage costs and risk.
11 -1 1 4 2 8 8 8 8 8 24 26 29 27 29 28 26 22 23 20 2011 2012 2013 2014 2015
Drivers of RoE Investment Banks
Profitability Sanity Risk weight Leverage factor
6.2
0.5
2.1 2.6
1.3
2011 2012 2013 2014 2015
5. Statistical model and result
This section shows an indicative statistical analysis. Explaining and summarizing the data of the sample selection. Seeing that the number of observations is limited, the outcome of analysis will be deemed indicative and might not robust enough.
Firstly, I constructed the correlation table to capture the variables that correlate with RoE. Few observations were;
Table 2: Correlation matrix for several variables
Cost income ratio (CIR) negatively correlates with the RoE, the higher the CIR, the lower the RoE. this is in-line with the empirical studies.
Loan loss provision over total loan (LLPOTL) as well negatively correlates with RoE, an increase in write-off and risk costs lead to a decrease in RoE. This is in-line with empirical studies.
Total loan growth (TLGr) positively correlates with RoE, an increase in loan might result in an increase in revenue.
RoE RoA NIM CIR EOTA ETR FC GDP IIS LLPOTL LTD LTIR TLGr TAGr TLS NIOTI TIORWA RWA0TL LF
RoE 1.00 RoA 0.96 1.00 NIM 0.12 0.21 1.00 CIR -0.49 -0.47 -0.06 1.00 EOTA -0.05 0.09 0.71 0.05 1.00 ETR -0.05 -0.12 -0.02 0.12 -0.19 1.00 FC 0.21 0.20 0.54 -0.09 0.06 0.26 1.00 GDP 0.11 0.09 0.07 -0.16 0.06 -0.17 -0.12 1.00 IIS 0.08 0.07 0.63 -0.06 0.28 -0.02 0.39 0.07 1.00 LLPOTL -0.36 -0.30 0.59 0.47 0.48 0.19 0.41 -0.19 0.30 1.00 LTD -0.07 -0.16 0.26 -0.02 0.11 0.13 0.35 -0.01 0.42 0.32 1.00 LTIR -0.03 -0.09 -0.01 0.14 -0.28 0.76 0.35 -0.34 -0.02 0.20 0.18 1.00 TLGr 0.33 0.34 0.20 -0.27 0.06 -0.15 0.08 0.20 -0.16 -0.17 -0.08 -0.12 1.00 TAGr 0.37 0.37 0.33 -0.29 0.07 -0.15 0.34 0.34 0.18 0.03 0.19 0.13 0.48 1.00 TLS 0.12 0.08 0.56 -0.05 0.30 0.01 0.41 0.01 0.72 0.26 0.60 -0.03 -0.05 0.11 1.00 NIOTI 0.98 0.96 0.09 -0.55 -0.03 -0.11 0.16 0.10 0.07 -0.39 -0.05 -0.09 0.31 0.37 0.11 1.00 TIORWA 0.15 0.14 -0.19 -0.07 -0.18 -0.02 -0.12 0.05 -0.61 -0.25 -0.39 -0.06 0.37 -0.06 -0.41 0.12 1.00 RWA0TL -0.14 -0.04 0.76 0.15 0.79 0.06 0.24 -0.04 0.51 0.64 0.28 0.03 -0.09 0.09 0.48 -0.15 -0.58 1.00 LR -0.23 -0.09 0.66 0.13 0.97 -0.13 0.04 0.04 0.26 0.53 0.14 -0.26 -0.02 -0.03 0.29 -0.21 -0.20 0.79 1.00
Net income over total income (NIOTI) is profitability ratio. An increase in profitability ratio will ultimately result in an increase in RoE keeping all the other variable of DuPont analysis stable.
The rest of the variables are less than 0.25 and -0.25 which I consider not significant.
Secondly, I conducted an empirical study using OLS estimation using the following linear regression equation;
RoEit = c + β1CIRit + β2EOTA it + β3ETR it + β4FCit + β5GDPit + β6IISit + β7LLPOTLit +
β8LTD it + β9TAGR it + β10TLGR it + β11TLS it + ε it
Where profitability = RoE, c is a constant term; i = 1,…,N and t =1,…Nis the dependent variable, the rest on the right part of equation are the independent of bank internal specific factor, macro-economic factors.
The R-square of the regression showed that 44% of the model was explained. The results showed that funding costs, loan loss provisions, and total asset growth are significant determinants of bank profitability. Despite the limited number of the observations, the outcome in-line with the empirical studies.
Abbreviations
CIR Cost-to-income ratio
EOTA Equity-over-total loan
ETR Effective tax rate
FC Funding cost
GDP Global domestic product
IIS Interest income share
LLPOTL Loan loss provision-over-total loan
LTD Loan to deposit
LTIR Long term interest rate
RoE Return on equity
TAGr Total asset growth
TLGr Total loan growth
TLS Total loan share
Summary RoE banks
Regression Statistics Regression Statistics
Multiple R 0.664 R Square 0.440 Adjusted R Square 0.367 Standard Error 5.064 Observations 105 ANOVA df SS MS F Significance F Regression 12 1855.368 154.614 6.030 0.000 Residual 92 2358.838 25.640 Total 104 4214.207
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
Intercept -49.520 46.451 -1.066 0.289 -141.776 42.735 CIR -0.073 0.045 -1.620 0.109 -0.163 0.017 EOTA 0.415 0.523 0.793 0.430 -0.624 1.454 ETR 3.089 2.361 1.308 0.194 -1.600 7.778 FC 2.242 1.062 2.112 0.037 0.134 4.351 GDP -0.793 0.653 -1.213 0.228 -2.090 0.505 IIS -0.011 0.056 -0.190 0.849 -0.122 0.100 LLPOTL -4.923 1.577 -3.122 0.002 -8.055 -1.791 LTD -0.038 0.022 -1.696 0.093 -0.082 0.006 LTIR -0.960 0.930 -1.033 0.304 -2.806 0.886 TLGr 0.053 0.102 0.515 0.608 -0.150 0.256 TAGr 0.248 0.097 2.564 0.012 0.056 0.440 TLS 0.087 0.065 1.344 0.182 -0.042 0.216
6. Conclusion
Banking Industry, especially in the Eurozone, is experiencing some headwinds rising from the ultra-low interest rate, increases in regulatory requirement, increases in bank tax, competition from non-licensed financial services institutions and disruptors commercial known as financial technology (Fin-tech). Profitability in the industry is massively under pressure, simplification, automation, costs reduction, jobs cut, branch closure and consultation with the regulatory are the hype and headline of almost all the bank's annual report. Amongst all the headwinds, some banks still make a reasonable profit and report a higher return on equity.
The key question is what drive the profitability of the bank? Considering that RoE is one of the key measure of bank profitability and without disputing the results of the empirical studies. It is of great important to decompose the Return on equity into profitability, sanity (efficiency), risk weight and leverage factor to capture the drivers of return on equity. From the sample, I observed that in general, higher income does not correlate with higher profitability. The chosen business model and management strategy might impact the profitability of the bank. On average, Lending banks are more profitable than Hybrid and Investments Banks due to stable interest income but are also more vulnerable in a low-interest rate environment. Hybrid banks do not necessarily deliver higher returns but benefit from more diversified sources of income (interest, fee and other income). Most of the investment banks are not delivering up to expectation despite the well-diversified source of income mainly due to a high-cost base.
In conclusion, it is very difficult and unrealistic to quantify the determinants of bank profitability notable return on equity without decomposing and analyzing the core drivers from individual bank perspectives. By using DuPont analysis in decomposing RoE, It is obvious and transparent to see the sustainable banks from risky ones. A sustainable and
profitable bank return on equity should show high profitability ratio, good sanity, moderate risk weight and leverage ratio within the regulatory requirement. This paper might have some limitation, further investigation is necessary on this topic.
