BANK PROFITABILITY IN A DEVELOPING ECONOMY

Factors Influencing Bank Profitability in a Developing Economy

TABLE OF CONTENTS

China3

Introduction3

Brief Overview of the China Financial System6

Related Studies12

Malaysia21

Introduction21

Brief Overview of the Malaysian Financial System23

Related Studies27

Methodologgy42

Performance Measure43

Internal Determinants45

External Determinants52

Econometric Specification57

Estimation Results62

Robustness Checks75

Concluding Remarks80

Appendix A85

Appendix B89

References102

Factors Influencing Bank Profitability in a Developing Economy: China & Malaysia

China

Introduction

The banking sector is the backbone of China's financial system and plays an important financial intermediary role in the country's economy. At year-end 2006, the banking sector constituted a sizeable 85% of total external corporate funding versus 10% via bond issuance and 5% via equity issuance. Therefore, their health is very critical to the health of the general economy at large. Given the relation between the well-being of the banking sector and the growth of the economy (Levine, 1998; Rajan & Zingales, 1998), knowledge of the underlying factors that influence the banking sectors' profitability is therefore essential not only for the managers of the banks, but also for numerous stakeholders such as the central bank, bankers association, the central government, and other financial authorities.

For much of the last 30 years, China banks functioned largely as conduits for government grants, and it is only over the last decade that banks started to operate on a more commercial footing. The China banking sector has consistently been accused for its lack of efficiency due to the high amount of provisions set aside for loan losses. Unsurprisingly, in an environment of heavy government influence over the lending process, underdeveloped risk management practices, and little experience in risk management, a large proportion of loans extended over the years have gone bad. Furthermore, bank capitalization, solvency, and profitability are still below international standards.

In 1997, the Chinese government started a comprehensive banking sector reform with the objective of transforming banks into market functioning and profitable institutions. The reform has so far focused on the restructuring of the four State Owned Commercial Banks (SOCBs) that had long served as lending arm of the State Owned Enterprises (SOEs). The restructuring has been conducted through capital injections and the carving out of nonperforming loans (NPLs). In parallel to the restructuring of the SOCBs, the Chinese government has taken important measures to liberalize the banking system. Among others the ceiling on lending rates and the floor on deposits are lifted, the share of directed lending are reduced, and the capital account is opened up on a gradual basis.

It is reasonable to assume that these developments posed great challenges to banks in the China banking sector as the environment in which they operated changed rapidly, a fact that consequently had an impact on the determinants of profitability of the Chinese banks. As Golin (2001) pointed out adequate earnings are required for banks to maintain solvency, to survive, grow, and prosper in a competitive environment.

This article seeks to examine the performance of the China banking sectors over the period 2005-2009, which is characterized as a time of significant reform in the country's banking sector. Although there have been extensive literatures examining the profitability of banking sectors ...