The Determinants of Profitability of Commercial Banks Operating in Nepal

Group 5: Seema Bhattarai, Smita Shakya,Sristi Shrestha, Subodh Adhikari and Sunena Maharjan General Background The Banking sector acts as the life blood of modern trade and commerce to provide them with a major source of finance.Financial system of Nepal is still in its primary stage of development. Small and fast growing financial sector comprises of commercial banks and other financial institutions like development banks, finance companies, cooperatives etc. Financial sector is the backbone of economy of a country. It works as a facilitator for achieving sustained economic growth through providing efficient monetary intermediation. A strong financial system promotes investment by financing productive business opportunities, mobilizing savings, efficiently allocating resources and makes easy the trade of goods and services. Results are expected to confirm the importance of bank level factors such as; assets, capital adequacy, operational efficiency, and liquidity; and macroeconomic factors such as growth in GDP and inflation in explaining bank profitability. Further, the results provide evidence that the banking sector over the study period had persistence in profitability behavior towards equilibrium. By studying the determinants of banks performance the study provided additional knowledge about commercial banking sector that is important for policy making. Regression results are based on return on average assets (ROAA) and net interest margin (NIM) as measures of banks profitability. (Ezra Francis,2006). Every business organization has the objective of earning maximum profit.. Profitability is related with the net profit of an organization with reference to different variables. Profitability reflects the efficiency of the business firms. A commercial bank by denition, is a prot hunting institution. The bank has to earn prot to earn income to pay salaries to the staff, interest to the depositors, dividend to the shareholders and to meet the day-to-day expenditure. Since cash is the least protable asset to the bank, there is no point in keeping all the assets in the form of cash on hand. The bank has got to earn income. Hence, some of the items on the assets side are prot yielding assets. They include money at call and short notice, bills discounted, investments, loans and advances, etc.

These asset provide income or revenue to the banking firm which contributes to profitability of the institution. Loans and advances, though the least liquid asset, constitute the most protable asset to the bank. Much of the income of the bank accrues by way of interest charged on loans and advances. But, the bank has to be highly discreet while advancing loans. In addition, there has been proliferation of financial services and overlapping of markets between bank and non bank financial intermediaries. The demand side changes are influenced by rapid economic growth, expanding middle class society and the rise of consumerism. The suppliers have responded by expanding branch networks and new products where as the consumers have responded by reducing their savings rate, disintermediating and shifting from low to high yielding deposits. As a result commercial bank profits may be under pressure from lower loan yields and higher cost of funds.Commercial banks in Malaysia will have to review the way they have been doing business in the past and they would need to understand the internal and external factors, which influence their profitability performance. A great deal of earlier research on bank profitability had focused on the impact of market structure, in particular market attentiveness on bank profitability(K. Guru,2000). The internal determinants are derived from the books of the bank, such as the profit and loss account, the balance sheet and the off balance sheet items. These can be classified as managerial and microeconomic variables. Whereas the external factors reflect the economic, financial and legal circumstances that affect the performance of banks. Internal factors include risk level, operational strategies and managerial expertise, while macroeconomic factors refer to economic growth rate, unemployment rate, interest rate and exchange rate levels etc...

In general, empirical studies focusing on the evaluation of performance bank are paying special attention to the explanation of both bank net interest margin and profitability (Salloum & Hayek, 2012). The evidence generated suggests that for any consistent or systematic size the profitability relationship is relatively weak. Most of the bank-specific determinants were found to significantly affect bank profitability. A more ambiguous picture emerged when the macroeconomic factors were considered (Alexiou, Constantinos; Sofoklis, Voyazas,2009).

However, the profitability, which is an important criteria to measure the performance of banks in addition to productivity, financial and operational efficiency, has come under pressure because of changing environment of banking. An efficient management of banking operations aimed at ensuring growth in profits and efficiency requires up-to-date knowledge of all those factors on which the bank is profit depends. Accordingly, in this paper we have made an attempt to identify the key determinants of profitability of Public Sector Banks in India.

The purpose of this research is to examine the relationship between bank-specific and macroeconomic characteristics over bank profitability by using data of top fifteen Pakistani commercial banks over the period 2005-2009. This paper uses the pooled Ordinary Least Square (POLS) method to investigate the impact of assets, loans, equity, deposits, economic growth, inflation and market capitalization on major profitability indicators i.e., return on asset (ROA), return on equity (ROE), return on capital employed (ROCE) and net interest margin (NIM) separately. The empirical results have found strong evidence that both internal and external factors have a strong influence on the profitability (Gul et al, 2011).

While size of the banks is a significant indicator for profitability where return of assets is used as proxy for measuring banks profitability and insignificant relation where return on equity is used as proxy to measure the profitability of commercial banks (Akhtar et al, 2011). Thus the research is expected to include all the factors effecting the firms profitability which may match with the results of some researcher and may differs from the others. Nepal a developing country needs to improve the performance of the banking sector for economic development.

Statement of the problem

Commercial banks have always played an important role in the tremendous economic development that has taken place in the region over recent years. In the light of these developments, the objective is to identify the determinants of profitability of commercial banks. The determinants of profitability and theories thereof used in this review are those frequently described in conventional banking studies and literature. The profitability determinants were basically divided into two main categories, namely the internal determinants and the external determinants. The internal determinants include management controllable factors such as liquidity, investment in securities, investment in subsidiaries, loans, non-performing loans, and overhead expenditure. Other determinants such as savings, current account deposits, fixed deposits, total capital and capital reserves, and money supply also play a major role in influencing the profitability. Similarly, external determinants include those factors which are beyond the control of management of these institutions such as interest rates, inflation rates, market growth and market share. This study therefore deals with the following issues: What are the main factors that determine the profitability of the bank? What is the relationship between determinants of profitability and bank performance? How can the performance of the bank be measured? What are the effects of organizational and economical variables on profitability of Nepalese banks?

Objective of the Study

The main purpose of this study is to identify internal and external determinants of profitability of commercial banks operating in Nepal. The specific objectives are as follows: To show the relationship between the dependent and the independent variables to detect the determination of bank profitability during the period. To estimate the impact of several internal and external factors on the performance of Nepalese Bank. To examine the behavior of Nepalese banks regarding performance. To emphasize the effect of organizational and economical variables on profitability of banks operating in Nepal.

Organization of the study

The report of our analysis will be divided into five chapters. Foremost chapter deals with the background of the study, statement of the problem, objectives of the study, organization of the study. The second chapter will deal with literature review of the study. The third chapter is about research methodology that deals with how the study is conducted, source of data, data selection procedures. The fourth chapter deals with analysis and findings or results. Finally, the last chapter includes conclusions and recommendations of the research.

Research Methodology
Research design This study consists of 5 commercial banks of Nepal. We are attempting to get information and accuracy data using the regression model. This study includes the statistical test such as T statistics, F test Durbin-Watson. Here the three models are used as a dependent variable such as Return on Assets (ROA), Net Interest Margin and expanded Net Interest Margin. After the analysis conducted by Pooled OLS method Durbin Watson test is used to detect the existence of autocorrelation. Nature and sources of data

This study aims to test the relation between dependent variables and factors of determination of profitability at 5% level of significance. The study is conducted in the area of banking institutions in Nepal. Official web sites of Nepal Rastrya Bank (www.nrb.org.np) are also used to collect the required financial data for the ten years period that the study covers. Annual reports of the companies are analyzed to reach a conclusion of the analysis The main source of data is Banking and Financial Statistics published by Nepal Rastra Bank, NRB Directives, legal provisions incorporated in Companies Act, 2063 and concerned by-laws regarding corporate governance. Similarly, the provisions on Bank and Financial Institution Act, 2063 are reviewed for the purpose of analysis. In addition to these, different published articles, reports, books and magazines are also analyzed. The study has eight independent variables that are assumed to determine the financial performance. The first independent variable is external factors like inflation, market structure, growth rate and others. The study employs panel data techniques and uses balanced panel data. All models are tested for individual effects by running F test. Selection of Enterprises The overall sample size depends on the decision of the sample size .This study employs panel data techniques to measure the relation between dependent and independent variables. For this we are selecting five in the banks in the industry. Method of Analysis The relationship between independent variables and financial performance measures is analyzed by employing 3 models. ROA is used as the dependent variable of Model 1. Model 2 and Model 3 uses consequently NIM and Expanded NIM as dependent variables. The findings of this study will be analyzed in the context of economical and social structure in Nepal for the sound analysis of the findings. The models of this study are: Model 1: ROA=+1(Market structure)+2(inflation)+3(growth rate)+ 4(opportunity cost) + 5 (credit risk)+ 6 (capital ratio) + 7(operating costs)+ 8 (bank size)

Model 2: NIM= +1(Market structure)+2(inflation)+3(growth rate)+ 4(opportunity cost) + 5 (credit risk)+ 6 (capital ratio) + 7(operating costs)+ 8 (bank size) Model 3: ENIM= +1(Market structure)+2(inflation)+3(growth rate)+ 4(opportunity cost) + 5 (credit risk)+ 6 (capital ratio) + 7(operating costs)+ 8 (bank size)