The role of banks in economy

Banks play a central role in the economy to keep the savings of the public and finance the development of business and trade. In addition, numerous research argue that the efficiency of financial intermediation affects economic growth while others indicates that bank under-performance can lead to in systemic unstable financial situation which have potential adverse consequence for the economy as a whole. What do we mean by the word perform when it comes to banks? In this case performance refers to how adequately a bank meets the needs of its stockholders (owner), employees, depositors and other creditors, and borrowing customers. At the same time, bank must find a way to keep government regulators satisfied that their operation policies, loans, and investments are sound, protecting the public interest. The success or lack of success of these institutions in meeting the expectations of others is usually revealed by a careful study of their financial statements. (Rose and Hudgins, 2010)

Thus, the performance of banks has been a keen issue of major stakeholders such as depositors, customers, investors and regulators as well. While traditionally bank performance has been evaluate on the basis of financial ratios, advances in operational research (O.R) and artificial intelligence (A.I) (Feith and Pasiouras, 2009).

The efficiency and competitiveness of financial institutions cannot be easily gauged due to intangible nature of their services and products, although the desire to investigate the efficiency characteristics of financial institutions has been inspired by academics, policy makers, as well as bankers. Many researchers have attempted to measure productivity and efficiency of the banking industry using costs, outputs, efficiency and performance.

There are variations of bank performance measurement apart from the bank efficiency measurement. Revell (1980) uses interest margin as a performance measure for U.S. commercial banks and defines interest margin is the difference between interest income and interest expense which are divided by total assets. Arshadi and Lawrence (1987) use normal correlation analysis to assess bank performance. Their multidimensional indexes include indexes of pricing of bank services, profitability and loan market share. However, those measures of bank competitiveness are not the ones evaluated by the financial market.

The scale and scope economies of banking have been one of the most important events pertained to competitiveness and efficiency of banking industry extensively. Murray and White (1983) used a translog cost function to evaluate the scale and scope economies. He recognized the multi-product nature of financial intermediaries of credit unions in Canada. Gilligann et al. (1984) applied the translog cost function to examine scale and scope economies in U.S. banking firms. Both of them found scope economies and not economies of scale among U.S. banks in their analysis. Hunter et al. (1990) applied multi-cost production function and an intermediation approach to examine the U.S. bank production. In their research, they found no evidence of cost complementary and no sub-additive cost functions.

There are also several studies have analyzed scale and scope economies across European banking Industry. Molyneux et al. (1996) used the hybrid translog cost function to analyzed economies of scale and scope three European countries including France, Italy and Spain and found there were differences in cost characteristics between countries while scope and scale economies appeared to be evident in each country, however, over a wide range of bank out- put levels. The European Commission (1997) also analyzed the cost characteristics of various European banking sectors, while measuring the potential gains brought about by the 1992 Single Market Program.

Size has great impact on the efficiency of banks. Previous research, according to (Short, 1979; Miller and Noulas, 1996), especially in the United States, show that scale economies is considered by small banks and not in large ones. But Miller and Noulas, 1997) recent research shows that the levels of size for the existence of scale economies are higher due to economic development and market liberalization. Moreover, Peterson and Rajan, (1995) and Hardy and Simigiannis(1998) supported that small banks could only survive in the new competitive European environment, if they specialized in few of their activities. Lang and Welzel (1996) were examined the efficiency and technical progress of German cooperative banks. according to this sample, All banks enjoy productivity which are higher in small banks.

Miller and Noulas (1996) examined the technical efficiency of large banks and revealed that larger and more profitable banks have higher levels of technical efficiency and at the same time, larger banks are more likely to operate under decreasing returns of scale. The performance of the new US commercial banks was analyzed by DeYoung and Hasan (1998) and showed that during the first years of operation the profit efficiency of the new banks improves rapidly, but on average it takes about nine years to reach as a established bank standards. Small banks lend a larger proportion of their assets to small businesses than do large banks. In the USA, Jayaratne and Wolken (1999) recognized that the probability of a small firm to have a line of credit from a bank does not decrease in the long run but this is done when there are few small banks in the area, although short-run disruptions may occur.

Giokas (1991) used Data Envelopment Analysis (DEA) and loglinear model analysis to study the operational efficiency of individual branches of a bank as well as whether operations in the bank branches were conducted in regions of increasing, constant or decreasing returns to scale. The DEA outcomes propose that increasing, constant or decreasing returns to scale may be observed in different regions of the production function, on the other hand the loglinear model proposes that in- creasing returns to scale are in operation.

Athanassopoulos (2000) indicated that operations management problems can't be avoided of developing an efficiency assessment framework of bank branch operations with the help of Data Envelopment Analysis. This framework recognizes the internal operations taking three different economic behaviors that is the transaction-specific, the production-specific and the intermediation- specific efficiency. It is applied to a branch network of a mortgage bank which performs a specialized function as far as the core products it markets but on the other hand it constitutes a mainstream bank activity. The outcomes from this relatively small branch network indicate the presence of high efficiency discrepancies within the network that can be eradicate with efficient management initiatives.

Drake (2001) investigate relative efficiencies within the sector and to analyze productivity change in UK banking Industry using a data sample covering the main UK banks over the period 1984-1995. He used the Data Envelopment Analysis and found important insights into the size-efficiency relationship in UK banking. Spathis et al. (2002) investigated the differences of profitability and efficiency between small and large Greek banks, as well as the factors of profitability and operation related with the size of banks through a multicriteria methodology. They found that though small banks seem to be more efficient and vulnerable, large ones have lower operating costs due to the scale economies and their network.

Several studies attempt to investigate the factors that that influence the efficiency of banks. Some studies examine only bank-specific factors and others examine both bank-specific aspect and as well environmental determinants.

Usually size, profitability, capitalization, loan to asset are considered as bank-specific factor (Casu and Molyneux, 2003; Ataullah and Le, 2006; Ariff and Can, 2008). Isik and Hassan (2003a) examine further feature of bank-specific factor such as the educational profile of bank personnel and CEO- Chairman Tie up.

According to Hauner, (2005); Ataullah and Le, (2006), market concentration, presence of foreign banks, ratio of private investment to GDP, fiscal deficits to GDP, GDP growth are considered as country-specific factor . More recently, Pasiours (2008a) examined the supervisory power and bank entry into the industry, private monitoring, banks' activities and relationship between technical efficiency and regulations related to capital adequacy.

Some empirical researches emphasis on relationship between corporate governance and bank performance and recognized on the relationship between corporate governance and performance is mixed. For examples, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2002) find evidence of higher firm performance in countries with better protection of minority shareholders. Klapper and Love (2003) recognized that better operating performance is highly correlated with better corporate governance. Black, Jang, and Kim (2003) provide empirical evidence that the relationship between corporate governance and performance are positive co-relation, but they have no explanation about the causal relationship. Drobetz (2004) also finds that higher corporate governance rating is related to high performance.

Empirical research issues in financial banking also recognized the control effectiveness of private-owned banks versus public or state-owned banks. Cebenoyan et al. (1993) recognize different evidences that there are no significant changes between mutual and private ownership on bank performance. Sarkar, Sarkar, and Bhaumik (1998) also provide empirical evidence that in the absence of well functioning capital markets, there may not be substantial differences in the performance between private-owned firms and public-owned firms. Mester (1989) and Mester (1993) reveal that private banks have slight cost and profit disadvantage over their public-owned banks. While there is little evidence to suggest that private- owned banks are more efficient than their mutual and state-owned firm counterparts by Altunbas, Evans and Molyneux (2001)

Lang and So (2002) examine the mix of ownership structures of banks in emerging financial markets and observe that foreign banks have higher holdings than do domestic banks if state stakes are omitted. In terms of bank performance, ownership structure has no impacts on the bank performance. These findings suggest further study to rethink about the culture of state-controlled banks privatization system. While the state-controlled banks are privatized, Will the foreign banks have control of domestic banking system? While, Havrylchyk (2003) finds that foreign-owned banks are found to be more efficient than their domestic-owned bank counterparts.

While most of the above studies focus on the efficiency of banking institutions as a whole, several studies examine the efficiency of bank branchs as well. In general, branches are predominantly considered production units ( Camanho and Dyson, 1999,2006) Zenios et al.(1999), Soteriou and Zenios ( 1999b), Golany and Storbeck (1999), Athanassopoulos and Giokas (2000) and Hartman et al. (2001) where output is measure by the number of various accounts and /or transactions as contrast to the intermediation approach applied by Portela and Thanassoulis (2005,2007), Portela et al. (2003), Giokas (2008a ) where branches are seen as intermediaries, and thus outputs are measured in monetary terms.

There are studies which consider the changing role of bank branches from a predominantly transaction-based on to a sales-oriented role. Cook et al.(2000) and Cook and Hababou (2001) distinguish sales and services (transactions) functions of bank branches in a Canadian Bank where inputs are usually shared between these two function. To model the shared resources Cook et al. (2000) extend the usual methodology to develop a model which incorporates the best resource split and optimizes the aggregate efficiency score. Further, Cook and Hababou (2001) model the shared resources concept by using the Additive model, in a recent novel application, portela and Thannasoulis (2007) use a post-hoc analysis to compare service quality index with efficiency measures and find that operational and profit efficiency are positively related with service quality.

The purpose of this paper is to investigate the determinants of profitability of domestic commercial banks in the UK during the period 2005-2010, which has witnessed substantial growth and change following deregulation of the UK banking industry. In the literature reviewed below we find a number of studies investigating the determinants of bank profitability for other countries, while prior studies on UK banks have focused mainly on other aspects of bank performance. For example, Drake (2001) and Webb (2003) study the efficiency of the UK banking sector. Holden and El-Bannany (2004) investigate the significance of information technology developments on the profits of major UK banks. Kosmidou et al. (2006a) analyze performance factors to identify the distinguishing characteristics of UK foreign and domestic banks' profits. Other studies on bank profitability have considered UK banks as part of a larger sample pooled across a number of countries (e.g. Molyneux and Thorton, 1992; Pasiouras and Kosmidou, 2006). Ashton (1998) examines the efficiency of the UK retail banking sector over the period 1984-1995, using a time trend to measure average technical change. Webb (2003) applies Data Envelopment Analysis to analyze the efficiency of large UK retail banks during the period 1982-1995. Over the period of the analysis, he reveals that lower mean inefficiency levels in comparison to past studies, with reduced efficiency for all banks in the sample, and falling overall long run average efficiency trend. To examine the relationship between profits and asset-liability composition Kosmidou et al. (2004a) use a statistical cost accounting method on a sample of 36 domestic and 44 foreign banks operating in the UK. The results indicate differences between high profit and low profit banks in comparison to domestic and foreign banks. Kosmidou et al. (2004b) applying a multi-criteria decision aid methodology and reveal that domestic banks attribute higher overall performance compared to foreign banks over the period 1996-2002. Kosmidou et al. (2006a) use logistic regression to examine how foreign banks differ from domestic banks in the UK and find that the latter are characterized by, net interest revenue to total earning assets, higher return on equity and loans to customer & short-term funding. Finally, Kosmidou et al. (2006b) compare the performance of large and small UK banks and recognized that small banks attribute higher overall performance compared to large banking institutions.

This paper presents a comprehensive review of the use of calculating financial ratio in the assessment of bank performance. The evaluation criteria in this study involve ratio based on the financial statements of banks. There are predetermined financial ratios which can be used for the evaluation of banks performance. For a instance, Golin (2001) provides a list of over 80 ratios covering the major categories of capital, asset quality, profitability and efficiency, liquidity and funding. This study focuses on asset quality, capital adequacy, operations and liquidity in order to measure the performance of some top High-street commercial bank operating in the UK. In this paper initially considered financial ratios that are proposed and calculated by the Bankscope Database of Bureau van Dijk's company, however, after screening for data availability.


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