Determinants of Bank Profitability and Basel Capital Regulation: Empirical Evidence from Nigeria

This study, empirically, investigates the determinants of bank profitability. The debate on whether Basel capital regulation affects bank profitability continues to attract research interest, globally. I contribute to this debate by providing a country specific study. Overall, I find that Basel capital regime had no significant effect on bank profitability. The result is significant because it lends support to the view that modified Basel accord in different countries might be aimed to meet other prudential objectives relative to the intended objective - to reduce excessive bank risk-taking. Second, after employing NIM and ROA profitability metrics, I find that the determinants of bank profitability, and its significance, depends on the profitability metric employed. Third, I find that loan quality significantly influences bank interest margin while bank size and cost efficiency significantly influences return on asset. Finally, bank capital adequacy ratio is observed to be a significant determinant of bank profitability.


Introduction
1989, reports a positive relationship for state-owned banks. In developing countries, Vong and Chan (2006) investigated the determinants of bank performance of Macao Banking industry for a 15-year period using small sample of banks and found a positive relationship. Also, bank size 5 , as a determinant, reports mixed conclusions. For example, Sinkey (1992) and Boyd and Runkle (1993) both reports an inverse relationship between large banks and profitability but, interestingly, Sinkey (1992) found a positive relationship for smaller banks. For developed countries, Naceur (2003) reports a negative relationship between bank size and profitability in Tunisia. Cost to income ratio measures banks` expense management. Bourke (1989) found a negative relationship between expense and profitability while a European study (Molyneux and Thornton, 1992), Malaysian study (Guru et al, 1999) and a Tunisian study (Naceur, 2003) documents a positive relationship between expenses and profitability. 6 Therefore, conclusions on the relationship of this variable is mixed. Also, prior research reports mixed relationship for external determinants of bank profitability. For example, Guru et al (1999) in a study of Malaysian banks and Jiang et al. (2003) in a study of banks in Hong Kong, both, report a positive relationship between inflation and bank profitability while Abreu and Mendes (2000), in a study of European banks, reports a negative relationship. Similarly, Demirguc-Kunt and Huizinga (1999) in a study of banks in developing countries, found a negative relationship.
However, inflation cannot be a sole determinant of bank profitability when examined in isolation.

Capital Regulation and Bank Profitability
The theoretical literature predicts that capital regulation should have a negative impact on bank profit. For example, Santos (2000) argues that bank regulation through higher capital requirements negatively affects bank development and credit expansion by increasing fixed costs and operating costs, though, net interest income may increase also. Calem and Bob (1999) suggests that increased capital regulation can force under-capitalized banks to engage in risk-5 Vong and Chan (2006) argued that though banks have size-related economies and diseconomies of scale, however, bank size alone does not guarantee high profitability. Therefore, conclusions on this variable should be interpreted with caution. 6 Vong and Chan (2006) suggests that a positive relationship for this determinant might be explained by the fact that banks are able to pass their overheads to depositors and borrowers in terms of lower deposit rates or by transferring the bank's tax burden to customers who are faced with an inelastic demand for banking services, thereby, transferring a large portion of cost to bank customers. In contrast, other empirical studies reports mixed conclusions (e.g. Barth et al, 2004;Chiuri et al., 2002;and Pasiouras et al., 2008). Barth et al (2004) examined the relationship between regulatory and supervisory practices and banking-sector development in 107 countries and found that direct regulation and supervision of banks activities by the government significantly hinders bank performance. Also, in a study of 572 banks in 15 developing countries after controlling for banking crises, Chiuri et al (2002) show evidence that enforcing capital regulation led to a reduction in bank loan supply which is a major source of bank interest income. 7 In a study of 615 publicly quoted commercial banks over a 4-year period, Pasiouras et al (2008) found that bank regulation, in the form of bank restriction and capital regulation, had a negative impact on profit efficiency but a positive impact on cost efficiency. Overall, there seem to be mixed conclusions on some determinants of bank profitability as well as the effect of regulation on bank profitability.

Dataset
Data is obtained from bank financial statements.

Variable Description
Similar to other studies, I employ three measures of bank profitability. The choice of ratios is consistent with prior studies (e.g. Guru et al, 1999). The dependent variables are return on asset and net interest margin. Return on assets is measured as profit after tax scaled by total assets.
Return on equity is measured as profit after tax scaled by total equity. Net interest margin is measured as net interest income (interest income less interest expense) scaled by earnings assets interest-earning assets. Independent variables includes five bank-specific variables and three external determinants. Capital adequacy ratio (CAR) measures the ability of bank capital to mitigate the risk of insolvency. It is expected that the higher this ratio, the lower the need for external funding and, therefore, the higher the profitability of the bank. I hypothesize a positive relationship between capital adequacy ratio and bank profitability. Cost to income ratio measures management's ability to control operating cost. It is expected that higher expenses is associated with lower profitability, therefore, I hypothesize a negative relationship between bank's costincome ratio and profitability and vice versa. Asset quality (AQ) measures how much provision banks set aside against loan losses on its loan portfolio. In theory, a positive relationship between asset quality and profitability is expected. Similarly, theory predicts a positive relationship between bank size and bank profit. Also, in theory, a positive relationship between bank profitability and the inflation variable is expected because high inflation rates are associated with high loan interest rates and, thus, high interest income. In theory, growth in real GDP rate in periods of low risk of default on bank loans leads to increased demand for bank services, therefore, improving bank profitability, thus, a positive relationship is expected.
However, in periods with high risk of default on loans, a negative relationship might be expected. Regulation is expected to affect bank performance but it is difficult to predict this sign.
The regulatory dummy variable equals one in the post capital regulation regime and zero, otherwise. A significant positive sign on this variable indicates that capital regime improves bank profitability while a significant negative sign suggests that the capital regimes negatively affect bank profitability. Table 1 presents the descriptive statistics for the full sample. The mean and median value of ROA, NIM, CAR appears to be normally distributed while CI, AQ, INFR, GDPR appears to be less normally distributed. Table 4 shows the Pearson correlation coefficients of the sample variables. Table 4 show that NIM is significantly correlated with AQ and GDPR and is consistent with apriori expectations, relative to ROA. REG coefficient is not significant but is negative for NIM and positive for ROA. This might suggest that capital regulation was intended to decrease risk-taking associated with bank interest activities. However, the insignificant sign on both measures of profitability do not support this inference. ROA reports a significant positive relationship with BSIZE which suggests that economics of scope in banks make them more profitable. GDPR and CI coefficients show a significant negative sign with ROA.

Results and theoretical consistency
First, I observe the sign on the coefficients in Table 2 to identify consistency with theoretical expectations. The signs on CAR, CI and AQ, is consistent with apriori theoretical expectations while GDPR and INFR show conflicting signs. Note: T-statistics is significant at *10%, **5% and ***1% significance levels

Determinants of Bank Profitability and Regulation
In table 3(i), capital adequacy ratio (CAR) and loan quality (AQ) are significantly related to bank interest margin (NIM) at 10% and 1% level of significance. The significant positive coefficient of the CAR variable is consistent with the findings of Bourke (1989), Berger (1995), Vong and Chan (2006) and Anghazo (1997). The positive sign on AQ coefficient indicates smoothing.
This is consistent with the findings in Ozili (2014). Also, ROA is significantly related with CAR, CI, BSIZE and GDPR. The significant positive sign on BSIZE suggest that large banks are profitable relative to small banks. The significant positive sign on CAR indicates that capital regulation has a positive effect on bank profitability. Overall, capital regulation regime variable (REG) had no significant effect on bank profitability (NIM and ROA).