Determinants of Bank Profitability in Different Business Cycles

Abstract

This thesis examines bank performance drivers in the Nordic countries during and before the financial crisis of 2007-2009. Due to the nature of banks’ operational model, banks always expose to many kinds of risk. As seen in the latest financial crisis, disturbances in the financial market can have a devastating impact in the entire economy. Thus, knowing what drives bank performance and risks across business cycles is important information for the entire economy.

Previous studies have found that bank-specific and macroeconomic variables affect bank profitability. This thesis investigates the factors that explain bank profitability in the Nordic countries before and during the crisis. Generalized Method of Moments (GMM) is used for the dynamic panel data. Three time periods, the entire time period of 2000-2009, pre-crisis period of 2000-2006 and the crisis period of 2007-2009, are studied to investigate the differences in the performance determinants. The sample is an unbalanced panel consisting of 368 banks in four countries.

The results imply that bank-specific and macroeconomic variables affect bank performance. Sufficient fiscal buffers allowed banks to perform relatively well in the Nordic countries during the financial crisis. Still, profitability declined substantially. Capital ratios declined, costs relative to income and funding costs rose substantially, loan loss reserves decreased and loan intensity rose. Similar banks performed well in the pre-crisis and crisis periods. Banks with more capital performed better in both periods. The positive impact is greater in the crisis when capital buffers allowed banks to absorb losses and banks with more capital got cheaper funding. Cost-to-income ratio has a negative impact on performance implying that more efficient banks peformed better. Share of interest income has a minor negative impact in performance in terms of ROAA and ROAE suggesting that more diversified banks are more profitable while banks focusing more on traditional banking activities have higher NIM. Banks which get cheaper funding perform better due to lower risk level. Bank profits are found to be pro-cyclical and inflation is found to have a negative impact on performance suggesting that banks have not been able to adjust interest rates according to the inflation.