Factors Affecting Profitability of Comme

© 2019 IJRAR March 2019, Volume 6, Issue 1 www.ijrar.
org (E-ISSN 2348-1269, P- ISSN 2349-5138)
Factors Affecting Profitability of Commercial Banks

in Ethiopia
Tadesse Wubie Abate1 and Enyew Alemaw Mesfin2
1
Lecturer, Department of Accounting and Finance, Jinka University, Ethiopia
2
Research scholar, Department of Commerce and Management, Andhra University, India
Abstract
This study examines the bank-specific, industry-specific and macro-economic factors that affect bank profitability
of nine commercial banks in Ethiopia, during the period of 2007-2016. To this end, the study adopts a quantitative
method of research approach and 9 sample commercial banks were purposively selected from 18 banks operating
in Ethiopia. Random effect regression model was run to analyze the raw data collected through audited financial
statements. The findings of the study show that capital adequacy, leverage, liquidity, and ownership have
statistically significant and positive relationship with banks’ profitability. On the other hand, operational
efficiency GDP, inflation and interest rate have a negative and statistically significant relationship with banks’
profitability. However, the relationship between bank size and number of branch is found to be statistically
insignificant. Therefore, Ethiopian commercial banks should not only be worried about internal structures and
rules, but they have to give attention for both the internal and the macroeconomic variables together in fashioning
out plans to pick up their performance.
Key Words: Profitability, Internal Factors, External Factors, Commercial Bank
Introduction
The financial system plays a fundamental role in the economic growth and development of a country. The
significance of a well-ordered financial sector lies in the reality that ensures domestic resources mobilization,
making of savings and investments in the sectors. Actually, this financial system is the system by which a country
needs the most profitable and efficient sectors to make more productive bases for future growth. The major
function of a financial system is not only to shift funds from savers to investors but also to make sure that funds
are being transferred to the sectors which are most essential for an economy. Bank performance gets a great deal
of consideration in the finance literature bearing in mind that banks serve as a critical role in the economy (Bekalu
and Abel, 2017).
Financial institutions play a vital role for bringing financial stability and economic growth through their expected
contribution by mobilizing financial resources across the economy (Masood & Ashraf, 2012). Banks, as financial
institutions, act as an intermediary in the economy by channeling financial resources from those surplus economic
units to deficit economic units. This role is their important role in the developing economies (Felix Ayadi et al.,
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© 2019 IJRAR March 2019, Volume 6, Issue 1 www.ijrar.org (E-ISSN 2348-1269, P- ISSN 2349-5138)
2008 and Zhang et al., 2013). A sound and profitable banking system is better able to improve financial system
stability and economic growth as it makes the economy more endurable to negative and external shocks
(Athanasoglou et al., 2008). On the other hand, insolvency of the system leads to economic crisis (Chaplinska,
2012, Fang et al., 2014 and Fu et al., 2014). Moreover, profitability is considered as precondition for an
innovative, productive and efficient banking system (Chen & Liao, 2011). Therefore, investigation of the
determinants of profitability is vital for the growth and stability of the whole economy.
Throughout the past two decades the banking sector has experienced universal major change in its working
environment. Both external and domestic factors have affected its structure and performance. Despite the
increased tendency toward bank disintermediation observed in many countries, the role of banks left overs central
in financing economic activity in general and diverse segments of the market in particular. A sound and profitable
banking division is better to resist negative shocks and contribute to the consistency of the financial system.
Consequently, the factors that affect bank performance gets the attention of academic researchers as well as bank
management, financial markets and bank supervisors (Athanasoglou et al., 2008).
The profitability of a bank is influenced by several factors. These determinants may be related to the banks overall
management activities on capital structure, liquidity, credit risk, loan portfolio, expense and diversification of a
bank’s line of products or activities. The external factors may consists factors linked to the degree of competition
in the banking business, barriers of entry and exit from the industry, speed of economic growth, regulation and
supervision of the industry, inflation, financial deepening, and financial and physical policies, are among others
(Rao & Tekeste, 2012). The aim of this study is to examine factors affecting the profitability of commercial banks
in Ethiopia.
Review of Empirical studies
In the literature there are three main alternative measures of profitability, namely ROA, ROE and NIM1. Many
scholars recommend that ROA is the major ratio for the assessment of bank profitability given that ROA is not
distorted by high equity multipliers, while ROE disregards the risks related with high leverage and financial
leverage Sufian, (2011). A number of studies used ROA as measurement of profitability, for instance, (Pasiouras
& Kosmidou, 2007); Athanasoglou et al., 2008 and Olweny & Shipho, 2011). Thus, this study tried to measure
profitability by employing ROA as most of the above mentioned researchers. As noted in Olweny & Shipho
(2011), ROA is measured as net profit divided by total assets2.
1
Return on assets, return on equity and net interest margin respectively.
2
Net profit after tax divided by total assets
The factors are classified into bank specific, industry-specific and macroeconomic factors as previous researches
in the determinants of banks profitability (Athanasoglou et al., 2008; Flamini et al., 2009 and Sastrosuwito &
Suzuki, 2011). The internal factors are bank size, capital adequacy, liquidity, leverage, and operational efficiency.
Bank size is measured by logarithm of total assets (log A). Bank size accounts indicates the existence of
economies or diseconomies of scale (Naceur & Goaied, 2008). Theoretically, a firm enjoys economies of scale
up to a certain level, beyond which diseconomies of scale set in. This implies that profitability increase with
increase in size, and decrease for the moment is diseconomies of scale. Hence, the literature has shown that there
may be positive or negative relation between the bank size and profitability, but most empirical studies shows
that there is a positive relationship between them (Staikouras and Wood, 2004; Athanasoglou et al., 2005; Flamini
et al., 2009; Dietrich and Wanzenrid, 2009).
Capital adequacy is significantly and positively related with bank profitability (Wasiuzzaman and Gunasegavan,
2013 and Perera et al., 2013). This result validate the fact that well-capitalized banks can pursue business
opportunities more successfully and obtain deposits and other funding at small cost and has more time and
flexibility to deal with problems arising from unanticipated losses.
Liquidity represents the ability of banks that customers deposit can be met if they withdraw at any time. The
ratio of liquid assets to total asset is used to measure the liquidity of a bank (Rao & Tekeste, 2012). As noted by
Daniel, (2011) the total debt ratio is considered as a proxy for leverage.
Cost income ratio (CIR) reflect bank’s operational efficiency and it is defined as non interest costs divided by
total of interest income and non-interest income (Dietricha and Wanzenriedb, 2009). According to Athanasoglou
et al. (2005) investigation on Greek banks during the period 1985-2001 observed that operating expenses appear
to be an important determinant of profitability. Efficient expenses management was one of the most significant
factor in explaining high bank profitability (Guru et al., 1999).
A dummy variable was assigned to ownership of banks. Noman, et al., (2015) suggests that both development
banks and private commercial banks are more profitable and better performed than public commercial banks in
Bangladesh. Ummeran, (2011) also noted that government owned banks perform worse compared to the
shareholder owned banks.
The gross domestic product growth is use as a measure of macroeconomic conditions in this study. There is a
positive relationship between economic growth and profitability of commercial banks (Bikker et al., 2002, and
Athanasoglou et al., 2008). Therefore, a positive relation between real GDP growth and profitability is expected.
Inflation rate is another important macroeconomic variable and its effect is depend on whether the inflation is
anticipated or unanticipated (Perry, 1992). If inflation is anticipated, the interest rates are adjusted accordingly,
which results increase in revenues faster than costs and will have positive effect on profitability of banks. On the
contrary, in unanticipated case, banks may be weak in adjusting their rates of interest resulting in a faster increase
cost of banks than revenues and accordingly, having negative effects on the profitability. However, most
empirical studies, for instance, Amdemichael (2012) and Melaku (2016) found a negative relationship between
inflation and profitability. So, the expected impact of inflation on banks profitability is negative.
Another macroeconomic determinant that affects profitability is interest rate. The interest rate spread, i.e. lending
interest minus deposit interest, is the measurement of interest rate. A positive relationship is expected to have
between interest rate and profitability in the heart of lend-long and borrow-short argument (Vong and Chan,
2008).
Research methods
To achieve the stated objective explanatory research design is employed and the design helps to identify and
evaluate the causal relationships between the different variables under consideration (Marczyk et al., 2005). For
the study the target population was all commercial banks registered by NBE and under operation currently.
Currently, the country has one public-owned and seventeen private commercial banks which are operating
throughout the country (NBE, 2017). But only 9 selected banks are taken because of lack of 10 years data that is
required for the analysis purpose purposively.
The panel data collected was analyzed using descriptive statistics, and OLS random effect panel linear regression
analysis. The rational for using OLS is that it outperforms the other estimators when the cross section is small
and the time dimension is short Petra (2007). To do so, the following general multivariate regression equation
was adopted:
𝑱 𝒋
𝝅𝒊𝒕= αi+ ∑𝒋=𝟏. 𝜷𝒋 𝑿𝒊𝒕 +∑𝑴
𝒎=𝟏 𝜷𝒎 𝑿𝒊𝒕 +𝒖𝒊𝒕, 𝒖𝒊𝒕 =𝝁𝒊 +𝒗𝒊𝒕, ……………… (1)
𝒎
Where 𝜋𝑖𝑡 is the profitability of banks i at time t, αi is a constant term and 𝑢𝑖𝑡, is the error term. The explanatory
𝒋
variables are divided into 1×m vectors of bank-specific (𝑿𝒊𝒕 ) and macroeconomic variables (𝑿𝒎
𝒊𝒕 ) where m refers
to the number of slope parameters for the different variables classes. Here, the model includes a one-way error
term 𝒖𝒊𝒕 , capturing a bank-specific or fixed effect (𝝁𝒊 ) and a remainder or idiosyncratic effect that vary over time
and between banks (𝒗𝒊𝒕, ). Given, the model stated in equation (1) above it can be specified as follows.
ROAit= α+ β1 BSit + β2 CAP it + β3 LQit +β4 LEVR it+ β5 OE it + β 6 NB it +𝞫7 OWSHP it + 𝞫8 GDPit + 𝞫9 IFLit+ 𝞫10 IRit + ε ……… (2)
Where; ROA= return on asset for bank i at time t, αi = bank specific effect, β= coefficients, ε = the error term
Results and Discussion
In this study diagnostic tests are carried out to ensure that the data fits the basic assumptions of classical linear
regression model. All of the classical regression model error assumptions are fulfilled (see Appendices A, B, C,
D and E).
The selection between fixed effects (FE) and a random effects (RE) model is based on the Hausman test.
According to this test null hypothesis the random effects model is appropriate than the fixed effects model
(Brooks, 2008). The p-value is insignificant, indicating the random effects specification is to be preferred, since
fail to reject the null hypothesis even at 10% significant level.
Table 1: Regression Results for factors affecting Ethiopian banks profitability
Variable Coefficient Std. Error t-Statistic Prob.

C -0.274590 0.065946 -4.163829 0.0001
BS -0.001131 0.001119 -1.010263 0.3158
CAP 0.353185 0.071201 4.960396 0.0000
LEVR 0.409138 0.076007 5.382936 0.0000
LQ 0.034566 0.010289 3.359362 0.0013
OE -0.000820 0.000218 -3.760368 0.0003
OWSHP 0.015041 0.008230 1.827584 0.0719
DNB -0.004045 0.007608 -0.531650 0.5967
GDP -0.246161 0.098550 -2.497817 0.0148
INR -0.011332 0.005624 -2.014853 0.0478
IR -1.053034 0.173249 -6.078158 0.0000
R-squared 0.550508 S.E. of regression 0.006549
Adjusted R-squared 0.486295 Durbin Watson stat 1.650799
F-statistic 8.573129
Prob(F-statistic) 0.000000
Source: Own computation using Eviews 9
From table 1, the R-squared statistics and the adjusted-R squared statistics of the model is 55.05% and 48.63%
respectively. The result indicates that the changes in the independent variables explain 55.05% of the changes in
the dependent variable. That means variables included in the model are collectively explain 55.05% of the
changes in ROA. The remaining 44.95% of changes in ROA is explained by other determinants that are not
incorporated in this model. Consequently, these variables together, are good explanatory variables of the
commercial banks profitability in Ethiopia. As the p-value is very low the null hypothesis of F-statistic that the
R2 is equivalent to zero is rejected at 1% which enhanced the reliability and validity of the model.
As shown in the above table, all internal factors except bank size and number of branch had statistically significant
effect on profitability. On the other hand, all the three macro-economic independent variables used in this study
are significant. Among the significant variables, leverage, capital adequacy, management efficiency, liquidity
and interest rate are significant at 1% significance level. On the other hand, ownership, GDP and inflation are
significant at 5% significance level. Finally, ownership is significant at 10% significance level.
The Table also shows that the coefficient of operating efficiency, GDP, inflation rate, bank size, number of branch
and interest rate against ROA are negative as far as the coefficients for those variables are negative. Hence the
decrease of those factors will increase ROA.
On the other hand, variables like, capital adequacy, leverage, liquidity, and ownership had a positive relationship
with profitability. This revealed that there is a direct relationship between these independent variables and ROA.
In general as per the regression results provided in table 1, among the 10 independent variables used in this study
eight of them are significant.
The coefficient of capital adequacy which is measured by the equity to asset ratio is positive and statistically
significant at 1% significance level shows that an increase in capital adequacy effect in increased profitability.
The positive coefficient for capital adequacy is in favor of the signaling or bankruptcy costs. As noted in (Berger,
1995) the signaling hypothesis dictates that a high equity to asset ratio is a positive signal to the market value of
a bank. The bankruptcy costs hypothesis suggests that in a case where bankruptcy cost are unexpected high a
bank hold more equity to avoid period of distress (Berger, 1995). Further, the finding is as well in compliance
with prior studies of (Almazari, 2014; Amdemikael, 2012; Habtamu, 2012 and Samuel, 2015) and it also point
out that well Capitalized Ethiopian banks face small costs of going bankrupt, which decreases their cost of funding
or that they have low wishes for outside funding which consequences in high profitability.
The ratio of liquid asset to total asset is positive and significant relationship with profitability. Inadequate
liquidity is one of the main causes for failure of banks. The ratio is significant at 1% level of significance. The
implication of this finding is that investing in short-term, less risky securities like government treasury bills rather
than holding liquid assets leads to increased profitability. The finding is consistent with previous studies
undertaking by (Olweny and Shipho, 2011; Dang, 2011; Gemechu, 2016 and Melaku, 2016).
Debit to asset ratio has positive and significant impact on commercial banks profitability. Logically higher debit
to asset ratio indicates, commercial banks get more of their funds from debt financing and they can issue more of
their funds in the form of interest bearing loans, consequently banks can have generating more profit. This
finding is consistent with the risk-return trade off theory which says that enhancing debit to asset ratio and thus
lowering the equity directs to a higher return. Moreover, this result is also consistent with the existed reality in
the Ethiopian banking industry where the leverage is definitely higher.
The coefficient of operational efficiency is negative and statistically significant at 1% significance level. This
indicates that reducing commercial banks operating expenses would certainly increase the banks performance in
general and profitability in particular in Ethiopia. This finding was consistent with previous studies of
Athanasoglou et al., (2008), Sufian & Chong, (2008) and Samuel, (2015). Consequently, the cost to income ratio
is statistically significant in explaining the commercial banks profitability in Ethiopia.
Interest rate spread also a main variable in determining the return on asset of commercial banks in Ethiopia and
is significant at 1% level of significance. The effect of interest rate as measured by interest rate spread is negative.
The result is consistent with (Moges, 2017).
Inflation has a negative relationship with profitability and it is significant at 5% significance level. A negative
relation of inflation and profitability of banks would suggest that Ethiopian commercial banks are unable to expect
or incorrectly predict the impact of inflation in their operational costs to increase earnings during the study period.
This negative relation with profitability is found to be consistent with previous studies of (Kussa 2013; Ally et
al., 2014; Tariq et al., 2014 and Amdemichael 2012) and it is consistent with the findings of (Athanasoglou et
al., 2008). This might be because of the existence of a lower real interest rate which is obviously lower than the
real inflationary rate due to unexpected inflation, resulting in costs increased faster than revenue.
In this study the impact of the economic growth rate on bank performance is negative and it appears a significant
driver of commercial banks performance. The negative effect of gross domestic product shows that high
productivity is adverse for profitability of commercial banks in Ethiopia. The significant negative effect of growth
domestic product on commercial banks profitability is consistent with prior study of (Noman, et al., 2015 and
Ongore & Kussa, 2013). The Recent (2012) data from MOFED indicates that the financial intermediation share
in the GDP is only 2.7%.
As measured by dummies assigned to private owned and government owned commercial banks ownership has a
significant effect on commercial banks profitability at 10% significance level. The result of this study revealed
that private commercial banks are more profitable than public commercial bank in Ethiopia. Their profitability is
greater by 1.5% than government bank. The finding is consistent with the recent study of (Noman, et al., 2015 &
Ummeran, 2011).
Conclusion
This study aims to examine the main internal and external factors that can affect Ethiopian commercial banks
profitability. The study found that both internal and external factors are the major determinants of the profitability
of commercial banks in Ethiopian. Leverage, capital adequacy, liquidity have a direct and significant effect on
banks profitability in Ethiopia. On the other hand, operating efficiency, GDP, inflation, interest rate, annual
inflation rate and interest rate spread are significant and negatively affect the profitability of the banks. Lastly,
bank size and number of branch are factors that have insignificant effect on the profitability of Ethiopian banks.
The Ethiopian banking capital structure provides promising profit for well capitalized banks; therefore, stake
holders are advised to build large capital to asset ratio through selling their share for better solvency and reducing
fund costs, and ultimately to succeed their objectives of maximizing profits. Lastly, the study confirms that having
large amount of leverage enables commercial banks to be more profitable.
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Appendices
Appendix A: Heteroskedasticity Test: White
F-statistic 1.531234 Prob. F(60,20) 0.1457

Obs*R-squared 66.51943 Prob. Chi-Square(60) 0.2626
Scaled explained SS 67.32734 Prob. Chi-Square(60) 0.2408
Appendix B: Breusch-Godfrey Serial Correlation LM Test:
F-statistic 1.475869 Prob. F(6,64) 0.2007

Obs*R-squared 9.845177 Prob. Chi-Square(6) 0.1313
Appendix C: Normality Test
20
Series: Standardized Residuals
Sample 2008 2016
16 Observations 81
Mean -1.23e-16
12 Median 0.000795
Maximum 0.019178
Minimum -0.019651
8 Std. Dev. 0.007389
Skewness -0.217448
Kurtosis 3.172706
4
Jarque-Bera 0.739000
Probability 0.691080
0
-0.02 -0.01 0.00 0.01 0.02
Appendix D: Correlation between independent variables

BS CAP LEVR LQ OE OWSHP NB GDP INR IR
BS 1
CAP -0.371 1
LEVR 0.614 -0.828 1
LQ -0.492 0.058 -0.229 1
OE 0.084 -0.141 0.307 -0.253 1
OWSHP -0.307 0.046 -0.421 0.306 0.048 1
DNB 0.092 -0.064 -0.027 -0.362 0.013 0.026 1
GDP -0.130 0.015 -0.004 0.473 -0.217 -9.25e-17 -0.151 1
INR -0.157 0.062 -0.099 0.289 -0.189 -9.8e-18 0.003 0.518 1
IR -0.201 -0.016 0.037 0.420 0.078 -3.0e-18 -0.337 -0.059 -0.231 1
Appendix E: Unit root test for explanatory variables

Variables P value Stationary at
Return on asset 0.0007 Level
Bank size 0.0110 Level
Capital adequacy 0.0033 Level
Leverage 0.0127 Level
Operational efficiency 0.0015 Level
Liquidity 0.0226 Level
Number of branch 0.0325 First difference
Growth domestic product 0.0003 Level
Inflation 0.0000 Level
Interest rate 0.0031 Level

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© 2019 IJRAR March 2019, Volume 6, Issue 1 www.ijrar.

org (E-ISSN 2348-1269, P- ISSN 2349-5138)

Factors Affecting Profitability of Commercial Banks

Review of Empirical studies

Results and Discussion

Table 1: Regression Results for factors affecting Ethiopian banks profitability

Variable Coefficient Std. Error t-Statistic Prob.

Source: Own computation using Eviews 9

F-statistic 1.531234 Prob. F(60,20) 0.1457

Appendix B: Breusch-Godfrey Serial Correlation LM Test:

F-statistic 1.475869 Prob. F(6,64) 0.2007

Appendix C: Normality Test

Appendix D: Correlation between independent variables

Appendix E: Unit root test for explanatory variables

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