A look inside banking profitability: Evidence from a dollarized emerging country

Abstract

We empirically analyze the determinants of private banking profitability in Ecuador for the period 2002−2017. We contribute to the growing literature in four ways. First, we propose a more robust measure to quantify technical efficiency by using a two stages DEA with a Fractional Response Model. Second, we propose to jointly use three competition – market power measures, in line with the new industrial organization approach, to improve the analysis of industry determinants, which has always been done assessing separately every market power measure. Third, we introduce two new factors that may influence banking profitability: regulatory/institutional variables and dollarization derived factors, to test how being a dollarized (with foreign currency) economy may affect banks’ profitability. Finally, to address the weakness coming from the dynamic form of the Generalized Methods of Moments (GMM), we perform an improved version of it by treating the capital as an endogenous variable and several micro-determinants as given. We also perform some robustness checks by using a Bayesian Model Averaging (BMA) in order to identify a robust set of determinants. Our results show that capital ratio, lending rate, labor productivity, size, efficiency and assets composition are micro-stable determinants of banks ‘profitability. In addition, we found that market power is a strong determinant of Ecuadorians’ banks profitability. Regarding macroeconomic factors, we found that the GDP cycle, inflation and spread are determinants of banking profitability while the regulatory variables did not show any relation. Finally, our results show that dollarization derived factors have an effect on private banking profitability.