Determinants of bank profits and its persistence in Indian Banks: a study in a dynamic panel data framework

Abstract

The paper examines the impact of bank-specific, industry-specific and macroeconomic factors affecting the profitability of Indian Banks in a dynamic model framework. The persistence of bank profits and endogeneity of the factors had been accounted for using Generalised Method of Moments as suggested in Arellano and Bond (Rev Econ Stud 58(2):277–297, 1991). The panel data for the study have been obtained from 42 Indian Scheduled Commercial Banks for the period from 2000 to 2013. The lag of bank profit variable ROA has been found to be significantly indicating a moderate degree of persistence of profits in Indian Banking Industry. The study finds that the product markets of Indian Banks are moderately competitive, and less opaque due to asymmetry in information. The adjustment towards equilibrium is partial and not instantaneous, implying that the elimination of abnormal profits through competition is by no means instant, and banks can continue to retain a significant percentage profits from 1 year to another. The Indian banking sector is not far away from becoming a perfectly competitive industry. Bank-specific variables; capital to assets ratio, operating efficiency and diversification have been found to be significantly and positively affecting the bank profits. Credit risk, measured by provisions for bad debts, negatively impacts the bank profitability. The study also tests the Structure Conduct Hypothesis by using Herfindahl–Hirschman Index and finds evidence in its support. Bank profits respond positively to GDP growth, indicating that bank profits are pro-cyclical to the growth of economy whereas the increase in inflation rate affects bank profits negatively. It is observed that the crisis period did not make any significant impact on the profitability of banks. The study concludes that there is a moderate degree of persistence of bank profits, and most of the determinants of profits have a positive and significant impact on profitability of banks, which implies that Indian Banks in the last decade have been moving towards efficiency and dynamism.