The conundrum of profitability versus soundness for banks by ownership type: Evidence from the Indian banking sector

Abstract

Banks pursue profit like any business, but in their role as custodians of domestic savings, they are required to be cautious. Riskier but profitable advances may cause asset quality deterioration, thus affecting the long-term viability of the entity. Financial sector reforms in India from the early 1990s, have raised the level of competition for banks of different ownership types — public sector (PSB), old private banks, new private banks, and foreign banks. We use panel data on 75 banks across the ownership spectrum, for the period 2000–13, to examine their performance vis-à-vis these two measures — profitability and soundness. We find evidence of significant heterogeneity in performance across ownership type. Overall, we find that there is a negative association between the profitability and soundness measures, though these effects vary by ownership type. PSBs, constrained by social outreach commitments, perform comparatively worse. A reluctance to increase commercial loans implies a lack of investment in the knowledge capital necessary for effective risk management. The smaller old private banks have a dedicated client base; despite the pressure of non-performing assets, they remain profitable. Foreign banks maintain high capital adequacy ratio and relatively higher return on assets. The results also provide evidence that good human resource policy is vital for bank performance.