Banks' profitability, institutions, and regulation in the context of the financial crisis

• Date: 01 April 2020
• Published date: 01 April 2020
• DOI: http://doi.org/10.1002/ijfe.1753

RESEARCH ARTICLE

Banks' profitability, institutions, and regulation in the

context of the financial crisis

João C.A. Teixeira

1

| Francisco J.F. Silva

1

| Fernando A.T. Costa

2

|

Dário M.C. Martins

2

| Maria da Graça Batista

1

1

School of Business and Economics and

Centre of Applied Economics Studies of

the Atlantic, University of the Azores,

Ponta Delgada, Portugal

2

School of Business and Economics,

University of the Azores, Ponta Delgada,

Portugal

Correspondence

João C. A. Teixeira, School of Business

and Economics and Centre of Applied

Economics Studies of the Atlantic,

University of the Azores, Rua da Mãe de

Deus, s/n, 9501‐801 Ponta Delgada,

Portugal.

Email: joao.ca.teixeira@uac.pt

Funding information

Fundação para a Ciência e a Tecnologia,

Grant/Award Number: UID/ECO/00685/

2019

Abstract

This paper empirically examines how banks' dividend policy, the institutional

environment, and banking regulation affects banks' profitability using panel

data of a sample of 567 banks, mainly from Organisation for Economic

Cooperation and Development countries, for 2004–2015. It further examines

whether the effect of the institutional environment and banking regulation

varies for crisis and noncrisis years. The estimation results reveal that banks'

dividend policy influences positively banks' profitability, whereas higher levels

of the institutional environment or stricter banking regulation reduces banks'

profitability. The negative effect of the institutional environment and banking

regulation was of lower magnitude during the global financial crisis, followed

by the Eurozone crisis, and for less‐developed countries and larger banks.

KEYWORDS

bank profitability, bank regulation, dividend policy, financial crisis, institutions

JEL CLASSIFICATION

G01; G21; G28; P26

1|INTRODUCTION

The global financial crisis that started in 2007 quickly

turned into a global recession and changed the way most

financial institutions operate, as they had to comply with

an economic cycle of lower demand, more difficult

financing conditions, and stricter regulation. These

structural adjustments in the economy and the reforms

of the financial system may have had an important effect

on banks'profitability and, consequently, on banks'capacity

to survive in the short run. Therefore, it is important to

study the determinants of banks' profitability in the context

of the global financial crisis.

Althoughthere is a vast literature that studieda broad set

of bank‐specific, industry‐specific, and macroeconomics

determinants of banks' profitability (e.g., Albertazzi &

Gambacorta, 2009; Micco, Panizza, & Yañ ez, 2007;

Pasiouras & Kosmidou, 2007), there are still some i mportant

issues that deserve to be further investigated.

First, on the set of bank‐specific determinants, the

effect of the dividend policy is still unexplored. A recent

study by Ashraf and Zheng (2015) recognizes that the

dividend policy may even be more important for banks

than for nonfinancial firms, as dividends may increase

banks' external ratings (Bolding & Legget, 1995), may s ignal

future growth opportunities (Abreu & Gulamhussen, 2013),

or may reveal banks' financial robustness (Teixeira, Silva,

Fernandes, & Alves, 2014). In this context, it is particularly

important to understand how banks' dividend policy

influences future profitability.

Second, a factorthat deserves further investigation on its

effect on banks' profitability is the institutional environment,

especially due to the mixed empirical evidence in this area.

Although Beltratti and Stulz (2012) found a negative

Received: 22 May 2018 Revised: 5 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1753

Int J Fin Econ. 2019;1–24. © 2019 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 1

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association between the institutional environemnt and

banks' performance, Hartwell (2015) found a positive

association. Their results appear to be conditional on the

type of sample,as the effect of the institutional environment

may depend on the level of development of each country, in

particular on the stability of the institutions. One important

question that needs clarification is whether the effect of

the institutional environment on bank's profitability differs

for transition economies and Organisation for Economic

Cooperation and Development (OECD) countries.

Third, it is important to extend the analysis on the

effect of banking regulation on banks' profitability, in

particular on banks' return on assets. The literature in

this area concentrates on the effect on bank's equity

returns (Beltratti & Stulz, 2012) or on some performance

measure (Kalyvas & Mamatzakis, 2014). Moreover, i t is still

unexplored the study of the effect of a tightening of recent

prudential regulatory measures on banks' profitability.

Finally, the investigation of the effect of the

institutional framework and banking regulation on

banks' profitability should take into consideration the

global financial crisis or even the Eurozone crisis. These

two crises were important drivers of changes in the

institutional framework and the regulatory environment

across the world, so it is particularly salient to examine

whether the effect of institutions and regulation was

more or less pronounced during these crises, as suggests

some of the empirical evidence (Beltratti & Stulz, 2012;

Hartwell, 2015).

This paper addresses these four questions and,

hence, contributes to a better understanding of the

determinants of banks' profitability in the context of the

global financial crisis.

Using panel data of a sample of 567 banks, 246 from

Europe and 321 from the United States, spanning 20

countries, for the period 2004–2015, we find that banks

that pay more often dividends or higher dividend yields

tend to be more profitable in the future. In addition, the

overall effect of a higher institutional framework or

stricter banking regulation on banks' profitability is

negative, although not constant across crisis and noncrisis

years: the negative effect was less pronounced during the

Eurozone crisis and even less pronounced during the

global financial crisis. Furthermore, we find evidence

that this negative effect is of lower magnitude for

less‐developed countries and larger banks. Finally, we

find that European banks had, on average, outperformed

U.S. banks for 2004–2015 and the global financial crisis of

2008–2009 clearly reduced banks' profitability.

This paper contributes to the empirical literature of the

determinants of banks' profitability as follows. First, it

extends the typical profitability model of the literature

by incorporating, as a novelty, the dividend policy and,

at the same time, includes, in an innovative way, the

countries' rating as an explanatory variable. This is, as

far as we are concerned, the first paper to investigate

the direct effect of the dividend policy on banks' returns

on assets. Second, it contributes to the literature on the

relation between the institutional framework and banks'

profitability, in particular the studies by Beltratti and

Stulz (2012) and Hartwell (2015), by examining if the

effect of the institutional environment varies through

the years of the global financial crisis and the Eurozone

crisis as well as for more developed countries and larger

banks. Third, it extends the literature on banking regula-

tion and profitability, as Beltratti and Stulz (2012), Lee

and Hsieh (2013), and Kalyvas and Mamatzakis (2014),

by explicitly estimating the effect of banking regulatory

measures on banks'return on assets, for crisis and noncrisis

years, for more developed countries and larger banks,

and the effect of a tightening of prudential regulatory

instruments. This is, as far as we are concerned, the first

study to examine the effect of a tightening of prudential

tools on banks' profitability.

The remainder of this paper is organized as follows.

Section 2 presents the related literature on the predicted

effect of the dividend policy, institutional framework,

and banking regulation on banks' profitability, whereas

Section 3 examines the data and methodology. Section 4

debates the estimation results and the corresponding

robustness checks. Section 5 concludes.

2|RELATED LITERATURE

2.1 |The effect of dividend policy on

banks' profitability

As pointed out by Ashraf and Zheng (2015), according to

the “substitute hypothesis,”managers can use dividends

payouts as a substitute for weaker investor protection.

This idea follows Brockman and Unlu (2009) argument

that the substitute hypothesis explains the connections

between the agency costs of debt, creditor's rights,

and observed dividends payouts, as restrictive dividend

policies substitute for weak creditor's rights.

The banking literature is scarce on discussing the

direct relation between banks' dividend policy and their

profitability. However, as discussed by Ashraf and Zheng

(2015), some of the literature highlights that the dividend

policy may even be more important for banks than for

nonfinancial firms. For instance, Baker, Dutta, and Saadi

(2008) find that managers of financial firms put more

preference on dividends as a signalling device than the

managers of nonfinancial firms. Bolding and Legget

(1995) provide empirical evidence that dividend payments

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