Determinants of income generation power of government owned banks

• Author: Bei Zhao/W.P Wijewardana
• Position: Professor, School of Management, Xiamen University,Xiamen, Fujian Province, PR of China/PhD Candidate, School of Management, Xiamen University,Xiamen, Fujian Province, PR of China

1. Introduction

A key element in customer perception when evaluating a financial institution is its stability and reliability. This is especially so when changes in the macro and competitive business environments take place bringing with it a diversity of negative factors that can shake the foundations of a financial institution. As a financial institute has over the years experienced it is able to withstand any economic or financial crisis [Anne L. Beatty, Bin Ke, Kathy R, Petroni, 2002]. On the other hand, a steadily growing sign of the bank’s income is the main criteria to measure the financial stability and reliability of the bank. Commercial banks have long been subject to explicit or implicit limits on their income generating ability. Banks earn their income through several different ways. Bankers often argue that high income generating ability to earn higher return is due to gradual increase in income rather than the overall cost low. Banker uses different types of income generating strategies [Robert DeYoung and Tara Rice, 2004]. Some banks use traditional banking strategies and methods such as low cost household deposits in exchange for interest payments and transaction services and earning a profit by lending those funds to business and other customers at higher interest rates, pawing at a higher interest. Other banks use non-traditional strategies and methods, such as credit cards and debit cards. Banks or mortgage banks that offer few depositor services, sell off most of their loans soon after making them, and earn profits from the fees they charge for servicing these loans. In between these two strategies lie a range of traditional and non-traditional approaches to banking focusing on the serving of customers nationwide. Banks use these strategies and methods in a competitive and complex business environment.

Prior to the 1980s, sources of income generation of the government owned commercial banks were relatively homogeneous and maintained pure monopoly power in the market. This strategic variety is a byproduct of two decades of deregulation and technological changes in the structural dimensions of assets and liabilities management. These changes are remarkable and it is essential that they focus. On the present customer needs and attitudes which directly influence income of the banks. After the 1990s by sweeping away most monetary restrictions and other restrictions on non state banking and by the expansion of branch banking industry were given the freedom to enter new investor locally or internationally. At present, the financial and banking services industry is among the industries that have been most altered by technological changes. Loans and advances in information flows, communications infrastructure, and financial markets have altered the way in which banks assess the creditworthiness of their loan customers, service their deposit customers, process payments, and produce and distribute nearly all of their other products and services. Automated and computerized network branches, information intensive oriented became more cost effective and efficient due to income volume increased. Entry by large, out-of-non government banking companies has increased competitive rivalry in local state commercial banking markets and created incentives for increased efficiency at local banks including government and non government banks. Automated credit cards lending and online bill paying are low cost ways to introduce large volumes of traditional banking services, but these processes have changed the nature of retail banking from a high touch, relationship based service to an arm’s length, financial commodity business. These kinds of innovative banking operations positively affect the increasing non banking income as well as the interest income. The income of the state commercial banks mainly depends on its business profile segment. The state commercial banks business profile segments operate into the key areas of retail banking, corporate banking, treasury and international operation, and development banking. Several significant products and services are offered under these remarkable changes. Small banks face these vital changes differently. The major gravity to this conclusion is that very small banks tend to operate at a financial disadvantage, regardless of their business model. In order to earn a market return for their shareholders, banks must capture at least some of the scale economies that are available in banking production functions.

The importance of this paper is three fold. First, we show trends and contribution for income generation in the relative contribution of traditional, non-traditional banking operations and non deposit funding in banks’ assets as well funding mix for a sample period in state own commercial banks. Second, we present empirical evidence on the correlation of the traditional, non-traditional and different funding shares, by examining how these variables are related to selected financial and economic variables. Finally, we measure how different activity mixes and funding patterns are associated with state commercial banks risk and return. Overall aspects examine the income generating power of the sample.

The remainder of this paper is organized as follows. Section two discusses the overview of the study. Section three is devoted to describe the data, sample construction and descriptive statistics. Section four, in turn, analyses the correlation of income and funding. Section five presents the evidence of banks risk. Section six concludes by summarizing the discussion and presenting our results for the viability of different factors for income generation

2. Overview

Similar to company income, banks earn its income by offering their financial products to their customers. Income of the state owned commercial banks can be divided into interest and non-interest income. DeYoung, Robert, and Tara Rice (2004) emphasized that the non-interest income now accounts for nearly three third of all operating income generated by commercial banks. The increasing importance of non-interest income at commercial banks is a direct result of structural changes. Conversely, Banks compete the complicated market competition they must diversified their income both interest and non-interest income. Ability to generate the income of the bank is mainly based on its asset and liability composition. In addition, in the background of the favorable economic performance is the factor for bank incomes. Favorable economic performance is evidenced by lower inflation, increased in export earnings and external resources, decline in market interest rate, relatively stable exchange rates, curtail recurrent expenditure etc. As a bank, these economic performances affect the reductions and continued liquidity in the market, and call market rates too declined resulting in a reduction in leading rates of state commercial banks.

Reduction of interest costs and improvement of the operating income are the significant drivers in the growth of income due to favorable behavior of the macroeconomic indicators. Low interest expenses on customer deposits and other borrowed funds reductions are favorable factor to the income growth. Recoveries of substantial amount of non- performing loan (NPL) favorably affect the growth of bank performance. The extensive progress in state bank income has three fundamental causes:(i) improved cost and revenue efficiency due to advances in information technology (ii) financial processes; improved cost and revenue efficiency in response to the competitive pressures brought on by industry deregulation; and (iii) the generally improved banking environment, as reduced loan loss provisioning.

It is important to consider, when increasing the bank income, management must be...