# Abstract relationship between internal factors and bank profitability

Abstract

The soundness of a country’s economy has a close connection with its banking system. If banks are not capable of providing funds or capital towards small potential businesses, they are unable to spread their influence at a higher level which potentially will help with economic growth. Thus, failure of the banking system would also mean the failure of the economy to grow higher due to insufficient of funds. The purpose of this paper is to investigate the relationship between internal factors and bank profitability that is aimed specifically at local commercial banks located in Malaysia within the period of 8 years, from 2009-2016. This research paper involves eight local banks listed in the Bursa Malaysia. There are five independent variables consistings of internal factors, and the dependent variables are measured by using the return on asset (ROA) and return on equity (ROE). Data are tested by using the Spearman Rank correlation analysis, and the result shows that the variables are insignificant with dependent variables. The limitation of this paper is time series of data used which are not sufficient to find any significant relationship between variables in this research. The result could probably be significant if the study is conducted at within a longer period of time.

Keywords: Bank Profitability, Commercial bank, Internal Factors, Augmented-Dickey Fuller test, Bursa Malaysia.

1. Introduction

The banking industry plays a pivotal role in providing capitals whereby the financial intermediaries would be channelling the funds to companies or institutions that is are in dire need of funds to expand their businesses. Presence of the banking sector has helped decrease the unemployment rate as well. The banking sector is well known for giving financial advices to their customers regarding funding, and it also creates job opportunities towards for the Malaysian citizens itself. It is important for banks to be sustainable in terms of their profitability performance as it acts as an indicator of success of the management, and it is also one of the attractive sights that investors would look for.

The purpose of this paper is to investigate the relationship between internal factors and bank profitability that is aimed specifically at local commercial banks located in Malaysia in the period of 8 years, from 2009-2016. This research paper involves eight local banks listed in Bursa Malaysia.

This paper highlights the relationships between five independent variables consistings of internal factors and dependent variable, which is the bank profitability which that are measured by using return on asset (ROA) and return on equity (ROE). Data are then being tested by using Augmented Dickey-Fuller (ADF) for unit root test and Shapiro-Wilk to test the normality of variables. To test correlation analysis between variables, Spearman Rank Correlation was used to investigate and the relationship between two quantitative and continuous variables.

2. Review of literature

As financial intermediaries, banks profitability play a significant role in the economic activities and growth of most nations. The banking sector profitability contributes in economies and makes economies to endure negative and external financial shocks and contribute in financial system stability (Athanasoglou et al., 2005). For banks profitability, ROA is a common measure to analyse and evaluate the ability of banks to generate return from its sources of funds to produce profit. ROE represents the effectiveness of bank management in handling the shareholders’ funds to generate profits.

Capital adequacy shows the strength of banks and sufficiency amount of banks’ equity to absorb any shocks that the banks may experience and reflects the ability of the banks to withstand losses or financial risks. According to Hassan and Bashir (2003), capital adequacy indicates a negative relationship with bank performance.

Bank size is one of the important factors that influence bank profitability. Based on Dietrich and Wanzenried (2011), there is a positive and statistically significant relationship between bank size and bank profitability because large banks have high degree of loans and product diversifications compared to small and medium banks.

Previous study by Sufian and Habibullah (2009) found a negative relationship between operating efficiency with ROA, and it is not not a significant correlation. Operating efficiency does not contribute to bank profitability as much as other independent variables, but it reflects the ability of bank management.

Banks rely significantly on customer deposits to allocate credits to other customers. Menicucci and Paolucci (2015), shows that the deposit variable has a positive and significant impact on bank profitability. Thus, banks will be able to provide more loan opportunities to customers and generate more profits if they are able to gain high deposits.

Loan loss provision is an indicator to measure the effect of a bank’s asset quality on profitability. The bank will experience high default risk if bank’s asset quality is bad as it is directly reducinged the interest income and loan provision will be higher. Therefore, it can affect the banks’ profitability. Menicucci and Paolucci (2015) found that there are is a significant but negative relationship between Loan Loss Provision and bank profitability.

The hypotheses are as below:

i. Capital Adequacy

H0: There is no significant relationship between capital adequacy and commercial bank profitability.

H1: There is a significant relationship between capital adequacy and commercial bank profitability.

ii. Bank Size

H0: There is no significant relationship between bank size and commercial bank profitability.

H1: There is a significant relationship between bank size and commercial bank profitability.

iii. Operating Efficiency

H0: There is no significant relationship between operating efficiency and commercial bank profitability.

H1: There is a significant relationship between operating efficiency and commercial bank profitability.

iv. Deposit

H0: There is no significant relationship between deposit and commercial bank profitability.

H1: There is a significant relationship between deposit and commercial bank profitability.

v. Loan Loss Provision

H0: There is no significant relationship between loan loss provision and commercial bank profitability.

H1: There is a significant relationship between loan loss provision and commercial bank profitability.

3. Research Design and Methodology

This research paper involves eight local commercial banks listed in Bursa Malaysia. The data used are secondary data that were collected from annual reports of each banks over the period of 8 years from 2009-2016. As this paper are studyingstudies group of banks, the best sampling types is purposive sampling because it is a non-probability sampling method. Local commercial banks are being selected as sampling population because this study only focuses on local commercial banks that are listed in Bursa Malaysia.

Bank size, capital adequacy, operating efficiency, deposits and loan loss provision are independent variables in this research paper while bank profitability acts as the dependent variable that are measured by using ROA and ROE.

Shapiro Wilk test is used because the sample size is considered small and will be able to identify whether the data are normally distributed or not. The Ttest conducted for reliability test is the Augmented Dickey-Fuller (ADF) test, where it is the simplest approach to test for a unit root. ADF is utilized for a larger and more complicated set of time series models. Spearman’s Rank correlation coefficient is used for correlation analysis to identify and test the strength of a relationship between two sets of data in this research paper.

4. Findings

· Shapiro-Wilk test

Variables

P-Value

ROA

ROE

Bank Size

Operating Efficiency

Capital Adequacy

Deposit

Loan Loss Provision

0.439

0.122

0.677

0.811

0.000

0.136

0.024

Table 1: Shapiro-Wilk test

Table 1 represents the normality test that have been conducted by using the Shapiro-Wilk test in SPSS. This test is conducted in order to see whether or not the data are normally distributed. Data are considered normally distributed if the p-value is more than 0.05. Based on the table, it shows that the data are normally distributed for all the other variables besides Capital Adequacy and Loan loss provision where the p-value shows a result that is less than 0.05.

· Augmented Dickey-Fuller (ADF) Test

Level and Intercept

Probability

Bank Size

0.2828

Capital Adequacy

0.1244

Operating Efficiency

0.0000

Deposits

0.2249

Loan Loss Provision

0.2249

Table 2: Augmented Dickey-Fuller (ADF) Test

The Augmented-Dickey Fuller test that can be observed in table 2 is conducted in order to see whether or not the data used are stationary. If the result shows a p value higher than 0.05, it can be concluded that the data are stationary. Based on the findings, it can be observed that all variables are stationary except for one which is Operating Efficiency.

· Spearman Rank Correlation

Variables

N

Correlation Coefficient

Sig. (2-tailed)

ROA

Bank Size

Operating Efficiency

Capital Adequacy

Deposit

Loan Loss Provision

8

8

8

8

8

-0.571

0.024

-0.515

0.381

-0.310

0.139

0.955

0.192

0.352

0.456

ROE

Bank Size

Operating Efficiency

Capital Adequacy

Deposit

Loan Loss Provision

8

8

8

8

8

-0.143

0.167

0.072

-0.143

-0.563

0.736

0.693

0.866

0.736

0.146

Table 3: Spearman Correlation

The table above denotes the Spearman Correlation result on the independent variables which are tested on both the dependent variables ROA and ROE. The significant 2 tailed result shows whether or not the variables are significant or not in comparison with the dependent variables. Based on the significant value between dependent variables and independent variables, it shows that our variables are considered insignificant, and we have failed to reject null hypothesis as mentioned previously in our review of literature, where we say that there is no significant relationship between independent variables and ROA.

· Descriptive Statistics

Variables

N

Minimum

Maximum

Mean

Std. Deviation

Dependent Variables

ROA

ROE

8

8

9.4322

0.9466

14.5233

1.2176

12.492113

1.096863

1.8259930

0.1115284

Independent Variables

Bank Size

Operating Efficiency

Capital Adequacy

Deposit

Loan Loss Provision

8

8

8

8

8

139372354.13

0.0838

0.0127

0.7120

0.0014

288400839.63

0.2028

0.0153

0.8295

0.0067

216728291.28

0.104350

0.014088

0.791725

0.002938

55569250.7

0.0403218

0.0008425

0.0380923

0.0017517

Table 4: Descriptive Statistics

Table 4 represents the result that is obtained from running a descriptive statistic on both the dependent and independent variables. The N denotes the sample size of our research, and there is a total of 8 sets of data collected from 2009 – 2016. The bank profitability is measured by ROA and ROE and based on the mean value of both variables, it shows that ROA has a mean score of 12.492113 while the ROE is 1.096863. The standard deviation is 1.8259930 and 0.1115284 for both ROA and ROE respectively. There are five independent variables that are used in this study. The Bank Size shows a mean of 216728291.28 with a standard deviation of 55569250.7 while the Operating Efficiency shows a mean of 0.104350 and a standard deviation of 0.0403218. Meanwhile, the mean for the other three variables, Capital Adequacy, Deposits, and Loan Loss Provisions are 0.014088, 0.791725, and 0.002938 respectively. The standard deviation follows with 0.0008425, 0.0380923, and 0.0017517 for Capital Adequacy, Deposits, and Loan Loss Provisions.

5. Conclusions

WithIn regards to the soundness of the economy, it can be observed from a healthy financial sector which can be seen from the profitability of the local banks of the country itself. The purpose of this research is to investigate the relationship between internal factors and bank profitability that is aimed specifically at local commercial banks located in Malaysia.

This research focuses on local commercial banks, and the research findings reveals that there are no significant relationships between bank profitability towards the independent variables which are Bank Size, Capital Adequacy, Operating Efficiency, Deposit, and Loan Loss Provision.

The limitation of this research would be the small sample size that have been observed from the year 2009 – 2016. Perhaps in future research, in order to widen the sample size, the sample size could be increased by comparing the performances of local commercial banks and foreign commercial banks that to investigate the factors that lead to banks profitability.