Bank profitability and GDP growth in China: A Note

Yong Tan* and Christos Floros

Economics and Finance subject group, Business School, University of Portsmouth, PO1
3DE, U.K.

*Email: [email protected]

ABSTRACT

This article examines the effect of GDP growth on bank profitability in China over the period
2003-2009. The one-step system GMM estimator is used to test the persistence of
profitability in Chinese banking industry. The empirical findings suggest that cost efficiency
is positively related to bank profitability, while lower profitability can also be explained by
higher taxes paid by banks. In addition, there is a negative relationship between GDP growth
and bank profitability. Furthermore, the results show that (1) the profitability in Chinese
banking industry is significantly affected by the level of non-performing loans, and (2)
Chinese banks with higher level of capital have lower profitability. Finally, we find that the
departure from a perfect competitive market structure in Chinese banking industry is
relatively small.

Key words: bank profitability, GDP, GMM, China

JEL Classifications: G21, E00, C23.

 1. Introduction

China’s banking sector is very important in the development of financial system as it

provides support to the economic growth in China [1]. However, the problems of
undercapitalization and large volume of non-performing loans (NPL) need to be solved in
order to improve the stability of the banking sector. The performance of banks, and therefore
their profitability, can be assessed by looking at the NPL as well as other key variables (Beck
et al., 2005). According to Goodhart and Zeng (2006), the NPL balance of state-owned
Chineses banks was RMB1013.5 billion in June 2005, which is lower than the volume of
NPL at the end of 2003 (RMB1916.8 billion). However, after adjusting for transfer of NPL,
the NPL balance of state-owned banks is not significantly lower than 2003. Furthermore, the
highest capital adequacy ratio of Chinese banks is no more than 12%, which is much lower
than the average ratio of listed banks in Hong Kong (18%). This paper examines the
relationship between bank profitability of Chinese banks and GDP using recent data; we also
test (1) if poor profitability is explained by the large volume of NPL, and (2) if banks with
higher capital levels show high probability (Garcia-Herrero et al., 2009).

There are few studies investigating the determinants of Chinese banking profitability. A
principle component approach is used by Shih et al. (2007); they compare the performance of
Chinese banks using several bank-specific factors [2]. The results show that there is no
relationship between bank size and bank profitability. The linear regression model is used by
Fadzlan and Khazanah (2009) to examine the effects of bank-specific and macroeconomic
determinants of state-owned and joint-stock commercial banks in China during 2000-2007.
The findings suggest that banks with larger assets, higher credit risk and higher level of
capital normally have higher profitability, while the lower profitability can be explained by
higher overhead cost. Furthermore, the study shows that there are positive impacts of
economic growth [3] and inflation on bank profitability. The system GMM estimation is used
by Heffernan and Fu (2008) to investigate the effects of bank-specific and macroeconomic
determinants [4] of profitability in China. The results show that GDP growth and
unemployment rate are significantly related to bank profitability in China, while the effects of
non-traditional activity and bank size on bank profitability are insignificant. Garcia-Herrero
et al. (2009) use system GMM method to examine the determinant of bank profitability in
China over the period 1997-2004 [5]. The results show that banks with higher technical
efficiency and higher capital level typically have higher profitability, while the impact of
concentration on bank profitability is negative.

To the best of our knowledge, there is no empirical investigation on the effect of GDP growth
on bank profitability in China while controlling for comprehensive bank-specific and industry
specific variables. Our aim is to investigate three different kinds of determinants affecting
Chinese banking profitability, namely the bank-specific, industry specific and
macroeconomic variables (GDP growth). The first group of bank-specific determinants of
profitability involves bank size, credit risk, liquidity, taxation, capitalization, cost efficiency,
non-traditional activity and labour productivity. The second group of determinants describes
industry-structure factors that affect bank profitability - which are concentration ratio,
banking sector development and stock market development. The third group relates
profitability to the macroeconomic environment within which the banking system operates; in
this context, we include GDP growth among the explanatory variables.

The rest of this article is organized as follows: section 2 describes the empirical model and
data, section 3 reports the empirical results and section 4 concludes the paper and suggests
future research.

2. Data and methodology

We use a sample of 101 banks from China over the period 2003-2009. Because not all banks
have all the information available for each year, our study opts for unbalance panel dataset.
There are mainly three data sources, as follows: 1. Bankscope maintained by
Fitch/IBCA/BUREAU Van Dijk (source for bank specific variables), 2. the World Bank
database and 3. the China Banking Regulatory Commission (sources for industry-specific and
macroeconomic variables).

With regards to the methodology, endogeneity, unobserved heterogeneity and profit

persistence are the three main problems which make the OLS improper in estimating bank
profitability in our case. Fixed or random effects are used by Maudos and Fernandez de
Guerara (2004) and Claeys and Vennet (2005); however, their suggested method cannot solve
the above problems. Arellano and Bond (1991) derive a consistent GMM estimation which
accounts for endogeneity. The GMM estimator uses as instruments lagged values of the
dependent variable in levels and in differences, as well as lagged values of other regressors
which could potentially suffer from endogeneity; therefore, it is called difference GMM. This
method is inefficient when the instruments are weak as argued by Arellano and Bover (1995)
and Blundell and Bond (1998). Hence, another system GMM estimator is developed which
includes lagged levels as well as lagged differences. Roodman (2006) argues that the
problems of endogeneity, unobserved heterogeneity, autocorrelation and profit persistence
can be solved by difference and system GMM estimation. Bond (2002), however, argues that
difference GMM estimator will be biased if unit root exists while the system GMM estimator
yields a greater precision result. Hence, in our paper, the one-step GMM estimator proposed
by Athanasoglou et al. (2008) is used to conduct the empirical analysis. Our GMM is given
below:

Where is the profitability of bank i at time t, which i=1,…..,N, t=1,…..,T, C is the

constant term. is the lag value of the dependent variable, are the explanatory
variables and the disturbance term, with the unobserved bank-specific effect and
the idiosyncratic error. This is a one-way component regression model, where ～IIN(0,
) and independent of ～(0, ). The ’s are grouped into bank-specific , industry-
specific and macroeconomic variable .

3. Empirical results
Table 1 reports the summary statistics for variables used in this study. The reported values
suggest that the differences of liquidity and cost efficiency among banks are not as big as the
differences of non-traditional activity and labour productivity. Looking at the values of
banking sector development, concentration, GDP growth and stock market development, we
suggest that the banking sector and macroeconomic environment are more stable in China.

The empirical results [6] from the GMM method are presented in Table 2. The results show
that taxation is significantly and negatively related to bank profitability in terms of ROA and
NIM, suggesting higher cost incurred through higher taxes paid by banks which decreases the
profitability. The cost efficiency has significant and positive impact on ROA and NIM,
indicating that efficient expense management is helpful in increasing the profitability in
Chinese banking industry. With respect to the industry specific variables, the signs of
concentration are positive and the coefficients are significant which reflect the oligopolistic
structure and supported by the structure-conduct-performance (SCP) hypothesis. The banking
sector development affects the NIM and ROA significantly and positively, suggesting that
banks in more concentrated market are more profitable. The stock market development is
positively and significantly related to ROA and NIM. This positive relationship shows that
there are complementaries between stock market and banking development in China. The
GDP growth is found to be significantly and negatively related to bank profitability in China.
This result partially supports the view that high economic growth improves business
environment and lowers bank entry barriers. The consequently increased competition
dampens bank’s profitability.

The significant and negative relationship between capitalization and NIM suggests that lower
level of capital increase the net interest margin of Chinese banks, which is indirect contrast to
the findings by Ben Khediri and Ben-Khedhiri (2011) for the Tunisian banking industry.
Although credit risk is significant, the signs are different than expected; we report a positive
sign for ROA and negative sign for NIM. We also find that big bank size can translate into
lower NIM in Chinese banking industry possibly due to bureaucratic reasons.

The positive and significant impact of labour productivity on ROA indicates that higher
labour productivity increases ROA in our case. The negative and significant impact of non-
traditional activity on NIM implies that financial institutions that derive a higher proportion
of their income from non-interest sources such as fee-based services typically have a lower
level of profitability. Finally, a significant and positive relationship between liquidity and
profitability in terms of NIM is reported; this implies that more interest revenue will be
generated from the larger share of loans to total assets. This finding is also supported by
Bourke (1989) for several banks.

<< Table 1 – here >>

<< Table 2 – here >>

 4. Conclusion

This article uses an unbalanced panel data to investigate the determinants of 101 Chinese
banks for the period 2003-2009. The results indicate that banks with lower taxation and
higher cost efficiency tend to have higher profitability in China. In addition, higher
profitability of Chinese banks can be explained by higher banking and stock market
development. We show that higher GDP growth leads to lower bank profitability in China.
Furthermore, we find that the profitability in Chinese banking industry is significantly
affected by the level of NPL; this supports the literature. In addition, we report that Chinese
banks with higher level of capital have lower profitability (this applies to NIM only). Finally,
we argue that the departure from a perfect competitive market structure in China banking
industry is relatively small. Future research should examine the relationship between risk,
profitability and competition under different measures in Chinese banking industry.

The empirical results have several practical and policy implications which are as follows: 1)
the overhead cost should be better controlled in order to increase efficiency (bank efficiency
has a positive impact on bank profitability); 2) the decision on making loans to high risk
project/business should be better considered by bank managers as it may decrease the ROA
of bank and increase the NIM; 3) relevant policy should be made by the Government to lower
the speed of economic development as high GDP growth may decrease the profitability of
Chinese banks; 4) banking regulatory authority should further push down the capital of banks
to increase the NIM; and 5) the financial reform needs to ensure that the Government
intervention and repression in the banking system is reduced by lowering the tax burden of
banks and liberalizing the financial system as high profitability of Chinese banks is explained
by well-developed banking and stock market systems.

Notes:

[1] It accounts for 66% of total financial assets and 17.5% of GDP (as of 2006).

[2] The factors include asset turnover ratio, ratio of long-term debt to short-term debt,
overdue loan ratio, stagnant loan ratio, lost loan ratio, core capital ratio, capital adequacy
ratio, capital risk ratio, asset profitability ratio, and capital profitability ratio.

[3] Logarithm of GDP is used as the indicator of economic growth.

[4] The bank-specific variables include size, capitalization, liquidity, cost efficiency, credit
risk, non-traditional activity. The inflation, unemployment rate and GDP growth rate are used
as the macroeconomic determinants.

[5] The bank-specific variables mainly include technical efficiency, liquidity, capitalization,
etc. while the macroeconomic variables include concentration, GDP growth, inflation,
volatility of interest rate, etc.
[6] Correlation among variables is tested through the correlation matrix and shows that there
is no multicollinearity problem in our sample; these results are available upon request.

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Table1. Summary statistics of variables

Name Mean Standard Min Max

deviation
ROA 0.007 0.006 -0.003 0.11
NIM 2.85 1.11 1.89 3.76
Bank size 4.67 0.95 0.71 7.07
Credit risk 0.009 0.007 -0.002 0.042
liquidity 53.39 9.35 17.97 83.25
taxation 0.41 0.37 -4.56 3.18
capitalization 5.1 2.97 -14 31
Cost efficiency 0.012 0.004 0.004 0.04
Non-traditional 13.91 15.2 -34.22 128.42
activity
Labour 0.008 0.004 3.50e-06 0.019
productivity
Concentration(C3) 14.54 1.95 10.19 16.29
Concentration(C5) 20.61 2.5 14.66 22.12
Banking sector 51.98 15.49 16.86 63
development
Stock market 77 49.47 31.9 184.1
development
GDP Growth 11 1.72 9.1 14.2

Table 2. One-step GMM system estimation (Results)

ROA NIM
Independent coefficient T statistic coefficient T statistic
 variables
Lag of dependent -0.12*** -3.39 0.39*** 10.16
variable
LTA -0.0001 -0.56 -0.16*** -11.59
LLPTA -0.19*** -3.35 12.75*** 2.77
LA 0.00001 0.66 0.004*** 2.1
TOPBT -0.005*** -5.64 -0.31*** -4.87
ETA -0.0001 -0.95 -0.03*** -4.62
CE 0.52*** 6.9 122.45*** 16.14
NTA 7.01e-06 0.49 -0.02*** -14.25
LP 0.13*** 2.98 4.89 1.35
C(3) 0.001*** 7.00
C(5) 0.1*** 11.75
BSD 0.0001*** 4.79 0.008*** 6.38
SMD 0.0001*** 11.37 0.007*** 10.83
GDP growth -0.002*** -7.77 -0.15*** -7.61
F test 250.26*** 5241.26***
Sargan test 145.47*** 116.8***
AR(1) test Z=-2.86 P=0.004 Z=-3.90 P=0.000
AR(2) test Z=-0.47 P=-0.639 Z=-1.21 P=0.225