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Addis Ababa University

College of Business and Economics


Masters of Business Administration

Factors influencing the Profitability of Private


Commercial Banks in Ethiopia
Abraham Redi
I.D. No. 1444/07
Section I

Submitted to: Matios Ensermu (PhD)

Presented as a Partial Fulfillment for the course Business Research


Methodology (MGMT601)
December, 2015
Addis Ababa, Ethiopia

1|Page

Factors Influencing the Profitability of Private Commercial Banks In


Ethiopia

I.

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er 2015

Table of Contents

Chapter One.1
1.1

Introduction.......................................................................................................................1

1.2

Background of the Study...................................................................................................3

1.3

Statement of the Problem..................................................................................................5

1.4

Research Questions...........................................................................................................6

1.5

Objectives of the Study.....................................................................................................7

1.5.1 General Objective of the Study.........................................................................................7


1.5.2 Specific objective of the study..........................................................................................7
1.6

Scope and Limitation of the Study....................................................................................7

1.6.1 Scope of the Study............................................................................................................7


1.6.2 Limitation of the Study.....................................................................................................8
1.7

Significance of the Study..................................................................................................8

1.8

Operational Definitions.....................................................................................................9

1.9

Organization of the paper..................................................................................................9

Chapter Two...10
2

Literature Review............................................................................................................10

2.1

Measures of Bank Performance/Profitability..................................................................10

2.2

Factors Influencing Bank Performance/Profitability......................................................10

2.3

The influence of Bank-specific factors on Bank Profitability.........................................11

2.3.1 Capital Adequacy............................................................................................................11


2.3.2 Assets Quality.................................................................................................................12
2.3.3 Management Efficiency: Operational Costs Efficiency..................................................12
2.3.4 Earning ability: Diversification of Income.....................................................................13
2.3.5 Liquidity..........................................................................................................................14
2.4

The Influence of Industry-specific Factors on bank profitability...................................14

2.4.1 Bank Size:.......................................................................................................................14


2.4.2 Market Concentration.....................................................................................................14
2.5

The Influence of Macro-economic Factors on Profitability............................................15

2.5.1 Economic Growth...........................................................................................................15

Factors Influencing the Profitability of Private Commercial Banks In


Ethiopia

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2.5.2 Inflation...........................................................................................................................15
2.6

Earlier Studies on Ethiopian Banking Industry...............................................................16

2.7

Conceptual Framework...................................................................................................19

Chapter Three.20
3

Research Methodology...................................................................................................20

3.1

Research Design..............................................................................................................20

3.2

Methods of Data Collection............................................................................................20

3.3

Sampling Techniques or Selection of Banks...................................................................20

3.4

Data Analysis..................................................................................................................20

3.4.1 Model Specification and Description..............................................................................20


3.4.2 Operationalization of the Study Variables.......................................................................20
3.4.3 Multiple Linear Regression Analysis..............................................................................21
4.

List of References...23

I.

List of Table

Table 1:1 List of banks in Ethiopia.4


Table 3.1: Operationalization of the study variables19

II.

List of Figure

Figure 2:1 Schematic Diagram showing relationships between variables...21

Factors Influencing the Profitability of Private Commercial Banks In


Ethiopia

III.

List of Acronyms

ASQ

Asset Quality

CAMEL

Capital adequacy, Asset quality, Management quality, Earning quality,

Liquidity
CAP

Capital Adequacy

CAR

Capital Adequacy Ratio

GDP

Gross Domestic Product

HHI

Hefindihal Hirchman Index

IDV

Income Diversification

LAS

Logarithm of total asset

LIQ

Liquidity

MAC

Market Concentration

MGE

Managerial Efficiency

NBE

National Bank of Ethiopia

NIM

Net Interest Margin

NPL

Non Performing Loans

RGD

Real Gross Domestic Product

ROA

Return on Asset

ROE

Return on Equity

Decemb
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Factors Influencing the Profitability of Private Commercial Banks In


Ethiopia

Decemb
er 2015

Abstract
This paper will investigate factors influencing profitability of Ethiopian private commercial
banks considering bank specific and external variables on bank profitability for the period
covering year 2006-2015. The empirical investigation will use the accounting measure Return
on Assets (ROA) to represent Banks performance.
Keywords: Factors, Influencing, Bank, Profitability, Ethiopia

Chapter One
1.1 Introduction
A bank is an institution which deals with money and credit. It accepts deposits from the public,
makes the funds available to those who need them and helps in the remittance of money from
one place to another. Banks by contraction and expansion of credits and redirect funds from part
to part, aside from helping to stabilize the economy at the large level, have an important role in
the regulation of the economy. Due to the lack of necessary development of capital market in
economy of underdeveloped country, banking is more vital (Shefali,et al,2013).
Today banks offer a variety of services to its clients, including deposits, granting loans and new
services that are offered through the World Wide Web. Banking system through directing
resources to manufacturing and service sectors, to fulfill their social responsibility can create
production; employment and economic growth in the country. The fields of activity in banking
are divided into three parts resource mobilization, allocation of resources and services. Thus
identification of banks performance in the implementation of each of its tasks can present a range
of strengths and weaknesses in banks. Since banks just like the other firms seek economic
profitability to achieve this important goal, it is necessary to identify effective variables. (Berger
1995; Athanasoglou et al, 2006).

With growing competitiveness in the banking industry and similarity of services offered by
banks, it has become increasingly important that banks identify the factors that determine the
profitability of the banks. In business term, profit is the excess of income over expenditure and is
an absolute measure of any firms performance. Profitability in commercial banks is determined
by the ability of the banks to retain capital, absorb loan losses, support future growth of assets
and provide return to investors. (Shefali et.al, 2013)

Profitability is the most important and reliable indicator as it gives a broad indicator of the ability
of a bank to raise its income level. Banks profitability is given due attention after the great
economic depression is experienced in the United States of America in 1940s. The recent global
financial crisis of 2007-2009 also demonstrated the significance of bank profitability both in
national and international economies and the need to keep it under surveillance at all times. If the
banking industry does not perform well, the effect to the economy could be huge and broad.
Because, banks are the critical part of financial system, play a pivotal role in contributing to a
countrys economic development. (Rasidah and Mohd, 2011)

With regards to the main focus of this study, the elaboration of the various profit measures and
determinants theories which has been considered in other related studies is very significant to the
realization of the factors to be investigated in this study. There has been a number of research
papers was written on determinants of profitability of commercial banks. Some of the research
papers focused on single country while others were concentrated on panel of countries. These
studies divide the determinants of commercial banks performance and profitability into two
categories. The Internal and the External factors (Tobias and Themba 2011; Athanasoglou et al,
2006)

Theinternalfactorsincludemanagementcontrollablefactorssuchasthelevelofdeposit,the
levelofloansandadvances,nonperformingloans,andnoninterestincomes.Otherdeterminants
suchastotalcapitalandcapitalreserves,andmoneysupplyalsoplayamajorroleininfluencing
theprofitability.Similarly,externaldeterminantsincludethosefactorswhicharebeyondthe
controlofmanagementofthebanksuchasmarketshare,marketgrowth,marketconcentration,
interestrates,inflationrates,andGDPgrowth.

Generally, internal profitability influencing factors can be accounted and analyzed as bank
specific determinants of profitability because they are controllable by the specific bank
management.Onthe otherhand,external profitabilityinfluencing factors could beanalyzed
underindustryspecificdeterminantswhicharevariablesspecifictothebankingsectoralone
suchasbanksizeandmarketconcentration,andundermacroeconomicdeterminantssuchas
countrywideeconomicgrowth,inflationandinterestrates.

1.2 Background of the Study


OverviewoftheEthiopianBankingSystem
As per the web sites of the National Bank of Ethiopia (NBE) the modern Banking in Ethiopia
dates back to the year 1905 when the Bank of Abyssinia was established. Bank of Abyssinia was
formed under a fifty- year franchise agreement made with the National Bank of Egypt, which
was owned by the British by then. To widen its reach in the country the Bank had expanded its
branches to Dire Dawa, Gore and Dessie. It also had an agency and a transit office in Gambella
and at the port of Djibouti respectively. After its formal liquidation on August 29, 1931 the Bank
of Abyssinia was replaced by the Bank of Ethiopia. According to NBE (2010) Bank of Ethiopia,
which was also known as Banque National Ethiopienne, was a national Bank and one of the first
indigenous banks in Africa. The Bank of Ethiopia operated until 1935 and ceased to function
because of the Italian invasion. During the five years of the Italian occupation (1936-41), many
branches of the Italian Banks such as Banco ditalia, Banco de-Roma, Banco Di-Napoli and
Banco Nazianali del lavoro were operational in the main towns of Ethiopia. After evacuation of
Italians, the State Bank of Ethiopia was established on November 30, 1943 with a capital of one
million Maria Theresa dollars. Pursuant to the Monetary and Banking Law of 1963 the State
Bank of Ethiopia that had served as both a central and a commercial bank was dissolved and split
into the National Bank of Ethiopia and Commercial Bank of Ethiopia Share Company.
Accordingly, the central banking functions and the commercial banking activities were
transferred to the National Bank of Ethiopia and the Commercial Bank of Ethiopia Share
Company respectively.

Further, due to change of government in 1974, and the command economic system which had
prevailed in the country, the Commercial Bank of Ethiopia S.C. and other banks and financial
institutions were nationalized on January 1st, 1975. The nationalized banks were re-organized
and one commercial bank, the Commercial Bank of Ethiopia; two specialized banks- the
Agricultural and Industrial Bank (AIB), renamed as the Development Bank of Ethiopia (DBE)
and a Housing and Savings Bank (HSB) currently named as the Construction and Business Bank
(CBB); and one insurance company, the Ethiopian Insurance Corporation were formed. During
the era of state socialism (1974-1991), Ethiopias financial institutions were charged with
executing the national economic plan; state enterprises received bank finance in accordance with
the plans priorities. This system based on the template of the Soviet Union, saw little need to
develop the tools and techniques of financial systems. Following the change of Government in
1991 and the change of economic policy directions, financial institutions were re-organized to
operate towards a market oriented policy framework. Proclamation No. 83/1994 which had
allowed the establishment of private banks has marked the beginning of new era in the Ethiopian
banking sector development. Commercial Banks both public and private are currently
operational in line with Banking Proclamation No. 592/2008.
Following the enactment of the banking legislations in the country in the 1990s, private
commercial banks were allowed to operate and they started to gain market share, and now they
have some growing market share in the Ethiopian economy and are some of the major players in
the Ethiopian economy. Presently, there are 19 banks in Ethiopia of which 16 are private banks
and the rest are government owned banks.
Table 1:1 List of banks in Ethiopia
NO.
1
2
3
4
5
6
7
8
9

Name of the Bank


Development Bank of Ethiopia
Commercial Bank of Ethiopia
Construction and Business Bank*
Awash International Bank
Bank of Abyssinia
Wegagaen Bank
United Bank
Nib International Bank
Dashen Bank

Year of Establishment
1909
1963
1983
1994
1996
1997
1998
1999
2003

NO.
Name of the Bank
10 Cooperative Bank of Oromia
11 Lion International Bank
12 Oromia International Bank
13 Zemen Bank
14 Bunna International Bank
15 Berhan International Bank
16 Abay Bank
17 Addis International Bank
18 Debub Global Bank
19 Enat Bank
Source: www.nbe.gov.et

Year of Establishment
2005
2006
2008
2009
2009
2010
2010
2011
2012
2013

*Aspernewssources,ConstructionandBusinessBankisrecentlyannexedwithCommercialBankofEthiopia.

1.3 Statement of the Problem


Agreatdealofliteraturesonthebankingsectorhaspointedoutthateconomicactivitywouldbe
seriouslyhinderedifcommercialbanksdidnotexecutetheirfunctionproperly.Asoundand
profitablebankingsectorisabletoresistnegativeshocksandcontributestothestabilityofthe
financialsystemandsustainabilityofoveralleconomicdevelopment.Thus,identifyingthekey
successfactorsofcommercialbankscouldallowfortheprofitabilityofthebankingindustry.

Although, a number of earlier studies on factors influencing bank profitability add their own
contribution to the theory of profitability and stated their own policy implications, they were
inclined towards to the developed economy, and hence, less developed countries including
Ethiopia received little attention in various literatures on this issue as compared to other
developed countries.
Specifically the Ethiopian banking sector is not a well studied area, though, few studies have
been conducted on the determinants of bank performance of Ethiopian commercial banks, the
findings are contradictory in some key commercial bank profitability indictors. Therefore, this

study will fill the knowledge gap by providing information on selected internal 1 and external
factors which influence the profitability of Ethiopian private commercial banks.

1.4 Research Questions


In line with the broad purpose statement highlighted above, the following research question was
formulated:
What are the internal and external factors influencing bank profitability in Ethiopia and
how do these factors influence the profitability of Ethiopian private commercial Banks?

1.5 Objectives of the Study


1.5.1 General Objective of the Study
The main objective of this study will be to investigate factors influencing the profitability of
private commercial banks in Ethiopia.

1.5.2 Specific objective of the study


The specific objectives will be
ExaminingtheimpactofCapitaladequacy,Assetquality,Managementefficiency,
Earning ability and Liquidity management on the profitability of Ethiopian
commercialbanks;
AnalyzingthesignificanceofbankspecificdeterminantsonEthiopiancommercial
banksprofitability;(i.e.,basedontheCAMELframework)
Examiningtheimpactofbanksizeandmarketconcentrationontheprofitabilityof
Ethiopiancommercialbanks;
1 The study will use CAMEL framework in order to assess internal determinants.

AnalyzingthesignificanceofindustryspecificdeterminantsonEthiopiancommercial
banksprofitability;
ExaminingtheimpactofeconomicgrowthandinflationonEthiopiancommercial
banksprofitability;and
AnalyzingthesignificanceofmacroeconomicprofitabilitydeterminantsonEthiopian
commercialbanksprofitability.

1.6 Scope and Limitation of the Study


1.6.1 Scope of the Study
This study will be confined to factors influencing the profitability of selected Ethiopian private
commercial banks by analyzing the financial statements starting from year 2006 to year 2015.
The study will comprise all private commercial banks which started operation before 2006. As a
result, out of the sixteen private commercial banks, eight private commercial banks; Awash
International Bank, Bank of Abyssinia, Wegagaen Bank, United Bank, Nib International Bank,
Dashen Bank and Cooperative Bank of Oromia, and Lion Intentional bank were selected under
this study. All sampled banks are operated at least for a decade and the study will use ten years
data except for Lion International Bank.

1.6.2 Limitation of the Study


The research will focus on financial/quantitative variables only as a result further investigations
could be done on non financial/qualitative variables. The current researcher will use financial
reports of the past ten years, which might be affected by different non modeled variables in the
state of the economy and in turn will result failure to measure the actual effects of the internal
and external factors influencing profitability of the bank. Moreover, the study might reflect the
overall picture of profitability of the Ethiopian banking industry, if the government owned banks

considered in the study.

1.7 Significance of the Study


This study will have significance in showing the degree and extent of the impact of bankspecific, industry-specific and macroeconomic determinants on the profitability of private
commercial banks. To this end, particularly this study will have importance for the following
parties.
It will provide a road map for managers and shareholders of private commercial banks to
evaluate their bank performance with respect to internal and external factors influencing
profitability,
It will give direction for policy makers to measure the impact of the private bank industry
performance on the economy and its implications,
It will help investors to measure the performance of their portfolios and proceed with
readjustments as required, and
It will help as a base for other interested researchers to undertake detailed and further
studies in the area.

1.8 Operational Definitions


Profitability refers to measuring the results of a firm's policies and operations in
monetary terms. These results are reflected in the firm's return on asset, return on
equity, and net interest margin.
o Return on asset (ROA): measured by the ratio of profit before tax to total average
assets.

o Return on equity (ROE): is more concerned about how much the bank is earning
on their equity investment, the net income per birr of equity capital.

o Net interest margin (NIM): How well a banks assets and liabilities are affected
by the spread between the interest earned on liabilities.

1.9 Organization of the paper


The rest of this proposal is organized as follows: Chapter two presents empirical and theoretical
review of the literature related to the issue of determinants of bank profitability; Chapter three
provides research design and methodology employed in the analysis and finally a Reference
of related research works is incorporated.

Chapter Two
2

Literature Review
2.1 Measures of Bank Performance/Profitability

The literature on the determinants of bank performance has closely tied bank performance with
quantifiable profitability measures such as ROA, ROE and NIM (Tesfaye, 2014). On the other
hand, according to Athanasoglou et al. (2008) many scholars remind that ROA is the key ratio for
the evaluation of bank profitability given that ROA is not distorted by high equity multipliers,
while ROE disregards the risks associated with high financial leverage. In this respect, it is rarely
to find the paper utilizes ROE as a single measure of profitability. Most of the time, research
papers utilize ROE for checking the consistency with ROA (Izhar and Asutay, 2007). The rate of
return on assets, ROA, is the most comprehensive accounting measure of banks overall
performance. Because of this, the bulk of studies employed ROA as profitability measure, for
instance, (Izhar and Asutay, 2007) and Flamini et al (2009).
2.2 Factors Influencing Bank Performance/Profitability
Many studies have introduced some useful variables in the profit function of commercial banks
to shed light on key factors that make a difference in bank profits. Such studies are not without
ambiguity especially with regard to the measurement of the variables and the results reported
thereafter. However, there is general agreement that bank profitability is a function of internal
and external factors. Koch (1995) observed that the performance differences between banks
indicate differences in management philosophy as well as differences in the market served.
Athanasoglou et al, (2006) concurred and argued that profitability is a function of internal factors
that are mainly influenced by a bank's management decisions and policy objectives such as the
level of liquidity, management efficiency, capital adequacy, asset quality, loan, deposit and bank
size, and the external factors related to industrial structural factors such as ownership and market
concentration and other macroeconomic factors. Though most of the studies on bank profitability
are based on developed countries especially the USA and Europe, a couple of studies focusing on
developing countries (Tobias & Themba (2011), Naceur (2005)) have also used more or less the
same variables to study the determinants of bank profitably.

2.3 The influence of Bank-specific factors on Bank Profitability


CAMEL is used to examine factors affecting bank profitability in many countries. CAMEL
stands for Capital adequacy, Asset quality, Management efficiency, Earnings performance and
Liquidity. The system was developed by the US Federal Deposit Insurance Corporation (FDIC)
for early identification of problems in banks operations (Uzhegova, 2010). Though some
alternative bank performance evaluation models have been proposed, the CAMEL framework is
the most widely used model and it is recommended by Basle Committee on Bank Supervision
and IMF (Baral, 2005).
2.3.1

Capital Adequacy

Capital adequacy shows that the sufficiency of the amount of equity to absorb any shocks that
the bank may experience (Kosmidou, 2008). The capital structure of banks is highly regulated.
This is because capital plays a crucial role in reducing the number of bank failures and losses to
depositors when a bank fails as highly leveraged firms are likely to take excessive risk in order to
maximize shareholder value at the expense of finance providers (Kamau, 2009).
Though there is general agreement that statutory capital requirements are necessary to reduce
moral hazard, the debate is on how much capital is enough. Regulators would like to have higher
minimum requirements to reduce cases of bank failures, whilst bankers in contrast argue that it is
expensive and difficult to obtain additional equity and higher requirements restrict their
competitiveness (Koch, 1995).
Gavila et al (2009) argues that, although capital is expensive in terms of expected return, highly
capitalized banks face lower cost of bankruptcy, lower need for external funding especially in
emerging economies where external borrowing is difficult. Thus well capitalized banks should be
profitable than lowly capitalized banks. Neceur (2003) using a sample of 10 Tunisian banks from
1980 to 2000 and a panel linear regression model, reported a strong positive impact of
capitalization to ROA.
The NBE has set specific measure of the capital adequacy position of Banks, which is the Capital
Adequacy Ratio (CAR) (NBE Directive No. SBB/9/95). The directive clearly set out the

computation mechanism and the conversion factors for both on and off-balance sheet items.
Dang, 2011 asserts that regardless of such regulatory framework, the major intention of holding
capital is to build the internal strength of the bank to withstand losses during crisis, as cited by
Tesfaye, (2014). NBE upgraded initial capital of new entrant banks to Birr 500 million. (NBE
Directive No. SBB/50/2011)
2.3.2

Assets Quality

Credit risk is one of the factors that influence the business of an individual bank. The degree of
the credit risk depends on the quality of assets owned by an individual bank. The quality of
assets held by a bank depends on exposure to specific risks, trends in non-performing loans, and
the health and profitability of bank borrowers (Baral, 2005). Aburime (2008) affirms that the
profitability of a bank depends on its ability to foresee, avoid and monitor risks, possibly to cover
losses brought about by risks arisen. Hence, in making decisions on the allocation of resources to
asset deals, a bank has to take into account the level of risk to the assets.
Kosmidou (2008) applied a linear regression model on Greece 23 commercial banks data for
1990 to 2002, using ROA and the ratio of loan loss reserve to gross loans to proxy profitability
and asset quality respectively. The results showed a negative significant impact of asset quality to
bank profitability. This was in line with the theory that increased exposure to credit risk is
normally associated with decreased firm profitability. Indicating that banks would improve
profitability by improving screening and monitoring of credit risk.
2.3.3

Management Efficiency: Operational Costs Efficiency

In the literature on bank performance, operational expense efficiency is usually used to assess
managerial efficiency in banks.
Although the relationship between expenditure and profits appears straightforward implying that
higher expenses mean lower profits and the opposite, this may not always be the case. The
reason is that higher amounts of expenses may be associated with higher volume of banking
activities and therefore higher revenues. In relatively uncompetitive markets where banks enjoy
market power, costs are passed on to customers; hence there would be a positive correlation
between overheads costs and profitability (Flamini et al, 2009). Neceur (2003) found a positive

and significant impact of overheads costs to profitability indicating that such cost are passed on
to depositors and lenders in terms of lower deposits rates/ or higher lending rates.
2.3.4

Earning ability: Diversification of Income

Financial institutions in recent years have increasingly been generating income from off-balance
sheet business and fee income. Albertazzi and Gambacorta (2006) as cited by Uzhegova (2010)
noted that the decline in interest margins, has forced banks to explore alternative sources of
revenues, leading to diversification into trading activities, other services and non-traditional
financial operations. The proponents of activity diversification or product mix argue that
diversification provides a stable and less volatile income, economies of scope and scale, and the
ability to leverage managerial efficiency across products (Choi and Kotrozo, 2006).
The opposite argument to activity diversification is that it leads to increased agency costs,
increased organizational complexity, and the potential for riskier behavior by bank managers.
Kotrozo and Choi (2006) mentioned that activity diversification results in more complex
organizations which makes it more difficult for top management to monitor the behavior of the
other divisions/branches. They further argued that the benefits of economies of scale/scope exist
only to a point. The costs associated with a firms increased complexity may overshadow the
benefits of diversification. As such, the benefits of diversification and performance would
resemble an inverted-U in which there would be an optimal level of diversification beyond which
benefits would begin to decline and may ultimately become negative.
Uzhegova (2010) using a HH index of interest income, commissions, fee income, trading
income, non-interest income and other operating income found empirical support of the idea that
banks involved in diversification activities expect some benefits. While Kotrozo and Choi 2006,
using a similar index found that activity diversification tends to reduce performance compared to
banks more focused in their activities.

2.3.5

Liquidity

Another important decision that the managers of commercial banks take refers to the liquidity
management and specifically to the measurement of their needs related to the process of
deposits and loans. It is argued that when banks hold high liquidity, they do so at the opportunity
cost of some investment, which could generate high returns (Kamau, 2009). Thus management
is faced with the dilemma of liquidity and profitability. Myers and Rajan (1998) as cited by
(Uzhegova, 2010) emphasized the adverse effect of increased liquidity for financial Institutions
stating that, although more liquid assets increase the ability to raise cash on short-notice, they
also reduce managements ability to commit credibly to an investment strategy that protects
investors which, finally, can result in reduction of the firms capacity to raise external finance
in some cases.
In the Ethiopian context, the NBE directive issued in 2012 in relation to liquidity states that
private commercial banks are obligated to allocate 27 percent of their gross loan disbursement to
finance government bonds (Addis fortune 15 January 2012).
2.4 The Influence of Industry-specific Factors on bank profitability
2.4.1

Bank Size:

There is consensus in academic literature that economies of scale and synergies arise up to a
certain level of size. Beyond that level, financial organizations become too complex to manage
and diseconomies of scale arise. The effect of size could therefore be nonlinear; meaning that
profitability is likely to increase up to a certain level by achieving economies of scale and decline
from a certain level in which banks become too complex and bureaucratic. Hence, the expected
sign of the coefficient of bank size is unpredictable based on academic literature. This analysis
uses the logarithm of total asset to capture the potential non-linear effect of size similar to
Athanasoglou et al. (2006)
2.4.2

Market Concentration

According to Nzongang and Atemnkeng (2006) high degrees of market share concentration are
inextricably associated with high levels of profits at the detriment of efficiency and effectiveness
of the financial system to due decreased competition.

Tregenna (2009) using a sample of USA commercial banks and savings institutions from 1995 to
2005 and a linear regression panel model, found robust evidence that concentration increases
profitability in USA banks and then concluded that the high profitability of banks in the USA
before the 2007/2008 financial crisis was not earned through efficient processes, but through
market power and the profits were not reinvested to strengthen the capital base of the financial
institutions. Nzongang and Atemnkeng (2000) examined the effects of concentration to the
profitability of Cameroonian commercial banks from 1987 to 1999. Unlike Tregenna (2009),
who used the concentration ratio of the 3 largest banks in the USA to model market
concentration, Nzongang and Atemnkeng (2000) used the Herfindahl-Hirschman index to
measure market concentration in Cameroon. The results indicate that market concentration
power is of paramount importance in the determination of bank profitability.
2.5 The Influence of Macro-economic Factors on Profitability
Wide varieties of literature support the impact of the macroeconomic factors influence on bank
performance. The macroeconomic policy stability, Gross Domestic Product, Inflation, Interest
Rate and Political instability are also other macroeconomic variables that influence the
performances of banks.
2.5.1

Economic Growth

Positive impact of economic growth to Bank performance is supported by many literatures. For
instance, the trend of GDP affects the demand for banks asset. During boom the demand for
credit is high compared to recession (Athanasoglou et al., 2005). Bourke (1989) presents
evidence that economic growth, if particularly, associated with entry barriers to the banking
market, would potentially lift banks profits.
2.5.2

Inflation

Inflation is also another important determinant of banking performance. In general, high inflation
rates are allied with high loan interest rates and thus high income. Athanasoglou et al., 2005,
state in relation to the Greek situation that the relationship between inflation level and banks
profitability is continued to be debatable.
The review of literature has revealed that bank profitability can be influenced by bank-specific
factors and external factors. Bank-specific factors are those factors within the direct control of

managers and can be best explained by the CAMEL framework, while external factors include
industry-specific and macroeconomic factors. The review of literature also revealed that the
multiple linear regressions method is the most used in modeling the relationship between bank
profitability and its factors.
2.6 Earlier Studies on Ethiopian Banking Industry
There were few studies conducted in Ethiopian commercial banks profitability. Among others the
following four papers are selected for further review. The title of the research papers are: The
Determinants of Ethiopian Commercial Banks Performance by Tesfaye Boru (2014),
Determinants of commercial banks profitability: An Empirical Review of Ethiopian Commercial
Banks by Belayneh Hailegiorgis (2011), Factors Affecting Profitability: An Empirical Study on
Ethiopian Banking Industry by Amdemikael Abera (2012), and What Drives the Performance of
Commercial Banks in Ethiopia? by Abebaw and Depaack (2011):
The first paper was done on the determinants of Ethiopian Commercial Bank performance.
According to Tesfaye (2014), the determinants of Ethiopian banks performance considering bank
specific and external variables on selected banks found out that bank specific variables by large
explain the variation in profitability. High performance is related to the ability of banks to control
their credit risk, diversify their income sources by incorporating non-traditional banking services
and control their overhead expenses. On the other hand, he argued that banks capital and
liquidity status are not significant to affect the performance of banks. Moreover, he stated that
bank size and macro-economic variables such real GDP growth rates have no significant impact
on banks profitability. However, he argued the inflation rate is determined to be significant
driver to the performance of the Ethiopian commercial Banks.
The second research paper reviewed was undertaken by Belayneh (2011), it was analyzed to see
the three major determinants of commercial banks profitability; bank specific factors, industry
specific determinants and macroeconomic variables. With regard to banks specific factors such
as, equity capital Belayneh argued those Ethiopian commercial banks that increase their equity
have a lower cost of capital and thus are more profitable. Bank size, loan, and non-interest
income of Ethiopian commercial banks are also positive and highly significant factors of

profitability. Credit risk is the main significant factor, which challenges the profitability of banks
in Ethiopia. Fixed deposit and non-interest expenses are also the major causes that deter
Ethiopian banks profitability. In relation to industry specific factors, he used market
concentration as the only industry specific determinants for Ethiopian commercial banks. He
stated that market concentration has a negative and highly significant impact on Ethiopian banks
profitability. He used Hefindihal Hirchman Index and the result shows that a better competition
in the market erodes the price making power of a single bank (Commercial Bank of Ethiopia)
and in turn reduces the banking sector profitability. Finally concerning with the macroeconomic
variables Belayneh (2011), said that the only significant factor of Ethiopian commercial banks
profitability is real GDP growth. According to the author, the current real economic growth of the
country makes commercial banks to be more profitable. However, inflation rate and lending
interest rate played immaterial role in Ethiopian commercial banks profitability.
The third research reviewed was conducted by Abebaw and Depaack (2011), this paper too
investigate the impact of bank-specific characteristics, macroeconomic conditions and financial
market structure on Ethiopian commercial banks profits, measured by return on average assets
(ROA). A balanced panel data set of 62 observations, covering the period 2001-2008, provided
the basis for the econometric analysis. Abebaw and Depaack (2011) argued that size of bank has
a positive effect on profitability supporting the economies of scale argument. The impact of
overhead to net interest income and nonperforming loan ratios are negative and significant. After
assessing the external factors, they found out that these factors have a relatively small impact on
the profitability of Ethiopian banks. Moreover, they concluded that none of these factors was
significant. Finally they recommended that the key for success in profit for banks rely on
individual bank specific characteristics implying proper management of activities by individual
banks is indispensable to be profitable.
The fourth paper by Amdemikael (2012) was also investigate the impact of bank specific,
industry-specific and macro-economic factors affecting bank profitability for a total of eight
commercial banks in Ethiopia, covering the period of 2000-2011. The findings of his study show
that capital strength, income diversification, bank size and GDP have statistically significant and
positive relationship with banks profitability. On the other hand, variables like operational

efficiency and asset quality have a negative and statistically significant relationship with banks
profitability. However, the relationship for liquidity risk, concentration and inflation is found to
be statistically insignificant. He suggests that focusing and reengineering the banks alongside the
key internal drivers could enhance the profitability as well as the performance of the commercial
banks in Ethiopia. He further stated that banks in Ethiopia should not only be concerned about
internal structures and policies, but they must consider both the internal environment and the
macroeconomic environment together in fashioning out strategies to improve their performance
or profits. Finally, he recommended that the government needs to revisit its requirements
imposed solely on private banks like investing 27% of their total loans on bonds at a relatively
lower interest rate.

2.7 Conceptual Framework

The conceptual scheme of the relation between the independent variables and dependent variable
distilled from the literature review by the researcher is shown on Figure 2.1 below. It assumes
that the relationship between the independent variable and dependent variables is linear.

Figure 2.1: Schematic Diagram showing relationships between variables


The Independent
Variables

Bank specific Factors


Capital Adequacy
Asset Quality
Operational cost Efficiency
(Management Efficiency)
Diversification of income
(Earning ability)
Liquidity Management

The Dependent
Variable

Internal factors

Bank Profitability
affects

Return on Assets
(ROA)

Industry-specific Factors
Bank size
Market concentration
Macroeconomic Factors
Level of GDP
Inflation
Source: Self extracted

External factors

Chapter Three

Research Methodology
3.1 Research Design

The main objective of this study was to investigate the determinants of private commercial banks
profitability in Ethiopia and this study adopted an explanatory approach by using balanced panel
research design to realize a stated objective. As cited by Tobias and Themba (2011), (Baltagi
2005) stated that the advantage of using panel data is that it controls for individual heterogeneity,
less collinearity variables and tracks trends in the data something which simple time-series and
cross-sectional data cannot provide.
3.2 Methods of Data Collection
The study will use data from secondary sources for selected banks in the industry. The major data
sources are the various annual publications of the NBE and each private commercial bank. The
coverage of the data is intended to be from 2006 to 2015.
3.3 Sampling Techniques or Selection of Banks
The Bank selection is done following the historical formation time of banks and in fact with
consideration of their ownership structure.
3.4 Data Analysis
The collected data will be analyzed using descriptive statistics, graphs, correlations, and multiple
linear regression analysis.
3.4.1

Model Specification and Description

Standard deviation, mean, minimum, maximum and graphs as appropriate will be used to
analyze the general trends of the data from 2006 to 2015 for the variables included in the study.
3.4.2

Operationalization of the Study Variables

This study will use the following measurements to operationalise the study variables before the
application of the linear multiple regression analysis.

Table 3.1: Operationalization of the study variables


Variable

Measurement

Notion

Dependent variable
Profitability

Ratio of profit before tax to total average assets.

ROA

Independent variable
1. Bank-Specific variables
Capital
Adequacy
Asset
Quality
Operational
Cost
Efficiency (Management
Efficiency)

Income
Diversification (Earning
ability)

The ratio of gross capital over total assets


The ratio of total NPL to total loan and advances. Higher
ratio indicates poor asset quality
Ratio of operating expenses (staff wages and
administrative expenses) net operating income (net
interest income, net foreign exchange income, net fees
and commission, and other income). Higher ratio
indicates inefficiency
1-( Herfindahl-Hirschman (H-H) index of net interest
income, foreign exchange income, commissions and
fees, and other income). Index ranges from 1 to 0.
Where 1 indicates complete diversification, 0 indicates
complete focus

Liquidity

Ratio of liquid assets to total liability deposits.


2. Industry-specific Factors

Bank size

Natural logarithm of total asset of the bank


Herfindahl-Hirschman (H-H) index of the annual deposits
of all commercial banks in the market. Index ranges from
10,000 to 0. Indicating an uncompetitive market to a
competitive market
3. Macroeconomic Factors
The yearly real gross domestic product (GDP) growth
rate
The annual inflation rate

Market
Concentration

GDP
Inflation

3.4.3

CAP
ASQ

MGE

IDV
LIQ
LAS

MKC

RGD
INF

Multiple Linear Regression Analysis

A multiple linear regression model will be used to determine the relative importance of each
independent variable to determine banks profitability. The multiple linear regressions model
based on Olweny & Themba (2011) for ROA is shown on equations below.
= o +1CAP+2ASQ+3MGE+4IDV+5+ 6it+ 7MKCit+ 8RGDt + 9INFt +
it

Where;
ROAit = return on asset of bank i at time t
CAPit = Capital Adequacy bank i at time t
ASQit = Asset quality of bank i at time t
MGEit = Managerial efficiency of bank i at time t
IDVit = Income diversification of bank i at time t
LIQit = Liquidity of bank i at time t
LASit = size of the bank i at time t
MKCit= Market concentration of bank i at time t
RGDt = Real GDP growth rate at time t
INFt = Inflation rate at time t

it = is the error term.


Where t = 2006-2015, o = constant for each bank (fixed effects), 1-9= bank specific factors
coefficients, industry-specific and macroeconomic factor coefficients,

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