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Decoding Profitability Black Box of Indian Banking Sector – An Empirical Study

The aim of this research study is to decode the profitability black box of Indian banking sector so as to identify important determinants of their profitability. Banking sector is closely interlinked with all sectors of economy and hence their financial health is a matter of importance not only for themselves but also for their share holders, vast customer base, employees, policy makers and economy as a whole. This research study comprises seven variables viz. Profit After Tax to Total Revenue, Capital Adequacy Ratio, Cash to Deposit, Employee Cost to Total Expenses, Growth in Net Profit, Total Debt to Equity and Yield on Advances. These variables were critically investigated over a period of ten years employing various statistical techniques including multiple regression analysis. The Yield on Advances emerged as the most important variable influencing the profitability of Indian banking sector. The Employee Cost to Total Expenses was found to be moderately influential on profitability. However, Capital Adequacy Ratio, Cash to Deposit, Growth in Net Profit and Total Debt to Equity were detected as statistically irrelevant variables in this attempt of decoding the profitability black box of Indian banking sector.


INTRODUCTION:
Banking is normally understood as business activity of accepting deposits and providing financial facilities. In any country banking is contemplated as backbone of the economy primarily because the performance of almost every sector of economy in one or another way is reflected in the performance of banking sector. At the same time a financially sound bank has the potential to support financial well being of several industrial enterprises. In addition they touch almost every citizen as custodian of their hard earned money besides being cheaper and fair source of funds both in the short run and long run. The banking sector in India, besides being mark of trust for general public at large have also played significant role in the economic development of the nation. Responding to the changing needs of the economic environment Indian banking sector has adopted customer centric multi product approach in their endeavor to substantially extend their reach. Advent of information technology has brought along with it substantial reduction in transaction time and cost. Advanced artificial intelligence is on its way to further revolutionize entire banking sector in India. However amidst the promising developments a high degree of surveillance on profitability is a must as it is the profitability which would ensure long term financial health of the banking sector. At the same time decoding profitability black box of Indian banking sector is not an easy task as profitability in itself is a complex and dynamic function of several variables such as deposits, advances, investments, last mile reach, infrastructure cost, interest differential, employee cost, cost of developing innovative products etc. therefore Profit generation task of bank managers is extremely complex and laden with enormous difficulties. It is neither feasible nor desirable for bank managers to concentrate on all the parameters affecting the profitability. It is therefore imperative that a research based approach is adopted to identify key parameters. In this research paper the author has attempted to decode profitability black box of Indian banking sector.

NEED FOR THE STUDY:
The Indian banking sector is of considerable importance for individuals, business enterprises and the nation as a whole. In the times to come it will have to continue to contribute to the financial well being of all the stake holders and thereby support creation of national prosperity. Profitabilty of Indian banking sector, therefore, is a matter of concern not only for bankers, individuals, business enterprizes, economic policy makers and researchers but also for the nation as a whole. In an humble attempt to contribute to the scarce literature on research related to Indian banking sector the author decided to decode the profitability black box by examining few micro factors influencing profitability of Indian banking sector. The variables considered in this research are: 1. Profit After Tax / Total Revenue (PATTR) 2. Capital Adequacy Ratio (CAR) 3. Cash To Deposits ( CTD) 4. Employee Cost to Total expenses (ECTE) 5. % Growth in Net Profits (GNP) 6. Total Debt to Equity (TDTE) 7. Yield on Advances (YOA) From amongst the variables enumerated above PATTR is the dependent variable and the remaining are independent variables.

LITERATURE REVIEW:
The researchers have evaluated the different aspects of banking from multiple angles to develop better understanding of variables affecting profitability of banking sector. Some authors have examined macro economic factors while others have looked into micro economic factors, A few authors have also looked into comparison of public sector banks with that of private sector banks. Their research outputs are further discussed below. David B. Humphrey and Lawrence B (1997) critically investigated the profitability of 683 banks of United States of America. According to them input prices and output prices had influence on profitability of the banks. Interest on deposit emerged to be one of the important factor having negative effect on profitability. Demirguc-Kunt, Asli, Huizinga and Harry (1999) conducted a global study using bank-level data for 80 countries in the year's 1988-95. They noticed that in developing countries foreign banks enjoyed higher profits than domestic banks. However, in the developed nations the trend was exactly reverse i.e. domestic banks enjoyed higher profits than foreign banks. They further noticed that the corporate tax burdenwas fully passed onto the customers of the banks. Lawrence M. Seiford and Joe Zhu (1999) in their study of 55 banking companies of United States of America detected an interesting aspect that larger banks performed better in terms of profitability while smaller banks performed better in terms of marketability. Chaudhuri Sumitra (2002) ( 2009)

HYPOTHESES DEVELOPMENT:
The literature review and the variables mentioned above lead us to formation of the following hypotheses : (1) To understand the association of CAR,CTD, ECTE, GNP,TDTE, YOA and with PATTR of the Indian banking sector (2) To examine the degree of influence CAR, CTD, ECTE, GNP,TDTE, YOA exert over PATTR of the Indian banking sector. (3) To gain insight into decoding profitability black box of banking sector in India.

Data Collection and Techniques of Analysis:
In this research paper we have considered only the Indian banking companies registered with the Reserve Bank of India and listed on Bombay Stock Exchange and /or National Stock Exchange. The data required was historical and enormous in nature. For collection of data f published audited annual reports and data bases such as CAPITAline were relied upon. The data for all the variables viz. CAR,CTD, ECTE, GNP,TDTE, YOA and PATTR was collected for each bank for a period of 10 years with a view to remove cyclical effects of the economy and get better understanding of the behaviour of the said variables. Thereafter, various statistical techniques including Multiple Regression were used to decode the relationship of independent variables with dependent variable and to know the extent of influence independent variables exert over the dependent variable. F test and Multi co linearity Test -VIF Statistics were worked out to provide greater validity to the results so arrived.

RESULTS AND DISCUSSIONS:
(1) The standardized β depicting regression co-efficients of the independent variables with their corresponding direction, values and significance level are stated in the Table -1. The standardized β of CAR, as stated in Table  -1, is -0.051 pointing out that CAR has negative relationship with PATTR and its significance level of 0.0.471 makes it statistically insignificant. The weight of evidence advocates that null hypothesis H0 (CAR) be accepted and the alternate hypothesis Ha (CAR) be rejected. This means CAR does not exert any significant influence over PATTR.
(2) The standardized β of CTD is +0.008 points out that CTD has positive relationship with PATTR, but its significance level of 0.886 does not allow it to be statistically significant at all. The weight of the evidence therefore propounds that null hypothesis H0 (CTD) be accepted and the alternate hypothesis Ha (CTD) be rejected. This means CTD does not exert influence over PATTI.
(3) As depicted in Table-1, the standardized β of ECTE is -0.094 suggesting that ECTE has negative relationship with PATTR. The corresponding significance level 0.193 indicates that this regression co-efficient is statistically significant in a moderate manner. The weight of the evidence, thus, propounds that null hypothesis H0 (ECTE) be rejected and the alternate hypothesis Ha (ECTE) be accepted. Hence a change in ECTE has moderate influence over PATTR.

Total Debt To Equity (TDTE):
The TDTE displays positive relationship with PATTR but it's unacceptable significance level does not permit it to play any significant role in exerting influence on the profitability

Yield On Advances (YOA):
The YOA has a positive relationship with PATTR. Amongst all the independent variables the power of this regression coefficient is the maximum at 0.995. It's significance level standing at 0.000 is also highly acceptable. Consequently YOA is considered as a very important variable exerting its influence on the profitability. Higher the YOA better it is for the bank. This propels us to believe that Advances as a portfoliothe traditional bastion of bankersis still the most important generator of profitability for banks. As a result management of banks, would prefer to keep it at the highest possible level.

RECOMMENDATIONS & MANAGERIAL IMPLICATIONS:
Reckoning with the analysis and findings described above YOA with highest power of regression coefficient and highly acceptable level of significance emerges to be the most important determinant of profitability of Indian banking sector. YOA is followed by ECTE which has moderate influence. The remaining variables are not found to be important. This research study clearly points out that the "Advances portfolio" a traditional portfolio of present day bankers is the largest contributor to the profitability of banks. Naturally the practicing managers in the Indian banking sector should give more importance to management of YOA and ECTE to improve profitability of the banks. This has wider ramifications in the sense that management of YOA, and ECTE, will become critical performance criteria for managers. The academicians should devise superior models for Management of YOA, and ECTE.

FUTURE RESEARCH DIRECTIONS:
This research study has investigated only Indian banking companies listed on Bombay Stock Exchange and National Stock Exchange. Replica research studies can be undertaken to assess the influence of variables used in this study for banking industry in other developing countries. A global research study to critically examine profitability determinants of banking sector in developed nations and the ones in developing nations can also be carried out. Further research can also be conducted by considering more variables such as growth rate of economy, inflation and foreign exchange reserve etc.