CHAPTER 1: LITERATURE REVIEW OF RELATIONSHIP BETWEEN OWNERSHIP
1.1.2. Relationship between ownership structure and bank financial performance
1.1.2.1. Bank ownership structure
Commercial banks serve as the key financial intermediaries in the economy. Based on the concept of the ownership structure of enterprises in general, the ownership structure of a commercial bank reflects the size of capital according to the composition of the bank's owners. Commercial banks are divided into five groups based on their ownership structure: state-owned commercial banks, joint-stock commercial banks, joint venture banks, foreign branch banks, and commercial banks that are 100% owned by foreigners. Varied types of banks will have different operational and governance features, which will influence the performance of the bank.
13
In addition, cross-ownership in banking systems is a phenomenon that originates from cross-ownership in the corporate system. When one or more banks own shares in each other as well as shares in non-banking firms, this is known as cross-ownership. This phenomenon has gained traction in a number of nations throughout the world, particularly in those with commercial banking systems that are larger and play a more vital role than the stock market, such as Germany, Japan, and China.
1.1.2.2. Financial performance of commercial banks
The performance of commercial banks can be assessed through criteria such as brand value, reputation of the bank in the financial market, and other qualitative indicators that demonstrate the bank's success. These qualitative assessments are concretized through the quality of products and services provided by the bank, the professionalism and breadth of the distribution system, the management and administration capacity of the bank's leadership team, along with HR policies, marketing... These factors represent the bank's reputation, service quality, and the extent to which investors and consumers employ the bank's services.
However, compared to these criterias with such a lack of clarity, quantitative factors are prioritized to be used when analyzing the effectiveness of commercial banks.
Commercial banks are also a type of enterprise, so the indicators used to assess corporate financial performance can also be applied to commercial banks. There are two types of indicators to evaluate the financial performance of commercial banks based on the characteristics of commercial banks as financial intermediaries for the economy. The first is accounting-based metrics that include performance ratios (ROA and ROE are commonly used), and the indicators of profitability, growth, liquidity and risk level are also representative.
In commercial banks, ROA provides investors with information about the profits generated from the total assets held by the bank, including equity and external capital, while ROE reflects the ability of the bank to use its capital to profit. Some typical indicators such as NIM, NPL, LDR, and CAR are summarized as follows:
14
Net interest margin (NIM):
NIM = Net interest income – Net interest expense Average interest earning asset
NIM is one of the characteristic indicator for a bank's profitability and growth. It reveals how much the bank is earning in interest on its loans compared to how much it is paying out in interest on deposits. This metric helps prospective investors determine whether or not to invest in a given financial services firm by providing visibility into the profitability of their interest income versus their interest expenses.
Nonperforming loans to loans ratio (NPL ratio):
NPL ratio = Nonperforming loans Total loans
An NPL ratio is used to measure the level of the bank's credit risk and the quality of outstanding loans. A high ratio means the bank bears a greater risk of loss if it fails to recover the owed amounts, while a low ratio means that the outstanding loans pose a low risk to the bank.
Loan-to-deposit ratio (LDR):
LDR = Outstanding loans Total deposits
The LDR ratio is used to assess a bank's liquidity by comparing a bank's total loans to its total deposits for the same period. This ratio shows a bank's ability to cover loan losses and withdrawals by its customers. Investors event of an economic downturn resulting in loan defaults.
15
Capital adequacy ratio (CAR):
CAR = Tier 1 Capital + Tier 2 Capital Risk Weighted Assets
The capital adequacy ratio is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. It is used to protect depositors and promote the stability and efficiency of financial systems around the world.
The second method to evaluate bank financial performance is based on market ratios, where Tobin's Q or EPS are the most commonly used. Tobin's Q is the market price of a bank over its replacement cost of capital, if this coefficient is high, the bank will invest more since the cost of acquiring new capital is lower than the bank's market cost. Earning per share (EPS) is the portion of profit that a bank allocates to each share of common stock outstanding. This indicator is often meaningful in comparing and evaluating the ability of banks to use capital.
In this research, ROA and NIM are used to measure the bank’s financial performance.
1.1.2.3. Relationship between ownership structure and bank financial performance:
Impact of state ownership on bank financial performance
Although most of the state-owned banks in the world following the trend of integration have been equitized, it is undeniable that state ownership still plays a very important role in the financial system of some countries. La Porta et al. (2002) pointed out that a government presence is necessary to finance socially desirable projects and to initiate both financial and economic development in countries subject to their institutional underdevelopment. Government ownership will stimulate economic growth when financial institutions are not fully developed or the private sector does not meet the requirements of the market. The central bank, through intermediaries that are state- owned commercial banks, will have a basis to perform its role more easily. Specifically,
16
government-owned commercial banks are considered to be the leaders in implementing national monetary policy, thereby contributing to stabilizing the money market and banking system. These commercial banks usually have a large scale with a dominant market share, so they can lead the market. In addition, state ownership has the advantage of a rich reputation, gaining the trust of customers, and reducing liquidity risks and lending costs. Corporate governance and long-term sustainable profit orientation help prevent excessive risk-taking by management and prevent unfair competitive practices like private commercial banks.
On the other hand, state-owned commercial banks in their operations have revealed many of the same shortcomings as state-owned enterprises in general. Barth et al. (2000) argue that public-owned banks have a negative impact on productivity and efficiency and are also associated with weak capacity and higher levels of corruption. Even if these government-owned commercial banks have a reasonable operating management mechanism, the conflict between the business functions and the implementation of policies as directed by the Central Bank has limited the competitiveness and transparency of the banking system. When faced with the same risks as privately owned commercial banks, state-owned commercial banks still have a higher risk of loss. This leads to a limited ability to withstand uncertain risks as well as the ability to increase capital through retained earnings.
Impact of private ownership on bank financial performance:
According to La Porta et al. (2002), for developing countries with a large state ownership rate in the banking sector, privatization is an important solution. Private banks will replace the presence of the Government with private investors, thereby limiting loans affected by the political decisions of the State Bank. Micco et al. (2004) stated that state-owned joint-stock commercial banks have lower profitability ratios than private joint-stock commercial banks. Cornett et al. (2010), after performing research in 16 East Asian nations between 1989 and 2004, came to conclusions that government-owned banks had lower profitability, lower tier-one capital ratios, but more credit risk, worse
17
liquidity, and inferior managerial efficiency than private banks. Before this, the findings of Berge et al. (2002) in the Argentine context in the 1990s also showed that the performance of government-owned banks improved significantly after experiencing a long period of bad performance before privatization.
If only a small part of privatization is carried out, with a modest decrease in State ownership or a low level of participation in banking by foreign investors, it will be difficult to see significant improvement in bank performance. In research papers related to privatization, Boubakri (2005) conducted research on state-owned banks post- privatization in 22 developing economies and found that, while several profit indicators of these banks declined dramatically initially, they eventually improved after two years.
Mwathi (2009) investigated the relationship between Kenyan commercial banks' financial performance and ownership structure from 2004 to 2008. She discovered that both private and state-owned banks had a negative relation with ROA as the financial performance indicator. Thus, the presence of internal investors in the bank ownership structure can have a good impact, but it can also have a detrimental impact if the monitoring is inadequate, allowing these shareholders to exploit their authority for their own or a group of shareholders' profit.
Impact of foreign ownership on bank financial performance:
A considerable number of studies suggest that the presence of foreign investors in the ownership structure has a favorable influence on bank performance, or at the very least does not have a negative impact. However, additional examination reveals that this effect varies between banks in developed and developing countries. Demirguc-Kunt &
Huizinga (1999) found that commercial banks with foreign ownership are less profitable than domestic commercial banks in developed countries, but that the opposite is true in developing countries, where foreign commercial banks are more profitable. The reason for this is that, in the undeveloped financial sector, foreign banks have technological, human resource, and international experience advantages over domestic banks; however,
18
these are not considered strengths in the developed market, where most banks have such technologies and management experience.
Foreign investors are projected to bring beneficial change to developing markets since they are more likely to adopt a profit maximization strategy than state-owned banks or other domestic institutions. Banks with foreign elements will operate as a conduit for providing money to enterprises and industries with promising futures, so increasing the economy's capital allocation efficiency. According to studies, commercial banks with foreign contributions have lower expenses than local commercial banks, which has a favorable influence on the banking sector's overall competitiveness and improves the competitiveness of domestic banks. This can be explained because of the fact that foreign banks have access to cheaper international capital due to their international connections (Wanniarachchige & Uddin, 2011) and all these banks can get loans from the parent bank to save costs (Galac & Kraft, 2000). In addition, parent banks are usually large- scale banks with professional operations, so they inherit positive factors in terms of technology, operating models, products and services, or human resource management and thereby become more efficient. Because foreign banks participate more actively in the local banking industry, the gap between deposit and lending interest rates in the market narrows, forcing domestic banks to operate more efficiently and reduce expenses in order to remain competitive and sustainable. Furthermore, foreign bank participation helps the credit access procedure. Interest rates are frequently cheaper and access to loans is often simpler in nations with a high ratio of foreign banks to foreign investors than in countries with low rates.