The Determinants of Commercial Bank Profitability in Sub-Saharan Africa

INTRODUCTION

Commercial banks appear very profitable in Sub-Saharan Africa (SSA). Average returns on assets were about 2 percent over the last 10 years, significantly higher than bank returns in other parts of the world. This picture holds true whether returns on assets are assessed by country, by country income group, or by individual banks (Figures 1-5). An alternative measure of profitability, net interest margins, provide a similar picture (Figures 6 and 7). Why are banks so profitable in Africa? Standard asset pricing models imply that arbitrage should ensure that riskier assets are remunerated with higher returns. Bank profitability should then reflect bank-specific risk, as well as risks associated with the macroeconomic environment (non-diversifiable, systemic risk). Progress has been achieved by many SSA countries in banking, supervisory and regulatory reforms, as well as in the implementation of structural reforms to reduce financial risks and promote financial development. However, banks in most SSA countries still operate in risky financial environments, which include weak legal institutions and loose enforcement of creditor rights. Hence, risk appears a good explanation for high returns. Weak economic performance also expose banks to risk as low economic growth promotes the deterioration of credit quality, and increases the probability of loan defaults. Other factors can have an impact on bank returns. For example, market power and regulations can prevent arbitrage, and, consequently keep returns high. While in most SSA countries, there are few barriers to bank entry, aversion to a high risk environment is likely to impose a natural barrier to foreign bank entry. Should high bank returns be seen as a negative feature for financial intermediation in SSA countries? This could be the case if high returns imply high interest rates on loans. Moreover, if high returns are the consequence of market power, this would imply some degree of inefficiency in the provision of financial services. In this regard, high returns could be a negative outcome that should prompt policymakers to introduce measures to lower risk, remove bank entry barriers if they exist, as well as other obstacles to competition, and reexamine regulatory costs. But bank profits are also an important source for equity. If bank profits are reinvested, this should lead to safer banks, and, consequently high profits could promote financial stability. This paper seeks to understand the determinants of high bank profits in SSA and explores the relationship between profits and equity in the region's commercial banking sector. The analysis is based on a sample of 389 banks, operating in 41 countries2 from 1998 through 2006. We follow an extensive literature that focuses on bank-specific risk, market power, and regulations as the main determinants of bank returns. However, bank risk is a forward looking concept, and, as such, it is difficult to find comprehensive risk measures download