Financial Structure and Bank Profitability

Countries differ widely in their relative reliance on bank vs. market finance. Germany and Japan, for instance, are regarded as bank-based, as in these countries the volume of bank lending relative to the stock market is rather large. At the same time, the United States and the United Kingdom are considered to be more market-based. Recently, Demirguc-Kunt and Levine (1999) have constructed indices of the organization of the financial system, or financial structure, for a large set of developing and developed countries. They measure the relative importance of bank vs. market finance by the relative size of stock aggregates, by relative trading or transaction volumes, and by indicators of relative efficiency. Developing countries are shown to have less developed banks and stock markets in general. The financial sector - banks, other financial intermediaries and stock markets - becomes larger, more active and more efficient, as countries become richer. Further, in developing countries financial systems tend to be more bank-based. The variety of financial systems around the world poses economists with several interesting questions. A substantial body of literature has already shown that both banking sector development and stock market development may lead to higher growth at the firm, industry and country level.2 However, as discussed in Stulz (1999), financial structure - the relative importance of banks vs. markets - may also have important implications for firm performance and long-run economic growth. Demirguc-Kunt and Maksimovic (2000) and Levine (2000) analyze the impact of financial structure on firm performance and economic growth, respectively. In this paper we focus on the performance of the banking sector itself across different financial systems. The purpose of this paper is twofold. First, we investigate the impact of financial development on bank profits and margins. Second, after controlling for the level of financial development, we examine if financial structure has an independent impact on bank performance. If banks operating in different financial structures show differences in performance (especially bank margins), this could have important implications for economic growth. After all, if financial structure differences do not translate into differences in the cost of bank financing for firms, it becomes much less clear that they are important. To our knowledge, this is the first paper considering the impact of financial structure on bank performance. Using bank-level data for a large number of developed and developing countries over the 1990-1997 period, we investigate if there is any relationship between measures of bank performance on the one hand, and levels of bank and stock market development, and financial structure on the other. We consider two measures of bank performance: bank profitability (measured as profits divided by assets), and bank interest margins (measured as net interest income divided by assets). As an accounting identity, the bank interest margin equals (pre-tax) profits plus bank operating costs, plus loan loss provisioning (and minus non-interest income). Bank profitability and bank interest margins can be seen as indicators of the (in)efficiency of the banking system, as they drive a wedge between the interest rate received by savers on their deposits and the interest paid by lenders on their loans. As 4 such, these variables will affect the cost of bank finance for firms, the range of investment projects they find profitable and thus economic growth,download.