Conundrum of Profitability Vs Soundness

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Summary

Competition in the Indian Banking Sector has risen ever since the financial sector reforms of the 1990’s. Today, we find mostly four types of banks with regards to ownership – public sector (PSB), old private banks, new private banks and foreign banks. It is quite obvious that, like most other for profit organizations, banks look for profit maximization as well. However, as the protector of the nation’s wealth, they have to follow a more cautious path to ensure stability as well. Normally, all banks are subject to certain norms and regulations set by the Reserve Bank of India (RBI). The basic aim of this study is to find out whether banks can be profitable and sound at the same time or whether there exists an inverse relationship between the two.

To come to a conclusion, a sample of 75 banks have been evaluated in terms of operational efficiency, which includes competitive efficiency, profitability and financial stability. Historically, PSBs have been poor performers given the fact that they have more social obligations to fulfill as compared to the other three categories. However, that gap has been bridged from around 1999-2000. The major reason behind the troubles of Indian banks has been due to the presence of a significant amount of Non-Performing Assets (NPAs). The ratio of NPAs to total loans rose from 2.3% in 209 to 3.6% in 2012 and 85% of NPAs belonged to the PSBs. The study has been conducted using commonly used accounting ratios. To measure overall competitiveness, the Cost to Income Ratio (CIR) has been used. For profitability, the study looks into Return on Assets (RoA) and Return on Equity (RoE). Finally, the Capital Adequacy Ratio (CAR) and the Net Non-Performing Assets Ratio (NNPA) have been used to look into the soundness of banks.

Analyzing the past banking data, various other researchers have also published papers to estimate the productive efficiency of PSBs with private and foreign banks. In this paper, the operational efficiency of different banks is estimated in terms of competitive efficiency, profitability, and financial stability. The paper tests the existence of the inverse relationship using regression analysis on banking data statistics from 2000-2013 to include the impact of Basel Capital Accord and GFC on the financial sector.

Various operational and competitive factors associated with bank’s operation and its profits are also utilized in this analysis. To study soundness of banks Tier1 capital, Tier2 capital and profit/employee are used as control variables. Competition in the banking sector is represented by Cost to Income Ratio (CIR), number of offices and wages. Advances, Investments, deposits, interest spread, Cash to Deposit Ratio (CDR) and SDBankex signify profitability of banks. The different values of variables for different banks indicated the variation in performance of foreign and domestic banks.