With reference to the sample of U.K schedule commercial banks, this dissertation attempts to examine determinants of bank profitability and interest margin from 2002 to 2008. We have run regression on a comprehensive set of hypothetical determinants that consist of bank- specific, industry-specific and macroeconomic indicators.

Our results suggest that among many factors a a high inflation environment positively affect bank profitability. However, high bank capitalisation, credit risk, overheads and high economic growth have a negative effect on bank profitability. On the other hand, high credit risk and overheads have a positive impact on bank performance. Further, macroeconomic indicators have no effect on the bank's interest margin indicating a greater influence of the competitive environment in which the banks operate in.

Chapter 1: Background

1.1 Background of the study

Banks have always been critical in every economy as they are a mean to channelize funds from sources to investors. The link between economic growth and financial development has been a feature of discussion in many studies like (Aburime 2008, Beck & Levine, 2004).The banking sector on a world scale has acknowledged the major transformation in operating environment in the last two decades. Financial institutions today face a rapid vibrant and competitive environment to global extent. Hence, the nature of environment has forced financial institutions to revise and examine their performance for their mere existence in this dynamic economy of twenty first century.

Both economic and macro economic factors have been responsible for the change in the structural and performance of the banks. The main drivers for the changes in the macro environment are mainly liberalisation and regulation of the domestic markets. Bank profitability is significant at micro and macro level. At the micro level, profitability helps the survival of banks and enables them to remain competitive while at the macro level it helps in the foundation of building a sound and profitable banking sector which has the ability to withstand an amount of negative shocks and provide stability to financial system. Therefore, the determinants of bank performance have been popular among the economist and researchers (Athanasoglou 2005).

Of the various measures that have been used for analyzing performance in the research relating to banking industry, profitability and net interest margin are the most important measures. Profitability is explained as profits generated from multiple products offered by the banks, these include interest income as well as non interest income, while net interest margin gives emphasis on income generated by banks through a more traditional way of business i.e. collecting deposits and granting loans.

Banks and financial institutions play a crucial role towards the economic development of a country and have a wide range of implication for an overall sound financial system. Therefore, at a macro economic level a sound and profitable banking system will have the ability to withstand the negative shocks in adverse conditions and this factor will contribute significantly to help to strengthen the financial system. As mentioned earlier, the significance of bank profitability at both a macro and micro economic scale have been made by researchers, bank regulators, economists, academics and bank management to develop substantial interest on the factors that help to determine banks profitability(Athanasoglou et al., 2008).

On the other hand it is essential to analyze and conduct a research on the determinants of net interest margin because banks play a crucial role in the distribution and channelling and intermediation of funds in the economy. Intermediation of prices is significant in net interest margin. Therefore, examining the factor that determines and effects interest margin is of double interest.

Firstly, from the perspective of social welfare a lower cost of intermediation is enviable, which suggests that banks are in the fore front of economic development of a country. However, alternately this can be true when the problem of transferring of risk can be effectively prevented and if interest and credit risk can be priced sensibly.

Demiguc-kunt and Huizinga (1999) had stated that, financial intermediation has a critical and significant effect which can have an impact on net returns to savings, and the gross return for investments. It was also indicated that the spread between the two returns reflects interest margin of banks, in addition to cost of transaction and taxes faced directly by investors and savers. Finally, it was concluded that bank interest margin, can be interpreted as an indicator of bank performance.


The primary aim of this study is to investigate empirically the main determinants that affect bank profitability and interest margin for commercial banks in the U.K between 2002 to 2008.

The banking system in the U.K has been witness to a substantial growth and a change in recent years and its total assets have rapidly expanded since 1990.The sector consists of both domestic and foreign banks. The assets of U.K owned banks represent a 48% of the total assets of the U.K banking sector and have increased by 5% since 1990.The major trends in the U.K banking sector over the last years include the conversion of building societies into banks, the consolidation of U.K banking industry and the entrance of non-financial firms into the financial service market. Following the building societies act 1986 a number of building societies have converted themselves into banks themselves into banks especially between 1994 to 1997 .In addition an increase in commercial freedom was experienced by building societies act 1997.These changes enhance the scope of increase in competition and also benefited the consumer with more choices.

According to Mc cauley and White (1997) and White (1998), the U.K had an increase in merger and acquisition in its banking sector (in values terms) between 1991 to 1997 than any other European country. Finally a while back, new players such as supermarkets, insurance companies and football clubs were given a chance to enter the retail financial market in Britain and are now are offering a wide range of financial services which enhances their reputation such as credit cards, unit trust etc.

It is reasonable to assume that all changes that were mentioned posed great challenges to U.K banks, because of rapid change in the environment they were operating in, which had a direct effect on their performance. However, despite the massive structural changes and the significant increase of competition in the U.K financial services sector in the recent years, the U.K banking sector remains relatively under researched (Drake, 2001). In most studies the focus is either on financial performance of U.K major banks or building societies performance. The purpose of this study is to examine the internal (i.e. banks characteristics) and external (i.e. macroeconomics and financial structure) factors that affect performance of U.K owned banks over the last years.

1.2 Methodology and Data:

This study employs a multiple regression model to examine the main determinants of commercial banks profitability and net interest margin in the U.K. A single equation framework is employed in this study i.e. the effect of bank - specific, industry- specific and macroeconomic determinants of bank profitability and net interest margin. A similar approach was adopted by Bourke (1989), Molyneux and Thornton (1992), Nigo (2006), Barajas et al., (2000) among various theory.

The study uses unbalanced panel data collected from bank scope database and the Bank of England (online).The data in this study is composed of balance sheet and income statements of commercial banks operating in the U.K.

1.3 Structure of the Study:

The study has been divided into six chapters and they are organized as follows: Chapter 2 reviews the literature and past statistics along with some key determinant that have been used in earlier studies. Chapter 3 will give a brief introduction and background of U.K banking sector and summarizes its structure and current scenario .Chapter 4 gives us a detailed description of data and methodology used in the study further, it provides a brief introduction used in the study. Chapter 5 gives the description of empirical results and discussions. Finally the Chapter 6 provides the conclusion and limitation of the given study.


2.1 Introduction:

The purpose of this chapter aims to provide a theoretical framework of the factors that affect bank profitability.

2.2 Bank Profitability

Like any business, the main aim of banks is by earning profits which is in turn means earning more money that what they pay in expenses. The bulk of profit earned by banks come from the fees that it charges in return for services rendered to its customers and the interest returns on its assets. The major expense is the interest paid on its liabilities.

Measures of Profitability

Traditionally the measures of profitability of any organization are its return on Assets (ROA) and Return of Equity (ROE).

Where assets are used by organizations for the generation of income, Loans and securities are assets for a bank and provide maximum of a bank's profit. However, for the generation of loans and securities a bank must have money, which is generated primarily from bank's owners in the form of Bank Capital, Depositors and money that it borrows from peer banks or by sale of debt securities.

The ROA is calculated by the amount of fees that it earns on its services and its net interest margin.

Return on Equity

Return of Equity as a measure of Profitability is of primary importance to the bank's owners because it epitomise their return on investment and does not solely depend upon the return of Assets but also on the total value of assets that generate income. Return on Equity measures a firm efficiency and ability to generating profit for every unit of share holder's equity. It also portrays how well an organization uses its funds from investment to generate profit.

Net Interest Margin

Net interest margin (NIM) reflects the ability and efficiency of a bank to generate income and margin indicates a bank that operates efficiently and also indicates future profitability.

Net Interest Margin = Net Interest Income

Average Total Assets

Measuring Risk

Interest rate risk

Risk that has a direct impact on earnings or capital from the fluctuation of interest rate can be termed a interest rate risk. This risk occurs when there are differences, the timing of rate of changes and the timing of cash flows. The fluctuation of interest rate has an impact on a bank's reported earning and book capital if changes are made to:

  • The market value of trading accounts.
  • Expenses and income that are interest sensitive, such as mortgage servicing fees.
  • Net interest income.

Change in interest rates has an effect on the economic value of the bank.

Credit Risk

When a bank borrows on a counter party fail to meet an obligation which is agreed upon that potential is termed as Credit Risk. In terms of banks, loans are considered as the largest and obvious source of Credit Risk.

Hefferman(2005) explains that when an asset or a loan that becomes irrecoverable in case of delay or default of payment then the situation can be termed as Credit Risk. It can be defined as Profitability of default on a loan agreement.

Hempel and Simonson (1999), state that the risk is greater if banks hold more medium quality loans, but this also fetches a higher return. If banks start considering loans that have a lower element of risk attached to them this would have a finest effect with returns, hence banks should diversify and have a large portfolio of loans which ranges and has different degree of risk and return attached to them.

Liquidity Risk

The risk that an asset owner faces when he is unable to recover the full value of the asset when he decides to sell the desired asset is known as Liquidity Risk.

An alternative definition would be the risk of being unable to satisfy a claim without impairment of financial capital can be termed as liquidity Risk.

For banks Liquidity Risk arises when the amount withdraws exceeds deposits unexpectedly and they have no other alternative but to borrow funds at a higher rate of interest.

Liquidity Risk threatens any financial institution and can lead to bankruptcy. These situations can be avoided by banks by maintaining a high reserve but this strategy can have an impact on the banks return.

Capital Risk

Hempel and Simonson(1999),states capital Risk is an indicator of the amount of asset that can decline before the creditor and depositors position can be endangered. Capital Risk can be referred to as leverage risk. From the investors point of view he takes on Capital Risk every time he invests in any other than exception of a risk free Capital Risk to limited to the amount of one has invested.

Single country studies

The Empirical evidence on the US banking sector is due to Berger(1995),Neeley and Wheelock(1997) and Angbazo(1997).Berger(1997) performed a study on the US banking system to determine the relationship between the Return of equity(ROE) and Capital Asset Ratio(CAR) for a sample of US banks from the period of 1983 - 1992.He used the Granger Causality Model, to show that the Return of Equity and Capital Asset Ratio are positively related Neeley and Wheelock (1997) performed a similar study to explore the profitability of sample of insured banks in US between the period of 1980 - 1995.They found that bank performance has a positive relation to the annual percentage change in the state's per capital income. Anghazo(1997) conducts a study that investigates the determinants of bank Net interest Margin(NIM) for a sample of Us bank between the period of 1989 - 2003.

His results for the Pooled sample document show that default risk, opportunity cost of non-interest bearing reserves, leverage management efficiency have all got a positive return to the bank's interest spread. .

Barajus et al (1999) conducted a study on the significant effects of financial liberalization on interest margins for banks in Columbia. However the overall spread of the financial reform has not reduced; there was relevance between the different factors that affected bank spreads by such matters. Afanasieff et al (2002) did a study using panel data techniques to determine the main determinant s of Brazil banks interest spread. A two step approach was used to measure the relative impacts of micro and macro- economic factor due to Ho and Sanders (19981).The outcome of the results suggest that macro economic variables were more accurate to determine the interest spread of Brazilian Banks.

Determinants of Tunisian bank performance was investigated by Ben Nacear and Goaied (200 1) during the period of 1980 - 1995.Their results indicates that banks who have struggle towards the improvement of labour and capital productivity have the best performance, these banks have to maintain a high level of deposit accounts relative to their assets and those whose equity have been reinforced.

A study based on a sample of seventeen Malaysian Commercial Banks between the period of 1986 - 1995 was conducted by Guru Et Al (2002).He attempts to identify the determinants that have a successful impact on deposit banks to help and provide a practical guideline for improved profitability and performance of these financial institutions. The Determinants of Profitability were divided into two Segments, internal determinants (liquidity Capital adequacy),expense management and external Determinants (firm size ,ownership and external economic conditions).The results of the study reveal that on efficient expense management was considered to be more significant in explaining a high bank profitability .Further, the macro-indicators suggested a high interest ratio was directly proportionate to low bank profitability and inflation shows to have a positive effect on bank performance.

Panel Country studies

The panel country studies had a focus on European companies, Molyneux and Thorton (1992) Adreu and Mendes (2002),Goddard Et Al (2009),on developed and developing countries (Demerguc - Kunt and Huizinga 1999,2001),MENA countries (Bashir,2000).

Molyneux and Thorton (1992) were the first to investigate on a thorough scale, the determinants of bank profitability on a set of countries. A sample of 18 European countries was used by them to investigate during the period 1986 - 1989.Their findings show a significant correlation between Return of Equity (ROE) and the interest rate levels in each country bank concentration and government ownership. Abreu and Mendes (2002) had investigated the Determinants of bank's interest margin and profitability of a few European countries in the last decade. Their results suggested that a bank that is well capitalized faces a lower chance of bankruptcy and this translates into better performance and profitability.

Goddard Et Al (2004) performed a study on 6 European Counties which constituted of 665 banks on the Determinants of profitability in European banks between 1992- 1998.A cross sectional and dynamic panel model was employed in the study. The result of the study suggested that total asset and capital to asset ratio had a positive relation with profitability. The results also show that there is an increase in abnormal profit despite intensifying competition. The study also explains that if abnormal profit is earned by a bank in the current year, its expected profit from the following year should include a healthy amount of current year's abnormal profit despite intense competition.

Demerguc - kunt and Huizinga (1999) perform a comprehensive study to examine the determinants of bank profitability and interest margin using bank level data for 80 countries for the period between 1988-1995.The variables used in this study includes several factors accounting for bank characteristic macro-economic condition, taxation, financial structure, legal indicators and regulations. The results of this study suggest that a large ratio of banks assets to GDP and a low market concentration ratio lead to low margin and profits. A high margin and profit is maintained by foreign banks compared to domestic banks in developing countries, while in developed countries the opposite prevails.

Bashir (2000) examines the determinants of Islamic bank's performance across 8 Middle Eastern countries for the period of 1993 - 1998.The study uses several internal and external factors to predict profitability and efficiencies .The results suggest that a higher leverage and large loans to assets ratios leads to higher profitability for variables controlling, for controlling macro-economic environment, taxation and financial situation. The study also reveals that foreign-owned banks tend to be more profitable than domestic banks. This study also reveals that taxation has a negative impact on bank profitability, while macroeconomic setting and stock market development has a positive impact on profitability.

2.4 General Determinants of Bank Performance:

Primarily evaluation of performance in books is based on firm, industry and country - level factors which are as follows:

Factors relating to firm level include:

  • The products and services offered to the market.
  • The efforts taken by the division of a bank, which sells the products and manages their customer account.
  • The client bases a bank target and this determines the results the banks obtain.
  • The size of bank i.e. the larger the size the greater will be the economies of the scale achieved by the banks and lesser will be the cost.
  • The degree of specialization or diversification from the bank output.
  • The market share captured by the institution.

Factors relating to industry level include:

  • Ownership status the bank. As for government banks the main focus is on economic development.
  • Competition in a specific industry may lead to concentration of the firm i.e. higher the competition lower the concentration of the firm and vice-versa.

Factors relating to the country level include:

  • Change in the economic environment of the country i.e. during the period of recession the asset site of banks become risky and the chances of default increases and vice-versa.
  • The changes in the inflation where there is constant change in the general price level in the economy, which has an influence on revenue and cost of banking institutions.

Among the results that could have affected income and expense of the bank, the following are listing :

  • Probable chances of high short-term interest rates, shortening margins and creating fund problem due to increase in costs.
  • A possible increase in variable, cost due to the fact that financial environments have become highly competitive.
  • The possibilities of market ability for tax exempted securities along with credit problem arising.
  • Rare occurrence of comparatively low interest rate, murky income compared to high interest rates.
  • A risk that, successful innovators will be focused on expansion, both inside and outside their trading areas which can result in generation loss for banks.

Hence, from all the factors given above we can identify internal and external factors as the two main factors that determine the performance of banks.

Internal determinants are factors that can be controlled by management. These factors are obtained from accounts (balance sheet, income and expenditure statement) and thus can be termed as micro or bank specific determinants of bank profitability.

Factors that are beyond the control of management are stated as external determinants. These determinants are factors that are not correlated to bank management but reveal legal and economic environment that effects the operation and performance of financial institutions. They are further limited into industry -specific and macroeconomic factors.

Determinants of Bank Performance:

In general the banks performance would be gauged by taking into various factors into considerations. They are:

  • Market share and market concentration.
  • Cost efficiency
  • Cut throat competition in the loan market,
  • Capital strength
  • Broad based retail net work
  • Having quality assets

Basically determinants can be classified into two types:

A. Internal determinants:

Internal determinants are those internal factors that greatly influence the management decisions which in turn affect the operating results of banks. The quality of banking performance reflects largely in its operating performance. As such, the operating performance can be clearly revealed in the Balance sheet and the Income Statement of banks.

Balance Sheet:

Balance sheet is a statement that would highlight the financial strength of the banks. The items that are being shown in the balance sheet are the direct indicators of the earning capacity of the bank. Assets and liability composition plays a prominent role as determinant of banking performance.

One of the very important determinants is the capital ratio. It helps us to assess the capital adequacy, general safety and soundness of the banks. Well capitalized banks, because of solid capital background can very easily sweep through the credit risks and thereby avoid any loss that may occur at the time of financial distress and this ability of solving financial crisis would be translated into profitability. So the conclusion here is higher the capital ratio, the more profitable the banks would be. It has been found that higher capital ratio with higher profitability works well with foreign banks in comparison with domestic banks in developing countries. So there exists the relationship between the capital ration and financial performance.

Next to the cost of capital, the assets and liability composition play a major role in determining the performance of banks. The major asset of the bank is the deposit collected by the banks and its interest payment is primary expense of the day to day operation of the banks. The collection of deposits helps banks to lend for the development of the economy as whole. Similar to the interest on deposit which is the important operating expense in the banking activity, collection of interest upon loans is the foremost revenue for the banks. Accepting deposits and lending money for the productive purposes are the traditional activity of each and every bank.

Apart from the cost of capital and assets and liability composition, the size of the banking business is to be considered as a important determinant of the performance of the banks. The size of the banking business denotes the economies of scale .The bank with wide spread retail net work with branches in every nook and corner of the country denotes the large scale economy. But in such kind of the size of the bank the cost of maintaining many branches will be too high and this would definitely reduces the profitability of the banks. The banks in important cities perform better than the bank with too many branches.

Income statement:

The financial position is being revealed in the Balance Sheet. The method of operation can be clearly visualized in the income statement. The operating ratios would indicate the efficiency of management and the banks success for a particular period of time. By analyzing the income statement, one can assess the banks efficiency in controlling the costs and generating the income.

Determinants based on income statements

Control of costs

The profitability of banking business can be increased by controlling the unnecessary costs. The closure of unprofitable branches or retail outlets would surely help in the reduction of costs. Timely collection of loan amount avoids the bad debts. Also the non-performance of certain assets would create maintenance costs upon which no revenue has been earned.

Higher wages and salary will definitely increase the profits of the banks (Tunisia, Malaysia)

Like the reduction of cost increases the profit, the increase of certain costs would definitely increase the profitability of the banking company. Payment of higher wages and salary to the employees would boost the moral of the employees and would be a great motivating factor for them. Their performance may be in high quality in the sense they can give better service to the customer with smile on their faces and the work may be finished in less than the standard time allotted.

Lower payment of interest on deposits and higher revenue from loans - this wide disparity may lead to higher profitability of the banks.

There exists wide disparity of interest earned and interest paid. The difference between the two is the profit for the banks. For deposits less interest is paid whereas the interest that is paid for loans and advances is too high. Another motto the banks follow is to take the deposit at a shorter period, but lending is for a longer period. This means definite income for a longer duration.

Passing of tax burden to the shoulders of customers.

The tax that is to be paid by the banks would be shifted to the shoulders of customers in one way or the other. The interest on loan may be increased or some bank charges would be imposed for the services rendered by the banks to the customers. The credit card system introduce is a convenient platform for the banks to earn by way of fine and penalty. The provision of ATM facilities and other services brings considerable revenue to the banking industry. Thus banks earn income apart from the interest on loans and advances, fees for services providing like maintaining Demat Accounts, maintaining and giving ATM facilities and so on.

B. External determinants:

They are events outside the banks. These external determinants should be foreseen by taking into various factors into consideration and appropriate steps should be undertaken to combat such a situation external determinants also can be classified into:

1. Macro economic variables:

During the all round of economic growth, there will be a great demand for huge capital for the purpose of investment both in capital intensive goods and consumer goods. Setting up of an industry in a backward regions or hilly place where there exists potential for tourism development will have a spiralling effect. It will create employment opportunity and thereby increasing the purchasing power of the people. This increase in purchasing power of the people will create many wants in the minds of the people which in turn create demand. So production of goods and services require more funds and such funds can be provided by the banks.

During this time which is a boom time, the credit risk is less. Because of employment opportunity, and increasing purchasing power of the people the debt servicing ability of the people will raise.

Thus Inflation plays a vital role in increasing the earning capacity of the banks.

2. Financial Structure Variables

“Many studies in the banking literature investigate whether financial structure which is defined as the relative importance of banks, plays a role in determine banking performance. In general a high bank asset to GDP ratio implies that financial development plays an important role in the economy. This relative importance may reflect a higher demand for banking services, which in turn attracts more potential competitors to enter the market when the market becomes more competitive, banks need to adopt different strategic moves in order to sustain their profitability”

Competitive pricing behaviours may increase the profitability of banks.

Lower interest rate for the loans and advances in comparisons with other banks would attract many customers towards the bank.

Low rate of interest and large number of customers may enable the banks to earn more profit rather than few customers and high interest rate.


The purpose of this chapter is to identify the general determinants of bank profitability. The evaluation of profitability has been done as a complex evaluation of earning and expenses which include tough cost control and new protection commission.

Further, factors through which profitability can be calculated have been identified as firm level, industry-level and country level determinants along with factors that affect bank income and expenses. These chapters also describes relevant literature review and on the basic of part study. An impressive number of studies have been conducted in single country and panel country framework. These studies have a top let internal and external factor to determine bank performance. However, there are certain limitations regarding past studies. Hence, this chapter also describes the contribution of existing literature to this study.



3.2 Aims and objectives:

The core objective of Bank of England is two fold. They are:

A. Price Stability:

The first and foremost objective of the Bank of England is to bring the currency stability in the country. Currency stability means stabilizing the value of home currency in relation to currencies of other countries. This currency stability will be followed by price stability domestically which is the primary goal of the Apex Bank of the country. In bringing the stability of prices and subsequently the currencies, interest rates play a pivotal role. The government of U.K. has setup a target of controlling inflation at 2% level, and to achieve this target of the Government, the Central Bank decides short term interest rates i.e., interest rates should be fixed every month by taking into consideration various economic variables. The ultimate aim is the economic growth and developments of the country as a whole.

The next core objective of Bank of England is to achieve the financial stability. Financial stability indicates the stability of the capital market. Capital market should be stable in the sense that it denotes favourable prevailing atmosphere for the smooth carrying of various activities like production, distribution, employment and marketing. Financial instability is an indicator of recession and downward movement in which situation there would prevail unemployment, stagnation and poverty.

Hence to achieve this monetary and financial stability, Bank of England follows various strategies. These strategies are:

  • Maintaining the inflation rate at 2% level
  • providing required liquidity during normal and stressed conditions
  • establishing financial stability
  • Strengthening inter- relationship among central banks.
  • Delivering effective and efficient banking services.
  • Making the public understand the role of the bank in the development of the country.
  • Increasing the accountability and efficiency across the organization.

The above strategies are the revised strategy as per the Bank of England Act of 2009. The strategies provided in general are:

  • In maintaining the inflation as targeted, the monetary policy committee, should get the efficient and quality supporting services from the banks.
  • The banks should provide regular and necessary information's to monetary policy committee from time to time in order to enable the committee to take suitable decisions to push or pull down the inflation rate around 2% level.

The Bank of England maintains the financial stability by adopting 3 methods they are:

  • Stabilizing sterling interest rates
  • Open market operations
  • By means of liquidity ratio.

The monetary policy committee gives proper directions and suitable guidelines in determining the interest rates, maintaining the liquidity ratio and operating the open market.

  • While issuing the notes in the course of money supply, utmost care has been taken by The Bank of England. The notes printed and circulated should be highly secured against counterfeiting. Moreover one of the objectives of the bank, are to consistently maintain integrity and quality. This integrity and quality is possible only by efficient and secured circulation of bank notes.
  • The banks should have enormous data concerning financial markets. Those required data can be collected through wide market network which, in turn, would help in achieving the financial stability.
  • Finally, the banks should practice safe and efficient payment and settlement system. Ultimately the banks should aim at highest professional standards.

3.3 Structure of U.K Banking Sector:

The structure of Bank of England on the basis of activities is fourfold in nature. They are:

  1. Monetary Policy Analysis and Statistics
  2. Markets
  3. Financial Stability
  4. Banking Services

These are the main operational areas with the aim of achieving core purposes. This structure was introduced in June 1978 in England and it reflects the new responsibilities, the U.K. Banks have to undertake as per the provisions of Bank of England Act.

The Apex body in the structure of Bank of England is the court of Directors. According to provisions of the Banking Regulation Act of England and rules made there under, the functions of court of Directors are as follows:

  • The court of Directors of the Bank is responsible in framing the rules, regulations and procedures that are to be followed by monetary policy committee.
  • It determines the methodology of collecting necessary data and information's with which the monetary policy committee formulate the various monetary policies for the economic development of the country.
  • According to section 3 of the Act, the court of Directors of the Bank can delegate some of their authorities to sub committees, to enable them function freely and independently.

A. Monitory Policy Committee

It is a nine member committee. Out of those nine members, five members are internal members permanently employed. They are all employees of the Bank and such employees are:

  • Governor
  • Two Deputies of the Banks
  • The Chief Economists
  • The head of markets

The monetary policy committee operates on a monthly cycle basis. This is essentially because, according to the provisions of the Act and rules made there under, the committee should meet and setup the interest rates every calendar month.

In fixing the interest rates the committee would consider various aspects and will have discussion in the meeting.

Monetary Analysis Division:

Monetary Analysis division ‘MA' works under the control of monetary policy committee. The main function of this division is to provide information by conducting economic analysis to the MPC.The economist conducts research and analysis of current and prospective development not only in U.K. but also the world at large. It produces periodical inflation report. It helps the monetary policy committee in assessing current monetary and economic situations in the U.K. It also brings quarterly bulletin. It is a publication which paves way for broader research and analysis that helps in a great deal in taking policy decisions.

It has got twelve agencies working under it. They are duty bound in providing analytical information to the MPC so that the committee can understand the true picture of prevailing economy and take necessary action in maintaining the inflation to the point of 2%. The division also undertakes special studies regarding the International economic conditions.


The market division of the monetary policy committee takes care of open market operations and sterling money market. It manages Bank of England's balance sheet, and foreign exchange reserves. It greatly helps the MPC to bring the financial stability by providing valuable analysis and information's about the market.

The market division consists of two divisions. One is risk management divisions and another is financial services authority.

Risk Management Division

This division is responsible for the management of risk that arises in financial operations. It provides the strategic support in reducing the risks of the markets that is sterling money market, capital market and foreign exchange market.

Financial Services Authority

One of the markets that are being controlled by the monetary policy committee is the Gilt market. The participant of this market is controlled by Financial Services Authority that regulates this market. It was set up during 1997 and became full fledged in the years 99/2000. This FSA frames rules for the chanelized transactions and trading in gilts and gilt derivatives.

C. Financial Stability:

Financial stability is the core objective of monetary policy committee. To achieve this goal, it works in co-ordination with two divisions that is HM treasury and Financial Services Authority under the memorandum of understanding. The financial stability objective has been given a statutory status by the Act of Bank of England 2009.

The high level functionary in the Financial Stability Activity is the Financial Stability Executive Board.The board would identify the risk prone areas and advise the necessary actions that are to be taken in bringing down such risks. Thus the board helps to strengthen the financial structure of the United Kingdom both at home and abroad. Financial stability report makes the public to understand the issues concerning the financial stability.

Memorandum of understanding between HM Treasury, the Bank of England and the Financial Services Authority.

The memorandum of understanding establishes a framework for co-operation between HM Treasury, the Bank and FSA. It sets out the role of each authority and explains how they work together towards the common objective of financial stability in U.K.

The division of responsibilities is based on four guiding principles. They are:

  • Clear Accountability: Each authority should have unambiguous and well defined responsibilities and should be accountable for their actions.
  • Transparency: The responsibility of each authority should be made known to the public at large.
  • Avoidance of duplication: Each authority should have a well defined role. They must exercise utmost care in avoiding inefficiency and unnecessary duplication of effort.
  • Regular information exchange: Efficient and effective discharge of responsibilities is possible only by means of regular exchange of required information.

Thus financial stability activities are being carried on by the MPC.

Banking Services - Central

The Banking Services activities have been divided into three divisions. They are:

  • Customer Banking Division:
  • This division renders its services to the government, Financial Institutions and other Banks.
  • Notes Division:

This division manages the issue of notes. It is the responsibility of this division to see counterfeit notes are not being circulated.

Market Services Division:

  • This division operates the real time gross settlement system.
  • This system is a funds transfer mechanism where transfer of money takes place from one bank to another on a ‘real time'. It means payment transaction is not subjected to any waiting period. The transactions are settled as soon as they are processed. Gross settlement means the transaction is settled on one to one basis without combining with any other transactions. Once processed, payments are final and irrevocable.
  • Thus the central services division consists of several groups that contain efficient and intelligent people; they provide support functions to the bank.

3.4 Pre-Reform Period

UK Banks, prior to the advent of Bank of England Act 1998. Which introduced new structure of activities with the object of achieving monetary stability and financial stability, did not witness any big crises as of United States, European countries and others like Japan. Various crises such as the great depression of 1930, Bubble scam of housing market in 1988-89, Bond and Equity market crash in 1987, global credit crunch in 1982 and so on rocked the whole world, but Great Britain was not affected much during those periods. This is because of consistent traditional practices adopted by the UK Bank. In the mid eighties and before, the structure of UK Banking activities were of two fold one is general function and other one is economic function.

General Functions:

  • The general functions of the banks were
  • Collections of deposits and maintaining various accounts of the customers
  • Borrowing money by issuing bank notes and bonds
  • Lending money and giving advances to customers on current accounts
  • Investing in marketable debt securities
  • These general activities helped many businesses in UK flourish and small businesses were established and developed with the help of the bank loan.

Economic function:

  • The general functions were carried on in micro level, but economic functions helped the country in macro level. Such economic functions were
  • Issue of Bank notes
  • Acts as collection and paying agent
  • Inter banks clearing
  • Borrowing in short and lend in long.
  • In this scenario, the UK banks experienced only internal crises. Such internal crises were rectified by taking suitable measures and thereby ensured the smooth functioning of the economy as whole.
  • UK Banks were cautious in their banking business. They used to have very sound, profitable business models. They collected savings from customers and then lent it out. They were very careful to whom they lent money and were scrupulous in checking their incomes. Because of this UK Banks did not suffer major financial crises like that of its counterpart US and other countries. Many crises affected the globe but not the Great Britain as the country was strong in their policy of having monetary and financial stability.
  • Prior to the 1998, there were two types of crises that Great Britain faced. They were

1. Internal Crises

2. External Crises

C. Internal Factors:

Internal factors that greatly affected the UK Banks before 1998 were

Liquidity Crises:

Banks were able to raise the required cash at negligible cost as and when they arose the need for liquid cash. Because of this lack of liquid money, they were not able to meet their obligations when they become due, and they had to accept certain losses.There existed a difference between short term assets and liabilities and loans t o private sect or was very great in comparison with the total assets. Also the total deposit of the bank consisted large share of other banks deposits. Banks relied more on the deposits for lending purpose which got reduced as the panic stricken depositors with drew their money. Banks relied heavily on few large depositors, and this constituted one of the major factors for liquidity crises.

Credit Risk:

  • One of the major activities of the banking business is lending. Large revenue has been generated as the banks give more loans for various purposes. Development of the economy through the development of large as well as small scale industry is possible only when their existed well established bank with adequate funds to provide. But in giving loans, care and cautious should be practiced in order to avoid defaults. Scrupulous scrutiny is required for knowing the credit worthiness of the borrowers.
  • At certain times UK Banks experienced the credit risks in the following circumstances.
  • a. Less credit worthy customers availed the loan facility of the Bank and their default led to the credit crunch.
  • b. Poor judgement of credit risks and failure to take precautionary steps
  • c. Having high risk weighted assets in comparison to risk free assets.
  • The bank failure in to would be avoided by considering the above factors.

Miscellaneous Crises:

  • Miscellaneous variables that may affect the Banking system are:
  • Bank management
  • Bank size
  • Fore seeing the risk that may arise.

Smooth and solid banking business can be achieved only if banks are maintained by well informed and well experienced professionals who can steer the business easily during the time of crises. Secondly size of the banks is to be considered as too many branches will not be cost effective and may lead to the downward trend in the profitability. Finally banks should be able to foresee the future risks that may arise due to various factors and at the same time be prepared to combat such risks with suitable and effective steps.

D. External factors

The external factors that affected the UK banks only to a certain extent were BCCI scandal and the great depression.

The Bank of Credit and Commerce International SA was setup in the year 1972 in Luxumberg by Pakistani Financier, Agha Hasan Abedi. Within ten years of time, it had developed to a huge extent, having 400 branches operating in 78 countries. In the early 80s it became the 7th world's largest bank.

It had 248 top officers functioning at utmost secrecy and refused to come under the one regulatory authority. The vast and speedy growth of BCCI caused enormous capital problems as the deposits of deposit holders had been used in funding the operative expenses of the Bank. Price water house was the accountants of BCCI. They announced in 1990 an unaccountable loss of hundreds of millions of dollars. This loss was made good by Sheikh Zayed bin Sultan Nahya, by increasing his shareholding to 78%. Many irregularities surfaced - one among them is 1.48 billion worth of loans to its own shareholders. Secondly giving loan to single person or family more than the capital of the concern and it would be very risky to do so.

The standing banking practices requires that the bank should not give more than 10% of its capital to single customer.

The bank was implicated in drug money laundering.

The sandstorm report of price water house revealed widespread fraud and manipulation.

These factors brought the BCCI's closure by making millions of depositors lose their money.

The Great Depression in the United Kingdom:

The great depression which is otherwise called a s the great s lump was famous during 1930 and it was the period of economic downturn for the united kingdom. Great Britain was not prepared and yet to come out of the effect of the World War I. The First World War brought the financial instability in many European nations as they incurred huge debt due to the war, Great Britain did not get caught in such kind of debt trap but suffered in other ways. It funded the war expenses through the sales of foreign assets. In that way it lost $300 million through foreign investments. The ex ports had been greatly reduced due to the global depression that had spread across the world. This reduction in exports led to the reduction of foreign exchange earnings of Great Britain. This led to serious consequences internally. Unemployment became rampant.

Government revenues fell as the national income contracted. The labour government in UK introduced various bills to reduce unnecessary expenditure and wage cut. This led to the great labour strike in the year 1931. The purchasing power in the hands of people decreased and subsequently the demand for product got reduced. Many production companies incurred loss and ultimately this led to bank runs and bank failures. Banks revenue was not enough to meet the bank operational expenses. Moreover the loan given was not able to be collected as the bank met many defaults. People's confidence eroded as they were panic-stricken and there was a great rush towards the bank for withdrawing their deposits as early as possible.

The Wall Street crash of stock market in United States was not only the stock crash but led to the great depression that engulfed the whole world. Some economists attributed the fact of great depression towards bank failures and stock market crash, others had pointed out towards Britain's decision in returning back to gold standard. It was largely due to the failure of the government to regulate interest rates, curtail bank failures and con troll the money supply.

By taking into consideration these factors, Bank of England Act of 1998 was passed with object of strengthening the UK economic system.

3.4 Current Crisis:

The present financial crises shows similarities to the crisis that occurred in 1929.A high credit a growth and an asset bubble which led to significant losses in the banking sector were similar to both the crises of 2008 and 1929 (Von Merden 2007).

While an accurate cause for the present global crisis and the weigh age given to them towards national context are a source of debate, there are a number of observations and points that are widely accepted. The root cause for the recession was the financial crisis, embracing banks and other organization in many countries, which gave rise to widespread default of “sub-prime” mortgage holders in the USA. But, many argued that for such default to generate substantial damage to the global financial system and the world economy, certain contribution conditions needs to be in place for this to take such an affect as it has caused.(e.g. Perton 2008,Cable 2009,Swan 2009,House of Commons Treasury Committee 2009).

Some of the causes for the current recession include:

  • A limited reach of regulatory framework.
  • The creation of structure and finance (products to escape regulatory requirements.)
  • The availability of funds to western capital market.
  • How interest rates which has given a significant increase for the demand of credit for investment and consumption.
  • The emergence of ‘Shadow Banking System' which enabled financial institution to undertake certain banking functions which resulted in loosening the rules governing, borrowing and lending.
  • The global trading of securities like (mortgage backed securities which problems internationally.

Each of these factors along a few have arguably contributed to the present crises. Firstly by having impact on finance provider balance sheet and secondly by influencing the demand and supply for credit to individuals and businesses.

Roots of the Banking Crisis:

The origin of the banking crisis had many causes, one of them being low interest rates, excessive risk taking and a search for yield, excess of liquidity and a misplaced faith in the financial innovation. These factors were the root cause to create an atmosphere which was rich in our own confidence and over-optimism. Many believe that some banks were the architect of their own demise.

The Collapse of the Banking sectors:

On 2 April 2007 a total of nine banks occupied in the FTSE 100 all share indexes. The combined market capitalizations of these banks were 316.9 billion which constituted the single largest component by sector of the index. By 7 April 2008, Northern Rock and Bradford & Bingley, had dropped out of the index which left the capitalization at 245.1 billion. Finally by 6 April 2009, the FSE top 100 banks sector was worth only 8.1 billion.

Most of the major financial institutions in the UK and institutions throughout the world have been victim to the banking crisis the extent to which they have been affected / open to debate.

Bradford & Bingley

Bradford &Bingley place has a history that date back to early 1851, where both Bradford Equitable Building Society and Bingley Building society were established. There was a merger between the two societies in 1964 and operated as Bradford & Bingley Building society until 2000 when the society members vote to demutualise the society and convert it into a public limited Company. After being established for 149 years as a mutual, Bradford & Bingley's lifespan as a public limited company lasted a little over eight years, which ended on 29 September 2008.On this date an announcement was made by the Chancellor that under the Banking Supervisors Act 2008, Bradford & Bingley's retail deposit business and branch networks would be transferred to Abbey and the Remainder of the business will be taken into public ownership. He was estimated that the losses for Bradford & Bingley would fall in the range of 600 m - 800m and no guarantee that these estimated losses would not exceed.


The Royal Bank of Scotland (RBS) was established in Edinburgh in 1727 and grew as a consequence of both organic growth and acquisition made throughout the nineteenth and twentieth century, while maintaining its image as a regional bank focused on retail banking in the UK, predominantly in Scotland and Northern England.

During the 1980's the group diversified by setting up a car insurance company, direct line in 1985 and by acquiring an American Company in Rhode Island's called Citizen Financial Group in 1988.Following a succession of acquisition, citizen became one of the largest banks in the US, spanning a branch network that operates in 13 states. In 2000, RBC acquired the Nat West Group which would help to create a much larger group with a more diversified portfolio which rendered services to customers on the personnel, business and corporate level. This includes a large part of what is RBS's global Banking and market division and Greenwich capital, a lender with exposure to sub-prime losses in the US, which constituted to a major amount of recent RBS losses. Since 2000, RBS has been involved in the acquisition of first Active from the Republic of Ireland, Charles One in the US and Churchill insurance in the UK.

More recently, in October 2007, RBS's it was involved in a share of the major Dutch Bank ABN Amro, which was to prove a fatal step to its survival as a privately owned entity. RBS later announced a 20 billion capital raising programmes in October 2008, was underwritten by HM Treasury. The RBS shareholders found the term of the share offers unattractive, and the Government had to intervene by acquiring major stake in the bank. RBS, a once proud financial institution with a history of fine heritage in prudent banking, had to be bailed out by the tax payers.

3.5 Conclusion



The primary aim of this chapter is to describe the data and methodology employed in this stating is to calculate the determinants of bank profitability and interest margin of commercial banks in the UK. The chapter is fixed into six sections. Section 5.2 describes the methodology employed in the study. Section 5.3 states the source of accounting as well as economic data along with the information on sample size. Section 5.4 gives a detailed description of dependent and independent variables and also states the relationship between the independent with the dependent variables. Section 5.5 looks at the descriptive statistics of the data. Section 5.6 provides the chapter's summary and conclusion.


A majority of statistics on book profitability and interest margin use multiple regression analysis as an estimation procedure. The main aim of regression analysis is to examine the relationship between dependent variable and a number of independent variable. We have adopted Bourke (1989) Molyneux and Thornton (1992).Methodology in our study while many recent studies have also employed a multiple regression equation in their study. Hence, we employ a single equation framework of bank- specific, industry-specific and macro-economic variables to determine profitability and interest margin of UK commercial banks which is expressed as follows:


This study uses accounting data of UK banks as well as macro-economic and data that is financial market specific drawn from the year 2002 to 2008.The data for calculating internal factors were obtained from banks cope data base of Bureau Van Disk's company. The macro-economics and other data structure were obtained for Bank of England's website and British Bankers Association (BBA) website.

Banks should meet the following conditions in order to be included in the sample. First they had to be classified as UK banks in the institution included within the United Kingdom Banking Sector (at 31st. December 2008).Nationality analysis of the banks of England. Secondly, they should be characterized as Commercial banks in the bank scope database. Third, they should have annual accounting statements (balance sheet and income statements) for all the years between 2002 and 2008 in the bank scope database. The time period was chosen considering that it offers recent time services. Observation and also contributes to a period of structural changes in the UK Banking System. The time period between 2007 to 2008 is essential because it relates how credit crisis had affected the functioning of UK Commercial Banks.

The above procedure yielded a final unbalanced data of 27 Commercial Banks over the period of 2002 to 2008, consisting of 184 observations.

A total of 4 banks had to be excluded from the sample size because of inconsistency with values which has been explained in the limitation of study.


This section gives an introduction and explanations of the variable as estimated in the equation 4.1.Finally bank profitability and interest is explained in table 4.1.


Theories of financial management present a number of criteria for evaluating banks performance. This includes profitability (ROA), (ROE) and net interest margin since these measures have been employed in the past statistics for the evaluation of banks performance and closely link to the measurements that were recommended in the literature. For evaluating banks performance in developing market (Barldrop and Mc Naughton 1992) with UK being a developed market.

is the dependent variable of bank i at time t, with i=1,…,…N, t= 1,……, T, c is aconstant term, 's are independent variables and is the disturbance term. 's grouped into bank-specific, industry-specific and macroeconomic variables. The β's are unknown parameters associated with each's.

To estimate the coefficient of multiple regressions the test of ordinary least square (OLS) is required. The OLS is the best linear unbiased estimator. This indicates that multiple linear relationships are coefficient and they have minimum variance.

4.5 Measuring Bank Performance

A. Dependent Variable

Return on Assets:

ROA reflects the profitability of the banks which indicates the potential of a bank to a generate profit from the given asset base. ROA refers to a profit generated from a multiple products offered by banks which include interest income as well as non-interest income. According to Dinger and Hogan (2004) and Naceur (2003) ROA measures the profit produced per dollar of Assets and reflects how well profits are generated using the Bank's real investment. Therefore, we employ net profit before tax to total Assets to proxy results for ROA which is one of the following two measures for profitability.

Return on Equity:

ROE meanwhile measures the profitability from the shareholders point of view and reflects the management's ability to utilize funds in order to generate maximum returns to the shareholders. It is calculated by dividing Net Income Margin to Share holder Equity. ROA, ROE are combined by Assets to Equity Ratio known as Equity Multiplier. This Equity Multiplier is used to measure financial leverage. Banks with lower leverage (higher equity) will generally report higher ROA but lower ROE (Athanasaglou, 2005).

Net Interest Margin

The core business of Banks is to pay interests on deposits and charge interest on loans and business, thereby making profits in between (Kosak and Cok, 2008) .NIM suggests that profits made by banks on its products which charges interest. In a nutshell banks earn from interest activities by charging high rate of interest on loans and advances while accepting deposits on a lower rates.

NIM is calculated as Net Interest Income (interest income minus interest expense of the banks) divided by total value.

It measures the banks price margin and can be informative to the extent of market power in pricing (Dinger and Hagen (2004); NIM reflects income generated by banks through a more traditional way of doing business i.e. collecting deposits and granting loans.

B.Independent Variables: Among the various independent variable used in the past studies ,this study classifies them into Banks-specific and macroeconomics determinant of bank profitability and net interest margin .The study employs Bank-specific variables emphasizing on the condition of the Banking Sector in the U.K.

Bank Specific Determinants:

Capital Ratio- Capital ratio is the measurement of total shares capital over total assets to proxy bank capitalization. It is also stated as capital deficiency Ratio. According to Hempel and Simonson (1999) capital is essentially revised for chartering a bank as well as an important function towards the abolition of risk. According to Athanasaoglou at.el (2008) and Hgo (2006) capital refers to the amount of own funds accessible to maintain the safe running of Bank's business, therefore, capital acts as a safety net for banks for adverse conditions. However Jackson and Fethi (2000) states that due to risk-return trade- off in the banking sector, higher capital ratio tends to lower banks profitability. This indicates that banks that are higher capitalized prefer a more safe and low earning portfolio instead of higher earning portfolio (Jackson and Fethi, 2000).On the other hand Demirguc-kunt and Huizinga (2000) stated that banks with higher equity capital is likely to borrow at relatively low cost to maintain a level of assets resulting in higher banks profitability and interest margin. Similarly many previous studies have observed that a positive relationship between capital and banks profitability and interest margin. They suggest that banks that are well capitalized maintain a low rate of bankruptcy for their own and customers which lessen the cost of capital. Therefore, we expect a positive relationship between capital and bank profitability.

Credit Risk- A risk management system in the banking sector is necessary because of the banking nature of the banking business. The theory suggest that poor quality of assets ensuring in non- performing loans is an important factor in the failure of banks and therefore, an important determinants of bank profitability. Therefore, the ratio of total loans to total deposits is used as a proxy to credit risk. Further Miller and Naulas (1997) state that when a larger number of commercial banks are open to an element of high risk loans the further will be the actual of unpaid loans and lower will be the profitability Ceteris Paribus (Athanasaoglou et al 2008).Thus we expect an inverse relationship between Credit risk, bank profitability and interest margin.

Overheads- Overheads is measured by operating expense to total assets a proxy for overheads as it is essential towards cost control and a vital ingredient towards bank operation. Variation in operating cost of banks can affect their profitability and efficiency as overheads is closely related to the notion of management efficiency. Similarly, Athanasaoglou et al. (2008) also states that efficient banks are to operate are expected to lower cost since higher overhead ratio has a negative impact on banking profitability. On the other hand, changes in the operating expenditure can also have an impact on the bank's net interest margin. As Abreu and Mendes (2001) and Demirguc-Kunt and Huizinga (2000) argues that banks with higher operating cost charges a higher interest rate on loans and, or pay a lower rate of interest on borrowing, thus transferring cost to customers and thereby increase profit. Similarly Molyneux and Thornton (1992) observed that higher profit earned by banks is suitable for higher payroll expense incurred due to more prolific human capital.

Macro-Economic Determinants:

Inflation- In this study inflation is measured by taking annual changes in consumer price index (CPI). Inflation may have a direct effect on profitability like in cost particularly staff expense or it can have an instinct effect like rise in interest rate or in asset market value (Saviours and Woods, 2003). Inflation is considered to have an impact on with interest rate which means with rise and fall with inflation can directly affect the interest rates, thus also having an impact on profitability. According to the listing of Perry (1992) anticipated inflation leads to profitability as banks change their interest rate in advance to cut cost. However, if inflation is anticipated and banks are slow to change their interest rate, the bank will in turn incur lost and profitability will be affected. However, several statistics have investigated an inverse relationship between overheads, bank profitability and net interest margin. Therefore, we expect a negative relationship between overheads since it illustrates management efficiency which suggests that higher the ratio of overheads, the lower will be the efficiency and performance which has a direct impact on profitability and vice-versa.

Economic Growth- GDP is most commonly used macro-economics indicator which measures total economic activity in an economy. In this study growth in GDP at current prices is to capture the effect of economic activities on bank profitability. An influential and strong factor on the demand and supply of loans and advances is reflected by GDP. Further, growth in economic activities is related to growth in financial intermediaries. King and Levine (1993) found a positive and significant relation of GDP with banks profitability. Overall, table 4.1 summarizes the dependent and independent variables together and also gives a description and expected relationship between the variables and bank profitability and interest margin.

4.6 Descriptive Statistics of variables

Table 4.2 summarizes the descriptive statistics of the variables used in this study. Generally the variables are supposed to have a large deviation from the mean value as measured by standard deviation.




Standard Deviation



















































Capital Ratio- Capitalisation ratio INF- Inflation


This chapter summarizes issues to data and methodology which was used in the study. The accounting data for commercial banks was collected from bank scope, while country specific data has been collected from Bank of England websites. In order to analyze the effect of various internal and external determinants on profitability in the UK, the regression analysis has been used on panel data of statistical commercial banks. This chapter also provides a comprehensive description of variables and their applicability in regard to the study.



The purpose of the chapter is to investigate the main determinants of commercial bank profitability and interest margin in the U.K. The chapter is divided into 5 sections. Section 6.2 consists of the model used in the study. Section 6.3

Section 6.4 provides the empirical results and discussion of the studies.

Finally, Section 6.5 provides summary and conclusion of this chapter.


This model is used in this study is based on the estimation procedure used by Bourke (1989) and Molyneux and Thornton (1992) among various others. To examine the Determinants of Profitability and in this margin for commercial banks in the UK from the period 2002 to 2008 the multiple regressions equation will be used.

The estimation model will be formed as follows:

Is the banks performance measures as return on (ROA) and net interest margin (NIM) for the jet bank at year t; is the vector bank specific variables; is the vector industry-specific variable and is the country specific variable.


We have employed the following bank-specific variables. (As components of the Vector):

Capital Ratio= Capital over Total Assets.

Credit Risk= Loans over Deposits.

Overheads= Operating Expenses over Total Assets.

Finally, we employ the following country-specific variables (as components of the country vector):

Inflation= Consumer Price Index.

Economic Growth (GDP) = GDP per capita of each year.

5.3 Validity of the Study

In order to ensure the validity and reliability of the regression results, some classical assumptions had to be satisfied. However, to satisfy these assumptions of multicollinearity we have obtained multicollinearity test results by carrying out person correlation matrix (see appendix1).

5.4 Empirical result and Discussion:

Determinants of Profitability and interest margin of commercial banks in the U.K are estimated by using multiple regression model (equation6.1).The panel data banks for the U.K was analyzed by using excel and Stata software. Table 5.1 summarizes the regression results for 3 dependent variables. Return of assets (ROA), Return of equity (ROE), Net Interest Margin (NIM) and five independent variables: Capital Ratio, Credit Risk, Overheads, Inflation and GDP/

Table 5.1 Determinants of U.K Commercial banks ROA, ROE and NIM





Std. Err.


Std. Err.


Std. Err.






















Capital Ratio







Credit Risk



































Number of Observations= 189

Number of Observations= 189

Number of Observations= 189

R-sq =0.5614

R-sq =0.4512

R-sq =0.5612

R-sq (adj) =0.5444

R-sq (adj) =0.4300

R-sq (adj) =0.5442

Notes - Authors own calculation.

ROA- Profitability ROE- Profitability

CAP- Capitalisation ratio NIM- Net Interest Margin

OV- Overhead Expenses CR- Credit Risk

GDP- Economic Growth INF- Inflation

In this regression equation of ROA, overheads (operating expenses by total assets) have a negative impact of ROA while, ROE (equity by total assets), NIM (net interest revenue by total assets), capital ratio, (share capital /total assets) and Credit risk (loans / deposits) and Inflation (CPI) have a positive impact with ROA.

  • In this regression equation of ROE, NIM (net interest/total assets), capital ratio (share capital/total assets), credit risk (loan/deposits), overheads(expenses/total assets), Inflation (CPI) have a negative impact. ROA, ROE while ROA (net income by total assets) have a positive impact with ROE.

  • In the regression equation of NIM, ROE (net income/total equity), credit risk (lo0ans/deposits) have a negative impact with NIM. However, the effect of other independent variables on NIM is not important.
  • Table 5.1 gives the description of regression. Regression results of banks - specific, industry - specific, and macro - economics variables. Hence, to discuss the effect of these variables in detail we have categorized them into bank - specific, industry - specific, and macro - economic determinants which are as follows:

A. Bank - specific determinants:

Capital ratio

Capital ratios have long been used as variable tools for assessing the safety and competency of banks. The formal use of ratio by banks regulates and supervises goes back well over century (Mitchell, 1909). In the United States for instance, minimum Capital ratio have been required in the regulation since 1981, and the Basel Accord has applied capital ratio requirements to banks internationally since 1988.It is argued that capital ratio should bear a significant negative relationship to the risk of subsequent bank failure.

Theoretically Buser et al. (1981) argued that banks need to remain well capitalized when they have a high franchise value. Positive relationship between bank performance and capitalization was notice by Demerguc- kunt and Hwizinga (1999) and Naceur (2003) emphasizing that the well capitalized bank maintains a lower expected rates of bankruptcy which benefits them as well as their customers and also lessens their of cost of capital.

The capitalization of commercial banks in the U.K has been positive for two of the determinants ROA and NIM. As discussed in the literature, higher the equity to asset ratio, lower would be the banks need for finance externally leading to profitability. Capital refers to the amount of own funds available to support business generated by the banks and thus it acts as a safety reserve that can be used when there is a level of turbulence in the financial climate or adverse condition (Athanasoglou, 2005).

However, Commercial banks capitalization for the U.K is negatively related to ROE. We also noted that ROE (return of equity can be broken down using the Du pont Decomposition, into the product of ROA and equity multiplier (which is the reciprocal of the capital ratio).It therefore signifies that a negative relationship between ROE and capital ratio should be more stable the more stable is the general level of ROA. This means, banks have an incentive to maximize the amount of equity invested in order to maximize their ROE.

Credit Risk

The ratio of total loans/total deposits is employed to measure loan quality. Credit Risk possesses a significant negative impact with relation to profitability.

The result for ROA shows that there is a positive relation with credit risk. This shows that the banks in the sample size, managers who try to maximize their profits, follow a risk-seeking approach, they are willing to dish out high risk loans in order to make as much profit as possible. For these banks the risk management structure should be sound and risk management team should constantly monitor and screen the quality of loans the banks are lending. Furthermore, it can also be stated that volatility in U.K commercial banks profitability is largely characterized by the volatility in the credit risk and as higher exposure to credit risk is generally associated to lower bank profitability (Duca and Mclaughlin 1990).

A similar relationship was also investigated by Miller and Noulas(1997) and stated that when more commercial banks are opened to elements of high risk loans, the further will be the accrual of unpaid loans and lower will be the profitability. These findings are consistent with credit risk possessing a negative relationship between ROA and NIM. This indicates that U.K banks which are risk averse in their approach than to work with lower interest margin.

Bobakova (2003) states that banks can increase their profitability and interest margin by improving their forecasting, monitoring and screening of risk and can cover up the losses generated from high risk.

Overhead Expenses

Another important determinant of bank profitability and interest margin is bank overhead. It signifies management efficiency of the bank as it includes operating expenses of the bank. As efficient bank are expected to operate with lower cost, a higher overhead ratio is expected to inversely affect the bank profitability (Athanasoglou et al. 2008).

As expected the relationship between overheads and profitability is negative. This implies that an increase in cost leads to decrease in profitability. Previous studies like Guru et al. (1999), Kosimidou (2006) and Pasiouras (2005) and Kosimidou (2006) found a negative relationship between cost and profitability mainly due to poor expense management. However, in the case of NIM the ratio positively related. Similar to the findings of Naceur, (2003) suggesting that a part of cost is being passed to its depositors and lenders in the form of higher lending rates or lower deposit rates.

B. Macro Economic Determinants

Economic Growth

We now turn to effects of macro - economic and financial structure variables. A positive and significant impact of GDP growth between GDP, Profitability and Interest margin supports the argument of the association between the economic groups and financial sector performance. The findings are similar with results of Kosimidou and Pasiouras(2005) and Hassan and Bashir (2003). As expected that change in GDP has a positive effect on profitability, which in turn implies when GDP increases, the profit of banks increase.

On the other hand we discovered a negative relationship with GDP and NIM. This suggests that the market growth has an affect on the bank's NIM. This can further explained by suggesting that NIM is more driven by economic development of a country rather than the competitive environment of the banking industry.

Inflation (CPI)

Inflation has been unpredictable when comes to profitability of banks. It can have a positive impact like Chessens et al; (1998), Demirguc - Kunt and Huizinga (1999). Hassan and Bashir (2003) and Athanasogluo et al; (2005) or it can have a negative impact as per studies of Uche (1996), Ogowewo and Uche (2006) and Naceur (2003) most recent evidence have found for inflation being insignificant.

Our results show that inflation, ROA and NIM is positive and consistent with the results of the previous studies. Chessens et al;(1998), Demirguc- Kunt and Huizinga; (1999), Hassan and basher (2003) and Athanasoglou et al; (2005). This implies that during the period of our study inflation was anticipated which benefited the banks and gave them an opportunity to adjust their interest rates accordingly, which resulted in revenues that increased faster than costs, with positive impact on profitability. Further, Hanson and Rocha (1986) analyzed inflation as one of the determinants of bank costs and profits. They indicated that a rise in inflation leads to excessive branching, high personnel cost and high income from bank floats.


  • To validate our studies we have tested multicollinear relationship between independent variables by employing Pearson Correlation test. Further, the study employs Return on assets (ROA), Return on equity (ROE) and Net Interest Margin (NIM) as the three dependent variables. From the analysis undertaken it was discovered that the profitability and net interest margin of U.K banking system is influenced by banks -specific, industry -specific and macro-economic factors.
  • The result generally indicated that Capital Ratio has a positive impact with ROA and NIM, but had a negative Impact with ROE. The positive effect states that banks are following more risk seeking approach. Further, Credit Risk has a negative effect with ROE and NIM, but seems to have a positive effect with ROA. This shows that banks are giving high loans which in turn has a very high rate of interest attached to it in order to increase profitability. Furthermore, overhead has a negative impact on ROA, ROE, stating that increase in expenses reduces profitability and margin of U.K banks. However, NIM has positive effect with overheads. Suggesting a part of cost is being passed to its depositors and lenders in the form of high lending rates and lower deposit rates. Further, GDP has a positive effect on profitability determinants ROA and ROE which implies that when GDP increases profitability of banks also increase. However, GDP had a negative effect with NIM suggesting that market growth has an effect on bank's NIM. Finally, inflation had a positive effect on ROA and NIM which suggests that bank were able to anticipate change in interest rate and could able to adjust them accordingly.


6.1 Introduction:

This dissertation examines the main determinants banks profitability and net interest margin of the UK commercial banks form 2002 to 2008.Three performance measures have been employed in this study namely ROE, ROA and Net Interest Margin. Profitability of banks indicates the generation of profits through multiple product offered by banks which include interest, income and non-interest. On the other hand, Net Interest Margin reflects on the generation of income by banks through a more conventional and traditional way of business i.e. collection of deposits and granting loans.

This study contributes to the existing study on developed markets and particularly in the case of U.K. This study also emphasis to this stating a regression model was used to test influential power of individuals' variables and profitability. The dependent variable (ROA, ROE and NIM) and several independent variables were analyzed using multivariate regression analyses.


The U.K banking sector is the third in the world after US and Japan. In addition to having the largest commercial banking industries, the U.K is also a major centre for investment and private banking. The U.K banking system has witnessed a substantial growth and change in recent years and its total assets have expanded since 1990.The major trend in the U.K banking sector over the last years includes the conversion of building, societies into banks, consolidation of the U.K banking industry and entrance of non-financial firms into the financial service market. As of December 2008, total assets of U.K deposits taking banks were £7.4 trillion- which is approximately 5.3 times UK's output annually.

This is a consolidated number which neglects inter bank lending. Suggest that, there is no double counting hidden in that outrageous large total. Back in 1991, U.K banks had assets totalling to £1.2 trillion. Back then it was described to be a much more modest banking system. In the intervening 18 years, the sector had grown by 501 percent. It resulted in an average growth rate of almost 2.5 percent a quarter, which is around 10 percent a year. This unprecedented and dangerous rate of growth was the reason for mainly for bad lending on enormous scale.

The major banks in the U.K are continuing to increase their participation in the syndicated loan market have become increasingly reliant on wholesale funding. This in turn makes them more vulnerable to falls in market liquidity. Large exposures to large complex financial institutions (LCFI's) are maintained by U.K banks, whose profitability reduce becau8se of record trading revenues, The major U.K banks are further exposed to counter party credit and interest rate risk, through their lending which goes on between each other and to other financial institutions. To further add on this, they are also exposed to market and liquidity risk through their activities of wholesale funding and trading, where the latter is concentrated among internationally active banks.

Our facts suggest that bank profitability and net margin interest are affected by internal and external factor. First banks, characteristics explain a substantial part of variation in banks profitability and interest margin. Low capitalization ratio tends to increase banks profitability.

Indicating the U.K banks follow a risk seeking approach. Results also indicate that credit risk has a negative impact on ROE and NIM but have a positive relationship with ROA suggesting that banks in the U.K are offering high risk loans which attract a higher rate of interest. However negative impact of overheads on ROE and NIM suggests that lack of confidence towards the management of expenses by U.K banks. One reason could be that they operate in highly competitive environment that has forced banks not to overcharge their customers. On the other overheads has a positive impact on NIM, size.

On the other hand inflation has a positive relationship with ROA and NIM suggesting that U.K banks prediction of future banks is accurate and are accordingly managing their operational cost. However, inflation has a negative effect on ROE.

In general the results of this stating the support the existing literature and agrees of those of what researchers have quoted. These results indicate that profitability and not interest margin of commercial banks in the U.K is mainly influenced by high lending towards risk seeking approach and a very competitive U.K banking sector.


The data used for analyzing performance and profitability in the U.K commercial banking sector was collected from bank scope database. There has been inconsistency with data and the financial information which had to be researched and analyzed. Firstly the data on priority sector lending had information only on high street banks and was an overall figure. This variable had to be removed from the sample because of this reason.

Further, there was an unavailability of a reverse ratio in the U.K, so this variable also had to be excluded. With this regard to the credit risk the data on loan loss provisions and loan loss revenues had a lot of missing data on the balance sheet and income statement, hence, loans and deposits had to be calculated to determine the credit risk. For banks to be included in the sample size they had to possess the latest information as of 31.10.2008 as cut off. Due to missing data large amount of banks had to be excluded from the sample size. Hence the total sample size had a figure of 27 banks with 189 observations. A total of 4 banks had to be excluded from the sample at the last moment due to range of values. Further, a total of 5 banks had a difference in the currency (J.P.Morgan ,Gold Sachs international, National bank of Kuwait, and Bank Mandiri )in USD and (Melli Bank) in Euros they had to be converted to GDP since it has been the standard currency used in this study. Data was obtained from Bank of England for Dollar and Euros conversion.

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