Globalization, regulation and profitability of banks: a comparative analysis of Europe, United States, India and China.

Author:Paulet, Elisabeth
 
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  1. Introduction

    Since several decades, banks have faced the dilemma of arbitraging between profit margin and stability. After the last crisis, performance and stability indicators are assumed to be the outcomes of strategic decisions for banks. The aim of this paper is therefore, to provide evidence of the transformation of banking structures on a global scale. Traditionally five main dimensions are used to describe business models of financial institutions: risk characteristics, systemic stability, bank performance, efficiency and corporate governance (Ayadi, R.et al., 2011). Beyond a discussion of all these aspects, this paper will focus on risk management and efficiency evaluation in order to identify the evolution of banking performance (Ramlall, I., & Ramlall, I., 2018). More specifically, we intend to identify the main factors that influence performance of banking institutions in the new regulatory environment.

    A discussion taking into account the situation among banking activities in Asia, Europe and the United States will help to offer insights into the differences existing among banking institutions globally. In developed countries like the United States or Europe, banking systems enjoy free and relatively liberal activities. The situation is slightly different in China or India, where the intervention of the State could prevent or enhance profit and stability for banking institutions. Our international comparison leads us to discuss the influence of State intervention on the banking system structure, particularly for the Chinese case. We cross-validate this aspect by also developing models for public versus private banks.

    In addition, we make a methodological contribution by explicitly addressing the potential correlations that could exist among a large number of ratios that could elaborate the links between stability and performance of banking institutions. Specifically, we employ available data for a sample of banks in different geographical areas to develop a pooled or transversal structural equation model. We analyse and contrast this with region-specific models for geo-specific insights. Unlike conventional regression equation modeling, our design has the advantage of allowing us to compare multiple model specifications to identify the best model for the pooled data and to underline the differences that could emerge from multiregional comparison using this pooled model as a referential benchmark.

    After having presented the banking structures in Asia, Europe and United States and discussed the concept of performance and stability, the paper will present the dataset and the relevant ratios necessary to comprehend performance and stability for banking institutions. The structural equation models are explained in section 3. Section 4 discusses our baseline results. Section 5 concludes.

  2. Hypothesis development

    2.1. International banking structures: Key characteristics that influence performance

    Europe offers several freedoms: freedom of establishment, freedom of capital circulation and freedom of provision of financial services. However, this is quite different in China or India. The aim of this section is to establish a topology of the banking systems selected in our sample in order to understand their strategic outcomes.

    European banking systems are essentially constituted by universal banks (Paulet, 2005). These institutions can be understood as organisational structures, which maintain close relationships between firms and their financiers in order to guarantee a regular source of capital. While reserve requirements actually constrain banks, the European financial market is competitive and the universal bank model possesses a greater aptitude for the collection of information (with banks operating directly through representation on the Shareholders board), enabling them to better manage financial risks by a higher level of asset diversification. American banks enjoy the same competitive strength with a dominance of commercial and investment banks. The financial sector is largely dominated by the market, which explains the profit and risk encountered by banks.

    The situation is more diversified in India. After a liberal period up to the mid 1960s, the banking industry experienced a wave of nationalization lasting up to the beginning of the eighties. But these public banks appear to be insufficiently competitive compared to foreign banks (Tzeremes, 2015). Therefore the Reserve Bank of India (RBI) initiated a banking reform towards deregulation in accordance with the traditional international standards (Koeva, 2003; Jayaraman and Srinivasan, 2014). Since 2000, Indian banks operate in a competitive environment (Prasad and Ghosh, 2005), and contribute to the economic development. The Indian Banking System consists of scheduled commercial banks (public sector banks, private sector banks), foreign banks, cooperative banks comprising of urban co-operative banks and rural co-operative credit institutions, and non-banking financial companies. Since the last global crisis, India adopted Basel III leading to higher and better quality capital. Banks have improved their risk management systems and have met the credit needs to satisfy the liquidity necessary for investment opportunities of companies. Nowadays, public sector banks remain dominant in the whole banking sector and represent about 75% of total advances in the Indian banking industry, whereas private sector banks are accountable for a share of 18.2% of the banking industry. Even if the ownership in the banking sector remained predominantly in the public sector despite a gradual decline in their share, India benefits from a liberal and friendly investment climate. Except for the particular structure of the financial institution, it seems that performance and stability of banking institutions are based fundamentally on the same criteria as their Western peers.

    The Chinese banking system, in particular, deserves a closer review, as it is becoming a major actor in the global market. In 2005, Chinese banks intermediated about 72% of the capital in China, more than double the US percentage and 1.5 times higher than in other Asian countries (Farrel et al. 2006). Recently, their business model has been transformed due to the credit boom following the subprime mortgage crisis (Ho and al. 2013), the reduction in deposits and the development of 'shadow banking' (Valla 2013 ; Ma et al. 2013) . This situation remains one of the major preoccupations in the global world as China could induce difficulties for most developed and emerging economic areas.

    The existing banking structure of China has gradually evolved from a Soviet-style mono-bank People's Bank of China (PBOC) system to a plural banking system since the inception of reforms in 1978. At that time, Chinese authorities established a two-tier banking system where top-tier banks (Agricultural Bank of China, Bank of China, China Construction Bank, Industrial and Commercial Bank of China) were under the control of the Central Bank and were originally responsible for serving distinct economic sectors and to grant loans for policy objectives (Fu et al. 2009) . In 1994 these banks were absolved of their policy lending objectives and were re-instated as commercial banks with the capacity to enter in direct competition with one another (Wong, 2000), despite remaining under government control.

    The reforms between 1978 and 1994 have profoundly transformed the current Chinese banking structure. Nowadays, it includes various financial institutions in the form of commercial banks, policy banks, cooperative banks and non-bank financial institutions. By the end of 2014, China's banking system comprised 5 state-owned commercial banks (SOCBs), 12 joint stock commercial banks (JSCBs which focus mainly on specialized financial products and are partly owned by local government, state owned enterprises, and in few cases, by private corporations), 133 city commercial banks and 665 rural commercial banks. Further, there are 3 policy banks along with China Development Bank and 41 foreign banks. Nowadays, China's financial system remains a bank-dominated system. State intervention is still predominant: there exist persistent incentives to lend to state owned enterprises rather than private sector enterprises. However, the liberalization movement enhances a trend towards a convergence of Chinese banks versus the Western business model. This is precisely the focus of our empirical analysis. We intend to analyze if market development contributes to decreasing the importance of government intervention and improving banking performance.

    Our previous discussion illustrates that banking systems could display wide diversity even with regard to their governance as in the case of China and India. As soon as the stock market developed, and financial liberalization occurred, the magnitude of this diversity began to shrink. Therefore, if determinant factors for performance were slightly different in the four geographical areas selected for our study, these differences could diminish over time. This will not be without influence on the stability of these financial institutions. This leads us to the following hypothesis:

    H1 Stock market development and government intervention influence the geographic disparity and stability of the banking system.

    2.2. Performance, liquidity and risk management for banking systems

    Determinants of banking profitability are first categorized by internal variables. These factors, such as capital ratio, are commonly used to examine the correlation between bank profitability and risk management. A large body of literature states a high connection between bank's capital ratio and profitability. Brissimis, Delis, & Papanikolaou (2008) found that capital plays an important role in explaining a bank's profitability. Since the recent financial crisis, regulations have imposed higher capital requirements on...

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