Chapter 4 Does Financial Regulation Affect the Profit Efficiency and Risk of Banks? Evidence
3. Literature Review
4.2 Definition of Z-Score
financial ratios (e.g. the ratio of nonperforming loans to total loans, the ratio of provisions for nonperforming loans to total assets, etc.). These variables have been criticized by the empirical literature because the ratio method is not based on any theoretical basis, and even in its most elaborated form, the ratios method does not take into account the impact of diversification on risk.
Therefore, we will use the Z-score measure to assess the bank risk and to overcome the shortcomings of the ratios method. This comprehensive measure takes into account both risks related to banking business and the degree of coverage of these risks by the capital (Goyeau and Tarazi, 1992). According to Beck, Demirgüç-Kunt, and Levine (2010), “if profits are assumed to follow a normal distribution, it can be shown that the z-score is the inverse of the probability of insolvency”, because “z indicates the number of standard deviations that a bank’s return on assets has to drop below its expected value before equity is depleted and the bank is insolvent”.
The Z-score indicator can be estimated using the probability of default extracted from Roy (1952) and developed by Goyeau and Tarazi (1992). The probability of default is the probability that losses exceed the equity, or when the net worth becomes negative (Roy, 1952;
Boyd and Graham, 1988). This may be written as:
Probability of default = Prob (π<−E)
It is possible to calculate different indicators of banking risks depending whether we divide the two terms of the inequality by the equity or by the total assets.
In this study, dividing by the value of assets results in an indicator in terms of return on assets. It provides an indicator Z , which allows separating explicitly the risk effect from the risk coverage of the bank capital. The probability of default can be written as:
) is the indicator of fragility.
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The indicator Z can be considered as an indicator of bank fragility. A higher value of Z corresponds to a lower default risk.
4.3 Tobit and OLS Regression Model 4.3.1 Model and Variable
To investigate the relationship between financial regulation and the profit efficiency and risk of commercial banks, we adopt the following financial regulation variables. The first type of variable involves indicators that have already been implemented in accordance with the provisions of the CBRC, but the indicators are not in the Basel III provisions (e.g., the loan loss provision and loan-to-deposit ratio28). Another type of variable entails indicators that are expected to be implemented under the new Basel III regulations, but the CBRC adopted more stringent regulations than Basel III did (e.g., the leverage ratio and Core Tier 1 ratio).
According to the CBRC, we divided the financial regulation variable into four categories: asset quality, benefit and efficiency, liquidity, and capital adequacy. In all respects, we therefore select the provision coverage, loan-loss provision ratio, cost-to-income ratio, loan -to-deposit ratio, current ratio, capital adequacy ratio, and leverage ratio as the explanatory variables. We finally use the establishment time as control variables to level their effects on financial regulation. Table 4-3 lists the definitions for these variables. The descriptive statistics for regulation variables are represented shown in Appendix Table A4-3.
We then used the Tobit regression model to determine the relationship between financial regulation and profit efficiency. The explained variables in the Tobit regression model were obtained from the profit efficiency in the profit model. The efficiency scores (as the explained variable) from DEA are limited to value between 0 and 1. Because the explained variable in the regression equation cannot be expected to have a normal distribution. Thus, we cannot expect the regression error also meet the assumption of normal distribution. The OLS method as a result often leads to biased and inconsistent parameter estimates (Greene, 1981). We therefore use Tobit estimation (Coelli, Prasada Rao and Battese, 1998; Fried, Schmidt and Yaisawarng, 1999; Wang, Tseng, and Weng, 2003; Lin, 2002) in this study.
28 While catching up with international standards, CBRC also retain some requirements widely used among Chinese commercial banks, such as a loan-to-deposit ratio of no more than 75 percent.
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Table 4-3 Definition of explanatory variables Variable code Variable name Description
1. Asset Quality
RES_NPL provision coverage ratio
non-performing loans to loan outstandings RES_Loan loan-loss-provision
ratio
loan-loss reserves to loan outstandings 2. Benefit and Efficiency
CIR cost-to-income ratio
operating costs to operating income 3. Liquidity
LIQ current ratio current assets to current liabilities LDR loan-to-deposit
net capital to risk weighted assets Leverage leverage ratio Basel III definition：
core capital to the adjusted on-and off-balance sheet assets of the relevant bank
Our study definition：
tier 1 capital to total asset
It is difference in the definition of denominator.
The ratio in our study is only for estimation and may be deviation from the actual level.
5. Control Variables
Time the establishment time
It is the cumulative year of the establishment time
Model 1：
We then used the OLS regression model to determine the relationship between financial regulation and risks. The explained variables in the OLS regression model were obtained from the Z-score.
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financial regulation and profit efficiency, risk, as shown in Table 4-4.Assets Quality：‘Loan Loss Reserve’ for loan impairment is the amount that reduces the recorded investment in a loan portfolio to the carrying amount on the balance sheet. The ratio estimates the portion of total loans that may prove to be bad loans and acts insurance reserves for potential problem loans. It provides an indication of the extent to which the bank has made provisions to cover credit losses, and in turn to impair net interest revenue on the income statement. The higher the ratio, the larger is the amount of expected bad loans on the books, and the higher are the risks despite having been provisioned (Ayadi and Pujals, 2005). On the other hand, a higher ratio also indicates the improvement in asset quality management.
Table 4-4 Hypothesis
Hypothesis Description Related literature
H1 The provision coverage ratio has no effect on the profit efficiency (or risk) of a bank.
Aasset Quality
H2 The loan-loss provision ratio has no effect on the profit efficiency (or risk) of a bank.
Ayadi and Pujals, 2005
Benefit and Efficiency
H3 The cost to income ratio has no effect on the profit efficiency (or risk) of a bank.
Xiong and Sun (2009), Francis (2004) , Ghosh, Narain, and Sahoo (2003)
H4 The current ratio has no effect on the profit efficiency (or risk) of a bank.
Liquidity
H5 The loan to deposit has no effect on the profit efficiency (or risk) of a
Athanasoglou, Delis and Staikouras (2006), Ayadi and Pujals (2005), Caprio, D'Apice, Ferri and Puopolo (2010)
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bank.
H6 The capital adequacy has no effect on the profit efficiency (or risk) of a bank.
Capital Adequacy
H7 The Leverage ratio has no effect on the profit efficiency (or risk) of a bank.
Zhong (2007)
Benefit and Efficiency：The cost income ratio, defined by operating expenses divided by operating income, can be used for benchmarking by the bank when reviewing its operational efficiency. Lower is better. Francis (2004) observes that there is an inverse relationship between the cost income ratio and the bank's profitability. Ghosh, Narain, and Sahoo (2003) also find that the expected negative relation between efficiency and the cost-income ratio seems to exist. Xiong and Sun (2009) pointed that the cost to income ratio had a significant negative effect on efficiency of bank. Shehzad and Haan (2012) mentioned that if the cost to income ratio is lower, managerial efficiency will be better.
Liquidity：A liquidity problem usually arises from the possible inability of a bank to accommodate decreases in liabilities or to fund increases on the assets’ side of the balance sheet (Athanasoglou, Delis and Staikouras 2006) The higher this ratio is, the stronger is a position of a bank to absorb liquidity shocks (Ayadi and Pujals, 2005). However, since liquid assets tend to be low yielding, a higher ratio implies lower earnings. As a measure of liquidity, the ratio may reflect how well the funding sources match the funding uses. Caprio, D'Apice, Ferri, and Puopolo (2010), among others, point out that while a high loan-deposit ratio indicates high intermediation efficiency, a ratio significantly above one also suggests that private sector lending is funded with non-deposit sources, which could result in funding instability.
Capital Adequacy：Capital Adequacy is a measure of a bank’s financial strength, in terms of its ability to withstand operational and abnormal losses. Adequate bank capital can function to reduce bank risk by acting as a buffer against loan losses, providing ready access to financial markets in turn to guards against liquidity problem and limiting risk taking but also constraining growth (Zhong, 2007). Most banks regulators see capital adequacy regulation as a means of strengthening the safety and soundness of the banking industry. In China, with the establishment of the CBRC in 2003, the 8% minimum capital adequacy ratio. As a supplement to capital adequacy ratios, a leverage ratio is introduced. If the ratio is set too low, it will not effectively constrain the banks’ rapid expansion
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5. Empirical Analysis 5.1 The Correlation Analysis
We further study whether the characteristic of financial regulation affects the efficiency and risk of bank. We then used the Tobit (OLS) regression model to determine the relationship between the financial regulation and the profit efficiency (i.e., risks) of large and small banks.
We apply the correlation analysis on explanatory and explained variables to examine multicollinearity. The correlation coefficient of the capital adequacy ratio was highly related with leverage ratio (0.805). Appendix Table A4-4 lists the coefficient of correlation.
5.2 The Relationship between the Financial Regulation and Efficiency and Risk
The explained variables in the Tobit regression model were obtained from the profit efficiency in the profit model; the explained variables in the OLS regression model were obtained from the Z-score. Then, we estimate the relationship between financial regulation and the profit efficiency and risk of bank between 2004 and 2011. As shown in Table 4-5.
Table 4-6 lists the significant empirical results. Table 4-7 summarizes of hypotheses results.
Asset Quality
The loan loss provision ratio had a significant positive effect on efficiency of large banks.
The higher the ratio is, the higher the efficiency of a bank. The coefficient for the provision coverage ratio is significantly positive, which implies that the higher the ratio is, the lower the risk for a bank. This shows that large banks have greatly enhanced the ability to resist risks.
But, these two ratios did not a significantly affect small bank’s efficiency and risk.
Benefit and Efficiency
The cost to income ratio had a significant negative effect on efficiency of large and small banks. The higher the cost-to-income ratio is, the lower the efficiency of a bank. For large banks, the coefficient of cost to income ratio is significantly negative. The higher the cost to income ratio, the more risk for a bank. But, the ratio did not a significantly affect small bank’s risk. This shows that large banks should pay more attention to the cost of control than small banks should.
Liquidity
The current ratio had a significantly negative effect on the efficiency of large banks; a higher ratio of liquidity may significantly impede the efficient operation of banks because of fund idle. But, the current ratio had a significant positive effect on efficiency of small banks.
The purpose of CBRC regulates the current ratio is reduce the risk of bank. By our empirical results, the current ratio did not affect the risk and lead to different efficiency results of large and small banks
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Loan to deposit ratio only affect the efficiency and risk of small banks. The higher the ratio, the less efficiency and more risk for a bank. Therefore, the CBRC regulates the ratio seems reasonable and meaningful for small banks. The loan to deposit ratio did not a significantly affect large bank’s efficiency and risk. The loan to deposit ratio of large banks is lower than small banks, the sources of funding is more stable.
Capital Adequacy
The capital adequacy ratio and leverage ratio did not a significantly affect large bank’s efficiency and risk. For small bank, the capital adequacy did not a significantly affect on efficiency, but it can reduce the risk. The leverage ratio had a significant positive effect on efficiency of small bank. The higher the ratio is, the lower the risk for a bank. The capital requirement can reduce the risk of small banks.
Control Variable
The establishment time had a significant negative effect on efficiency of large banks. The longer the establishment time, the lower efficiency and risk for a bank.
Table 4-5 distinguishes between large and small banks and lists the significant empirical results. An increase in the provision coverage ratio, however, can reduce the risks of large banks. The coefficient for the cost-to-income ratio is significantly negative, which implies that a higher ratio indicates a lower efficiency and greater risk for large banks. Therefore, the CBRC regulates the provision coverage ratio and cost-to-income ratio, which seems relevant to large banks. However, these two ratios had no effect on the risks of small banks. For small banks, the loan-to-deposit ratio is significantly negative, implying that the ratio increases as risks increase. A higher loan-to-deposit ratio implies lower efficiency. Small banks with higher capital adequacy ratios and leverage had lower risks. Nevertheless, these three ratios did not significantly affect the risks of large banks.
We think the adoption of the New Standards is likely to put pressure on Chinese banks. It is imperative for commercial banks to change the profit model. Especially, as China commercial banks still follow the conventional business model which highly dependent on credit supply to make profit. The scale expansion of loan will bring an increase in capital. In order to keep up with the regulatory requirements on capital adequacy ratio, bank will be faced with the needs for capital supplementation. Then, the new capital requirements will greatly restrict commercial banks’ credit expansion. Upon the implementation of the new rules, Chinese banks will have to consider possible ways of replenishing capital again.
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Table 4-5 The relationship between financial regulation and profit efficiency and risk for large and small banks
Explained variable Efficiency Risk
Model Model 1 Model 2 Model 3 Model 4
Bank type Large banks Small banks Large banks Small banks Large banks Small banks Large banks Small banks Coeff.(SD)
R-squared 0.4490 0.0546 0.3373 0.0560
Adjusted R-squared 0.3878 0.0243 0.2637 0.0257
Note：***, **, * represent significance at the 1%, 5%, and 10% levels, respectively.
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Table 4-6 Significant results under the Tobit and OLS regression model：distinguish between large and small banks
Large bank Small bank
Regulation variable
Efficiency Risk Efficiency Risk
RES_NPL no effect positive no effect no effect
RES_Loan positive no effect no effect no effect
CIR negative negative negative no effect
LIQ negative no effect positive no effect
LDR no effect no effect negative negative
CAR no effect no effect no effect positive
Leverage no effect no effect positive positive
Time negative positive no effect no effect
Note: (positive) indicates that the regulation variable had a significantly positive effect on the efficiency (risk) of large (small) banks；(negative) indicates the regulation variable had a significantly negative effect on the efficiency (risk) of large (small) banks.
6. Conclusion
The CBRC released a set of guidelines for the banking industry, including imposing requirements on capital bases, leverage, provision and liquidity. This research investigated the characteristics of China's financial regulations and explored how the regulations affect the profit efficiency and risk of commercial banks in China. The CBRC regulates the current ratio to reduce the risks of banks. Based on our empirical results, the current ratio did not affect the risks and led to different efficiency results between large and small banks.
The empirical results indicate that an increase in the provision coverage ratio can reduce the risks of large banks. A higher cost-to-income ratio implies lower efficiency and greater risks for large banks. Conversely, these two ratios had no effect on the risks of small banks.
Therefore, the CBRC regulates the provision coverage ratio and cost-to-income ratio, which seems relevant to large banks. Small banks with a higher capital adequacy ratio and leverage have higher efficiency and lower risks. For small banks, the loan-to-deposit ratio increases as risks increase. A higher loan-to-deposit ratio implies lower efficiency. However, these three ratios did not significantly affect the risks of large banks. Similarly, the CBRC regulates the loan-to-deposit ratio, capital adequacy ratio, and leverage ratio, which seems relevant to small banks.
In an environment with asymmetric information, a bank decision-making is unobservable. The characteristics of financial regulation provide market clues if a bank is
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operating at the most efficiency condition. This also explains that the policymaker and banks face a trade-off between financial risk and efficiency. Stricter regulation may be good for bank stability (reduce risk), but not for bank efficiency. In order to fit the new requirements, it is imperative for commercial banks to change the profit model. Therefore, the banking sector should make more efforts on credit structure adjustment and credit quality improvement in the coming period of time, which is also the expected goal of the CBRC in its efforts to boost the implementation of new regulatory standards.
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Table 4-7 Summaries of hypotheses results
Efficiency Risk
Efficiency and risk
Regulation index and hypothesis Large bank Small bank Large bank Small bank
Regulation index
Hypothesis Descriptions Model 1 Model 2 Model 1 Model 2 Model 3 Model 4 Model 3 Model 4
H1 The provision coverage ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent consistent inconsistent consistent consistent consistent Asset
Quality
H2 The loan-loss provision ratio has no effect on the profit efficiency (or risk) of a bank.
consistent inconsistent consistent consistent consistent consistent consistent consistent
Benefit and Efficiency
H3 The cost to income ratio has no effect on the profit efficiency (or risk) of a bank.
inconsistent inconsistent inconsistent inconsistent inconsistent inconsistent consistent consistent
H4 The current ratio has no effect on the profit efficiency (or risk) of a bank.
inconsistent consistent inconsistent consistent consistent consistent consistent consistent Liquidity
H5 The loan to deposit has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent inconsistent consistent consistent consistent inconsistent
H6 The capital adequacy ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent consistent consistent consistent inconsistent consistent Capital
Adequacy
H7 The Leverage ratio has no effect on the profit efficiency (or risk) of a bank.
consistent consistent consistent inconsistent consistent consistent
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consistent inconsistent
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Chapter 5 Concluding Remarks and Future Researches 1. Concluding Remarks
Major shareholders of acquiring banks had greater controlling power to decide whether to merge during the financial restructuring period. During the financial restructuring period, a bank merger using the financial restructuring scheme had less static and dynamic efficiency in the short run, but gradually increased in the long run. Such an observation is consistent with the hypothesis that controlling shareholders pursue long-term efficiency in a bank merger.
The second essay uses the DSBM to study the relationship between the financial regulation and the dynamic efficiency of China listed commercial banks; the third essay uses
The second essay uses the DSBM to study the relationship between the financial regulation and the dynamic efficiency of China listed commercial banks; the third essay uses