Profitability drivers for Indian banks: a

dynamic panel data analysis

Alfiya Rizvi, Aman Dwivedi, Akshat Shukla

Received: 19 May 2016/Revised: 20 July 2017/Accepted: 3 October 2017

Eurasia Business and Economics Society 2017

Abstract:
The study aims to find the factors such as bank specific factors, banking industry factors and macroeconomic
factors that affect bank profitability in India. The paper employs the data from Indian Public sector and Indian
private sector banks. Both these banks contribute to more than 90% of total business of scheduled commercial
banks in India. The study applies the dynamic panel data analysis. The analysis is conducted over a period of 10
years in which the Indian banking sector has gone under different changes such as demonetization and issues
related to banking sector sustainability and banking sector frauds. The analysis is based on balanced panel data
over a period ranging from 2008 to 2017 for commercial Indian banks. Profitability of Indian banks is measured
by two proxies, namely, return on assets (ROA) and return on equity (ROE), whereas bank size, assets quality,
capital adequacy, liquidity, operating efficiency, deposits, leverage, assets management, and the number of
branches are used as bank‐specific factors. Further, a set of macroeconomic determinants such as gross domestic
product, inflation rate, interest rate, exchange rate, financial crisis, and demonetization, include bank specific
factors, banking industry factors, and economic factors. Among the bank specific factors, non performing loans
and cost to income ratio negatively affects the bank profitability, and diversification measures do not affect the
bank profitability are used as independent variables.
Stationary test along with pooled, fixed, random effect models and panel correction standard error are used in this
study. The results revealed that bank size, the number of branches, assets management ratio, operational
efficiency, and leverage ratio are the most important bank‐specific determinants that affect the profitability of
Indian commercial banks as measured by ROA. Furthermore, among the bank‐specific determinants, the results
revealed that bank size, assets management ratio, assets quality ratio, and liquidity ratio are found to have a
significant positive impact on ROE. With regard to the macroeconomic determinants, the results revealed that the
inflation rate, exchange rate, the interest rate, and demonization are found to have a significant impact on ROA.
However, in the case of ROE, the results show that all macroeconomic determinants except demonization have a
significant impact on the bank's profitability as measured by ROE.

And also the paper examines the impact of bank-specific, industry-specific and macroeconomic factors affecting
the profitability of Indian Banks in a dynamic model framework. The persistence of bank profits and endogeneity
of the factors had been accounted for using Generalized Method of Moments as suggested in Arellano and Bond
(Rev Econ Stud 58(2):277–297, 1991). The panel data for the study have been obtained from 42 Indian Scheduled
Commercial Banks for the period from 2000 to 2013. The lag of bank profit variable ROA has been found to be
significantly indicating a moderate degree of persistence of profits in Indian Banking Industry. The study finds
that the product markets of Indian Banks are moderately competitive, and less opaque due to asymmetry in
information. The adjustment towards equilibrium is partial and not instantaneous, implying that the elimination of
abnormal profits through competition is by no means instant, and banks can continue to retain a significant
percentage profits from 1 year to another. The Indian banking sector is not far away from becoming a perfectly
competitive industry. Bank specific variables; capital to assets ratio, operating efficiency and diversification have
been found to be significantly and positively affecting the bank profits. Credit risk, measured by provisions for
bad debts, negatively impacts the bank profitability. The study also tests the Structure Conduct Hypothesis by
using Herfindahl–Hirschman Index and finds evidence in its support. Bank profits respond positively to GDP
growth, indicating that bank profits a pro-cyclical to the growth of economy whereas the increase in inflation rate
affects bank profits negatively. It is observed that the crisis period did not make any significant impact on the
profitability of banks. The study concludes that there is a moderate degree of persistence of bank profits, and most
of the determinants of profits have a positive and significant impact on profitability of banks, which implies that
Indian Banks in the last decade have been moving towards efficiency and dynamism

Keywords: Bank specific factors Banking industry factors, Macroeconomic factors, Profitability,
Diversification, Non-performing loan (NPL) Bank specific factors, commercial bank, demonetization, financial
crisis, India, profitability determinants , Credit risk , Operational efficiency , Persistence , Market power

1 Introduction
The performance of a country's economy to a large extent depends on the performance of its banking sector.
Banks play a vital and substantial role in the development of any economy (Menicucci & Paolucci, 2016). Since
the 1990s, India has witnessed a significant liberalization with the intentions to increase productivity and to
enhance the efficiency of Indian banks (Ghosh, 2016). Following the liberalization in 1991, the Indian banking
sector has become a fast flourishing industry that has contributed to the growth of other major industries (Singh,
Sidhu, Joshi, & Kansal, 2016). India is the largest country in South Asia with a considerable financial system
characterized by diversified financial institutions (Ghosh, 2016). The banking system in India composes of 27
public, 26 private, 46 foreign, 56 regional rural, 1,574 urban cooperative, and 93,913 rural cooperative banks.
Public sector banks represent about 70% of the total assets of the Indian banking system (Shrivastava, Sahu, &
Siddiqui, 2018). The financial system of India is dominated by the commercial banks. In a competitive,
challenging, and regulatory environment like India, the Indian commercial banks have to allocate effectively and
efficiently their assets and liabilities to increase the profitability (Viswanathan, Ranganatham, &
Balasubramanian, 2014). Return on asset (ROA) and returns on equity (ROE) have deteriorated over the period
from 2013 to 2017. In spite of declining the profitability of Indian banks in the last recent years, some critical
questions that may arise in this regard are “What are the determinants of the profitability of Indian commercial
banks?” And also, what are the main causes for such kind of decline in the profitability measures during this
period?
The main aim of this paper is to evaluate the impact of bank‐specific factors and macroeconomic determinants on
profitability of the Indian commercial banks. The current study focuses on a major and important sector in an
emerging economy such as India. Taking into consideration some new governmental policies and procedures such
as demonetization process that may affect the profitability of Indian banks and global financial crisis 2008.
Moreover, fraud cases that raised recently in Feb 2018 when tax department estimated that Indian banks could
take a hit of more than U.S. $3 billion as a result of Punjab National Bank scam which is the country's second ‐
biggest governmental bank. Furthermore, the biannual Financial Stability Report of India's central bank (Reserve
Bank of India [RBI]) was released on June 30, 2017, which raised some big concerns about the sustainability of
the country banking system. RBI warned that the sector is under severe stress, with mounting bad loans and an
increase in banking frauds. All the above policies and measures show the importance of this study that pushes all
policymakers and researchers to examine the external and internal factors affecting the profitability of the Indian
commercial banks.

Indian banking is receiving increased attention in recent years because of higher gross domestic product (GDP)
growth rates. During the global financial crisis, while banks from developed countries were affected, Indian banks
to some extent remain insulated. Despite the fact that India is an important emerging market economy, we find
that little attention is given to explore the drivers of bank profitability. In this context, the study on performance
of Indian banking will be of greater interest when studied both before and after the global financial crisis. Various
profitability

measures are used to assess the performance of banks. Return of average assets (ROAA) is considered as an
accepted measure to measure the profitability. In addition to return on average assets, return on equity is also
considered. With the growing pressure on intermediation which has resulted in decrease of net interest margins,
banks look at generating additional revenue through addition of noninterest income. The ratio of non-interest
income to operating income is considered as a measure of revenue diversification. It is observed that the ratio of
measures of diversification for Indian banks is less as compared to that of developed countries. With the growing
pressure on net interest margin (NIM) for Indian Banks, it is likely that Indian banks will also look to enhance
revenue through diversification. Non performing loans (NPL) have been examined from the perspective of cost
efficiency (Podpiera and Weill 2008), quality of management, macro-economic variables including interest rates,
fiscal deficit, GDP growth (Beck et al. 2015; Kauko 2012; Nkusu 2011). The study is build on the work by
Boateng et al. (2015) which examined banking factors, and economic factors. The paper applies the Arellano and
Bond estimator, which is based on moment conditions where lags of the dependent variable and first differences
of the exogenous variables are used as a first-differenced equation. The method has a major advantage since it
tackles the problem of endogeneity, heteroscedasticity, and autocorrelation (Arellano and Bover 1995; Lee et al.
2012). We use the data from both public sector and private sector banks in India from the year 2006–2007 to the
year 2012–2013.
For many years, performance differences based on ownership have been the matter of public debate and
academic interest. The objective of the paper is to assess the performance of Indian banking industry, majorly
comprising of both public sector banks and private sector banks. There is a realization that private sector banks
with a focus on technology showed better performance. The paper examines the impact of ownership, non-
performing assets, bank size, cost to income ratio, and income diversification on profitability measure through
ROAA and ROE. In the past, performance analysis has extensively relied on Data Envelopment Analysis (DEA)
for Indian banks. We have deployed dynamic panel data as it provides the advantage of considering lagged values
of dependent variable to exploit the dynamic nature of the data and it also eliminates endogeneity issue while
using lagged levels and lagged differences of the regressors as instruments.

In last two decades, financial sector underwent significant changes, ranging from interest rate deregulation to
the entry of foreign players in the market, to stabilise the fiscal deficit through investments. The sluggish growth
momentum of the economy coupled with asset impairment has hindered the profitability of banks in the current
phase. A sustained profitability of the banking sector is desired as it contributes to economic growth. A more
efficient banking system can mobilise and allocate resources for accelerating economic growth. Since the
profitability of banks is one of the driving forces of capital, it is crucial to identify the factors which could cause
possible dangers to it. The depletion in profitability of banks is more likely to affect the solvency ratios that
ultimately threaten the economic system. The emerging Indian banking system and the turbulence in the Indian
economy provide a strong case for studying factors responsible to profitability of banks in detail. Academicians
and regulatory authorities have always been interested in bank profitability studies so that they can take necessary
steps to assess and manage risk for ensuring stability in the financial system. Persistence in bank profits is defined
as the tendency for an individual bank to retain the same place in the profit performance distribution of the
banking industry. The level of bank profit persistence determines the degree of competitiveness of product market
and informational asymmetry. Bhavani and Bhanumurthy (2012) examined whether the financial sector reforms
lead to an improvement in the overall health of the financial sector or not in the post reform period. The analysis
of trends in three indicators namely; capital to risk-weighted assets ratio, NPA ratio and net interest margins
pointed out that all banks had strictly followed the stipulated norm of 9 % capital adequacy, and this had been
increasing over the years. The NPA ratio shows a declining trend across the years after financial sector reforms.
These statistics indicated that the health and soundness of the banking sector had improved post-reforms. The
study concluded that though the financial sector had come a long way since the inception of reforms, a lot more
need to be done in terms of operational and technical efficiency to compete at the global level. The Financial
Stability Report (2013) by Reserve Bank of India, points out an increase in vulnerability of the Banking Stability
Indicator (BSI) since 2010. This makes a strong case for identifying the factors responsible for banks’ profitability
in the current scenario. From the comparative chart, it is evident that even though total earnings of banks
significantly increased, there has not been a major increase in the bank profits of Indian Scheduled Commercial
Banks in the last 5 years. This analysis makes a case to study various determinants which are responsible for
affecting the profitability of banks. Banks today have moved away from their traditional banking activities, they
offer more diversified services since they face increased competition within the banking sector as well as from
non-banking companies and capital markets. Diversification of banking activities and relaxation to entry of new
players in the market have amplified the level of competition. As a consequence, their sources of income
generation have shifted from the traditional fund based activities to more non-fee and non-fund based services and
activities. These changes in the style of functioning of banks along with the global slowdown have compelled us
to continuously monitor banks’ profitability. A decline in the quality of asset profile of banks is another major
cause of concern. There has been an increase in the levels of substandard assets, which adversely contributes to
the profit margins of banks. Therefore, an analysis of these factors on banks’ profitability has also become an
investigating issue. In the past decade, bank consolidation through various mergers and acquisitions helped in
rescuing distressed banks, which lead to higher efficiency and economies of scale. This has resulted in a
considerably concentrated banking industry. This type of change in the market structure may intensify the power
of larger banks, as they may collude and hinder productivity. Therefore, we need to study the implications of these
changes taken place in the market structure in the last decade as well. The Indian Banking Industry comprises of
scheduled commercial banks of both domestic and foreign origin. We collect all available balanced panel data on
42 Indian origin scheduled commercial banks for the period 2000–2013 from Reserve Bank of India, Bloomberg
and CMIE Prowess databases for the present study. We study the impact of Bank-specific, industry-specific and
macroeconomic factors affecting the profitability of Indian Banks in a dynamic model framework. The persistence
of bank profits and endogeneity of the factors have been accounted for using Generalised Method of Moments
(GMM) as suggested in Arellano and Bond 1991. The study empirically tests the various factors that determine
the profitability of Indian Scheduled Commercial Banks and analyse their performance during different stages of
the economic cycle.

The paper is structured as follows. Section 2 describes Indian banking and Sect. 3 discusses the literature review. Section 4
DETERMINANTS OF PROFITABILITY OF INDIAN COMMERCIAL BANKS
2 offers methodology and data. Section 5 Econometric specification
covers model specification, and Sect. 6 presents empirical findings. Section 7 concludes and offers managerial
discussion and implications.

This paper is organized as follows: Section 2 provides the literature review. Section 3 presents the determinants
of profitability of Indian commercial banks. Section 4 shows the data and methodology of the study. Analysis and
results are given in Section 5. Section 6 concludes the paper and gives recommendations
3 Indian banking
The Indian banking sector is broadly classified into scheduled banks and nonscheduled banks. The scheduled
commercial banks include scheduled Commercial Banks and scheduled Co-operative Banks. Scheduled Co-
operative Banks consist of Scheduled State Co-operative Banks and Scheduled Urban Cooperative Banks.
Scheduled Commercial Banks in India include following major types: State Bank of India and its Associates,
Nationalized Banks, Private Sector Banks, Foreign Banks, Regional Rural Banks. Both state bank and its
associate and nationalized banks are considered as public sector banks. Based on ownership, Indian banking can
be divided into public sector banks, old private sector banks, foreign banks, new private sector banks, cooperative
banks and regional rural banks. Among the scheduled commercial banks, both public sector and private sector
banks contribute to about 93% of the deposits and 92.8% of the credit in the year March 2013. Among the banks,
banks types such as regional rural banks and cooperative banks have a regional focus but do not command a large
banking share. There is no regulatory restriction for other banks to operate in specific regions We provide an
overview of evolution of banks in India by including banking structure in India. India inherited a financially weak
banking system, and was overly urban focus though majority of population lived in rural areas at the time of
independence in the year 1947. After the independence, Indian Government have shown interest in offering social
banking. As a result, the trend was towards strengthening Indian public sector movement and the major objective
was to spread banking among general public. India went through bank nationalization during the year 1955 (State
Bank of India), 1959 (State Bank and its associate), 1969 (14 Nationalized Banks) and 1980 (7 Nationalized
Banks). In the year 1990, a large account deficit led to balance of payment crises. By the year 1990, Public sector
banks had 91% of the total bank branches and handled 85% of the total banking business in the country and there
was a marginal presence of foreign banks. Government introduced economic reforms, leading to the liberalization,
privatization and globalization of Indian economy (Bapat and Naik 2013). The structural reforms in 1990s led to
privatization with new private sector banks entering the Indian Banking. Although foreign banks and new private
sector banks contributed to growth in their balance sheet, the public sector banks continued to have predominant
share in total deposits, advances and investments (Patt 2009). The new entrants, majorly domestic private sector
banks, made large investments in technology right from the start. The results of privatization were mixed as some
banks emerged as strong players, some banks incurred losses and got merged. The type of bank credit underwent a
change as the banking system continued to develop. There was a sharp increase in retail exposure with
contribution of retail loan increasing from 10% in 1980 to 25% in March 2007 (Chandrasekhar 2009). With the
financial sector reforms in 1990s, Government allowed private sector banks to enter the banking industry with an
objective to enhance competition and to improve efficiency. Performance of these banks were mixed as few banks
(Global Trust Bank; United Western Bank) incurred loss, few banks (Times Bank, Centurian Bank of Punjab)
underwent merger and acquisition and some banks (ICICI Bank, Axis Bank, HDFC Bank and Yes Bank)
performed well. Countries where banking system is well developed find a higher contribution of bank’s credit in
its GDP. In India, the ratio of outstanding bank credit to GDP increased from 27.3% in March 1997 to 60% by
March 2008. This indicates that role of banks is growing in economy. It was in the year 2007–2008 that global
financial crisis impacted the banking industry across the world. It was in the year 2007–2008 that global financial
crisis affected the global banks. The global financial crisis highlighted the fact that bank failures could lead to
huge financial costs because of the need to deal with inherited bad debt. The Indian economy exhibited significant
resilience in the backdrop of an intense global financial crisis (Bapat 2012). With the growing pressure on
traditional income source, banks looked for revenues from other sources. Banks in India are permitted to engage
in investment banking, securities trading and derivatives trading (Ramasastri et al. 2004). The intensified
competition in core banking business has resulted in lower interest margins, which led to switching to noninterest
income more attractive.

Banking has been transformed by knowledge as a source of wealth, compared to other tangible and physical
assets (Bontis, 1998). Knowledge has become the new engine driving organizations' wealth, and the World Bank
(1999) stated that “knowledge is our most powerful engine of production.” Banks as service firms have been
classified as a knowledge intensive sector (Branco, Delgado, Sousa, & Sa, 2011), and studies explore the
relevance of knowledge to bank performance (Edvinsson & Malone, 1997; Firer & Mitchell Williams, 2003;
Kamath, 2015). This makes the recognition and development of knowledge management (intangible asset) an
important aspect of bank management. Originally, the entire operations of banks depended on creativity, offering
edge products and providing unique services in creating competitive advantage. Therefore, Chen, Cheng, and
Hwang (2005) stated that banks are sources of economic value, and higher productivity comes from their
intellectual capital (IC). This phenomenon has made the concept of IC popular in the current era of knowledge
economies, building on the knowledge-based theory (KBV) of a firm. Barney (1991) considered these intellectual
assets resources that can be physical capital, organizational capital, and human capital resources. Additionally, the
resources are exactly what Pulic (1998) referred to as the components of IC that form the value added intellectual
coefficient (VAIC) model. This model is useful in evaluating IC and in distinct features of organizations (El-
Bannany, 2008). The model combines capital employed and human and structural capital efficiency, which
enables comparative analysis between firms, sectors, industries, and countries. Some studies (Mondal & Ghosh,
2012; Onyekwelu, Okoh, & Iyidiobi, 2017; Soriya & Narwal, 2015) that have investigated IC and bank
performance have suggested that IC contributes to performance as an indicator of productivity, profitability, or
efficiency of firms. Therefore, investigating IC in the banking sector is imperative because the sector is classified
under knowledge concentrated/intensive firms. Acting mainly as a financial intermediary, banks offer
indispensable services to stimulate and promote economic growth. In doing so, banks require physical and other
intellectual assets for production (Goh, 2005). Moreover, in India, according to World Bank Group, 2017, about
46.2% of total production comes from the service sector, including banks. This means that bank productivity is an
important element in the development of the Indian economy. Many studies have been conducted on Indian banks
(Kamath, 2007; Mondal & Ghosh, 2012; Soriya & Narwal, 2015), however, few are on IC and bank productivity
alone. Also, none of the studies focused on commercial banks with emphasis on how IC influences bank
productivity. So the question remains as to how IC influences commercial bank productivity. This study,
therefore, covers commercial banks with high market capitalization and the disclosure of IC has been recorded by
commercial banks in recent years. Aside from this, the growing internalization that has been driven by the
continuous deregulation has increased competition and technological advancement in the Indian banking sector.
Boden and Miles (2000) have hinted that these transformations are considered features of a knowledge-based
economy. Deregulation, for instance, reduced public monopolies, which encouraged foreign banks to operate,
creating a more competitive environment that is conducive to innovation and growth. This is because these
foreign banks are already advanced in technology and acquainted with international banking standards and
practices, hence desire high competition in the industry. This is why in the second phase of the Narsimham
Committee recommendation in 1998 stated that the Indian banking system is completely outdated and needs
technological support in this knowledge era (RBI report, 1999). Because of these drawbacks, banks ought to be
technologically sound and be more innovative to be able to compete. To build and maintain a sustainable
competitive advantage, banks face a critical moment in managing their intellectual assets, given that they rely on
their intangible assets to excel. That is, banks' potential in building their competitive advantage relies on the
investment and efficient management of IC (Al-Musali & Ku Ismail, 2016). This is why it is so important to
examine how investment in IC has influenced productivity of commercial banks in India.

4 Literature review
Bank's profitability has been extensively investigated in different countries around the world. Although there are
three main common streams in the prior literature of a bank's profitability, all conducted studies have the same
purposes and outlines. Garcia and Guerreiro (2016) and Saona (2016) have focused their research on internal and
external factors affecting bank's profitability.
Further,Anbar and Alper (2011), Athanasoglou, Brissimis, and Delis (2008), Louzis, Vouldis, and
Metaxas (2012), Masood and Ashraf (2012), Rani and Zergaw (2017), Rjoub, Civcir, and Resatoglu (2017), A.
Singh and Sharma (2016), and Zampara, Giannopoulos, and Koufopoulos (2017) have examined bank‐specific
and macroeconomic factors affecting bank's profitability. Similarly, AL‐Omar and AL‐Mutairi (2008), Bougatef
(2017), Dietrich and Wanzenried (2014), Francis (2013), Marijana, Poposki, and Pepur (2012), Menicucci and
Paolucci (2016), Naeem, Baloch, and Khan (2017), Ongore and Kusa (2013), Pasiouras and Kosmidou (2007),
and Petria, Capraru, and Ihnatov (2015) have investigated the determinants and factors affecting bank's
profitability in different countries and from different regions.
These studies used ROA, ROE, or both as measurements and proxies of banks profitability (e.g., Chowdhury &
Rasid, 2017; Jara‐Bertin, Moya, & Perales, 2014; Menicucci & Paolucci, 2016; Naeem et al., 2017; Pathneja,
2016; A. Singh & Sharma, 2016; Tiberiu, 2015; Zampara et al., 2017). Banks profitability investigated by these
studies is commonly explained by both internal and external determinants. The internal determinants are
sometimes called microeconomic determinants (Louzis et al., 2012; Rjoub et al., 2017; Saona, 2016; A. Singh &
Sharma, 2016) that are specific to each bank and that, in many cases, are the direct result of managerial decisions.
These determinants have basically revealed the policy of provisioning, liquidity levels, operational efficiency,
bank size, capital adequacy, and expenses management (Menicucci & Paolucci, 2016). In majority of prior
studies, variables such as capital adequacy, liquidity, deposits, asset quality, operating efficiency, and bank size
are used as a function of internal determinants and micro or bankspecific factors of banking profitability (e.g.,
Bougatef, 2017; Chowdhury & Rasid, 2017; Garcia & Guerreiro, 2016; Menicucci & Paolucci, 2016; Naeem et
al., 2017; Pathneja, 2016; Petria et al., 2015; Rani & Zergaw, 2017; Rashid & Jabeen, 2016; Rjoub et al., 2017;
Salike & Ao, 2017; A. Singh & Sharma, 2016; Tiberiu, 2015; Zampara et al., 2017).
External factors are called macroeconomic determinants (Athanasoglou et al., 2008; Louzis et al., 2012;
Masood & Ashraf, 2012; Rani & Zergaw, 2017; Rjoub et al., 2017; A. Singh & Sharma, 2016). These are the
factors that reflect economic, industry, and legal environment that are out of the control of bank's management
(Ongore & Kusa, 2013). Factors such as inflation rate, gross domestic product (GDP), exchange, and interest rate
are some external determinants of banks profitability that are considered by previous studies (Acaravci & Çalim,
2013; Chowdhury & Rasid, 2017; Francis, 2013; Jara‐Bertin et al., 2014; Marijana et al., 2012; Masood & Ashraf,
2012; Menicucci & Paolucci, 2016; Ongore & Kusa, 2013; Pasiouras & Kosmidou, 2007; Saona, 2016).
Different studies are conducted and focused their investigation on single or several countries. For example,
some evidence drawn from these studies were focused on countries including Europe (Menicucci & Paolucci,
2016; Pasiouras & Kosmidou, 2007; Petria et al., 2015), Gulf Cooperation Council (GCC) countries (AL‐Omar &
ALMutairi, 2008; Chowdhury & Rasid, 2017), South Asian, East Asian, Middle East and African countries
(Masood & Ashraf, 2012), Latin American, Argentina, Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and
Venezuela (JaraBertin et al., 2014), Greek (Athanasoglou et al., 2008), Chile, Colombia, El Salvador, Honduras,
Mexico and Paraguay (Tiberiu, 2015), Pakistan (Rashid & Jabeen, 2016), 12 Asian economies (Salike & Ao,
2017), Tunisia (Bougatef, 2017), Portugal (Garcia & Guerreiro, 2016), and Macedonia (Marijana et al., 2012).
Although the prior literature is attempted to do analyses on different countries, evidence from developing and
emerging countries either still yielding mixed results or ambiguous evidence. However, there is no evidence of
bank‐specific and macroeconomic factors that determine the profitability of Indian commercial banks. Very few
evidence focus on the Indian context such as A. Singh and Sharma (2016) that investigated bank ‐specific and
macroeconomic factors that determined the liquidity of Indian banks. Their findings revealed that bank ownership
affects the liquidity of banks. They suggested that bank‐specific and macroeconomic factors such as bank size,
deposits, profitability, capital adequacy, GDP, and inflation significantly affect bank liquidity. Further, they found
that bank size and GDP have a negative effect on bank liquidity. On the other hand, deposits, profitability, capital
adequacy, and inflation showed a positive effect on bank liquidity.
Accordingly, the present study aims to evaluate the determinants of profitability of Indian banks. Specifically,
it empirically examines both bank‐specific and macroeconomic factors that affect the banks' profitability as
measured by ROA and ROE. This study bridges a gap in financial performance and profitability literature in
India. Furthermore, the current study extends and contributes to prior studies from different countries as it
employs panel data of 69 Indian commercial banks over a period ranging from 2008 to 2017 and comprehensively
using different bank‐specific and macroeconomic variables. Among the nine bank‐specific variables used by this
study, the number of branches of each bank has been included for the first time as compared with other prior
studies of banks' profitability.
The topic of bank performance has been the subject of considerable research and past studies examined various
drivers of bank performance. In the literature on banking, we find that bank profitability is measured by return on
average assets (Bapat 2013). Rivard and Thomas (1997) argued in favor of ROAA as it is not distorted by high
equity multipliers and it represents a better measure of the ability of firms to generate returns on their portfolio of
assets. ROAA depends on bank’s policy decisions as well as on bank’s uncontrollable factors relating to the
economy and government regulations. In recent years, we find that ROAA, as a measure of profitability, has
continued to receive acceptance (Apergis 2014; Menicucci et al. 2016). While investigating the impact of
ownership on ROAA and other efficiency parameters, the results indicate that privatization is not enough in
transition countries (Bonin et al. 2005). Tan and Floros (2012) investigated the reasons of low profitability using
two step generalized method of moment. Chronopoulos et al. (2015) suggested that changes in regulation affected
both the level and persistence of bank profitability for the period 1984–2010 in US. While assessing bank
profitability using ROAA and equity profitability using ROE, expense management was identified as a variable
affecting bank profitability (Islatince 2015). Researchers have examined the influence of internal determinants
and external determinants on bank profitability. According to study by Duca and McLaughlin (1990), variations in
bank profitability are attributable to variations in credit risk. The use of ROE is considered as analogous to profit
efficiency rank. ROE is a function of the allocation of equity to different asset categories (Berger et al. 2005).
Various drivers of bank performance such as asset quality, bank capital, ownership, financial structure, size, non-
performing loans (NPL), credit deposit ratio, ownership, size, economic factors and diversification have been
examined in the past. Banks pursued diversification because they faced pressure on core banking business. Fee
based income were at varied levels among various bank types and the study found the contribution of fee based
income at 13.3% for cooperatives; 15.4% for savings bank and 34.6% for commercial banks in Germany. The
advantages of diversification include increase in alternate sources of income, reduction in information asymmetry,
and stabilizing income (Shim 2013). The positive influence of diversification on bank performance has been
examined (DeYoung and Roland 2001; Stiroh 2004; Stiroh and Adrienne 2006; Mercieca et al. 2007). Busch and
Kick (2015) observed that risk adjusted returns on equity and total assets are positively affected by fee business
for German universal banks. Edirisuriya et al. (2015) found strong evidence that diversification is favorable to the
performance of Australian banks. DeYoung and Tara (2004) found difference between European and US banking
sector and observed that well managed banks are less engaged in non-interest income and large banks are more
engaged in non-interest income. However, there is disadvantage of diversification as it was realized that increased
activity of US banks in non-traditional business led to excessive risk taking. The analysis on Chinese banks for the
period 1996–2006 reveals that diversification were associated with reduced profits (Berger et al. 2010).
Using an analysis of 98 internationally active banks over the period 1994–2012, it is established that income
diversification is positively related with bank profitability (Gambacorta et al. 2014). In the study, income
diversification was measured as a ratio of non-interest income to interest income, and return of assets was used to
measure bank profitability. Similar results were confirmed by studies examining relationship between income
diversification and returns (Chinpiao et al. 2013). However, the findings on Bank Holding Companies (BHC)
suggest that diversification has no impact on risk reduction. Furthermore, risk reducing potential at BHC are
offset by their lower capital ratios and larger commercial and industrial loan portfolios (Demsetz and Strahan
1997). The study by Dubey (2012) indicate that non-performing assets (NPA) impact the health of bank. Non-
performing assets are emerging as one of the major concerns for banks in India with a decline in asset quality,
particularly in public sector banks. Naceur and Goaied (2008) find loan-toasset ratio had a positive impact on
interest margin and profitability. On the other hand, some studies confirmed negative relationship between loan
ratio and profits (Hasan and Marton 2003; Staikouras and Wood 2003).
The role of ownership has been subject to extensive research. With the incidence of government intervention in
banking sector, researchers and policy makers are keen to assess the impact of change in ownership on bank
performance. Jensen and Meckling (1976) argued in favor of disperse ownership which can lead to improvement
in efficiency. The problems of ownership concentration relate to excess monitoring (Burkart et al. 1997; Kyle and
Jean-Luc 1991). An overall agreement could not be established between ownership control and bank performance
(Altunbas et al. 2001; Pinteris 2002). The relation between ownership and bank performance has received
renewed interest in recent years (Ochi and Saidi 2012). While examining the impact of ownership on bank
performance, the influence of size is also investigated. Researchers have shown keen interest in studying size
distribution of banks (Goddard et al. 2014; Hughes et al. 2001). Feng and Serlitis (2010) and Wheelock and
Wilson (2000) confirmed the presence of economies of scale in US Banks. Drake and Hall (2003) observed strong
relationship among bank size, technical efficiency and scale efficiency. It was observed that Hungarian Banks
favored large banks as they are more efficient (Hasan and Marton 2003). The results on bank size indicate that
smaller banks were more involved in the non-interest generating activities, which is due to better specialization
and availability of differentiated services (Karray and Chichti 2013). The empirical results related to study of
Syrian Banks observed a positive relationship between bank size and profitability. The study considered
dependent variable as return on average assets (ROAA). Similar results were obtained from studies by Goddard et
al. (2004), Kosmidou and Pasiouras (2005) and Flamini et al. (2009). Contradictory results were obtained by
studies from Naceur and Goaied (2008) and Sufian and Habibullah (2009). Few contrasting results were obtained
while examining relationship between bank size and performance. The study by Gunjan (2007) in Indian context
could not establish conclusive relationship between the efficiency and the size of banks. The study by Barra et al.
(2016) confirmed that technical efficiency of cooperative banks in Italy deteriorates in comparison to other banks
during the global financial crisis.
Attempts were also made to compare the levels of diversification between bigger and small banks. Using a panel
of Pakistani banks, it is observed that bigger banks are more diversified than small banks. This happened because
of greater outreach and size of credit portfolios (Afzal and Mirza 2012). The importance of GDP growth rate is
confirmed by Afanasieff et al. (2002). In contrast, Naceur (2003) finds no impact for the economic growth on
bank profitability. Demirgu¨c¸-Kunt and Huizinga (1999) observed that banking assets with a larger portion are
less profitable. Neely and Wheelock (1997) found that bank earnings are affected by state level banking activity.
It has been widely discussed about the impact of recent global financial crisis. The recent global financial crisis
has adversely affected the performance of most banking sectors around the world for the period 2007–2009
(Mirzaei 2013).

Early literature in the area of bank profitability studies focused on Net-Interest Margin as the basic indicator of
bank performance. Various studies concluded that net-interest margin has a substantial impact on business cycle
(Ho and Saunders 1981; Allen 1988; Demirgu¨c¸-Kunt and Huizinga 1999). Progressively, this importance of net-
interest income is subsiding over the years as non-interest income in the form of commissions, fee and trading
income constructs a major part of the income now. Bank profits are generally measured by return on assets, which
is a combined effect of internal determinants and external factors. Empirical research on the determinants of
banks’ profitability have primarily been done in a cross country analysis, by forming a panel of different
countries. Bourke (1989), Molyneux and Thornton (1992), Demirgu¨c¸- Kunt and Huizinga (1999) and Bashir
(2003) have conducted studies using a panel framework. However, some studies consider a specific country,
which includes studies by Berger et al. (1987), Berger (1995), Afanasieff et al. (2002), Angbazo (1997), Naceur
and Goaied (2001), Guru et al. (2002) and Neely and Wheelock (1997). These above studies include external and
internal determinants of bank profitability. Internal determinants are specific to the bank and are under the control
of bank’s management, whereas external determinants may include macroeconomic as well as industry-specific
factors. Flannery (1981) investigated the impact of market rate variability on bank performance and found it to be
negative. He added that most of the banks had effectively hedged themselves against any market rate risk.
Demirgu¨c¸- Kunt and Huizinga (1999) used bank-level data for 80 countries from 1988 to 1995 and found that a
large ratio of bank assets to GDP and low market concentration ratio led to lower profits. They also compared
foreign and domestic banks and concluded that foreign banks had higher margins and profits than domestic banks
in developing countries, on the contrary, the opposite was true for developed countries. Bourke (1989) used a
pooled time series approach to regress measures of performance against various internal variables of bank
profitability. Molyneux and Thornton (1992) replicated Bourke’s methodology and investigated Edwards–
Heggestad–Mingo hypothesis, which accounts for risk avoidance by banks with high market power. They took a
sample of European banks across 18 countries. Coffinet et al. (2013) proposed a stress testing methodology to
analyze the sensitivity of banks to macroeconomic shocks for French Banks. Credit risk is one of the main factors,
which also affects the profitability of banks. A change in credit risk leads to a change in the bank’s loan
portfolio’s strength which in turn affects its performance, (Cooper et al. 2003). Studies also indicate that larger
exposure to credit risk is usually associated with decreased firm profitability (Miller and Noulas 1997).They also
observed that exposure to high-risk loans accumulated unpaid loans and reduced profitability. Altunbas et al.
(2000) and Girardone et al. (2004) studied the effect of sub standard assets on bank efficiency. Their results linked
inefficiency with a higher level of bad assets. In general, it is explicitly assumed that increased exposure to credit
risk leads to a decline in profitability (Athanasoglou et al. 2008). The empirical studies by Bourke (1989),
Demirgu¨c¸- Kunt and Huizinga (1999), Goddard et al. (2004), Pasiouras and Kosmidou (2007), and Garcı´a-
Herrero et al. (2009) point out that banks with higher profits maintain an excess of capital in comparison to their
assets. Repullo (2004) and Athanasoglou et al. (2008) find that excess capital acts as a cushion to absorb any
adverse shocks in the economy. Other studies suggest that any bank having higher capital relative to its asset is
less likely to be bankrupt and can achieve lower funding costs, (Claeys and Vander Vennet 2008; Chortareas et al.
2011). Whereas, in another scenario, a higher equity can reduce the cost of capital and increase the bank profits
(Molyneux and Thornton 1992). However, according to the risk-return hypothesis, higher risks may also lower the
profitability (Curak et al. 2012). With respect to expenses, reduced costs are positively related to performance,
which implies better cost decisions, (Athanasoglou et al. 2008; Bourke 1989). However, some studies explore a
positive relationship suggesting that the high expenses and high profits may be attributed to higher expenditure on
human capital, which generates profits, (Molyneux and Thornton 1992). The size of a bank incorporates the effect
of economies of scale in the banks. If the economies of scale persists, it could lead to a positive relationship
between size and profitability, (Akhavein et al. 1997; Bourke 1989; Molyneux and Thornton 1992). Studies have
also concluded that cost savings can be achieved by increasing the size of the bank. Berger et al. (1987), Boyd et
al. (1993), Miller and Noulas (1997) and Athanasoglou et al. (2008) explored a non-linear relationship between
size and profitability. The sensitivity of bank profitability to macroeconomic variables has assumed greater
importance in the wake of financial crisis. In general, increased economic growth leads to increased demand for
credit, which allows them to increase their charges, subsequently increasing the profitability of banks. Neely and
Wheelock (1997) suggests that per capita income has a strong positive effect on bank profitability. Bourke (1989),
Molyneux and Thornton (1992), Demirgu¨c¸-Kunt and Huizinga (1999) and Athanasoglou et al. (2008) point
towards a positive relationship between inflation, GDP growth and bank profits. To understand the impact of
concentration on bank profits, the structure-conduct-performance (market-power) hypothesis was formulated,
which points out that a higher market power through deeper concentration will yield monopoly profits. Molyneux
and Thornton (1992) indicates a positive and significant relationship between concentration and the profitability
of a bank. However, the estimations by Berger (1995) and Mamatzakis and Remoundos (2003) oppose the
Structure-conduct-performance hypothesis. With respect to the studies in the Indian Banking system, Bodla and
Verma (2006) did a multivariate regression analysis on determinants of Indian profitability and found a significant
impact of operating expenses, non-interest income on net profits. Sharma and Bal (2010) analyses the changes in
market concentration over the years and concludes that there has been a considerable increase in concentration
ratios over the years which pointes out towards an increase in competition. Bank deposits in case of Indian Public
Sector Banks grew by an estimate of 18 percent and advances increased by 20 percent. This has happened despite
a marginal increase of 5 percent in bank offices and one percent increase in bank employees (Bapat 2013). The
next decade for Indian Banking is crucial, as it is expected to play a significant role in the backdrop of new
customer additions, changing customer requirements and rapid technological developments .

5 DETERMINANTS OF PROFITABILITY OF INDIAN COMMERCIAL BANKS

4.1| Dependent variables

A measure for profitability substantially depends on the type of industry in which the company is functioning. In
case of banks, return on assets is the commonly used indicator of profitability, and it is defined as the ratio of
profit after taxes to the total of average assets of a bank. ROA measures how effectively a bank’s management
can generate revenue from its assets. A much simpler and more widely adopted approach is to use ROA as a
profitability measure, which finds support from studies, such as Evanoff and Fortier (1988). Golin (2001) also
considers ROA as a key ratio for the measuring profitability of banks. Return on equity (ROE) could be used as
an alternative measure of profitability of banks, which measures the return to shareholders on their investments.
Banks with lower leverage or higher capital may report lower ROA but higher ROE. However, higher ROE
disregards the risk associated with higher leverage .
Two common measures were used by prior studies to measure the profitability of banks which are ROA and ROE.
Following prior studies (e.g., Athanasoglou et al., 2008; Garcia & Guerreiro, 2016; Naeem et al., 2017;
Pathneja, 2016; A. Singh & Sharma, 2016; Tiberiu, 2015; Zampara et al., 2017), this study uses ROA and ROE as
proxies of banks' profitability. ROA is used to evaluate bank's ability to generate returns from available sources of
funds. It has been calculated as the ratio of net profit for a year to the total assets of the same year. Additionally,
ROE is used to analyse the return generated by the funds that shareholders have invested. It has been calculated
as the ratio of net profit for a year to the total equity of the same year.

4.2 Independent variables

Two categories of independent variables were used in this study as shown in Figure 3. Bank ‐specific
(independent) variables were considered as internal factors, which include bank size, assets quality, capital
adequacy, liquidity, operating efficiency, deposits, leverage, assets management, and the number of branches.
Another category of independent variables is macroeconomic (external) determinants of profitability, which
includes GDP, inflation rate, interest rate, exchange rate, financial crisis, and demonetization. Following is an
explanation of both categories of independent variables.

4.2.1 Bank‐specific determinants

Assets size (natural logarithm of total assets [LNAS]) Bank size is measured by total assets as a proxy. Assets
size proxy is commonly used in the prior literature (e.g., Acaravci & Çalim, 2013; AL ‐Omar & AL‐Mutairi,
2008; Anbar & Alper, 2011; Bougatef, 2017; Chowdhury & Rasid, 2017; Masood & Ashraf, 2012; Petria et al.,
2015; A. Singh & Sharma, 2016). Bank's size is represented by the LNAS. A positive and negative impact of
bank size on profitability were found by prior literature. Anbar and Alper (2011) and Masood and Ashraf (2012)
found a positive impact of banks size on profitability whereas Gul, Irshad, and Zaman (2011) A. Singh and
Sharma (2016) reported a negative impact of bank size on bank's profitability.

FIGURE Framework of the study. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of
branches; CAD: capital adequacy ratio (%); CRISIS: a dummy variable of 0 for the financial years 2008 and 2009
and 1 for the year 2010 to 2017; DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the
year 2017; DEP: deposits of the total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%);
INF: annual inflation rate (%); INTR: lending Interest rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%);
LNAS: natural logarithm of total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of bank net profit to
total assets; ROE: ratio of net profit to shareholders equity [Colour figure can be viewed at
wileyonlinelibrary.com]

1. Capital adequacy (CAD)

Capital adequacy ratio is one of the basic ratios to determine the strength of capital. Capital adequacy is
calculated as the ratio of equity to total assets (Abel & Le Roux, 2016; Anbar & Alper, 2011; Masood &
Ashraf, 2012). A positive relationship was found between capital adequacy and profitability of commercial
banks (Ebenezer, Omar, & Kamil, 2017).
2. Assets quality (AQ)
Assets quality is measured as the ratio of loans to total assets. The ratio of loans to total assets measures the
bank's income source and is expected to affect bank's profitability negatively except the bank is at unbearable
level of risk (Rani & Zergaw, 2017).
3. Liquidity (LIQ)
Following Bougatef (2017), Chowdhury and Rasid (2017), Jara‐Bertin et al. (2014), Menicucci and Paolucci
(2016) in measuring bank's liquidity, the ratio of liquid assets to total assets is used. Higher liquidity ratio
implies that banks are more liquid and accordingly an opportunity cost of higher return may arise. Inadequate
liquidity is considered as one major cause of bank's failure. Both negative and positive relationships between
liquidity and banks profitability were reported by prior studies (Ebenezer et al., 2017; Loh, 2017).
4. Deposits (DEP)
Deposits are the major source of funds for banks. However, banks are required to maintain adequate liquidity
to meet customers' demand (A. Singh & Sharma, 2016). Numerous studies measured deposits as the ratio of
total deposits to total assets (Acaravci & Çalim, 2013; Anbar & Alper, 2011; Menicucci & Paolucci, 2016;
Zampara et al., 2017). The negative relationship was exhibited between banks profitability and deposits (Gul
et al., 2011).
5. Asset management (AM)
The ratio of assets management is calculated by dividing operating income to total assets. The higher assets
management ratio, the better banks' profitability (Masood & Ashraf, 2012).
6. Operating efficiency (OPEF)
Operating efficiency can be defined as the ratio of total expenditure to run a business operation to the total
revenues obtained from the business. For banks, this ratio is defined in term of operating expenses and
interest income (Rashid & Jabeen, 2016).
7. Leverage (LEV)
Leverage is the ratio of total debt scaled by total assets (Bose, Saha, Zaman, & Islam, 2017). Banks with
higher equity (lower leverage) generally exhibit lower ROE but higher ROA (Athanasoglou et al., 2008).
8. Branches (BRNCH)
It is the number of branches that every bank has. It reflects the market share, power, and the geographical
distribution of the bank.

4.2.2 Macroeconomic determinants

This study aims to investigate the impact of macroeconomic variables represented by GDP, inflation rate, interest
rate, exchange rate, financial crisis, and demonetization on the profitability of Indian commercial banks.

1. Annual real GDP

 GDP is the most widely common macroeconomic measurement that is used to measure the impact of
macroeconomic factors on banks' profitability. Further, it is a measure of total economic activity within an
economy (Francis, 2013; Marijana et al., 2012; Masood & Ashraf, 2012; Ongore & Kusa, 2013; Pasiouras &
Kosmidou, 2007; Petria et al., 2015; Rani & Zergaw, 2017; Saona, 2016; A. Singh & Sharma, 2016).
2. Annual inflation rate (INF)
It is the rate at which the general price level of goods and services rises and, as a result, the purchasing power
of currency falls (A. Singh & Sharma, 2016). Different authors from finance literature advocated the impact
of inflation rate on banks' profitability (Anbar & Alper, 2011; Chowdhury & Rasid, 2017; Jara‐Bertin et al.,
2014; Masood & Ashraf, 2012).
3. Interest rate (INTR)
It is the lending interest rate that a bank can earn. It is expected to affect positively the profitability of banks.
Empirical findings of INTR on banks' profitability from prior studies are mixed. For example, Rashid and
Jabeen (2016) found that interest rate has a negative impact on banks' performance. Contradictory, Yahya,
Akhtar, and Tabash (2017) reported a positive impact.
4. Exchange rate (EXCH)
It is the real exchange rate calculated as the average exchange rate during the year. Several studies
recommend that foreign exchange rate should be considered as an important determinant of banks
profitability (Chowdhury & Rasid, 2017; Menicucci & Paolucci, 2016).
5. Financial crisis (CRISIS)
Bogdan and Ihnatov (2014), Dietrich and Wanzenried (2014), Maria, Lodh, and Nandy (2017), and Tafri,
Hamid, Meera, and Omar (2009) have used financial crisis impact in their studies. They used a dummy
variable for the crisis period. This study measured the financial crisis as a dummy variable of 0 for the years
of financial crisis and 1 otherwise.
6. Demonetization (Demo)
It is a dummy variable of 0 for the years before demonization and 1 for the year of demonization.
4.2.3 Provisions for non-performing assets to total loans
This ratio is obtained from a bank’s income statement, signifies credit quality and acts as a proxy for credit
riskiness. Banks, as per the standards set by RBI, set aside a specific amount to cushion them from any
degeneration which may occur in their profits due to credit risks. Since, a higher exposure to credit risk is
expected to decrease profitability; an inverse relationship between the two is hypothesized.

4.2.4 Capital to assets ratio

This variable is the ratio of total capital to total assets, and the resultant effect of this variable on bank profits has
been found positive and negative both in previous studies. Berger (1995) in the context of the conventional risk-
return hypothesis describes that a lower capital on the bank’s balance sheet indicates a risky position so that we
might expect a negative association with profitability. However, lower capital and a risky position can generate
higher profits. Molyneux and Thornton (1992) finds that higher equity can cause a decline in the cost of capital,
which signals a positive impact on profitability. However, a larger capital in capital structure for any institution in
developing economy acts as a buffer to resist any adverse situation during a crisis.
4.2.5 Annual growth of deposits
It is a measure of bank’s growth. A bank with faster growth in deposits can expand its business quickly
and acquire higher profits. However, this increase in profits due to higher deposit growth depends on a
number of other factors as well. Primarily, it depends on the ability of a bank to convert its deposits into
income generating assets, which reflects its operational efficiency. Higher growth is generally associated
with higher profitability. However, higher growth may also attract more competition from other players,
which in turn may reduce the profits.
4.2.6 Bank size
To explain the effect of bank size, we use total assets of banks in our study. It is a debatable topic in the literature,
whether lower bank size or higher bank size optimizes bank profits. To examine this, we use a dummy variable
for large and small banks based on their total assets. Larger banks attribute to economies of scale and greater
diversification, which reduces risk and increases bank profits. Smirlock (1985) shows a positive relationship
between bank profits and size. However, Stiroh and Rumble (2006) and Pasiouras and Kosmidou (2007) suggest
that an increased bank size may have an opposite effect of decreasing bank profits because the expenses are also
incurred in managing such large banks, expenses include overhead and bureaucratic processes costs.

4.2.6 Non-interest income

Banks have moved away from their traditional activities, they offer more diversified services since they have risk
in capital markets, and face more competition within the banking sector as well as from non-banking companies.
As a consequence, the sources of income generation have shifted from the fund based activities to more fees and
nonfund based activities. It has been argued that, more diversification can yield better profits. However, fee-based
income can actually exert a negative impact on profitability since non-interest income, such as trade in
derivatives, etc., are subject to more intense competition in comparison traditional income activities.
Nevertheless, higher revenue stemming from non-traditional activities increases the share of non-interest income,
which in turn increases the profitability of the bank.

4.2.7 Operating expenses to total assets

This ratio includes the expenditure made towards the general operations of a bank, which takes account of salary
paid to staff and property costs. Higher operating costs may put a negative impact on profitability. However, it
has also been argued that higher operating costs to total assets accounts for operational efficiency, and many
efficient banks may effectively manage these expenses to generate higher profits.
4.3 Industry-specific variables
A whole new trend of studies, relating to market power and financial profits started with the emergence of
Structure Conduct Hypothesis (SCP), which states that an increased market concentration will yield monopoly
profits. We measure the market concentration in terms of Herfindahl– Hirschman Index (HHI) which is
calculated as the sum of squares of market shares of each bank, where market share is expressed as fractions.
Banks in an extremely competitive industry set up, earn monopoly profits due to collusive behaviour, (Gilbert
1984). This collusive behaviour involves price setting by larger firms. In case of banking industry, this collusion
could be in the form of higher interest rates for loans and lower rates given to customers on deposits. Thus, a
higher concentration may lead to a positive impact on profitability. Arguments also point out that this increase in
profits is not due to collusive behaviour but due to exploitation of economies of scale, and efficiencies achieved
by larger banks. Opponents of the SCP hypothesis argue that higher profits may not always be due to collusion by
the banks but also due to efficiency of scale. This hypothesis has been termed as the efficient structure hypothesis
(ESH). Although the effect of concentration on profits is similar in both the theories, the reasons for the impact of
concentration are different. We empirically wish to determine the impact of this market power on profits.

6 Econometric specification
In general, the model for determinants of bank profits can be given by the following equation:

Berger et al. (2000) specifies that bank profits tend to persist over time reflecting impediments to market
competition, informational opacity and/or sensitivity to regional/macroeconomic shocks to the extent that they are
serially correlated. Goddard et al. (2004) suggests that bank profits tend to persist. Therefore, we use the
following dynamic specification by including a lagged dependent variable as one of the regressors, to empirically
test the effect of internal and external determinants on the profitability of Indian Banks

and l are explanatory variables representing bank-specific factors, industry-specific factors and macroeconomic
factors, respectively. is the disturbance term with unobserved bank-specific effect vi and uit the idiosyncratic
error where Here, one period lag of profit variable as one of the
independent variables makes the specification dynamic, and its coefficient d denotes the speed of adjustment. A
value of d between 0 and 1 indicates the persistence of profits. A d value near 0 suggests that the industry is
relatively competitive (high adjustment speed), and a d value near 1 indicates that the industry is less competitive
(slow as adjustment speed). It is possible to remove the unobserved firm specific effects by taking first difference
of the Eq. (2) as follows
n static panel data model, estimation is done using fixed or random effects model. However, using a lagged
dependent variable as one of the regressors would yield a model which is of dynamic in nature. Consequently,
least square estimation would produce biased and inconsistent results (Baltagi 2008). Arellano and Bond (1991)
suggest that ‘‘consistency and efficiency gains can be achieved by using all available lagged values of the
dependent variables as instruments plus the lagged values of all independent variables, as instruments.’’ Another
estimation issue is that the capital to total assets ratio variable may potentially suffer from endogeneity. Banks
could increase their earnings by increasing their capital to assets ratio and the reverse causality can also be true.
Therefore, capital to assets ratio should be modelled as an endogenous variable.
Table 1 Description of the factors used in the study

Moreover, the level of provisions to be kept aside for bad debts are decided and adjusted for at the beginning of
each financial year by the banks. Therefore, provision for loan losses to total loans ratio, which accounts for credit
risk, is modelled as a predetermined variable in the above model. The lagged dependent variable as a regressor in
Eq. (3) creates a problem of endogeneity, as it becomes correlated with the differenced error terms. To account for
the endogeneity bias, following Garcı´a-Herrero et al. (2009) and Athanasoglou et al. (2008), we address the
above
mentioned issues by using the generalized method of moments (GMM) for estimating the parameters of the
model. We use the difference GMM estimator proposed by Arellano and Bond (1991), in which lagged levels of
the endogenous variables are used as instruments in the differenced equation. Thus, this estimation process
accounts for the endogeneity of factors and dynamic nature of the dependent variable as well.

Data
We use bank-level data for 42 Scheduled Indian Commercial banks, as reported by RBI and CMIE over a period
of 14 years from 2000 to 2013. This forms a balanced panel data set resulting in 588 bank-year observations. The
model estimation is done using ROA as a dependent variable as specified in Eq. (3) using data from 2000 to 2013
as a whole. We also estimate the same model separately for the crisis period from 2006 to 2009. We make all
explanatory variables stationary at the same level to estimate the dynamic model given in Eq. (3) by using GMM
estimation technique. The problems related to stability of coefficients, presence of autocorrelation in the errors,
problem of over-identifying restrictions and goodness of fit of the model have been duly addressed. Table 2
shows results of cross-correlation analysis among the independent variables. It is observed that the variables do
not possess multicollinearity problem. Descriptive statistics of the variables in the study reveal some interesting
insights (Table 3). The mean for return on assets is recorded at 0.93 % over the entire sample period. The large
gap between the minimum and maximum values of credit risk (loan loss provisions to total loans ratio) suggests
that some banks suffer from a huge burden of bad loans whereas a few banks have managed their bad debts quite
well. The mean for capital to asset ratio is 10 % suggesting Indian Banks are well capitalised. The difference
between maximum and minimum values of deposit growth variable suggests the heterogeneity of bank deposits
among banks.

Empirical results
To select fixed or random effects model, we estimate the Eq. (2) using random effects and then check for the
presence of fixed effects using Hausman Test. However, as mentioned earlier, least square estimation with fixed
effects in the presence of lagged dependent variable as a regressor will produce biased and inconsistent results.
Therefore, we use GMM to account for the problems in the estimation and consistency of results. We report the
results of Hansen J Statistics and Wald’s test for testing over-identifying restrictions in the model and to test the
goodness of fit, respectively. Lagged dependent variable of profitability measure, ROA, comes out to be highly
significant across both the time periods in the study. Therefore, it confirms the dynamic nature of the model
specification and justifies the use of a dynamic model. The coefficient of lagged dependent profit variable takes a
value of 0.337, indicating a moderate degree of persistence of profits. This shows that the product markets of
Indian Banks are moderately competitive, and less opaque due to asymmetry in information. The positive
significance of lagged dependent variable suggest that the banks are able to retain a considerable amount of their
profits from 1 year to another, and the elimination of abnormal profits by competition is by no means
instantaneous. This implies that the adjustment towards equilibrium is partial and not instantaneous (Table 4). To
check for the stability of our coefficients, we run the model regression twice, once with bank-specific, industry
specific and macroeconomic variables and for a second time with only bank-specific variables. Our results
indicate towards stable coefficients of the variables under study. Hansen J test shows a case of no over-identifying
restrictions, and it suggests that the model seems to be valid in the present context. The AR(1) term is found to be
significant with p value 0.0409 whereas AR(2) term is found to be insignificant with p value 0.4113. This implies
the presence of negative first order autocorrelation, but this does not imply inconsistency in the results.
Inconsistency will imply if second order autocorrelation is present, (Arellano and Bond 1991). Wald’s test gives
Chi square value 1648.2 with 10 degrees of freedom rejecting the null hypothesis that all regression coefficients
are equal to 0 indicating that the model has predictive power (Table 4). We run the model across different time
periods to assess the changes in the determinants especially during the crisis period as it would be of interest to
see the impact of financial variables on profitability during the crisis period (Table 5).
Coefficient of capital to assets ratio is found to be positive and significant throughout all the time periods,
indicating a sound financial position of the Indian Banks. A well-capitalised bank can grab more business
opportunities; it can also meet any unexpected loss which may arise in the future, thus, achieving greater
profitability. The level of capitalization can affect bank profitability in various ways; (a) higher capital might
increase the share of total advances which increases bank profits, (b) higher capital implies better
creditworthiness, and (c) adequately capitalised banks will borrow lesser in comparison to their counterparts,
which will reduce their funding costs. It can also be pointed out that when banks hold excess capital in accordance
with the statutory requirements, they can invest this capital in various securities and portfolios of risky assets,
thus, earning higher profits. The effect of credit risk, measured by the ratio of provisions for loans losses to total
loans, is found statistically significant and negative across all time periods. These substandard assets increase the
provisioning costs which reduces profitability. In the last decade, various banks have adopted measures to
improve the quality of their assets. Lending to sensitive sectors is of primary importance to banks as per RBI
requirements; however, while granting credit, banks need to keep in mind credit quality or the quality of assets,
which may drain out their profits in the future. Operating expenses to total assets ratio have also found to be
significant, which implies efficient cost management has been taken care of by the banks. We may link this
positive impact to higher spending by banks on hiring efficient managerial personnel, which helps banks to
become profitable. Effective cost management is a precondition for higher profitability, and the positive impact of
these expenses on profitability shows a mature level of cost management done by the Indian Banks. This indicates
a positive relationship between better-quality management and profitability. It may be suggested that banks in
India have reached a maturity level where higher spending may be linked to generating higher profits. However,
this ratio is found insignificant in the crisis period, implying a restrictive spending on hiring skilled manpower
and managerial expertise during the crisis period. Deposit growth, another variable for banks’ efficiency, has been
found to affect profitability significantly. This shows that banks have been able to convert its liabilities in the
form of deposits into assets, which generate income. However, in the crisis period, this impact was lesser, as there
were lesser opportunities for banks during that time. Furthermore, banks had adopted a more conservative attitude
during the crisis period and did not freely invest in assets to generate income. It suggests that banks with a higher
share of deposits may earn higher returns on their investments. With respect to the dummy variable for size of the
bank, we observe a positive impact of size on ROA, which indicates that larger banks have a higher return on
assets than banks which are smaller in size. It implies that larger.
banks operate at a more efficient scale than smaller banks. Thus, they exploit all economies of scale to reap higher
benefits. This suggests the positive effect of size on bank profitability. Our analysis shows that banks which have
a larger share of non-interest income as a fraction of their total assets are more profitable. Banks have now moved
away from their traditional business activities and are more diversified. This leads to a higher share of non-
interest income as a part of their total income that includes fee-based income as well as income generated from
financial services. It has been found that non-interest income has a significant impact on profitability during the
entire period of study. The variable HHI is positive and highly significant suggesting a positive and significant
effect of market concentration on bank profits, which supports the structure conduct performance (SCP)
hypothesis indicating that market concentration positively affects bank profitability. However, a positive impact
of market concentration and profitability of banks does not always point towards collusive behaviour among
banks in the market. It may not be the case with Indian Banking Industry with a rigid regulatory framework. The
positive significance of HHI variable also suggests that banks by exploiting the efficiency of scale, providing
products and services at a lower cost, with updated technology in a concentrated market may generate higher
profits. This means higher bank profits in the highly concentrated industry could be achieved by increasing their
productive efficiency. The study finds that GDP growth impacts bank profits positively and significantly. With
the growth in GDP, the demand for credit increases during cyclical upswings which leads to higher bank profits.
During the boom period banks, in general, expand lending and charge a higher interest rate on loans as well as
generate higher fee income through increased transactions in the stock market. Moreover, banks create fewer bad
assets (NPAs) and ultimately earn higher returns. The study finds that the effect of inflation to be negative, which
can be attributed to the fact that banks have been unable to anticipate the expected rise in inflation and, thus, have
incurred higher costs leading to a decline in profitability. The effect of size of the banks and operational efficiency
on profitability had been found insignificant during the crisis period. This suggests that banks, during the crisis
period, reduced their operational expenditures pertaining to hiring managerial expertise and skilled manpower.
The variable of size is also found to be insignificant during crisis time, which means that the crisis affected all
banks in a similar manner irrespective of their size. The variable for credit risk is found to be highly significant
suggesting that banks with higher credit riskiness have been less profitable during the crisis period. To analyze the
differences between public and private sector banks, we introduce interaction terms between ownership and bank-
specific factors. To this end, we build dummy interaction terms with each bank-specific factor. The dummy takes
the value 1 if it is a public sector bank and 0 otherwise. The results indicate significant differences in the case of
operating expenses as well as loan loss provisions of public sector banks. It is observed that the loan-loss
provisions in case of public sector banks have a significant positive effect on return on assets and the operating
expenses to total assets ratio also have a significant positive impact on profitability. The effect of other bank-
specific factors is found to be insignificant (Table 6)

5.1| Data collection and sampling

We use annual bank level data for Indian Public Sector Banks and Indian Private Sector Banks from Performance
Highlights for Indian Public Sector Banks and Performance Highlights for Indian Private Sector Banks published
by Indian Banks Association. Table presents the summary statistics of the selected variables. 42 banks were part
of the study of which 25 banks were public sector banks and 17 banks were private sector banks. The period of
the data was from the year 2007 to the year 2013. Other economic indicators were captured from World Bank
statistics. Table describes the summary of variables.
Our study incorporates various variables such as banking industry specific variables, bank specific variables
and macroeconomic indicators. The study included both public sector banks and private sector banks. Both these
bank groups constitute more than 90% of the business of scheduled commercial banks. The source of data was
performance highlights for public sector banks and performance highlights for private sector bank, a publication
from Indian Banks Association (IBA) and database from AceEquity.

The dataset for the bank‐specific variables used by this study is fetched from RBI database, which supplies all
information regarding all banks working in India. Thus, it is considered the most common and authenticated
database for banking system information. The database provides annual information for 27 public banks, 26
private banks, 46 foreign banks, 56 regional rural banks, 1,574 urban cooperative banks, and 93,913 rural
cooperative banks, in addition to cooperative credit institutions.
The current study focuses only on commercial banks working in India as shown in Table 1. It is clear from
Table 1 that there are 101 commercial banks in India. The sample of this study is based on panel data that consists
of 69 commercial banks with 690 observations for a period of 10 years from 2008 to 2017. Importantly, the study
covered all public‐sector banks that include both National and State Bank of India and its Associates, which
accounts for about 70% of the banking system assets. The criteria for selection of these banks are based on the
availability of data for the period covered by this study. Further, the current study considers only the commercial
banks whereas regional rural banks and urban rural cooperative banks were excluded.
The empirical investigation of Indian banks' profitability using panel dataset of commercial banks over a
period ranging from 2008 to 2017 is considered very critical during this period as the financial performance of
commercial banks in India has declined during this period as shown in Figure 1. Moreover, several financial
challenges in this period hit commercial banks, particularly, demonetization process that took place in November
2016 and some fraud cases that reported during this period. This makes the investigation of banks profitability
during this period very interesting and very useful for policymakers.
As far as the comparison of the used sample in this study with the samples of prior studies is concerned, most
of the conducted studies on banks' profitability in different countries have employed panel data. For example, AL‐
Omar and AL‐Mutairi (2008) sampled seven Kuwaiti banks for the period 1993–2005, Athanasoglou et al. (2008)
studied Greek banks that covers the period 1985– 2001. In the same context, Rashid and Jabeen (2016) covered
the period 2006 to 2012 to investigate the profitability of Pakistani banks, Bougatef (2017) examined the effect of
perceived level of corruption on banks' profitability in Tunisia over the period 2003–2014, Garcia and Guerreiro
(2016) analysed the profitability of 27 universal banks in Portugal over the period from 2002 to 2011, and
Marijana et al. (2012) studied 16 banks in the Macedonian banking system in the period between 2005 and 2010.

5.2 Model specification and econometric

5.2 Tools

Regulators and investors consider Return on average assets (ROAA) as the best measure of bank profitability.
Berger et al. (2000) suggested that bank is able to
Table 1 Summary of variables
Variable Description Mean SD Source
data base
Dependent variable A proxy measure of bank
Return on average profitability measured as the 1.02 0.458 IBA
assets return to the average total
(ROAA in %) assets of the bank
Return on equity A profitability efficiency 16.9 6.7 Ace
(ROE in %) measure Equity
Database
Independent Bank specific factors
variables
Non-performing Calculated as net non 0.97 0.68 IBA
 loans (NPL) performing loans multiply by
100 divided by average net
advances
Income It is measured as the ratio 0.12 0.04 IBA
diversification between other income to
(other income to operating income
operating
income)
Credit deposit ratio It is calculated as the ratio 0.73 0.12 IBA
between total loans to total
deposits
Cost to income It is the ratio of operating 0.50 0.11 Ace
ratio expense to the operating Equity
income Database
Independent Banking industry factors
variables
Banking industry Specific. It was a dummy IBA
ownership variable. Public sector banks
were given value of 1 and
private sector banks were given
value of 0
Bank size Logarithmic of the bank 4.94 0.52 IBA
business
Independent Economic indicators
variables
Financial crisis Dummy values of 0 to the year 0.57 0.49 –
2007, 2008 & 2009 and value
of 1 to the year 2010, 2011,
2012 and 2013
GDP growth The average GDP growth rate 7.00 2.27 World
for the country Bank
Inflation The average consumer inflation 9.42 1.91 World
rate for the country Bank
sustain performance over time. Gracia-Herrero et al. (2009) highlighted the problem of potential endogeneity
when assessing bank profitability determinants. In addition, additional proxy of dependent variable, return on
equity (ROE), was also considered as dependent variable. In our study, we introduced a lagged dependent variable
in the regression models by employing the generalized method of moments (GMM) estimators. The advantage of
GMM is that it allows us to control for persistence and endogeneity issues. It results in consistent estimates. Our
study is unique since it captures the impact of bank specific factors, banking industry factors and economic
indicators.
To test the relationship between bank profitability, bank specific factors, banking industry factors and
macroeconomic determinants, we estimate a line on regression in the following form:

ROAAjt = β1 ROAAjt–1 + β2 Σ Bank Specific factors + β3 Σ Banking Industry factors

+ β4 Σ Macroeconomic factors + Ij + ęi,t

ROEjt = β1 ROEjt–1 + β2 Σ Bank Specific factors + β3 Σ Banking Industry factors

 + β4 Σ Macroeconomic factors + Ij + ęi,t

where ROAAjt is the return of assets, ROE jt is return on equity, b1 is coefficient for Bank Specific factors, b 2 is
coefficient for Banking industry factors and b 3 is coefficient for macroeconomic factors. Bank specific factors,
banking industry specific factors and macroeconomic factors are identified as independent variables. The
correlation matrix is shown in Table 2.
We negate the existence of multicolinearity as the correlation is less than 0.80 and variance inflation factor
(VIF) was less than figure of 10. We present the regression equation as follows:

ROAAjt = β1 ROAAj t–1 + β2 x npl + β3 x Other Income to operating income

+ β4 x Cost to income ratio + β5 x Credit deposit ratio + β6 x Dummy financial crisis
+ β7 x GDP growth + β8 x Inflation + β9 x log GDP per capita + Ij+ ęjt

ROEjt = β1 ROEj t–1 + β2 x npl + β3 x Other Income to interest income

+ β4 x Cost to income ratio + β5x Credit deposit ratio
+ β6 x Dummy financial crisis + β7 x GDP growth + β8 x Inflation
+ β9 x log GDP per capita + Ij+ ęjt

where j denotes the bank, t the time period from the financial year 2006–2007 to 2012–2013 and e˛ represents the
disturbance term.

Empirical findings

The regression results between bank profitability and other independent variables are presented in Table 3. The
model exhibits goodness of it as confirmed by Wald X 2 statistics. Using Arrelano–Bond A R (2) test, at the 5%
significance level, our instruments are appropriately orthogonal and it is confirmed that no second order serial
correlation is detected. To validate the findings, we evaluate using Sargan’s test which are captured through X 2.
The significant lagged dependent variable coefficient confirms the dynamic character of the model specification.
So, it justifies the application of dynamic panel data model estimation (Sufian and Habibullah 2010). The
following Table 3 presents the dynamic panel regression results.
We present the results obtained from dynamic Arellando–Bond panel GMM robust estimators using two step
difference. Since two-step estimates are considered
n Total number of observations
The figure in the parenthesis indicates standard error
***,**,*indicates1,5,10%significancelevelsrespectively
more efficient than the one-step estimate, we have used two-step estimate for analysis. The analysis was based on
methodology suggested by Arellano and Bond (1991), Blundell and Bond (1998), Windmeijer (2005) and Bond
(2002). As the analysis is relevant for lagged values of dependent variable, there is a possibility of weak
endogenity (Bond 2002). The Sargan test deals test of the validity of instrumental variables and is a test involving
overidentifying restrictions. The calculated values of Sargan test also supports the analysis. In order to check the
robustness of the results, various tests were performed.

Model specification and econometric Prior literature on bank profitability revealed that the functional linear form
is the suitable form of analysis (Menicucci & Paolucci, 2016). Prior studies of banks' profitability either used a
linear regression models (pooled, fixed, or/and random effect models;e.g., AL‐Omar & AL‐Mutairi, 2008;
Pathneja, 2016; Rjoub et al., 2017; Salike & Ao, 2017; Tiberiu, 2015) or both generalized moments method
(GMM) and linear regression models (e.g., Athanasoglou et al., 2008; Bougatef, 2017; Chowdhury & Rasid,
2017; Dietrich & Wanzenried, 2014; Louzis et al., 2012; Masood & Ashraf, 2012; Rashid & Jabeen, 2016; Saona,
2016; Tiberiu, 2015).
TABLE 2 Sample description
Banks Foreign Private National SBI and its Associates Others Total
No. 46 26 21 6 2 101
Sample 25 18 20 6 0 69
Sample% 54% 69% 95% 100% 0% 68%
Note. SBI: State Bank of India.
GMM estimator accounts for possible correlations between any of the independent variables (Athanasoglou et
al., 2008). Further, Saona (2016) states that problems and issues related to individual heterogeneity are some
justifications for using GMM that are not present in this study. The difference of GMM estimators can be
subjected to serious finite sample biases if the instruments used have near unit root properties (Chowdhury &
Rasid, 2017). Both difference and system GMM estimators are suitable for situations with “small T, large N”
panels; independent variables that are not strictly exogenous; fixed individual effects; heteroscedasticity; and
autocorrelation (Roodman, 2006). Against this background, this study used linear regression models with pooled,
fixed, and random effect with an examination of all assumptions required to conduct a linear regression. Using a
linear regression of three models could help in obtaining more consistent and comparable estimates for the
parameters models. As such, panel data analysis is used rather than the new proposed GMM. Two main
advantages of adopting panel data analysis are confirmed by researchers. The first advantage is its efficiency of
econometric estimates over pure cross‐sectional or pure time‐series data analysis techniques (Baltagi, 2005; Hsiao,
2003). The second one is its ability to control for individual heterogeneity and multicollinearity (Kyereboah‐
Coleman, 2007). Panel data of 10 years for 69 Indian commercial banks is used to analyse the impact of bank ‐
specific and macroeconomic factors on bank's profitability. Following Anbar and Alper (2011), Brooks (2014),
Chowdhury and Rasid (2017), and Masood and Ashraf (2012), the essential structure and context of the panel data
is defined as per the following regression model

γnt ¼ αþβxnt þεnt; (1)

where γnt denotes the dependent variable (Profitability), α, is the intercept term on the explanatory variables, β is a
k × 1 vector of parameter to be estimated, and vector of observations is xnt, which is 1 × k, t = 1 …, T; n = 1, …, N.
the practical and operational form, the aforementioned model can be expressed as follows:

Profitability ¼ ʄðBank − specific variables; (2) Macroeconomic variablesÞ:

Profitability is measured by ROA and ROE. Bankspecific variables include asset size, capital adequacy, assets
quality, liquidity, deposits, assets management, operational efficiency, leverage, and branches. Macroeconomic
variables include GDP, inflation, exchange rate, interest rate, financial crisis, and demonetization. Expanding the
proxies used in Model 2, two models have been developed to investigate the factors that may determine banks'
profitability in India. The models hypothesize that the banks' profitability in India depends on internal factors
(bank‐specifics) and external factors (macroeconomic) that are as follows:
ROAit ¼ αi þβ1CAit þβ2AQit þβ3LIQit þβ4DEPit þβ5AMit þβ6OPEFit þβ7Log ASit þβ8LEVit þβ9BRNCHit

þβ10GDPit þβ11INFit þβ12INTRit þβ13EXCHit þβ14CRISISit

þβ15DEMOit þεit (3)

ROEit ¼ αi þβ1CAit þβ2AQit þβ3LIQit þβ4DEPit þβ5AMit þβ6OPEFit þβ7Log ASit þβ8LEVit þβ9BRNCHit

þβ10GDPit þβ11INFit þβ12INTRit þβ13EXCHit þβ14CRISISit

þβ15DEMOit þεit; (4)

where i refers to an individual bank; t refers to year; β1: β15 are the coefficients of determinant variables and ε is
the error term; and all other variables are as defined in Table 2.
Both models are estimated through pooled, random, and fixed effect regression. Further, the Hausman test is
applied to determine whether to select fixed effect estimates or random effect estimates. Pasiouras and Kosmidou
(2007) indicated that if the value obtained by the Hausman test is larger than the critical chi ‐square χ2 0.5,10 =
9.341 or χ2 0.005,10 = 25.182, then the fixed effects estimator is the appropriate choice.

6| DATA ANALYSIS AND RESULTS

| Descriptive statistics
Table 3 provides descriptive statistics for intra and extra bank determinants of the banks' profitability variables
over the period from 2008 to 2017. The minimum value of ROA and ROE are −4.21 and −44.37 whereas the
maximum values are 10.23 and 31.37, respectively. The mean values are 1.17 for ROA and 10.16 for
ROE. This indicates the negative skew distribution of ROA and ROE during 2008–2017. It is also shown in Table
3 that there is a variation between the average values and standard deviation of all independent variables. For
bank‐specific variables, the average value of LNAS is 12.65, the ratio of CAD, AM, DEP, and OPEF are 19.30%,
2.59%, 71.55%, and 0.65% with standard deviation of 16.85%, 1.69%, 18.52%, and 0.69%, respectively.
Further, the average values of AQ, LEV, and LIQ are
3.92%, 4.34%, and 3.65% with standard deviation of 0.47%, 0.34%, and 0.28%, respectively. With consideration
of industry‐specific variables, the interest rate has an average value of 7.10 with a standard deviation of 1.06 and
(Min. = 4.75, Max. = 8) and mean value of exchange rate
TABLE Definitions of commercial banks' profitability variables
Variabl Exp.
e Acronym Measure effect Evidence from prior studies
Dependent variables
Profitability ROA Net Profit Garcia and Guerreiro (2016); Pathneja (2016);
ROAit ¼
Total Assetsit Masood and Ashraf (2012); Menicucci and ROE Net
Profit Paolucci (2016); Naeem et al. (2017);
ROEit ¼
 Total Equityit Rani and Zergaw (2017); Yahya et al. (2017);
Zampara et al. (2017)
Independent variables: ‐
bank specificNatural logarithm of total Bougatef (2017); Pathneja (2016); A.
Assets size LNAS assets ± Singh and Sharma (2016)
Capital adequacy CAD Equity/total assets ± Bougatef (2017); Dietrich and Wanzenried
(2014);
Ongore and Kusa (2013); Petria et al.
(2015);
Salike and Ao (2017)
Assets quality AQ Loan + Acaravci and Çalim (2013); Anbar
AQit ¼ it and Alper (2011); Naeem et al.
Total Assetsit (2017); Ongore and Kusa (2013)
Liquidity LIQ Liquid Assts − Anbar and Alper (2011); Bougatef (2017);
LIQit ¼ it Francis (2013); Ongore and Kusa (2013);
Total Assetsit Pasiouras and Kosmidou (2007);
Rani and Zergaw (2017)
Deposit DEP Deposits + Acaravci and Çalim (2013); Menicucci and
DEPit ¼ it Paolucci (2016); Naeem et al. (2017);
Total Assetsit Zampara et al. (2017)
Asset management AM Operating Income + Yahya et al. (2017)
AMit ¼ it
Total Assetsit
Financial risk LEV Total Liabilities ±
LRit ¼ it
Total Assetsit
Operating OPEF Total Operating − Rashid and Jabeen (2016)
efficiency Expense
OPEFit ¼
it
Net Interest Incomeit
Branches BRNCH Number of branches +

Independent variables: macroeconomic

Economic activity GDP Annual real GDP growth ± Anbar and Alper (2011); Francis
rate (2013); Garcia and Guerreiro
(2016); Marijana et al. (2012);
Ongore and Kusa (2013);
Zampara et al. (2017)
Inflation INF Annual inflation rate + Jara‐Bertin et al. (2014); Pasiouras and
Kosmidou (2007); Petria et al. (2015);
Saona (2016)
Exchange rate EXCH Average exchange + Acaravci and Çalim (2013); Rani and
rate of U.S. $ in a Zergaw (2017);
year Rjoub et al. (2017)
 Interest rate INTRT Lending interest + Acaravci and Çalim (2013); Anbar and
Alper (2011); Rjoub et al. (2017)
Financial crisis CRISIS A dummy variable − A variable of 0 for the years 2008 and
2009 and 1 for the years 2010 to
2017
Demonetization DEMO A dummy variable − A variable of 0 for the years from 2008 to
2016 and 1 for the year 2017

is 52.94 (Min. = 41.49, Max. = 67.18). Macroeconomic variables show average values of 7.33 and 8.32 for GDP
and INF (SD = 1.81 and 2.40), respectively. The GDP
varies between a minimum of 3.89 and a maximum of 10.26. Similarly, inflation fluctuates between 4.91 and
11.99.

Descriptive statistics
Variables Obs. Maximum Minimum Mean Median Std. dev.
Panel A: dependent variables
ROA 690 10.23 −4.21 1.17 1.06 1.27
ROE 690 31.37 −44.37 10.16 10.97 9.78
Panel B: bank specific
determinants
LNAS 690 17.11 5.89 12.65 13.25 2.24
CAD 690 277.45 7.51 19.30 13.74 16.85
AQ 690 4.42 −0.34 3.92 4.08 0.47
LIQ 690 4.56 2.65 3.65 3.59 0.28
DEP 690 92.25 9.98 71.55 81.00 18.52
AM 690 12.98 −0.68 2.59 2.11 1.69
OPEF 690 9.39 0.13 0.65 0.57 0.69
LEV 690 4.55 0.26 4.34 4.45 0.34
BRNCH 690 18,280.00 1.00 1,306.46 469.00 2,230.28
Panel C: macroeconomic determinants
GDP 690 10.26 3.89 7.33 7.11 1.81
INF 690 11.99 4.91 8.32 8.86 2.40
INTR 690 8.00 4.75 7.10 7.58 1.06
EXCH 690 67.18 41.49 52.94 48.30 8.73
CRISIS 690 1 0 0.80 1 0.40
DEMO 690 1 0 0.10 0.00 0.30

Note. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of branches; CAD: capital adequacy
ratio (%); CRISIS: a dummy variable of 0 for the financial years 2008 and 2009 and 1 for the year 2010 to 2017;
DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the year 2017; DEP: deposits of the
total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%); INF: annual inflation rate (%);
INTR: lending Interest rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%); LNAS: natural logarithm of
total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of bank net profit
to total assets; ROE: ratio of net profit to shareholders equity.

| Unit root test

As a prerequisite requirement and the starting point for the econometric analysis of the models of the study,
stationarity of the panel data using a unit root test is conducted. Stationarity of the variables is tested by Levin,
Lin, and Chu, Im, Pesaran, and Shin, Augmented Dickey–Fuller, and PP–Fisher tests. As shown in Table 4, all
variables used in the models are found to be stationary at the first difference in all the applied tests. This leads to
reject the null hypothesis of a unit root. between dependent and independent variables. With regard to bank ‐
specific variables, there is a positive/negative correlation between bank‐specific variables and both ROA and
ROE. Where LNAS, AQ, BRNCH, DEP, and LEV have a negative correlation with ROA, they have a positive
correlation with ROE. However, CRISIS, DEMO, GDP, and INF have a negative correlation with both ROA and
ROE. Similarly, AM, EXCH, and INTR rate have a positive correlation with ROA and ROE. Further, CAD ratio
and LIQ ratio exhibit a negative correlation with ROE but a positive with ROA. GDP and INF have a negative
relationship with both ROA and ROE.
All independent variables have a low correlation that indicates the absence of multicollinearity issues in this
study. For more reliable analysis, Variance Inflation Factor (VIF) test is conducted to test multicollinearity issues.
As it is shown in Panel B of Table 5, VIF values do not exceed 6.33 for all variables that indicate that there is no
multicollinearity between independent variables.

| Results of model estimation

Tables 6 and 7 show the estimation results of pooled Ordinary Least Squares (OLS), fixed and random effect
TABLE 4 Unit root test
Level 1st difference

Levin, Lin, Im, Pesaran, ADF–Fisher PP–Fisher Levin, Lin,Im, Pesaran, ADF– PP–
& Chu t* and Shin W‐stat chi‐square chi‐square & Chu t* and Shin W‐stat Fisher chi Fisher
‐

Variable square chi‐

s square
Panel A: dependent variables
ROA 0.000 0.993 0.239 0.005 0.000 0.000 0.000 0.000
ROE 0.000 0.972 0.045 0.003 0.000 0.000 0.000 0.000
Panel B: bank specific
determinants
LNAS 0.000 0.105 0.007 0.000 0.000 0.330 0.314 0.000
CAD 0.000 0.037 0.022 0.000 0.000 0.000 0.000 0.000
AQ 0.002 0.842 0.797 0.398 0.000 0.018 0.000 0.000
LIQ 0.000 0.625 0.708 0.038 0.000 0.000 0.000 0.000
DEP 0.000 0.193 0.150 0.000 0.000 0.000 0.000 0.000
AM 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
OPEF 0.000 0.165 0.044 0.000 0.000 0.000 0.000 0.000
LEV 0.000 0.089 0.050 0.000 0.000 0.000 0.000 0.000
BRNCH 0.091 1.000 0.998 1.000 0.001 0.258 0.054 0.000
Panel C: macroeconomic determinants
 GDP 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
INF 0.000 0.000 0.000 0.794 0.000 0.020 0.120 0.009
INTR 0.000 0.000 0.000 0.030 0.000 0.000 0.000 0.000
EXCH 0.000 0.999 1.000 0.858 0.000 0.000 0.000 0.000

Note. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of branches; CAD: capital adequacy
ratio (%); CRISIS: a dummy variable of 0 for the financial years 2008 and 2009 and 1 for the year 2010 to 2017;
DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the year 2017; DEP: deposits of the
total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%); INF: annual inflation rate(%);
INTR: lending Interest rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%); LNASLNA: natural logarithm
of total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of bank net
profit to total assets; ROE: ratio of net profit to shareholders equity.

models in Equations (1) and (2). The analysis of the results is presented below and categorized into two groups;
bank‐specific and macroeconomic determinants of profitability using both ROA and ROE as dependent variables
that are regressed independently against both categories of explanatory variables as explained in Equations (3)
and (4). Following is the discussion of the results based on these two categories.

1. Bank‐specific determinants of Indian banks' profitability

As shown in Table 6, ROA is used as a dependent variable and a function of both categories of bank ‐specific
and macroeconomic determinants. To some extent, all the three models conducted show similar results. The
results in these models demonstrate that LNAS, AM, OPEF, LEV, EXCH, and DEMO have a significant impact
on profitability measured by ROA. However, only BRNCH shows a significant result in the case of pooled and
random effects models and AQ shows a significant impact in the case of pooled and fixed effect models. As
expected in Table 2, across the three models, it has been found that LNAS, AM affect significantly and positively
the profitability of Indian banks as measured by ROA at the level of 1% level of significance (P value < 0.01).
This is consistent with some earlier studies (e.g., AL‐Omar & AL‐Mutairi, 2008; Athanasoglou et al., 2008;
Chowdhury & Rasid, 2017; Menicucci & Paolucci, 2016) who agreed that banks with larger assets size lead to
greater profitability. On the contrary, Francis (2013) reported that bank size has a negative effect on banks'
profitability and Athanasoglou et al. (2008) found that bank size does not affect bank profitability significantly.
On the other hand, Yahya et al. (2017) consistently revealed that assets management has a significant and positive
impact on banks' profitability.
Along the same line, the results declare that LEV ratio affects significantly ROA at the level of 1% ( P value <
0.01). Expectedly, the coefficient of LEV ratio is found to have a negative value. The results are similar with the
studies of
TABLE 6 Model estimation results summary
Pooled Fixed Random
ROA
Variable Coeff. Sd. Er. t Prob. Coeff. Sd. Er. t Prob. Coeff. Sd. Er. t Prob.
C 1.08 1.60 0.67 0.50 0.89 0.86 1.03 0.30 0.04 0.81 0.05 0.96
Bank‐specific
determinants
LNAS 1.68 0.39 4.28 0.00 1.34 0.25 5.31 0.00 1.56 0.26 6.03 0.00
BRNCH 0.00 0.00 −3.87 0.00 0.00 0.00 −0.43 0.67 0.00 0.00 −2.01 0.04
AM 0.32 0.05 5.88 0.00 0.36 0.03 12.31 0.00 0.15 0.03 5.26 0.00
CAD 0.00 0.00 −0.59 0.56 0.00 0.00 −0.59 0.56 0.00 0.00 −0.71 0.48
AQ 0.03 0.02 2.00 0.05 0.02 0.01 1.89 0.06 0.01 0.01 1.50 0.13
LIQ 0.01 0.02 0.52 0.60 0.00 0.01 0.31 0.76 0.00 0.01 0.43 0.66
DEP 0.01 0.01 0.77 0.44 0.00 0.01 0.86 0.39 0.00 0.01 0.49 0.63
OPEF 0.27 0.12 2.22 0.03 0.17 0.07 2.61 0.01 0.13 0.06 2.11 0.04
LEV −0.04 0.01 −3.62 0.00 −0.03 0.01 −5.51 0.00 −0.02 0.01 −3.02 0.00
Macroeconomic determinants
GDP 0.07 0.69 0.11 0.91 0.13 0.37 0.35 0.72 −0.08 0.35 −0.24 0.81
INF −0.03 0.03 −0.97 0.33 −0.02 0.02 −1.22 0.22 0.00 0.01 0.09 0.93
EXCH −0.05 0.03 −1.74 0.08 −0.05 0.01 −3.31 0.00 −0.04 0.01 −3.09 0.00
INTR −0.12 0.12 −1.04 0.30 −0.10 0.06 −1.54 0.13 −0.08 0.06 −1.39 0.16
DEMO −0.63 0.28 −2.23 0.03 −0.65 0.15 −4.30 0.00 −0.40 0.15 −2.70 0.01
CRISIS −0.28 0.28 −0.98 0.33 −0.24 0.15 −1.60 0.11 −0.23 0.14 −1.62 0.11
Adjusted R 2
0.17 0.76 0.21

F‐statistic 9.64 25.06 10.85

Prob (F‐ 0.00 0.00 0.00

statistic)
Hausman test 0.000

Note. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of branches; CAD: capital adequacy
ratio (%); CRISIS: a dummy variable of 0 for the financial years 2008 and 2009 and 1 for the year 2010 to 2017;
DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the year 2017; DEP: deposits of the
total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%); INF: annual inflation rate (%);
INTR: lending Interest rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%); LNAS: natural logarithm of
total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of bank net profit to total assets; ROE: ratio of
net profit to shareholders equity.
Yahya et al. (2017) and Jara‐Bertin et al. (2014) who revealed that LEV ratio is negatively related to banks'
profitability (ROA).
In addition, the results in Table 6 demonstrate a significant impact of OPEF ratio on ROA in the three models
at the level of 5% (P value < 0.05). The coefficient has the expected positive sign that reveals a positive impact on
ROA. Consistently, AL‐Omar and AL‐Mutairi (2008), Marijana et al. (2012), Petria et al. (2015), Rashid and
Jabeen (2016), and Salike and Ao (2017) agreed that operating expenses ratio is significant and is one of the most
important determinants of banks' profitability. This argument is supported also by Jara ‐Bertin et al. (2014) and
Salike and Ao (2017) who proved that operational efficiency is a significant determinant in explaining banks'
profitability. Contradictory, Chowdhury and Rasid (2017), Francis (2013), and Yahya et al. (2017) found that
OPEF ratio has statistically significant negative impact on ROA but Naeem et al. (2017) reported a negative as
well as insignificant relationship with ROA.

TABLE 7 Model estimation results summary

Pooled Fixed Random
ROE
Variable Coeff. Sd. Er. t Prob. Coeff. Sd. Er. t Prob. Coeff. Sd. Er. t Prob.
C 2.48 0.12 20.11 0.00 2.55 0.10 25.11 0.00 2.49 0.11 22.72 0.00
Bank‐specific
determinants
LNAS 0.00 0.00 2.01 0.04 0.00 0.00 2.20 0.03 0.00 0.00 2.98 0.00
BRNCH 0.00 0.00 1.18 0.24 0.00 0.00 −0.56 0.57 0.00 0.00 0.13 0.90
AM 0.15 0.04 4.03 0.00 0.16 0.03 5.52 0.00 0.16 0.03 5.36 0.00
CAD 0.00 0.00 −0.35 0.73 0.00 0.00 −0.37 0.71 0.00 0.00 −0.41 0.68
AQ 0.01 0.01 1.04 0.30 0.01 0.01 1.31 0.19 0.01 0.01 1.29 0.20
LIQ 0.01 0.01 1.10 0.27 0.01 0.01 0.77 0.44 0.01 0.01 0.92 0.36
DEP 0.00 0.01 −0.03 0.98 0.00 0.01 0.47 0.64 0.00 0.01 0.38 0.70
OPEF 0.09 0.08 1.08 0.28 0.09 0.07 1.42 0.15 0.09 0.07 1.42 0.16
LEV 0.00 0.01 0.01 0.99 0.00 0.01 −0.40 0.69 0.00 0.01 −0.27 0.79
Macroeconomic determinants
GDP −0.09 0.05 −1.92 0.06 −0.10 0.04 −2.75 0.01 −0.10 0.04 −2.68 0.01
INF 0.03 0.02 1.39 0.17 0.04 0.02 2.20 0.03 0.03 0.02 2.09 0.04
EXCH −0.08 0.02 −3.70 0.00 −0.09 0.02 −5.15 0.00 −0.09 0.02 −5.06 0.00
INTR −0.20 0.08 −2.49 0.01 −0.23 0.07 −3.52 0.00 −0.23 0.07 −3.43 0.00
DEMO 0.13 0.34 0.37 0.71 0.24 0.27 0.88 0.38 0.22 0.27 0.80 0.43
CRISIS −0.56 0.18 −3.20 0.00 −0.65 0.14 −4.57 0.00 −0.63 0.14 −4.48 0.00
Adjusted R 2
0.12 0.44 0.17

F‐statistic 6.09 6.43 8.48

Prob (F‐ 0.00 0.00 0.00

statistic)
Hausman test 0.0001

Note. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of branches; CAD: capital adequacy
ratio (%); CRISIS: a dummy variable of 0 for the financial years 2008 and 2009 and 1 for the year 2010 to 2017;
DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the year 2017; DEP: deposits of the
total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%); INF: annual inflation rate (%);
INTR: lending Interest rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%); LNAS: natural logarithm of
total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of bank net profit.

Furthermore, the expected sign of BRNCH is revealed by the results of both pooled and random effect models.
Although BRNCH is found to be positively significant at the level of 1% (P value < 0.01) in the case of pooled
model, it is positively significant at the level of 5% in the random effect model ( P value < 0.05) but no significant
impact is found in the fixed effect model. Similarly, AQ ratio has the expected (positive) sign in both; pooled and
fixed effect models. This indicates that AQ ratio has a significant positive impact on ROA at the level of 10% ( P
value < 0.10). This is in agreement with AL‐Omar and AL‐Mutairi (2008) who concluded a significant
relationship between AQ and ROA. Inconsistently, to total assets; ROE: ratio of net profit to shareholders equity.
Naeem et al. (2017) found a negative relationship between AQ and ROA.
However, CAD ratio, LIQ ratio, and DEP ratio show insignificant impact on profitability of the Indian banks
as measured by ROA (P value > 0.10). Notably, the coefficients of these variables are found to have a positive
sign as predicted except for LIQ that expected to have a negative impact on ROA. These results are in agreement
with Ongore and Kusa (2013) who revealed that bankspecific factors significantly affect the performance of
commercial banks in Kenya, except for liquidity variable. Further, Bougatef (2017), Marijana et al. (2012),
Naeem et al. (2017), and Yahya et al. (2017) disclosed a positive impact of liquidity on bank's profitability. But
this contradicts Jara‐Bertin et al. (2014) and Francis (2013) who found a negative impact of liquidity on ROA.
However, Tiberiu (2015) declared that the level of liquidity has a mixed influence. Concerning CAD ratio, the
results of this study is in accordance with Naeem et al. (2017) who stated that CAD ratio has a positive but
insignificant impact on the profitability of banks. Differently, Bougatef (2017) and Salike and Ao (2017) reported
a significant positive impact whereas Yahya et al. (2017) declared a negative impact on the bank's profitability. In
the same vein, a similar result regarding DEP ratio was found by Menicucci and Paolucci (2016) who suggested
that banks with higher deposits tend to be more profitable but the effects on profitability are statistically
insignificant in some cases.
With regard to the impact of bank‐specific variables on the profitability of Indian banks as measured by ROE,
the results indicate that LNAS and AM are found to be significant and have an impact on ROE. Both variables
show a positive coefficient that is consistent with the expected sign. However, LNAS has a positive significant
impact on ROE at the level of 1% (P value < 0.01) in case of the random effect model, it is significant at the level
of 5% (P value < 0.05) in the pooled and fixed effect models. This finding is consistent with Masood & Ashraf,
2012 and Jara‐Bertin et al. (2014) who indicated that bank size is an important determinant of bank's profitability.
On the other hand, AM indicates a positive significant impact on ROE at the level of 1% (P value < 0.01) in all the
three models. This is in agreement with Yahya et al. (2017) who declared that assets management has a significant
and positive impact on banks' profitability. All other variables of bank‐specific factors show insignificant impact
on the profitability of Indian banks as measured by ROE across the three models. No evidence is found at any
level of significance (P value > 0.10).
For the reliability of the three used models, the adjusted R square in case of ROA is 17% for the pooled model,
76% in the fixed effect model, and 21% in the case of the random effect model. It shows that both bankspecific
and macroeconomic determinants are explaining about 17% to 76% of the variation of a bank's profitability as
measured by ROA. Similarly, the value of the adjusted R square in case of ROE is 12% in the pooled model, 44%
in the fixed effect model, and 17% in the random effect model exhibiting that both bank‐specific and
macroeconomic determinants are contributing about 12% to 44% to the profitability. To evaluate and compare the
results of the three models applied, it is clearly seen from the results of Tables 6 and 7 that all models have a P
value of less than 1% revealing that all models are fit and significant. Furthermore, Hausman test was conducted
for deciding the appropriate estimated model between both fixed and random effect models. The P value suggests
that fixed effect model is superior and appropriate than random effect model as the P value of Hausman test is less
than 0.05 (P value = 0.00 < 0.01). Accordingly, Hausman test suggests that fixed effect model is more appropriate
than random effect model.
 2. Macroeconomic determinants of Indian banks' profitability

Regarding the set of external factors affecting the profitability of Indian banks as measured by ROA, the
findings of this study reveal that GDP, INF, INTR, and CRISIS have no significant impact on ROA at any level of
significance but they are found to have statistically significant impact on ROE. Although both EXCH and DEMO
exhibited a significant impact on ROA and ROE, only DEMO shows no significant impact in the case of ROE.
EXCH is found to have a significant impact on ROA at the level of 1% (P value < 0.01) in the fixed and
random effect models but it is significant at the level of 10% (P value < 0.10) in the case of pooled model. Further,
EXCH shows statistically significant impact on ROE at the level of 1% (P value < 0.01) in all the three models.
Unexpectedly, the coefficient sign is found to be negative in both cases that indicate a negative impact on ROA
and ROE. This could be attributed to deterioration of exchange rate of the Indian Rupee as compared with the
other foreign currencies especially the U.S. $ (41.49 in 2008 and 67.18 in 2017). This contradicts Saona (2016)
and Tiberiu (2015) who found a positive association between foreign exchange and banks profitability.
Furthermore, DEMO shows a significant impact only on ROA at the level of 1% (P value < 0.01) in the case of
fixed effect model but it has a significant impact at the level of 5% (P value < 0.05) in the case of both pooled and
random effect models. It is found to have statistically insignificant impact on ROE at any level of significance. As
expected, DEMO reveals a negative coefficient that suggests a negative impact on ROA.
Although CRISIS has a significant impact on ROE at the level of 1% (P value < 0.01) across the three applied
models, other significant factors have different directions of impact from a model to another a model.
Consistently, Bogdan and Ihnatov (2014) and Maria et al. (2017) found a negative and significant impact of
CRISIS with profitability measured by ROA and ROE. Further, Dietrich and Wanzenried (2014) stated that the
financial crisis has statistically negative significant in high‐income countries. On the contrary, Saona (2016)
revealed that the financial crisis is positively and statistically significant.
GDP has statistically significant impact on ROE at the level of 5% (P value < 0.05) in case of both fixed and
random effect models but it is statistically significant at the level of 10% ( P value < 0.10) in the pooled model.
This result is consistent with Garcia and Guerreiro (2016) and Rashid and Jabeen (2016) who reported that the
real GDP growth has a negative impact on profitability. However, a contradictory result is found by Acaravci and
Çalim (2013) and Yahya et al. (2017) who stated that banks performance are positively related to economic
growth. Similarly, INTR rate is found to have a significant impact at the level of 1% ( P value < 0.01) in the fixed
and random effect models but it is statistically significant at the level of 5% (P value < 0.05) in the pooled model.
Unexpectedly, it shows a negative coefficient that indicates a negative impact on ROE. This is in agreement with
Rashid and Jabeen (2016) who revealed that interest rate is negatively related to bank's performance. Differently,
from the aforementioned external factors, INF rate has a statistically significant impact only under fixed and
random effect models at the level of 5% (P value < 0.05). The same finding was found by Jara‐Bertin et al. (2014)
and Yahya et al. (2017) who declared that INF has a positive and significant impact on banks' profitability.
Overall, and in connection with the Hausman Test, fixed effect model should be considered superior to the
random effect model. In this view, it can be concluded that all macroeconomic factors investigated by this study
except DEMO are substantial determinants of profitability of the Indian banks measured by ROE. In the same
vein, both EXCH rate and DEMO are significant and important macroeconomic determinants of profitability as
measured by ROA.

TABLE 8 Panel‐corrected standards error (PCSE)

| Robustness analysis

Beck and Katz (1995) validated that feasible generalized least squares (FGLS) generates severely underestimated
standard errors coefficients. However, as compared with FGLS, the “panel‐corrected standard errors,” (PCSE)
estimator creates accurate standard error estimate with no loss in efficiency. Accordingly, an alternative estimator,
based on OLS but using PCSE, produces accurate coefficient standard errors (Reed & Webb, 2010). The PCSE
standard error estimate is robust not only to unit heteroskedasticity but it is also robust against possible
 ROA: PCSE by: xtpcse, corr (psar1) ROE: PCSE by: xtpcse, corr (psar1)

Variable Coef. Std. Err. z P>z Coef. Std. Err. T P>t

contemporaneous correlation across the units (Bailey & Katz, 2011). Coupled with the fact that FGLS is
appropriate for panels with T > N; this study applied PCSE where the panel is constituted by 69 banks in 10 years,
the PCSE is the most suitable estimator (Marques, Fuinhas, & dos Santos Gaspar, 2016).
Table 8 provides results of the PCSE. PCSE is a panel correction standard error that arbitrary accounts for
heteroscedasticity within cross‐sectional correlation (Beck & Katz, 1995). With reference to bank‐specific factors
and ROA, PCSE model provides evidence that LNAS, BRANCH, AM ratio, OPEF ratio, and LEV ratio have
statistically significant impact on ROA. All of these factors are found to be statistically significant at the level of
1% (P value < 0.01) except LNAS that is statistically significant at the level of 5% (P value < 0.05). Notably, they
all have a positive coefficient that denotes a significant positive impact or increase on profitability of the Indian
banks as measured by ROA except LEV ratio that has a negative coefficient suggesting a significant decrease in
ROA. The coefficient sign is met with the expected sign stated in Table 2.
In terms of ROE, among the bank‐specific factors, the results show that only LNAS, AM ratio, AQ ratio, and
LIQ ratio have statistically significant impact on ROE. Although both LNAS and AM ratio have a significant
effect on ROE at the level of 1% (P value < 0.01), AQ ratio is statistically significant at the level of 5% (P value <
0.05). However, the LIQ ratio is significant at the level of 10% (P value < 0.10).
However, the majority of macroeconomic results factors show significant impact on profitability as measured
by ROA. All factors except GDP growth and CRISIS have a significant impact on ROA. INF rate and DEMO are
significant at the level of 1% (P value < 0.01) but EXCH rate and INTR rate are significant at the level of 5% (P
value < 0.05). Similarly, all macroeconomic factors excepting DEMO reveal a significant impact on ROE. This
significant impact is at the level of 1% (P value < 0.01) for GDP growth, EXCH rate, INTR rate, and CRISIS and
at 5% (P value < 0.05) level of significance for INF rate.
Bank‐specific
determinants
LNAS 0.64 0.28 2.26 0.02 0.00 0.00 3.17 0.00
BRNCH 0.00 0.00 −3.78 0.00 0.00 0.00 0.08 0.94
AM 0.36 0.03 10.96 0.00 0.19 0.05 3.76 0.00
CAD 0.00 0.00 −1.55 0.12 0.00 0.00 −0.70 0.49
AQ 0.01 0.01 0.92 0.36 0.04 0.01 2.51 0.01
LIQ 0.00 0.01 0.17 0.87 0.02 0.01 1.71 0.09
DEP 0.00 0.01 0.84 0.40 0.00 0.01 −0.08 0.94
OPEF 0.15 0.05 2.87 0.00 0.10 0.07 1.41 0.16
LEV −0.03 0.01 −3.82 0.00 −0.01 0.01 −0.55 0.58
Overall, the estimated adjusted R squared for PCSE model is 55% in case of ROA and 42% for ROE. This
suggests that both bank‐specific and macroeconomic variables investigated by this study are contributing about
55% and 42% to the variability of ROA and ROE, respectively. In other words, 55% and 42% of the total
variability is accounted for by the models stated in Equations 3 and 4.

C 1.23 0.81 1.52 0.13 2.56 0.13 20.30 0.00

Macroeconomic determinants
GDP 0.01 0.35 0.04 0.97 −0.16 0.05 −3.26 0.00
INF −0.05 0.01 −3.46 0.00 0.04 0.02 2.23 0.03
 EXCH −0.03 0.01 −2.58 0.01 −0.12 0.02 −5.47 0.00
INTR −0.14 0.07 −2.08 0.04 −0.40 0.09 −5.47 0.00
DEMO −0.72 0.16 −4.58 0.00 0.30 0.36 0.86 0.39
CRISIS −0.13 0.14 −0.97 0.34 −0.96 0.19 −5.19 0.00
No. of obs 620 620
No. of groups 69 69
Est. covariances 2,415 2415
Est. coefficients 16 16

R2 0.55 0.42

Wald χ2 (15) 354.34 92.67

Prob > χ2 0.0000 0.000

Note. AM: assets management (%); AQ: assets quality (%); BRNCH: no. of branches; CAD: capital adequacy ratio (%); CRISIS: a dummy variable of 0 for
the financial years 2008 and 2009 and 1 for the year 2010 to 2017; DEMO: a dummy variable of 0 for the years from 2008 to 2016 and 1 for the year 2017;
DEP: deposits of the total assets (%); EXCH: exchange rate; GDP: real gross domestic product (%); INF: annual inflation rate (%); INTR: lending Interest
rate (%); LEV: financial risk (%); LIQ: liquidity ratio (%); LNAS: natural logarithm of total assets; OPEF: ratio of operating efficiency (%); ROA: ratio of
bank net profit to total assets; ROE: ratio of net profit to shareholders equity.

1 | CONCLUSION AND RECOMMENDATIONS

The Indian banking sector has witnessed significant issues and changes. Different changes such as demonization,
banking fraud, and sustainability are recently noteworthy issues that affect the performance of Indian banks.
Further, the increasing trend of the balance sheet indicators especially deposits, borrowings, loans and advances,
and the declining in profitability over the few last years raises a major concern on the performance of Indian
banks. This study examined bankspecific and macroeconomic determinants of 69 Indian commercial banks'
profitability over a period ranging from 2008 to 2017. ROA and ROE were taken as dependent variables, whereas
independent variables were divided into two categories. The first category includes bank‐specific variables
(internal), namely, assets size, capital adequacy, asset quality, liquidity, deposit, asset management, operating
efficiency, and financial risk. The second category represents macroeconomic variables such as GDP, inflation
rate, exchange rate, interest rate, financial crisis, and demonization.

The results indicate that bank‐specific factors such as bank size, number of branches, assets management ratio,
and operational efficiency have a positive impact on ROA. On the other hand, there is a negative impact of
leverage on ROA. With regard to the impact of macroeconomic determinants on ROA, the results revealed that
inflation rate, exchange rate, interest rate, and demonization have a negative impact on ROA. Concerning the
bank‐specific and macroeconomic determinants of profitability of Indian banks measured by ROE, the results
indicate that bank size, assets management ratio, assets quality ratio, liquidity ratio, and inflation rate are found to
have a significant positive impact on ROE. Further, there is a negative relationship between economic growth,
exchange rate, interest rate, and the financial crisis from one side and the profitability of Indian banks measured
by ROE on the other.
By using balanced bank level panel data, the study seeks to examine the impact of bank specific factors, banking
industry factors and macroeconomic factors on the performance of Indian Banks. Using information from 44
banks which included 25 public sector banks and 17 private sector banks, we deployed return on average assets
(ROAA) and return on equity (ROE) as a dependent measure for bank profitability. We find that bank specific
factors affect bank profitability in a pronounced manner. The findings indicate that non-performing loan (NPL)
and cost to income ratio negatively affects the bank profitability, but diversification measure does not affect the
bank profitability. The results are same across ownership with a change in values. Asset quality, which is
measured through NPL is a major determinant to assess financial soundness and health of the bank. The
deterioration in NPL can put additional stress as Indian corporates exhibit difficulty in servicing the bank loans.
Cost to income ratio is used to differentiate banks from the perspective of operational efficiency. The high cost to
income ratio makes it vulnerable, the ratio is used by investors to judge future prospects. The negative
relationship with bank profitability requires the need for regular monitoring. The results indicate that
diversification does not affect bank profitability. While diversification measures vary on ownership structure,
there is viewpoint that higher diversification is risky for banks with inadequate prior experience. However, the
level of diversification is comparatively low than that in developed countries. The results indicate that
diversification did not influence bank profitability.

Ever since the financial reforms of early 90’s, the Indian banking industry has observed unprecedented changes in
its structure. Most of these changes notably occurred in terms of capital adequacy, market concentration and non
performing assets. The study assesses the impact of bankspecific, industry-specific and macroeconomic
determinants on bank profitability, in a dynamic model framework and provides useful insights into factors that
determine the profitability of banks and their relevance. The study also assesses the resilience of the banking
system during the financial crisis period. It applies GMM technique developed by Arellano and Bond (1991), an
appropriate technique for dynamic panel data estimation, which accounts for the problem of endogeneity of
factors by specifying a dynamic econometric model, to study the persistence of bank profits. The lag of profit
variable ROA has been found to be significant across all the time periods indicating its persistence. Persistence in
bank profits is defined as the tendency for an individual bank to retain the same place in the profit performance
distribution of banking industry. The level of bank profit persistence determines the degree of competitiveness of
product market, informational asymmetry. This shows that the product markets of Indian Banks are moderately
competitive and less opaque due to asymmetry in information. At the outset, the Indian Banking sector is not far
away from becoming a perfectly competitive industry. Bank-specific variables, capital to assets ratio, operating
efficiency, deposit growth and ratio of non-interest income to total assets, are found to be significantly positively
related to bank profits. Whereas the credit risk has been found to be substantially negatively affecting bank
profits. Large banks have been found more profitable than the small banks. We also find evidence in support of
the SCP (market power). Herfindahl–Hirschman Index indicates that banks in the Indian banking industry
respond positively to market concentration. Even though the number of market players within the industry is
increasing, they have structures with greater productive efficiency and are able to exploit the updated technologies
which increase their efficiency. Profit variable ROA also responds positively to GDP growth indicating profits are
pro-cyclical, and banks earn higher profits during boom periods. However, the effect of inflation has been found
to be negative. The effect of size of the banks and operational efficiency on profitability has been found
insignificant during the crisis period. However, the variable for credit risk is found to be highly significant
suggesting that banks with higher credit riskiness have been less profitable during the crisis period. The following
policy implications are suggested: 1. There exists a moderate to a high degree of competition within the Indian
banking industry. Therefore, banks need to offer more diversified products and services to gain competitive
advantage and maintain a particular profit level within the industry. 2. Capital to asset ratio, in the case of banks,
acts as a buffer to withstand any financial shocks in the economy. It contributes towards an increase in profits.
The study finds that higher capital to asset ratio reaps higher bank profits. 3. Since banks in India have been trying
to bring operational efficiency, they can afford to spend on human capital, which may help them to achieve higher
profitability through their managerial expertise. Since we observe that ratio of operational expenses to total assets
has a positive impact on return on assets of banks, this implies that banks may spend on human capital, which will
be positively affecting returns. 4. Banks need to focus on attracting a greater amount of deposits, which will be
further converted into income generating assets since we find a positive significance of deposits on return on
assets. 5. Being productively efficient Indian Banks can become more profitable even though if market
concentration increases, due to the increase in number of market players within the industry .

The findings of this study have considerable implications for bankers, policymakers, regulator, analysts, and
academicians. Bankers and policymakers should focus on the bank‐specific factors that play an important role in
the profitability of Indian banks. More emphasis should be given to the deposits and liquidity ratios for efficient
utilization and effective performance of the Indian banks. Further, minimizing the costs, increasing the portfolio
of the equity financing over the debt financing, and an efficient managing of the financial risk are some important
bank‐specific factors that should be given more consideration by bankers and policymakers. Banks' managers,
bankers, and other professionals should focus on the bank‐specific factors for effectively utilizing their resources
in such a way that affect positively the financial performance of the Indian banks. In addition, policymakers and
regulators should give more consideration to the macroeconomic factors especially interest rate, exchange rate,
inflation, and demonization which proved that have an important role in the profitability of Indian banks. It is
recommended that regulators and policymakers should consider the macroeconomic factors in such a way that
improve the profitability of the Indian banks. Finally, future research could investigate this issue by including
more variables or using other techniques of analysis such as GMM, ARDL or other techniques. Further, future
studies may compare the profitability of Indian banks with the private and public sectors.
This study sought to bridge a gap by providing new empirical evidence on the bank‐specific and
macroeconomic determinants that affect the profitability of Indian commercial banks. The findings of the present
study have considerable contributions to the existing stock of prior studies by comprehensively explaining and
empirically analysing the current state of profitability among the commercial banks of India. It focuses on a major
and important sector in an emerging economy like India. It gives attention to some crucial events that happened
during the period of the study such as demonetization process, some big concerns about the sustainability of the
country's banking system, severe stress, bad loans, and an increase in banking frauds. Further, a unique
contribution of this study is to consider the impact of demonization and the number of branches on the
profitability of Indian banks.

7 Managerial discussions and implications

This study has important implications for managers and scholars. Banks in India underwent followed the
prescription of privatization as a fallout of financial sector reforms in 1990s. While the study by Boateng et al.
(2015) considered both banking and economic factors, our study included banking industry factors such as
ownership and size in addition to banking and economic factors.
The impact of privatization banks was mixed in India. By 2008–2009, although global banks were affected by
financial crisis, past studies confirm that banks in India were not affected by global financial crisis. During the
period, the performance of public sector banks was comparable with private sector banks. Our major area of
interest is drivers of bank profitability. We considered the major variables such as non-performing loans, cost to
income ratio, and diversification. Non performing loans are area of concern and are associated with bank failures
and financial crisis in the past. They play a role in economic downturns and macroeconomic volatility. Regulator
needs to be concerned with increase in NPL beyond the permissible levels. Cost to income ratio is considered as
an important efficiency parameter. Diversification was calculated as ratio of non-interest income to operating
income. Different measurements are available to calculate diversification. For instance, Gambacorta et al. (2014)
consider the diversification measure as the ratio of non-interest income to total income, Mostak ( 2017) calculate
the diversification measure similar to Herfindahl–Hirshman measure, and referred the measure as focus. The
higher value indicates the focus, the lower value shows the diversification. There is considerable gap when we
review the income from bancassurance for public sector and private sector banks. For example, the income for 26
public sector banks is Rs. 73 billion and income for 20 private sector banks is 196 billion. The findings indicate
that diversification did not affect the bank profitability, which was calculated using ROAA and ROE.
During the period under study, the performance of public sector slipped downwards and increasing level of
non-performing assets is negatively affecting bank profitability. With the higher requirement of capital after the
post global financial crisis, banks are required to generate higher level of profits from the same assets. There was
a significant increase in NPL for public sector banks in recent years, and in such a scenario, effective bad debt
management is crucial to maintaining profitability. NPL is identified as the threat for banking stability and
regulators have expressed concern over deteriorating asset quality in Indian banks, particularly public sector
banks. Among various factors, directed lending in the priority sector credit and interference of government in
distorting the credit culture, specifically for public sector banks. It is suggested that public sector banks need to
change their focus on improving profitability factors rather than relying on increasing the balance sheet size.

Acknowledgements The author wish to thank the Editors and anonymous reviewers for providing notes that significantly improved the manuscript in all
stages of the peer review process.

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