Pacific Business Review International

Volume 5 Issue 11 (May 2013)

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Determinants of Return on Assets of Public Sector

Banks in India : An Empirical study
Subhendu Dutta*, Nitin Gupta**, P.Hanumantha Rao**
The time period after 2008 was very volatile for financial markets throughout the world. The global banking
system was adversely affected by the weakening of global growth, escalation of the sovereign debt crisis and
nancial market crisis. However, the fundamentals of the banking sector in emerging economies were
comparatively better, which was reflected in higher economic growth and sound capital base in those economies.
As far as India is concerned, we observe that RoA and RoE of most of the banks in India have dipped during last
one or two years. This makes the study on the determinants of ROA of public sector banks very significant
particularly when the banking system in India is predominantly led by public sector banks. From the study, we
find that the most significant factors influencing RoA of public sector banks are spread, operating expenses,
provisions & contingencies and non interest income.
Key words: Return on Assets, Public Sector Banks.

Introduction
A well regulated financial system is helpful for sustainable
economic growth and development of a country. It not only
ensures the most productive allocation of investible funds in
the economy but also thwarts any external threats that we may
face any time; particularly when the economy is open.
'Financial innovation and integration have increased the speed
and extent to which shocks are transmitted across asset classes
and countries, blurring boundaries between systemic and nonsystemic institutions (RBI, 2008-09).' Recent global financial
crisis is one of such threats which affected financial sectors
across the globe. It also weakened Keynes' theory which
revived U.S. in 1930s. Against this background the present
paper makes an attempt to examine the ROA performance of
public sector banks during in last two years.
The economic crisis has exposed the vulnerability of the
financial systems across the globe. It has at the same time
established the importance of the banking sector in fuelling
sustainable growth of the country. Improved performance of
the banking industry in India has helped the economy to
bounce back to a positive growth level. According to the
Reserve Bank of India, the banking sector in India is sound,
adequately capitalized and well-regulated.
Indian financial and economic conditions are much better
than in many other countries of the world. Credit, market and
liquidity risk studies show that Indian banks are generally
resilient and have withstood the global downturn well.
Though the Indian banks have performed well on the
parameters of asset quality and profitability, there are several
notable limitations which hamper the growth of the sector
thus; Indian banks are yet to get rid of financial bruises.

Confederation of Indian Industries's (CII) survey on "Health

of Indian Banking sector in current regulatory environment"
assessed the prevailing market conditions vis--vis asset quality,
capitalization of banks and growth estimate of the banking
sector while focusing upon the current regulatory environment
and its impact on bank business and profitability taking
feedback from 15 lenders including five state-owned, three
private sector and seven foreign entities. In 2012-13, the
report said that their profitability is likely to "decline sharply"
because to two reasons (a) stricter regulatory requirements and
(b) stress assets. "From an average growth of 23 per cent
witnessed during the last year (FY 2011-12), the surveyed
banks have projected an increase of 14 per cent in profit after
tax (PAT) for FY 2012-13. However, it is interesting to note
that this has been forecasted to rise to 21 per cent in FY 201314, reflecting increased optimism of banks for a change in
scenario positively. Furthermore, the Basel III capital
requirements are likely to have the highest impact on
profitability of the Indian banking sector followed by the
revised guidelines on Priority Sector Lending (PSL), the Gross
NPAs level of the Indian banking sector which was already at
its highest level in last six years (as at end March 2012) is
expected to worsen with significant rise in restructured loan
accounts. This is going to have major impact on bank's
profitability.
The last five years have been very volatile for not only the
Indian economy but also for the entire world economy. Lots of
investors have lost their money as the stock prices have fallen
flat all over the world during this period. Banking sector has
always been one of the important sectors for investment. In
the time of uncertainty, when some are arguing that the
economies are in the process of recovery and while others are

* Faculty, Department of Economics, IBS Hyderabad.

** Faculty, Department of Finance And Accounting, IBS Hyderabad.

Pacific Business Review International

opining that the world is set for another recession soon.

Slowing growth along with higher interest rates can have a
number of multiple implications for the operations of the
banks. First of all, low rate of business growth restricts the
capacity of banks to levy higher interest rates from borrowers.
Deposit growth in the system declines in comparison to the
credit growth which has an adverse effect on banks' ability to
lower interest offered to depositors. Both these factors have a
significant effect on the net interest income (NII) and net
interest margin (NIM) of the banks. In addition to this, the
loan servicing capacities of business community comes under
pressure, which strains the asset quality of the banking system.
When non-performing assets (NPAs) increases, banks are
required to make higher provisioning, which ultimately affects
their profitability.
Profitability of the banks can be examined with the help of
number of parameters. One of such parameter is ROA.
Return on assets is an indicator of how profitable a company is
relative to its total assets. It gives an idea of the efficiency of the
management in using its assets to generate earnings. The
growth in net profit of commercial banks has slowed down,
mainly due to steep increase in interest expenditure. Also, Net
Interest Margin (NIM) declined marginally during 2011-12 as
compared with the previous year. As a result of this, during the
same time period, two major indicators of profitability, RoA
and RoE have declined marginally compared with the previous
year, mainly reflecting the slowdown in net profit caused by
increased interest expenditure. As public sector banks still
accounts for two-thirds of total assets of all scheduled
commercial banks, it becomes very relevant to examine the
determinant of ROA of public sector banks in India.
Literature Review
A review of literature on profitability and performance of
Indian banks has thrown ample light on banks' status in the
present economic scenario. A few selected studies were
reviewed, some of which are mentioned as under.
Narang et al (2011), Chaudhry (2012), and Uppal et al (2012)
and many others have examined Indian banking system in
terms of their performance and profitability. Narang et al
(2011) found that some banks achieved excellent performance
with regard to index of interest earned to total assets ratio.
Chaudhary (2012) made an analysis of the performance of
selected public and private banks in India on the basis of
parameters recommended in the CAMEL Model. Researchers
have taken various parameters to evaluate banks' performance
such as business per employee, profit per employee, total
deposits, total advances, total investment, total assets, total
income, total expenditure and net profits. Uppal (2010) and
Ramaratnam et al (2011) examined certain key parameters to
evaluate the performance of the Indian banks during the global
financial turmoil. Chaudhary et al (2011) made a comparative
study of public and private sector banks to evaluate their
performance. They suggested that suitable and stringent

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measures should be taken to get rid of NPA problem and an

efficient management information system should be
developed. Koundal (2012) measured the relative performance
of Indian banks. Koeva (2003) provided empirical evidence on
the impact of financial liberalization on the performance of
Indian banks by examining the behaviour costs and
profitability during the liberalization period. The study
observed that ownership type has a significant effect on the
some of performance indicators.
Reviews of work revealed that various reform measures
introduced in India have indeed strengthened the Indian
banking system in thwarting the new challenges ahead. It was
observed that India is lagging in many aspects. It is still far away
from the 100 per cent globalization. Less use of technology
along with high NPAs in Indian banks and poor human
resource management are other concerns. It was also found
that reform measures taken in India have largely benefited
foreign and private sector banks. Public sector banks are still
lagging behind in terms of various financial parameters and
needs much improvement.
Objective of The Study
Performance of banking sector has a very significant influence
on the economic growth. Last three years were very significant
as most of the economies started recovering from the financial
crisis. As public sector banks accounts for major proportion of
banking business in India, their profitability studies have
always assume great importance. The performance of the
banks is said to be satisfactory if the ROA exceeds 1%. The
average return on assets of the public sector banks is 0.88 for
2011-12 whereas as it was 0.96 in the year 2010-11. So, we
can find a decline in the ROA of public sector banks. The main
objective of the present study is to critically examine the
determinants of ROA of banks in public sector. Further, it also
aims to predict the ROA performance of public sector banks in
India on the basis of some parameters.
Research Methodology
The study focuses on all banks in India under public sector. It
included 19 nationalized banks, SBI and its associates and also
one new public sector bank (IDBI Ltd.).
Key Variable: Dependent variable for the purpose of study is
Return on Assets of banks. Spread as a percentage of assets,
Credit deposit ratio, investment deposit ratio, Capital
adequacy ratio, operating expenses, provision for
contingencies, net NPA as a percentage of net advances and
non interest income of banks have been taken as independent
variables.
1. Spread Ratio (SP) (Spread/Total Assets): Spread is the
difference between interest earned and interest paid.
The ratio is calculated as a percentage spread to total
assets. The higher the ratio, the more will be the
profitability.

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2. Provisions and Contingencies (PC): (provision &

contingencies/ total expenses) A portion of profits
which is kept aside for contingent situations and
expenditure is known as provision for contingencies,
and it has a direct bearing on the profitability.
3. Non-Interest Income (NII): (Non interest income /
total assets) Non interest income refers to the Income
of a bank from its allied and non-banking activities.
Banks should aim to increase their non interest
income to enhance their return on assets.
4. Credit-Deposit (CD) Ratio (Total advances/Total
deposits). Higher the CD ratio, higher is the
utilization of depositor's money which helps banks to
earn higher return on their assets.
5. Operating Expense (OE) Ratio (Operating
Expenses/Total expenses): The ratio has a negative
relationship with profitability, and a high OE ratio
highlights operational inefficiency of a bank.
6. I n v e s t m e n t - D e p o s i t ( I D ) R a t i o
(Investments/Deposits): The ratio indicates the
efficiency of a bank to invest its deposits and surplus
cash so as to generate profits.
7. Capital Adequacy Ratio (CAR) (Capital/Riskweighted assets): In the adoption of risk management
strategies by a bank, the ratio determines the cushion
available to a bank against the credit risk, operational
risk and market risk.
8. Non-Performing Asset (NPA) ratio (NPA/Total
assets): The ratio bears a negative relationship with
profitability as it indicates the credit risk of a bank.
Time Period: We have taken data for three years covering time
period from 2009-10 to 2011-12.
Source of data: Secondary data have been collected from the
annual reports and websites of respective banks, the website of
Reserve Bank of India and Indian Banking Association and
their bulletins.
Hypotheses of The Study
The present study attempts to test a number of hypotheses
which as below:
H1: There is a positive relationship between spread as a %
assets and ROA.
H2: Provision for contingencies has a negative relationship
with ROA.
H2: There is a positive relationship between credit deposit
ratio and ROA.
H3: There is a positive relationship between Investment
deposit ratio and ROA
H4: CAR bears a positive relationship with ROA.

H5: Operating expenses has a negative relationship with ROA.

H7: Net NPA as a % of net advances has negative relationship
with ROA.
H8: Non interest income has a positive relationship with ROA
Statistical Tools: Backward multiple regression analysis was
used to analyze the impact of determinants on the ROA of
public sector banks.
Results and Discussions
We framed a regression equation to see the impact of various
predictors on the RoA of the public sector banks as under.

Where,
Y = Return on Assets (RoA)
X1 = Spread Ratio (SP)
X2 = Credit-Deposit (CD)
X3 = Investment-Deposit Ratio (ID)
X4 = Capital Adequacy Ratio (CAR)
X5 = Operating Expense (OE)
X6 = Provisions and Contingencies (PC)
X7 = Non-Performing Asset Ratio (NPA)
X8 = Non-Interest Income (NII)
First multivariate regression is run by including all the
independent variables mentioned above, the results of which
are shown below. From our first model (1) for the year 200910, we find that 88.3% of variation in the dependent variable
was explained by all the eight variables taken together.
Similarly, the models explained 81.7% (model-2) and 87.5%
(model-3) of variation in RoA in 2010-11 and 2011-12
respectively. All the three initial models were found to be
significant at 1% level. However, we found many of the
independent variables to be insignificant in the regression
models for the time periods-2009-2012.

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Then backward multiple regression was run to remove

insignificant variables and get a fit model for explaining the

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variations in RoA. The results of the backward regression

analysis for the three periods are shown in Table 1below.

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Since neither of the predictor variables has a variance inflation

factor greater than ten during all three periods in the final
models (4 to 6) as shown in Table 3 (appendix), there are no
apparent multicollinearity problems; in other words, there is
no variable in the model that is measuring the same
relationship as is measured by another variable or group of
variables.
Table 1 above shows that 83 per cent of variation in ROA is
explained by the factors viz., SP, PC, NPA, and NII during
2009-10 and 85 per cent of variation by all independent
variables. The coefficients of SP, PC, NPA and NII were found
to be statistically significant and theoretically sound. F-statistic
in the model (33.262) is significant at 1 % level indicating that
our model is fit. Though during 2010-11, adjusted R2 explains
72 per cent of the variation in ROA by SP and NPA and 77 per

E stands for the variables eliminated in the final regression

model. All the results of variables in the final model is as per
our hypothesis.
Conclusion
On the basis of the results of the present study, we can conclude
that the variables, viz., SP, OE, PC, NPA, NII were found to be
the significant determinants of ROA of public sector banks.
Of them, spread and NII had positive influence and all other
had negative impact. So, in order to improve their ROA,
public sector banks should focus on reducing their Operating
expenses, Provision and Contingencies and NPAs. Positive
spread and NII give us the impression that public sector banks
have done very well on maintaining their spread margins as
well as non interest incomes.

cent by independent variables, but model is significant for

explaining banks' profitability. During 2011-12, 83 per cent of
variation in ROA is explained by SP, OE and NII. Coefficients
such as SP and OE during this period were found to be
statistically highly significant. We found that NII has the most
positive impact on ROA of public sector banks. It is statistically
significant at 1% level. Spread as a percentage of assets is
another variable with positive impact on ROA and found to be
statistically significant at 1% of significant for all the three
years. PC and NPA had the negative impact on the ROA.
Both PC and NPA were found to be statistically significant at
10% level in 2011-12. Durbin-Watson test is done to find if
there is the problem of autocorrelation in the model/s. During
all three years, the Durbin-Watson statistic shows absence of
autocorrelation.

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Chaudhry, S. (2012). Performance Appraisal of Indian
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Koeva, Petya (2003). The Performance of Indian Banks during
Financial Liberalization, IMF working paper,
WP/03/150,http://www.imf.org/external/pubs/ft/w

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p/2003/wp03150.pdf
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