IMPACT OF BANK INTERNAL FACTORS ON

PROFITABILITY OF COMMERCIAL BANKS IN SRI

LANKA: A PANEL DATA ANALYSIS

S.Jeyan Suganya & Kengatharan.L

Department of Financial Management
University of Jaffna, Sri Lanka.
jeyansuganya@gmail.com, lingesiya@univ.jfn.ac.lk

ABSTRACT
Banking system takes a major part to provide better financial services to the people in
a country. Aim of this study is to examine what extent bank internal factors impact on
profitability of commercial banks in Sri Lanka. Capital adequacy, Operating cost
efficiency, Non-performing loans, Bank size, Liquidity, Assets Quality and
Managerial efficiency are considered as bank internal factors while Return on assets
is considered as profitability measure of this study. Panel data has been collected
from published financial statement of nine commercial banks listed on Colombo Stock
Exchange (CSE) for the period of ten years from 2006 to 2015. Fixed effect and
random effect models are performed to investigate the best model to evaluate the
impact of bank internal factors on profitability. Results of the study reveal that
random effect model is the best model using Hausman specification test. As per the
random effect model, capital adequacy has positive and significant impact on
profitability while non-performing loan and operating cost efficiency have negative
and significant influence on profitability. Rest of the selected variables such as bank
size, liquidity, assets quality and managerial efficiency don't have any significant
impact on profitability of commercial banks in Sri Lanka. The finding of this study
provides information to present and future investors for making best decision on which
internal factors should be well analyzed when they make investment on banking sector
in Sri Lanka.

Keywords: Profitability, Capital adequacy, Operating cost efficiency, Non-

performing loans, Bank internal factors

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1. Introduction
Commercial banks play a significant and energetic role for developing an economy of
a country. When the banking sector in a country is functioning in an efficient,
effective, and disciplined way it leads to bring a rapid growth in the various sectors in
the country. Many factors may impact on profitability of commercial banks. Basically,
it can be categorized as bank internal factors and bank external factors. Bank internal
or specific factors are capital adequacy, liquidity, operating expenses, assents quality,
managerial efficiency, bank size and etc (Flamini et al., 2009 and Athanasoglou, et al.,
2006). Changes of these factors may lead for occurring unsystematic risk. It can be
controllable by the management of the bank. External factors of the bank such as
inflation rate, interest rate, gross domestic product and money supply cannot be
controlled by the management of the bank as the risk occurred by them is
uncontrollable called systematic risk. Both risks may have greater influence on
profitability of the bank.
In Sri Lanka, commercial banks take important part for operating the economy by their
process such as taking money as deposit from the people who have surplus fund and
providing such money to the people who want to invest in development activities.
Commercial banks are listed under the sector of bank finance and insurance
companies, which is one sector among 20 diversified sectors in Colombo stock
exchange (CSE) in Sri Lanka. Altogether 25 licensed commercial banks consist of 13
domestic banks and 12 foreign banks and 7 licensed specialized banks are functioning
in Sri Lanka. Central bank of Sri Lanka was established in 1950 as an apex institution
to supervise, direct and control entire activities of banking and financial sectors in Sri
Lanka. In order to protect financial institutions from unexpected losses, external
parties of the banks such as Central Bank of Sri Lanka and Basel Committee are
developing policies and releasing guiding articles time to time
Many researchers in different countries have investigated impact of internal and
external bank factors on profitability of the bank. But they don't give a clear picture on
how each factors influence on profitability. Weerasainghe and Perera ( 2013) carried
out a study in Sri Lanka, have found that the favorable macroeconomic environment
seems to stimulate higher profits in banking sector. Samarathunga and
Madurapperuma (2016) have done another study in Sri Lanka; have revealed that
efficient management of the bank-specific factors and implementation of favorable
economic policies lead to an economic growth can contribute immensely to uplift the
performance of the banking industry in Sri Lanka. Rahaman and Akhter (2015) have

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done a study in Bangladesh, where they have revealed that bank-size and deposit have
significant negative impact on the return on assets. Abdullahi and Usman (2017)
revealed from their study conducted in Nigeria that banks should focus on increasing
their equity to total asset ratio and credit risk management due to its impact on
financial performance. Results of each study in various countries are not consensus.
Therefore, this study aims to examine impact of bank internal factors on profitability
of commercial bank in Sri Lanka.

2. Literature review
Capital adequacy (CA)
Capital adequacy is a measure of financial strength of the banks. It express ability of
the bank to manage unexpected losses. This ratio is positively related to the financial
soundness of the bank, thus it is negatively related with a possible failure (Kumar and
Thamilselvan, 2014). Bandara (2015) have carried out a study in Sri Lanka, found that
capital adequacy ratio has significant and positive impact on return on average equity
but it doesn't have any significant impact on return on assets. However, Swarnapali
(2014) done a study in Sri Lanka found that there was a negative relationship between
capital adequacy ratio and bank profitability. But researches carried out in other
countries have found that positive relationship between capital adequacy ratio and
profitability of commercial banks in Sri Lanka (Flamini et al. (2009), Rao and Lakew
(2012), Nouaili et al. (2015) and Obamuyi (2013)). Capital adequacy is measured
using the formula:

(Tier One Capital + Tier Two Capital)

Capital Adequacy Ration = x 100
Risk Weighted Asset
H1: There is a significant impact of Capital adequacy on profitability of commercial
banks

Operating cost efficiency (OCE)

Efficiency of management in a bank can be managed by operating cost efficiency.
Operating cost efficiency is an important bank internal factor that can influence bank
capital and the cost of financial intermediation (Agapova and McNulty 2016; Berger
and Patti, 2006). In Sri Lanka, Bandara (2015) has done a study and revealed that cost
to income ratio had a negative and statistically significant relationship with the
financial performance of the bank. Another study done by Pradhan and Parajuli

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(2017) in Nepal revealed cost income ratio has negative impact on return on assets.
Operating cost efficiency is measured using the formula:

Total Operating expenses

Operating Cost efficiency =
Total Operating income

H2: There is a significant impact of operating cost efficiency on profitability of

commercial banks

Assets quality (AQ)

Assets quality reflects amount of credit risk with the loan and investment portfolio.
Basel Committee on Banking Supervision (BCBS), for the effective supervision of
banking system are related with the asset quality of bank and loan risk management
and this indicates that the asset quality become an important aspect for supervision
authorities of each country worldwide (Abata,2014). According to the findings of
Adhikary (2006) lower asset quality reaching substantial amount may lead to bank
bankruptcies and economic slowdown. The studies done by Abata (2014), Bace
(2016), Ozurumba (2016), Ongore and Kusa (2013) and Duraj and Moci (2015) have
found that lower asset quality affecting profitability of banks negatively.
H3: There is a significant impact of assets quality on profitability of commercial
banks

Managerial efficiency (ME)

In terms of deposit amount, banks with a higher deposit amount generate better
managerial efficiency. Improvement in efficiency will ultimately lead to larger profits
and lower costs. The average profit and cost per employee are also taken as indicators
to measure the efficiency of employees. Few researchers have considered managerial
efficiency is as a bank internal factors for their analysis. Therefore, there is no much
literature for it. Senarath (2015) in Sri Lanka has found that there is a positive
relationship between bank efficiency and profitability.
H4: There is a significant impact of managerial efficiency on profitability of
commercial banks

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Nonperforming Loans (NPL)
When the borrower doesn't make any interest payments or principal on loan amount,
such loan is classified as non-performing loan by the bank. Akter and Roy (2017),
Kaaya and Pastory (2013) and Kirui (2014) have found negative relationship between
non-performing loans and profitability of the banks. In Sri Lanka, Rathnasiri (2016)
has found non-performing loan has significant negative impact on profitability of the
commercial banks in Sri Lanka. Another study done in Sri Lanka by Sujeewa (2015)
has found that non-performing loans and provisions have an adverse impact on the
profitability

Total non - Performing loans

Nonperforming ratio =
Total loans and advances

H5: There is a significant impact of Nonperforming loans on profitability of

commercial banks

Bank size (BS)

Generally, size of a firm is measured using its total assets. A study carried out by Yong
and Floros, (2012) and Staikouras and Wood, (2003) in their studies revealed that bank
size was found to be negatively related to profitability. Another study in Nigeria done
by Ayanda et al., (2013) has found that the size of the bank does not have significant
relationship with profitability. Weerasinghe and Perera (2013), Madhushani and
wellappuli (2016), Sufian and Chong (2008) and Deger and Adem (2011) have found
that bank size has positive relationship with profitability. But the study done in Kenya
by Alice Gatete (2015) shows that there is a positive and significant impact of bank
size and profitability. Bank size may be calculated using proxy:

H6: There is a significant impact of bank size on profitability of commercial banks

Liquidity (LQ)
An ability of the bank to meet its financial obligations as they come due is called as
liquidity. Athanasoglou et al, (2005), Demirguc-Kunt and Huizinga (1999) and Dang
(2011) revealed that adequate level of liquidity is positively related with bank
profitability. However, Weerasinghe and Perera (2013) and Shafana (2013), found

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negative significant relationship between liquidity and profitability in Sri Lanka.
However, Kawshala and Panditharathna (2017) found that there is not a significant
relationship between liquidity and profitability of commercial banks in Sri Lanka. It is
measured by using the formula:
Liquid assets
Liquidity =
Total assets
H7 : There is a significant impact of liquidity on profitability of commercial banks

3.Methodology
Research design
In order to carry out this explanatory study, quantitative data on bank internal factors
and profitability measures have been collected from the published annual report of
commercial banks listed on Colombo Stock Exchange (CSE) in Sri Lanka. The study
has been conducted using secondary data collected for the period of 10 years from
2006 to 2015.

Target Population
Population of the study is 25 commercial banks listed on Colombo stock exchange
(CSE) in Sri Lanka consists of 13 domestic banks and 12 foreign banks.

Sampling Frame
In order to carry out this study, only nine listed commercial banks have been selected
using random sampling method among twenty five commercial banks. Financial
statements of the selected banks have been used to get data.

Variables
Independent variables of this study are Capital adequacy ratio (CA), Operating cost
efficiency (OCE), Assets quality (AQ), Managerial efficiency (ME), Nonperforming
loan (NPL), Liquidity (LQ), Bank size (BS) while Return on assets (ROA) is treated as
dependent variables to measure profitability.
Statistical model of this study is given below:

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4. Data Analysis

As per the Basel III, capital adequacy ratio should be 7.75% since 2017. The result in
the descriptive statistics table shows mean capital adequacy ratio of selected banks is
13.72%. It means that commercial banks are maintaining capital requirement in an
acceptable manner. Its standard deviation is also at level of 0.0247. Approximately
half of the operating income is used for spending on operating expenses. But standard
deviation is slightly high 13.76%. Mean of assets quality is 4.61 with the standard
deviation 14.24. Managerial efficiency has mean of 29.29 with the standard deviation
47.91. It has largest mean and standard deviation when compared with other selected
variables for this study.
Average nonperforming loans on total loans and advances are 5.8%. It can be reduced
more and more if the banks use some techniques to manage credit risk. Average liquid
assets are 8.52% of total assets. Thereby, banks may face liquidity risk in the future.
Mean and standard deviation of the bank size are 5.3443 and 0.4538 respectively.
Average return on assets is 1.32% and it is very lower than average return on equity as
17.96%. Standard deviation is also very lower for ROA = 0.0046.

Journal of Business Studies, 5 (1) -67- 2018

According to the result revealed in the table 4.2, positive correlation (r = 0.375) is
identified between capital adequacy and ROA. It is significant at 0.01 level (p =
0.000). Operating cost efficiency, assets quality and non-performing loans have
negative and significant relationship with ROA (r = -0.410, p = 0.000, r = -0.271, p =
0.009 and r = -0.475, p = 0.000 respectively). Further, Managerial efficiency, bank size
and liquidity have no relationship with ROA of commercial banks listed in Sri Lanka
since p value of them are above significant value 0.05.

VIF test is performed to measure multicollinearity problem among predictor variables

of the study. As per the result of Table 4.3 VIF for each independent variable is less
than 10 (cut off VIF) & the mean of VIF is also less than 2. All are near to 1. Tolerance
value of each construct is less than 0.10 (cut off tolerance statistic). Therefore, model
of this study is free from the multicollinearity problem.

Regression Analysis
In this section, researcher employed panel data analysis to examine the impact of
internal factors on profitability of listed commercial banks in Sri Lanka. The study so
assumes that the different intercept for each bank and for both fixed and random effect
regressions.
Table 4.4, presents the results of panel data multiple regression analysis. Fixed effect
and random effect models are performed to examine the impact of internal factors on
profitability. The F-statistics value for the fixed effect model was 3.36 (p<0.05) which

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shows that the independent variables are jointly statistically significant to explain the
variations in profitability. The R-square statistics value of 0.241 which shows that the
independent variables jointly account for about 24% of variation on profitability in the
fixed models respectively. Similarly, Wald Chi2 value of random effect model is 31.94
(P < 0.01) which explains that model is significant. R-square value of random effect
mode is 0.238 which explains that around 24% of the total variability of the model is
explained by internal factors. In order to evaluate whether fixed effect or random
effect model are most suitable to examine the impact of internal factors on
profitability, Hausman Specification test is performed and with the results of test
(Chi2 = 0.95, Prob > Chi2 = 0.995) random effect model is considered as most
appropriate model to examine the impact of internal factors on profitability.

From the results presented in the random effect model, there is a significant positive
relationship of CA (â = 0.0656, P < 0.01) with profitability. OCE (â = -0.00761, P <
0.05) and NPL (â = -0.0254, P < 0.05) are significantly and negatively related to
profitability. However, AQ, ME , BS, LQ do not show any significant relationship
with profitability. Therefore, as per the random effect model presented in the table 4.4,
H1 is supported with the results of the study that there is a significant positive influence
of CA on profitability. Further, H2 & H5 are also supported with the results of the study
that OCE and NPL are significantly negatively influenced on profitability. H3, H4, H6, &
H7 are not supported with the results of the study that AQ, ME, BS & LQ are not
significantly influenced on profitability.

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5.Conclusion
The major aim of this study is to examine the impact of bank internal factors on
profitability of commercial banks in Sri Lanka. Data has been collected from nine
commercial banks for ten years period from 2006 to 2015 from annual reports of
randomly selected banks. The findings of this study revealed that capital adequacy has
positive significant impact on profitability of the banks while operating cost efficiency
and non-performing loans have negative and significant impact on profitability in
terms of ROA. Further assets quality, managerial efficiency, bank size and liquidity
have no any significant impact on profitability of commercial banks in Sri Lanka. As
per the finding of the study, capital adequacy of each bank should be maintained as it is
or more than it. Operating cost efficiency can be increased by reducing unwanted
operating expenses in the bank. Management of the bank can use some credit risk
management strategies such as reduce percentages of non-performing loans on total
loans and advances, screening the details of the customers according to the CAMELS
and 5C methods, providing loans to their customers, diversification of loans and
analyze capacity of loans receivers with the help of Fitch rating agencies.

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