DECLARATION

I, Prosper Mintah hereby declare that this dissertation consists entirely of my own work and

that the authors of the references made have been dully acknowledged. No part of this

dissertation has been presented for another degree elsewhere.

…………………..

Prosper Mintah

(STUDENT)

…………………………

Mr James Doku

(SUPERVISOR)

1
 DEDICATION

I dedicate this work to my family especially my wife Dora Mintah, my daughter Benedicta

Mintah, my son Joy Mintah and my parents Mr Ephraim Kofi Mintah and Aurelia Mintah

whose encouragement brought me this far and make realization of this dream a reality. I also

dedicate this work to my dear aunt Emma Akorli and the husband Mr Seth Latey for

supporting me with advice to enable me get this far.

2
 ACKNOWLEDGEMENTS

First of all, I give thanks to the Almighty God for seeing me through the Economic Policy

Management Program, and also praise him for the strength, wisdom, good health and the

financial resources for the program.

I am indebted to several persons and organizations not only for the successful completion of

this dissertation, but also for making the write up a challenging and rewarding experience.

Firstly, I would like to express my heartfelt gratitude to my supervisor Mr James Doku

of the faculty of business of the Methodist University Ghana for the invaluable help he

provided in shaping the topic and for the help and support he provided throughout the entire

exercise. Secondly, I would like to thank Mr Ernest Gabrah of Bank of Ghana for his support

in this study.

Last but not the least; I would like to express my gratitude to the people who are closest to

me, especially Mabel Goza for her great assistant offered in typing the write up for me, and

my friends especially my colleagues Mr William Amponsah for taking up my responsibilities

in the office that allowed me to gain excused duties to perused the course. The views

expressed in this study, and all the potentially remaining errors are the sole responsibility of

the author.

3
 ABSTRACT

This study investigates the determinants of Banks’ performance among Ghanaian banks. The

main objectives of the study are: to examine the main determinants of bank profitability, to

explore the impact of key macroeconomic variables on bank performance, and to examine the

impact of bank-specific control variables on bank Performance. Using data covering a period

2005-2009 with ten banks within a panel data methodology, the results from the study

indicate that the key determinants of bank performance in Ghana are bank size, equity-to-

asset ratio (a proxy for bank capital), bank credit risk (provision for bad debt/advances), bank

expenses out of income and returns on earnings assets. Macroeconomic variables such as

inflation and GDP growth rate and inflation rate were also discovered as determinants of

bank performance.

The findings show that efficient management is likely to enhance bank performance whereas

inefficient management will increase bank cost and lower profit. Thus, for bank managers

aiming at enhancing the bottom line for their shareholders, the solution is a conscious attempt

to minimise cost. The study also highlights the role of effective credit administration on bank

performance. Large banks in Ghana can enhance their performance by exploiting the

economies of scale associated with large size in terms information processing, research and

development as well as better monitoring and screening credit applicants at low cost. The

findings also indicate that increase in inflation if not anticipated and banks being sluggish in

adjusting their interest rates adversely affect bank performance. The comparative

performance of the selected domestic and foreign banks shows no significant difference in

the results.

4
 Table of Contents

Declaration……………………………………………………………………………………..i

Dedication………………………………………………………………………………..........ii

Acknowledgement…………………………………………………………………………… iii

Abstract………………………………………………………………………………………..iv

DECLARATION.......................................................................................................................1

DEDICATION...........................................................................................................................2

ACKNOWLEDGEMENTS.......................................................................................................3

ABSTRACT...............................................................................................................................4

Table of Contents.......................................................................................................................5

3.6 Impact of bank supervision and Regulation on the banking industry.........26

CHAPTER FOUR....................................................................................................................33

Research Methodology.............................................................................................................33

4.0 Introduction ...............................................................................................33

4.1 Variable Definition and Method of Analysis................................................34

4.1.1 Dependent Variables ..........................................................................34

4.1.2 Independent Variables.........................................................................34

CHAPTER FIVE......................................................................................................................41

Analysis of Findings and Discussions......................................................................................41

5.0 Introduction................................................................................................41

CHAPTER SIX........................................................................................................................50

Conclusions/Recommendations...............................................................................................50

6.1 Conclusion..................................................................................................50

6.2 Recommendations......................................................................................52

References................................................................................................................................54

5
 CHAPTER ONE

1.0 Background of the Study

Ghana had well developed banking systems that businessmen and women rely so much upon

for loans to finance their activities. Financial inst

itutions provide intermediation services by accepting deposits from individuals, businesses

and the government and allocating them among demanders of funds. Financial experts have

conducted several investigations that have established a direct relationship between financial

development and economic growth (Levine, 1996). Levine investigated the efficiency of

commercial banks and their performance and came out with revelation that financial

institutions are capable of making great impact on the development of the nation. Existing

studies on commercial banks performance have focused their analysis on the returns on bank

assets, return on equity and net interest margins. Some earlier studies have also delved into

the effects of bank characteristics on bank performance and other macroeconomic factors. Al-

Haschimi (2007) used accounting decomposition as well as panel regression to explain

determinants of bank performance. According to Flamini et al (2009), determinants of

6
commercial banks performance in Sub Saharan African countries macroeconomic variable

and regulatory conditions have a pronounced impact on bank performance. According to

them, lower market concentration ratios lead to lower margins and profitability hence poor

performance on the part of most commercial banks. He finds that credit risk and operating

inefficiencies explain most of the variations in net interest margins across the region.

According to him, macroeconomic risk has only limited effect on net interest margins.

Demirgue-Kunt and Huizinga (1998) investigated the impact of bank characteristics and the

overall banking environment on both interest rate margins and bank returns. Their

investigation reveals that there is a direct link between bank characteristics, bank

environment and bank performance. According to Flamini et al (2009), determinants of

commercial banks performance in Sub- Sahara Africa, macro economic variable and

regulatory conditions have a pronounced impact on bank performance. According to them,

lower market concentration ratios lead to lower margins and profitability hence poor

performance on the part of most commercial banks.

Clarinda and Friedman (1984) demonstrate that relative to the predictions of a structural

model, bank performance in Ghana especially among the local banks has not been

encouraging. Osei (2008) questions the reasons behind the poor performance of most banks

in Ghana in spite of the gains in the microeconomic stability. He concluded by saying that the

activities of most financial institutions in this era of competition rather increases their

operating cost, limits their investment and retards growth of most sectors of the economy.

Gelos (2006) studies the determinants of commercial banks performance in Sub Sahara

African countries. His empirical findings reveal that the spreads are large because of very

high interest they charge, less efficient banking procedure high reserve requirement and poor

management of most banks.Athansoglou et al (2006) conducted a study into the performance

of banks in south eastern European banking industry. Their research revealed that the effect

7
of market concentration is positive whereas macro economic variables are not very clear to

identify.

Recent literature has focused on analyzing bank performance however most of the studies

conducted were on advanced economies such as those of the United States of America and

Europe with very little on the developing economies such as Ghana. My research paper will

contribute towards bridging the gab. The study will go to every extent to answer the question

associated with determinants of bank commercial banks performance in Ghana.

1.1 Statement of the Problem

Every policy towards economic growth and economic development in Gahanna is centered

on the banks and other financial institutions within the financial market. One of the reasons

that can be attributed to the importance attached to banks is that they play a very important

role towards economic development and towards raising the living standard of people in

Ghana. This is evident in their basic or fundamental role of mobilizing funds and giving out

these funds in the form of loans to individual, firms, corporate bodies and even government

agencies. From the earlier illustration, it is very clear that the banks within the financial

market of Ghana have the ability to alter the path of economic progress of the nation. Of

recent times many researchers have become interested in investigating into determinants of

bank performance in Ghana because of the proliferation of banks and their important role in

economic development .Financial sector reforms in Ghana which lead to increases in foreign;

especially Nigerian Banks in Ghana is a direct call for investigations into bank performance

in Ghana. There is therefore the need for inquiry into bank performance with special

8
reference to ownership and chacteristics.This research paper will also extend its boundaries to

investigate whether there is any difference at all between the operations of the foreign banks

and that of the local banks, and if there is to examine the impact of the differences in

operations on their performance.

1.2 Objectives of the Study

This research paper seeks to explore into bank performance in Ghana’s financial market. The

following are therefore the objectives of the study:

• To investigate into factors that influence bank performance in Ghana.

• To examine the effects of bank performance on economic growth and economic

development of Ghana.

1.3 Research Questions

Based on the objectives clearly stated above the following questions are worth asking:

• What are the determinants of commercial banks performance in Ghana?

• How do key macroeconomic variables influence commercial bank’s performance in

Ghana?

1.4 Significance of the Study

Existing studies established the fact that for an economy to grow there is the need to for a

well developed banking sector with high performance standards. According to Levine (1996),

financial intermediation can affect economic development hence the standard of living of the

people. Commercial banks performance however is often determined by macroeconomic

factors, bank specific and regulatory policies within the environment. The aim of this study is

to provide an illumination on the key macroeconomic variables that affect commercial banks

9
performance in Ghana. It will also serve as a foundation for further studies into banking

activities and performance in Ghana. , it will add to academic knowledge in the area of

banking in Ghana and finally it will be of great importance to those responsible for

policymakers and regulators in the financial sector.

1.5 Scope and Limitations of the Study

This research paper will extend its boundaries to cover commercial banks in Ghana so that

the researcher will be in the position to fully explain the impact of key macroeconomic

variables on bank’s performance. Due mainly to logistic, financial and data availability

problems, the study will be limited to those banks that have the required financial data. The

banks that do not have accurate financial and other non financial data will be eliminated. This

will likely affect the efficiency of the econometric and regression models to be employed in

analyzing the findings; however, the researcher believes the object of the work would be

achieved.

1.6 Organization of the Study

Chapter one: This chapter provides the background, objectives of the study, significance and

problems statement and research questions that relate to the research.

Chapter two: This chapter provides an overview of the banking sector in Ghana.

Chapter three: This chapter makes a complete review of the relevant literature.

Chapter five: This deals with the analysis of the economic data and the discussion of the

findings.

Chapter six: This chapter provides a summary of the findings, conclusion and

recommendations based on the findings.

10
 CHAPTER TWO

Overview of the Banking Sector Developments in Ghana

2.0 Introduction

This part of the research is focused on recent development in the arena of banking in Ghana.

It is devoted to discussing the reforms in the banking sector of the Ghana banking policies

and their administration in Ghana and also the recent development in the banking landscape

in Ghana.

2.1 New developments in the financial sector of Ghana

The reforms in the financial sector of Ghana have to do with establishment of banks by the

government, banking administration and regulation through the use of prudential policies.

Establishment of public sector banks was one of the early initiatives of the government of

public sector banks was one of the early initiatives of the government who took office after

the colonial administration. During the post independendence era there was full involvement

11
of the government in developing a vibrant financial market. According to Gockel (1995)

interest rates were administratively controlled by the bank of Ghana (BOG) and a variety of

controls were imposed on asset allocation role of the banks. The main reason why the then

government came out with policies to regulate the banking sector was due to the fact that the

desired pattern of investment could not be supported without extensive government

intervention in the financial market which was inherited from the colonial masters. There

were two main reasons for the establishments of local commercial banks during the post

independence era (Browbridge, 1996).There were:

• The believe that certain sectors like industry and agriculture are key to national

development hence require specialized financial institutions to supply their financing

needs.

• The believe that the operational focus of the foreign banks were too narrow

According to Gockel and Browbridge (1996), the Ghana Commercial Bank (GCB) was set up

in 1953 to improve people’s access to credit. The commercial banks then expand their

operations and assume the status of the largest bank with 36% of the total bank deposit in the

late 1980s .Following the high standard performance of the Ghana commercial bank, three

development banks were established in 1963 to provide long term finance for industry. These

banks were: The National Investment Bank (NIB) established in 1963 to provide long term

finance for industry, the Agriculture Development Bank (ADB) was also established in 1965

to provide financial support to the agricultural sector and finally the Bank for Housing and

Construction (BHC), established in 1974 to provide loans for the housing industrial

construction and companies producing building materials.

2.2 The banking sector policies, regulation and supervision

12
The act that regulates the activities of the banks in Ghana is the Banking act (1970).This act

provides policy and framework for banking sector regulation and supervision in Ghana. The

Act imposes minimum paid up capital of 2 million and 5million cedis respectively for all

foreign and local banks respectively in the country. This requirement had to be adjusted from

time to time to cope with the level of inflation in the country. At the end of 1983, the

minimum paid up capital for all local banks was equivalent to 16000 dollars. Banks were also

required to maintain capital and reserve adequacy of at least 5% of their total deposit (Gockel

and Brownbridge, 1996). The banks examination Department (BED) of the bank of Ghana

was charged with the banking act and bank of Ghana directives. BED was also charged with

the banking act of ensuring that banks comply with directive and monetary policy directives

such as sectoral credit directives and reserve requirements Gockel (1997). BED however was

faced with several problems which made their operations and activities very difficult. Some

of the problems were lack of resources to monitor and inspect the banks. Bank supervision

and examination was infrequent and bank reporting was impeded because of improper

records (World Bank 1986).

2.3 The role of the Government in improving Bank Performance in Ghana

In 2004 the Bank of Ghana (BOG) directed all commercial banks in the country, to abolish

and in some instances reduce, what it described as unfair bank charges and fees being

charged by the various commercial banks operating in the country.

The directive also required the banks to bridge the gap between lending and savings rates.

The BOG’s directive was described at the time by sections of the Ghanaian public as a feeble

attempt to clear a mess it has created through its own ineffective supervision of the banks.

Some bankers Public Agenda interviewed at the time expressed the view that the BOG’s

directive, like the several that had preceded it, will only be another whirlwind that subsides

13
just as quickly as it swirls. Six years on, BOG has been urged to conduct a thorough

investigation into the high lending rate charged by banks in Ghana as against low deposit

rates, suggesting that a major anomaly that the 2004 directive had sought to cure still persists.

Dordunoo (2006) observed that, it is difficult to find reasons for Ghana’s high lending rate as

against very low deposit rate. According to him the wide spread is incomprehensible. He

described the situation as unfair, arguing that, the banks are the only ones benefiting, leaving

the poor masses to languish in poverty. "The spread between lending rate and deposit rate in

Ghana has been widening over the years and has earned Ghana the reputation of having the

highest lending rate in sub-Sahara African," ( Dordunoo,2006) . He noted that, the situation

accounts for the slow growth rate of the economy, as private businesses are unable to borrow

at the current interest rate to expand their businesses so as to create employment to absorb the

unemployed masses. He recalled that whereas European countries and the US reduced their

rates in order to absorb the shocks during the financial crunch, he noted with regret that Bank

of Ghana rather increased prime rate creating a rather difficult situation for businesses. He

urged government to use other measures rather than monetary instruments to control inflation

since monetary instruments end up aggravating the situation.

Dordunoo (2006) again revealed that the banking population of Ghana is about 15% to 20%

and regretted that many Ghanaians do not save with the banks because of the low interest

returns. He explained lending rate to mean the cost incurred when one borrows money from

the bank, non-banking institution or a person. Banking experts are of the view that there is

high rate of loan default in the country; however the ongoing national identification will help

drop the high rate of default which is a major problem for the banks.

With regards to the private sector, most of the small scale and medium enterprises are not

well organized, for example in the areas of documentation, record keeping and planning.

Such imprudent practices are not innovative to encourage the banks to assist them financially

14
Gockel (2005). In an interview with a private entrepreneur on bank performance in Ghana,

Mensah (2004) suggested that government should force banks to reduce the lending rates and

increase the deposit rate.

Currently Bank of Ghana is using moral suasion to encourage the commercial banks to

respond to the diminishing inflationary expectation and the reduction in the prime rate by

reducing their lending rate. However, moral suasion has its own limitation, especially in a

deregulated- lending rate environment. The wake-up call to the Bank of Ghana(BOG) by

some entrepreneurs, is to be up and doing, and to ensure that the commercial banks do not

constitute themselves into cartels, to exploit customers, and putting very little back into the

economy ,(Dordonoo ,2008). Lending rates of banks continue to remain high despite Bank of

Ghana (BOG) adjusting its policy rate-the prime rate from 18 percent to 16 percent in

February this year.

15
 CHAPTER THREE

Review of Relevant Literature

3.0 Introduction

Financial sector development in Ghana has become very necessary since the main agenda of

most of the past colonial governments was to enhance economic growth and development.

This they realised cannot be achieved without a vibrant financial market Osei (2004).

Financial institutions like banks channel huge amounts of money into productive ventures.

The efficiency and profitability of these institutes is thus very important to ensure

achievement of economic growth and economic development Danny, (2001).

3.1 Relationship between commercial banks performance and interest rate movement

According to Fin, (2001), the "quality" structure of interest rates affects the performance of

commercial banks. In the face of uncertainty about payments, lenders would demand a higher

rate of return or "risk premium". The interest rate to a particular borrower would be the sum

of a "risk-free" rate plus the risk premium. Default risk is not simply the failure to pay

16
principal, but is rather a matter of degree. There are many possibilities short of complete loss,

sometimes as small as a "skipped" or late payment. Loan arrangements with little probability

of a problem are said to be of high quality (Dai, 1997).

According to Enrico (2005), the higher the severity and probability of a problem, or the lower

the quality, the higher would be the risk premium. Hull (2005) continues that this quality

structure is also apparent in bank loan interest rates. The prime rate is the rate charged to

large customers with established relationships. Borrowers with less admirable credit records

(or smaller accounts that are comparatively more expensive) would pay a higher rate.

Collateral is also important. Unsecured personal loans, such as credit card credit, would

ordinarily pay a higher rate than car loans, which would in turn pay more than home

mortgages (Eric, 1994). An important characteristic of loan arrangements is liquidity. An

asset that can be converted to cash quickly at a fair price is liquid; if price concessions are

required for rapid sale the asset is illiquid. Many loans have been relatively illiquid; so that

once the loan is made the creditor was locked in. This lack of freedom of action increased the

risk of the lender, resulting in higher interest rates. More recently, a number of classes of

loans have been "securitized" by being bundled into portfolios against which securities are

issued. This added liquidity reduces lender risk and lowers the interest rate on the underlying

loan classes (International Review of Financial Analysis, 2004).

Banks are financial and profit-oriented entities that generate their profit from their traditional

functions of financial intermediation. Additionally, they stand to offer other services that

generate incomes and fees for them. Interest rate represents the cost of credit in the financial

intermediation process. Generally, banks prefer to borrow or mobilise financial resources

from the financial market at relatively cheaper cost and lend at higher rate to generate profit.

Therefore, unless structured to take advantage of rising rates, falling interest rates have a

positive effect on banks for several reasons. One is that net interest margins can expand, at

17
least in the short-term. This is because banks can earn a higher-than-market yield on loans to

customers, while the cost of funds declines more quickly in response to the new, lower rates.

An interest rate decline also enhances the value of a bank’s fixed-rate investment portfolio,

since a bond with a higher stated interest rate becomes more valuable as prevailing rates drop.

Moreover, an environment of declining rates often motivates loan demand and reduces

delinquency rates, because the cost of credit declines, Of course, not all banks are affected

equally by rate decreases. Banks that rely more heavily on borrowed funds than on customer

deposits to fund loan growth typically reap greater benefits. Fluctuations in interest rates,

while important, don’t have an absolute influence over the net interest margins of banks,

primarily because banks can adjust in time to such fluctuations. In theory, banks can match

the maturities of their assets (loans and investments) and liabilities (deposits and borrowings)

so that rates earned and rates paid move more or less in tandem and net interest margins

remain relatively stable. In practice, however, banks can deviate from a perfectly balanced

position which results in risk taking with the objective of earning a reward.

Banks are financial and profit-oriented entities that generate their profit from their tradition

functions of financial intermediation. Additionally, they stand to offer other services that

generate incomes and fees for them. Interest rate represents the cost of credit in the financial

intermediation process. Generally, banks prefer to borrow or mobilise financial resources

from the financial market at relatively cheaper cost and lend at higher rate to generate profit.

Therefore, unless structured to take advantage of rising rates, falling interest rates have a

positive effect on banks for several reasons. One is that net interest margins can expand, at

least in the short-term. This is because banks can earning a higher-than-market yield on loans

to customers, while the cost of funds declines more quickly in response to the new, lower

rates. An interest rate decline also enhances the value of a bank’s fixed-rate investment

portfolio, since a bond with a higher stated interest rate becomes more valuable as prevailing

18
rates drop. Moreover, an environment of declining rates often motivates loan demand and

reduces delinquency rates, because the cost of credit declines, Of course, not all banks are

affected equally by rate decreases. Banks that rely more heavily on borrowed funds than on

customer deposits to fund loan growth typically reap greater benefits. Fluctuations in interest

rates, while important, don’t have an absolute influence over the net interest margins of

banks, primarily because banks can adjust in time to such fluctuations. In theory, banks can

match the maturities of their assets (loans and investments) and liabilities (deposits and

borrowings) so that rates earned and rates paid move more or less in tandem and net interest

margins remain relatively stable. In practice, however, banks can deviate from a perfectly

balanced position which results in risk taking with the objective of earning a reward.

3.2 Theoretical Framework

The relationship between bank performance or profitability and changes in macroeconomic

variables has attracted much attention in research. It has been pointed out that bank

performance can be explained by bank specific characteristics, macroeconomic variables and

ownership effects.

3.3 The link between commercial banks performance and bank specific factors

Bank performance can be explained by bank specific factors such as the size of the bank, net

profit to total asset ratio, loan to asset ratio, on interest expense to net revenue ratio. These

variables have been explained in details. Regarding the size, it would be expected that the

larger the bank, the higher the level of profitability due to economies of scale. Akhave et al

(1997) and Smir Lock find a positive relationship between the size of a bank and bank

performance. According to short(1979) the size of a bank is positively related to bank

performance since relatively large bank tend to raise less expensive capital hence become

more profitable.Others such as Heslem (1965),Bourke (1989), Molyneux and Thornton

19
(1992) all argued that bank size is positively related to bank performance. Many

otherresearchers such as Berger et al (1987) and argued that eventually very large banks

could face the problems of diseconomies of scale which amounts to inefficiency.Big banks

may also have lower degree of being bunkrupt hence size is considered as a determinant of

bank performance.Bikker and Hu (2002).The bigger a bank’s equity capital to total assets

ratio, the less tendency for the operations. This therefore will enhance the performance of the

bank.

According to Agbanzo (1997), the proxies for default risk, the opportunity cost of net interest

bearing reserves, leverage and management efficiency are all statistically significant and

positively related to bank interest margin. The bank characteristic variables used in the

banking performance literature has been referred to as internal determinants of bank

performance studies into the area employ variables such as size, capital, risk management and

expenses management to explain bank performance. According to Thornton (1992), poor

asset quality and low level of liquidity are the two main causes of bank failure. During

periods of increased uncertainty, financial institutions may decide diversify their portfolios

and raise their liquid holdings in order to reduce their risk. In this respect, risk can be divided

into credit and liquidity risk.

3.3.1 Relationship between commercial banks performance and macroeconomic

variables

Macroeconomic control variables that may influence bank’s performance include inflation

rate, interest rate of money supply Revell (1979). Revell admits that the effect of inflation on

bank performance depends on whether bank’s wage and other operating expenses increase at

a faster rate than inflation. Penny (1992) states that the extent to which inflation affects bank

performance depends on whether inflation expectations are fully anticipated .This implies

20
that when banks fully anticipate inflation changes, the management can appropriately adjust

interest rates in order to increase their revenue faster than their cost. The existing literature

indicates that performance of banks can be explained by the bank’s own specific

characteristics such as the size, proxy by the total assets, equity-capital-to-asset ratio, loan-to-

asset ratio, non-interest-expense-to-net-revenue ratio, and bank concentration ratio. These are

commonly employed explanatory or control variables in many bank performance studies.

Explanations have been offered in support of these variables. For instance, in terms of the

size of the bank, it would be expected that large or big banks would enjoy economies of scale

and high efficiency in their operations hence high profitability compared to smaller banks.

Akhavein et al. (1997) and Smirlock (1985) find a positive and significant relationship

between size and bank profitability. Demirguc-Kunt and Maksimovic (1998) suggest that the

extent to which various financial, legal and other factors (e.g. corruption) affect bank

performance is closely linked to firm size. In addition, as Short (1979) argues, size is closely

related to the capital adequacy of a bank since relatively large banks tend to raise less

expensive capital and, hence, appear more profitable. Using similar arguments, Haslem

(1968), Short (1979), Bourke (1989), Molyneux and Thornton (1992) Bikker and Hu (2002)

and Goddard et al. (2004), all link bank size to capital ratios, which they claim to be

positively related to size, meaning that as size increases, especially in the case of small to

medium-sized banks, profitability rises. However, many other researchers suggest that little

cost saving can be achieved by increasing the size of a banking firm (Berger et al., 1987).

Big banks may also have lower degree of being bankrupt hence size is considered as a control

variable in studies that have attempted the determinants of banks performance. Furthermore,

the higher a bank’s equity capital to total assets ratio, the less tendency for the bank seeking

external financing for its operations. This will enhance its performance and net income

21
margin. It may represent risk or stability of the bank against external shocks. Specifically, in

a study of performance for a sample of banks in four European countries, Molyneux, Lloyd-

Williams and Thornton (1992) include a capital-to-asset ratio and a loan-to-asset ratio to

account for bank-specific risk, on the grounds that their dependent variable (total interest

revenue per dollar of assets) is not risk-adjusted. In a similar vein, Samolyk (1994) states that

“Differences in loan/asset ratios and bank capitalization are important factors in assessing the

relative profitability and risk of banks”

A study by Demirgüç-Kunt and Huizinga (1999) investigates the determinants of bank

interest margins using bank-level data for 80 countries in the years 1988-1995 using a set of

variables accounting for bank characteristics, macroeconomic conditions, explicit and

implicit bank taxation, deposit insurance regulation, overall financial structure, and

underlying legal and institutional indicators. Demirgüç-Kunt and Huizinga report that the

bank interest margin is positively influenced by the ratio of equity to total assets, by the ratio

of loans to total assets, by a foreign ownership dummy, by bank size as measured by total

bank assets, by the ratio of overhead costs to total assets and macroeconomic variables such

as inflation rate and the short-term market interest rate in real terms. The ratio of non-interest

earning assets to total assets, on the other hand, is negatively related to the bank interest

margin.

Angbazo (1997) studies the determinants of bank net interest margins for a sample of US

banks using annual data for 1989-1993. The results for the pooled sample suggest that the

proxies for default risk (ratio of net loan charge-offs to total loans), the opportunity cost of

non-interest bearing reserves, leverage (ratio of core capital to total assets), and management

efficiency (ratio of earning assets to total assets) are all statistically significant and positively

22
related to bank interest margins. The ratio of liquid assets to total liabilities, a proxy for low

liquidity risk, is inversely related to the bank interest margin

Also, Brock and Rojas-Suarez (2000) explore the determinants of interest rate spread for a

sample of five Latin American countries (Argentina, Bolivia, Colombia, Chile, and Peru). For

each country, regressions for the bank interest spread include variables controlling for non-

performing loans, capital ratio, operating costs, a measure of liquidity (the ratio of short term

assets to total deposits) and time dummies. Their findings show positive coefficients for

capital ratio (statistically significant for Bolivia and Colombia), cost ratio (statistically

significant for Argentina and Bolivia), and the liquidity ratio (statistically significant for

Bolivia, Colombia, and Peru). As for the effects of non-performing loans, the evidence is

mixed. Apart from Colombia, where the coefficient for non-performing loans is positive and

statistically significant, for the other countries the coefficient is negative (statistically

significant for Argentina and Peru). The authors explain these findings as “a result of

inadequate provisioning for loan losses: higher non-performing loans would reduce banks’

income, thereby lowering the spread in the absence of adequate loan loss reserves”.

The bank characteristic variables used in the banking performance literature has been referred

to as internal determinants of bank performance and studies dealing with internal

determinants employ variables such as size, capital, risk management and expenses

management. The need for risk management in the banking sector is inherent in the nature of

the banking business. Poor asset quality and low levels of liquidity are the two major causes

of bank failures. During periods of increased uncertainty, financial institutions may decide to

diversify their portfolios and/or raise their liquid holdings in order to reduce their risk. In this

respect, risk can be divided into credit and liquidity risk. Molyneux and Thornton (1992),

23
among others, find a negative and significant relationship between the level of liquidity and

profitability. In contrast, Bourke (1989) reports an opposite result; while the effect of credit

risk on profitability appears clearly negative (Miller and Noulas, 1997). This result may be

explained by taking into account the fact that the more financial institutions are exposed to

high-risk loans, the higher is the accumulation of unpaid loans, implying that these loan

losses have produced lower returns to many commercial banks.

3.3.2 Relationship between bank ownership and bank performance

Bank ownership may be explained as to whether the ownership is n the hands of Ghanaians

or foreigners. According to Huizinga (2001), foreign banks provide the channel through

which capital inflows finance domestic activities .Again it has been argued that the increase

in competition among banks whether domestic or foreign will improve the performance of

banks and provide financial services at lower average cost. Levin and Min (1998) contended

that unlike the optimists about foreign banks’ entry, the capital flow channel may serve rather

as a path for capital flight. Another point raised by opponents was that foreign banks may

have competitive advantage that allows them to pick among the available domestic funding

options, choosing the better performing and low risk option and leaving the less profitable

and higher risk option for domestic institutions. Finally, foreign banks from developed

countries may introduce complexities not seen by domestic regulation and supervision

worsening rather than improving the regulatory and supervisory process.

3.4 Empirical evidence on commercial banks performance

24
Using accounting decomposition as a well panel regression Al-Haschimi (2007), studies the

determinant of bank performance in sub Sahara African countries. He finds that credit risk

and operating inefficiencies explain most of the variation in net interest margins across the

region. Using bank level data for 80 countries in 1988, Husinga (1988) analysed how bank

characteristics and the overall banking environment affects bank performance. Results

suggest that macroeconomic and regulatory conditions have a very great impact on bank

performance. Existing results indicate that differences in bank ownership and characteristics

also influence Bank performance. Analysing the performance of foreign banks alongside that

of the local banks, foreign banks ere noted to have higher margins and profit than local banks

in developing countries whereas the opposite holds in the developing countries. In a study

conducted in the United States Angbanzo (1997) finds that net interest margins reflect credit

and macroeconomic risk. More recently a number of studies have emphasised the relationship

between macroeconomic variables and bank performance. Allen and Sanders (2004)

conducted a survey on the credit and market risk exposures. Their findings were that such a

cyclical operations effects mainly results from systematic risk.

3.5 Regulation and Supervision of the banking sector

The Banking Act (1970) provided the regulatory framework for the banking industry whilst

the Bank Examination Department (BED), established in the BOG in 1964, was to perform

supervisory functions. The Act imposed minimum paid up capital requirements for foreign

and locally owned banks of ¢2 million and ¢0.5 million respectively (the latter was

subsequently raised to ¢0.75 million). However, the minimum capital requirements were not

able to withstand the inflationary pressure in the system by the early. At the end of 1983, the

minimum paid up capital for a local bank was equivalent to only $16,000. Banks were also

25
required to maintain capital and reserves of at least 5% of their total deposits instead of their

risk adjusted assets which would be more relevant (Gockel and Brownbridge, 1996)

The prudential regulations did not incorporate clear accounting rules regarding the

recognition of loan losses, provisioning for non-performing assets and the accrual of unpaid

interest and thus the true state of banks’ balance sheets, including the erosion of their capital.

As a result, loan losses could be concealed. Although the Banking Act did provide some rules

to constrain imprudent behaviour by banks, penalties for infractions were minimal. There

were also important regulatory omissions, such as limits on single borrower loan exposures.

(Gockel and Browbridge, 1997)

The activities of the Bank Examination Department (BED) were largely confined to ensuring

that banks complied with allocative and monetary policy directives, such as sectoral credit

directives, and reserve requirements, rather than prudential regulations. The BED also lacked

adequate resources to monitor and inspect the banks. On site examinations were infrequent

and off site supervision was impeded because of deficiencies in bank reporting. Hence the

BED lacked the information necessary to evaluate the condition of banks’ asset portfolios,

their profitability and solvency (World Bank, 1986).

3.6 Impact of bank supervision and Regulation on the banking industry

The pre-reform policies had important consequences for the banking system. Financial depth

declined, bringing down with it the ability of the banking system to supply credit, even to

priority sectors. With the exception of those banks which retained foreign equity participation

(i.e. Barclays Bank Limited (Barclays), Standard Chartered Bank Limited (SCB) and

26
Merchant Bank Ghana Limited (MBG)), all other banks became insolvent as a result of bad

debts and investments in commercially unsuccessful ventures.

Financial Depth

The policies in place severely dented the level of financial depth in Ghana. The broad

money/GDP ratio, which had been relatively stable at around 20% from 1964-74, rose briefly

in the mid 1970s (to a peak of 29% in 1976) and then shrunk to 11% in 1983 as presented in

Table 2.2 below. Moreover bank deposits became less attractive relative to cash as indicated

by a rise in the currency/M2 ratio from 35% in 1970 to 50% in 1983, reflecting a process of

disintermediation from the formal financial system (Aryeetey and Gockel, 1990). Bank

deposits amounted to only 7.4% of GDP in 1984, having fallen from 19.5% of GDP in 1977.

Aryeetey and Gockel (1990), in a study of the informal financial sector, found that “street

banking” was increasing in contrast to formal sector intermediation. The main causes of the

decline in financial depth included the sharply negative real deposit rates, which deterred

savers from holding financial assets.

Banks were discouraged from active deposit mobilisation because interest rate controls and

the very high statutory reserve and liquid asset requirements prevented banks from

channeling depositors’ funds into lucrative outlets. At times the banks refused to open new

time and savings deposit accounts and refused to pay interest on accounts above a certain

amount (Leite, 1982).

During the period 1990-1995, the banking sector was characterised by the following: The

Central Bank, Commercial Banks, Merchant Banks, Development Banks and Rural Banks. In

1989 a new banking law, PNDC Law 225 was enacted to institute prudential and regulatory

27
requirements for the banking system. Thereafter the Financial Sector Adjustment Programme

(FINSAP) was introduced in 1990 to restructure the distressed banks and also to strengthen

the banking system to enable it play a more effective role in the economy. The banking sector

has experienced some significant developments over the years, especially within the past

fifteen years. Some of these developments are:

• The entry of foreign banks, mainly from Nigeria bringing the total number of

banks to twenty six (26).

• The Bank of Ghana deregulated some of the activities of the banks whilst

maintaining and strengthening its supervisory capacity. The foreign exchange

market in particular witnessed significant deregulation over the years.

• The Government in pursuance of its policy of encouraging the private sector to be

the key player in the economic development programme has already off-loaded a

significant proportion of its holdings in a number of state-owned banks to both

foreign and local private investors.

• To safeguard banks against political interference, the first stage of privatisation

began in 1995 when the government sold part of its equity stake in the SSB to the

public and then sold 30% of its shares in GCB in 1996.

• In view of high rates of inflation in the 1990s, the GHC200m ($1m in 1989)

required to open a locally owned commercial bank had fallen to only $117,000 by

mid 1996.

• Interest rates have been liberalised making it more responsive to market forces.

• The open and liberalised market environment which is founded on competition,

initiative and creativity has resulted in the restructuring of the operations of most

of the banks to meet the challenges ahead.

28
 • The market witnessed new products such as: Cedi Travellers Cheques, Sika Card,

Automated Teller Machines (ATM), Western Union Money Transfers etc.

• The Bank for Credit & Commerce (the Ghanaian subsidiary of BCCI which was

closed down by regulators in the UK and USA in 1991) has been technically

insolvent since 1991 as a consequence of incurring a large foreign exchange

liability, and has been managed under BOG supervision since then.

• The local subsidiary of Meridian BIAO was closed in 1995 after incurring a large

foreign exchange exposure to its parent bank.

• The stock market outperformed most emerging markets in the world in 1993 and

1994 due to the relative stability in macro economic indicators such as low

inflation and interest rates had a favourable impact on the performance of the

GSE. Many new investors, both local and foreign took advantage of the situation

and shifted funds from the money market to invest on the stock market for

potentially higher returns.

The Ghanaian economy experienced setbacks in the second half of the 1990s due to

inappropriate policies, delays in donor disbursements and adverse terms of trade shocks that

had serious deleterious effects on economic activity. Economic growth became weaker and

declined from the relatively impressive 5% in 1996 to 3.7% by close of 2000. The period saw

the value of the cedi depreciating more than four times from GHC1,740 in 1996 to

GHC7,312 by close of 2001. Domestic inflation rose significantly to 41% by December 2000,

falling to 22% by close of 2001. The difficult economic environment that prevailed in 2000

reflected in the performance of the stock market. High levels of inflation, the rapid

depreciation of the cedi, and high interest rates eroded investor interest in the market. Despite

the difficult situation, the GSE managed a 16.55% nominal rise compared to the negative

return of 15.22% recorded in 1999.

29
Central Bank, during the period 2002 to 2007 continued to hold tight the monetary position

through intensified open market operations and thereby ensured price and exchange rate

stability. During the period, economic aggregates made significant progress towards

macroeconomic stability. The period was characterised by a steady but consistent decline in

inflation and interest rates. Year-on-year inflation, which was 15.5% by end of Dec, 2000

dropped steadily to 10.1% by close of Sept 2007.Fin, (2001)

Some recent achievements of the commercial banks in the financial market of Ghana

The banking sector has remained one of the best performing sectors in the economy. Despite

increasing competition and declining margins, the sector has continued to record significant

growth and increased profitability over the years. In the last 2 years, 4 new Nigerian banks

have been licensed to operate in the country and other new entrants are expected in the near

future. Competition within the industry is intense with banks introducing new products and

services, expanding branch networks and going into mergers and acquisitions. Low inflation

and interest rates have accounted for the narrowing margins. Banks are under intense pressure

to reduce the cost of their services by being more efficient.

Total Assets and Deposits grew by 67% between years 2004 to 2006. The sector is dominated

by 12 banks which controlled more than 90% of the industry’s assets and deposits in years

2004 and 2006. Increasing competition has reduced the share to an average of 85% in year

2007. Brooks, (2008)

Ghana’s banking industry is fast evolving and becoming increasingly competitive. It is

BOG’s desire to make Ghana the financial hub of West Africa and Government is therefore

30
pursuing policies that will facilitate the attainment of these goals. Key developments in the

industry include:

i. Introduction of New Legislation & Regulation

A Credit Reporting Bill, which will ensure that credit ratings are assigned to institutions and

individuals, has been passed into law. It is expected that this will enrich the lending process

for banks and improve the quality of bank loans. The BOG is also re-examining the Know-

Your-Customer (KYC) process in order to introduce new guidelines to ensure its conformity

with the prevailing environment while making sure they are consistent with anti-money

laundering procedures.

The Institute of Chartered Accountants Ghana (ICAG), in collaboration with regulatory

bodies such as the BOG and the Securities and Exchange Commission, introduced new

financial reporting standards, the International Financial Reporting Standards (IFRS), with

effect from January 1, 2007 for banks, listed companies and other large companies in Ghana.

ii. Expanding Customer Base

There is a growing presence of foreign nationals in the Ghanaian business environment

leading to increased foreign direct investment. Additionally, greater number of Ghanaians

are requiring and gaining access to banking services. There is also the huge untapped

informal sector, which controls significant funds. Government also estimates that significant

amounts of money remain outside the banking system. These present huge opportunities for

the growth of the entire industry.

iii. Innovative Products & Services

31
The stiff competition in Ghana’s banking sector has made it imperative for banks to focus on

product development and quality service delivery as the main channels for effective

competition. Banks are introducing new products aimed at satisfying the unique needs and

taste of their customers. Personal loan products have become very attractive due to the

declining interest rates and so is private banking and electronic banking services.

iv. Re-denomination of the Cedi

The BoG successfully embarked on the planned re-domination of the Cedi in July 2007. Ten

thousand cedis (¢10,000) was equated to one new Ghanaian cedi (GH¢1). This new

development is expected to provide banks with efficient gains in transaction processing

which will eventually improve their profitability.

v. BOG Proposal to increase minimum capital

The Bank of Ghana has stated that the current reforms in the banking industry have enabled a

cluster of banks with relatively low capital base and depth that are inadequate to support

significant levels of lending to emerge. Subsequently, these banks could be vulnerable to

minor swings in macroeconomic fundamentals thus entry to the industry has to be selective,

well managed and paced over time. Clear exit rules and prudential supervision would be

vigorously enforced to safeguard systemic stability.

The Bank of Ghana therefore proposes to increase the capital requirements of banks from GH

¢7.0 million to between GH¢ 50.0 – 60.0 million. Banks are expected to submit

capitalization plans by the end of June 2008. Submission of capitalization plans would

guarantee continued access to the settlement and primary dealership systems. After December

2008, participation in the settlement system will be restricted to institutions that have met the

32
capital requirements. The banking system would allow for lower tier banks after December

2008 which will comprise of Banks that do not meet the capital requirements.

CHAPTER FOUR

Research Methodology

4.0 Introduction

This research will employ appropriate statistical tools such as regression, correlation,

econometrics for the purpose of analyzing the results of this research paper. In statistical

analysis, relationships between two or more variables are often best tested in a regression

analysis. In a typical regression analysis, there is an assumption that one variable called

dependent variable is explained by one or more independent variables. This is the generally

accepted classical Ordinary Least Squares (OLS) regression analysis with the following

assumptions:

• The first assumption holds that there is a linear relationship connecting a

dependent variable expressed as a function of an independent variables addition to

an error term,

• The expected value of the error term is zero,

• The disturbance or error terms all contain the same variance and not correlated

with each other,

33
 • The observations on the independent variables can be regarded as fixed,

• The number of observations is greater than the number of independent variables

Another form of regression analysis or method is panel data analysis. This study would

utilise, a panel data technique as the basis of the econometric modeling and data analysis. It

would be used to examine the determinants of commercial banks’ performance in the

Ghanaian financial market.

4.1 Variable Definition and Method of Analysis

4.1.1 Dependent Variables

The data for this study is made up of bank-specific, macroeconomic specific and ownership

variables obtained from annual reports published by the Bank of Ghana for the period 2000-

2009. In order to test the accuracy of the results of this study, three performance measures in

banking literature are used, namely, Return on Assets (Earnings before interest and tax

divided by total assets), Return on Equity (Earnings after interest and tax divided by

shareholders fund) and Net Interest Margin (Net Interest divided by Total Asset).

4.1.2 Independent Variables

4.2 Bank-specific performance determinants

4.2.1 Bank Capital

We use the ratio of equity to assets (EA) to proxy the capital variable, when adopting ROA as

the profitability measure. Also, we relax the assumptions underlying the model of one-period

perfect capital markets with symmetric information. Firstly, the relaxation of the perfect

capital markets assumption allows an increase in capital to raise expected earnings. This

positive impact can be due to the fact that capital refers to the amount of own funds available

to support a bank’s business and, therefore, bank capital acts as a safety net in the case of

34
adverse developments. The expected positive relationship between capital and earnings

could be further strengthened due to the entry of new banks into the market. Secondly, the

relaxation of the one-period assumption produces an opposite causation, since it allows an

increase in earnings to increase the capital ratio. Finally, the relaxation of the symmetric

information assumption allows banks that expect to have better performance to credibly

transmit this information through higher capital. In the light of the above, capital should be

modeled as an endogenous (as opposed to a strictly exogenous) variable. It can also be argued

that financial markets are not perfect and that, well-capitalized banks need to borrow less in

order to support a given level of assets, thus they may tend to face lower cost of funding due

to lower prospective bankruptcy costs. Also, in the presence of asymmetric information, a

well-capitalized bank could provide a signal to the financial market of a better than average

performance should be expected (Athanasoglou et al., 2005). Therefore, well-capitalized

banks, in this regard, appear less risky and profits should be lower because they are perceived

to be safer. Again, EQUITY/TA is included in the model because domestic and foreign

banks may use different degrees of leverage. Lower capital ratios in banking imply higher

leverage and risk, and therefore greater borrowing costs. Berger and Mester (1997) have

pointed out that, it is an important control variable used to account for differences in risk

among banking institutions. In this regard, we would expect to observe a negative association

between capital and profits.

4.2.2 Bank Credit Risk

To proxy this variable we use the loan-loss provisions to loans ratio (PL). Theory suggests

that increased exposure to credit risk is normally associated with decreased firm profitability

and, hence, we expect a negative relationship between ROA (ROE) or net interest margin and

PL. Banks would, therefore, improve profitability by improving screening and monitoring of

35
credit risk and such policies involve the forecasting of future levels of risk. Other ratios that

have been used to measure credit risk and/or liquidity risk were loans/assets, loans/deposits

and provisions/assets. In this study, I proxy for this variable by using bad debt provision

divided by total loan advances.

4.2.3 Bank Expenses management

The total cost of a bank (net of interest payments) can be separated into operating cost and

other expenses (including taxes, depreciation etc.). Only operating expenses can be viewed as

the outcome of bank management. The ratio of these expenses to total assets is expected to be

negatively related to profitability, since improved management of these expenses will

increase efficiency and therefore raise profits. In this study, I used operating expenses divided

by total income to examine the extent to which management efficiency influences bank

profitability. I expect negative relationship between this variable and bank profitability.

4.2.4 Bank Size

One of the most important questions underlying bank policy is which size optimizes bank

profitability. Generally, the effect of a growing size on profitability has been proved to be

positive to a certain extent. This may be due to the fact that there is scale economies

associated with larger size-firms in production. On the other hand, for banks that become

extremely large, the effect of size could be negative due to bureaucratic and other reasons.

Hence, the size-profitability relationship may be expected to be non-linear. We use the banks’

real assets (logarithm) and their square in order to capture this possible non-linear

36
relationship. I expect positive relationship between bank size and profitability variables used

in the model.

4.2.5 Macroeconomic Variables

The literature recognises the sensitivity of Bank performance to macroeconomic control

variables. The macroeconomic variables used in this study are GDP growth as a control for

cyclical output effects, which we expect to have a positive influence on bank profitability and

inflation. As GDP growth slows down, and, in particular, during recessions, credit quality

deteriorates, and defaults increase, thus reducing bank returns. Demirgüç-Kunt and Huizinga

(1998) find a positive correlation between bank profitability and the business cycle. By

employing a direct measure of business cycle, Athanasoglou, et al. (2005) find a positive,

effect on bank profitability in the Greek banking industry, with the cyclical output being

significant only in the upper phase of the cycle. In his study, Al-Haschimi (2007) finds that

the macroeconomic environment has only limited effect on net interest margins in SSA

countries.

Again, with regards to inflation, the extent to which inflation affects bank performance

depends on whether future movements in inflation are fully anticipated, which, in turn,

depend on the ability of firms to accurately forecast future movements in the relevant control

variables or not. An inflation rate that is fully anticipated raises profits as banks can

appropriately adjust interest rates in order to increase revenues, while an unexpected change

could raise costs due to imperfect interest rate adjustment. Other empirical studies, such as,

Molyneux and Thornton (1992), Demirgüç-Kunt and Huizinga (1998), have found a positive

relation between inflation and long term interest rates with bank performance.

37
4.2.6Bank performance measures: ROA, ROE (Net Interest Margin-Interest Revenue

-Interest Expenses /Total Asset)

Control variables: Bank Capital, Bank Credit Risk, Bank expenses management, Bank Size,

4.3 Econometric Method of Analysis

This study applies panel data approach which involves pooling twenty banks over a period of

ten years (2005-2009). The use of panel data does not only improve sample size and

efficiency of estimations relative to single-period cross-sectional analysis, but is also better

able to capture effects that are dynamic other than either using cross-sectional or time-series

data alone (Hsiao, 1986; Baltagi, 1995). Because of the several data points in the use of panel

data approach, degrees of freedom are increased and collinearity among the explanatory

variables is reduced thus the efficiency of economic estimates is improved (Baltagi, 1995).

The panel regression equation differs from a regular time-series or cross-section regression

by the double subscript attached to each variable. There are different forms of panel data

estimation, namely, the fixed effects, random effects and constant coefficients effects model.

The constant coefficient effect model is appropriately utilized under the assumption that there

are no significant variations in both intercepts (cross-sectional units) and slopes (temporal

effects) in a model. In that regards, the data can be pooled and run an Ordinary Least Squares

(OLS) regression. However, in a situation whereby the slope is constant but there are varying

intercepts across the firms, the fixed effects model is applicable. While the intercepts vary

from firm to firm, they may not change over time. Essentially, the fixed effects estimation

makes it possible to control for individual characteristics of cross-sectional units that are

unobservable or unmeasured. This unobserved component is referred to as “unobserved

heterogeneity”.

The fixed effects model can be formulated as follows:

38
Yit = β1 X it + ai + uit .......... .......... .......... .... 1

i =1…………………N

t=1…………………… T

Where i denotes firms and t, time. The uit is the error term which is subscripted with i and t.

Xit =Vector of explanatory variables. β= vector of coefficients,

Ai= individual unobserved heterogeneity. Uit = error term.

The unobserved heterogeneity, ai., is not subscripted with t, implying that its effect varies

across cross sections but is fixed over time. The error term (what is unaccounted for in the

model) is thus the time-varying (or idiosyncratic) error and represents the unobserved factors

that change over time and affect our dependent variables. It is also assumed to be independent

and identically distributed IID (0, σu2).

When it is observed that the ai.is correlated with the included explanatory variables in the

model, the OLS and Generalised Least Squares (GLS)-the random effects estimates give

biased and inconsistent results. In that regards, the fixed effects provide consistent results and

vice versa. However, the use of the fixed effects depletes the model of degree of freedom. In

order to avoid this problem, the ai. is assumed random hence the use of the random effects

model. Furthermore, it is suggested that a choice between the fixed and random effects model

depends on the results of Hausman test (a test suggested by Hausman (1978) that decides on

which of the models to apply.

Concerns have been raised with regards to estimations in which standard errors and residuals

are not dependent. Literature provided various means of dealing with standard errors in panel

data. Petersen (2007) argues that the chosen method is often incorrect and the literature

39
provides little guidance to researchers as to which method should be used. He further argues

that, some of the advice in the literature is simply wrong and sometimes produce incorrect

estimates. OLS estimation while common in literature may be biased, owing to a failure to

control for time-invariant firm-specific heterogeneity. When the residuals are correlated

across observations, OLS standard errors can be biased and either over or underestimate the

true variability of the coefficient estimates and produce t-statistics that are very large. This is

why the correct method to estimate standard errors is important.

Petersen (2007) proved that both OLS and the Fama-MacBeth standard errors are biased

downward. His results show that only clustered standard errors approaches are unbiased as

they account for the residual dependence created by the firm effect. An alternative approach

for addressing the correlation of errors across observations is the Newey-West procedure

(Newey and West, 1987). The Newey-West standard errors are also biased but the bias is

small compared to the other methods. The mode of estimation used in this study is linear

regression; correlated panels corrected standard errors (PCSEs).

40
 CHAPTER FIVE

Analysis of Findings and Discussions

5.0 Introduction

It is an acknowledged fact that there is a positive association between efficient financial

intermediation and bank performance. Efficient and well-developed financial intermediation

and financial markets are necessary for overall economic development of a nation. This is

due to the fact that, financial intermediation plays an important role in accelerating the pace

of economic growth by allocating the flow of funds from the surplus spending unit to the

deficit spending unit. With this background, the efficiency and performance of banks

especially in a developing nation like Ghana cannot be underestimated. The performance of

banks affects every area of an economy. The existing literature indicates that the performance

of banks is explained by bank specific factors and macroeconomic variables. This study

examines the determinants of bank interest margin and profitability in Ghana within a panel

data framework. This section discussed the results of the empirical investigation. Analysis of

bank performance starts with the discussion of summary statistics, correlation matrix and

finally the regression results. The table below shows the relevant statistics and variables used

in the study.

41
Table5.1 Summary Descriptive Statistics Bank specific and Macroeconomic variables

Std.

Variables Obs Mean Deviation Minimum Maximum

Return on Assets 100 0.0342932 0.038318 -0.2895543 0.1538848

Return on Equity 100 0.3200143 0.1798984 -0.3606557 0.8687016

Inflation 100 0.1823188 0.0844329 0.1050000 0.4050000

1
GDP 100 0.051770 0.0106335 0.0370000 0.0730000
Bank Assets 100 3.00000 3.0000 1436000 1.640000
91 Days T bills 100 0.209870 0.0997050 0.106000 0.0450000
Equity/Total assets 100 0.1274283 0.0844994 0.0008027 0.8028551
Operating Cost/Total 100 0.073775 0.0328117 0.0002877 0.3227021

assets 1
No of Branch 100 38.110000 35.00675 1.000000 0.322702136

Table 5.1 is a summary statistics which explains the mean, standard deviation, minimum and

maximum values. For a mean of 3.4%, the return on assets has a minimum loss of 2.8% and a

maximum profit 1.5% Thus, stakeholders with the banks under survey during that period of

the study will earn on average 3.4 with a maximum being 15%. There is some level of

variation in this earnings indicated by the standard deviation of 3.8%. With regards to return

on equity-earnings after interest and tax, it has a mean of 32% for shareholders within the

period under study, a minimum loss of 36% and a maximum gain of 87%, there is also some

level of variation within this statistics. The bank capital measure, equity divided by total

assets, poses a mean of 12.7% with minimum and maximum values 0.08% and 80%

respectively. Considering the level of variation, it appears the mean value of this variable

shows that the banks covered under the study are highly leveraged-they turn to finance their

42
asset base largely through the use of more debt as against equity. Also, the management

efficiency measure, expenses/income, has a mean of 42.2%, a maximum of 25.3% and a

minimum value of 51.3%. This indicates that management expenses constitute larger

percentage of the banks expenses under the period covered. This is likely to have some

implication on the level of bank profitability. Bank credit risk measure, provision for bad debt

divided by total advances has a mean of 4.2% with a maximum 26.2%. On average, banks are

very much cautious about the impact of credit risk on their profitability. Inflation and GDP

growth rate have a mean of 18.2% and 5.2% respectively. The indication is that the current

Increase in the level of GDP and the fall in inflation rate have contributed to the improved

performance of the commercial banks in recent times as compared to the situation of the past.

Total Asset base of banks have increased recently following incorporation of more new bank

and the arrival of some foreign ones .This has also boosted the performance of the banking

industry as a whole and has made the industry more competitive. Considering operating cost

to total asset, one may conclude that the operating cost of commercial banks have increased

as a result of their effort to increase employee welfare, bank environment, and improved

quality of service. The mean is 0.74%, a maximum of 32.2% and a minimum of 0.029%.The

high operating cost coupled with high level of impairment losses as a result of non

performing loans have resulted in low level profit on the part of most of the banks such as

Barclays Bank, ADB, and GCB.

Considering the number of branches a bank operates, there is a mean of 38.11%, a standard

deviation of 35% a minimum of 1% and a maximum of 136%. This is an indication that the

more branches a bank operates the better its performance but this cannot be achieved without

carefully considering the site , the economic activities of the area, management competence

among other things. GCB and BBG seem to have the highest number of branches but this

does not make much difference in their performance.

43
44
 Table 5.2 Correlation Results on Commercial Banks performance using available data

Variables ROA ROE CPI L.G L.A DAY EQTA OPCTA BRL

ROA 1.00

ROE 0.6504 1.00

Inflation 0.1996 0.2536 1.00

GDP -0.1186 -0.2601 -0.4479 1.00

Bank Asset 0.1838 -0.0564 -0.2875 0.4316 1.00

91 day T bill 0.1896 0.2698 0.8545 -0.4529 -0.3544 1.00

EQTA -0.6060 -0.5257 0.0601 -0.1435 -0.2083 0.0886 1.00

OPCTA -0.7455 -0.6038 -0.0248 -0.0255 -0.1677 -0.0028 0.7722 1.00

No. of Branches 0.4399 0.1482 0.0101 0.0413 0.4371 -0.0007 -0.2452 -0.2814 1.00

Correlation analysis is a statistical approach used to determine the level of association

between two variables to explain the direction of a variable if that of the original data should

change or remain unchanged. Thus, the degree of correlation indicates the direction of

movement between the variables. Correlation enables a researcher to predict the effect of one

variable on the direction of the other. It is worth pointing out that correlation does not suggest

causality, rather, the direction of the change or movement.

From the table above, there is a positive correlation between return on equity and return

asset, this means that when return on asset is increasing, return on equity is also increasing.

45
Inflation index has a positive correlation with return on asset, and return on equity

respectively. This means that when the level of inflation is rising in the country, the return

that investors make on their investment rises. The same applies to the return shareholder

make on their equity.

Growth in GDP has a negative correlation with return on asset, return on equity, and inflation

respectively. Bank asset has a positive correlation with return on asset and growth in GDP.

This means that an increase in bank assets implies an increase in GDP or vice versa.

Regarding interest rate, an increase in 91 days Treasury bill for example would lead to an

increase in return on assets, return on equity, inflation rate since in each case there is a

positive correlation, but the same increase in the Treasury bill rate would lead to a fall in the

GDP growth rate, and bank asset level.

Equity to total asset has a negative correlation with return on assets, return on equity, GDP

growth rate and bank assets; however, it has a positive correlation with inflation and 91 days

Treasury bill rate. Operating Cost to total assets has a negative correlation with all the other

variables except equity to total assets. Number of branches has a positive correlation with all

the other variables apart from the 91days Treasury bill rate and equity to total assets.

46
Table 5.3 Panel-Corrected Standard Error Regression Result (ROA)

ROA
Variables co-eff Std error t-squre p-value 95% conf.
Inflation 0.0028114 0.0059668 0.47 0.638 -0.0088
GDP -0.0384301 0.01124 -3.42 0.001 -0.06046
Bank Asset 0.0017977 0.00088 2.04 0.041 0.00714
91day T bill 0.054918 0.24995 2.20 0.028 0.005929
EQTA -0.11209 0.045940 -2.44 0.015 -0.202136
OPCTA -0.591677 0.109372 -5.41 0.000 -0.806044
No of Branch 0.0144887 0.003358 4.31 0.000 0.007907
Constance -0.1076489 0.461416 -2.33 0.020 -0.198085

Table 5.4 Panel-Corrected Standard Error Regression Result (ROE)

ROE
Variable co-eff Std error t-squre p-value 95% conf.
Inflation -0.0021643 0.0448147 -0.05 0.961 -0.08999
GDP -0.225036 0.082441 -2.73 0.006 -0.3866182
Bank Asset -0.0009091 0.0059656 -0.15 0.879 -0.0126014
91day T bill 0.2471264 0.1889273 1.31 0.191 -0.123164
EQTA -0.2235964 0.2227272 -1.00 0.315 -0.66013
OPCTA -2.580282 0.6050165 -4.26 0.000 -3.766093
No of Branch -0.0057893 0.016891 -0.34 0.731 -0.0388521
Constance -1.1547451 0.313351 -0.49 0.621 -0.7689018

5.1 Discussion of regression results

Bank Specific versus Profitability determinants

Four bank specific profitability determinant variables are used here. The first is the equity-to-

asset ratio. From the table above, there is a positive and statistically significant relationship

between return on assets and equity-to-asset ratio. This may mean that, the high leverage

position of the banks under this study may not enhance bank Performance. On the other hand,

the higher equity-to-asset ratio, the lower the need for a bank to seek external funding to

augment its capital base and therefore better performance may be assured and vice versa. A

well capitalised bank can also withstand macroeconomic shocks and hence improves upon its

profitability. It also a sign that well capitalised banks face lower costs of going bankrupt and

47
then cost of funding is reduced. Lower cost of funding may translate into higher above

average market value and better performance. Financial market cannot be described as

perfect simply because there is some degree of asymmetric information on the market.

According to Athanasoglou et al., (2005) a well-capitalized bank could provide a signal to the

financial market that a better than average performance should be expected. On a similar

study by Berger (1995) and Dermerguç-Kunt and Huizingua (1999), they find a positive

relationship between bank performance and capitalization. Thus, this result seems consistent

with these studies. On the other had, lower capital ratios in banking may imply higher

leverage and risk, and therefore greater borrowing cost. An increase in equity implies a fall in

leverage which will further reduce ROE. In this regard, there will be a negative relationship

between ROE and equity-to-asset ratios finding indicates.

Another bank specific performance determinant is expenses divided by income that seeks to

measure managerial efficiency. Efficient management determined to minimize cost and

maximise returns on invested funds is expected to lead to higher profit. The opposite is true.

This study indicates a statistically significant negative relationship between management

efficiency and ROA and ROE. This means that improved management efficiency is likely to

enhance bank profitability whereas inefficient management that incur more expenses will

increase bank cost and lower profit. Thus, for bank managers aiming at enhancing the bottom

line for their shareholders, the magic is a conscious attempt to minimise cost. Another

variable that measures managerial efficiency is returns on earnings assets. From the results

above, ability of bank managers to enhance their managerial efficiency by enhancing earning

ability of assets that generate income to the bank is likely to translate into high profitability.

This study indicates positive and significant relationship between returns on earning assets

and both ROA and NIM but negative with regards to ROE. Furthermore, bank credit risk is

48
recognised as having negative impart on bank performance. The results above from the

regression table indicate that an increase in the provision for bad debt against total loans

advanced reduces both ROA and ROE. It is not clear where the result is positive with regards

to net interest margin. However, one can conclude that on a whole, to increase the

performance of banks, managers and more specifically, credit officers need to enhance their

credit administration capacity to enhance their loan monitoring and credit checks. This would

go along way to reduce the exposure of banks to credit risk-inability of customers to repay

loans on credit.

The last but one of the bank-specific control variables is the size measure. There are

advantages associated with large size even as there are disadvantages. In all the three

profitability measures, the size of the bank shows positive and statistically significant

relationship. Thus, large banks in Ghana can enhance their performance and net interest

margin by exploiting the economies of scale associated with large size in terms information

processing, research and development as well as better monitoring and screening credit

applicants at low cost. This will translate into higher profit and hence better performance.

5.2 Commercial banks Performance versus Macroeconomic Variables

Two macroeconomic variables used in this study are inflation and growth in Gross Domestic

Product (GDP). The effect of inflation on bank performance and hence depends on whether

the inflation is an expected or not. High inflation rates are generally associated with high

lending rates, and therefore, high incomes for banks. However, if increase in inflation is not

anticipated and banks are sluggish in adjusting their interest rates then there is a possibility

that bank costs may increase faster than bank revenues and hence inflation would adversely

affect bank profitability. This study reports the positive relationship between inflation and

49
ROA but negative with regards to ROE and NIM. The GDP growth rate is expected to have a

positive impact on bank’s performance according to the well documented literature on the

association between economic growth and financial sector performance. The findings from

this study indicate positive and statistically significant association between GDP growth and

ROA.

CHAPTER SIX

Conclusions/Recommendations

6.1 Conclusion

This research investigates bank performance in Ghana. The main objectives of the study are:

to examine the main determinants of bank performance, to explore the impact of key

macroeconomic variables on bank performance, and to examine the impact of bank-specific

control variables on bank performance. Using data covering a period 2007-2009 with ten

banks made up of foreign and domestic banks within panel data methodology, the results

from the study indicate that the key determinants of bank performance are: bank size, equity-

to-asset ratio (a proxy for bank capital), bank credit risk (provision for bad debt/advances),

bank expenses out of income and returns on earnings assets. Macroeconomic variables such

as inflation and GDP growth rate and inflation rate were also discovered as determinants of

bank performance.

The findings show that there is a positive and statistically significant relationship between

return on assets and equity-to-asset ratio. This means that, the higher equity-to-asset ratio, the

50
lower the need for a bank to seek external funding to augment its capital base and therefore

better performance and vice versa. Furthermore, a well capitalised bank face lower costs of

going bankrupt and the cost of funding is reduced. Lower cost of funding may translate into

higher above average market value and higher performance. Another bank specific

determinant of bank performance is expenses divided by income that seeks to measure

managerial efficiency. This study indicates a statistically significant negative relationship

between management efficiency and ROA and ROE. This means that efficient management

is likely to enhance bank performance whereas inefficient management will increase bank

cost and lower profitability. Thus, for bank managers aiming at enhancing value for their

shareholders, the secret is a conscious attempt to minimise cost. Another variable that

measures bank performance in Ghana is returns on earnings assets. This study indicates

positive and significant relationship with bank performance. Furthermore, bank credit risk is

reported as having negative impart on bank performance. The findings from this study

indicate that an increase in the provision for bad debt against total loans advanced reduces

bank performance. By implication, to increase the profitability of banks, managers and more

specifically, credit officers need to enhance their credit administration capacity to enhance

their loan monitoring and credit checks. This would go along way to reduce the exposure of

banks to credit risk-inability of customers to repay loans on credit.

The last but not the least of the bank-specific control variable is the size measure. There are

advantages associated with large size even as there are disadvantages. In this study, the size

of the bank shows positive and statistically significant relationship with bank performance.

Thus, large banks in Ghana can enhance their performance by exploiting the economies of

scale associated with large size in terms information processing, research and development as

well as better monitoring and screening credit applicants at low cost. The findings also

51
indicate that increase in inflation if not anticipated and banks being sluggish in adjusting their

interest rates adversely affect bank performance. With regards to the GDP growth rate, the

findings from this study indicate positive and statistically significant association between

GDP growth and ROA.

6.2 Recommendations

Based on the findings from this study, the following are recommendations for policy and

future research agenda:

• There should be collaboration between the government, stakeholders and policy

makers in the banking as well as other industries to find appropriate ways of dealing

with interest rate

• The Central Bank should regularly review performance of banks that are in operation

because of the interest rate processes.

• Increasing the capital based of the banks in Ghana would go along way to enhance

their performance and even their resilience to changes in external shocks. In this

regard, the recapitalisation policy of the central bank is appropriate. It will help

strengthen the banking system as well as enhance their performance,

• Again, bank managers should attempt to minimise the expenses made in order to

enhance the wealth of stakeholders. This does not however mean, there should not be

incentives to motivate productive effort and behaviour. Rather, bank managers should

ensure that managerial expenses are kept within optimal levels consistent with profit

maximisation objectives of the bank,

• Effective management of credit administration should also be pursued to minimise the

level of default on loans. Credit officers and loan officers should be well equipped

with the required skills needed to conduct proper and due diligence on loan

52
 applicants. Also, effective monitoring of credit would also help keep the level of

default within acceptable limit to enhance the profitability of banks,

• Banks are profit-oriented entities and thus, appropriate response of their policy to

reflect the macroeconomic realities in the economy would enhance their performance

and increase shareholders wealth. Bank managers should be able to appropriately

forecast and incorporate in their periodic credit policy changes, the effects of

changing general price level which is likely to affect their cost of operation and the

consequential negative impact on performance, if not timely and appropriately

recognised and reflected in managerial decision making.

• Aggressive policy to increase the asset based of banks would also enhance their

profitability. Assets represent sources of revenue to banks and hence a credit policy

aimed at expanding the asset-based of the banks through offering of differently

customised and flexible products that reflect customer needs, status and expectation is

likely to be patronised by customers and hence increase in revenue and profitability of

banks.

• Logistical and time constraints however limited the scope of the study the few

commercial banks having the required financial data. The period covered was also

short. Further studies could increase the period and also add more variables as well as

more banks to provide interesting and enhance knowledge. These studies can also

examine the comparative performance of foreign and domestic banks.

53
 References

1. Frank Fehle, The components of interest rate swap spreads. The Journal of Futures

Markets, Vol. 23, No. 4, 347-387 (2003).

2. Hua He (2000) Modeling term structure of swap spreads, Yale School of Management

June 2000, working paper No.00-16.

3. Hull, J (2005) Options, Futures and Other Derivates, 149-150.

4. Hull, J., 1989. Assessing Credit Risk in Financial Institution.s off-Blance Sheet

Commitments. Journal of Financial and Quantitative Analysis 24, 489-501.

5. In, F., Brown, R., Fang, V. (2003) Modeling volatility and changes in the swap

spread. International Review of Financial Analysis, (12) 545-561.

6. Jun Liu, Francis A. Longstaff, Ravit E. Mandell (2006) The Market Price of Risk

Interest Rate Swaps: the Roles of Default and Liquidity Risks. Journal of Business, 2006.

vol.79.

7. John Kambhu, Federal Reserve Bank of New York, Staff Reports, Trading Risk and

Volatility in Interest Rate Swap Spreads, Staff Report no. 178, February 2004.

8. Bondnar, G.M., Hayt, G.S., Marston, R.C., & Smithson, C.W. (1995). Wharton

survey of derivatives usage by US non-financial firms. Financial Management, 24, 104-

114.

9. Anane, A., (2005), bank ownership, characteristics and performance: a comparative

study of domestic and foreign banks in Ghana

54
10. Brooks, C (2002) Introductory Econometrics for Finance.

11. Brown, K. C., Harlow, W. V., and Smith, D.J. (1994). An Empirical Analysis of

Interest Rate Swap Spreads. Journal of Fixed Income, 3, 61-78.

12. Collin-Dufresne, P., and Solnik, B. (2001). On the Term Structure of Default Premia

in the Swap and LIBOR Markets. Journal of Finance, 56, 1095-1115.

13. A guide to Econometrics (2003), fifth edition by Peter Kennedy, The MIT Press

Cambridge, Massachusetts

14. Afanasieff T., P.Lhacer and M. Nakane. (2002). “The determinants of bank interest

spreads in Brazil”, Banco Central di Brazil Working Papers.

15. Berger, A.N. and Mester, L.J. (1997), “Inside the Black Box: What Determine

Differences in the Efficiency of Financial Institutions?” Journal of Banking and Finance

16 (7), 895-947.

16. Demirgüç-Kunt, A. and A. Huizinga (1998). “Determinants of Commercial Bank

Interest Margins and Profitability: Some International Evidence,” World Bank Economic

Review 13, 379-408.

17. Gelos, G. (2006). “Banking Spreads in Latin America,” IMF Working Paper 06/44.

18. Ghana Banking Survey, 2007 by Price Water House Coppers, Ghana.

19. Guru B., J. Staunton and Balashanmugam. (2002). “Determinants of commercial bank

profitability in Malaysia”, University Multimedia working papers.

20. Valentina Flamini, Calvin McDonald, and Liliana Schumacher (2009), the

Determinants of Commercial Bank Profitability in Sub-Saharan Africa, IMF Working

Paper

21. Al-Hashimi, A. (2007). “Determinants of Bank Spreads in Sub-Saharan Africa,” draft.

55
22. Athanasoglou P., Delis M. and C. Staikouras (2006). “Determinants of Banking

Profitability in the South Eastern European Region,” Bank of Greece Working Paper

06/47.

23. Barajas, A., R. Steiner, and N. Salazar. (1999). “Interest spreads in banking in

Colombia 1974-96”, IMF Staff Papers, Vol. 46: 196-224.

24. Ben Naceur S. and M. Goaied. (2001). “The determinants of the Tunisian deposit

banks’ performance”, Applied Financial Economics, Vol.11:317-19.

25. James Bicksler; Andrew H. Chen, Analysis of interest rate swaps, The Journal of

Finance, Vol. 41, No. 3, Papers and Proceedings of the Forty-Fourth Annual.

26. Kodjo M. Apedjinou, What drives interest rate swap spreads? 2003 An empirical

analysis of structural changes and implications for modeling t of the swap term structure

56
 APPENDIX 1: LIST OF BANKS SELECTED FOR THE STUDY

BANK YEAR, 2002-2005

GHANA COMMERCIAL BANK LTD (GCB)
BARCLAYS BANK GHANA LTD (BBG)
INTERCONTINENTAL BANK GHANA LTD
PRUDENTIAL BANK LIMITED
MERCHANT BANK LTD
ECOBANK (GHANA )LTD
GHANA TELECOM BANK LTD (GTB)
CARL BANK LTD
STANBIC BANK LTD
UNIBANK GHANA LTD

57