1 s2.0 S0378426613002148 Main

Journal of Banking & Finance 37 (2013) 29202937
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Journal of Banking & Finance

journal homepage: www . elsevier . com/locate/jbf

Does market structure matter on banks profitability and stability?
Emerging vs. advanced economies

Ali Mirzaei, Tomoe Moore
, Guy Liu
Department of Economics and Finance, Brunel University, Uxbridge, Middlesex UB8 3PH, UK

a r t i c l e i n f o

Article history:
Received 5 March 2012
Accepted 22 April 2013
Available online 6 May 2013

JEL classification:
G01
G21
G28

Keywords:
Market structure
Bank profitability
Bank stability
Emerging banks

a b s t r a c t

We empirically investigate the effects of market structure on profitability and stability for 1929 banks in 40
emerging and advanced economies over 19992008 by incorporating the traditional structure-con-duct-
performance (SCP) and relative-market-power (RMP) hypotheses. We observe that a greater market share leads
to higher bank profitability being biased toward the RMP hypothesis in advanced economies, yet neither of the
hypotheses is supported for profitability in emerging economies. The SCP appears to exert a destabilising effect on
advanced banks, suggesting that a more concentrated banking system may be vulnerable to financial instability,
however, the RMP seems to perform a stabilising effect in both economies. Evidence also highlights that
profitability and stability increase with an increased interest-margin revenues in a less competitive environment for
emerging markets. Overall, these results suggest that although policy measures to promote competition may
dampen economic rent, excessive implemen-tation may have an undesired destabilising impact on banks.

2013 Elsevier B.V. All rights reserved.

1. Introduction

It is argued that the market structure matters for banks power in
setting interest rates that can directly affect their performance. A
positive statistical relationship between measures of market struc-ture,
such as concentration or market share and profitability has been
reported by many banking studies (e.g. Molyneux and Thorn-ton,
1992; Berger, 1995). Berger (1995) advocates two hypotheses from
such a relationship. One of them is the structure-conduct-performance
(SCP) paradigm, where, in highly concentrated mar-kets, firms can set
prices that are less favourable to consumers as a result of imperfectly
competitive markets. In a concentrated banking system, a bank can
set higher spreads by imposing higher lending rates and lower deposit
rates. The other hypothesis is the relative-market-power (RMP)
paradigm where firms with well-dif-ferentiated products can increase
market share and exercise their market power in pricing products, thus
earning supernormal prof-its. With respect to the impact of market
structure on banking sta-bility, both economic theory and empirical
evidence are inconclusive. In the literature, there are two contrasting
views on the relationship between concentration and stability, namely
the concentration-stability and the concentration-fragility views.
According to the former, more of a concentrated banking system

Corresponding author. Tel.: +44 1895274000; fax: +44 1895269770.
E-mail addresses: ali.mirzaei@brunel.ac.uk. (A. Mirzaei), tomoe.moore@
brunel.ac.uk (T. Moore), guy.liu@brunel.ac.uk (G. Liu).

0378-4266/$ - see front matter 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jbankfin.2013.04.031

may decrease risk through increasing franchise value, whilst the latter
suggests that market power gained through concentration increases
risk through the setting of higher interest rates. While there is a large
literature that banks rationally choose more risky portfolios when
confronted with increased competition (less con-centration), new
studies find risk-incentive mechanisms that banks take on more risk
when they become more concentrated.
This paper empirically re-examines the effect of market struc-ture
on both profitability and stability in banking sectors. We uti-lise data
from 23 emerging economies (10 Eastern European and 13 Middle
Eastern countries) and 17 Western European countries, containing
relatively large panel data for a total of 1929 banks over the period
19992008. Incorporating both the traditional struc-ture-conduct-
performance (SCP) and the relative-market-power (RMP) hypotheses,
the market structure analyses are performed by regressing bank
performance indicators on measures of market power together with
bank-specific characters, financial structure variables and
macroeconomic conditions. We make an allowance for the differences
between banks operated in emerging and devel-oped countries. We
aim to address some fundamental questions. Firstly, can the
hypotheses of RMP and SCP be applied to the emerging market
banking system in terms of profitability and sta-bility? Secondly, why
are banks operated in the emerging economies more profitable than
their counterparts in advanced economies?
1
Thirdly, to what extent
are discrepancies in

1
We statistically verify this in Section 2.
A. Mirzaei et al. / Journal of Banking & Finance 37 (2013) 29202937 2921

determinants of bank risk and returns due to variations in factors under
the control of bank management and/or factors relating to financial
structures? We systematically compare the emerging mar-ket banking
systems with their counterparts in advanced markets. In particular,
identifying the factors that lead to the differences may ex-plain the
effectiveness of financial institutions and also help us bet-ter
understand the banking industry in emerging economies.
The main contributions of our paper are largely twofold. Firstly, this
is a joint analysis of profitability and stability. The international banking
industry has undergone substantial struc-tural reforms over the last
two decades. There have been funda-mental changes in the behaviour
of banks with emphasis not only on profitability, but also on stability
with comprehensive asset management in recent periods. It is
particularly important for emerging countries to ensure that the banking
system is sta-ble. Such a banking development should lead to private
and infrastructural projects being financed effectively and funds allo-
cated efficiently. As Albertazzi and Gambacorta (2009) argue, be-
cause of phenomena such as globalisation, growing international
financial markets, deregulation and advances in technology, identifying
the determinants of bank performance is an impor-tant predictor of
unstable economic conditions. Athanasoglou et al. (2008) also point
out that a profitable banking system is likely to absorb negative
shocks, thus maintaining the stability of the financial system. On the
other hand, an inadequate regu-latory bank environment with a higher
degree of information asymmetry may lead to high profitability, but it is
indicative of high risk premia, and these can cause financial instability
(Hell-mann et al., 2000). The investigation of such a joint effect on both
profitability and stability of market structure is, to the best of our
knowledge, extremely limited. In this paper, we can ana-lyse whether
the relatively high returns of banks are accompa-nied by increased
stability by exerting market power due to less competitive market
conditions. If this is the case, the exces-sive implementation of
measures to promote competition may have destabilising effects on
banks. Since there is a wider inter-est in the effect of augmented
competition and deregulation on banking systems, our empirical
results may provide useful policy implications.

The second contribution is the behaviour of emerging market. In
the new global economy, there has been an increasing interest in
measuring profitability in emerging markets. However, studies of the
profitability-market power relationship in emerging markets have been
limited, being considerably less rigorous, lacking in de-tailed accounts
of the determinants of bank profitability. This pa-per fills the gap by
widening the scope of explanatory variables, not only in terms of
market structure, but also with a wider range of other control factors,
without which the model would suffer from the omitted variables.

The importance of our comparative study lies in the develop-ment
and improvement of the banking sector in emerging econ-omies. The
Middle East and the Eastern Europe would appear to be one of the
appropriate choices for the study of emerging economies, since each
has its unique points of difference. The Middle Eastern banking system
is fairly concentrated being dom-inated by Islamic banks and, at least
until the late 1990s, was tightly regulated and protected from foreign
competition. Hence, the improvement of the banking environment in
this region would provide more opportunities to enter into the
international markets. Eastern Europe formerly dominated by state-
owned banks has recently converged with the European Union and fol-
lows European banking rules. It follows that legal and financial
infrastructures need to be established in order to penetrate the major
EU markets. The Western banking system is a good bench-mark in
which banks operate under a highly competitive envi-ronment. Indeed,
in the preliminary data analysis in Section 2,

we have found distinctive features in profitability and market structure
between these emerging markets and developed EU markets,
providing the meaningfulness of our study.
Different determinants call for different policy actions. If prof-itability
and stability determinants can be effectively identified in relation to the
market structure, fundamental reform could be undertaken by policy
makers. If, on the other hand, determi-nants were dominated by bank-
level variables, promoting more stakeholder power would be desirable.
If determinants are clearly identified macroeconomic variables, actions
in terms of bank reform could be undertaken by macroeconomic policy
makers.

The main empirical findings are as follows. As in many studies
presented in banking literature, we find a positive relationship be-
tween profitability and market share in advanced economies: banking
systems in developed countries are generally biased to-ward the RMP
hypothesis. However, the data do not seem to sup-port the hypothesis
on the profitability in emerging market banking systems. The results
also show that the more concentrated the banking system in advanced
economies is, the more vulnerable it is to systemic risk, supporting the
concentration-fragility hypothesis, yet a higher market share seems to
exert a stabilisation effect in both economies. Bank-specific variables
and financial structures seem to exert a significant effect on both types
of banks, in particular, higher interest rate spreads increase profitability
and stability. For emerging banks this seems to be one of the key fac-
tors to increase their profitability.

The remainder of this paper is structured as follows. In Section 2
we compare the state of market structure and profitability for both
emerging and advanced banking systems, which reinforces the
importance of our study. Section 3 presents a literature review of
related studies. Section 4 specifies the model for estimation and
describes the variables used for this study. Section 5 summarises the
data descriptive statistics. The empirical results are reported in Section
6. Section 7 concludes and provides a number of policy implications.

2. Market structure and profitability for emerging and
advanced banks

In order to elaborate the level of profitability and market structure,
we measure return on assets for 308 selected banks
2
located in
emerging countries (Eastern Europe and Middle East) and 1621
selected banks in developed countries (Western Europe) over the
sample period. Fig. 1a illustrates the trend of returns on average
assets (ROAA in %) during the period 19992008. Bank profitability in
the emerging economies, which has an upward trend till 2007, is
extremely high as compared to that observed for developed
economies, where ROAA is relatively constant, being around 0.5%.
The main question one might want to address is what explains such
differences in bank profitability between two different markets.

One possible answer could be the market structure in these
economies. We have computed a market share for each bank and
market concentration for different countries where these banks are
located. Fig. 1b displays the Lorenz Curve for market share.
3
The
horizontal and vertical axes show the proportion of banks and market
share respectively. It shows that 10% of emerging banks, accounting
for 23 banks, holds nearly 40% of the market share,
4
whereas the
same 10% of advanced banks accounting for 116 banks

2
See Section 5 for the bank selecting procedure.
3
In generating the Lorenz Curve, some banks were dropped due to missing
observation.
4
Market share is measured as a percentage of a banks assets to total assets of
banks in the country.
2922 A. Mirzaei et al. / Journal of Banking & Finance 37 (2013) 29202937

( ) ( )

2.5%
Banks in emerging economies
100

Banks in advanced economies

2.0%

(
%
)

80

R
O
A
A

1.5%

M
a
r
k
e
t

S
h
a
r
e

60

1.0%

40

Emerging economies (234 banks)

Advanced economies (1164 banks)

0.5%

20

0.0%

0

a

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 0 10 20 30 40 50 60 70 80 90 100
Year
Percentage of bank

( )

( )

.30

100%



.25

90%
H
e
r
f
i
n
d
a
h
l

I
n
d
e
x

C
o
n
c
e
n
t
r
a
t
i
o
n

.20

80%

.15

70%

.10

60%

.05

50%

.00

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Year
Year

Fig. 1. (a) ROAA (%). (b) Lorenz curve of market share. (c) Five-firm concentration (%). (d) Normalised Herfindahl-Hirschman index. Source: Authors calculation based on data from
BankScope. Sample period 19992008. ROAA (return on average assets): net profits before taxes as a percentage of total assets, market share: a percentage of a banks assets to total
assets of banks in the country, concentration: a percentage of five-bank assets to total assets in the country, Normalised Herfindahl-Hirschman index: the summation of a square of
market shares of all banks operated in each country. For the detailed definition of these variables, see Table 1

holds as much as 70% of market share. Fig. 1c and d shows the 5-firm
concentration
5
(CR
5
) and normalised HerfindahlHirschman index
6

(NHHI), respectively. It can be seen that the degree of CR
5
in emerg-
ing market banking systems declines dramatically over the sample
period. Yet, even with the lowest CR
5
of around 70%, the structure is
still highly concentrated, and banks may be very conducive to price
collusion. Conversely, in the advanced banking system, CR
5
is
relatively stable at around 60%. In Fig. 1d NHHI shows a downward
trend in emerging economies which is consistent with CR
5
, and ap-
pears to converge to that in advanced economies. These comparative
illustrations provide a powerful motivation to investigate the market
structure nexus with bank performance for the two types of markets.

3. Existing studies on bank market structure, performance and stability

Most research into the determinants of bank performance is based
on the traditional structure-conduct-performance (SCP) par-adigm.
The SCP or collusion hypothesis postulates that market

5
CR5 is calculated as the total assets of the five largest banks to the total assets of
all banks in the country.
6
HerfindahlHirschman index (HHI) is the summation of each countrys square of
market share: If MSi represents the market shares by firm i and N is the number of firm
in the market then HHI
P
N
i MS
2
i . In general, the HHI in a market with N equal-
sized firms is
1
, and hence it ranges from 1/N to one. To rescale this and make it in the
N
HHI_N
1

range of zero to one we use the normalized HHI, computed as NHHI 1_N
1

.

structure influences the conduct or behaviour of firms through, for
instance, pricing and investment policies, and this in turn influ-ences
corporate performance. Bourke (1989), for example, found a positive
relationship between market concentration and bank profitability in
Europe, North America, and Australia. For European banking markets,
Maudos and Fernndez de Guevara (2004) found a statistically
significant positive correlation between concentra-tion and bank
interest margins for the period 19932000. See also Demirguc-Kunt
and Huizinga (1999) for banks throughout the world, and Molyneux
and Thornton (1992) for Europe. By contrast, Smirlock (1985) reports
that concentration does not explain bank profit rates for 2700 state
banks operating in the USA. Goldberg and Rai (1996) also fail to find a
positive association between con-centration and profitability for a
sample of large banks located in 11 European countries for the period
19881991.
Some of the recent research attempts to explain market struc-ture
hypotheses together with the profit-efficiency relationship by specifying
X-efficiency and scale-efficiency (Berger, 1995)
7

7
The concept of X-efficiency can be applied to situations where there is motivation of
management to maximise output, and it occurs when the output of firms is the greatest
from a given amount of input. Hence, X-efficiency asserts that firms with superior
management of production and technologies have lower costs and therefore higher
profits. The scale-efficiency hypothesis claims that firms tend to have equally good
management and technology, but some simply produce at more efficient scales than
others, and as a result, have lower unit costs and higher unit profits.

using the methods of the stochastic frontier analysis (SFA) and/or the
data envelopment analysis (DEA). Claeys and Vander Vennet (2008),
among others, investigated the determinants of bank interest mar-gins
in the Central and Eastern European countries to empirically
investigate whether the high profit margins of banks are caused by a
low degree of efficiency and/or non-competitive market condi-tions. By
employing the SFA techniques, they find that there is evi-dence to
support the SCP hypothesis, and low operational efficiency is reflected
in high bank interest margins in these coun-tries. In Park and Weber
(2006), by utilising the DEA approach (a non-parametric approach),
the findings suggest that the perfor-mance of banks in South Korea
depends on levels of efficiency, but not on market power, in terms of
neither market share, nor market concentration. This is contrasted with
the findings of the study by Tregenna (2009), who investigates the
effects of market structure, bank size and operational efficiency on the
high profit of American banks in the pre-crisis period (19942005). The
main findings are the weak efficiency effect on profitability, but a robust
and positive concentration-profit relationship.

Some studies find the important role of factors such as bank spe-
cific variables and financial systems together with market structure as
determinants of bank profitability. Demirguc-Kunt and Huizinga (1999)
measured the effects on profitability of a variety of bank and market
characteristics, such as taxation, the structure of financial systems and
financial regulations. Using commercial bank-level data from 80
developed and developing countries over 1988 1995, they
emphasised that banks with larger assets and/or lower concentration
ratios are more profitable. Demirguc-Kunt and Huiz-inga also reported
that in developing countries, the domestic banks earn smaller profits
than foreign ones, while the converse applies in developed countries.
In their extended work in Demirguc-Kunt and Huizinga (2000), they
argue that greater bank development brings about tougher
competition, higher efficiency and lower profits. Kos-midou et al.
(2005) analyse the UK commercial banking sector over the period
19952002, reporting that the cost to income ratio, cap-ital adequacy,
liquidity, and loan loss reserves affect profitability sig-nificantly.
Pasiouras and Kosmidou (2007) measure the effects of capital ratio,
cost to income ratio, loans to customers and short-term funding, bank
size, inflation, GDP growth, and concentration on bank returns for 584
domestic and foreign commercial banks in the 15 developed EU
countries over the period 19952001. The effects of all variables are
found to be significant, regardless of bank owner-ship status, except
for the concentration ratio. Furthermore, using data from seven south
eastern European countries over the period 19982002, Athanasoglou
et al. (2006) reported statistically signif-icant relationships between
profitability and such determinants as capital, inflation, operating
expenses, size, ownership status, and concentration.

With respect to the relationship between market power and bank
soundness, and focusing on concentration, it is classified by two
views: concentration-stability and concentration-fragility (e.g. Uhde
and Heimeshoff, 2009). Proponents of the concentra-tion-stability
view argue that larger banks in concentrated bank-ing sectors reduce
financial fragility through at least five channels: (i) larger banks may
increase profits, building up high capital buffers, hence allowing them
to be less prone to liquidity or macroeconomic shocks, (ii) larger banks
may increase their charter value, discouraging bank managers from
excessive risk-taking behaviour,
8
(iii) it is easier to monitor larger, but
fewer banks, resulting in the effective action of supervisory bodies, and
conse-quently reducing the risk of a system-wide contagion, (iv) larger
banks tend to be subject to providing credit monitoring services,

8
It is argued that increasing bank charter value arising from increases in market
power feeds financial stability, where increasing market share creates incentives for
bank managers to act prudently. This is substantiated by various empirical works.

and (v) due to higher economies of scale and scope, larger banks
have the potential to diversify loan-portfolio risks efficiently and
geographically through cross border activities. Beck et al. (2006) using
data on 69 countries during the period 19801997 provide strong
evidence that, in the concentrated banking system, financial crises are
less likely to occur.
On the other hand, advocates of the concentration-fragility view
argue that larger banks in a concentrated market weaken sta-bility
through three channels: (i) larger banks are seen as too big to fail
institutions, which receive guarantees from governments, and
consequently the moral hazard problem becomes more severe, (ii)
larger banks tend to charge high loan-interest rates due to their market
power, which may lead to risky projects undertaken by borrowers to
compensate for such high rates, and the consequence could be
increased default risks, and (iii) managerial efficiency such as risk
diversification in assets and liabilities may decline, resulting in high
operational risk.
Overall, the existing literature provides a fairly comprehensive
review of the effects of market power, financial structure and bank
activities on bank risks and returns. However some questions in
relation to emerging market banking systems still need to be ad-
dressed. The results of previous studies tend to indicate that the im-
pact of market power on bank performance is positive. However, such
a relationship may not be robust, in particular, when emerging
economies are taken into account. The results of empirical studies are
also mixed regarding the impact of bank concentration on finan-cial
stability, which provides scope for further investigation. This pa-per
aims at gaining greater insight into the factors affecting bank risk and
return in emerging and advanced economies.

4. The model specification and variable selection

4.1. The model specification

We develop a panel data model by building upon the existing
empirical models in bank performance through the potential influ-ence
of market structure. Following Berger (1995) and Smirlock (1985), the
traditional hypothesis can be tested by estimating prof-it using the
equation: P
ict
= f(Market Structure
ict
), where i denotes ith bank, c
denotes country, and t stands for time period, P mea-sures bank
performance, and market structure refers to either using market share
(MS) at a firm level, or using the concentration ratio (CR) at the market
level. The CR reflects the degree of collusive behaviour, where a firms
power to extract higher profits is due to oligopolistic behaviour. The
expanded version is as follows:
P
ict
a
0
a
1
MS
ict
a
2
CR
ct
e
ict
1

where CR is a measure of the 5-firm concentration ratio. This equa-
tion differentiates the two hypotheses of RMP and SCP. A coefficient
combination of a
1
> 0 and a
2
= 0 implies that banks with a higher
market share are more efficient than their rivals, and yield higher profit,
supporting the RMP theory. Conversely, a
1
= 0 and a
2
> 0, sug-gest
that the traditional SCP theory can be verified. This implies that firms
greater profitability is not affected by market share, rather rents arise
from monopolistic operation due to market concentration.
As control variables, we consider the measures of X-efficiency and
scale-efficiency (Claeys and Vander Vennet, 2008) together with other
bank-specific variables. Moreover, the model is aug-mented with
supplemented measures, which are particularly use-ful in providing a
comprehensive understanding of the factors underlying a banks net
margins and risk. In cross-country compar-isons, it is also necessary
to allow for variation in country-level variables, in which performance
determinants can vary systemati-cally across countries. We estimate
an equation of the following form:

J M

Pict a0 a1MSict a2CRct
X
bjXj;ict
X
cmYm;ct eict
2 j1 m1

eict l
i

k
t mict

where X
j
is a vector of bank-specific variables and Y
m
is a vector of
country-specific and overall financial structure factors. e
ict
is the er-ror
term, where l
i
is the unobserved individual specific effect, k
t
is the
unobserved time effects, and m
ict
is the normal stochastic distur-
bance. This is a two-way error component regression model where
l
i
_ IIN0; r
2
l
and m
ict
_ IIN0; r
2
m
.
For stability, we specify the analogous explanatory variables as in
equation (2). Hence, the financial stability (FS) model is given by:

J M

FSict a0 a1MSict a2CRct
X
bjXj;ict
X
cmYm;ct eict
3 j1 m1
eict l
i

k
t mict

This is suitable to study the impacts of banking market structure on
banking stability. The specification of CR allows us to investigate the
arguments of concentration-stability and con-centration-fragility.

4.2. Dependent variables and determinants of bank performance

In this section, we describe the dependent variables and deter-
minants of banking performance. The latter is classified into four
groups of market structure, bank-specific factors, financial envi-
ronment factors and macroeconomic environment.

4.2.1. Dependent variables
Following on from the banking literature, the profitability mea-sures are
net profits before taxes on average assets (ROAA) and net profits before
taxes on average equity (ROAE),
9
which indicates how effectively banks
assets and equity are being managed to generate rev-enues. Bank risk is
measured by the distance to default or Z-score, de-fined as the standard
deviation value that a banks rate of returns on assets has to fall for the
bank to become insolvent
10
and is computed as the ratio of the sum of
ROAA and equity-to-asset ratio over the vol-atility of ROAA. A higher Z
score indicates that the bank is more stable. An alternative measure of
bank stability, the interest coverage ratio (or interest multiplier) is also
employed, derived as net profits before taxes plus interest expenses
divided by interest expenses.

4.2.2. Market structure
The measure of RMP hypothesis is a market share, calculated as
the individual banks share of assets to total bank assets of the market.
It is expected that market share and bank profitability have a positive
relationship. The concentration ratio, which pro-vides estimates of the
extent to which the largest firms contribute to activity in an industry, is
taken to investigate the SCP hypothe-sis. Following Demirguc-Kunt et
al. (2004), we measure bank-mar-ket concentration as the fraction of
bank assets held by the five largest banks in a country.
11
The degree
of concentration of a mar-ket is expected to exert a negative influence
on competition in the market, hence it is likely to raise the banks
profits.

9
In order to capture any differences that appear in assets and equity during the fiscal
year, averages are employed.
10
Note that a more appropriate measure for bank risk is a non-performing loans ratio,
however, due to data limitations, no homogeneous proxy could be constructed for all
banks.

11
In most previous studies, the researchers used the fraction of assets held by five
largest firms in the market. Since in our sample, several countries have a limited
number of banks e.g. Estonia, Latvia, and some Middle Eastern countries, we also
applied the 4-firm concentration as well as the 3-firm concentration ratios for a
robustness test, and none of them violates our results.

4.2.3. Bank-specific variables
We consider eight bank-specific control variables that have been
shown to be instrumental in explaining bank performance. Firstly, the
interest rate spread (lending rate minus deposit rate) gauges the
extent to which interest earning capacity of an entity exceeds or falls
short of its interest cost obligations. We estimate lending rate as total
interest income over total loans and deposit rate as total interest
expenses over total deposits and short-term funds. We make an a
priori forecast of the positive influence of the interest rate spread on
risk and returns. The second variable is bank size measured by the
total assets of the bank, which cap-tures the effect of scale
efficiency.
12
Generally, the effect of a grow-ing bank size on
profitability has been proved to be positive. For example, Goddard et
al. (2004) argue that a bank size can affect the profit positively through
several channels; banks with higher as-sets benefit from economies of
scale and also large banks may ben-efit from their market powers
generating abnormal profits. Moreover, Smirlock (1985) argue that
larger banks are likely to have a higher degree of product and loan
diversifications than smaller banks, reducing risk. However, banks that
have become extremely large might show a negative relationship
between size and profit-ability. This is due to agency costs, the
overhead cost of bureaucratic processes and other costs related to
managing large banks.
Thirdly, following many studies, the ratio of equity to total as-sets is
employed as a measure of capital strength. In principle, all banks in
our sample are subject to the Basel II capital adequacy regulations
13

where capitalisation is seen as the main source to cover loan losses.
Well-capitalised banks increase banks creditwor-thiness reducing
costs of funding and lower risk of bankruptcy, and also have more
capability to develop business and deal with risks. It is, therefore,
expected that there will be a positive association with profitability and
stability (Pasiouras and Kosmidou, 2007). Note also that a bank can
benefit from holding capital in excess of the regula-tory minimum. For
example, it can possibly increase its portfolio of highly profitable
assets, because the accompanying potential risk can be insulated by
holding an adequate capital.
Fourthly, the ratio of overheads to total assets is considered to
provide information on variation in bank costs, and this is a proxy for
measuring the X-efficiency. A negative correlation between over-head
expenses and profitability and stability is expected, provided that
banks are efficiently operating with lower overheads.
14
Fifthly, the off-
balance-sheet activities to total assets ratio is specified in the model.
This variable is relatively recent in being recognised for its importance
in affecting bank performance. Casu and Girardone (2005) point out
that the European Union banking sector increasingly developed non-
traditional activities during the 1990s, therefore an empirical study
would suffer from biased results without the role of off-balance sheet
activities. Moreover, loan growth is specified based on the argument
that rapid growth is likely to yield relatively high profits. Finally, we
examine the effects of bank age and foreign own-ership status on
bank risk and returns. The dummy variable is used for banks of foreign
ownership. An institution is defined as a foreign bank if at least 50% of
the banks shares are held in foreign hands.
15

12
Due to a lack of data, we specify indirect measures of the efficiencies with the size
of the bank as a proxy of scale-efficiency and overheads to total assets ratio as an
overall measure of cost efficiency.

13
Banks are required to hold at least 8% of capital against their risk weighted assets.

14
Molyneux and Thornton (1992) among others, however, argue that high profits
earned by firms may be attributed to high salaries paid to productive human capital.

15
In this paper, in order to pursue uniformity between the two types of economy, we
maintain more than 50% share ownership to define foreign ownership. This is often
applied in the literature, for instance, see Micco et al. (2007) and Claessens and Horen
et al. (2012) who applied this definition to both developed and developing countries. It
is, however, noted that in developed markets, banks with diversified ownership can be
controlled with 20% or 30% share ownership. This caveat should be born in mind in
interpreting empirical results. Thanks are due to the anonymous referee for pointing out
this.


There is some evidence of difference in performance between foreign
ownership and domestic ownership. For example, using 7900 bank
observations from 80 countries over the period of 19881995, Claes-
sens et al. (2001) report that domestic banks in industrialised coun-
tries are more profitable than their counterparts in developing
countries, and the opposite is the case for foreign banks, indicating
that the foreign banks are more profitable in emerging economies (see
also Bonin et al., 2005).

4.2.4. Financial structure and macroeconomics
We specify two indicators of the financial structure of individ-ual
countries in the model. The first variable is domestic credit as % of
GDP provided by the banking system to all economic sectors including
financial and non-financial sectors, except to the gov-ernment sector.
A high ratio of bank credit to GDP may reflect higher risk of default for
banks. The second variable is the stock market turnover ratio,
computed as the total value of shares traded during the period divided
by the average market capitali-sation for the period. A high ratio
indicates the efficiency of stock markets, and since an efficient capital
market discloses more information about companies, banks can
benefit by reducing ad-verse selection and moral hazard risks,
improving their profitabil-ity and also stability.

In order to control the macroeconomic environment in which the
banks operate, we include the inflation rate and real GDP growth as
proxies for business cycle fluctuations. Demirguc-Kunt et al. (2004)
have shown that banks in inflationary environments have wider
margins and greater returns. Other studies (e.g. Bourke, 1989;
Molyneux and Thornton, 1992; Demirguc-Kunt and Huiz-inga, 1999)
have also demonstrated a positive relationship be-tween nominal
inflation rates and profitability. It is argued that the impact of inflation
on profitability depends on whether future inflation is perfectly
predicted or not. If bank managers fully antic-ipate inflation, then they
increase lending rates more than deposit rates, maintaining the level of
inflation-indexed real profits. According to Athanasoglou et al. (2008),
GDP growth has a positive effect on banks profitability, possibly due
to an increase in lending rates with less probability of a default rate.
However, the level of economic activity also affects the supply of
funds, i.e. deposits, and if deposit supply declines due to a rise in
consumption in line with GDP growth, the sign on the coefficient may
become negative.

5. Data sources and descriptive analyses

The source of data on the banks specific variables is the Bank-
Scope database.
16
The country level aggregate data are retrieved
from the World Bank database. Table 1 presents the dependent and
explanatory variables together with sample countries.
Several criteria are used to filter bank data. Banks must be ac-tive,
hence banks that went into bankruptcy are removed. In order to
enhance the quality of data and comparability across countries, we
selected banks that have total assets of more than a billion USD. Any
values below the 1% point and also above the 99% point in the sample
distribution were also removed. This helps alleviate the problems
arising from extreme outliers that affect estimation. These data are
only from depository and non-depository institu-tions involved in
providing funds for industry, excluding central banks and other non-
banking financial institutions. The above pro-cedure yielded an
unbalanced panel data set of 1929 banks, includ-ing 308 banks from
emerging economies (122 banks in 10 Eastern European countries
and 186 banks in 13 Middle Eastern countries)

16
The database is produced by the Bureau van Dijk, which includes more than
12,000 banks around the world, accounting for about 90% of total assets in each
country.

and 1621 banks from 17 Western European countries
17
over the
period 19992008.
Table 2 demonstrates the degree of correlation amongst depen-
dent and independent variables. Within the independent variables, the
maximum correlation is at 0.408 found between the variables of off-
balance-sheet activities (11) and equity to total asset (9). In general,
the degree of correlation among the determinants does not seem to be
of much concern as to cause a potential multicollin-earity problem.

The comparative study on mean values of the dependent and
explanatory variables are shown in Tables 3a3c in terms of region,
country and the type of banks, respectively. Comparing the statis-tics
across regions in Table 3a, wider variations are observed. This
particularly applies to the comparison between emerging banks vs.
advanced banks, whereas some of the mean values between East-ern
Europe and Middle Eastern countries seem to be close to each other.
It is observed that the returns in emerging market banks are almost
three times in terms of ROAA (1.45%) and twice in terms of ROAE
(13.27%) than those of West European banks. The t-statistics for the
mean equality for variables are mostly highly significant, confirming the
wider degree of variations. Table 3b shows sample means by country.
The higher returns are mostly found in Middle Eastern countries, e.g.
Qatar, Saudi Arabia and UAE, and the lower returns are found in many
advanced countries.
Table 3c compares the means and standard deviations (s.d.) of
variables for the commercial and non-commercial banks. Non-
commercial banks in emerging economies tend to exhibit higher
values of s.d. than those in advanced economies, highlighting a vol-
atile market. However, in the case of commercial banks, there is no
significant difference between the two markets. In the last column of
Total banks, the commercial banks appear to yield much higher
profitability measured by ROAA and ROAE than do the non-com-
mercial banks.

6. Estimation results

We first present the estimation results of the profitability and
stability models for the emerging and advanced economies. Then, we
show the empirical results for the Middle East and Eastern Eur-ope,
respectively. This is followed by the robustness tests and the
discussion of the key findings.
We estimate Eq. (2) to examine the impact of bank market
structure (i.e. bank market share and bank market concentration) on
profitability, then we estimate Eq. (3) to examine the impact of banking
market structure on the stability. Note that the models are augmented
with the interaction terms and the dummy vari-ables for the different
types of banks. The interaction terms inves-tigate whether interest rate
spread, bank age and ownership status have an independent effect on
bank returns and risk or whether their effect is channelled through the
market power possessed by banks.
18
Since the interaction terms are
highly collinear with their respective components, we run regressions
without the interaction terms in models (1), (3), (5) and (7) and with the
interaction terms but without the relevant individual components in
models (2), (4),
(6) and (8). With the bank dummy variables, all bank types are in
comparison with the counterpart of commercial banks.
In order to examine cross-section variation, the likelihood ratio and
Hausman tests are conducted for fixed and random effects,
respectively. The fixed effect models are run by the Least Square
Dummy Variable (LSDV) procedure and the random effect models

17
All banks included in the sample fall within the top 4500 banks in the world in
20102011, ranked by total assets. Furthermore, the sample covers approximately
65% of the total assets for the whole of the EU banking system and 61% of the total
assets in all Middle Eastern countries.

18
The selection of variables is based on empirical performance.

Table 1

Variables, units, expected effects, source and sample countries.

Variables Units Expected effect on returns Expected effect on risk Source

Bank profitability
ROAA Ratio BankScope
ROAE Ratio BankScope
Bank stability

Z-score Ratio BankScope
Interest coverage ratio Ratio BankScope
Bank structure

Market share Ratio Positive Positive BankScope
5-Firm concentration ratio Ratio Positive Positive BankScope
HerfindahlHirschman index (HHI) Ratio Positive Positive BankScope
Bank-specific characteristics

Interest rate spread Percentage points Positive Positive BankScope
Bank size Logarithm ? ? BankScope
Equity to assets Ratio Positive Positive BankScope
Overheads to assets Ratio Negative Negative BankScope
Off-balance-sheet activity to assets Ratio ? ? BankScope
Loan growth Ratio ? ? BankScope
Bank age Positive numb. ? ? BankScope
Foreign ownership Dummy ? ? BankScope
Financial structure

Domestic credit Ratio ? ? World Bank
Stock market turnover ratio Ratio Positive Positive World Bank
Macroeconomics

Inflation Percentage ? ? World Bank
GDP growth Percentage ? ? World Bank
Countries included
Emerging economies:
Eastern Europe: Bulgaria, CzechRep, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, Slovenia
Middle East: Bahrain, Egypt, Iran, Israel, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi, Syria, Turkey, UAE
Advanced economies:
Western Europe: Austria, Belgium, Cyprus, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Spain, Sweden, UK
Dependent variables:
ROAA: Net profits before tax as a percentage of total assets of a bank.
ROAE: Net profits before tax as a percentage of equity of a bank.
Z-score = (ROAA + CAR)/SROAA, where CAR represents capital assets ratio, and SROAA stands for standard deviation of return on assets.
Interest coverage ratio (or interest multiplier): Net profits before taxes plus interest expenses.
Market structure determinants:
Market share: Share of a banks assets to total assets in the market.
5-Firm market concentration: Share of five largest bank assets to total assets in the market.
NHHI (Normalised HerfindahlHirschman index): HHI is the summation of each countrys square of market share: If MSi represents the market shares by firm i and N is the

2

HHI_N
1

(NHHI is specified in the robustness test in Section 6.4).

number of firm in the market then HHI RMSi and NHHI 1 N
1

Other determinants: _

Interest rate spread: Difference between lending and deposit rates (lending rate as total interest income over total loans and deposit rate as total interest expenses over total
deposits and short-term funds), Bank size: Log of total assets, Equity to total asset: Capital to asset ratio, Overheads to total assets: Total overhead costs as a share of total assets,
Off-balance-sheet activities: Assets or debts that do not appear on a companys balance sheet as a percentage of total assets, Loan growth: Inflation-adjusted growth rate of bank
total loans, Bank age: the established year of a bank, Foreign ownership: Defined as a foreign bank if at least 50% of the banks shares are held in foreign hands, Domestic credit:
Domestic credit provided by banking sector as a percentage of GDP, Stock market turnover ratio: Total value of shares traded during the period divided by the average market
capitalisation for the period, Inflation: Based on consumer prices and GDP growth: Inflation-adjusted growth rate of GDP.

are by Generalised Least Squares (GLSs) procedure. The potential for
using the fixed effect, rather than the random effects model, is
determined by the highly statistical significance of the likelihood ratios
test. The fixed effect is also supported by the absence of het-
eroscedasticity based on the BreuschPagan test on the residuals
from our estimated model, indicating that the variance of each models
residuals is equal across banks.
19

19
The panel regressions are, in general, subject to endogeneity problems. The
endogeneity problem can be mitigated by applying the Generalised Method of
Moments (GMM) estimation using instrument variables. A good instrument would be a
variable which is highly correlated with regressors, but not with the error terms. One
and two lagged values of regressors and dependent variables are conventionally used
as instrument variables. However, the use of lagged variables implies loss of degrees
of freedom. This is particularly severe in our study, given the fact that the data set is an
unbalanced panel data and also with annual frequency of observations. The loss of two
degrees of freedom for each bank tends to generate poorer empirical performance. By
using the LSDV procedure, we have obtained relatively well-performed coefficients with
a satisfactory diagnostic of residuals, hence we present the LSDV estimates. In order
to check the robustness, we conducted a wider range of robustness tests in Section
6.3.

6.1. Bank profitability

Table 4 reports the empirical estimations for a banks ROAA in
panel A and a banks ROAE in panel B for banking systems in both
emerging and advanced economies separately. In order to avoid any
direct accounting links between dependent variables and inde-pendent
variables, we enter variables of total assets and overheads to total
assets with one lag into the equation.
20

The result shows that in advanced markets, the market share
coefficients are positive and statistically significant at the 5% level,
whereas the coefficients of market concentration are not signifi-cant.
This implies that market share seems to dominate market
concentration, supporting the relative-market-power (RMP), rather
than the traditional structure-conduct-performance (SCP) hypothesis.
This accords with Goldberg and Rai (1996), who also fail to find a
robust positive relationship between market concen-

20
Since ROAA
income before tax
, there is a direct accounting link between ROAA and

assets
assets.
Table 2
Correlation matrix for variables.
ROAA (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17)

(1) ROAE 0.825
***

(2) Z-score 0.431
***
0.338
***

(3) Interest cov.ratio 0.672
***
0.684
***
0.329
***

(4) Market share 0.294
***
0.285
***
0.400
***
0.249
***

(5) 5-Firm concentration 0.411
***
0.272
***
0.522
***
0.303
***
0.507
***

(6) HHI 0.410
***
0.277
***
0.456
***
0.299
***
0.489
***
0.949
***

(7) Interest rate spread 0.199
***
0.201
***
0.070
***
0.077
***
0.088
***
0.031
**
0.048
***

_0.111
***

(8) Bank size 0.090
***
0.167
***
0.108
***
0.274
***
0.326
***
0.125
***
0.089
***

_0.069
***

(9) Equity to assets 0.612
***
0.203
***
0.281
***
0.336
***
0.117
***
0.358
***
0.366
***
0.097
***

(10) Overheads to assets 0.231
***
0.058
***
0.074
***
_0.319
***
0.009 0.100
***
0.118
***
0.244
***
_0.377
***
0.322
***

(11) Off-balance-sheet activities 0.427
***
0.304
***
0.354
***
0.355
***
0.254
***
0.402
***
0.414
***
0.057
***
0.133
***
0.408
***
0.090
***

(12) Loan growth 0.344
***
0.310
***
0.237
***
0.312
***
0.170
***
0.297
***
0.290
***
_0.038
**
0.130
***
0.190
***
_0.008 0.264
***

(13) Bank age 0.083
***
0.080
***
0.026
*
0.070
***
0.036
**
0.091
***
0.090
***
_0.013 0.196
***
0.034
**
0.033
**
0.093
***
0.035
**

(14) Foreign ownership 0.149
***
0.190
***
0.111
***
0.299
***
0.256
***
0.115
***
0.119
***
0.105
***
0.281
***
0.044
***
_0.166
***
0.155
***
0.093
***
0.009

(15) Domestic credit _0.295
***
_0.221
***
_0.338
***
_0.102
***
_0.479
***
_0.378
***
_0.406
***
_0.141
***
_0.024 _0.228
***
_0.166
***
_0.243
***
_0.132
***
0.073
***
_0.053
***

(16) Stock market turnover ratio _0.021 _0.020 _0.095
***
0.032
**
_0.094
***
_0.067
***
_0.085
***
_0.033
**
0.232
***
_0.006 _0.124
***
_0.048
***
0.035
**
0.057
***
0.037
**
0.096
***

(17) Inflation 0.300
***
0.224
***
0.096
***
0.206
***
0.239
***
0.358
***
0.376
***
0.042
***
0.178
***
0.236
***
0.053
***
0.272
***
0.274
***
0.028
*
0.093
***
_0.326
***
0.122
***

GDP growth 0.312
***
0.325
***
0.384
***
0.310
***
0.334
***
0.360
***
0.346
***
0.111
***
0.108
***
0.157
***
_0.015 0.291
***
0.285
***
_0.007 0.137
***
_0.383
***
_0.020
***
0.253
***

*
Significance at 10%.

**
Significance at 5%.

***
Significance at 1%.

Table 3a
Descriptive statistics and tests of means of dataset by region average over 19992008.
ROAA (%) ROAE (%) Z-score Interest cov. Market 5-Firms HHI Interest rate Log(size) Equity to Overh. to Off. to Loan Domestic credit (% Stock turnover Regulation Inflation GDP
ratio (%) share (%) concen. (%) spread assets assets assets growth (%) of GDP) ratio (%) (%) growth (%)

Eastern European banks

Mean 1.29 13.13 1.64 82.31 11.2 79.71 1553 6.22 14.54 0.09 0.03 0.18 21.75 51.16 104.71 1.00 4.42 4.60
No. of observation 880 823 880 734 893 1076 1187 754 892 861 856 687 626 1017 1139 1220 1032 1178
Middle Eastern banks

Mean 1.55 13.36 2.13 123.42 8.66 77.68 1312 5.96 15.09 0.10 0.02 0.27 14.88 77.54 49.44 0.39 3.08 4.91
Total emerging market banks

Mean 1.45 13.27 1.94 102.05 9.63 78.56 1408 6.22 14.88 0.09 0.02 0.24 17.35 67.53 72.97 0.63 3.81 4.76

Western European banks

Mean 0.43 6.65 1.03 53.49 1.32 69.43 741 3.55 15.07 0.06 0.02 0.10 6.74 129.88 105.47 0.99 2.10 2.13
No. of observation 11540 11251 11,540 10,061 11,648 14,133 16,125 10,397 11,502 11,427 11,440 9998 9530 15,762 15,344 16,210 16,206 16,070
Tests of means (t-statistics)
_27.32
***
_25.95
***
_12.16
***
_45.35
***
_34.11
***
_63.02
***
_17.72
***

_28.03
***
_31.11
***
_16.96
***
_32.88
***

_3.49
***
_69.98
***
_48.23
***

Western vs. Eastern _36.59
***
11.35
***
108.01
***
0.50
Europe
_53.22
***
_34.52
***
_51.69
***
_27.81
***
_42.28
***
_70.52
***
_57.91
***
_11.99
***
_0.51 _39.00
***
_3.90
***
_42.56
***
_22.97
***

_27.30
***
_54.62
***

Western Europe vs. 79.66
***
40.28
***
133.75
***

Middle East
_4.81
***
_0.61 _10.43
***
_10.12
***

_9.48
***
_3.78
***

_19.22
***

_3.35
***

Eastern Europe vs. 4.89
***
12.63
***
27.38
***
16.36
***
18.83
***
9.53
***
9.34
***
28.88
***
43.44
***
11.56
***

Middle East
_57.48
***
_41.45
***
_3.35
***
_26.70
***
_52.69
***
_53.49
***
_33.92
***
_10.78
***

_45.27
***
_20.31
***
_41.44
***
_35.31
***

_50.85
***
_68.62
***

Advanced vs. emerging 6.20
***
117.26
***
29.41
***
85.33
***

economies

_
__
Significance at 5%.
***
Significance at 1%.

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Table 3b

Descriptive statistics of dataset by country average over 19992008.

Country No. of Bank profitability Bank stability Bank structure Bank-specific variables Financial structure Macroeconomics

banks

ROAA ROAE Z-score Interest Market 5-Firms Interest Log Equity Overh. Off. Loan Domestic Stock Inflation GDP

(%) (%) cov. share concen. spread (size) to to to growth credit turnover (%) growth (%)

ratio (%) (%) (%) assets assets assets (%) (% of ratio(%)

(%) GDP)

East European countries

Bulgaria 11 1.87 15.63 1.97 113.65 11.63 69.92 6.49 13.53 0.12 0.04 0.13 27.99 49.38 63.09 5.62 5.31

CzechRep 20 1.00 13.02 1.40 85.47 6.49 73.81 4.77 14.84 0.07 0.02 0.18 17.81 48.83 63.53 2.91 3.91

Estonia 3 1.61 16.78 3.77 127.87 34.48 99.44 5.21 14.79 0.09 0.03 0.18 24.23 60.49 82.51 4.01 7.39

Hungary 14 1.16 13.59 1.59 70.89 9.52 71.31 4.41 15.09 0.08 0.03 0.33 23.09 60.92 107.64 6.35 3.59

Latvia 8 1.57 15.11 2.12 113.47 16.39 69.25 6.27 15.09 0.09 0.03 0.12 27.80 67.83 99.37 3.98 7.22

Lithuania 4 1.00 11.65 2.72 62.63 25.64 90.75 6.66 15.09 1.00 0.03 0.12 26.74 49.39 70.14 2.09 5.71

Poland 25 1.33 12.91 1.42 75.36 7.63 79.46 7.23 15.03 0.09 0.03 0.17 20.96 40.69 114.18 3.22 4.20

Romania 13 1.65 11.66 1.68 77.62 10.20 76.17 10.36 14.24 0.12 0.04 0.17 26.43 38.31 87.53 7.06 5.09

Slovakia 11 0.95 13.80 1.45 62.08 11.90 87.59 6.07 14.65 0.08 0.03 0.18 14.21 51.50 92.66 5.16 4.54

Slovenia 13 1.09 10.59 1.25 77.63 9.43 79.36 4.69 14.44 0.09 0.03 0.24 21.39 58.37 92.41 5.43 4.43

Middle Eastern countries

Bahrain 15 1.63 14.52 1.92 179.37 8.47 73.90 6.83 15.06 0.11 0.02 0.17 15.46 60.27 29.82 1.81 5.99

Egypt 24 0.86 9.37 0.83 39.67 4.52 62.83 7.75 14.53 0.08 0.02 0.18 9.35 99.94 131.30 4.64 4.88

Iran 15 1.57 13.79 1.27 122.05 8.77 76.99 8.73 15.20 0.07 0.02 0.32 25.46 47.33 55.27 15.95 5.78

Israel 11 0.47 8.37 2.15 50.70 9.52 88.55 5.13 16.04 0.05 0.02 0.31 6.26 80.28 31.76 2.19 3.79

Jordan 9 1.22 11.34 2.09 116.73 11.11 88.09 6.36 14.88 0.10 0.02 0.27 12.88 97.29 35.88 2.78 6.02

Kuwait 14 2.28 16.12 3.47 159.23 11.11 71.02 7.42 15.43 0.12 0.02 0.18 16.82 78.03 26.48 2.51 2.62

Lebanon 18 0.83 12.55 2.71 120.29 7.41 59.99 5.93 14.91 0.07 0.01 0.08 11.02 180.57 27.65 3.73

Oman 8 2.24 14.90 3.38 164.04 14.08 86.93 4.47 14.21 0.13 0.02 0.35 13.76 39.02 18.59 1.55 3.72

Qatar 7 2.38 19.51 4.20 163.42 16.95 91.86 6.97 14.86 0.13 0.01 0.41 18.97 41.48 29.64 3.35 5.60

Saudi Arabia 11 2.33 18.61 3.57 179.10 10.10 69.73 4.08 16.38 0.11 0.02 0.23 15.73 58.15 23.31 2.58 3.42

Syria 5 0.38 7.51 0.16 159.17 20.83 94.50 7.09 14.50 0.07 0.01 0.35 20.52 33.98 38.07 4.04 3.89

Turkey 23 1.79 16.16 1.29 92.85 8.69 83.17 3.23 15.66 0.11 0.04 0.35 27.39 45.94 106.51 8.78 6.05

UAE 26 2.43 14.49 2.39 176.04 4.95 62.27 3.55 14.76 0.14 0.02 0.46 18.72 51.13 29.28 5.72

West European countries

Austria 78 0.42 7.92 0.99 72.97 1.79 37.24 2.57 15.00 0.05 0.01 0.10 8.74 124.52 100.69 2.00 21.87

Belgium 35 0.57 7.96 0.74 69.40 4.33 85.90 3.22 15.04 0.06 0.01 0.15 10.62 114.79 111.99 2.23 2.21

Cyprus 8 0.63 7.08 1.34 76.36 13.70 88.25 3.32 15.13 0.06 0.01 0.12 15.31 97.64 2.91 3.82

Denmark 42 1.01 9.52 1.42 97.64 3.61 72.89 3.03 14.91 0.10 0.02 0.27 16.70 148.88 86.79 2.22 1.69

Finland 8 0.60 7.91 0.94 89.40 14.71 98.11 3.36 16.53 0.07 0.01 0.16 12.72 70.65 100.27 1.87 3.16

France 217 0.60 8.68 0.93 71.67 0.72 53.10 3.73 15.42 0.07 0.02 0.15 9.76 109.77 114.01 1.78 2.20

Germany 627 0.23 4.45 0.92 29.81 0.17 41.08 3.52 14.65 0.05 0.02 0.06 3.32 141.36 99.06 1.62 6.03

Greece 16 0.42 6.62 0.13 48.19 8.64 86.41 3.49 16.03 0.08 0.03 0.16 23.52 98.14 93.05 3.30 3.92

Ireland 37 0.47 9.60 1.25 141.43 5.49 62.78 3.11 16.58 0.05 0.00 0.13 10.59 141.36 99.06 3.77 6.03

Italy 168 0.72 8.65 1.21 73.46 0.97 51.31 3.46 15.69 0.08 0.02 0.11 12.97 107.36 88.06 2.36 1.23

Luxembourg 64 0.58 11.84 1.09 132.79 2.04 43.78 7.93 15.32 0.05 0.01 0.18 8.11 125.17 105.36 2.40 4.12

Malta 6 0.99 11.77 6.66 146.96 28.57 89.79 4.08 14.96 0.08 0.01 0.15 4.23 134.39 115.42 2.50 2.44

Netherlands 33 0.69 9.78 1.29 104.74 5.52 90.76 2.99 15.58 0.06 0.01 0.13 13.35 164.03 101.76 2.22 2.42

Portugal 24 0.71 11.07 1.00 77.60 5.88 82.08 4.94 15.74 0.07 0.02 0.26 13.58 148.85 103.53 2.91 2.03

Spain 109 0.76 9.73 1.41 108.07 1.99 64.64 2.10 16.03 0.07 0.01 0.21 17.40 141.11 122.72 3.22 3.77

Sweden 22 0.81 10.42 1.26 97.05 6.80 77.26 1.95 15.74 0.07 0.02 0.20 12.92 108.22 97.15 1.60 2.95

UK 127 0.57 8.13 0.81 84.56 1.25 54.86 3.47 15.73 0.06 0.02 0.15 9.95 152.35 109.82 2.81 2.60

tration and profitability for a sample of large banks located in 11
European countries during the period 19881991.
21

In the emerging market banking systems, given an insignificant
coefficient of market share, market power gained through market
share does not seem to be the key factor in enabling banks to earn a
relatively high rate of return. A negative significant coefficient of market
concentration is unexpected but this reflects Fig. 1, where profitability
had an upward trend in contrast to the downward trend of market
concentration. We leave discussion of the effects of market structure
to Section 6.5.
With respect to bank-specific characteristics, all of the coefficients
are significant in models either with or without interaction terms at least
at the 10% level, except for the overheads to total assets in mod-els
(7) and (8). The variable interest rate spread is well-determined in the
profitability indicators with the correct positive sign for both

21
Some existing literature is supportive of the SCP hypothesis. For example, Claeys
and Vander Vennet (2008) argue that the SCP hypothesis holds well with Western
European banks. In a major survey, Gilbert (1984) reported that 32 out of 44 studies on
the US banking industry were found to support the traditional hypothesis of the
existence of collusive profits.

emerging and advanced economies. The magnitude of the coeffi-
cients is higher in banks operating in emerging economies, indicating
that these banks are likely to adjust interest rates more in order to
raise profits. The interaction of interest rate spread with market share,
however, enters with a negative coefficient in (2) and (4) in emerging
economies. Possibly, an increasing market share allows banks to
lower the spread which is already high at 6.22 (Table 3a), hence
increasing their deposit funds and raising their profitability. The reverse
situation occurs in the case of advanced economies, where the
coefficients on the interaction term is positive, indicating that, as banks
expand their market share, opportunities to raise the spreads are
enhanced to increase their returns.
Bank size enters with a negative coefficient for emerging econo-
mies, but with a positive coefficient for advanced economies. This
contrasting result suggests that larger banks have lower rates of re-
turn for the former, but have higher rates of return for the latter. The
result may reflect the scale inefficiencies in emerging large banks, and
explain the negative impact on profitability of market concentration
constituted by the five largest banks. While the theory provides
conflicting predictions about optimal bank asset structures, some
empirical literature also tends to find a similar result to ours
Table 3c

Descriptive staistics of dataset by bank types and region average over 19992008.

Variable Emerging economies (no. of obs. 3080) Advanced economies (no. of obs. 16,210) Total banks (no. of obs. 19,290)

Commercial Non-commercial Commercial Non-commercial Commercial Non-commercial
(2460) (620) (6350) (9860) (8810) (10,480)

Mean St. dev. Mean St. dev. Mean St. dev. Mean St. dev. Mean St. dev. Mean St. dev.

Bank profitability
ROAA (%) 1.43 1.25 1.52 1.37 0.6 0.87 0.34 0.42 0.87 1.08 0.39 0.56
ROAE (%) 13.38 8.17 12.78 8.78 9.16 8.62 5.43 4.57 10.52 8.71 5.78 5.1
Bank stability

Z-score 1.91 1.28 2.06 1.32 1.09 1.19 0.99 0.29 1.32 1.27 1.06 0.49
Interest cov. ratio (%) 99.17 77.94 119.74 83.1 77.82 81.3 43.26 47.57 84 80.91 45.34 50.43
Bank structure

Market share (%) 10.33 12.89 6.46 8.01 2.78 7.83 0.58 3.06 5.25 10.4 0.89 3.73
5-Firms concentration (%) 78.56 15.08 78.56 15.14 69.43 13.67 69.43 17.32 74.68 16.98 74.68 17.53
Bank-specific variables

Interest rate spread (%) 7.94 5.17 4.24 8.73 4.5 5.85 2.6 2.49 6.22 5.64 3.42 2.94
Log(size) 14.92 1.42 14.7 1.35 15.37 1.61 14.93 1.2 15.22 1.56 14.92 1.21
Equity to assets 0.09 0.04 0.1 0.05 0.06 0.04 0.06 0.03 0.07 0.04 0.06 0.03
Overheads to assets 0.02 0.01 0.03 0.02 0.02 0.01 0.02 0.01 0.02 0.01 0.02 0.01
Off-balance-sheet activities 0.245 0.19 0.21 0.222 0.161 0.169 0.076 0.08 0.191 0.18 0.082 0.096
Loan growth (%) 16.92 15.15 19.65 14.68 10.82 13.78 5.15 8.81 13 14.58 5.7 9.51
Financial structure

Domestic credit (% of GDP) 69.32 39.6 60.24 20.15 127.6 28.26 131.3 18.79 112.35 40.69 127.64 24.56
Stock turnover ratio (%) 75.41 55.99 62.89 55.22 100.08 47.59 109.02 54.65 93.63 51.08 106.57 55.65
Macroeconomics

Inflation (%) 3.81 2.59 3.81 2.59 2.1 0.87 2.1 0.87 2.28 1.28 2.28 1.28
GDP Growth (%) 4.75 2.34 4.81 2.32 2.47 1.87 1.9 1.45 3.01 2.21 2.03 1.62

with economies of scale and scope for smaller banks, and disecono-
mies of scale for larger financial institutions.
For both economies, the relatively high and significant coeffi-cients
of equity to total assets and overheads to total assets are found, with
the expected positive and negative signs, respectively. Capital
strength and overhead expenses appear to be the robust determinants
of bank profitability. A high capital adequacy in-creases ROAA and
ROAE, and this is consistent with previous stud-ies (e.g. Athanasoglou
et al., 2008) in support of the argument that well capitalised banks face
lower costs of external funding, result-ing in higher profitability, and
also bank capital acts as a safety net in the case of adverse
developments in the economy. The negative estimate on the
overheads is supportive of the X-efficiency hypoth-esis, in that efficient
management may contribute to reducing overhead costs, whilst raising
profitability. Controlling for all other relevant factors, the coefficient on
the off-balance-sheet activities is statistically highly significant for the
advanced markets banking systems. With a negative sign, it is
associated with lower returns, conflicting with Demirguc-Kunt and
Huizinga (2010).
22

Market growth, measured as real growth of total loans, appears to
be another important determinant for both types of economies; the
fast-growing banking market tends to yield a market environ-ment,
which promotes higher returns. Bank age is significant, yet the
direction of the effect is opposite for emerging economies and
advanced economies. Older banks in emerging countries are more
profitable, compared to their counterparts in advanced econ-omies.
We also find that foreign banks in emerging economies seem to earn
greater profits, whereas their counterparts in ad-vanced economies
earn lower profits. Foreign banks entrance to emerging markets may
not enhance competition, but with new technology and services they
can be superior to domestic banks in terms of profitability. In contrast,
foreign banks may face damp-

22
Using data for 1334 banks in 101 countries over the 19952007 periods, Demirguc-
Kunt and Huizinga (2010) found that expansion into fee income (non-interest income)
increases the rate of return on assets, and it could offer some risk diversification
benefits.

ened profitability in the intensified competition stemming from mature
domestic banks. The real impact of bank ownership status on returns
may also depend on market power in advanced mar-kets; in model (8),
the variable of the interaction between owner-ship and market share
yields a positive coefficient suggesting that foreign banks with a
substantial market share are more profitable.
Turning to financial structure and macroeconomic variables, there
are also different results between emerging and advanced economies.
While there is a highly significant relationship between domestic credit
and profitability, the coefficients have the opposite sign between the
two types of economies. One possible explana-tion of the negative
relationship would be that, in emerging econ-omies, providing credit to
the private sector may be often influenced by government policies, and
that banks may be obliged to provide credit even for unprofitable
investment projects.
23
On the other hand, in a competitive
environment, credit is released for viable projects in advanced banking
systems, consequently leading to the earning of higher profits. Since
increasing efficiency in stock markets should contribute to more and
better information and to making the process of selection and
monitoring of borrowers easier for banks, a complementary
relationship is expected between the development of banking systems
and the stock markets. Such asso-ciation is supported by the models
(3) and (6). The effects of inflation and GDP growth on bank
profitability are negative and positive respectively for advanced
economies: lower rates of inflation and high GDP growth are
associated with higher returns in mature banks. GDP growth
influences banks through raising demand for loans. By looking at the
types of bank, it is observed that investment banks generate higher
ROAA than do commercial banks, for both types of economies. Islamic
banks tend to be more profitable than commercial banks when the
profitability is measured by ROAE. Note that commercial banks in
advanced countries predominantly earn better returns when compared
with other types of banks, except for investment banks.

23
See, for example, Moore (2009) for the former Eastern European countries.

Table 4

Determinants of the returns (ROAA and ROAE): emerging economies vs. advanced economies.

Variable Panel A: ROAA Panel B: ROAE

Emerging economies Advanced economies Emerging economies Advanced economies

(1) (2) (3) (4) (5) (6) (7) (8)

Market structure

Market share 0.0051 0.0135
***
0.0944 0.2553
***

(0.35)
_0.0176
*

(2.80) (0.75)
_0.0431
*

(4.32)

5-Firms concentration _0.0165
*
0.0016 0.0009 _0.0215
*
0.108 0.0128

(_1.75) (_1.77) (0.71)

(1.01)
(_1.77) (_1.86) (1.04)

(1.23)


Interest rate spread 0.0980
***
0.0385
***
0.6573
***
0.2723
***

(5.75)
_0.1811
(10.51) (4.23)
_1.6185
(5.54)

Bank size: Log(total assets) _0.0245
*
0.2221
***
0.0612
***
_3.6616
**
1.7227
***
0.4883
**

( 1.73) ( 0.83) (7.75) (3.09) ( 2.22)
(_
1.20)
(4.76)

(2.01)

Equity to total assets
_ *** _ ***
0.7573
***
0.6921
*** _ ** *** *** ***
1.5912 1.1774 4.9956 7.7736 3.5258 2.8383
(7.02) (4.67) (21.49) (19.91) (2.53) (4.11) (7.54) (6.33)

Overheads to total assets _0.0164
*
_0.1373
*
_0.1045
***
_0.1245
***
_2.5139
**
_0.9354 _0.1345 _0.2395

( 1.77)
(_1.77)
(
_
2.98) ( 3.55)
(_
2.11) ( 0.39)
(_0.30)

(_0.55)

Off-balanc. to total assets
_ * *** _ *** * _ * *** ***
0.5703 0.3769 _0.4841 _0.6487 2.7875 5.4018 _7.7641 _8.7048
(1.69)
(0.94)
(
_
4.26)
(_
5.61) (1.82) (1.74) ( 5.39) ( 6.02)
Market growth: Loan growth 0.0094
*** *** *** ***
0.0785
***
0.0771
*** _ ** _
0.0089 0.0030 0.0022 0.0161 0.0097
(3.20) (2.67) (5.10) (3.68) (3.01) (2.81) (2.18) (1.32)

Bank age 0.0494
*
_0.0359
***
0.8686
***
_0.2641
***

Foreign ownership
(1.79) ***
(_7.79)
***
(3.49) **
(_4.54)
***

0.0413 _0.1417 0.0522 _0.1177

(3.70)
(_4.11)
(2.08)
(_3.83)

Overall financial structure
_0.0074
**
_0.0104
***

_0.0907
***
_0.0809
***

Domestic credit provide by banking 0.0024
***
0.0032
***
0.0467
***
0.0518
***

( 2.35) ( 2.77) (4.68) (6.21)
(_3.07) (_
2.62)
(7.10)
(7.92)

Stock turnover ratio
_ _
0.0004
*
_0.0004
***
_0.0042

_0.0002 0.0027 0.0250 0.0500 0.0011
(_0.12) (1.31)

(1.71)
(_1.53)
(1.50)

(3.13)

(0.26)
(_1.33)

Macroeconomics
_0.0153 _0.0130 _0.0454
***
_0.0682
***
_0.0850

_0.7101
***
_0.8729
***

Inflation 0.1060

( 0.94) ( 0.67)
(_
3.69) ( 5.55) ( 0.59) (0.69) ( 4.68) ( 5.86)
GDP growth
_ _ *** _ *** _
0.2453
* _ *** _ ***
0.0172 0.0110 0.0203 0.0222 0.2137 0.3250 0.3290
(1.11) (0.63) (4.85) (5.19) (1.60) (1.74) (6.24) (6.29)

Vector products
_0.0024
*

_0.0039

Market share
*
interest rate spread 0.0083
***
0.0445
**

(_1.79)

(5.36)

(_
0.35)
(2.28)

* **
Market share bank age 0.0004 _0.0001 0.0114 0.0014

* (0.67) (_0.90) (2.29) (1.37) ***

Market share ownership _0.0012 0.0081 _0.1655 0.6551

(_0.05)
(0.48)
(_0.95)
(3.19)

Bank type and regional dummies
_0.3130

Dummy investment 0.8087
**
1.0649
**
0.3081
***
0.3255
***
2.2980 0.6259 1.0281

Dummy Islamic
(2.20) (2.18) (3.25) (3.34) (0.49) ** (_0.06) (0.50) (0.81)

0.4323 0.3819 4.3504 3.7396

(1.61) (1.25)
_0.0820

_0.1495
***

(2.04) (1.61)
_3.0778
***
_3.4857
***

Dummy real estate 1.25,462
*
0.3344 8.9391 3.0305

Dummy savings
(1.69) ** (0.40) * (_1.52)
*** (_2.72) *** (1.45) ** (0.46) * (_4.51)
*** (_5.09) ***
1.3141 1.1445 _0.2009 _0.2601 11.0733 9.8667 _3.8315 _4.1693
Dummy cooperative
(2.22) (1.70) (_6.45) *** (_8.21) *** (2.21) (1.79) (_9.71) *** (_10.54)***

_0.7824 _0.8747 _0.1521 _0.2262 _4.8488 _5.1142 _2.9278 _3.4715

(_1.44) (_1.42) (_4.74) (_7.04) (_1.05) (_1.01) (_7.21) (_8.67)

AR(1) q = 0.0838 q = 0.0825 q = _0.0428 q = _0.0330 q = 0.1291
*
q = 0.0149 q = 0.0165 q = 0.0103

2 (1.48) *** (1.44) *** (_0.12) *** (_1.61) *** (1.78) *** (0.25) *** (0.87)
*** (0.54)
***
Likelihood ratio (v ) 408.26 389.41 3479.64 3510.95 418.98 418.30 3677.85 3747.99
F-statistic 10.65 8.71 11.90 11.31 6.23 5.51 9.70 9.58

R
2
-adjusted 0.75 0.72 0.69 0.67 0.63 0.60 0.64 0.63

Standard error of regression 0.54 0.58 0.28 0.29 4.31 4.51 3.47 3.48

No. of countries 23 23 17 17 23 23 17 17

The dependent variable in panel A is return on average assets defined as net profits before tax as a percentage of total assets of a bank. The dependent variable in panel B is return
on average equity defined as net profits before tax as a percentage of equity of a bank. Bank dummy variables: all bank types are in comparison with the counterpart of commercial
banks.
We estimate all regressions using bank and time fixed effects and clustering at bank level. t-Values are in parentheses.
AR (1): ArellanoBond test that average auto-covariance in residuals of order 1 is 0 (H0: no autocorrelation). In order to avoid any direct accounting li nks between dependent and
independent variables, we enter variables of Total assets and Overheads to total assets with one lag into the equation.
*

**
Significance at 5%.

***
Significance at 1%.

Table 5

Determinants of risk (Z-score and interest coverage ratio): Emerging economies vs. advanced economies.

Variable Panel A: Z-score Panel B: Interest coverage ratio


(1) (2) (3) (4) (5) (6) (7) (8)

Market structure

Market share 0.0408
*
0.0065
**
0.0189 0.0568
***

(1.78)
_0.0004
(2.15)
_0.0034
***

(1.05)
_0.0147
(5.15)
_0.0002

5-Firms concentration _0.0054 _0.0032
***
_0.0099 0.0007

(_0.36) (_0.03) (_6.12) (_6.51) (_0.98) (_1.49) (0.34)
(_0.08)


**
0.0010
*
0.0912
***
0.0273
***

(1.96)
_0.1923
(1.73) (4.49)
_0.0030
(3.06)

Bank size: Log(total assets) _0.7007
**
0.0101 0.0043 _0.2545 0.0667 0.0390

( 2.15) ( 0.59)
(0.55)
(0.24)
(_
1.15) (
_
0.02) (0.95) (0.87)
_ * _ * **
0.1036
** *** ***
0.5158
***
0.8379
***
0.5101 0.6001 0.2141 1.3999 1.4305
(1.71) (1.75) (2.15) (2.26) (3.53) (5.43) (5.61) (9.95)

Overheads to total assets 2.2145
***
2.2860
***
0.0639
***
0.0635
***
_0.4733 _0.3740 _0.3323
***
_0.4102
***

(4.94) (5.16)
(2.87)

(2.90)

(_
1.52) (
_
1.19) ( 3.98) ( 5.06)
Off-balanc. to total assets 0.3940 0.3682
*** *** ** ** _ * _ **
0.2551 0.2459 1.0471 1.0946 0.2763 0.4193
(0.64) (0.60) (3.57) (3.45) (2.44) (2.52) (1.87) (2.16)

Market growth: Loan growth 0.0052 0.0029 0.0010
***
0.0010
***
0.0046 0.0056 0.0013
*
0.0023
*

(1.04) (0.57) (2.65) (2.79) (1.34) (1.55) (1.78) (1.71)

Bank age 0.2958
***
_0.0035 0.1214
***
0.0028

(5.87)
(_
1.18) (3.46) (0.24)

Foreign ownership 0.2614
** **
0.1786
*
0.2834
**
0.1017
(2.10) (1.99) (1.73) (2.31)

_0.0242
***
_0.0195
***

_0.0017 _0.0020

***
0.0013
***
0.0062
***
0.0071
***

( 4.16) ( 3.38) (3.43) (4.00) (
_
0.42)
(_
0.49) (5.22) (6.00)
Stock turnover ratio
_ _
0.0003 0.0002
**
_0.0004 _0.0006

0.0015 0.0042 0.0018 0.0058

(0.45)

(1.24)

(1.42)

(1.32)

(0.75)

(2.53)
(_0.70) (_1.00)

Macroeconomics
_0.0642
**
_0.0523
*
_0.1333
***
_0.1365
***

_0.0267 _0.0220 _0.1388
***
_0.0966
***

Inflation

(_2.25) (_1.79) (_
17.32) ( 18.04) (
_
1.37) (
_
1.06) ( 4.91) ( 3.48)
GDP growth
*** _ *** *** ** _ *** _ ***
0.0094 0.0007 0.0393 0.0393 0.0624 0.0475 0.0695 0.0669
(0.35) (0.03) (14.92) (14.95) (3.44) (2.49) (7.18) (6.94)

Vector products

Market share
*
interest rate spread 0.0024 0.0025
***
0.0006 0.0041

(1.26) (2.64) (0.44) (1.14)

Market share
*
bank age 0.0015 _0.0001 0.0007 0.0004
**

(1.48)
(_
0.33) (1.03)
(2.05)

*
0.0389
* **
0.0068
** *
Market share ownership 0.0107 0.0320
(1.76) (2.03) (2.28) (1.77)

Bank type and regional dummies

_0.0251 _0.0249

Dummy investment 0.2977 0.2408 0.6539
*
0.5644 0.0378 0.0899

Dummy Islamic
(0.51) (0.40) (_0.53) (_0.53) (1.69) * (1.42) (0.17) (0.41)

0.1860 0.0436 0.3781 0.2136

(0.55) (0.12)
_0.0481
*
_0.0476
*

(1.68) (0.92)
_0.5402
***
_0.6200
***

Dummy real estate _0.1749 _0.3067 _0.0468 _0.4239

Dummy savings
(_0.16) (_0.28) (_1.89) (_1.89) (_0.06) (_0.58) (_4.36) *** (_5.02) ***

0.3295 0.1521 _0.0027 _0.0035 0.7183 0.6507 _0.4380 _0.5053
Dummy cooperative
(0.41) (0.18) (_0.18) (_0.24) (1.33) (1.17) (_6.07) (_7.06) ***

0.0307 _0.1285 _0.0193 _0.0222 _0.3131 _0.5041 _0.0821 _0.1890

(0.04)
(_0.17) (_1.28) (_1.51) (_0.66) (_1.03) (_1.11) (_2.61)

AR(1) q = _0.0381 q = _0.0242 q = _0.0343 q = _0.3522
***
q = 0.0513 q = 0.0278 q = 0.1381
***
q = 0.1382
***

( 0.61)
(_
0.38) ( 0.93) ( 4.48) (0.92) (0.50) 6.94 (6.94)
2 _ *** *** _ *** _ ***
307.70
***
291.72
*** *** ***
Likelihood ratio (v ) 333.42 341.66 2101.13 2129.09 3449.31 3508.36
F-statistic 3.71 3.75 5.90 5.95 8.52 7.82 14.08 14.24

R
2
-adjusted 0.46 0.47 0.49 0.50 0.71 0.69 0.72 0.73

Standard error of regression 0.90 0.89 0.18 0.18 0.60 0.61 0.65 0.64

No. of countries 23 23 17 17 23 23 17 17

The dependent variable in panel A is the Z-score, which is defined as [(ROAA + CAR)/SROAA], where ROAA is return on average assets, CAR represents capital assets ratio, and
SROAA stands for standard deviation of return on assets. The dependent variable in panel B is the interest coverage ratio (interest multiplier) is defined as net profits before taxes
plus interest expenses divided by interest expenses. Bank dummy variables: all bank types are in comparison with the counterpart of commercial banks. We estimate all regressions
using bank and time fixed effects and clustering at bank level. t-Values are in parentheses. AR (1): ArellanoBond test that average auto-covariance in residuals of order 1 is 0 (H0:
no autocorrelation). In order to avoid any direct accounting links between dependent and independent variables, we enter variables of Total assets, Equity to total assets and
Overheads to total assets with one lag into the equation.
*

**
Significance at 5%.

***
Significance at 1%.


Table 6

Determinants of risk and returns in emerging economies (Eastern Europe vs. Middle East).

Variable Panel A: bank profitability: ROAA Panel B: bank stability: Z-score

Eastern Europe Middle East Eastern Europe Middle East

(5) (1) (7) (3)

Market structure

Market share 0.0424 0.0042 0.0254
**
0.0147
*

(1.16) (0.20) (2.12) (1.76)

5-Firms concentration _0.0137 _0.0391
***
_0.0024 _0.0412

(_0.88) (_2.72) (_0.23) (_1.47)


**
0.1895
***
0.0069
*
0.0670
*

(2.26) (5.61) (1.87) (1.71)

Bank size: Log(total assets) 0.0224 0.3439 0.2937
*
_1.4165
*

(0.10)

(0.82)

(1.68)

(_
1.72)

* *** * **
0.4301 2.2128 0.3323 0.6618
(1.79) (6.20) (1.70) (2.91)

Overheads to total assets _0.1172
**
_0.7347
*
_0.6535
**
4.4631
***

(_
2.32) (
_
1.69) (
_
2.31)
(5.07)

Off-balanc. to total assets
*** ** *
1.7960 _1.2054 0.5010 0.6460

(3.06)

(_
2.27) (1.81)
(0.62)

Market growth: Loan growth
** *
_0.0003

0.0050 0.0068 _0.0120

(2.02)

(1.70)

(_
0.09)
(_1.50)

Bank age
*** **
0.0280 0.1692

(3.69) (2.14)

Foreign ownership _0.1005 0.0364
***
0.0943
**
0.1453
*

(_0.79) (3.80)

(2.07)

(1.69)

_0.0152
***

_0.0088 _0.0460
***

*

(1.71) (3.30) (_1.55) (_5.14)

Stock turnover ratio _0.0004 0.0025 0.0017 0.0078

(_0.12) (0.84)

(0.74)

(1.34)

Macroeconomics
_0.0625
*

_0.1191
*

Inflation 0.0033 0.0494
***

GDP growth
(0.13) (_1.82) * (2.49) * (_1.81)

0.0318 _0.0354 0.0544 _0.0511

AR(1)
(0.78)
(_1.94)
(1.74)
(_1.43)

q = 0.0662 q = _0.0381 q = _0.0504 q = _0.0059

(0.79)
(_
0.53) (
_
0.70) ( 0.08)
2
219.82
*** *** *** _ ***
Likelihood ratio (v ) 175.01 106.28 199.82
F-statistic 5.26 13.25 1.68 4.12

R
2
-adjusted 0.62 0.80 0.21 0.50

Standard error of regression 0.58 0.53 0.44 1.05

No. of countries 10 13 10 13

The dependent variable in panel A is return on average assets defined as net profits before taxes as a percentage of total assets of a bank. The dependent variable in panel B is the
Z-score, which is defined as [(ROAA + CAR)/SROAA], where ROAA is return on average assets, CAR represents capital assets ratio, and SROAA stands for standard deviation of
return on assets.
We estimate all regressions using bank and time fixed effects and clustering at bank level. t-Values are in parentheses.
AR (1): ArellanoBond test that average auto-covariance in residuals of order 1 is 0 (H0: no autocorrelation). In order to avoid any direct accounting links between dependent and
independent variables, we enter variables of Total assets, equity to total assets and overheads to total assets with one lag into the equation.
*

**
Significance at 5%.

***
Significance at 1%.

6.2. Bank stability

We next explore how a banks Z-score and interest coverage ra-tio
are related to the market structure and other determinants of bank
performance. Table 5 presents the regressions of the Z-score in panel
A and the interest coverage ratio in panel B. All explana-tory variables
in both panel regressions are analogous to the rate of return
regressions in Table 4, except for the fact that one period lag of equity
to total assets is specified in order to avoid direct accounting
relationships between capital and the Z-score.
24
The dependent
variables are the inverse indicators of bank risk, hence a positive
(negative) sign on the coefficients implies an increase (de-crease) in
stability.

24
Z
ROAACAR
, hence there is an accounting link between equity (CAR: capital asset rROAA
ratio) and Z-score.

Both the Z-score and the interest coverage ratio are, in general,
positively and significantly related to market share at least at the 10%
level, suggesting that a greater market share increases bank stability.
By contrast, the effect of market concentration on the Z-score is
significantly negative in advanced economies, meaning that
concentrated markets pose some risk; concentration may in-duce
incentives for banks to take-on more risk, supporting the
concentration-fragility hypothesis. This finding is in line with that of De
Nicolo et al. (2004) who find that banks with more concen-tration are
prone to be vulnerable to systemic failure for over 100 countries
banks, using an indicator of aggregated Z-index as stability. On the
contrary, Beck et al. (2006) using data on 69 coun-tries during the
period 19801997 provide evidence that in the concentrated banking
system financial crises are less likely to occur.

Given significant coefficients, the variables of the Z-score and the
interest coverage ratio are closely related to bank-specific

factors. With a positive sign on the coefficient of interest rate spread,
banks operating in both types of economies seem to be-come stable
as the spread widens. Bank size proxied by total assets does not
appear to improve bank stability. A high capital ratio is found to
contribute to bank stability, being consistent with theory. The
overheads are positively related to stability, when it is mea-sured by
the Z-score. The positive association can occur, for in-stance, if higher
overheads imply that banks invest more in human capital, and it
proves to be a valuable asset, we may ob-serve an increased stability
in banks with the specialised skills. Off-balance-sheet activities would
seem to contribute to stability in advanced economies. Note that in
Table 4, we find a negative impact of off-balance-sheet business on
the returns, but this new finding for risk indicates a trade-off between
risk and returns.
For advanced economies, market growth appears to provide a
favourable effect on the banks stability. Bank age matters in emerging
economies, where older banks seem to be more stable compared with
younger banks, which is intuitively plausible for the less developed
markets. Incumbent banks with an established reputation tend to have
a long stable relationship with customers, and to have a better access
to external funds, largely avoiding liquidity shortage. Notably, model
(8) suggests that the bank age effect is enhanced through market
share for advanced economies. The increasing presence of foreign
banks in an economy exerts a positive impact on bank stability for both
economies, which would be strengthened with the market power (see
models (2), (4), (6) and (8)).

In terms of the effect of financial structure, the sign on the sig-
nificant coefficients is consistent with that in the profitability
regressions. An increase in releasing domestic credit leads to lower
profitability and to increasing instability in emerging economies. The
result emphasises the fact that immature banks tend to invest in risky
investment projects or to release funds to low quality bor-rowers with a
lack of adequate screening and monitoring systems in place.
Moreover, the government intervention in allocation of credit in some
emerging countries may force banks to engage in some unproductive
projects. Stock market efficiency does not seem to be much
associated with bank stability.

Table 7
Normalised Herfindahl-Hirschman index (NHHI).

The macroeconomic variables seem to significantly impact on bank
risk. The stability improves when a country enjoys high GDP growth in
a deflationary period. Note that given the negative significant
coefficients on real estate, savings and cooperative banks in models
(7) and (8), commercial banks are shown to be more stable than these
counterparts.

6.3. Emerging economies

While the Western European banks are relatively uniformed in
terms of banking operations, regulations and structures, a heterog-
enous banking system is often observed among emerging econo-mies.
We estimate the model by separating the emerging banks into two
groups of the Eastern Europe and Middle East. See Table 6, where
the models are estimated for risk (Panel A) and return (Panel B) using
the same LSDV procedure. Note that Bank age is not spec-ified for the
Eastern Europe due to the fact that most of banks were established
around the transition period of early 1990s.
A couple of distinctive features are mainly observed in the bank-
specific significant variables between the two regions of emerging
countries. The effect of off-balance to total assets on profitability is the
opposite direction in the ROAA model. Eastern Europe gains with the
off-balance sheet activities by generating higher profitability, whereas
Middle East poses a decline in returns by engaging in this. Although
the inverse relationship is consis-tently observed for the effect of
overheads to total assets on prof-itability for both regions, with respect
to stability, it shows the opposite sign on the coefficient between
Eastern Europe and Mid-dle East. Overheads cost includes operating
expenses as well as personnel expenses, and it is argued that the
former differs across countries more than the latter does. Hence, the
different result may be due to the diverse operating systems in their
respective banking sector.

In terms of market structure, the results seem to be consistent with
the original consolidated result, supporting the key findings: For
profitability, market share remains insignificant, and concen-tration
continues to exerts an adverse influence. For the latter, a significant
effect is found only for Middle East, and one may

Variable Panel A: ROAA Panel B: ROAE


(1) (2) (3) (4) (5) (6) (7) (8)

Profitability model

Market structure

Market share 0.0136 0.0104
***
0.0204 0.3466
***

(1.27)
_0.3179
***

(4.34) (0.47)
_0.9076
**

(4.55)

NHHI _0.2843
***
0.0261 0.0752 _0.7640
*
0.6180 0.7190

(_3.79) (_4.22) (0.66) (0.46) (_1.88) (_2.31)
(0.39) (0.98)

Variable Panel A: Z-score Panel B: interest coverage ratio


(1) (2) (3) (4) (5) (6) (7) (8)

Risk model

Market structure

Market share 0.0513
*
0.0108
*
0.0129 0.0415
***

(1.77)
_0.1477
(1.75)
_0.0956
***

(1.20)
_0.1730
(4.07)
_0.5408

NHHI _0.0911 _0.0674
***
_0.2842
*
_0.2608
***

(_0.40) (_1.08) (_5.01) (_9.73) (_1.76) (_1.11) (_3.55) (_1.44)

We estimate all regressions using country and time fixed effects and clustering at bank level. t-Values are in parentheses.
The detailed results with other determinants are available from the authors upon request.
*

**
Significance at 5%.

***
Significance at 1%.


.016
(a)

Egypt

c
a
p
i
t
a

.014

p
e
r

.012

r
e
a
l

G
D
P

.010

.008

Iran

p
e
r

b
a
n
k
s

.006 Romania

Bulgaria
Poland Turkey
o
f

.004 Syria
Jordan

Lebanon

N
u
m
b
e
r

Cezch Rep.
.002
Hungary

Slovakia Latvia

Saudi UAE

Slovenia

Bahrain

.000
Israel Lithuania Estonia
Oman
Kuwait
Qatar
0.0 0.5 1.0 1.5 2.0 2.5

ROAA

.016
(c)

p
e
r

c
a
p
i
t
a

Egypt

.014

.012

G
D
P

.010

r
e
a
l

.008

Iran

p
e
r

b
a
n
k
s

.006

Romania
Bulgaria

Poland

Turkey

o
f

.004 Syria
Jordan
N
u
m
b
e
r

Lebanon

Cezch Rep.
.002
Hungary

Slovenia
Slovakia Latvia
Saudi

Israel
UAE Bahrain
Lithuania Oman Kuwait

.000
Estonia
Qatar
4 8 12 16 20

ROAE

(b)
.012

c
a
p
i
t
a

.010

France

p
e
r

Italy

G
D
P

.008

r
e
a
l

Spain

p
e
r

.006

b
a
n
k
s

UK

.004

o
f

Austria

N
u
m
b
e
r

.002
Ireland Belgium
Potugal

Netherlands Denmark
Greece Luxembourg
Sweden Malta

Cyprus

.000
Finland

0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2

ROAA

(d)
.012

c
a
p
i
t
a

.010

p
e
r

France

G
D
P

.008
Italy

p
e
r

r
e
a
l

Spain

.006

b
a
n
k
s

UK

.004

o
f

Austria

N
u
m
b
e
r

.002

Belgium Ireland
Potugal

Greece

Luxembourg

Denmark Netherlands

Cyprus
Finland
Sweden
Malta

.000

6 7 8 9 10 11 12 13 14

ROAE
Fig. 2. (a) Number of banks per real GDP per capita and return on assets (emerging economies). (b) Number of banks per real GDP per capita and return on assets (advanced
economies). (c) Number of banks per real GDP per capita and return on equity (emerging economies). (d) Number of banks per real GDP per capita and return on equity (advanced
economies).

wonder that this may be due to a stronger state intervention on large
banks in this region. With respect to Z-score models, it was found that
market share acted to stabilise the banking sector in Ta-ble 5, and this
effect is well-sustained in both types of emerging countries.

6.4. Robustness tests

We verify the robustness of the empirical results by applying an
alternative measure of market concentration, the normalised Her-
findahlHirschman index (NHHI).
25
Table 7 shows the results with the
model specification being analogous to Tables 4 and 5. In order to
save space, we only present the estimates of market share and
NHHI.
26
The coefficients are mostly consistent in terms of the statis-
tical significance and the sign with those based on the 5-firm market
concentration.

25
See Table 1 for the definition.

26
The detailed results are available from the authors upon request. Note that for
other explanatory variables, the results are broadly similar to those in Tables 4 and 5.

Our findings are also robust in a wider range of alternative
regressions. Specifically, we tried (i) adding more explanatory vari-
ables, namely, personnel expenses to size, square of bank size, cost
to income ratio, and stock market capitalisation; (ii) decomposing non-
commercial banks to investment, co-operative, savings, real estate
and Islamic banks, and removing each type of non-commer-cial banks
from the model one by one, which may have different objectives
amongst themselves; (iii) including a one-period lag of explanatory
variables, such as a capital adequacy lag, and interest rate spread lag;
and (iv) using net interest margin and the Sharpe ratio
27
instead of
ROAA and ROAE. None of these alternative ap-proaches yielded
significantly different results. For brevity, the re-sults are not presented
here, but are available from the authors upon request.

27
The Sharp ratio is risk-adjusted returns on equity that is given by the mean value of
the returns on equity divided by the standard deviation of the returns on equity. See,
e.g. Kosmidou et al. (2005), Pasiouras and Kosmidou (2007), and Demirguc-Kunt and
Huizinga (2010) for the use of these variables.

.016
(a)
.012

Egypt
o
f

b
a
n
k
s

p
e
r

r
e
a
l

G
D
P

p
e
r

c
a
p
i
t
a

b
a
n
k
s

p
e
r

r
e
a
l

G
D
P

p
e
r

c
a
p
i
t
a

.014
.010

.012

.010

.008

.008
Iran

.006
.006

Romania

Turkey
Bulgaria .004
N
u
m
b
e
r

o
f
Poland
Number

.004 Syria
Jordan

Lebanon

Cezch Rep.

.002
.002
Hungary

Slovakia Latvia
UAE Saudi

Slovenia Bahrain
LithuaniaOman
Estonia

.000
Israel Kuwait
.000 Qatar

0 1 2 3 4 5

Z-score

.016
(c)
.012

Egypt
o
f

b
a
n
k
s

p
e
r

r
e
a
l

G
D
P

p
e
r

c
a
p
i
t
a

.014
b
a
n
k
s

p
e
r

r
e
a
l

G
D
P

p
e
r

c
a
p
i
t
a

.010

.012

.010

.008

.008

Iran

.006
.006

Romania

Poland
Bulgaria
.004 Turkey
.004

Jordan

N
u
m
b
e
r

Syria

N
u
m
b
e
r

o
f

Lebanon

Cezch Rep.
.002
Hungary
Latvia
.002

Slovakia

Saudi

Bahrain

Slovenia UAE

Israel
Lithuania
Estonia
Oman

.000
Kuwait
Qatar
.000
20 40 60 80 100 120 140 160 180 200

Interest coverage ratio

(b)

France

Italy

Spain

UK

Austria

Potugal

Belgium Ireland
Greece LuxembourgNetherlands
Denmark

Sweden

Finland
Cyprus

0.0 0.4 0.8 1.2 1.6 2.0
Z-score

(d)

France

Italy

Spain

UK

Austria

Potugal

Greece
Belgium Denmark Ireland
Netherlands Luxembourg

Cyprus
Sweden
Malta

Finland

40 60 80 100 120 140 160

Interest coverage ratio
Fig. 3. (a) Number of banks per real GDP per capita and Z-score (emerging economies). (b) Number of banks per real GDP per capita and Z-score (advanced economies). (c)
Number of banks per real GDP per capita and interest coverage ratio (emerging economies). (d) Number of banks per real GDP per capita and interest coverage ratio (advanced
economies).

6.5. Discussion of the key finding

The empirical results support the view that greater market share
leads to higher bank profit rates in advanced economies, however, it
fails to explain the high bank returns among emerging markets. Also,
we find that the effect of concentration on profit is negative on
emerging markets, suggesting that the de-concentra-tion improves
returns. Overall, the empirical results are supportive to neither of the
hypotheses of RMP and SCP on bank performance in emerging
economies. There may be some other possible factors we should
emphasise based on the data.
Firstly, it is likely that as the number of banks in a market de-
creases (increases), the profitability indicators increase (decrease)
significantly. High entry barriers and restrictions on new or foreign
banks facilitate market collusion, with the consequence that even
markets with low concentration may exhibit collusive behaviour, raising
the profits of existing banks. In other words, market competitiveness
may depend on the number of participants in a

8
Emerging economies

Advanced economies
7

6

5

4

3

2

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

Fig. 4. Interest rate spread (in 100 basis points) in emerging and advanced
economies over 19992008.

country. We plot the number of banks and the returns in Fig. 2 and the
risk in Fig. 3. The trend-lines have a downward slope for emerging
banks, where many emerging economies tend to cluster around the
line in both Figs. 2 and 3. This appears to demonstrate that profitability
and stability increase in tandem with the de-creased number of banks.
This can be compared with those of ad-vanced banks, where the
relationship between the number of banks and bank performance is
less clear.
Another possible reason would be the high interest rate margins
between bank interest earnings and expenses, which remain sub-
stantially higher in emerging economies as compared with those in
advanced economies. The emerging banks have a mean interest rate
spread of 6.22 percentage points, compared with 3.55 percent-age
points for advanced economies (in Table 3a). See also Fig. 4, where a
relatively large gap between the emerging and advanced economies is
maintained throughout the sample period, in partic-ular, it is much
wider in the earlier sample period. The spread is widely regarded as
an indicator of the efficiency of financial inter-mediation. Hence the
higher spreads are an impediment to finan-cial intermediation, as they
discourage potential savers due to low returns, and increase financing
costs for borrowers, reducing investment and growth opportunities.
This is of a particular con-cern for countries in transition, where
financial systems are largely bank-based. The robust effect of interest
rate margins in emerging banking systems implies that banks can earn
high profits through increasing interest-margin revenues in a less
competitive financial market.

7. Conclusions and policy implications

This paper empirically investigates the effects of market struc-ture
by controlling bank-specific characteristics, overall financial structure
and macroeconomic environment on profitability and stability of banks
in emerging and advanced economies during the period of 19992008.
In particular, we assessed the extent to which the relatively high
profitability in emerging banking sys-tems can be attributed to less
competitive market conditions.
We have shown that there are large differences in profitability
among the banks in our sample, and that a significant amount of this
variation can be explained by the factors included in our anal-ysis.
Market share has no significant impact on bank profitability in
emerging markets, providing little evidence in support of the RMP
hypothesis, whereas we find evidence to support the hypothesis in
advanced economy banking systems. The effect of market concen-
tration on profitability is either insignificant on advanced banking
market or the unexpected negative impact on Middle East. Regard-ing
bank stability, concentration is negatively associated with bank
soundness in advanced economies, suggesting that concentrated
markets may encourage risk-taking behaviour in banks. This is
contrasted with the stabilising role of market share found for both
emerging and advanced banks.
The empirical findings have several implications for policy mak-ers.
Firstly, given the overall robust impact of bank-specific vari-ables that
are specified as control variables, the conventional wisdom of bank
prudential regulations continues to be imple-mented, e.g. bank
managers should undertake the necessary mea-sures to enhance the
role of capitalisation, and to create efficient cost-control.

Secondly, although during the period under study, there was a
significant decrease in the market concentration of emerging mar-ket
banks (recall Fig. 1c), there is scope for further reduction with-out
jeopardising the level of profitability. This should also be encouraged
for advanced economy banks, given the destabilising effect of
concentration. A fall in banking concentration ratios could be promoted
through a variety of ways. Antitrust enforcement or

anti-collusion regulatory action may indeed be stressed, also poli-cies
that penalise or impair mergers and acquisitions may be considered.

Thirdly, in emerging economies, profits seem to be derived at a
cost to the remainder of the economy where higher prices are im-
posed on borrowers and lenders, yet, at the same time, a higher profit
margin is found to be contributory to stability in emerging banks in a
less competitive environment. Thus, when implement-ing measures to
boost competition, such as the removal of unnec-essary restrictions
and entry-barriers in establishing new private or foreign banks, there is
need for a careful approach, otherwise excessive anti-competitive
measures may threaten bank stability. Another important implication
drawn from our empirical results is that although the RMP hypothesis
dominates in the advanced-market banking system, the power of
market share has an effect of stability, which policy makers should
bear in mind when they regulate their anti-monopolistic provisions.

Overall, these results suggest that although measures to pro-mote
competition may dampen economic rent, excessive imple-mentation
may yield an undesired destabilising effect on banks.

Acknowledgements

This is a revised version of the paper presented at the 26th An-nual
Congress of the European Economic Association, held at Oslo,
Norway in August 2011. The authors are grateful to the partici-pants of
this conference for their helpful comments and also the anonymous
referee of this journal. The usual disclaimer applies.

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