Seminar Paper On

“Macro- Economic factors as a

determinant of profitability of Indian
banks”

Shaifali

IES’ 2023
Supervisor: Dr. Girish Bahal
 Abstract
The Objective of the paper is to examine the impact of the Macro-Economic Factors on the
Profitability of Public Sector Banks by using empirical Framework. The period of study is 20
Years, from 2003 to 2022. Return on Assets (ROA) and Return on Equity (ROE) are taken as
proxy for profitability of Banks. While GDP growth rate and Inflation (CPI) are taken as
Macro- Economic factors. Bank Size being used as one of the control variable. The data is
panel is nature. Regression analysis is carried out to understand the relation between
measures of profitability and its indicators. There is a problem of correlation in panels, and in
order to correct that panel correlated standard errors (PCSE) being estimated. There is a
problem of Endogeneity and panels found to be correlated, hence in order to correct these
problem, Instrumental variables being Employed as a lagged of independent variables. The
results indicates that Both GDP and Inflation are impacting measures of profitability.
Banking Sector Reforms been used to determine their impact as well. One is Inderdhanush
Scheme and other is EASE (Easy Access and Surveillance Experience).

Motivation
Banks play crucial role in economic growth of any country and considered as heart of the
financial system. Hence, it is necessary to ensure that Banks witness enough profit margin,
which depend on both internal & external factors. There exist various Bank specific factors
(internal factors) such as bank Size, Liquidity, Bank Capital, Credit risk which has direct
impact on bank profitability. But there exist some external factors as well such as GDP
growth Rate and Inflation rate which indirectly impacts bank Profitability. My Objective is to
study these external factors as macroeconomic factors to determine its influence on banks
profitability. My study would focus on the influence of GDP-growth & inflation on the bank
profitability along with Bank Size as a control variable.

Introduction
In this paper, I carried out my work for eleven (11) public Sector Banks namely State Bank
of India, Punjab National Bank, UCO bank, Bank of Baroda, Bank of Maharashtra, Canara
Bank, Central Bank of India, Indian Bank, Indian Overseas Bank, Union bank Of India and
Bank of India. I restricted my work for public sector banks only. With the help of graph line,
it has been found that there is a steep decline in ROA and ROE values from 2016 onwards
and subsequently steep increase in both ROA and ROE from 2019s onwards.
This paper is divided into 8 sections. Section 4 throws light on the Trend analysis. Section 5
discusses Literature Review. Section 6 talks about the model specifications. Section 7
discusses the results and Section 8 concluded the results.
 Trend Analysis
According to the sources, Public Sector Banks cumulative profit crossed the Rs 1 lakh crore
mark in financial year 2023, with biggest public lender „State Bank of India‟ accounting for
nearly half of the total earnings. I analysed the trends of profit margin of all public sector
banks during the period of study from 2003 to 2022.

Return On Equity Trends

Return on Equity (ROE) keeps on fluctuating for the entire time period. In the first graph, I
considered top five public sector banks and found steep decline in ROE from 2016 period
onwards. May be because of demonetisation shocks but at the same time government also
introduced Indra Dhanush Scheme for the profitability of PSBs. Hence, in order to capture
that scenario Dummy being used.

Similar case witness for the UCO and Union bank Of India as well. Dummy for EASE
scheme being introduced in order to capture the positive trend from 2019 onwards.
 Return on Assets Trends
Like ROE, the trend analyses of ROA also showing similar results. Return on Assets keep
fluctuating for given period of study from 2003 to 2022. But showing steep decline (negative
values) from the year 2015 onwards. Bank Of Maharashtra witness maximum negative fall of
about 3%. Similarly, ROA start becoming positive after 2019. Bank of Baroda is special case
in which ROA not indicating large negative fall after 2015 onwards. It fall by just -1% in year
2016.
Returns on Assets (ROA) indicate very steep decline (negative) for Indian Overseas bank
from 2015 onwards and have steep positive slope from year 2020 onwards. On the contrary,
SBI indicated less fluctuations in terms of returns and witnessed about -1% returns on the
year 2018.
From this Trend Analysis, it can be stated that among all public sector banks, Indian bank &
State Bank of India (SBI) witnessed minimal negative returns over the whole study period
may be because of healthy balance sheet and efficient functioning.

Trend Analysis of Inflation

From the given graph line, it can be stated that Inflation has shown positive trend till 2010
& economy witnessed maximum inflation rate 12% during the year 2010. Then, it has shown
a steep decline since 2015. it is showing downward trend. One of the reasons could be fall in
domestic markets during demonetisation shock.
 14
12
Inflation Rate (%)
10
8
6
4
2
0
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22
YEAR

Trend of GDP
GDP keep on fluctuating over the study time period from 2003 to 2022. It has taken steep
negative decline of (-6)% during the year 2020 especially because of low investments. But,
after the recession period of 2020, it again took positive trend and increased to 8% in the year
2021.

10
GDP Growth Rate (%)

0
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22
-5

-10
YEAR

Literature Review
Profitability is an important indicator of the health of banking sector. It is also important for
the supervisors of the banking systems as well because to a large extent it also indicates the
risk involved in the activity. The factors determining profitability vary across countries and
across time line. A number of studies have been carried out to understand the drivers of
profits for a bank.
A paper by Ranajee (2018) on the “Factors influencing profitability of Indian banks”
empirically analyzed the factors determining profits for the 89 Commercial Banks in India
(Government & Non- Government) during the period 2005 to 2015 using the balanced panel
dataset. ROE and ROA taken as proxy for the bank‟s profitability. Study indicates that
profitability for banks depend upon on both internal and external factors. Pooled OLS
regression being done. Inflation coming out to be significant and positive for ROE.
A paper by Dr. Hemal Pandaya (2014) on the topic “Profitability analysis of Selected
nationalised banks In India accessed and evaluated the determinants of profits for the selected
five Indian Nationalized Banks using multiple regression and factor analysis technique during
the period 2000 to 2010.
For the purpose of study, financial ratios of different banks been considered. The study
suggests that there are five common factors across banks which affect their profitability and it
further shows that profitability fluctuates over the period of study. Correlation and Multiple
Regression Analysis approach used.
A paper by Mohammad Athar Ali & Rohit Bansal (2022) on “Analysing the performance of
banks in India: Robust Regression Analysis” approach accessed the impact of Bank specific
factors and macroeconomic factors to determine the finance performance of Public Sector
Banks using Robust Regression Technique. Return On assets (ROA) & Net Interest Margin
(NIM) considered as proxy for profits. Empirical findings suggested that among
macroeconomic factors GDP growth rate had no significant impact on ROA while
inflation(CPI) had positive impact on bank performance.
“Impact Of Inflation on profitability of Public Sector Banks” by Prof. Jeevitha & Dr. Binoy
Mathew (2019) determined impact of inflation on profits and how profit level influence the
investment decision of bank‟s lending. WPI used as measure for inflation rate. Data being
taken for the time period 2014- 2018. ROA, ROE and NIM taken as proxy for the
profitability. Study took place for five public sector banks. Correlation used as a tool of
testing and ANOVA is employed and results indicated that there is no relation between
profitability and inflation.
A paper on “Profitability of Public Sector Banks In India:” A study on determinants of
profitability using both bank specific and macro economic specific undertaken by KP
Venugopala Rao (2018). CAMELS model being used for bank specific factors while GDP,
WPI & Per capita net national income growth rate used as macro economic factors. Random
effect model performed which assumed variations across entities to be random &
uncorrelated with independent variables. Panel EGLS method being used. Results were not
significant for macro- economic factors while some of bank specific factors come out to be
significant such as Asset Quality, Earnings Quality & Sensitivity to Market Risk.
A paper by Dhananjay Bapat (2017) on Profitability drivers Of Indian banks: A dynamic
Panel data Analysis analyzed the profitability of Public and Private sector banks on the basis
of bank specific factors and Macroeconomic factors for the time period 2006-2012. ROA &
ROE considered as proxy for profitability. GMM model being used to control for endogenity
issues and for consistent estimates. Among the Bank Specific Factors Non performing loans
and cost to income ratio negatively impacted profitability of banks while diversification do
not affected the profitability. Both GDP & inflation impacting ROA but not ROE.
A paper on “bank specific, Industry specific and macro specific factors as a determinants of
profitability of Public sector banks” by A. Subbarayan considered ROA as profitability
measure. Panel data consist of PSB‟s for the period 2010-2015. GDP and Inflation used as
macro-economic factors. Pooled OLS method being undertaken to determine the results.
Among macro factors, Inflation had positive impact on banks profitability.

Data & Methodology

In this paper, Study is restricted to Public Sector Banks only. In present there are 12 Public
Sector Banks. But I found data for profitability measures namely, Return on Equity (ROE) &
Return on Assets (ROA) for 11 banks only except Punjab & Sind Bank. If we talk about data
source, Return on Equity , Return on Assets and Bank Size are taken from CMIE Prowess.
While data for Inflation (CPI) and GDP has been taken from World Bank data source. The
period of study is 20 years from 2003 to 2022. The frequency of data is annual. Panel data
approach being used in my study.

Parameters through which GDP, Inflation and Bank Size determine Bank profitability:

1) Interest Rate Sensitivity:

Banks' profitability is heavily influenced by interest rates. Changes in GDP and inflation
often lead to changes in interest rates, affecting the spread between interest earned on assets
and interest paid on liabilities, directly impacting profitability.

2) Economic Stability:
A strong or growing GDP often indicates a favorable economic environment, which can
positively influence a bank's profitability.

3) Risk Assessment:
GDP growth and inflation can serve as an indicator of potential risks and uncertainties in the
economy. High inflation rates might increase costs for banks, impacting profitability, while
economic growth can present opportunities for increased lending and investment activities.

4) Monetary Policy Impact:

Monetary policies, influenced by GDP and inflation, can significantly impact banks'
operations and profitability. Central banks adjust interest rates and other monetary tools to
manage inflation and stimulate or cool down economic growth, directly affecting banks'
interest income and expenses.
5) Economies of Scale :
Larger banks often benefit from economies of scale, which can lead to cost advantages. As a
bank grows in size, it can spread its fixed costs (e.g., infrastructure, technology) over a larger
customer base, potentially reducing its per-customer cost and improving profitability.
 Indicators & Variables
Variables Measurement Expected Sign
Dependent Variable
ROE Net Income/ Shareholder’s Equity
ROA Net Income/ Total Assets
Explanatory Variable
GDP Annual Growth Rate Positive
Inflation Annual CPI Positive/ Negative
Control Variable
Bank Size Log of Total Assets Positive/Negative
Instrumental Variable
Lagged Variable GDP L2 & Inflation L1 Positive

Model Specification:
As there are two dependent variables so there will be following two equations:
1) ROEit = c + α(GDPt ) + β(INFt ) +γ(Size)it + εit
2) ROAit = c‟ + α‟(GDPt) + β‟(INFt) + γ‟(Size)it+ ꙍit
where, ROEit stands for return on equity for ith bank in tth year.
ROAit stands for return on asset for ith bank in tth year.
GDPt stands for gross domestic product in tth year.
INFt stands for inflation in tth year.
Sizeit stands for Bank size for ith bank in tth year.
εit and ꙍit are error terms.
Since, Variables being standardized which would help to compare the relative importance of
different predictors in the model since they are on the same scale. Interpretation of the
coefficients becomes more straightforward.
Hence, model being transformed by using formula:
Z = (X – Xbar)/ σx
Now transformed Model is:
roe_sd = c + α(gdp_sd) + β(inf_sd) + γ(size_sd) + εit
roa_sd = c‟ + α‟(gdp_sd) + β‟(inf_sd) + γ‟(size_sd) +ꙍit
Steps followed:
Step1: OLS model is used on the standardized variables.
Step2: To check if OLS model can be accepted BREush and Pagan Test is done.
Step3 : If OLS being rejected then equation being estimated using fixed effect or random
model as suggested by Hausman.
Step3: For correction of endogeneity, Instrumental variables being employed as a lagged
value of explanatory variable.
Step4 : Test for Heteroscadasticity being done.

RESULTS

Equation 1: Estimating results for ROA

To estimate the equations three models being used, first is fixed effect then panel correlated
standard errors and then through Instrumental variable (IV). In Fixed Effect model,
coefficient of all the variables coming out to be significant even at one percent level. Trend
variable also being incorporated which indicating trend of return on assets (ROA) to be
negative in the whole study period.
Both Inderdhanush scheme and EASE scheme indicating significant results even at one
percent level of significance. Inderdhanush scheme indicating negative impact on
profitability of banks despite the fact that this is initiated with an aim to enhance the
profitability of banks. May be because that from the year 2016 onwards Demonetisation
shock came into picture which adversely impacted the profitability of banks. But EASE
scheme gave significant positive results.
For PCSE results, Inflation coming out to be significant at 5% level of significance. While
GDP gave significant positive results even at 1% level of significance.
In case of Instrumental variables (IV), both instrumented variables ( GDP L.2 & inflation
L.1) showing significant results , i.e influencing current value of explanatory variables.
After that endogeneity test also being done to check whether explanatory variables were
actually endogenous in nature or not. We found that GDP and Inflation were actually
endogenous in nature.
Coefficients plots being done for each of the case fixed effect, PCSE and IV test. Green
ploting for fixed effect, Red ploting for PCSE test and Blue ploting for Instrumental
variables. Coefficients value has risen for inflation (for which results are also coming out to
be significant in each case). Similarly, confidence intervals bands also tends to reduced as we
go towards IV model.

Equation 2: Estimating results for ROE

When Fixed model regression being done on transformed model, then all the explanatory
variables showing significant impact on return on equity (roe). Inflation_sd, size_sd and trend
variable coming out to be significant at one percent level of significance while gdp_sd
showing positive impact at ten percent level of significance.

For PCSE model, which is more efficient than fixed effect model as it is corrected for the
problem of correlation indicating that only GDP is determining impact on profitability.

With the Instrumental Variable case, inflation coming out to be significant (positive) and both
banking sector reforms giving significant results at one percent level.

Here, red symbols indicating coefficients for estimators by using PCSE results while Blue
symbols indicating coefficients with Instrumental variables (IV). Here, it can be seen that
coefficient for Inflation has risen in case of IV model.

While it has fall down to some extent for gdp although coefficients are not coming out to be
significant for IV model.
 Estimating Results for ROA
Variables FE PCSE IV

inflation_sd 0.1475* 0.1708** 0.3233*

(0.0493) (0.0712) (0.0986)
gdp_sd 0.1834* 0.1914* 0.1911***
(0.0403) (0.0594) (0.1027)
size_sd 0.3710 -0.1673* -0.1736*
(0.243) (0.0366) (0.063)
trend -0.1189* -0.0366*** -0.0361***
(0.0395) (0.0203) (0.0205)
Indu_Scheme -1.0069* -1.1606* -0.9079*
(0.1917) (0.2643) (0.2511)
EASE 1.3207* 1.1765* 1.0479*
(0.1502) (0.2004) (0.2115)
Constt. 1.403* 0.6141* 0.5059*
(0.3701) (0.1507) (0.1780)
inflation_sd L1 0.7476*
(0.0595)
gdp_sd L2 -0.6265*
(0.080)
N 220 220 198
adj. R sqr 0.524 0.653 0.633
 Estimating Results for ROE
Variables FE PCSE IV

inflation_sd 0.0959*** 0.1191 0.3304*

(0.0514) (0.0750) (0.0914)
gdp_sd 0.1564* 0.1644* 0.1561
(0.0421) (0.0626) (0.0952)
size_sd 0.4963*** -0.041 -0.0812
(0.2543) (0.0383) (0.0584)
trend -0.1641* -0.0819* -0.0546
(0.0412) (0.0215) (0.0192)
Indu_Scheme -0.8113* -0.9646* -0.7596*
(0.2001) (0.2786) (0.2327)
EASE 1.436* 1.2923* 1.0226*
(0.1568) (0.2112) (0.1960)
Constt. 1.792* 1.0046* 0.6034*
(0.3864) (0.1646) (0.1649)
inflation_sd L1 0.7476*
(0.0595)
gdp_sd L2 -0.6265*
(0.080)
N 220 220 198
adj. R 0.544 0.663 0.633

General Observation:
  The main determinant of ROA are gdp, inflation and bank size. While Bank size has
negative impact on profitability of banks.
 When we take ROE as a measure of profitability then, gdp is coming out to be
significant.
 Both ROE and ROA are procyclical to GDP growth rate.
 Two period lagged values of gdp and one period lagged value of inflation giving
significant variations in current time period.
 Banking Sector Reforms impacting significantly profitability of banks. Indra Dhanush
scheme which was introduced in 2015, indicates negative impacts on profitability
majorly because of demonetization shocks.
 Similarly, EASE scheme which was introduced in 2019, indicating positive impacts
on profitability measures due to several versions of this reform been introduced over
the time.

Limitation of the study:

 Endogeneity was the major concern here. Since, macro factors are impacted
by their own lagged values, hence different lagged values being used for the
correction of endogeneity.
 Different IVs experimented for the correction of endogeneity.
 Data for one of the bank was not available in the prowess site hence,
variations on Punjab & Sind Bank was not determined.

Conclusion

Our banking sector is very vibrant and plays a major role in our economy. With the help of
the study some of the key take away being determined:
 Fixed effect regression gives better result as compared to the overall pooled
analysis.
 Inflation coming out to be important factor determining profitability at annual
basis.
 Bank size has negative impact on profitability measures broadly because of the fear
of risk of too big to manage.

References:

Dr Hemal Pandya, ‘IDENTIFYING MAJOR DETERMINANTS OF PROFITABILITY FOR SELECTED

NATIONALIZED BANKS IN INDIA, International Journal Of Business and Administration Research
Review, Vol.2, Issue4, Jan-March, 2014.

Krishna, Dr. R.R (1996) :: “Profitability Analysis : an Overview,” Indian Banking Today and Tomorrow ,
Sept. 1996

Bolda B. S., & Verma, R (2007): “Determinants Of Profitability Of Banks In India: “A Multivariate
Analysis” , Journal Of Services Research, Vol.6, 75-89

Rakhe P.B, ‘Reserve Bank Of India Occasional Papers, Vol. 31, No.2, Monsoon 2010, ‘Profitability Of
Foreign Banks- a -vis Other Bank Groups in India – ‘A Panel Data Analysis’
Chandan C. L, & Rajput, P.K. (2002): “Profitability analysis of banks in India : A multiple regression
approach” , Indian Management Studies Journal. 6, 119-129

Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis 2008, ‘Bank specific, industry
specific and macro specific determinants of bank profitability’, International Financial markets,
institutions and money.

World Bank website

CMIE Prowess website