Internal Factors Affecting Bank Profitability: A Case of

private Commercial Banks in Ethiopia.

A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS

FOR THE DEGREE OF MASTER OF SCIENCE IN MARKETING MANAGEMENT.

BY: WONDIMAFERAW GABISO

May 2022
HAWASSA, ETHIOPIA
 INTERNAL FACTORS AFFECTING BANKS PROFITABILITY: A CASE OF
PRIVATE COMMERCIAL BANKS IN ETHIOPIA

BY: WONDIMAFERAW GABISO

ADVISER: HAILEMARIAM MAMO (PhD)

CO-ADVISER: HABTAMU MESERET (MBA)

A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS

FOR THE DEGREE OF MASTER OF SCIENCE IN MANAGEMENT

HAWASSA UNIVERSITY
SCHOOL OF MANAGEMENT
DEPARTMENT OF MARKETING

May, 2022
HAWASSA, ETHIOPIA

ii
 DECLARATION

I declare that, this paper was prepared for the partial fulfillment of the requirements for Masters
of marketing management entitled: “Internal Factors Affecting Banks Profitability: A Case of
private Commercial Banks in Ethiopia”, and it is my original work and has not submitted for
requirements of a degree and MBA in any other university. In addition, I certify that all sources
of materials used for the study indicated in the reference part of this thesis.

Declared by:-

Name: Wondimaferaw Gabiso

Signature_________________

Date of Submission: May, 2022

Place: Hawassa University

iii
 SCHOOL OF GRADUATE STUDIES

HAWASSA UNIVERSITY

ADVISORS’ APPROVAL SHEET

This is to certify that the thesis entitled “ internal factor affecting bank profitability: A case of
private commercial bank of Ethiopia’’ submitted in partial fulfillment of the requirements for
the degree of Master in marketing management, the Graduate Program of the School of
Management, and has been carried out by Wondimaferaw gabiso Id. No GpMaMaWA/0021/12
under our supervision. Therefore we recommend that the student has fulfilled the requirements
and hence hereby can submit the thesis to the school of management.

Hailemariam Mamo (PhD) _________________ ________________

Name of Principal Advisor Signature Date

Habtamu meseret (MBA) _________________

Name of Co-advisor Signature Date

iv
 SCHOOL OF GRADUATE STUDIES

HAWASSA UNIVERSITY

EXAMINERS’ APPROVAL SHEET

We, the undersigned, members of the Board of Examiners of the final open defense by
Wondimaferaw Gabiso have read and evaluated his thesis entitled “internal factor affecting
bank profitability: A case of private commercial bank in Ethiopia”, and examined the
candidate. This is, therefore, to certify that the thesis has been accepted in partial fulfillment of
the requirements for the degree of masters in marketing management.

_________________ ________________

Name of the Chairperson Signature Date

__________________________ ______________

Name of Principal Advisor Signature Date

___________________________ ______________

Name of Co- Advisor Signature Date

______________________ __ ______________

Name of Internal Examiner Signature Date

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Name of External examiner Signature Date

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SGS Approval Signature Date

Final approval and acceptance of the thesis is contingent upon the submission of the final copy of
the thesis to the School of Graduate Studies (SGS) through the School Graduate Committee
(DGC/SGC) of the candidate’s department.

v
 Abstract

The purpose of this study was to assess internal factors affecting banks profitability a case of
private commercial banks in Ethiopia by using panel data from the year 2011 to 2020G.c. The
study used quantitative research approach, purposive sampling technic and secondary financial
data was analyzed by using fixed effect models and with diagnostic tests were applied using
STATA software. Numbers of branch was Novel features of the study were the analysis of
variables which was missed by other researcher in the panel study in private bank with the same
topic. In this study used bank internal factors that affect profitability of private Commercial
Banks in Ethiopia. The study was used profitability (ROA) as a Dependent variable and Bank
branch number, capital adequacy, loan amount, liquidity risk, deposit amount, and non-interest
income as independent variables. The empirical results showed that Bank branch number,
Capital adequacy, deposit amount, loan amount, non-interest income has significant relationship
with profitability of private commercial bank. However, the result shows insignificant
relationship between profitability of private Commercial Banks in Ethiopia with liquidity risk
and loan amount. As a result, the study recommended that private commercial banks should on
focusing as well reengineering the banks alongside their key internal factor; this will enhance
banks performance and improve their profitability and bank should have work more to earn their
profit by adding volume of capital adequacy, deposits, non-interest income, loan and reduce
their liquidity risks.

Key words: profitability, ROA, internal factor, private Commercial Banks.

vi
 Acknowledgement

First and foremost thanks to almighty God for making this aspiration come to fruition through
his grace. Again I would like to express my genuine thank to my advisor, Hailemariam Mamo
(PhD) for his invaluable comments, inspiration and guidance at various stages of the study as
well as my co-advisor Habtamu Meseret (MBA).

Finally, my highest appreciation goes to my parents for providing me with their endless support
to achieve my master degree upon completing this study. I really appreciate their consideration
and patience for allowing me to concentrate on the study.

vii
Table of Contents
DECLARATION .............................................................................................................................................. iii
ADVISORS’ APPROVAL SHEET....................................................................................................................... iv
EXAMINERS’ APPROVAL SHEET ..................................................................................................................... v
Abstract ........................................................................................................................................................ vi
Acknowledgement ...................................................................................................................................... vii
Table of Contents ....................................................................................................................................... viii
List of table................................................................................................................................................... xi
List of figure ................................................................................................................................................ xii
List of Acronyms ..........................................................................................................................................xiii
CHAPTER ONE ............................................................................................................................................... 1
1. INTRODUCTION ......................................................................................................................................... 1
1.1 Background of the study ..................................................................................................................... 1
1.2. Statement of the problem ................................................................................................................. 3
1.3 Objectives of the Study ....................................................................................................................... 5
1.3.1. General Objective ....................................................................................................................... 5
1.3.2. Specific Objectives ...................................................................................................................... 5
1.4 Limitation ............................................................................................................................................ 6
1.5 Scope ................................................................................................................................................... 6
1.6 Hypotheses of the study ..................................................................................................................... 6
1.7 Significance of the study ..................................................................................................................... 7
1.8 Organization of the paper ................................................................................................................... 8
CHAPTER TWO .............................................................................................................................................. 9
2. REVIEW OF RELATED LITERATURE ........................................................................................................... 9
2.1 INTRODUCTION ................................................................................................................................... 9
2.2 Function of Banks................................................................................................................................ 9
2.3 The Role of Banks .............................................................................................................................. 10
2.4. Theories on Profitability ................................................................................................................... 11
2.4.1 Regulation .................................................................................................................................. 11
2.4.2 Efficiency Hypothesis ................................................................................................................. 12
2.5. Measure of Profitability ................................................................................................................... 13
2.6. Commercial Banks profitability ........................................................................................................ 13

viii
 2.7 Factors Influencing Banks Profitability.............................................................................................. 14
2.7.1 Determinants of bank profitability ................................................................................................ 15
2.7.1.1 Internal Determinants of bank profitability ............................................................................ 15
2.8. Empirical Study ................................................................................................................................ 19
2.8.1 Review of previous studies in other countries .............................................................................. 19
2.8.2 Review of previous studies in Ethiopia ...................................................................................... 22
2.10. Conceptual framework .................................................................................................................. 24
CHAPTER THREE .......................................................................................................................................... 25
3. RESEARCH METHODOLOGY ................................................................................................................... 25
3.1. Research design ............................................................................................................................... 25
3.2 Research Approach ........................................................................................................................... 25
3.3 Study Population ............................................................................................................................... 25
3.4 Sample Size and Sampling technique ............................................................................................... 25
3.5. Data type and source ....................................................................................................................... 26
3.6 Data analyzing method ..................................................................................................................... 27
3.7. Variable Definition & their measurements ...................................................................................... 28
3.7.1 Dependent Variable ................................................................................................................... 28
3.7.2 Independent Variables ............................................................................................................... 29
3.8 Summary of hypothesis .................................................................................................................... 31
3.9 Model Specification .......................................................................................................................... 31
CHAPTER FOUR ........................................................................................................................................... 33
4. RESULT AND DISCUSSIONS.................................................................................................................. 33
4.1 Introduction ...................................................................................................................................... 33
4.2 Descriptive Analysis .......................................................................................................................... 33
4.3 Model selection between Fixed and Random Effect Model ............................................................. 36
4.3.1 Hausman result .......................................................................................................................... 37
4.4 Panel Model Regression.................................................................................................................... 38
4.5 CORRELATION DIAGNOSTICS TESTS .................................................................................................. 41
CHAPTER FIVE ............................................................................................................................................. 46
5. SUMMARY, CONCLUSION AND RECOMENDATIONS............................................................................... 46
5.1 Summary of Finding .......................................................................................................................... 46
5.2 Conclusions ....................................................................................................................................... 46

ix
 5.3 Recommendations ............................................................................................................................ 48
REFERANCE ................................................................................................................................................. 50
APPENDICES ................................................................................................................................................ 60

x
List of table
Table3.1 List of selected studied banks ........................................................................................ 27
Table3.2 expected sign for hypothesis .......................................................................................... 31

Table4.1 Descriptive Statistics for the study variables………………………………………….. 34

Table4.2 hausman test……………………………………………………………………………37
Table4.3 wooldridge test for outocorrelation…………………………………………………….40
Table4.4 modified wald test for group wise heteroskedasticity………………………………… 42
Table4.5 multicilinearity test……………………………………………………………………. 44
Table4.6 panel model regression……………………………………………………………... 438

xi
List of figure

Figure 2.1: Schematic Diagram of Conceptual model .................................................................. 24

Figure 4 1 test for normality ......................................................................................................... 43

xii
 List of Acronyms
AB Abay bank
ADIB Addis international bank
AB Awash bank
BBN Bank branch number
BUIB Bunna international bank
BOA Bank of Abyssinia
CAP Capital adequacy
CBE Commercial bank of Ethiopia
CBO Corporative bank of Oromia
DB DashenBank
DBE Development bank of Ethiopia
DGB Debub Global Bank
DPA Deposit Amount
EB Enat Bank
ES Efficiency hypothesizes
FEM fixed effect Methods
GDP Growth rate of Economy
HP Hypotheses
LR Liquidity Risk
LA Loan Amount
LIB Lion international Bank
NBE National Bank of Ethiopia
NIB Nib international Bank
OIB Oromia International bank
ROA Return on Asset
ROE Return on Equity

xiii
SSA Sab Saharan African
UB United bank
WB Wegagen Bank
ZB Zemen bank

xiv
 CHAPTER ONE

1. INTRODUCTION
1.1 Background of the study

Since the 17th century the banking industry has been serving as most crucial financial sector for
any economy in the world. The performance of banks can make progress the economies of global
countries. It is better to remind that the banking sector was the major contributing factor in both
the great depression of the 1929 as well as the 2008’s economic recession (Shifa, Debela, &
Tarfa, 2019).

The financial system is an important ingredient in any economic environment of a country; Good
financial system can’t do without well-structured and efficient financial institutions specifically
the banking industry. Poor performance of these institutions does not only affect the economic
growth and structure of the particular country but also affects the entire world. Good
performance of these financial institutions is represented by affluence of economic growth in any
country or region (Gui-diby, 2020).

The banking sector is essential for the country economy and plays an important financial
intermediary role; therefore, its health is very critical to the health of the general economy at
large (Alemu, 2021). In the last twenty years there has been a rapid increase in the activity of
commercial banks in Ethiopia, and this has fostered rapid competitiveness among banks in
Ethiopia. In increasing world of business and finance, the task of each bank operating to make
more profit is becoming a challenge with each passing day (Abate & Mesfin, 2016). In any
organization like private commercial bank in Ethiopia to operate optimally, it has to be able to
measure its profitability with regards to its inputs and outputs (Abate & Mesfin, 2016).

The performance of banking institutions can affect economic growth while at the same time
institutional insolvencies can result in systemic crises which have unfavorable consequences for
the economy as a whole (Almahadin et al., 2021). Bank is one example of a financial institution,
Banks get a great deal of attention in the economic literature considering that banks play a
pivotal role in the economy (Shanko et al., 2012).
The banking system in a country is effective, efficient and disciplined it brings about rapid
growth in the various sectors of the economy (Ngure, 2014). The recent global financial crisis of
2007/2008 also demonstrated that the importance of bank performance both in national and
international economies and this need to keep it under surveillance at all times (Helleiner, 2011).

The determinants of profitability are empirically well explored although the definition of
profitability varies among studies. Disregarding the profitability measures, most of the banking
studies have noticed that both the internal environment of the organization and external
environment are important drivers of high profitability (Vong & Chan, 2009).

The financial sector in Ethiopia they are dominated under banking industry. The Ethiopian
banking industry is important to the Ethiopian economy and plays a vital financial intermediary
function. Banking institutions in Ethiopia play a great role in national growth and such roles are
growing day-by-day (Mohammed et al., 2015) Those banking sector plays the function of
financial intermediation between borrowers and savers that entails the mobilization of capital
from individuals with surplus cash and channeling the funds to the deficit economic units (Garr,
2021).

Profitability simply connotes the management efficiency and depicts how effective and
efficiently the bank management operate as they employ the organizations assets into the
earnings (shiferaw, 2018). The reflects of the efficiency is which the banks managers use banks
investment resources or assets in generation of income (Joshua, 2016). A high ROA ratio is a
clear indicator of a good performance or profitability of a banking entity (Mchembere, & Tesfay,
2016).

This study was to identify factors affecting bank profitability of private commercial banks in
Ethiopia, for the period of 2011 to 2020 G.C. The dependent variable is profitability (ROA) and
the explanatory or independent variables were: capital adequacy, loan amount, deposit
amount, bank branch number, non-interest income and liquidity risk; also quantitative
research analysis approach was used in the study.

2
1.2. Statement of the problem

It is widely believed that financial system plays a vital role in the economic growth and
development of a country. The importance of an efficient financial sector lies in the fact that, it
ensures domestic resources mobilization, generation of savings, and investments in productive
sectors. In fact, it is the system by which a country directs its most profitable and efficient
sectors to most productive sources of future growth (Wubayehu, 2017).

The main role of a financial system is not only to transfer funds from savers to investors but also
to ensure that funds are being transferred to the sectors which are most important for an
economy. Banks are the most crucial financial intermediaries in most economies that render a
bundle of different services. Economies that have a profitable banking sector are better able to
withstand negative shocks and contribute to the stability of the financial system (Alemu, 2015).
Therefore, it is important to assess and understand the factors which really affect the banking
sectors profitability.

The existence of less efficiency and little & insufficient competition in the country’s banking
industry is a clear indicator of relatively poor performance of the sector compared to the
developed world financial institutions. Thus, it is important to know the determinants of banks
profitability for an efficient management of banking operations aimed at ensuring growth in
profits and efficiency (Shanko et al., 2019).

Due to the variation of the environment and data included in the analysis the results of various
studies differ significantly. However, several researchers identified that there are some common
factors which influence profitability of a bank. Summarizing the results from numerous studies,
larger bank size, good asset quality, higher proportion of equity, deposit, loan, noninterest
income capital to asset, growth have generally been associated with greater profitability. Various
measures of costs are usually negatively correlated with profits. Greater provisions for loan
losses, higher liquidity, and more reliance on debt have been lower indicative of lower bank
profit (Ebenezer et al., 2017).

Private Commercial banks in Ethiopia are dominant in respect of accessibility, market share and
efficiency in the banking sector of Ethiopia (Million et al., 2015).

3
Private Commercial banks in Ethiopia have gone into significant changes after the liberalization
of the banking system. The reforms removed barriers to entry of commercial banks and
supported the improvement of institutional framework and more efficiently the performance of
commercial banks, with this it has affected the profitability of commercial banks and increased
banking competition even its infant stage when we compare the industry even to other
developing countries (Bezabeh & Desta, 2014). Profitability of commercial banks is pro
foundation for product innovation, diversification and efficiency of the commercial banks
(Hannah, 2002). Thus the stability of commercial banks as whole in the economy depends on
profitability level. Qin & Dickson, (2012) more profitability level has tendency to absorb risks
and shocks that commercial banks can face. Moreover profitability is the perquisite condition for
the efficiency of commercial banks (Tiisekwa, 2013).

Debela et al., (2019) has showed that the soundness of commercial banks performance depends
on profitability. Profitability of commercial banks is important for the efficiency of commercial
banks. However, there is improvement in profitability from time to time Ethiopian banks
performance has still remained poor with substantial gaps in service delivery to private agents,
particularly to the rural and lower-income population (Tekatel, w, 2019).

This is clearly indicated in the NBE (2008/09) annual report which states as one branch of a bank
on the average is estimated to serve around 126,258 people, which is way below even at the SSA
standard. This high people to bank branch ratio indicated that as Ethiopian banks performance is
still poor in terms of outreach even as compared to the SSA standards where the performance is
significantly poor This very limited access to basic payment services or saving accounts clearly
indicates as the industry is performing poorly (Abdulai, 2016). Ethiopian banking industry is
characterized by a quite high liquidity (Tewodros & Gedion, 2019).

In general, even if Ethiopian banks looks like profitable, but lack of competition, limited number
of branches, poor asset quality, low efficiency, higher levels of liquidity, low limit of loan
amount, deposit amount and others clearly indicate as above introduced they are still not
performing well and attaining the maximum profit that they can achieve (Lelissa, 2019).

4
Therefore, this study tries to fill the gap that the other study Shifa, Debela, & Tarfa, (2019);
Tewodros & Gedion, (2019); Lelissa, (2019); Tekatel, w & Nurebo, (2019); Bezabeh & Desta,
(2014); Million et al., (2015); Alemu, (2015); Wubayehu, (2017); Tesfay, (2016); shiferaw,
2018); (Mohammed et al., 2015); shanko et al., (2012); Abate & Mesfin, (2016); Alemu, (2021);
Shifa, Debela, & Tarfa, (2019) was study in the same area but still their findings are inconsistent
and was not describe and correlate profitability with bank branch number. So this study was tried
to add the variable as a gap. To describe later problem the study consider what factors affect the
private commercial bank profitability in Ethiopia has not been adequately investigated. While
taking in to consideration the absence of empirical inquiry into the factors affecting private
commercial profitability, the study attempts to work on such untouched empirical evidence in the
country.

1.3 Objectives of the Study

1.3.1. General Objective
The main objective of this study is to assess internal factors affecting bank profitability: A case
of private Commercial Bank in Ethiopia.

1.3.2. Specific Objectives

The specific objectives of the study are;

 To examine relationship between capital adequacy and profitability of private
commercial bank in Ethiopia.
 To assess the relationship between liquidity risk and profitability of private commercial
bank in Ethiopia.
 To examine the relationship between loan amount and profitability of private commercial
bank in Ethiopia.
 To identify the relationship between deposit amount and profitability of private
commercial bank in Ethiopia.
 To identify the relationship between bank branch number and profitability of private
commercial bank in Ethiopia.
 To examine the relationship between non-interest income and profitability of private
commercial bank in Ethiopia.

5
1.4 Limitation
The study used panel data from 2010 to 2020 to include banks like they were exist which came
to operation during before 2010 respectively. The study faced sample number problem due to
these excluded banks have only few years of life history and have made not to have more than
hundred observations, Under collection of data some banks officer are not accountable to give
necessary information; Absence of some banks’ audited financial statements in NBE this was
also imposed constraint on study, it has some restriction to collect data from NBE.

1.5 Scope

This research was delimited conceptually, methodologically and time scope.

Conceptually: This studies focused on the Assess Factors Affecting Commercial Banks
profitability in the case of private commercial bank of Ethiopia, study was focus only bank
internal factors such as bank branch number, capital adequacy, liquidity risk, deposit amount,
loan amount and non-interest income.

Methodologically: This study is quantitative research. Additionally, this study was used
purposive methods and the main sources of this data were secondary data.

Time scope: The data was collect from audited financial statements of NBE on ten private
commercial bank of Ethiopia. The data required for defining bank specific factors, it limits on 10
years 2011 to 2020.

1.6 Hypotheses of the study

In line with the broad purpose statement the following hypotheses are also formulated for
investigation. Hypotheses of the study stands on the theories related to a bank profitability that
has been developed over the years by banking area researchers and past empirical studies related
to bank profitability.

Hence, based on the objective, the present study seeks to test the following six hypotheses:

6
H1: Capital adequacy has significant effect on profitability of private commercial bank in
Ethiopia.

H2: Liquidity risk has significant effect on profitability of private commercial bank in Ethiopia.

H3: Loan amount has significant effect on profitability of private commercial bank in Ethiopia.

H4: Deposit amount has significant effect on profitability of private commercial bank in
Ethiopia.

H5: Branch number has significant effect on profitability of private commercial bank in
Ethiopia.

H6: Non-interest income has significant effect on profitability of private commercial bank in
Ethiopia.

1.7 Significance of the study

Furthermore, many parties would benefit from the results that were emerged from the results of
the study these parties are:

Head office Management: Administration interested to identifying indicators of success and

failure to take the necessary actions to improve the performance of the institution and choose the
right decisions. The study draws some conclusions and identifies the factors affecting bank
profitability significantly. Thus, it gives signal to the management of the banks and policy
makers to take remedial action.

Government: Government interested in knowing which companies operate successfully or failed

and to take the necessary measures to avoid crises of the bankruptcy in these institution.

Researchers: the study helps other researchers as a source of reference and as a stepping stone for
those who want to make further study on the area afterwards.

7
1.8 Organization of the paper

The study was organized into five chapters. Chapter one presents introductions of the study. The
literature review part of the study is presented in Chapter two. Chapter three presents the
research design sampling design and methodology. The fourth chapter is said to be the climax of
this study in which it associated with the results and findings. This chapter was focused on the
data presentation, analysis and discussion, and finally chapter five presents the conclusions and
recommendations.

8
 CHAPTER TWO

2. REVIEW OF RELATED LITERATURE

2.1 INTRODUCTION

In the empirical and theoretical evidence there are so many factors that influence banks
operations and banks profitability. The purpose of this chapter is to review the related literatures
of bank profitability and its factors. First, this chapter discusses the function of banks, followed
by theories about profitability then review related to bank profitability and its determinants as
well as factors and finally, reviews of the previous studies conducted in relation to bank
profitability and its factors in Ethiopia and other countries.

2.2 Function of Banks

This paragraph discusses the function of banks in the economy and examines the question why
banks exist. At first sight, the answer to this question is very intuitive and simple; banks act as an
intermediary between those who are in need for money and those who have excess of money.
Looking more closely to this question there could be a more detailed explanation (Jakab &
Kumhof, 2015). In a perfect capital market of Modigliani-Miller (MM), financial institutions are
superfluous; namely, entities can borrow and save directly through the capital market. In reality,
such perfect market does not exist; transaction costs and monitoring costs distort capital markets.
Furthermore, capital markets suffer from the information asymmetry and the agency problem.
The agency problem refers to the dissimilar incentives of borrowers and savers, in a broader
context it refers to the dissimilar incentives of principles and agents (Hoa Nguyen, 2013).

Another important aspect of banking is the function of maturity transformation. Banks receive
short-term savings from depositors and transform those savings into long-term loans to
borrowers. By holding a part of the short-term savings in liquid assets and cash, banks could
withstand daily withdrawals from depositors (Helgadóttir, 2016).

Capital markets cannot achieve maturity transformation with the same benefits as banks can.
Individual investors face liquidity, price and credit risk, which they cannot diversify to the extent

9
banks can. As savers do not withdraw their deposits at the same time, banks hold only a minor
part of the savings in liquid cash. Thus, banks diversify liquidity risks over a large pool of savers.
Individual savers can also diversify their investments in terms of credit and price risks but it
remains unlikely that they could withdraw the investments at any time without facing liquidity
issues (Sori, 2014).

Nowadays, bank activities are more diverse than ever. In the past decades, competition has
increased and new activities have emerged. The traditional form of banking, receiving deposits
and extending credits, has become less important. Ever since the complexity of balance sheet has
increased, as did balance sheet and risk management (Appiah-Kubi, 2018).

2.3 The Role of Banks

This paragraph discusses the role of banks in the economy and examines the question why banks
exist. At first sight, the answer to this question is very intuitive and simple; banks act as an
intermediary between those who are in need for money and those who have excess of money.
Looking more closely to this question there could be a more detailed explanation. Namely, in a
perfect capital market of financial institutions are superfluous, entities can borrow and save
directly through the capital market. In reality, such perfect market does not exist; transaction
costs and monitoring costs distort capital markets (Harun et al., 2020). Furthermore, capital
markets suffer from the information asymmetry and the agency problem. The agency problem
refers to the dissimilar incentives of borrowers and savers, in a broader context it refers to the
dissimilar incentives of principles and agents (Harun et al., 2020).

In a case of financial distress, borrowers are limited liable; implying that they have incentives to
alter their behavior by taking on more risk than savers are willing to accept (Engel, 2014).
Monitoring the borrowers’ behavior is time consuming, complex and expensive for individuals.
In general, in inefficient markets, financial intermediation is beneficial since banks have lower
monitoring and transaction costs than individuals, due to economies of scale and scope. Another
important aspect of banking is the function of maturity transformation (Cuza, 2009). Banks
receive short-term savings from depositors and transform those savings into long-term loans to
borrowers. By holding a part of the short-term savings in liquid assets and cash, banks could
withstand daily withdrawals from depositors (Meder et al., 2014). Banks offer a unique service;
lending long term while guaranteeing the liquidity of their liabilities to depositors, which can
10
withdraw their money at any time without a decline in nominal value (Diamond & Dybvig,
1983).

Capital markets cannot achieve maturity transformation with the same benefits as banks can.
Individual investors face liquidity, price and credit risk, which they cannot diversify to the extent
banks can. As savers do not withdraw their deposits at the same time, banks hold only a minor
part of the savings in liquid cash (Chen et al., 2018). Thus, banks diversify liquidity risks over a
large pool of savers. Individual savers can also diversify their investments in terms of credit and
price risks but it remains unlikely that they could withdraw the investments at any time without
facing liquidity issues. Nowadays, bank activities are more diverse than ever. In the past decades,
competition has increased and new activities have emerged (Harun et al., 2020; Milne &
Parboteeah, 2016). The traditional form of banking, receiving deposits and extending credits, has
become less important. Ever since the complexity of balance sheet has increased, as did balance
sheet and risk management (Amini et al., 2013; Basheer et al., 2019; Harun et al., 2020).

Besides the incorporations of liquidity, price and credit risks in banking activities, banks
increasingly faces market risks (e.g. interest rate risk and currency risk). One may assume that
banks’ risk managers properly diversify these risks and closely monitor borrowers‟ behavior to
avoid bank failure or financial distress. Nevertheless, monitoring bank behavior is required to
safeguard the continuity and stability of the banking sector due to moral hazard issues
(Kementerian , 2015).

The financial performance of banks affects the interests of depositors, shareholders, regulators,
potential investors and corporate owners. As banks dominate the financial sector in Ethiopia,
ensuring the financial health of these institutions is likely going to ensure the health of the
performance of the financial system of the country (Abdurazak & Harun, 2017).

2.4. Theories on Profitability

2.4.1 Regulation

The main objective of regulation and supervision in the banking is to deter excessive risk taking
in the banking sector. Without any regulation, politicians assume that banks will take on more
risks than necessary and acceptable for depositors. At the same time risk taking is beneficial for

11
average individual banks, one bank failure is highly undesirable for depositors and may spill
over to the entire banking sector (Agoraki et al., 2009; & Roe, 2004).

Regulators and supervisory entities that set minimums for equity capital, and establish other
types of regulations can affect the bank’s capital structure decisions, and hence its earnings
(Harun et al., 2020; Kashyap et al., 2010).

The regulators establish the conditions of entry to the banking industry, the compliance with the
capital ratios and liquidity rules, the enforcement of the larger exposure rules in the foreign
exchange market, the right of inspection and in our countries case require banks to buy NBE bills
etc. Furthermore, (Harun et al., 2020; Mohseni-Cheraghlou et al., 2013) the net regulatory
burden could also negatively influence bank performance. The net regulatory burden equals the
cost minus the benefits of regulation. Costs of regulation are e.g. compliance costs, referring to
the costs of preparing reports and statements to regulators, or costs of being restricted from an
optimal portfolio or capital structure (Scholes et al., 1976).

2.4.2 Efficiency Hypothesis

A theoretical attempt to offer an alternative explanation on the market Structure Conduct

Performance (SCP) relationship is the efficiency hypothesis which states that banks earn more
profit because they are more efficient than others. In other words, profitability of bank is
determined not by the market concentration but by bank efficiency (Khataybeh, 2013).

There are also two distinct approaches within the efficiency; the X-efficiency and Scale–
efficiency hypothesis. According to the X-efficiency approach, more efficient firms are more
profitable because of their lower costs. Such firms tend to gain larger market shares, which may
manifest in higher levels on market concentration, but without any causal relationship from
concentration to profitability (Athanasoglou, et., al, 2006).

The scale approach emphasizes economies of scale rather than differences in management or
production technology. Larger firms can obtain lower unit cost and higher profits through
economies of scale. This enables large firms to acquire market shares, which may manifest in
higher concentration and then profitability (Olalere et al., 2017).

12
2.5. Measure of Profitability

There are different ways to measure profitability such as: return on asset (ROA), return on equity
(ROE) and return on invested capital (ROIC). ROA is an indicator of how profitable a company
is relative to its total assets (Nakhaei & Hamid, 2013) It gives us an idea as to how efficient
management is in using its assets to generate earnings whereas ROE measures a company’s
profitability which reveals how much profit a company generates with the money shareholders
have invested. ROIC is a measure used to asses’ company’s efficiency in allocating the capital
under its control in profitable investments. This measure gives a sense of how well a company is
in using its money to generate returns. Comparing a company’s ROIC with its weighted average
cost of capital (WACC) reveals whether invested capital is used efficiently or not (Popa &
Ciobanu, 2014).

2.6. Commercial Banks profitability

Profitability of the banking sector is a subject that has received a lot of attention in recent years
and there is now a large literature which has examined the role played by management of
resources in determining bank profitability. Profitability connotes a situation where the income
generated during a given period exceeds the expenses incurred over the same length of time for
the sole purpose of generating income (Shingjergji, 2013). Profitability can be expressed either
accounting profits or economic profits and it is the main goal of a business venture. Profitability
portrays the efficiency of the management in converting the firm’s resources to profits. Thus,
firms are likely to gain a lot of benefits related increased profitability (Kajirwa & Mabonga,
2020).

One important precondition for any long-term survival and success of a firm is profitability. It is
profitability that attracts investors and the business is likely to survive for a long period of time
(Dees & Anderson, 2003). Many firms strive to improve their profitability and they do spend
countless hours on meetings trying to come up with a way of reducing operating costs as well as
on how to increase their sales (Anisere-hameed, 2021). According to(Affecting et al., 2016;
Ndungu & Muturi, 2019) the net income provides information on how well the bank is doing,
but the constraint on using it is that it is not adjusted for the size of the bank. This makes it
difficult to compare how well a bank is doing compared to one other. In this way a basic measure

13
of bank profitability is the return on asset (ROA) which corrects for the size of the bank. It is true
that ROA provides useful and necessary information on bank profitability but this is not on the
major interest of the bank’s owners (equity holders). They are more concerned about how much
the bank is earning on their equity investment, an amount that is measured by the return on
equity (ROE), the net income per currency of equity (Duraj & Moci, 2015).

Sufian & Habibullah, (2009) pointed out the ROA has recognized as the key ratio for the
estimation of bank profitability and has become the most basic measure of bank performance in
the literature. ROA is often expressed as a function of internal and external determinants. He
agreed with past researchers that ROA shows the profit earned per dollar of assets and also the
reflection of bank’s management’s ability to utilize the bank’s resources in order to generate
profits (Gremi, 2013b) At the same time, (Quin et al., 2012). ROA is the best choice to measure
bank profitability because it will not be affected by high equity multipliers. On the other hand,
the relationship between bank performances and ROA, as the indicator of bank’s profitability
measurement, is argued by (Sarifudeen, 2015).

2.7 Factors Influencing Banks Profitability

A number of factors have influenced profitability of commercial banks ranging from to those
which are under the control of bank management and policy objectives (internal factors) to those
factors which are beyond bank management level (external factors) (Maaka, 2013). The internal
determinants include management controllable factors such as liquidity, investment in securities,
investment in subsidiaries, loans, non-performing loans, and overhead expenditure.

Other determinants such as savings, current account deposits, fixed deposits, total capital and
capital reserves, and money supply also play a major role in influencing the profitability (Allen
et al., 2011). Similarly, external determinants include those factors which are beyond the control
of management of these institutions such as interest rates, inflation rates, market growth, Gross
Domestic Product (GDP) and market share (Nasif & Corresponding, 2010). The internal factors
reflect the management policies of the banks and decisions made about the sources of funds,
expenses and liquidity management (Widyastuti et al., 2017). Internal factors of bank
profitability can be defined as those factors that are influenced by the bank’s management policy
objectives and decisions. Management effects are the results of differences in bank management

14
policies, decisions, objectives, and actions reflected in differences in bank operating results,
including profitability (Duraj & Moci, 2015; Gremi, 2013b). That management decisions,
particularly regarding loan portfolio concentration, were an important factor contributing in bank
performance (Yigermal, 2017).

2.7.1 Determinants of bank profitability

The review of empirical literatures on bank profitability show that determinants are organized in
two parts namely internal and external determinants. The internal determinants include variables
driven from financial statement and variables internal by their very nature. Internal determinants
comprise review of industry-specific determinants which has impact on the banking sector
profitability alone. (Staikouras & Wood, 2011) So the researcher use only bank specific or
internal factor below we will see some of the internal factor that affect bank profitability is used
by researchers.

2.7.1.1 Internal Determinants of bank profitability

The internal (bank-specific factors) are factors that are related to internal efficiencies and
managerial decisions. Such factors include determinants such as bank capital, bank size,
Liquidity, asset composition, income diversification, credit risk and operational efficiency
(expenses management) etc. (Iloska, 2014). The internal factors reflect the management policies
of the banks and decisions made about the sources of funds, expenses and liquidity management
(Eyasu & Arefayne, 2020). Internal factors of bank profitability can be defined as those factors
that are influenced by the bank’s management policy objectives and decisions. Management
effects are the results of differences in bank management policies, decisions, objectives, and
actions reflected in differences in bank operating results, including profitability (Ally, 2014).
Duraj & Moci, (2015) has mentioned that management decisions, particularly regarding loan
portfolio concentration, were an important factor contributing in bank performance.

2.7.1.2 Capital Adequacy

Capital adequacy is measured by the ratio of equity capital to total asset. Bank equity capital can
be seen in two ways. Narrowly, it can be seen as the amount contributed by the owners of a bank
(paid-up share capital) that gives them the right to enjoy all the future earnings or more

15
comprehensively or it can be seen as the amount of owners’ funds available to support a bank’s
business (Berger et al., 2008). It examines the relationship between profitability and bank
capitalization. A strong capital structure is essential for financial institutions in developing
economies, since it provides additional strength to withstand financial crises and increased safety
for depositors during unstable macroeconomic conditions. A high capital asset ratio is assumed
to be indicator of low leverage and therefore lower risk (Sufian, 2012).

Capital adequacy refers to the sufficiency of the amount of equity to absorb any shocks that the
bank may experience (Kosmidou, 2008). The ratio of Equity to total Asset is employed as a
measure for bank Capital Adequacy. This measures the percentage of the total asset that is
financed with equity capital. Capital adequacy therefore describes the sufficiency of the amount
of equity that can absorb shocks that banks may experience (Heuvel, 2002). Capital adequacy
requirements generally aim to increase the stability of the banking system by decreasing the
likelihood of a bank’s failure and to resist unexpected negative externalities that exist in banking
system (Acharya, 2009).

Capital Adequacy Ratio (CAR) shows the banks’ ability to maintain sufficient capital. The main
activity of the bank is to collect funds and channel them back in the form of loans. If a bank has
enough capital or meet the requirements, it can operate to create profit (Acharya, 2009). In
addition, the bank can provide large loans and it has enough assets as collateral for third party
funds deposited in the bank so that it will increase public trust. So when the ratio of capital is
higher, the performance of the bank is better The theory that Berger developed to explain this
direct relationship between capital and profitability is the signaling hypothesis (Aiyar et al.,
2015). Under this theory, bank management signals private information that future prospects are
good by increasing capital. Finally, a third interpretation relies on the effects of the Basel
Accord, which requires banks to hold a minimum level of capital as a percentage of risk-
weighted assets. Higher levels of capital may therefore denote banks with riskier assets, which
translate, in turn, to higher revenues that increase the profitability of the bank (Iannotta et al.,
2007).

A bank should be required to have adequate capital to support its risk assets in accordance with
the risk-weighted capital ratio framework. Research studies indicated that capital strength have a

16
positive and dominant influence on profitability of commercial banks in Ethiopia (Elshaday et
al., 2018).

Gul et al., (2011) also stated that banks with high capital ratio tend to earn more profit through
translating the safety advantage into profit. Research studies conducted in Ethiopian commercial
banks also revealed a positive relationship between banks capital and profitability. Research
studies indicated that capital strength have a positive and dominant influence on profitability of
commercial banks in Ethiopia (Anteneh & Tewolde, 2017; Aragaw, 2015).

A higher capital level brings higher profitability for Ethiopian commercial banks since by having
more capital; a bank can easily adhere to regulatory capital standards and the excess capital also
can be provided as loans (Malimi, 2017). Capital adequacy is therefore considered to have effect
on profitability of commercial banks. According to risk-return tradeoff, a higher equity to asset
ratio leads to a lower expected return. Opposed to risk-return hypothesis, Berger (2015)
examined the signaling hypothesis and bankruptcy cost hypothesis; suggesting that a higher
equity to asset ratio increase profitability due to lower costs of financial distress. Therefore, there
is an ambiguous relationship between capital ratio and bank’s profitability (Abel & Roux, 2016).

2.7.1.3 Bank branch number:

In most literatures the effect of size on banks profitability are represented by total asset
(Aladwan, 2015; San & Heng, 2013). Size is used to capture the fact that larger banks are better
placed than smaller banks in harnessing economies of scale in transactions and enjoy a higher
level of profits (Ayel, 2012; Kosumi &, 2021; Molla, 2018).

Threatened by the costs emanated from aggressive branch expansion observed that banks have
been moving steadily in developing their offerings electronically, with a long-term vision of
reducing branches and services by developing self -service centers. Reducing branches and staff
would lower overheads, allowing the banks to become lower-cost providers and enabling them to
become more profitable and competitive (Zewdu, 2016).

17
2.7.1.4 Liquidity

Liquidity is a prime concern for banks and the shortage of liquidity can trigger bank failure.
Banking regulators also view liquidity as a major concern (Maaka, 2013). This is because banks
without sufficient liquidity to meet demands of their depositors risk experiencing bank run
(Ariffin & Kassim, 2013). Holding assets in a highly liquid form tends to reduce income as
liquid asset are associated with lower rates of return. For instance, cash which is the most liquid
of all assets is a non-earning asset. It would be expected that higher liquidity would negatively
correlates with profitability (Shingjergji, 2013). Liquidity risk is estimated by the ratio of liquid
assets to total assets.

2.7.1.5 Loan amount

Loan is the main source of income and is expected to have a positive impact on bank
performance. Other things constant, the more deposits are transformed into loans, the higher the
interest margin and profits (Naceur & Goaied, 2011). However, if a bank needs to increase risk
to have a higher loan-to-asset ratio, then profits may decrease. In addition, as bank loans are the
principal source of income, we expect that noninterest bearing assets impact negatively on profits
(Al-Tarawneh et al., 2017). Bank loans which is explained by total loans divided by total asset
provides a measure of income source and measures the liquidity of bank assets tied to loans.
Total Loan/Total Asset is included in the study of profitability as an independent variable to
determine the impact of loans on banks’ profitability. This variable is obtained through the ratio
of bank loans to total assets. Loan =loans to total assets One of the most important roles of banks
is to offer loans to borrowers and loans serves as the main source of earnings for commercial
banks (Malede, 2014). In different words, loans are the highest yielding asset on bank’s balance
sheet. According to Abreu and Mendes (2002) the more the banks offer loans the more they do
generate revenue and more profit they make. Therefore, loans should positively affect
profitability as the bank is working vigilantly and not taking excessive risk (Malede, 2014).

2.7.1.6 Deposit amount

Deposits to assets ratio is another indicator of measuring profitability of commercial banks

(Onuonga, 2014). DPTA is considered as liability of banks. Customers make current, fixed or
saving deposits in banks. These deposits are considered as Bank liabilities because they have to

18
be repaid back to the depositors. Banks invest these deposits in other projects and generate
profits on them. Therefore, these deposits are considered as the main sources of banks’ funding
and hence they influence the profitability of banks. This ratio can be calculated as dividing total
deposits by total assets (Tuyishime, 2015). Mathematically: DPTA= Total Deposits/Total Assets.
Deposits are the main source of bank funding and hence it has an impact on the profitability of
the banks (Dr. Mumtaz & Khan, 2021). Even though, the contribution of increasing amount of
deposits to the profitability depends upon a number of factors.

Firstly, it depends on the capability of the bank to convert deposit liabilities into earnings.
Increasing those means that a bank has more funds available to use in different profitable ways
and that should increase ROA (Aburime, 2008). But on the other hand, high growth rates might
attract additional competitors and this may cause the decrease of the profits for all market
participants. Thus, the sign of this variable is either positive or negative. Deposits are the ratio of
total deposits to total assets which is another liquidity indicator but is considered as a liability.
Deposits are the main source of bank funding and hence it has an impact on the profitability of
the banks. Deposits to total assets ratio is included as an independent variable in this study
(Gremi, 2013).

2.7.1.7 Non-Interest Income

This is defined as revenue that banks earn from areas outside their lending operation or any
income that bank earns from activities other than their core intermediation business (taking
deposit and making loans) or from investment concludes (Gichure, 2015). Examples of non-
interest income include deposit and transaction fees, insufficient funds (NSF) fees, annual fees,
monthly account service charges; inactivity fees, check and deposit slip fees, etc. (Ng’endo,
2012). Institutions charge fees that provide non-interest income as a way of generating revenue
and ensuring liquidity in the event of increased default rates (Jaffar et al., 2014).

2.8. Empirical Study

2.8.1 Review of previous studies in other countries

This sub section presents some of the previous studies in other countries reviewed by the
researcher chronologically.
19
Kofi & Aeron, (2010) employed regression analysis to estimate and examine the determinants of
the profitability of commercial banks, by examining the drivers of the bank‘s profitability using
the Ghana Commercial Bank Ltd and Merchant Bank Ltd as case studies, following an
examination of the performance of the two Banks in two decades. Results from the study reveal
that the performance of the Banks has been highly volatile with the banks recording negative
profits during some periods within the two decade under their study i.e. from 1990 to 2009.
The independent variables they used in their study are size, credit risk, non-interest income, non-
interest expense, capital adequacy, and size of the Ghanaian economy, growth of money supply
and annual rate of inflation (Nagaraju & Boateng, 2018). The study revealed that non-interest
income, non-interest expense, bank's capital strength, natural log of total assets, growth of money
supply, and annual rate of inflation are significant key drivers of banks’ profitability in Ghana.
However, the size of the Ghanaian economy and loan loss provision or provisions for bad debt
did not have any significant impact on the banks profitability (Bokpin, 2013).

Sastrouwito & Suzuki; (2011) paper aims to analyze the determinants of post crisis Indonesian
banking system profitability, covering the period 2001-2008. They employed Panel data in the
empirical estimation, and a fixed cross-sectional effect capture unobserved idiosyncratic effects
of different banks. The effect of bank-specific (expenses management, capital adequacy, loan
intensity (credits/total assets), size), industry specific (concentration) and macroeconomic
determinants (inflation) were examined. The estimation results show that expenses management,
capitalization, and loan intensity significantly affect bank performance. They also found
evidence of the structure-conduct performance (SCP) hypothesis, indicated by a positive and
significant effect of industrial concentration on profitability. Furthermore, the evidence of the
impact of macroeconomic environment cannot be confirmed due to insignificant result.

Al-Qudah & jaradat (2013) used panel data analysis fixed effects model and the generalized least
square method to determine the effect of macroeconomic variables and bank characteristic on the
profitability of Jordanian Islamic banks for the period (2000–2011). Their study used Capital
adequacy, Liquidity, Leverage, size, Logarithmic of Amman stock Exchange index, Logarithmic
of construction licensed square meters and broader money supply growth as determinants of
Jordanian Islamic banks profitability.

20
The empirical analysis shows that capital adequacy and bank branch number have a positive and
significant impact on return on assets (ROA) and return on equity (ROE). While leverage
measured by total deposit to total assets has a negative and significant impact on (ROA) and
(ROE) while liquidity has an insignificant effect on (ROA) and negative significant impact on
(ROE) (Pointer & Khoi, 2019). The study found that macroeconomic factors represented by
Amman stock exchange index, construction licensed square meters and money supply growth are
good determinants for Islamic banks profitability. Thus, they concluded that banks with high
asset quality and low non-performing loan are more profitable than the others. The other bank
specific factor liquidity management represented by liquidity ratio was found to have no
significant effect on the performance of commercial banks in Kenya (Ongore & Kusa, 2013).
The moderating role of ownership identity on the overall performance of commercial banks in
Kenya was not significant. Thus, they conclude that the interaction effect of ownership identity
on the financial performance of commercial banks in Kenya was not significant. In general, they
concluded from this empirical study that bank specific factors (factors under the control of
managers) are the most significant determinants of the financial performance of commercial
banks in Kenya (Wanjohi & A, 2013).

Frederic (2014) study seeks to establish the underlying factors responsible for performance of
domestic commercial banks in Uganda. The factors are analyzed in the light of structure conduct
performance (SCP) and Efficiency hypothesizes (ES). This is supplemented by Global advantage
theory together with Home field theory. The study used Bank liquidity risk, Capital adequacy,
loan amount, deposit performance (amount), bank branch number, and number of customer.

The study concludes that Management efficiency measured by Operating expenses to total
income; Asset quality measured by Loan loss provisions to total Loans; Capital adequacy
measured by equity to total assets; Interest income measured by net interest income to total
assets and Inflation measured by consumer price index (CPI), are significant factors affecting
performance of domestic commercial banks in Uganda (Amidu & Adjasi, 2018).

Duraji & moci, (2015) analyzed bank-specific, industry related and macroeconomic
determinants of banks profitability in Albania. They performed multi linear regression analysis
with secondary data using a sample of data from 16 banks in the period from 1999 to 2014 by

21
taking ROE as dependent variable and credit risk, liquidity risk, total loans, GDP and inflation as
independent variables. The result indicates that except for credit risk all the factors i.e. liquidity
risk, total loans, GDP and inflation were significant factors that influence banks profitability in
Albania in the period under their study.

Samad, (2015) examined the impact of bank specific characteristics and macroeconomic
variables in determining the banks’ profitability of Bangladesh banking industry with a panel
data. He analyzed a total of 42 Bangladesh commercial banks’ financial reports from 2009-2011;
by taking bank specific characteristics such as bank financial risk, bank operational efficiency,
and bank sizes as well as macroeconomic variables such as economic growth to estimate their
impact of bank profits. The results indicate that bank specific factors such as loan-deposit ratio,
loan-loss provision to total assets, equity capital to total assets, and operating expenses to total
assets are significant factors (Mahmud et al., 2016).

2.8.2 Review of previous studies in Ethiopia

This particular section provides related studies conducted in the context of Ethiopia. To the
knowledge of the researcher, there appears to be very limited work on the assessment of
determinants of profitability of banks until about 2012. These studies include the studies of
(Semu, 2010), (Damena, 2011), (Abera, 2012) but after 2012 there have been more researchers
done like the studies of (Kebede, 2014) , (Abate & Mesfin, 2016); (Alemu, 2021); (Shifa,
Debela, & Tarfa, 2019).

This particular section provides a detailed review of the above mentioned papers
chronologically. On the other hand, (Damena, 2011), applied the balanced panel data of ten
Ethiopian commercial banks that covers the period from 2011 to 2020. The paper used fixed
effect (FE) technique to investigate the factors of capital, loan, deposits, non-interest income,
liquidity, number of branch and saving Interest rates on major profitability indicator i.e., return
on asset (ROA). The estimation results show that all bank-specific determinants, with the
exception of saving deposit, significantly affect private commercial banks profitability in
Ethiopia. Market concentration is also a significant determining factor of profitability.

22
While the study made by Abera, (2012) found that that capital strength, income diversification,
bank size and gross domestic product have statistically significant and positive relationship with
banks’ profitability. On the other hand, variables like operational efficiency and asset quality
have a negative and statistically significant relationship with banks’ profitability. However, the
relationship for liquidity risk, concentration and inflation is found to be statistically insignificant.
The study suggests that focusing and reengineering the banks alongside the key internal drivers
could enhance the profitability as well as the performance of the commercial banks in Ethiopia.

Kebede, (2014) main objective was to assess the Impact of National Banks Regulation on private
commercial Banks Performance in Ethiopia. She chooses three regulatory factors affecting banks
performance in terms of return on asset and net interest margin. The three regulatory factors are
NBE bill purchase, Credit cap and reserve requirement. She used balanced fixed effect panel
regression for the data of six private commercial banks in the sample covered the period from
2004 to 2013. The results of panel data regression analysis showed that NBE bill purchase and
Credit cap had negative and statistically significant impact on banks profitability but reserve
requirement had negative and insignificant impact on profitability. While measuring banks cost
of intermediation through Net Interest Margin three of the regulatory variables (i.e. NBE bills,
Reserve requirement and credit cap) had negative and statistically significant effect on net
interest margin. Among the control variables bank size had positive and statistically significant
effect on both performance measures, which means ROA & NIM. Operating efficiency and GDP
had positive and statistically insignificant effect on ROA but both were statistically significant
on NIM. Equity had positive and significant effect on ROA but had negative and statistically
insignificant on NIM. Inflation had positive and insignificant effect on ROA but had positive and
significant effect on NIM.

Alemu, (2015) was to investigate determinants of commercial banks profitability in Ethiopia by

using panel data of eight commercial banks from year 2002 to 2013. The study used mixed
research approach and secondary financial data was analyzed by using multiple linear
regressions models for the bank profitability measure, Return on Asset (ROA). He used fixed
effect regression model to investigate the impact of bank size, capital adequacy, liquidity risk,
operating efficiency, management efficiency, employee efficiency, funding cost, banking sector

23
 development, real GDP, inflation rate and foreign exchange rate on Return on Asset (ROA). The
empirical result found that that bank size, capital adequacy and gross domestic product have
statistically significant and positive relationship with banks profitability. On the other hand,
variables like liquidity risk, operational efficiency, funding cost and banking sector development
have a negative and statistically significant relationship with banks profitability.
However, the relationship for Management efficiency, employee efficiency, Inflation and
foreign exchange rate is found to be statistically insignificant (Rani & Zergaw, 2017).

2.10. Conceptual framework

Different empirical evidences suggested that profitability of commercial banks influenced by

different factors. This study will focus on assessing internal factors that affect commercial bank
of Ethiopia profitability.

Figure2.1: Schematic Diagram of Conceptual model

Independent variables
Dependent Variables

Capital Adequacy

Branch number Bank Profitability

Deposit amount
(ROA)
Loan amount
Liquidity Risk
Non-interest income

Source: Callaghan et al. (1995) cited by Kojo

24
 CHAPTER THREE

3. RESEARCH METHODOLOGY

3.1. Research design

To achieve the stated objective research design used to identify and evaluate the causal
relationships between the different variables under consideration (Marczyk et al., 2010). The
study used explanatory research design to identify the factors affecting bank profitability.

3.2 Research Approach

The study used quantitative approach in respect with research variables, since it tries to describe
the problem and attempts to explain the phenomenon with quantitative research approach. The
quantitative data gathering methods are useful especially when a study needs to measure the
cause and effect relationships evident between pre-selected and discrete variables.

3.3 Study Population

All operational commercial banks in Ethiopia considered as taken as the study population. As
stated before currently there are 18 operational private commercial banks in Ethiopia. According
to NBE annual report (2017/18), Ethiopia consists of 18 Commercial banks. There are
Commercial Bank of Ethiopia (CBE), develop bank of Ethiopia(DBE), Dashen Bank S.C (DB),
Awash Bank S.C (AB), Wogagen Bank S.C (WB), United Bank S.C (UB), Nib International
Bank S.C (NIB), Bank of Abyssinia S.C (BOA), Lion International Bank S.C (LIB), Cooperative
Bank of Oromia S.C (CBO), Berhan International Bank S.C (BIB), Buna International Bank S.C
(BUIB), Oromia International Bank S.C (OIB), Zemen Bank S.C (ZB), Abay Bank(AB),Addis
International Bank(ADIB), Debub Global Bank(DGB), addis international bak(AIB) and Enat
Bank (EB). Since the study analyses more depend on the secondary data obtained from NBE
annual report.

3.4 Sample Size and Sampling technique

A sample is a sub set of the total population that is of interest for the study topic, to which the
results of the study can be generalized (Bell et al., 2022). The purpose of this study is to identify
25
the factors that affect the profitability of private commercial banks in Ethiopia. Because of this,
the sample population for the study is ten private commercial banks in Ethiopia and for this study
10 years data from 2011-2020 were used from annual financial reports.

Due to this, from 18 banks operating in Ethiopia, by using purposive sampling technique this
study was takes ten banks namely; Awash international bank, Dashen bank, Bank of Abyssinia,
Wegagen bank, United bank, Nib international bank, Cooperative banks of oromia, Lion
international bank, Oromia international bank, Bunna bank that were registered by NBE before
20010/11 G.C.

From the target population, sample selected based on purposive Sampling method which is a
non- probability sampling procedure that ensures to achieve a certain goal that the study want to
address. To select sample banks the study compares private commercial banks that ten years
experiences in data that they have.

3.5. Data type and source

Data collection method is a blue print used to describe the way or manner in which a researcher
gathers relevant information which is going to use to answer the research questions (Akhtar,
2016). There are basically two main sources by which the researcher can collect data. Primary
data source is when the researcher collects new information either through observations,
interviews, questionnaires and then uses this data for analysis (Kilpatrick et al., 2000). The study
also stated secondary data.

In order to a gather the effect of bank specific factors on profitability of the bank audited
financial statements of private commercial banks in Ethiopia for 10 consecutive years was
collect. The secondary data collect through document reviews are mainly from the records held
by ten private commercial banks of Ethiopia and NBE.

26
Table3.1 List of selected studied banks

No
Name of the Bank Establishment Year

1 1994
Awash International Bank
2 1995
Dashen Bank
3 1996
Bank of Abyssinia

4 1997
Wegagen Bank

5 1998
United Bank

6 1999
Nib International Bank
7 2005
Cooperative Bank of Oromia
8 2006
Lion International Bank
9 2008
Oromia International Ban
10 2009
Bunna International Bank

Source: NBE 2021

3.6 Data analyzing method

The study used panel data analyzing method, because panel data has the advantage of giving
more informative data as it consists of both the cross sectional information, which captures
individual variability, and the time series information, which captures dynamic adjustment, the
collected panel data was analyze using descriptive statistics and multiple linear regression
analysis. The descriptive statistics (Mean, maximum and minimum values and standard
deviations) was use to analyze the general trends of the data from 2011 to 2020. A multiple
linear regression model and t-static test was used to determine the relative importance of each
independent variable in influencing profitability. For data analysis purpose, fixed effect model
27
(FEM) method was used to estimate the relationship between profitability and its factors by
using STATA version 14 in econometric software packages.

In light of the above, to investigate the relationship between Bank branch numbe (BBN), capital
adequacy (CAP), deposit amount (DP), Liquidity risk (LIQ), non-interest income (NII), loan
amount (LA) with return on asset (ROA) the following fixed regression model is developed.

3.7. Variable Definition & their measurements

According to Creswell (2009), the variables need to be specified in quantitative researches so

that it is clear to readers what groups are receiving the experimental treatment and what
outcomes are being measured. Accordingly, the study identified both dependent and independent
variables. Below the definition of the dependent and independent variables discussed.

3.7.1 Dependent Variable

Banks Profitability is the dependent variable. In the context of this study, bank profitability is
measured by Return on Asset (ROA).

Return on Asset (ROA): Measures the overall effectiveness of management in generating profits
with its available assets. A company is efficient if it can generate an adequate return while using
the minimum amount of assets. Efficiently working company does not require too much cash for
everyday operations and can shift its excesses to investments in new spheres. Consequently, the
ROA is considered a critical ratio for determining a company’s overall level of operating
efficiency and it shows how much profit was earned on the total capital used to make that profit.
Here, the profitability ratio is measured in terms of the relationship between net profits and
assets. The ROA may also be called profit-to-asset ratio (Jewell & Mankin, 2011).

The formula is as follows:-

28
3.7.2 Independent Variables

This section describes the independent variables that determine the dependent variables under the
study. The following are the dependent variables that the study focused on.

Capital Adequacy (CAP): should be an important variable in determining bank profitability,

although in the presence of capital requirements, it may proxy risk and also regulatory costs. In
imperfect capital markets, well-capitalized banks need to borrow less in order to support a given
level of assets, and tend to face lower cost of funding due to lower prospective bankruptcy costs
(Aburime, 2008). The measurement of capital adequacy is as follows:-

Liquidity Risk

The liquidity of a firm is measured by its ability to satisfy its short-term obligations as they come
due (Eljelly, 2004). Liquidity also stands for ability of a company to convert its assets into cash
quickly and with lower costs as possible. Such liquid assets are necessary to cover any “financial
emergencies” and play as a buffer in company’s operations. Liquidity ratios reflect the short term
financial strength/solvency of a company (van Frederikslust, 2012).

Without the required liquidity and funding to meet short-term obligations, a bank may fail
(Akhtar, 2016). For the purpose of this research, liquidity positions of private commercial banks
are used as a measure of bank performance.

29
Noninterest Income

The importance of fee-based services of commercial banks and their product diversification is
captured by non-interest income to total income ratio (NII). Although fee based services in
general generates lesser income than loans, it is expected to add something on banks profit and
have a positive relationship with profitability.

Non-interest income = all fee based service of bank

Loan
Bank loans are expected to be the main source of income and are expected to have a positive
impact on bank performance (Vong & Chan, 2009). The ratio is captured by dividing total loans
to total assets.

Deposits

Deposits are the main source of bank funding and hence it has an impact on the profitability of
the banks. Deposits are the ratio of total deposits to total assets which is another liquidity
indicator but is considered as a liability. Deposits to total assets ratio is included as an
independent variable in this study.

Number of branch

Bank branch number lead to more stable banking system by enabling banks to better diversify
and profitability their asset and wide by depositor base. Bank branches were also the most
profitable ones, suggesting the existence of a relationship between service profitability (Carlson
& Mitchener, 2005) . Bank branch number is referring by quantity of each branch in number.

30
3.8 Summary of hypothesis
Table3.2 expected sign for hypothesis

Variables Measure Notation Expected Sign

Dependent variables

Return on Asset Net Income/Total Asset ROA

Independent Variables

Capital adequacy Equity/ total assets ratio CAP +

Liquidity risk Bank Loan/deposit LQ -

Loan amount Total loan/total asset LOA +

Deposit amount Total deposit/total asset PDA +

Bank branch number Quantify in number BBN +

Non-interest income All fee based service NNI +

3.9 Model Specification

The study used Panel data it is a combination of cross sectional and time series observations. For
this study, fixed effect model was selected. It is one of panel model which control for unobserved
heterogeneity among cross sectional units. The following equation indicates the general model of
the study

If the omitted variable is correlated with the included variable, the estimators are biased and
inconsistent. If the omitted variable is not correlated with the included variable, the estimators
are unbiased and consistent.

31
Where π it is the dependent variable and is observation on profitability measures of ROA, for

bank i at time t, and C is constant term is the vector of mth bank specific

variable is the error term.

= + 1 + 2LQ + 3LOA + 4DPA + 5BBN + 6NII +

Where:

= Return on asset for bank i at time t

= Capital adequacy for bank i at time t

= Liquidity risk for bank i at time t

LOA = loan amount for bank i at time t

DPA = deposit amount for bank i at time t

BBN = bank branch number for bank i at time t

NII = non-interest income for bank i at time t

= the error term

32
 CHAPTER FOUR

4. RESULT AND DISCUSSIONS

4.1 Introduction

This is one of the core chapters’ that with the discussion and analysis of data that are collected
from the sampled banks annual reports of the national bank of Ethiopia (NBE) and each private
commercial banks audited annual financial reports. The audited financial income statements of
the banks over the study period has been obtained from National Bank of Ethiopia, which is
responsible for maintaining and documented the audited financial statements of all private and
public commercial banks operating in the country and regulate their operating activities, the
country‘s central bank. Basically, the balance sheet and income statements were the main
sources of the relevant data to address the stated objectives of the study. Based on this the study
were analyzed in two major sections. The first section describes factors of private commercial
banks profitability using percentage ratio and the second section presented the correlation and
regression panel analysis to determine cause effect relationship between dependent and
independent variables with their testing formality.

4.2 Descriptive Analysis

Table 4.1 describes a summary of the descriptive statistics of the dependent and independent
variables for ten private commercial banks from the year 2011 to 2020 with a total of 100
observations. The table shows the mean, minimum, maximum, standard deviation and number of
observations for the dependent variable profit (ROA) and independent variables capital
adequacy, liquidity risk, loan amount, deposit amount, bank branch number and non-interest
income were analyzed in the table below.

33
Table4.1 Descriptive Statistics for the study variables

Variable Observations Mean Std. Dev. Min Max

ROA 100 1117.373 989.8006 46.28 6197.64

CAP 100 19994.3 16970.78 781.36 89287.99

LOA 100 570.9737 651.6785 1 3688.15

LQD 100 .2446 .1064621 .11 .52

DPA 100 18576.92 30048.64 491.32 277330.9

BBN 100 177.11 120.6714 11 541

NII 100 551.9 409.5153 39 2336

#except liquidity risk other variable were describe by birr (in million)

Source from STATA output

As shown in the Table 4.1 above, the mean value of return on assets (ROA) was around
1117.373 million for sampled private banks in Ethiopia. This means that a one birr investment in
total assets of private banks’ generates birr 11.17 birr average profits for the period of 2011-
2020. The standard deviation among banks in terms of profitability was 989.8 birr this confirms
that there was small variation among banks’ during the study period.

Output of the descriptive statistics indicates in Table 4.1 that the mean value of CAP 19994
million. This is to mean that on average in 10 years the banks owned total asset of birr 19994
million. On the other hand, the least and highest asset of the bank in 10 years is 781 and 89287
million respectively. The study data set of asset has experienced standard deviation equal to
16970 million which is closely to mean value in given data set which shows the asset of the bank
highly closed from mean asset from year to year.

34
The ratio of Liquidity (LQD) shown in Table 4.1 is measured by cash and bank balances to total
deposits ratio. The mean value of liquidity ratio was 0.24 %; it shows that the sector was
relatively no liquid risk. The standard deviation was 0.10%, while 0.11% and 0.52% observed as
minimum and maximum values respectively. As shown from the result, there were similar
discrepancies among banks regarding liquid management.

Loan amount (LOA) is another means of bank specific determinants which shows the loan
become efficient it means generating high total income. To examine whether the observed
improvements in loan growth have benefited bank profits, the rate of change in loan amount was
estimated. During the period 2011-2020 loan amount of Ethiopian private commercial banks
grew at annual average rate of 571miliion with standard deviation of 652 million. Further, it had
1% and 36.88% of minimum and maximum values. This describes there was a bit more
deviations among sampled banks concerning of a rate of change in loan amount.

Output of the descriptive statistics indicated in Table 4.1 that the mean value of deposit amount
(DPA) 18576 million. This is to mean that on average in 10 years the banks owned total deposit
of birr 19994 million. On the other hand, the least and highest deposit of the bank in 10 years is
491.32 and 277330 million respectively. The research data set of deposit has experienced
standard deviation equal to 30048 million which is standard deviation is not closed to mean
value in given data set which shows the deposit of the bank relatively not closed from mean
deposit from year to year.

Other internal determinant of bank profitability was noninterest income to total income of each
bank (NII). This is revealed that how much a bank generates fee based income other than interest
income as proportion to total income. On average, sampled banks mean have obtained 551.9
million non-interest income with standard deviation of 409.51 birr in million during the study
period. The minimum and maximum values of this birr in million were 38 and 2336 respectively.
This is still showed that there were higher variations among banks’ in terms of non-interest
income generation capacity.

On average the branches of the bank branch number in 10 years sample period are 177.11
Minimum number of branches during the study period is 11 at first year of the study and

35
maximum number of branches during the study is 541. Data set of study of number of branch has
experienced standard deviation equal to 121. This clearly shows that there was a higher deviation
among banks in branch number diversification during the study period.

4.3 Model selection between Fixed and Random Effect Model

It is also necessary to determine whether the fixed effect or random effect approach is suitable. A
common practice is to make the choice between both requests by running a Hausman test. To
conduct a Hausman test, the number of cross section should be greater than the number of
coefficients to be estimated. In this study, the number of cross section is ten banks included in
the sample and the number of coefficients of the explanatory variables is seven with dependent
variable.

To decide between which model to use from random effects and fixed effect model, researchers
often rely on the (Hausman, 1978) specification test Clark & Linzer,2015; Townsend et al.,
(2013); and Rahman & Miah, (2017). The Hausman test is designed to detect violation of the
random effect modeling assumption that the independent variables are Orthogonal to the unit
effects. Under the null hypothesis of orthogonality, H is distributed chi-square with degrees of
freedom equal to the number of repressor’s’ in the model. A finding that p < 0.05 is taken as
evidence that, at conventional levels of significance, the two models are different enough to
reject the alternative hypothesis, and hence to reject the random effects model in favor of the
fixed effects model (Gujarati 2004).

In this study as seen in the result table below, the Hausman test clearly rejects the null hypothesis
to use the random effect model by seeing the P-Value 0.0000 is less than 0.05. As a result, the
researcher can reject the random effect model in favor of fixed effect model. And hence, the
study chooses fixed effect model is more appropriate to estimate.

36
4.3.1 Hausman result

Table4.2hausman test

hausman fixed
---- Coefficients ----
| (b) (B) (b-B) sqrt(diag(V_b-V_B))

| fixed random Difference S.E.

-------------+----------------------------------------------------------------

capital | .0526122 .0563918 -.0037796 .0029762

liquidity | -126.1993 -457.437 331.2377 320.4379

loan | .0363226 .1176944 .0586283 .0203868

Deposit | .0012254 .0015301 -.0003047 .

branch no | -5.770349 -4.443128 -1.327221 .5679086

noninteres~m | 1.06475 .9302741 .1344763 .0233543

------------------------------------------------------------------------------

b = consistent under Ho and Ha; obtained from xtreg, t…fe

B = inconsistent under Ha, efficient under Ho; obtained from xtreg

Test: Ho: difference in coefficients not systematic

chi2(4) = (b-B)'[(V_b-V_B)^(-1)](b-B)

= 16.05

Prob>chi2 = 0.0000

(V_b-V_B is not positive definite)

Source from STATA output

Hausman, (1978) specification test was used to decide between random effects and fixed effects
model. The null hypothesis of the test was that random effects model is more appropriate; that is,
the difference in coefficients not systematic and the alternative hypothesis was that fixed effects
is appropriate.

37
Panel regression is variables that could vary with time and fixed in the model but might have
impact on the regression result. To avoid such a problem in the model, fixed panel model is
chosen.

2
On the table above, the result of Housman test show that the p-value of chi is statistically
significant at one percent (0.000) means that rejects the null and accepts the alternative. So, fixed
effect is the appropriate model for this specific statistics.

4.4 Panel Model Regression

Table 4.2 Regression Analysis of the factors of Ethiopian Private Banking profitability with
ROA using Fixed -effects regression Model.

Table 4.3 panel model regression.

Robust
ROA Coef. Std. Err. T P>t
CAP .058849 .0101216 5.81 0.000
LIQ -303.8818 183.0367 -1.66 0.131
LOA .053649 .1339524 0.38 0.716
DPA .0011291 .0003812 2.96 0.016
BBN -4.797993 1.056408 -4.54 0.001
NII 1.19382 .1801058 6.63 0.000
Cons 156.2276 124.3349 1.26 0.241
No. of observations = 100
No. of group=10
Over all R2 =0.9484
Prob > F = 0.0000
F(6, 9) = 87.51
# indicates the variable by their quantifying behavior

Source from STATA output

Table 4.3 presents the regression result of panel data using fixed effect model. The model was
established based on the hausman of panel data model which is known as fixed effect model.

38
Basically, 0.95% of the variation in the dependent variable is explained by independent
variables. 0.05% is not explained by the above independent variables.

Capital adequacy

According to the above regression the coefficient of the variable representing result capital
adequacy which is measured by total capital asset to total assets has significant effect by 5.88%
on profitability of private commercial banks. The coefficient of the variable representing capital
adequacy showed a positive coefficient and significant at increases profitability of bank’s by
5.88% holding other variables constant.

This positive association of capital and bank profitability is in line with earlier endeavors. As the
variable regarding capital adequacy in the model ratio of capital asset to total asset, it can be
concluded that if banks has high amounts of capital, that is, banks with relatively more
profitable, according the result, alterative hypothesis was accepted. Moreover the result was also
accepted with the existed reality in the Ethiopian banking industry, which shows that the finding
has direct and positive relationship with capital strength and bank profitability (Bekena, (2019)
Melaku, (2015) Amdemichael , (2012) Shifa, Debela, & Tarfa, (2019).

Liquidity risk

The above Table 4.3 results showed that Liquidity, which measures ability to cover current
obligations using current assets, in statistically finding shown that liquidity risk is insignificant
effect on the profitability of banks in Ethiopia because the respected coefficient is above
expectation and p-value greater than 5%. Even if this study shown insignificant effect, the result
is in line with the prior expectation and consistent with the findings of Suheyli, (2015); Abate
and Yuvaraj, (2013); John et al., (2013) and Agnes (2012) argued that the greater amount of the
resources that are tied up to meet the liquidity position, and also the result of other study who
found a significant positive relationship between liquidity ratio and profitability (Olokoyo, 2011
and Mitku, 2014). However in contrast with the study findings of Berhe and Kaur (2017), who
has concluded that liquidity is negatively related with profitability. Therefore alternative
hypothesis was rejected.

39
Loan amount

In the above Table4.3 Loan show insignificant impact on bank profitability in private
commercial bank in Ethiopia. Because the result shows that there is insignificant impact because
beta coefficient results shown in the above table it is beyond of p-value expectation. However
The result is in line with the prior expectation and consistent with the empirical findings of
Malede, (2014); Abera and Mendes, (2012) who has concluded that loan has positively
significant related with profitability. Therefore alternative hypothesis was rejected.

Deposit amount

The ratio of deposit amount is total deposit to total asset which is a measure of adding money to
bank account from customer have a positive effect on profitability, which is in agreement with a
prior expectation. In addition, this variable was also statistically significant at 1.6% significance
level (p-value =0.016) in explaining the variability in ROA of private commercial banks in
Ethiopia. The coefficient of the variable representing deposit amount showed a positive
coefficient and significant at increases profitability of bank’s by 0.16 % holding other variables
constant. Thus, DPA was considered as a one driver of the profitability of private Commercial
banks in Ethiopia. That means in the last ten years revenue generated from deposit activities
were one of the relevant drivers of their performance in general of profitability in particular. This
study was also consistent with the previous empirical findings of Sufian et.al, (2009); Flamini
et.al, (2016) and Trujillo- Ponce (2012) researcher who found deposit amount has significant and
positive relationship with bank profitability. Therefore the alternative hypothesis was accepted.

Number of branch

Number of branch was found negative significant effect in private commercial bank profitability
in Ethiopia with p- value at 0.001 significant level. The coefficient of operation efficiency is
negative significance at 4.8%. This tells a change in one percent of operation efficiency will have
an effect to a change in ROA in negative 4.8%. So, it is possible to say that banks profitability
negatively affected by branch number when branch numbers were expand will lose the profit.
The result is consistent with the empirical findings of (Aladwan, 2015; San & Heng, 2013) all of
these researchers found that branch number has negative and significant relationship with ROA.

40
However Selamawit taye, (2016) suggest that the relationship between bank branch number has
positive impact on profitability and she said when branch number increase that ensuring the
quality service then the profitability will increase. Therefore alternative hypothesis was accepted.

Non-interest income

The importance of fee-based services of commercial banks and their product diversification is
caught by non-interest income to total income ratio (NII). The result shows that there was a
positive relation with bank profitability and statistically significant at 1% confidence level. For
one unit increase in NII ratio, bank profitability is expected to increase by 10.2%.

The effect of Noninterest income on profitability is positive and significant. Noninterest income
also affects bank profitability positively at 1% level of significance. The result of this study is
consistence with the empirical result of other researchers found a positive and insignificant
relationship between NII and bank profitability (sufian & razali 2008), (selamawit 2016).
Therefore the alternative hypothesis was accepted.

4.5 CORRELATION DIAGNOSTICS TESTS

In this study as mentioned before diagnostic tests were carried out to ensure that the data fits the
basic assumptions of fixed effect model. Consequently, the results for the model assumptions test
are presented as follows.

Breusch-Pagan LM test correlation

The Table under appendix F suggests that the p- value of correlation is 0.1161 so that the
variable no crossectional dependency has no correlated because breusch-pagan test shows that
explanatory variable is no cross sectional dependency because the value is less than 0.5.

The statement of this assumption is that the errors associated with one observation are not
correlated with the errors of any other variable of observation. Brooks, (2008) it is assumed that
the errors are uncorrelated with one another. This is not much of a problem in panels with few
years and large number of cases. Panel cross dependence can lead to bias in tests results.
Breusch-Pagan LM test correlation is one of the tests used to check whether the residuals are

41
correlated across entities. The alternative hypothesis of the test is that the residuals across entities
are absolutely not correlated. The result presented on the Appendix F.

Wooldridge test for autocorrelation in panel data

Table4.4 wooldridge test for outocorrelation

Wooldridge test for autocorrelation in panel data

H0: no first-order autocorrelation

F( 1, 9) = 0.584

Prob > F = 0.4644

Source from STATA output

The above Table 4.4 showed that as recalled from hypotheses that postulate the relationship
between the dependent variable of private commercial banks profitably and the independent
variables.

In general, even though the correlation analysis shows the direction and degree of associations
between variables, it does not allow the study to make cause and affect inferences regarding the
relationship between the identified variables. Thus, in examining the effects of selected
independent variables on commercial banks profit, the fixed effect regression analysis which is
no serial correlation because of Prob > F = 0.4644 that means greater than 0.05 Serial
correlation.

Modified Wald Test for Groupwise Heteroskedasticity

Table4.5 modified wald test for group wise heteroskedasticity

xttest3

Modified Wald test for group wise heteroskedasticity

in fixed effect regression model

H0: sigma(i)^2 = sigma^2 for all i

chi2 (10) = 856.13

Prob>chi2 = 0.0000

42
Source: - STATA output

The above Table 4.5 error term ε can be heteroskedastic if variance of the conditional
distribution of εi given Xi cross dependency is non-constant for i = 1, 2… n, and specifically
does not depend on X; else, ε is homoscedastic.” Heteroskedasticity can result in wrong
estimates of standard errors for coefficients and hence of their t‐values. While the estimates of
fixed effect regression might not be biased in this case, standard errors do become wrong.
Results show that null hypothesis is rejected when (p-val < 0.05). And it can be concluded that
variables are not homogeneous.

Normality test

Figure 4 1 test for normality

Source from STATA output

From above figure 4.1, it can be noted that the density and residual is normally distributed to the
mean of zero, since the shape of the histogram is bell shaped. Therefore, the normality
assumption is fulfilled.

43
Multicolonearity test
Table4.6multicilinearity test

. multicolonearity
Variable | VIF 1/VIF

-------------+----------------------

capital | 17.28 0.057862

branchno | 10.42 0.095996

noninteres~m | 6.24 0.160184

loan | 4.62 0.216400

liquidty | 2.07 0.482322

deposit | 1.48 0.676476

-------------+----------------------
Mean VIF | 7.02

Source from STATA output

Tables4.6 above about variables relationship showed that the pair wise as well as average
variance factor correlation indicates there is no severe problem of multicollineraity between
independent variables in the model. According to (Kennedy,2008).

Since Multicolonearity test result show that p-value is statistically significant at 1%, 5% and
10%, the model has no multicollinarity problem.

In order to assess the separate influence of independent variables on the dependent variable
multicollinearity tests are very important. The result in Table 4.6 reports a mean of VIF 7.02 that
was lower than the limit of 10. The VIF for individual variables was also very low, supporting
the conclusion that the explanatory variables included in the model were not substantially
correlated with each other. Accordingly, in this study, there was no problem of multicollinearity,
which enhanced the reliability for regression analysis.

44
Table 4.7 Summary of expected and actual signs of explanatory variables
on the dependent variable.
Independent Variables Expected Statistical test Result

Capital adequacy Positive Significant Accept

Liquidity risk negative Insignificant Reject

Loan amount Positive Significant Reject

Deposit amount Positive Significant Accept

No of branch Positive Significant Accept

Non-interest income Positive Significant Accept

45
 CHAPTER FIVE

5. SUMMARY, CONCLUSION AND RECOMENDATIONS

5.1 Summary of Finding

This study is conducted with title of factor affecting the profitability of private commercial banks
in Ethiopia with the case study of private commercial bank of Ethiopia. The study intended to
identify significant internal factors of the banks by using data of 10 years from 2011 to 2020
from this profitable bank. The researcher developed relevant research hypothesis to reach the
objective. As the descriptive research, the study was used descriptive analysis for the data
presentation and result discussion of the study. The researcher collected quantitative data from
National Bank of Ethiopia and private Commercial Bank of Ethiopia. The researcher used fixed
effect model for regression analysis. Return on asset (ROA) is used as dependent variable in
order to measure profitability of the bank. Capital adequacy, liquidity risk, loan amount, deposit
amount, Bank branch number and non-interest income of the bank are used as independent
variable.

The findings revealed that capital adequacy, non-interest income, deposit amount, bank branch
number are the major significant determinants of the profitability of private commercial bank of
Ethiopia. According to this study capital adequacy, deposit amount and non-interest income have
significant positive effect on profitability of the bank but bank branch number and loan amount
of the bank have significant and the negative effect.

5.2 Conclusions

The empirical finding of the factor affecting the profitability of private commercial bank in
Ethiopia suggests the following conclusions.

The main purpose of this study was to find out the most internal factors that affecting bank
profitability of private commercial bank in Ethiopia. The necessary data was collected from
secondary sources which are held in NBE and each main office. Financial ratios were calculated
and statistical tools including; (percentages, averages, correlation, descriptive analysis of
variance the correlational and regression analysis) were utilized in testing the hypotheses.

46
As a result, this study investigated the effects of internal factor of profitability on private
commercial bank in Ethiopia over the period 2011 to 2020. The study used secondary panel data
which cooperated with time series and cross sectional and also collected from the National Bank
of Ethiopia and from each bank head office. The regression and correlational analysis was done
by using the fixed effect model.

First, among the bank internal variables as expected, the result showed a positive relationship
between capital adequacy and profitability with strong statistical significance. The coefficient for
the ratio capital adequacy is the first highest positive, showing that an increase in capital strength
will result in increased profitability. This is in line with the expectation as a bank with a strong
capital position is able to handle business opportunities more effectively and also flexibility to
deal with problems arising from unexpected losses, thus achieving increased profitability.

Loan amount have negative significant effect on profitability of the bank. This negative
relationship is suggesting that when loan of the bank is increasing, it earning lower profit through
diseconomies of scale. The private commercial bank of Ethiopia is still losing from diseconomies
of scale. From this result the researcher concludes the bank is losing from large loan it owns.
Therefore, loan of the bank is an important factor but negatively affecting profitability of private
commercial bank of Ethiopia.

The positive and significant impact of deposit amount on return on asset shows that increasing
deposit amount increase profitability of private commercial banks in Ethiopia. This implies that
the high costs generated by deposits lead to weigh positively on the performance of banks.
According to positive relationship between the amount of deposits and private commercial banks
profitability, since in this study the ratio of deposits to total assets have been used to measure this
variable, It seems that absorbing of long term deposits and the more absorption of short term and
current deposits caused the increase profitability of private commercial banks.

Non income has significant positive effect on profitability of the bank. According to the result,
the performance of the bank is best, it collects highest non income. Increasing non-interest
income is increasing net income of the bank and increasing its profitability. The researcher
concludes that when the bank that increases its non-interest income, it earns higher.

47
Therefore, non-interest income is among major determinants of the profitability of the bank that
it significantly determines performance of the bank. This suggests that there is possibility for the
banks to increase its profits by putting more effort to increase non-interest income. This can be
achieved by finding ways of optimal utilization of bank resources. Therefore, noninterest
expense is among major determinants of the profitability of the bank.

Branch expansion has negative significant effect on profitability of the bank. This negative
relationship is suggesting that when branch of the bank is increasing, it earning lose. The private
commercial bank of Ethiopia is still losing profit from branch expansion. From this result the
researcher concludes the bank is losing from branch expansion. Therefore, branch expansion
strategy is not effective to determining profitability of the bank. Liquidity risk is insignificant
impact on the private commercial bank of Ethiopia.

5.3 Recommendations

Based on the above findings the following recommendations are drawn.

 There is need for private commercial banks to consider raising their capital more as it is
found to have influence on profitability. Private commercial Banks should increase capita
asset, and proper mechanism instead using it to raise the capital in addition should have
contact with shareholder. The government should also continue to encourage banks to
raise their capital asset.
 Expansion of Branch is significantly and negatively affecting profitability of the banks. It
is one of the main strategies of Ethiopian banks used to increase its performance by the
adding banks and more accessible to the existing new customers. But branch expansion
comes with asset expansion that has negative impact on profitability. The study
recommends that all private commercial banks should have to revisit their inefficient
aggressive branch expansion strategy.
 It is advisable for private commercial banks to increase and expand loan amount. Because
of the effective loan system increase their profitability of banks. Managers should also
focus on maximize loan in efficient utilization on liquidity risk.

48
 Private commercial banks’ in Ethiopian should have enhance their strategies in
mobilizing deposits from the public by creating awareness in the society to increase
saving and they have to improve their service excellences, Because the study indicates
that deposit plays a great role as a source of profit.
 Finally, the study sought to carry out factors affecting profitability of private commercial
banks in Ethiopia. For comprehensive investigation future researcher should increase the
variable of observations by increasing the sample size and extending the period of time
with unbalanced data. In addition, future research should cover and take to capture
differences countries and to uncover difference from financial system and regulation
factors.

49
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 APPENDICES
Appendix1: descriptive, regression and autocorrelations test

Appendix A: descriptive

Variable Observations Mean Std. Dev. Min Max

ROA 100 1117.373 989.8006 46.28 6197.64

CAP 100 19994.3 16970.78 781.36 89287.99

LOA 100 570.9737 651.6785 1 3688.15

LQD 100 .2446 .1064621 .11 .52

DPA 100 18576.92 30048.64 491.32 277330.9

BBN 100 177.11 120.6714 11 541

NII 100 551.9 409.5153 39 2336

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Appendix B: panel regression output

Robust
ROA Coef. Std. Err. t P>t
CAP .058849 .0101216 5.81 0.000
LIQ -303.8818 183.0367 -1.66 0.131
LOA .053649 .1339524 0.38 0.716
DPA .0011291 .0003812 2.96 0.016
BBN -4.797993 1.056408 -4.54 0.001
NII 1.19382 .1801058 6.63 0.000
cons 156.2276 124.3349 1.26 0.241
No. of observations = 100
No. of group=10
Over all R2 =0.9484%
Prob > F = 0.0000
F(6, 9) = 87.51
# indicates the variable by their quantifying behavior

Note that the abbreviation ROA stand for return on asset, CAP for capital adequacy, LIQ stands
for liquidity risk, LOA stands for loan amount, DPA stands for deposit amount, BBN stands for
bank branch number, NNI stands for non-interest income.

Appendix C: Correlation test

. vif

Variable | VIF 1/VIF

-------------+----------------------
capital | 17.28 0.057862

branchno | 10.42 0.095996

noninteres~m | 6.24 0.160184

loan | 4.62 0.216400

liquidty | 2.07 0.482322

deposit | 1.48 0.676476

-------------+----------------------
Mean VIF | 7.02

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Appendix D: hausman fixed

hausman fixed

---- Coefficients ----

| (b) (B) (b-B) sqrt(diag(V_b-V_B))

| fixed random Difference S.E.

-------------+----------------------------------------------------------------

capital | .0526122 .0563918 -.0037796 .0029762

liquidity | -126.1993 -457.437 331.2377 320.4379

loan | .1763226 .1176944 .0586283 .0203868

Deposit | .0012254 .0015301 -.0003047 .

branch no | -5.770349 -4.443128 -1.327221 .5679086

noninteres~m | 1.06475 .9302741 .1344763 .0233543

------------------------------------------------------------------------------

b = consistent under Ho and Ha; obtained from xtreg, t…fe

B = inconsistent under Ha, efficient under Ho; obtained from xtreg

Test: Ho: difference in coefficients not systematic

chi2(4) = (b-B)'[(V_b-V_B)^(-1)](b-B)

= 16.05

Prob>chi2 = 0.0000

(V_b-V_B is not positive definite)

62
Xtsum

Variable | Mean Std. Dev. Min Max | Observations

-----------------+--------------------------------------------+----------------
banks overall | 5.5 2.886751 1 10 | N = 100
between | 0 5.5 5.5 | n = 10
within | 2.886751 1 10 | T = 10
| |
year overall | 2015.5 2.886751 2011 2020 | N = 100
between | 3.02765 2011 2020 | n = 10
within | 0 2015.5 2015.5 | T = 10
| |
profit overall | 1117.373 989.8006 46.28 6197.64 | N = 100
between | 657.1649 468.033 2431.316 | n = 10
within | 766.2245 -290.4632 4907.353 | T = 10
| |
capital overall | 19994.3 16970.78 781.36 89287.99 | N = 100
between | 14067.34 6200.299 47503.14 | n = 10
within | 10397.47 -8641.727 61779.16 | T = 10
| |
liquidity overall | .2446 .1064621 .11 .52 | N = 100
between | .0980376 .146 .461 | n = 10
within | .0509565 .1596 .4876 | T = 10
| |
loan overall | 570.9737 651.6785 1 3688.15 | N = 100
between | 363.3143 141.529 1186.974 | n = 10
within | 551.9849 -615.0003 3072.15 | T = 10
| |
deposit overall | 18576.92 30048.64 491.32 277330.9 | N = 100
between | 18135.39 4610.132 63629.14 | n = 10
within | 24574.94 -31401.43 232278.7 | T = 10
| |
branch no overall | 177.11 120.6714 11 541 | N = 100
between | 114.6066 46.6 373.9 | n = 10
within | 51.19552 46.21 344.21 | T = 10
| |
nonint~m overall | 551.9 409.5153 39 2336 | N = 100
between | 249.0365 286.1 1020.9 | n = 10
within | 333.6491 -36 1867 | T = 10
| |
_est_f~d overall | 1 0 1 1 | N = 100
between | 0 1 1 | n = 10
within | 0 1 1 | T = 10
| |
_est_r~m overall | 1 0 1 1 | N = 100
between | 0 1 1 | n = 10
within | 0 1 1 | T = 10

. correlate capital liquidity loan deposit branch no non interest incom

(obs=100)

Appendix E: variable xtsum

63
Appendix F: Correlation matrix of residuals:
Correlation matrix of residuals:

__e2011 __e2012 __e2013 __e2014 __e2015 __e2016 __e2017 __e2018 __e2019 __e2020

__e2011 1.0000

__e2012 0.6081 1.0000

__e2013 -0.4323 -0.0156 1.0000

__e2014 0.5148 -0.0961 -0.4779 1.0000

__e2015 0.6595 0.0346 -0.2963 0.7557 1.0000

__e2016 0.6325 -0.0642 -0.2538 0.5378 0.8410 1.0000

__e2017 0.8061 0.2700 -0.2384 0.4833 0.6210 0.7643 1.0000

__e2018 0.2867 0.0199 0.2839 -0.1292 0.2637 0.5404 0.3963 1.0000

__e2019 0.4599 0.4095 0.3465 -0.2396 0.3503 0.4794 0.5211 0.7431 1.0000

__e2020 0.6498 0.3510 0.0346 0.0463 0.5744 0.7660 0.6495 0.5627 0.7961 1.0000

Breusch-Pagan LM test of independence: chi2(28.91) = 108.717, Pr = 0.1161

Based on 10 complete observations over panel units

Note: on correlation matrix only focus on p-value on Breusch-Pagan LM test

Appendix F: multicolonearity
. multicolonearity

Variable | VIF 1/VIF

-------------+----------------------
capital | 17.28 0.057862
branchno | 10.42 0.095996
noninteres~m | 6.24 0.160184
loan | 4.62 0.216400
liquidty | 2.07 0.482322
deposit | 1.48 0.676476
-------------+----------------------
Mean VIF | 7.02

64
Note: - below in appendix financial income statement in banks order no1 for awash, 2 for
dashen, 3 for abbsinya, 4 wogagen, 5 for united, 6 for nib, 7 for cooperative oromia, 8 for lion, 9
for oromia international, 10 for bunna.

banks Year profit capital liquidity loan deposit branch NNI

1 2011 865.7 10115.99 0.4 300.75 7743.78 70 532
1 2012 925.01 11936.68 0.27 360.18 9204.36 86 442
1 2013 1495.65 16079.55 0.22 559.59 12545.21 114 529
1 2014 1446.55 20028.29 0.25 1078.12 15039.71 152 832
1 2015 1506.56 23869.61 0.16 985.58 18520.42 207 839
1 2016 1729.79 29609.6 0.2 1403.96 22832.03 245 901
1 2017 2353.81 41974.86 0.17 2192.97 30590.9 339 1176
1 2018 3453.83 55268.11 0.21 2455.05 43451.38 382 1203
1 2019 5784.23 74635.4 0.15 2848.17 59616.06 423 2079
1 2020 6197.64 89287.99 0.16 3688.15 70577.9 481 2336
2 2011 1080.53 14659.79 0.42 384.57 11841.24 65 678
2 2012 1545.29 17520.31 0.33 564.31 14065.6 75 827
2 2013 1933.73 19747.17 0.31 765.41 15851.26 112 796
2 2014 1670.07 21962.2 0.3 627.98 17681.34 142 1004
2 2015 1692.94 24763.88 0.22 807.31 19814.11 164 1101
2 2016 1677.66 28576.43 0.24 1186.87 22758.5 218 1211
2 2017 1735.87 34624.6 0.15 1464.18 27782.52 302 1244
2 2018 2072.36 45425.37 0.16 1115.58 35986.8 378 1186
2 2019 2295.83 56218.42 0.11 2115.72 44721.51 416 1053
2 2020 3327.26 68261.33 0.13 2857.84 63493.87 431 1381
3 2011 439.31 7277.56 0.4 102.77 6075.26 57 245
3 2012 504.9 8239.72 0.31 171.11 6771.46 61 225
3 2013 616.23 10160.11 0.24 160.74 8496.15 86 281
3 2014 622.19 11276.39 0.24 272.12 9096.48 109 278
3 2015 665.71 13667.55 0.46 1 11118.17 136 353
3 2016 828.12 16828.06 0.28 336.22 13634.96 176 535
3 2017 1306.66 25324.8 0.14 781.79 20700.81 224 791
3 2018 1328.51 31983.03 0.14 642.19 25794.54 262 552
3 2019 1801.02 39294.43 0.11 592.27 32146.45 323 784
3 2020 1924.79 56890.53 0.11 1267.6 47627.61 541 833
4 2011 781.41 8060.93 0.51 234.61 3922.8 53 500
4 2012 794.49 8347.15 0.33 346.92 5957.48 60 408
4 2013 796.25 10393.61 0.27 358.23 5758.18 79 365
4 2014 732.23 11528.76 0.26 376.1 7550.66 100 408
4 2015 805.02 13711.36 0.18 416.71 8385.11 119 472
4 2016 854.12 16189.76 0.19 850.45 9870.94 161 508

65
4 2017 1240.3 20947.16 0.19 1125.07 11078.55 212 798
4 2018 1843.65 27390.91 0.15 735.68 14018.23 287 971
4 2019 1356.1 29770.02 0.14 877.99 20506.13 345 690
4 2020 1908.99 38159.59 0.17 788.29 23545.2 389 1171
5 2011 554.37 7725.44 0.46 174.07 6065.82 50 291
5 2012 704.36 8786.85 0.33 195.9 6757.51 69 312
5 2013 656.12 9985.99 0.21 104.54 8063.47 75 404
5 2014 639.2 11876.36 0.28 290.11 9402.64 99 325
5 2015 639.56 14360.87 0.19 227.97 11804.36 128 385
5 2016 767.57 17269.86 0.17 646.04 13037.64 144 447
5 2017 870.42 21902.92 0.15 563.09 16505.15 196 461
5 2018 1277.06 28030.92 0.16 749.29 23079.05 226 604
5 2019 1563.12 35736.09 0.11 842.66 29079.85 278 553
5 2020 1628.92 42998.49 0.12 1 34771.65 341 650
6 2011 590.5 7111.69 0.51 149.96 5157 51 323
6 2012 675.71 8275.75 0.36 227.48 5838 58 325
6 2013 691.05 9144.59 0.25 305 6655 72 280
6 2014 688.05 10747.28 0.18 240.19 7923.29 94 280
6 2015 777.87 13256.12 0.14 146.67 9774.11 115 320
6 2016 881.65 15830.32 0.19 108.53 12423.02 155 289
6 2017 1125.55 21019.7 0.15 367.43 16416.44 203 448
6 2018 1170.04 26688.92 0.15 200.83 21619.24 228 404
6 2019 1649.19 33717.42 0.12 115.17 27663.71 279 476
6 2020 2347.48 42463.76 0.13 380.05 33651.12 322 640
7 2011 115.53 2500.35 0.49 26.83 1980.41 43 97
7 2012 241.79 3670.39 0.34 67.38 2797.54 51 131
7 2013 455.16 6537.47 0.52 474.06 4465.04 74 300
7 2014 818.13 7350.37 0.24 350.35 5450.1 105 459
7 2015 793.43 11461.95 0.21 299.44 7367.89 141 524
7 2016 75.98 10687.34 0.2 455.21 8488.32 184 254
7 2017 447.41 17724.23 0.2 559.54 14276.79 256 408
7 2018 1024.82 29888.03 0.27 896.72 65807.59 297 657
7 2019 1424.81 41790.8 0.22 667.27 36168.28 389 900
7 2020 2605.23 52488.49 0.13 755.93 45510.89 414 1582
8 2011 105.55 1808.05 0.51 30.04 1297.37 30 65
8 2012 180.12 2463.03 0.42 96.51 1736.66 36 103
8 2013 262.12 2942.34 0.33 64.18 2105.86 45 128
8 2014 223.76 3613.34 0.31 55.72 2686.98 62 132
8 2015 375.98 5859.36 0.26 264.1 4457.39 88 312
8 2016 480.44 8119.23 0.23 196.64 6333.56 121 367
8 2017 619.38 10975.92 0.24 257.72 8774.85 142 279
8 2018 871.11 14319.6 0.21 307.5 11639.59 198 334
8 2019 1234.57 20391.6 0.18 539.85 16396.67 226 545

66
 8 2020 1423.74 31782.6 0.22 689.9 26131.47 266 433
9 2011 101.15 1961.83 0.43 1 1526.32 36 91
9 2012 114.68 2767.39 0.4 1 2117.3 41 106
9 2013 158.51 3911.23 0.31 1 3050.44 65 137
9 2014 359.33 6151.66 0.3 1 5004 109 218
9 2015 515.73 9534.84 0.17 168.26 8005.99 152 329
9 2016 376.87 11281.95 0.19 124.69 9348.1 210 273
9 2017 667.08 16292.9 0.2 652.11 13414.13 234 583
9 2018 1665.75 23796.75 0.24 523.77 19927.02 257 826
9 2019 1747.23 31779.31 0.16 642.69 26589.12 274 831
9 2020 1925.63 33831.48 0.16 344.99 277330.9 311 681
10 2011 46.28 781.36 0.48 10.69 491.32 11 39
10 2012 66.96 1365.03 0.29 49.64 903.31 24 46
10 2013 113.6 2127.84 0.27 78.46 1547.61 33 50
10 2014 187.58 3011.94 0.29 195.54 2151.59 63 115
10 2015 316.4 4499.69 0.18 102.13 3501.04 82 173
10 2016 438.32 6820.95 0.18 149.9 5384.6 105 243
10 2017 466.65 9820.01 0.21 575.94 7479.58 143 293
10 2018 742.49 13021.15 0.21 468.49 9947.37 176 359
10 2019 1086.4 14494.78 0.16 619.06 10586.66 209 550
10 2020 1023.48 18867.11 0.16 1095.99 13650.78 243 502

67