Income Structure, Profitability and Stability in the Tunisian Banking Sector
Abstract
This study examines the effect of revenue diversification across and within interest and non-interest income on bank stability and performance in Tunisian banks over the period 2001-2014. Using panel estimations and instrumental variables approach to handle the endogeneity problem of diversification variables. We find that revenue diversifications among and within interest and non-interest revenue generating operations boost bank profitability and stability. Our findings suggest also that the benefits from diversification are largest for banks with more shifts to nontraditional banking business lines (investment banking) while, absent for banks which follow cross-selling strategies of financial services.
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Introduction
The banking industry in both developed and developing countries has experienced important shifts that have been related to its increasing deregulation and competition. This has led banking institutions to diversify their income generating activities toward non-interest income operations. Unsurprisingly, the share of the classical financial intermediation operations has decline in both developed and developing banking industries. While the major source of income for banks is interest revenue from credits to customer, new banking business lines which generate non-interest revenue, have emerged such as fee generating activities, trading securities, investment banking and other operations.
The effects of shifts toward non-traditional banking activities on bank performance and stability have been widely examined in developed economies while rarely addressed in developing economies. There has been no large consensus in the empirical literature regarding the impact of the shift toward non-interest income generating operations on bank performance and risk in developed countries. For instance, Stiroh (2004a, 2004b, 2006), Stiroh and Rumble (2006) and Lepetit and al. (2008) find that non-interest activities positively affect bank performance but negatively impact bank stability. This is because noninterest income generating operations are highly volatile. However, diverging results have been found in the context of developing countries (Sanya and Wolfe, 2011; Nguyen and al., 2012; Pennathur and al., 2012). Thus, one of the aims of this study is to contribute to the limited literature that analyzes the impact of bank’s income diversification on performance and stability in the context of developing economies. As this group of countries presents different features compared to developed countries mainly in terms of banking regulatory framework and maturity and structure of the banking sector, we would expect to find different effect of income diversification on bank performance and risk.
The recent financial crisis has shown that banking supervisors should be concerned with banks’ business models in addition to the classical prudential norms such that bank capitalization, liquidity and risk management. The analysis of banks’ business models which signals the way in which banks generate profits and serve customers can provide banking supervision authorities with a deeper understanding of the sustainability of bank performance and stability (Köhler, 2015).
The recent financial crisis has showed that not all banks were impacted equally. The effect of the crisis has been related to the business model chosen by each bank. Banks with traditional banking model, mainly those relying on the classical financial intermediation function, faced huge losses (ECB, 2010). In fact, banks with high rates of loan growth have reported a significant decrease in their performance during the recent financial crisis. For instance, in Europe, the return-on-equity (ROE) of EU banks with the highest average rate of loan growth within the period 2003-2006 dropped, on average, from 13.34% in 2006 to 6.77% in 2008. However, the ROE of banks with the lowest loan growth rates decreased less importantly from 10.46% to 5.65%. Interestingly, in 2009, while the performance of the first group of EU banks declined further, the ROE of the second group of banks (with the lowest rates of loan growth) increased (Köhler, 2015). Thus, if we consider the decline in banks’ profitability as an indicator of risk-taking, we would argue that banks with high growth rate in terms of lending activity have incurred greater risks than those with low growth rate of their lending activities.
While large banks with high share of non-interest income have also faced large losses during the recent financial crisis, small banks relying on non-interest banking activities have benefited from diversification of their income sources as it has allowed them to be less dependent on overall business condition and therefore to be more stable (Liikanen, 2012).
Conclusion
In this study we use a detailed dataset on eleven banks operating in Tunisia over the period 2001-2014 to examine the relationship between revenue diversification and bank performance and stability. Using a panel data estimation as well as instrumental variables approach (2SLS) to handle the endogeneity problem of diversification variables, we find that income diversifications between and within interest and non-interest income generating activities enhance bank performance and bank stability.
Our findings confirm those of previous studies on emerging banking sectors. For instance, over the period 2001-2014, Tunisian banks show a relative large reliance on interest income generating activities (62%) which is made mainly through interest on loans to customers with a share in total interest income of 96%. Also, like in developing countries (Sanya and Wolfe, 2011), our findings suggest that banks benefit from a better revenue diversification. In fact, the diversification of income structure leads to better trade-off between the expected level and variance of banks’ performance. Of course, for this positive effect of revenue source diversification to hold, banks’ income-generating operations should not be perfectly correlated. Also, the positive effect of revenue diversification toward non-interest income generating activities can be explained by its role in lowering the cyclical variations in profits if incomes between bank activities are not perfectly correlated. This in addition to the role played by income diversification in increasing competitive pressures between banks across a large number of banking business lines which can increase innovation and efficiency in the provision of banking services.
The results also indicate that diversification gains are largest for banks with more shifts to nontraditional banking business lines while, absent for banks which follow cross-selling strategies of financial services.
Furthermore, our results show that the effect of revenue diversification does depend on the category of non-interest revenue and its correlation with interest revenue and its components. In fact, we found the diversification gains to be more pronounced when banks shift to non-interest income generating activities that are not correlated with interest income and are stemming from nontraditional banking activities such as investment banking and fee-based income from nontraditional operations (like for example commissions, fees and premiums earned from insurance activity).
One explanation of this result is that nontraditional banking operations are not subject to the same fluctuations as interestgenerating operations which leads to lower earnings volatility. However, non-interest income coming from traditional banking activities worsens bank stability.
This study can be extended in several directions. One way for future researches would be to explore more channels through which revenue diversification can affect bank performance and stability. One channel would be the improved banking competition and innovation in presence of income diversification.