Thursday, October 29, 2009

Oil prices and bank profitability

Bank balances oil-exporting economies have suffered in recent times. This column offers the first empirical evidence that links the price of oil to the activities of banks in these economies. It suggests that the simple observation of the price of oil can indicate the macro-prudential regulation in these countries and to mitigate pro-cyclicality of bank lending.

The recent financial crisis and a sharp drop in oil prices hit the economy of exporting countries in the Middle East and North Africa (MENA). Export revenues to the government and financial balances fell sharply, reducing GDP growth and asset prices / real estate, which has made tensions both in the corporate and the banking balance sheet, loan growth in the private sector has deteriorated substantially. In some countries, governments were forced to intervene in the domestic financial sector to guarantee deposits, maintaining liquidity, capital injections or asset purchases (using state features, such as sovereign wealth funds), as indicators of financial sector deteriorated. In particular, banks that provide a lot of credit for the purchase of real estate and other tangible assets have suffered the heaviest losses due to falling prices of these them.

Given the dependence on oil exports, the relationship between the price of black gold, and the efficiency of the banking system, the stability of the whole system is interesting from the standpoint not only of the current crisis, but also the previous cycles oil booms. Do the prices of oil on the efficiency of the banking system, and, if so, through what channels? Or still no direct link between oil prices and banks, if we have a view of macroeconomic and bank-specific factors? Are there any differences between commercial, investment and Islamic banks? What was the impact of the global financial crisis on the profitability of banks and the relationship with oil prices

The influence of oil prices on the efficiency of banks
• Oil prices affect the economy through direct and indirect channels. Shocks in oil prices may affect the profitability of banks directly via an increase in non-oil lending, business activity or excess liquidity in the banking system.

• Indirectly, the prospects for oil revenues affect the budget since oil revenues make up the largest part of external and government revenues in the MENA. This, in turn, affects the corporate and bank profitability through the provision of credit to the private sector.

• Another indirect channel is connected with the expectations and the general sentiment in the business in the country. Rising oil prices may lead to an increase in domestic demand, which will provide feedback to a large bank credibility, lending and interest rates.

• On the part of aggregate demand, production capacity of the country can also be expanded to include new public and private investment, fueled by high oil prices, driving the growth rate even further.

Similar effects were evident during the pre-crisis boom (IMF, 2009). Between 2005 and 2008, supported by high prices for oil-exporting countries have participated in major investment programs to diversify the national economy and development of human capital. Financial institutions receive a handsome profit and seemed to be resilient, having sufficient capital to low-performing loans.

What does the literature?
In general, the study of profitability of banks cover a wide range of countries and regions, and in the banking literature is that profitability depends on the particular bank and macroeconomic factors. From the standpoint of the bank - specific factors, such as credit risk, liquidity, size, efficiency and ownership, has been found, are the main factors determining the effectiveness of the Bank (Molyneux and Thornton, 1992, Miller and Noulas, 1997, Demirguc-Kunt and Huizinga, 2000). Profitability of banks can also be very constant, (Athanasoglu et al, 2008) that permits a certain level of concentration and market power in the banking industry of both capital and manufacturing markets.

In terms of macroeconomic variables, researchers found a link between inflation, interest rates and profitability, as well as with business cycles and bank efficiency (Demirguc-Kunt and Huizinga, 2000; Flamini et al, 2009). Banks usually have the ability to adjust interest rates if the (expected) inflation increases, which can provide feedback to higher revenues and profits. Communication from Council of the Gulf Cooperation (GCC) may be somewhat different, since the exchange rate pegged to the dollar, and this means that inflation is imported from abroad (bearing in mind that monetary policy aims at maintaining the course).

Empirical academic literature on the differences in commercial and Islamic banks are very rare and mostly affect the financial stability (Cihak and Hesse, 2008), without considering its relationship with the oil - the main source of revenue for oil-exporting countries. Conceptually, the fact that Islamic banks often tend to finance their bonds, bypassing the Sharia-compliant deposits and higher oil prices due to higher liquidity and, consequently, the influx of deposits, which contribute to lending, so a positive correlation between oil prices and bank performance for Islamic banks seems quite likely. Oil prices have fallen from their peak of $ 140 per barrel and reduced liquidity not only struck by the Islamic banks but also for their traditional partners, so that the differential impact is not obvious a priori. One would expect that the investment banks with their typical model of wholesale trade and more potent effect than the rules and other Islamic banks suffer from liquidity shortage.

New proof
In Poghosyan and Hesse (2009), we empirically examine the relationship between shocks to oil prices and bank performance in MENA countries (Algeria, Bahrain, Iran, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Sudan, UAE and Yemen), using banking data for the period 1994-2008 and dynamic management techniques. To our knowledge, no research clearly affects the exporting country and bank efficiency. Inclusion of changes in oil prices and turmoil, as the system variables, in this context is the innovation and the use of different definitions for shocks ensures reliable results. As the business model of commercial, investment and Islamic banks were likely to show differences, we also investigate the influence of banking expertise to its profitability. Our data suggest that oil prices affect the banking profitability indirectly, through macro-channels. In particular, the main macro-channels serve as fiscal relations, inflation, and (in part) the real growth of GDP. In terms of differences in the types of banks, we see that investment banks are at highest impact and most sensitive to oil price shocks, which are caused by its buoyancy, costs, trade and income received during the price peak, and also supported by extra-related Oil liquidity that is included in the financial system. However, this result should be interpreted with some caution, since we are not responsible for the real estate prices (due to lack of data), which could have a significant impact on the profitability of commercial and Islamic banks. Moreover, given the heterogeneity of data on bank balance sheets, we can not fully grasp the relationship between the type of bank and oil price shocks. We also found preliminary evidence that the global financial crisis has reduced the positive impact on the connection between the jumps in oil prices and the profitability of banks. In terms of bank-specific variables, greater liquidity and efficiency, capitalized banks have higher profits and maintain it for some time.

Implications of policy
Our results have interesting political implications, since they provide the first evidence of the importance of systemic jumps in oil prices for banking efficiency in the exporting countries. We had presumed evidence of this relationship, but they have not been verified empirically. In particular, these results indicate that the oil price shocks can be used for the purposes of macro-prudential regulation in the countries of MENA, as oil prices tracked more easily than using conventional measures of business cycle (such as the deviation of GDP from its potential level). For example, the capitalization of the bank's relationship with the shock to oil prices could help alleviate the pro-cyclical bank lending and allow banks to use their bag, created during the boom period, in order to ensure that lending during recessions.



Authors Heiko Hesse, IMF economist for the Middle East and Central Asia, and Tigran Poghosyan, an economist at the IMF.

VoxEU.com
October 27

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