Determinants of profitability in commercial banks in Albania

CONTENTS

CHAPTER 1
1.1 A General Overwiew
1.2 Evidence of the Problem
1.3 Objective of the Study
1.4 Hypothesis of the Study
1.5 Conceptual Framework
1.6 Methodology and Data
1.7 Study Limitations
1.8 The Importance of the Study
1.9 Organization of the Study

CHAPTER 2
2.1 A Short History of the Albanian Banking System
2.2 Economic Importance of Commercial Banks
2.3 Structure of Financial/Banking System
2.4 Main Developments in the Performance of the Albanian Banking System

CHAPTER 3
3.1 Introduction
3.2 Theoretical Profitability Analysis
3.3 Determinants Factors of Profitability
3.4 Internal FactorsType text or a website address or translate a document.Translate from: EnglishFaktorwt hdsh
3.5 External Factors

CHAPTER 4
4.1 Research Approaches
4.2 The Applied Method
4.3 Data Collection
4.4 Data Analysis and Model Specification (ROA/ROE)
4.5 Statistical Examination of Determinants
4.6 Diagnostic Tests of the Model
4.7 Hypotheses of Study

CHAPTER 5
5.1 Tests for Model Validation (ROA/ROE)
5.2 Correlation Analysis for Profitability Models (ROA/ROE)
5.3 Descriptive Data Statistic for Profitability Models (ROA/ROE)
5.4 Granger Cause Test for ROA Model
5.5 The Results of the Regression Analysis for the Model (ROA)
5.6 Granger Cause Test for ROE Model
5.7 The Results of the Regression Analysis for the Model (ROE)
5.8 Bank Profitability Analysis (ROA/ROE) by Groups
5.9 Interview Findings

CHAPTER 6
6.1 Conclusions
6.2 Recommendations

Bibliography

APENDIX I

APENDIX II

Abstract

This study examines the determinants of profitability of commercial banks in Albania. These determinants are categorized into two groups, internal factors that are the bank specific factors and external factors that are further divided into macroeconomic factors and industry specific factors. The main objective of the study is to determine the factors affecting the profitability of commercial banks and making some recommendations, that maybe can help the management and policy making. A panel data with 16 commercial banks in Albania is analyzed for the period 2009-2014. Two indicators are used (dependent variables) for the measurement of profitability, return on assets (ROA) and return on equity (ROE). Banking specific factors that are used in this study include variables such as bank size, asset management, credit risk, liquidity of assets, capital adequacy, operational efficiency and cost of financing. On the other hand is taken into consideration only one industry specific factor, which is the concentration and macroeconomic factors such as GDP, inflation and exchange rate. To meet the main object of the research, the study is based mainly on quantitative research method, which is supplemented by a qualitative method. Quantitative data were obtained mainly from the financial statements of commercial banks, by INSTAT, Bank of Albania, the World Bank and Bankscope, in order to make empirical analysis needed to identify and measure the determinants of bank profitability. In particular, multiple regression analysis was used to measure the impact of the determinants of bank profitability. On the other hand, qualitative data were collected through unstructured interviews conducted with executives of finance in the albanian commercial banks. Also for both models was undertaken Granger causality test to identify the causal connection between the dependent and independent variables. After the empirical analysis was applied to all data panel considering all banks together, further, the banks were analyzed by dividing into groups. Also, before sharing the panel data by group was realized a discriminant analyzes to evaluate the data. The findings showed that some data deviated from the center of the group, so the analysis by groups was conducted for 74 observations (from 96). To realize empirical analysis were used the software SPSS 22 and Eviews 7.

The results showed a positive relationship between capital adequacy and profitability in both the models (ROA/ROE), but with strong statistical significance only in the ROA model. It results a negative correlation between operational efficiency and profitability (ROA/ROE), but with strong statistical significance only for the ROE model. Natural logarithm of total assets had a positive impact on profitability (ROA/ROE), with low coefficient of importance to ROA model and statistically important for ROE model. While liquidity assets has a negative relationship with probitability in both the models (ROA/ROE), but for the ROA model was insignificant and for the ROE model was statistically significant at 1%. Credit risk had an inverse relation with profitability in both models, statistically significant at 5% and 1% for ROA and ROE model, respectively. Concentration as the only industry specific factor as expected, had a negative relationship with profitability (ROA/ROE), but statistically insignificant. While, in terms of macroeconomic factors, GDP had a positive relationship with profitability (ROA/ROE) and statistically significant for both models. On the other hand, inflation and exchange rate showed a positive relation with profitability (ROA/ROE) but statistically insignificant for the models.

Key words: Albania, Bank Specific Factors, Industry Specific Factors, Macroeconomic Factors, Profitability, ROA, ROE

CHAPTER 1

This chapter begins with a brief description of the study topic which is followed by the problem. In addressing the problem, highlights the reasons why this study is being conducted. The general and specific objectives of this study are further defined. After that, the rest presents the research questions. Finally,there is presented the importance and limitations of the study, as well as the way of organizing the work.

1.1 A General Overwiew

In recent decades, most Central and Eastern European countries have adopted structural reforms in function of increasing the size, stability and efficiency of financial systems. The opening up of the external sector and the structural reforms of the financial sector have supported the development of a competitive and efficient financial system. Some authors such as Berger and Humphrey (1997), Kumbhakar et al. (2001), Isik and Hassan (2003), Brisimis et al. (2008), Wanzenried and Dietrich (2009), Sami and Zouari (2011), Melkamu (2010), Betty and Jones, (2007), Vong and Chan (2009), Mensi and Zouari (2010), as well as other authors such as Wheelock and Wilson (1999) , Davydenko (2010), Sufian (2011), Sima (2013) consider that liberalization has a negative impact, determining a decrease in allocation efficiency or taking into account that financial liberalization often leads to financial crises.

The international financial system is changing rapidly, economies and financial systems are going through traumatic years. Globalization and technology are at a steady pace, financial arenas are becoming more open with new products and services (Sandeep, Patel and Lilicare, 2002; Guntz, 2011). An international wave of mergers and acquisitions has involved the banking industry, so that the boundaries between financial sectors and products are unclear dramatically (Amdemikael, 2012). In this new and bold world, one fact remains unchanged: There is a need for countries to have sound banking systems with good corporate governance that can strengthen and improve the institution to survive in a more and more environment open (Belayneh, 2011). Factors affecting the profitability of banks are important for stakeholders such as central banks, governments, bankers' associations and other financial authorities as well as bank executives (Rajan and Zingales 1998; Levine 1998; Pasiouras and Kosmidou, 2007; Ayayi, 2012; Birnahu, 2012).

Creating an effective and strong financial system is an important objective of the reform process and transition from a centralized economy to a market economy in Central and Eastern Europe. Liberalization of prices, liberalization of the flow of goods, services and capital, liberalization of financial systems, globalization and mutations at the level of the economic, social and political environment had a significant impact on the development of the banking system of central and eastern European banks. Banking systems in developing countries underwent multiple mutations in order to create some efficient banking institutions with a high degree of accuracy capable of facilitating economic growth (Yildirim and Philippatos, 2007).

In the financial industry, banks represent financial institutions of high importance, where the level of profitability always has a major impact on the global economy. In banking history, the first banking operations were mentioned in the years 3000-2000 BC in the work "Code of Hamurab," written in the period 1792-1750 BC (Isik and Hassan, 2003). Bank performance evaluation was later introduced with the development of math and business sciences. Nowadays, in the modern century of global diversity and competition, the importance of accurate and diversified banking appreciation is becoming indispensable. It is worth noting that before 1933 the banks were not separated on the basis of their function (Halligan, 2009).

The profitability study is important not only because of the information it provides about the health of the economy every year, but also because profits are a key determinant of growth and employment in the medium term (Dissanayake, 2012). Changes in profitability are an important contributor to economic progress through the impact that profits have on investment and savings decisions of companies (Damena, 2011). This is because an increase in profits improves the cash flow position of companies and provides greater flexibility in the source of finance for corporate investment (eg through retained earnings). Easier access to finance facilitates investment to a greater level by boosting productivity, manufacturing ability, competitiveness and employment (Ogunleye, 1995; Said and Tumina, 2011; Francis, 2010; Gul; Irshad and Zaman, 2011).

The existence, growth and survival of a business organization largely depends on the profit that an organization is able to generate. It is true that when profitability increases, the value of shareholders may increase to a considerable extent. The term profitability refers to the ability of a company to retain its profit year after year (Iezza, 2010). The profitability of the organization will definitely contribute to the economic development of the country through the provision of additional employment and tax revenues for the government treasury. Moreover, it will contribute to the income of investors by having a higher dividend and thus improve the standard of living of people (Heffernan and Fu, 2008; Jorgensen, 2011).

In order for a business entity (whether public or private owned) to continue to progress, needs its revenue to be relatively stable for its expansion and growth over time. In addition to its revenue level, the external environment needs to be carefully understood and predicted reliably. Businesses need to ensure that a fair technology is pursued to achieve organizational objectives (Burns and Mitchell, 1946; Sabo, 2003; Aremu, Mejabi, and Gbadeyan, 2011; Sami and Zouari, 2011; Aremu, 2012).

Profits and business environments are so serious issues that a business needs to study and understand in order to face its chances and challenges with energy and determination. Therefore, perhaps this explains why there has been ongoing research by modern businesses around the world to improve their production methods needed to cut costs and develop new products or add attributes to existing products, which can bring greater satisfaction to their customers. On the other hand, environmental and cyclical conditions are usually unstable and dynamic (Sabo, 2003; Aremu, 2006; Aremu, 2012).

This underlines the need for business firms to be able to reliably perform the forecast not only for their future requirements or for selling their goods and services but also for other variables that affect them directly such as their staff and future earnings (Sargent, 1987).

The process of financial liberalization aimed at increasing the level of competition, the efficiency of the financial intermediation process and increasing financial stability (Bonin and Wachtel, 2003; De Haas and Van Lelyveld, 2006). In the case of developing countries, studies focus on the impact of liberalization, privatization of state-owned banks, foreign bank inflows and their effects on banking performance (Jildirim and Philippatos 2007; Asaftei and Kumbhakar, 2008; Koutsomanoli-Filippaki et al., 2009; Pasiouras et al., 2009).

Studies in the field carried out in Central and Eastern European countries have shown that structural reforms at the banking system level have determined the improvement of the efficiency of financial intermediation. Fries et al., (2005) have shown, based on a performance analysis of a group of 289 banks from 15 transition countries during 1995-2004 that financial liberalization is seen in the form of bank privatization and bank access loans, resulting in lowering the banking cost and increasing the financial services market.

The presence of foreign banks can be beneficial to consumers by offering superior products and services to the financial industry by increasing the quality of services and the economy by increasing efficiency (Jildirim and Philippatos, 2007). However, the entry of foreign banks is not without risk, especially when this entry is made without prior consolidation of the institutional framework. Claessens et al. (1998) have shown that the presence of foreign banks can facilitate increased competition, improved credit distribution and access to international capital markets. But this also entails costs related to the entry of foreign banks, the costs which may consist of increased systemic risk caused by increased competition.

Special interest has been devoted to the financial performance of European banks (Molyneux and Thornton, 1992; Hellmann et al., 2000; Altunbas et al., 2003; Bos and Schmiedel, 2007). However, over the last decades there has been an increasing interest in the profitability and take-up of banks' risk in emerging markets (Said and Tumina, 2011; Olson and Zoubi, 2011; Sufian, 2011). Together with the globalization of financial markets, more and more interest is gained in understanding the impact and importance of international divergences (Berger, 2007) and interactions (Claessens, Demirgüç-Kunt and Huizinga, 2001; Carbo et al., 2009; Hannan and Prager, 2009). For example, Hannan and Prager (2009) noted that profitability in banks in less competitive domestic markets was positively influenced when the most diversified banks entered the market. One explanation may be that geographically diverse banks do not adopt prices in the local market.

It is a known fact that banks are the main contributing factor to the economic development of each country as they remain in the center of the economy because of their role as financial intermediaries (Ramlall, 2009). The banking sector can be considered as a derivative of future prosperity and development of local and international economies (Kyj and Isik, 2008).

Over the last two decades, the banking sector has undergone major transformations around the world in its operating environment. Both as external and internal factors have influenced its structure and performance. Despite the growing trend towards direct banking transactions observed in many countries, the role of banks remains central to financing the economic activity in general and different market segments (Fries and Taci, 2005).

Banking performance assessment is a process that requires special attention to various factors, affecting macroeconomic and microeconomic levels. In developing countries it is highly desirable to have good, stable and rapid economic progress, which can be intensified by increasing the benefits of all financial institutions. It is imperative that every country has the banking sector, well structured and profitable so that it is competitive and successful. For the existence of this kind of sector, it is of particular importance the rate of profit realized by the banks. The stability of the financial system depends on the profitability of the banking sector (Fries and Taci, 2002; Letenah, 2009).

Profitability determinants are empirically explored even though the profitability definition varies between studies. Regardless of the ways of measuring profitability, most banking studies have noted that the ratio of capital, loan loss provisions and operational efficiency are the most important indicators for a high profitability (Lislevand, 2012). In this study, the factors to be taken into account are divided into two categories namely endogenous (internal) and exogenous (external) factors or profitability factors.

Also, the banking crisis has had a very different impact on the developed countries' banks compared to emerging economies. Among the factors that reduce the impact of the current financial crisis on emerging markets, we may consider the prevalence of less risky assets and smaller investments in the banking business, as well as the existence of high capital ratios and low credit ratio deposits. Moreover, the impact of the current crisis is different across emerging economies. So far, few jobs have analyzed the impact of the recent financial crisis on bank performance determinants. While some studies have analyzed the relationship between business cycle and banking performance (Athanasoglou et al., 2008; Albertazzi and Gambacorta, 2009; Bolt et al., 2010).

However, it seems that previous empirical research has suggested a possible link between bank profitability and various internal and external determinants such as bank assets, loan loss provisions, total deposits and inflation. Therefore, this study is an attempt to shed more light on this controversial issue by examining more empirical literature on the opposite sides of this topic.

In summary, from the literature research, it was noted that most of foreign studies on benefit determinants are concentrated in developed countries, while few studies have been conducted for developing countries to examine banks' profitability. While banking banking performance in Albania is little or no discussion in financial literature, mainly focused on narrow and non-inclusive discussions. At a time when Albania's banking sector has radically changed after the reforms. Therefore, this study will modestly try to study bank profitability and its determinants in the Albanian context, seeing in a broader perspective the situation. For this reason, it is hoped that the theme of this dissertation with its empirical results can contribute to some actors.

Banks mobilize, distribute and invest most of the savings of economic agents. Therefore, their performance has significant consequences on capital distribution, expansion of the firm, industrial growth and economic development. Therefore, the efficiency and profitability of banks is of interest not only at the level of individual banks, but is also important at a wider macroeconomic level (Damena, 2011).

The main role of the financial system is to channel funds from the savers to the borrower. If this process is done efficiently, then the benefit will improve, the funds flow will increase, and there will also be better quality services for consumers. Indeed, financial intermediation determines, among other things, the efficient distribution of savings, as well as the return on savings and investments (Arem and Mejabi, 2013). In developed countries, financial markets and the banking system work together to achieve this key goal. In contrast, in emerging economies, financial markets are usually underdeveloped and small, so in this case, banks fill the gap between borrowers and depositors and ensure secure and cost-effective channeling of funds. Taking into account that savings and investments are the most important determinants of economic growth, the health of a country's general economy depends significantly on the sound functioning of the financial system. This is especially true of countries like Albania, where the banking sector is the backbone of the economy. Albania's financial sector is characterized by the dominant role of commercial banks.

There are many aspects of banks that can be analyzed, but this study will focus specifically on the profitability of banks. Profitability is a reflection of how banks are run, given the environment in which they operate. More specifically, it reflects the quality of bank management and stakeholder behavior, bank's competitive strategies, efficiency and risk management skills (Aburime, 2007). Bank profits affect the cost of capital growth in both ways, as a direct contributor to capital financing and as an indicator for the assessment of the external investor of the financial strength of the bank. Low profitability weakens the bank's capacity to absorb the negative shocks, which would eventually affect solvency. In general, sustainable profitability is vital in maintaining the stability of the banking system and contributes to the financial system's state of affairs. Therefore, the bank's performance determinants have attracted the interest of academic scholars, as well as bank management, financial markets, and bank supervisors. Profitability determinants have been empirically analyzed even though the profitability definition varies between studies. Notwithstanding the ways of measuring profitability, most banking studies have pointed out how the organization's internal environment and the external environment are the most important profitability impacts. Therefore, in this study, the main direction is related to the consideration of both categories, called internal and external or otherwise, profitability factors.

The internal factors of bank performance or profitability can be defined as factors that are influenced by bank management decisions. Such management effects will definitely affect the operating results of banks. Although quality management would lead to good bank performance, it is difficult, if not impossible, to assess the quality of management directly. In fact, it is implicitly assumed that such quality will be reflected in operational performance. As such, it is not unusual to look at a banking performance in terms of those financial variables found in the financial statements, such as the balance sheet and the income statement (Krakah and Ameyaw, 2010). The external determinants of bank profitability are factors that are beyond the control of banking management. They represent events outside the bank's influence. However, management can anticipate changes in the external environment and try to position the institution to benefit from the foreseen developments. The two main components of external determinants are the macroeconomic and financial structure factors (Krakah and Ameyaw, 2010).

In the context of the above discussion, the purpose of this study is to assess the factors affecting the financial performance (profitability) of commercial banks in Albania. The remaining discussions in this chapter are addressed in the following sections.

1.2 Evidence of the Problem

It is widely believed that the financial system plays an important role in the growth and economic development of a country (Claessens and Hore, 2012). The importance of an efficient financial sector lies in the fact that it provides for the mobilization of internal resources, the generation of savings and investments in the most productive sectors. In fact, it is the system by which a country directs its most lucrative and efficient sectors to the most productive resources that will bring growth in the future. 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 sectors that are most important for an economy (Lindblom, Olsson and Willesson, 2011). Banks are the most important financial intermediaries in most responding economies with various service packages. Economies that have a profitable banking sector are better able to withstand the negative shocks and contribute to the stability of the financial system (Athanasoglou, Brissimis and Delis, 2008). Therefore, it is important to understand the factors that really affect the banking sector's profitability. Albania's financial sector, like most developing countries, is dominated by the banking industry. The banking sector currently occupies 90.4% of the financial system's assets and 91.7% of the country's GDP (Bank of Albania, 2014).

A considerable number of studies have been conducted in the area of profitability of commercial banks and its determinants, given the importance of this area at the international level. They verified that there is a direct link between profitability in the industry of commercial banks and its internal and external determinants (Bourke, 1989; Rajan and Zingales, 1998; Eichengreen and Gibson, 2001; Meyer, 2002; Letenah, 2009; Jorgensen, 2011; Melkamu, 2012). Although many researchers have conducted studies in this area, profitability determinants have been at the center of debates for many years and are still an unresolved issue in financial literature. Indeed, what makes debates about profitability determinants is the fact that these determinants are dynamic from time to time and vary with the nature of the firm's operation from one country to another (Flamini et al., 2009; Ommeren, 2011).

To summarizy, there are no universally accepted findings on the profitability determinants of the banking sector. Because countries differ with each other from their economic systems, financial systems, political systems, and operating environments. Thus, the study will be a modest attempt to empirically examine the key profitability determinants of all Albanian commercial banks, taking into account the specific banking, industry and macroeconomic factors during 2009-2014. The time period of 2009-2014 was selected because only after 2009 data on banks can be considered as homogeneous. To this end, consulting variables such as bank size, asset management, credit risk, asset liquidity, operational efficiency, equity ratio, cost of financing, concentration, economic activity, inflation and exchange rate rates that are thought to be potentially responsible for determining profitability in banks. The selection of which has been reinforced also thanks to the responses of the interviews by the finance directors. Although the number of empirical studies is increasing day by day in this area, contributing to the theory of profitability, they mostly tend to analyze developed economies, and less to emerging economies such as Albania. So between this study can be achieved to fill the gap in literature.

1.3 Objective of the Study

There are many aspects of banks that can be analyzed, but this study focuses specifically on the profitability of banks. Benefit is a reflection of how banks are run, given the environment in which they operate. More specifically, it reflects the quality of a bank's management and stakeholder behavior, bank's competitive strategies, efficiency and risk management capability (Aburime, 2007; Songul, 2013). Earnings affect the bank's cost of capital growth in both ways as a direct contributor to capital financing and as an indicator of the external investor's assessment as a potential financial strength of the bank. Moreover, even if the solvency is high, poor profitability affects the weakening of the bank's capacity to absorb the negative shocks, which will eventually affect solvency. Generally, healthy and sustainable benefits are vital in maintaining the stability of the banking system and contributing to the financial system's state of affairs. Therefore, bank performance determinants have attracted the interest of academic research, as well as bank management, financial markets, and bank supervisors. In this context, the main objective of this study is to identify the internal and external factors (specific to industry and macroeconomics) that affect the profitability of all commercial banks operating in Albania.

- The study has several specific objectives as follows:
- To assess and analyze the degree of impact of specific bank factors (internal determinants) on the profitability of the commercial banks industry in Albania.
- To check the effects of external determinants (both industry and macroeconomic) on the profitability of commercial banks.
- To identify the behavior of the Albanian banking sector's market structure over the past decade.
- To identify the significant benefit determinants of all commercial banks operating in the country through special empirical analyzes.
- To make an empirical analysis at the bank-level level and compare with the findings as a whole.
- Make recommendations about key profitability principals based on empirical findings.

1.3.1 Research Questions

To provide answers to the broad objective of the research described above, they are adapted to the following research questions:

- What are the determining factors affecting the Bank's ROE and ROA in Albania?
- What are the internal determinants of profitability in commercial banks, in the case of Albanian banks?
- What are the external (specific industry and macroeconomic) determinants of profitability in the case of all Albanian banks?
- How much influence have these factors (specific banking, industry and macroeconomics) on the profitability of commercial banks?
- How do research results appear when commercial banks are divided into groups?

1.4 Hypothesis of the Study

In accordance with the definition of broad scope in the study, there are formulated also the hypotheses in the chapter 4. The hypotheses of the study are based on the theories related to bank profitability that have been developed over the years by banking sector researchers and other empirical studies related to bank profitability. The results from the literature review (to be addressed in the third chapter) are used to set expectations for the relationship between the various determinants in the study. In general, based on research questions and study objectives, a major hypothesis and eleven sub-hypotheses for each model (ROA/ROE) are developed. Below are two main hypotheses for the first model (ROA) and the second model (ROE):

Ho: Specific banking, industry and macroeconomic factors do not affect banks profitability (ROA).

H1: At least one of the specific banking, industry and macroeconomic factors affects banks profitability (ROA).

and

Ho: Specific banking, industry and macroeconomic factors do not affect banks profitabilily (ROE).

H1: At least one of the specific banking, industry and macroeconomic factors affects banks profitability (ROE).

as well as sub-hypotheses,

illustration not visible in this excerpt

1.5 Conceptual Framework

Different empirical evidence suggests that the profitability of commercial banks is influenced by internal factors (specific banking) and external factors (industry and macroeconomic). This study has used both internal and external decision makers of commercial banks' profits, including variables such as bank size, asset management, credit risk, asset liquidity, operational efficiency, equity ratio, financing cost, concentration, economic activity, inflation and the exchange rate. The relationship between profitability and its determinants analyzed in the following chapters is as follows.

Figure 1.1. The relationship between profitability and its determinants

illustration not visible in this excerpt

Source: Author

1.6 Methodology and Data

For the realization of this study, several phases that are described below have been followed. From where it can be concluded that the literature review, source and quality of data contributed to performing reliable analyzes.

Phase 1: Literature Review. Concrete textbooks of various international authors have been reviewed, also theoretical and empirical scientific articles are analyzing at practical level the profitability of banks for different states or groups of states. Phase 2: Selecting the data. Broad literature review, coupled with the thoughts of finance managers in interviews, has helped determine the most important factors that are eventually thought to affect Albania as well as further raised hypotheses. The variables used to measure profitability are considered return on assets and return on equity, while independent variables are divided into two types of factors, both internal and external. Among internal factors are bank size, asset management, credit risk, asset liquidity, operational efficiency, capital adequacy, financing cost, while for external factors are economic activity, inflation and exchange rate rates, while for industry factors are considered concentrations. Phase 3: Data Collection. A mixed approach was used to achieve the main objectives of the research. In order to collect data on internal and external factors for profitability, a structured review of annual official documents for all commercial banks has been conducted. Therefore, in order to obtain the necessary data, the audited financial statements are used as an accounting balance sheet and income statement to build a database to determine the importance of factors potentially affecting banks' profitability in Albania. The study is based mainly on secondary data, but data obtained from interviews with finance managers in all banks served in determining the factors of the study and in drawing conclusions and reinforcing the results. For the study of the determinants of profitability in Albania, data on dependent and independent variables are obtained from: 1. Audited financial statements of commercial banks operating in the country; 2. INSTAT; 3. Bank of Albania; 4. Bankscope and 5. World Bank. But since the selection of determining factors was initially made by the literature review, which is totally foreign, it was thought that in order to make the subject more tangible to the real situation of our economy, we would take some interviews with the finance directors 16 commercial banks operating in the country. The data generated by the interviews were used to support the selection of variables and to reinforce the conclusions from the empirical analysis. Stage 4: Data Analysis. Various statistical analyzes were used in the study during the study SPSS version 22 and Eviews 7. For empirical analysis, the data for the selected variables were analyzed for the period 2009-2014, where the least square method was used (effect method fixed) for evaluating multiple regression parameters. Initially, diagnostic tests were applied to assess the validity of the models. Then generating descriptive statistics and further correlation analysis, and subsequent regression analysis for both models (ROA/ROE). The selected level of alpha importance will be 5% for all empirical analyzes. To test the importance of the model and the individual significance of the variables, the Fisher test and the probability value were used. While the dependency coefficient is used to see the variability of variables dependent on independent variables.

1.7 Study Limitations

The first limitation of the study stems from the fact that although there are many variables affecting the profitability of commercial banks, the study will focus only on eleven such as bank size, asset management, credit risk, asset liquidity, operational efficiency, capital ratio, cost of financing, concentration, economic activity, inflation and exchange rate. Second, responses to unstructured interviews can be interpreted subtly through descriptions using words rather than numbers, which can cause unilateral interpretation of results.

1.8 The Importance of the Study

Taking into account the main objective of this study, it is expected that it will provide empirical evidence on the profitability of all commercial banks in Albania. Moreover, it is thought that modestly many parties can benefit from the results that will emerge from this study, and as a consequence these parties are: Management: Administration is interested in identifying success and failure indicators in banks to undertake the actions needed to improve the performance of the financial institution and to resolve the right decisions. Government: The government is interested in knowing which banking institutions operate successfully or fail to take the necessary measures to avoid the bankruptcy crisis in these institutions. Investors: Investors are interested in such studies to protect their investments, and to direct their investments into the best potential investment. Consumers: Consumers are interested in knowing the ability of commercial banks to deposit because they place their deposits based on bank success indicators. This research can play a modest role to bring to light / understand better what determines the profitability of financial institutions, especially commercial banks in our country. Moreover, this study may be of importance in providing a good foundation for bank managers, business professionals, business initiatives and policy makers. Moreover, this relevant study it will potentially contribute as a step for further research in this area.

1.9 Organization of the Study

This paper is organized in six chapters. By focusing on the objective of the study, the rest of this study is organized as follows.

Chapter One: It presents a theoretical picture of the study, points out the problem, defines the objectives and purpose of the study, and the importance and benefits that can be modestly generated. Chapter Two: Present a detailed picture of the financial/banking system developments during the analysis period, 2009-2014. Illustrating charts, graphs and figures for profitability factors considered for the model. Chapter Three: Reviewing the literature that includes conceptual work in terms of profitability, overall theories of impact on bank profitability, benefit determinants, previous studies in this area and finally defines the knowledge gap for this topic. Chapter Four: This chapter describes the data, identifies the resources and explains the methodology used for the study. It also outlines and demonstrates the ways of measuring benefit, as well as the internal and external variables selected for study. Chapter Five: The results of the various methods used are presented in the chapter. Initially, profitability (between the two indicators: ROA and ROE) was measured by considering all the banks together and then, in the second half, the profitability by bank groups was analyzed. Chapter Six: Finally, this chapter presents the conclusions of the analysis by providing the relevant conclusions and recommendations.

CHAPTER 2

This chapter begins with a brief history of the Albanian banking system, presented in section 2.1. Section 2.2 discusses the economic importance of commercial banks, between analyzing their main function, which is financial intermediation. Further, in Section 2.3, the financial system as a whole and the banking system in particular are treated, illustrating their respective structure, as well as a tabular presentation of the indicator of the expansion of the banking network by the end of 2014. In section 2.4 provides an expanded picture of the main developments in the performance of the Albanian banking system over the years considered in the 2009-2014 study, illustrating with graphs, tables and figures the indicators addressed. Finally, a summary is made with the chapter's conclusions.

2.1 A Short History of the Albanian Banking System

The performance of the banking system can be grouped over three moments: a) Establishment of genuine commercial banks; b) the development of banks after the collapse of pyramid schemes; and c) the development of banks after the privatization process of state-owned banks. Although the first currency, bank and money efforts date back to the beginning of the 19th century, but in fact, only the end of this century and the beginning of the twentieth century began their activity with the first banking institutions with the opening of branches of the Turkish Agrarian Bank and of the Otoman National Bank. At the beginning of the twentieth century, ideas for the establishment of a bank in Albania emerged, in which, apart from the ideas of our rebirths, the first projects appeared. Of course, with the proclamation of Albania's Independence, the interest of not only Albanians, but also of foreigners, was greatly enhanced by the establishment of banking institutions. The most serious efforts were made by the government headed by Ismail Qemali, with a concessional foreigners project that resulted in the establishment of the first bank in Albania, albeit short-lived. Of particular interest is the project of the creation of the National Bank of Albania, a project that began in 1922, when the Albanian government addressed the League of Nations for the assessment of foreign investment opportunities in Albania, with the conclusions of the report proposing the establishment of a bank, with the sending of foreign experts for the establishment of the bank and ending with the relevant agreement and the commencement of the operation of this bank in 1925. Of particular interest are also the facts about the activity of this bank until 1944. But, after Independence, until 1944, several other banking institutions were operating in Albania. Many of these institutions were controlled only by foreign capital, others from foreign and domestic capital.

During the period 1944 to 1991 the most important bank in the country was the Bank of the Albanian State. It was a state bank (central bank), but also a commercial bank. Initially, this bank has had the lending and payment monopoly in Albania, but the scale of economic developments in this scale was abolished, and some of its activities were transferred to other banks, such as the Agricultural Bank. Depositing from the free savings population was a monopoly function of the Saving and Insurance Institute. While the Agricultural Bank enjoyed the monopoly of lending to enterprises and agricultural cooperatives. The links between these banking institutions were very strong and conditional. The Deposits of the Population at the Institute of Saving and Insurance Savings were used by the Albanian State Bank and the Agricultural Bank for lending their clients. The Savings and Insurance Saving Institute did not credit the economy, and the other two banks did not collect deposits from the population. The system of commercial banks in Albania after 1991 is distinguished for a gradual, but significant entry of banks with foreign capital from different European countries and other countries, starting with banks that entered the Albanian market through various agreements, with banks that entered through a clean licensing process and with banks that were created with Albanian private capital^[1].

2.2 Economic Importance of Commercial Banks

The importance of the role of commercial banks and the daily involvement of banking services in people's lives has been recognized earlier (Hughes, 2002). Commercial banks, through their functioning, influence the development of the economic system, between various functions such as financial intermediation, liquidity creation, credit rating and credit tracking, solving asymmetric information problems, improving the efficiency of monetary policy, economic stabilization, improving the efficiency of payment systems, financing foreign trade and encouraging exports by performing their business with the motive of profit as a business firm (Yagcilar, 2011).

Bank is called the financial institution, the establishment of which is licensed by special procedures and conditions, by the highest monetary authority of the country, with the main objective of collecting savings and free capital of individuals, companies, institutions, etc. form of monetary deposits of different types (with a certain interest) and, on the other, putting them through lending and lending (but with another interest) in the service of the economic activity of those who need additional capital (Uruçi , 2006). The Bank is an enterprise that performs the task of supplying the clientele with means of payment and mediates the supply and demand for capital while simultaneously acting as a borrower and lender (Zanichelli, 1983; Rahman et al., 2007).

Heffernan (1996) defines banks (as a separate financial intermediary) as intermediaries between depositors and borrowers participating in the economy. Banks are distinguished by other types of financial firms because they offer deposits and loans. To complement this definition, Bossone (2001) suggests that banks are a special intermediary as they have a special capacity to finance production, from lending, to agents who are willing to accept it. As such, banks manage their obligations, but also lend money and thus create bank values. In general, brokering banks has to do with the provision of payment services to consumers. Banks can also be defined as supply transactions and service portfolio manager according to Fama (1980).

A financial intermediary is defined as an institution that acts as an intermediary in capital markets (Beck, 2001). This is achieved by comparing the supply and demand on the capital market. For this reason, a financial intermediary is an intermediary institution between lenders and borrowers. It provides market transparency between its role. Thus, intermediaries facilitate risk transfer, as they are well positioned to deal with complex financial instruments and markets (Allen and Santomero, 1997; Rose, 1999; Beck, 2001). At the same time, financial intermediaries reduce participation costs, which are the costs involved in learning about and using the markets regularly. Of course, this is an important explanation of the changes that have taken place (Jan, 2012).

However, Kareken (1985) has paid more attention to the role of banks in managing the payment system. At the same time, there is a special feature of banks acting as delegated borrowers' monitors in the lender's final order, where monitoring is costly (Corrigan, 1982). Basically, banks produce a net social benefit by utilizing economies of scale in processing information involved in monitoring and enforcing contracts with borrowers. They reduce the costs of delegation through the diversification of their loan portfolio (Fama, 1985).

As borrowers keep deposits to them, banks can observe cash flow movements and acquire private information on borrowers, which can then be used to provide new loans (Bossone, 2001). Thus, banks generate money in the form of their debt claims and inject them into the system by lending, which exemplifies the use of foreign currency with their obligations to deposits (Heffernan, 1996).

Integration of lending and payment of intensive information services distinguishes banks from other intermediaries, according to Goodfriend (1991). In short, banks are in the risk management business - they value, take over and manage the risk. The risks faced by banks include liquidity risk, interest rate risk, credit risk, etc. The traditional risk management risk in the banking system has been in the interest rate and liquidity risk management, where the credit risk a bank is usually managed by a separate department or division (Heffernan, 1996). Apart from the role as financial intermediaries, banks also play an important role in the functioning of large economies.

Levine (1997) conducted a study and the result revealed that the efficiency of financial intermediation could affect economic growth. Most importantly, financial intermediation affects net returns on savings and gross return on investment (Demirgiic-Kunt, 1999). Many of the authors mentioned in the literature point out that the efficiency of financial intermediation affects the economic growth of the country (eg Rajan and Zingales, 1998; Levin, 1997, 1998).

2.3 Structure of Financial/Banking System

In Albania, banking reforms have started at a slow pace. In the early 1990s, the country was characterized by a low level of financial intermediation and money laundering problems. Listed in the dictionary - View detailed dictionaryThe efforts to harmonize banking activity in Albania with the reforms and developments of the new historical process began with the transition during the '90s and beyond they moved to the market economy. With the adoption of the Law on Bank of Albania in April 1992 and later of the Law on Banking System, the reform focused on the establishment and introduction of two-tier banking system by the Bank of Albania as the highest body responsible for the design and overseeing the implementation of monetary policies, the entire banking system and commercial banks, mainly of the universal type (Hallunovi, 2008).

The Albanian banking system was characterized by important developments. The increase in the number of banks in the system, the restructuring and privatization of state-owned banks, the establishment of new domestic-owned banks, in addition to the increase of investments in foreign-owned banks, have given the Albanian banking system a dynamic environment, where all banks struggled to get a better position on the market. Nowadays, banks are working on a dynamic business environment where they are experiencing competitive experience and changes in customer requirements, so understanding the changing needs and customer expectations is a prerequisite for the financial sector (Joseph et al., 2005).

The adoption of the Law "On the Bank of Albania" and the Law "On the banking system in the Republic of Albania" marked the transition of the banking system from one level to a two level banking system. At the first level there is the Bank of Albania or the show and in the second level there are other (commercial and specialized) banks. The following is a schematic depiction of the structure of the banking and financial system at the end of 2014, consisting of 16 commercial banks, 22 non-bank financial institutions, 356 foreign exchange bureaus, 113 savings and loan associations and 2 unions of companies savings and loan.

Figure 2.1 Structure of the banking/financial sector Abbildung in dieser Leseprobe nicht enthalten

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Source: BoA, 2014

All commercial and specialized banks have the main purpose of their profit-making activity (given as the difference between income earned from active transactions and payments made by passive operations and bank operating expenses) (Wang et al., 2003 ). Specialized trading banks perform two main types of transactions: a) passive operations and b) active operations. In the first case, all actions for which the bank pays interest to third parties or makes expenditures from its own funds are included. In active actions, all interests that the bank collects, commissions and other incomes are included (Bikker and Bos, 2005).

Banks develop their business with other people's money, making them more special but sensitive to other businesses. Because bankruptcy of a bank would affect a large number of individuals. World experiences have shown that banking crises are a phenomenon that has accompanied and accompany the development of the banking system, yet they are accompanied by high costs. As was the Asian crisis during 1980-1982, which was accompanied by a 55% share of GDP (Haderi, 2006). By the end of 2014, banks operate through 500 branches/agencies located within the territory of the country, while only one bank continues to have a branch outside the territory of the Republic of Albania, namely the National Commercial Bank in Kosovo. With regard to the expansion of the banking system by 2014, Tirana (according to geographic distribution of branches and banking agencies within the territory of the Republic of Albania by prefectures) still remains the country with the largest number of branches and agencies by 40%, as there is the highest concentration of the population and businesses by 27%, where it is noticed that the distribution of branches and banking agencies is in proportion to the population (Bank of Albania, 2014).

Below are the indicators of the expansion of the banking system for the entire banking system:

Table 2.2 Indicators of the expansion of the banking network at the end of 2014

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Source: BoA, 2014

During 2014, the ratio of financial system assets to GDP, ie, financial intermediation has expanded moderately compared to 2013, where it is in Albania 101.4%, increasing its share in the country's economic activity. The moderate expansion of the banking sector and the growth of private investment funds have affected the diversification of the financial system. The banking sector is estimated to be significantly exposed by non-bank financial segments (insurance companies, savings and loan associations and non-bank financial institutions). However, these segments do not pose a direct risk to the banking sector. On the other hand, the exposure of the banking sector to other segments of the financial system (mainly in the form of loans and equity participation of non-bank financial institutions and in the form of funds collected from them) account for only 1% of the assets value, indicated for a negligible level. Banks play a key role in the structure of financial system assets. By the end of 2014, 90.4% of the financial system's assets and 91.7% of the country's GDP belonged to the banking sector. Therefore, for the assessment of financial stability it is very important to identify and evaluate the risks arising from banking activity. The table below illustrates the share of banking sector to GDP over the years (2009-2014).

Table 2.4 The weight of the banking sector to GDP over the years

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Source: BoA , 2014

2.4 Main Developments in the Performance of the Albanian Banking System

According to the analysis of the economic indicators of the Bank of Albania and the Albanian Banking Association, this section presents a summary of the main developments of the banking activity during 2014. Financially, the Albanian economy and its financial system recognized progress during 2014, improving the liquidity, profitability and asset quality indicators. However, the banking sector's intermediary activity remains low and its balances continue to suffer from non-performing loans. The economic activity at the end of 2014 is estimated to have increased by 2.42% or 1.12% compared to the third quarter of the same year, but the world economic activity has also improved gradually, but at a lower rate than expected with apparent differences between the regions. Since the fall in oil prices, global economic activity is expected to improve but at sluggish rates. It is estimated that the main component of economic growth remains the growth of domestic demand. Factors such as improving economic agents' confidence along with reducing risk premiums and stimulating monetary conditions have boosted domestic demand, albeit foreign demand has been weaker than expectations. Annual inflation declined to 0.7% in December 2014, reflecting low inflationary pressures, both from the domestic economy and from the external one. Therefore, the Bank of Albania's monetary policy has continued to remain stimulating throughout the year.

The budget deficit is estimated at about 5.1% of GDP and is financed by 58.5% mainly from domestic sources. Data on FDIs show that they recorded a net inflow of 229 million euro, ie about 93% of the financial account. For 2014, the unemployment rate has increased, marking a value of 18% from 17.1% a year earlier. According to forecasts for the future, it is estimated that economic growth will be strengthened, supported by domestic demand, low interest rate and credit enhancement. The contribution of foreign demand to the economy will continue to remain unfavorable. Interest rates have continued to decline, particularly in the primary securities market, in credit and banking sector products, as well as in the interbank market in financial markets, thanks to the BoA's easing monetary policy and also the nominal value of the lek in exchange for the main currency basket has fallen. Following mainly the developments in the international exchange markets, the lek exchange rate has been stable against the euro, but on the other hand it is depreciated against the US dollar and the currencies that follow it. The European currency is depreciated against the major currencies, particularly against the US dollar.

At the end of 2014, the banking sector had satisfactory levels of liquidity and returnability, but although the ratio of non-performing loans declined, credit risk was assessed as high and disturbing. Banking sector's generally "foreign exchange" position positions somewhat mitigated the exposure to exchange rate depreciation. Despite lower interest rates, affecting the borrower's ability to improve solvency, the risk of growth again should be taken into account. Also, the banking system's capitalization position is satisfactory, providing a stable hedge against bank exposures to risks. The financial result of the financial system has increased considerably despite the increase in provisions for covering loan losses. In addition to the growth of the loan portfolio, the growth of banking activity in securities instruments was also increased by about 8.2%. Credit activity provided strong recovery signals in the framework of the steps implemented for the process of repaying government arrears and collateral execution, which should also mention the impact of improving economic activity. On average, in 2012 and 2013, the loan portfolio consisted of 48% of total bank assets, while in 2014 it represented about 45% of total bank assets. About 60% of the total domestic debt emitted by our government is owned by the albanian banking sector.

Meanwhile, about 82% of total banking sector assets consist of deposits (of which deposits of lek and foreign currency and deposits of individuals and businesses have contributed), being also the main financier of banking activity. Banking sector deposits grew 4.6% year-on-year and grew faster than the previous year (3.4%), where this increase is attributed to the fact that 60% of deposits were made in December and half of them were the product a large bank that is part of banks of group 3. Of which, of course, 73.4% of the total deposits during 2014 were collected by the banks of group 3. The tendency is that interest rates in major banks are lower than the higher rates of return to medium and small banks. Over the last quarter, the highest growth of about 10% had deposits of businesses and institutions, while household deposits continued to grow steadily, with an annual average of about 2.6%. The shift of savings from the securities market and short-term deposits to deposit products with maturity over two years, which provides higher yields, has contributed to the performance of deposits, mainly in the third quarter of 2014. The paid-in capital in the banking system during 2014 increased by 3.2% compared to the previous year. The capital structure continues to be dominated by foreign capital, dominating the capital structure, representing about 89.5% of the paid-in capital of the banking system, compared to 2013 with a decline of about 2.5 percentage points.

Financial data for commercial banks for 2014 show that total banking system assets increased by 4.8% or ALL 59.4 billion, from 3.9% in 2013, or 1.7% more than the third quarter of 2014. Meanwhile that the loan portfolio has increased by 28 billion albanian lek or 4.9%. In the albanian economy, the presence of the banking system has appeared dominant, as the share of total assets to GDP grew, as can be illustrated in the table below, with an upward trend from year to year (study period 2009-2014). Even the ratio of loans to GDP shows upward trends due to the higher growth of total credit compared to GDP growth.

Table 2.5 The share of total banking system assets and loan portfolio to GDP

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Source: BoA, 2014

The outstanding credit extended by banks to the private sector during 2014, marked the highest growth by about 17.9 billion albanian lek or 3.1%. The new loan disbursed at the end of 2014 was 10% more than in the third quarter of the year, while the total of new disbursed loans throughout 2014 was about 16.4% higher than the disbursed in 2013. About 48% of it was disbursed in albanian lek, thus pointing to shifting to lending in local currency, albeit with slow growth. Liquidity needs have been the main reason for borrowing from individuals and businesses. Provisioning level continues to grow, showing higher growth than the growth of non-performing loans. At the end of 2014, the coverage ratio with non-performing loans provision was 67.1%, from 65.2% the previous year (2013). The outstanding credit extended by banks to the private sector during 2014, marked the highest growth by about 17.9 billion albanian lek or 3.1%. The new loan disbursed at the end of 2014 was 10% more than in the third quarter of the year, while the total of new disbursed loans throughout 2014 was about 16.4% higher than the disbursed in 2013, About 48% of it was disbursed in albanian lek, thus pointing to shifting to lending in local currency, albeit with slow growth. Liquidity needs have been the main reason for borrowing from individuals and businesses. Provisioning level continues to grow, showing higher growth than the growth of non-performing loans. At the end of 2014, the coverage ratio with non-performing loans provision was 67.1%, from 65.2% the previous year (2013). The banking sector signaled a positive financial result with a significant increase compared to 2013. Where, of course, the main cause was the improvement of net interest income (where this improvement is attributable to contraction due to the negative performance of lending and low interest rates in foreign financial markets) and the decline in provisioning for loss of activity. However, banks have tried to maintain a low cost-to-income ratio, focusing mainly on large and small banks.

The banking system remains liquid and stable, with a capital adequacy ratio of 16.8% at the end of december 2014 from 17.9% at the end of 2013, so the capital adequacy ratio is above the regulatory minimum level of 12 %, which is the minimum rate required by the Bank of Albania. Where, of course, the accelerated growth of risk-weighted assets has increased, increasing by 8% in annual terms, so we can say that the level of capitalization is moderate, and also the regulatory capital has had a positive performance impacted by improving the financial performance of the sector and increasing capital.

Table 2.6 Capital adequacy indicator over years, in percentage

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Source: BoA, 2014

Meanwhile, the main margin contribution keeps the financing costs, which have followed the developments in deposit volume at a lower growth rate in recent years and mainly the fall in interest rates for them. Below are estimates the costs of funding over the years.

Table 2.7 The performance of financing costs over the years, in percentage

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Source: BoA, 2014

For 2014, the ratio of non-performing loans dropped to 22.8% from the previous year, which was 24.1%. The slight improvement in the quality of the portfolio was mainly due to the growth of the loan portfolio (estimated at 5% for 2014, mainly in foreign currency), but also from the fact that banks have been more reasonable by removing the lost loans balance. But if there are good levels of reserve funds (provisions), then this can positively impact on the mitigation of credit risk. For the banking sector, the provision coverage ratio at the end of 2014 reached 67.1% from 65.2% in the previous year, increasing by 1.9 percentage points, indicating that banks compared to a year ago maintained and/or increased the provision coverage rate for non-performing loans. At sector level, the ratio of non-performing loans to outstanding loans decreased to 7.5% from 8.2% in the previous year (2013). Also, the "net debt/regulatory capital" ratio at the end of 2014, mainly driven by the expansion of regulatory capital, had declined. Reserve funds for covering loan losses resulted in about 91.7 billion albanian lek, an increase of about 4.1 billion albanian lek by the end of 2013.

However, there has been a decrease in the share of loans with net equity problems from 40.2% in 2013 to 38.3% at the end of 2014, indicating an increase in the ability of the system to cover capital losses that may come from the deterioration of the loan.

The liquidity situation of the banking system remains satisfactory, the liquidity indicator reached 40.4% at the end of 2014, an increase of 5.7 percentage points compared to the end of last year. Liquid assets account for 31.9% of total banking sector assets by the end of 2014, with an incalculable decline during the first half of the year, but still 4.3 percentage points higher than in the same period of the previous year (2013). Banks of group 3 have contributed to a greater extent to this indicator, which has an expanded ratio of 10.8 percentage points compared to the previous year, at 37.8%. The table below shows the assets liquidity indicator and graphically its movement by banking groups over the years.

Table 2.8 Liquidity indicator of assets over the years, in percentage

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Source: BoA, 2014

The banking sector envisages manageable the direct impact of exchange rate and interest rate developments, but is vulnerable to adverse impacts that may cause unfavorable exchange rate movements and interest rates on customers. Because a depreciation of the exchange rate or an interest rate increase may damage the solvency of banking sector customers, mainly in the business sector. The modified index of foreign currency mismatches measures banks' exposure to direct and indirect exchange rate risk.

This index deteriorated slightly to -10.2% at the end of 2014 versus the previous year, when the index marked -11.1%, as a result of the largest expansion of foreign currency liabilities along with unhedged credit compared to foreign currency assets. Banks of group 3 were positioned to "buy" foreign currency, further increasing exposure to albanian lek exchange rate appreciation. Meanwhile, the banks of group 1 and 2 are less exposed to the exchange rate. The system efficiency indicator at the end of 2014 increased by 3.5 percentage points compared to the previous year, in terms of operating income decreasing by 1.3 billion albanian lek or 2.9%, and operating costs increased by only 0.8 billion albanian lek or 3 %. Concentration indicators expressed through the Herfindahl Index calculated for the total of assets, deposits and loans during 2014, continue to remain stable, pointing to a low and constant concentration.

Table 2.9 Index H (Herfindahl) concentration of assets, deposits and loans

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Source: BoA, 2014

Domestic currency on an annual basis appreciated by about 0.4% against the European currency and depreciated about 3.9% against the US dollar. In the same period, the nominal effective exchange rate dropped in average terms, expressing a lek appreciation by about 0.5% in annual terms. By the end of 2014, in real terms, domestic currency appreciated on average by 1.7% on an annualized basis. Below are summarized some of the economic indicators that point to the financial health of an economy. The financial result of 2014 was positive, at a value of 11.2 billion albanian lek or 4.6 billion albanian lek higher than that of 2013. The fact that the financial result is positive and higher than last year, the performance of the main indicators of profitability (ROE) and return on equity (ROE) were valued at 0.89% and 10.53% respectively for the end of 2014.

Table 2.10 Key profitability indicators, in percentage

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Source: BoA, 2014

According to estimates, banks in the group 3 have contributed to the increase of profitability indices (ROA and ROE), against small and medium-sized banks that are with negative values. Below is a graphical presentation of the profitability indicators according to the banks of groups 1, 2 and 3. Albania's economic and financial stability indicators generally improved, though the Albanian economy continues to operate with incomplete capacity and face an unfavorable external environment. In the macroeconomic aspect, inflation and inflation expectations continued to remain at low levels, while the exchange rate appeared stable. The table below shows the performance over the years of macroeconomic indicators included in the study as independent variables.

Table 2.11 Progress in the years (2009-2014) of macroeconomic indicators

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Source: BoA, 2014

Therefore, we summarize that the banking sector remains the main segment of financial intermediation in Albania and is dominated by five banks, which together account for 68.4% of the system loan portfolio and 73.4% of deposits. From where its assets at end-December 2014 accounted for 91.7% of Gross Domestic Product, accounting for a 1.2 percentage point increase over 2013. The performance of the banking sector is estimated to be stable. The financial result showed improvement and the capitalization and liquidity indicators of the activity are on a steady level. The banking sector remains relatively protected from direct market risk while being exposed to credit risk. Financing of the activity is ensured by the increase of deposits from the public, which account for 82.3% of the total banking sector's assets. Gross domestic product is estimated to have increased, marking improvement from the previous year. The average annual inflation rate was 1.63% for 2014, remaining below the 3% target of the Bank of Albania. In an economic environment with low inflation and growth of under-potential economy, pursuit of a stimulating monetary policy. While the nominal effective exchange rate on the other hand appeared stable.

CHAPTER 3

The previous chapter presented a complete picture of the history of the evolution of the Albanian banking system, the role and importance of commercial banks and the economic development of the banking system in economic terms for the period studied 2009-2014. In this chapter an attempt will be made to review the broad literature on dissertation. From the results of the literature review we can foresee the relationship of different determinants in the study to the bank profitability. This chapter is organized as follows. Section 3.1 makes an analysis of the importance of the profitability study; section 3.2 makes a theoretical analysis of some of the most important profitability works over the years and defines the key profitability indicators used in different studies, sections 3.3, 3.4 and 3.5 extends a review of the determinants of profitability, factors Banking Specificity (bank size, asset management, credit risk, asset liquidity, operational efficiency, capital adequacy, financing cost), specific industry factor (concentration) and macroeconomic factors (economic activity, inflation and exchange rate rate).

3.1 Introduction

Profitability is one of the main reasons for the existence of business ventures, and business enterprises continue to operate by providing profits. Banks are business ventures that are intended to secure profits just as other enterprises. In this regard, the bank's profitability performance shows the success of the bank's management. Therefore, bank profitability is one of the most important indicators for investors (Melkamu, 2012). Since the creation of the Structural Adjustment Programs at the end of 1980, the banking sector throughout the world has experienced major transformations in its operating environment. Different states have facilitated interest rate controls, reduced government involvement, and opened their doors to international banks (Olweny and Shipho, 2011). Because of this reform, developed state companies have become more visible in developing countries through their affiliates and branches or between buying foreign companies.

More specifically, the presence of foreign banks in other countries across the globe has come with an extraordinary increase. Since 1980, many foreign banks have established their branches or affiliates in various parts of the world (Claessens and Hore, 2012). Even in Albania in the last decade, the number of foreign banks has increased considerably. On the contrary, the number of local banks has decreased (Association of Albanian Banks, 2012). This phenomenon in the world has attracted the interest of scholars to review the performance of the banking system in relation to these reforms. While in Albania the number of genuine studies is negligible. An important change has been noted in the financial configurations of the states in general and their effect on the profitability of commercial banks in particular.

The role of the bank remains at the center of financing the economic activity and its efficiency can exert a positive impact on the overall economy. Since a profitable and lumpy banking sector is able to withstand better the negative shocks and contribute to the stability of the financial system (Athanasoglou et al., 2005). Therefore, bank performance determinants have attracted the interest of academic researchers, as well as the management of banks, financial markets and bank supervisors, as knowledge of internal and external bank decisors is essential for different parties. Between the intermediation function, financial performance of banks has critical impacts on the economic growth of the countries. Since mediation plays a vital role in the efficient allocation of country resources through the mobilization of resources for productive activities, by transferring funds from those who have no productive use to those with productive ventures. In addition to resource allocation, banks' good performance rewards shareholders with a sufficient return on their investments. This, in turn, encourages additional investment and brings economic growth. Therefore, a poor banking performance may lead to bank failure and crises, which have negative consequences on economic growth. The banking crisis can bring the financial crisis, which in turn raises difficult economic situations as it did in the US in 2007 (Marshall, 2009). That is why governments regulate the banking sector through their central banks to promote a sound banking system and to avoid bank crises and depositors' protection and the economy as a whole (Heffernan, 1996; Shekhar and Shekhar, 2007).

So, to avoid crises, due attention is paid to banking performance. A more organized banking performance study began in the late 1980s (Olweny and Shipho, 2011) with the application of the Theory of Market Power (MP) and Effectiveness Structure (ES) (Athanasoglou et al., 2005). From the aforementioned theories, it was concluded that banking performance is influenced by internal and external market factors. According to Athanasoglou et al., (2005) internal factors include bank size, capital, operational efficiency and risk management capacity. The same researchers say that the main external factors affecting banking performance are macroeconomic variables such as interest rates, inflation, exchange rate, economic growth and other factors such as ownership. The profitability of banks is a very important indicator of the strength of the financial system and its development, especially in Central and Eastern European countries (eg in 2012 data on the total banking sector's total assets to GDP were: Albania 90%, Slovenia 126%, Czech Republic 124%, Hungary 108%, Serbia 94%, Bosnia and Herzegovina 87%).

Short (1979) and Bourke (1989) conducted first studies to analyze bank profitability. In the course of their early work, a number of recent studies have tried to identify some of the key determinants of bank profitability. Relevant empirical studies have focused their analysis on specific countries and/or between countries. Many studies have focused on the banking sector to identify the most important bank benefiting factors such as Demirguc-Kunt and Huizinga (1999); Mamatzakis and Remoundos (2003); Micco et al., (2007); Pasiouras and Kosmidou (2007); Athanasoglou et al., (2008); Naceur and Goaied (2001, 2008); Athanasoglou et al., (2008); Garcia-Herrero et al., (2009); Fadzlan, (2010); Alper and Anbar, (2011); Suminto and Yasushi, (2011); Dietrich and Wanzenried, (2011); Kanas et al., (2012); Ani, Ugwunta, Ezeudu and Ugwuanyi (2012); Bolt et al. (2012); Lee and Hsieh (2013).

Studies on bank profit determinants can be divided into two groups: Focus-focused studies in a particular country. The main works for this group belong to Berger et al., (1987); Molyneux and Thornton (1992); Berger (1995); Angbazo (1997); Neely and Wheelock (1997); Barajas et al. (1999); Demirguc-Kunt and Huizinga (1999); Guru, Staunton and Balashanmugam (1999); Naceur and Goalied (2001); Abreu and Mendes (2002); Naceur (2003); Mamatzakis and Remoundos (2003); Staikouras and Wood (2004); Goddard et al., (2004); Athanasoglou, Brissmis and Delis (2006); Micco et al., (2007); Pasiouras and Kosmidou (2007); Aburime (2008); Athanasoglou et al., (2008); Stork and Vries (2010); Deger and Adem (2011); Alper and Anbar (2011); Tan and Floros (2012); Wubitu (2012); Abuzar (2013); Obamuyi (2013); Weersainghe and Ravinda (2013) etc. The empirical results of these aforementioned studies differ from: data sets, time frames, investigated environment, and countries analyzed. However, there are some common elements that allow to further categorize the bank profitability determinantsThe papers on determining bank profitability within a single country includes Berger (1995) and Angbazo (1997) papers who studied banking operations in the United States; Guru et al., (1999) focused their work on studying banks' profitability in Malaysia; Mamatzakis and Remoundos (2003); Koeva (2003); Kosmidou and Pasiouras (2005), studied banking profitability in Greece; Pasiouras et al., (2005); Sanyal and Sankar (2007) analyzed the profitability of banks in Australia, Barajas et al., (1999) in Columbus; Afanasieff et al., (2002) in Brazil; Heffernan and Fu (2008) in China; Ramlall (2009) in Taiwan; Dietrich and Wanzenried (2009) in Switzerland; Javaid, Anwar, Zaman and Gafoor (2011) in Pakistan; Lui and Wilson (2010) in Japan; Sufis (2011) in Korea, etc. Studies that analyze bank profitability, including several banks at the same time, provide more detailed literature.

Studies focused on particular factors within a range of countries. The works of Haslem (1968); Short (1979); Berger et al., 1987; Bourke (1989); Molyneux and Thornton (1992); Neely and Wheelock, 1997; Demirguc-Kunt and Huizinga (1999); Bashir (2000); Abreu and Mendes (2001); Demirguc-Kunt and Huizinga (2001); Abreu and Mendes (2002); Staikouras and Wood (2003); Hassan and Bashir (2003); Goddard, Molyneux and Wilson (2004); Sabo (2007); Pasiouras and Kosmidou (2007); Micco, Panizza and Yanez (2007); Koutsomanoli-Filippaki, Margaritis and Staikouras (2009); Lindblom, Olsson and Willesson (2011); Liu and Wilson (2010); Ommeren (2011); Radulescu and Tanascovici (2012); and other works that can be classified in this group. All the above studies examine the various combinations of internal and external determinants of bank profitability.

Finally, variables such as capital adequacy, liquidity, operational efficiency, bank deposit growth, bank size, share of interest income, credit risk, ownership, concentration, central bank intervention, inflation rate, GDP growth , the effective tax rate and time structure of interest rates have a major or lesser impact on banks' profitability.

3.2 Theoretical Profitability Analysis

According to Sanni's conclusions (2006), profitability reflects a situation where earnings generated over a given period exceed expenditures incurred over the same time interval with the sole purpose of generating income. Where the required income and expenses are required to occur during the same timeframe and income is a direct consequence of the expenditure. The importance of profitability is related to the fact that it is the main purpose of a business. If profit is thought to be an unattainable target, then the best solution would be to get out of business. Profitability in the banking sector is a topic that has taken a lot of attention in recent years in the world. But it can not be left without mentioning the fact that most of the studies have been conducted for developed countries, and few studies have been conducted for developing countries.

Christensen, Jorgensen and Lau, (1970) were the first scholars who appreciated a flexible profit function. However, when calculating the flexible profit function they used square technique or variants of the least squares technique, in which error terms were assumed to be symmetrically distributed with a mean zero (Kumbhakar and KnoxLovell, 2000). However, it can be said that the validity of their research has been compromised by the assumption made regarding the distribution of the term of error.

Duca and McLaughlin (1990), among other things, concluded that changes in banks' profitability are largely attributable to changes in credit risk as increased credit risk exposure is usually associated with lower profitability of the firm . This causes a discussion not about the volume, but the quality of credits made.

Molyneux and Thornton (1992) were the first to explore bank profitability determinants in a number of countries. They use a sample of 18 European countries during the period 1986-1989. They find a significant positive relationship between return on equity and interest rate levels in each country, banking concentration and ownership.

Berger (1995) investigated the relationship between return on equity and equity ratio to US banks for the period 1983-1992 and found a positive relationship between the two variables.

Angbazo (1997) examined the net interest margin in US banks for the period 1989-2003 and found that management efficiency and leverage were positively correlated with the profitability indicator.

Bourke (1989) and Jiang et al. (2003) found that their studies found a negative correlation between spending and profit, implying that profitable banks are able to operate at lower cost.

Miller and Noulas (1997) suggested an oblique relationship between high risk loans and profitability, concluding that the higher the accumulation of unpaid loans, and the lower the profitability.

Demirguc-Kunt and Maksimoviq (1998) suggest that the degree to which different financial and legal factors affect the bank's profitability are closely related to the size of the firm.

DemirgucKunt and Huizing (1998) used data from eighty-nation banks in 1988-1995 and analyzed how banking characteristics and the overall banking environment affect interest rate spreads and bank returns. During the review of the two measurements, this study provided a breakdown of revenue effects on a significant number of determining factors affecting the behavior of the depositor and the borrower, as opposed to that of the shareholders. The results suggested that macroeconomic and regulatory conditions have a significant impact on profitability. Low market concentration ratios led to margins and lower profits, while the effect of foreign ownership varied between industrialized and developing countries. In particular, foreign banks have higher margins and profits compared to domestic banks in developing countries, while the opposite occurs in developed countries.

Guru et al., (2002) investigated for bank profitability determinants in Malaysia. They used a sample of 17 commercial banks during the period 1986-1995. Profitability determinants were divided into two main categories, namely internal determinants (liquidity, capital adequacy and expenditure management) and external determinants (ownership, firm size and economic conditions). The findings showed that cost-effective management was one of the most important in explaining bank profitability. Among the macroeconomic indicators, the high interest rate was associated with a low level of bank profitability and inflation was found to have had a positive effect on banking performance.

Cooper (2003), show that changes in credit risk may reflect changes in the health of a bank's loan portfolio, affecting the performance of the institution.

Bikker and Hu (2002) and Goddard et al. (2004) link the bank's size to the equity ratio of assets, and they argued that higher capital ratios reflected banks' stability and security as well as capital growth, profitability grew because relatively large banks tended to increase capital in a less expensive way, and so they were more profitable.

Bikker (2002) in his study showed that diversified banks in Hong Kong seem to be more profitable. When banks are more diverse, they can generate revenue streams, reducing interest-dependence that is easily influenced by the negative macroeconomic environment.

Guru et al. (2002) and Naceur (2003), respectively in Malaysia and Tunzi, found a positive relationship between profitability and spending, arguing that banks are able to spend their total spending on depositors and borrowers lower deposit rates and / or larger lending assets.

Demirguc-Kunt and Huizinga (1999), Bashir (2000), and Jiang et al. (2003) in their studies of profitability, came to an important conclusion on the relationship between the profit tax rate and profitability. Such a positive relationship exists between tax and profitability variables. Although the corporation tax rate is not a choice for banks, the management of the bank should be able to allocate its portfolio to minimize its tax. Since consumers face an inelastic demand for banking services, most banks are able to pass the tax burden on consumers.

Abreu and Mendes (2002) investigated the influence of specific banking factors on bank profitability in the banks of four European countries for the period 1986-1999. They found that well-capitalized banks have little bankruptcy costs. The operational cost had a positive attitude relationship.

Jiang et al., (2003) analyzed the profitability of the banking industry in Hong Kong between 1990 and 2002, the empirical results showed that both specific banking and macroeconomic factors are key determinants in the profitability of banks. With regard to macroeconomic factors, real GDP growth, inflation and real interest rates had a positive impact. On the other hand, the size, represented by loans or deposits, had a negative relationship with profitability, suggesting that, on average, larger banks have a lower ROA than the smaller ones. The completion of this study showed that a profitable banking sector is better able to withstand the negative shocks and contribute to the stability of the financial system.

Koeva (2003) provided new empirical evidence on the impact of financial liberalization on the performance of banks in Indian private banks. The analysis focused on the behavioral review and bank intermediation cost determinants with profitability in the liberalization period. Empirical results suggested that the type of ownership has a significant effect on some performance indicators and that the growth observed in competition during financial liberalization has been associated with lower intermediation costs and profitability of Indian private banks.

Goddard et al., (2004) study the profitability of the European banking industry. The empirical study was conducted in six European countries: Denmark, France, Germany, Italy, Spain and Great Britain (665 banks in total) and found that the relationship between the equity ratio and profitability (ROE) was positive.

Staikouras and Wood, (2004), explored the determinants of profitability in 685 European banks. Their analysis focused on variables such as credit risk, capital adequacy, interest rate, operational efficiency, bank size, GDP growth rate, and gross per capita income for each European country. The authors concluded that capital adequacy and size of the bank had a positive effect on the banking profit (ROA), while the credit risk was negatively related to the bank's profitability. As for macroeconomic variables, interest rates had a positive effect, while the GDP growth had a negative effect on the profitability of banks.

Chantapong (2005) investigated the performance of domestic and foreign banks in Thailand during the period 1995-2000. In all banks, they found that they had reduced their exposure to credit during the crisis years and had gradually improved their profit during the post-crisis years. The results showed that the level of profitability in foreign banks is higher than the profitability average at domestic banks in the post-crisis period, the gap between the profitability of foreign and domestic banks' profitability declined, suggesting that the financial restructuring program yielded some results positive.

Athanasoglou et al. (2005) investigated the profitability of Greek banks between 1985 and 2001 and found that credit risk and operating expenses had a negative impact on profitability, while inflation was positively related to financial performance.

Athanasoglou et al., (2006) studied the behavior of banks' profitability in southeastern Europe during the period 1998-2002. Empirical results suggested that increasing banks' profitability in those countries required new standards in risk management and operational efficiency, which, based on the evidence presented in the study, affected profits. An important result is that the market concentration effect is positive, and the macroeconomic variables are mixed.

Athanasoglou et al., (2006) applied a dynamic data panel model to study the banking profitability of Greek banks over the period 1985-2001, and the results found that the market structure is not entirely competitive. The results also showed that Greek banks are well-capitalized, while the industry structure does not seem to have a significant impact on profitability.

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^[1] Albanian Association of Banks