Determinants of profitability in the banking sector: A study of OECD countries

Banks, as central institutions in the financial system, have historically played a vital role in enhancing social welfare. Acting as intermediaries, banks channel savings from depositors to borrowers and investors. Through this intermediary function, banks facilitate the efficient allocation of resources across the economy, thereby contributing to economic growth and development. Moreover, the high profitability of the banking sector strengthens financial stability and investor confidence, ultimately supporting improved economic performance. Given the crucial role of the banking sector in the macroeconomy, this thesis investigates the determinants of banking sector profitability in OECD countries between 2002 and 2019 using static panel data techniques. Three distinct analytical models were developed, each based on a different measure of banking sector profitability. The determinants of profitability were grouped under three categories: macroeconomic variables, banking sector variables, and institutional variables. The analysis revealed that economic growth, financial development, and bank stability—measured by the banking Z-score—are the primary determinants of profitability across all three models. Additionally, non-performing loans, inflation, bank inefficiency, and improvements in institutional quality were found to have consistent effects on at least two profitability measures, highlighting their significant influence on banking sector performance. Furthermore, the study found that the impact of increased non-interest income and public debt on bank profitability varies depending on the specific profitability indicator used. Lastly, the capital adequacy ratio—an essential measure of regulatory capital—and unemployment were shown to have statistically significant effects on only one profitability indicator, suggesting a weaker influence compared to other variables. These findings should be taken into account by policymakers in OECD countries when designing strategies to enhance the profitability of their banking sectors.