Oil Prices and bank profitability: Evidence from major oil-exporting countries in the Middle East and North Africa

Heiko Hesse, Tigran Poghosyan 27 October 2009

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The recent economic and financial crisis and the sharp fall in oil prices have hit hard many of the oil-exporting countries in the Middle East and North Africa (MENA). Exports, government revenues, and fiscal balances have fallen dramatically, declining GDP growth and equity/ real estate prices have put strains on both corporate and bank balance sheets, and credit growth to the private sector has significantly worsened. In some countries, governments had to intervene in the domestic financial sector with deposit guarantees, liquidity support, capital injections, or equity purchases (via their government-owned vehicles such as sovereign wealth funds) as financial sector indicators worsened. In particular, banks that lent heavily for real estate purposes and equity purchases have suffered losses with the collapse of these asset prices.

Given the dependence of these countries on oil exports, the link between oil prices and bank performance and stability is of interest with regard to not only the current crisis but also previous boom-bust oil cycles. Do oil prices influence bank performance, and, if so, through what channels? Or is there no direct link between oil prices and bank performance if we account for macroeconomic and bank-specific factors? Are there differences across commercial, investment, and Islamic banks? What has been the impact of the global financial crisis on bank profitability and its link to oil prices?

Oil prices’ influence on bank performance

Oil prices affect the economy through both direct and indirect channels.

  • Oil price shocks could affect bank profitability directly via increased oil-related lending, business activity, or excess liquidity in the banking system.
  • Indirectly, prospects of oil income affect fiscal spending, since oil receipts form a large part of external and government income in MENA countries. This in turn influences corporate and bank profitability via lending to the private sector.
  • Another indirect channel operates via expectations and the overall business sentiment in the country. Higher oil prices could lead to higher domestic demand, which would feed back into higher bank confidence, lending, and repayment rates.
  • On the aggregate supply side, the productive capacity of countries is also likely to be expanded with new public and private investments fuelled by high oil prices, pushing growth rates even further.

Such effects were evident in the pre-crisis boom (IMF, 2009). Between 2005 and 2008, bolstered by high oil prices, oil-exporting countries have engaged in large investment programs to diversify the domestic economy and develop human capital. Financial institutions reaped sizable profits and appeared financially stable with sound capital adequacy levels and low non-performing loans.

What does the literature say?

In general, studies on bank profitability have covered a wide range of countries and regions, and the banking literature finds that bank profitability depends on both bank-specific and macroeconomic factors. In terms of bank-specific factors, credit risk, liquidity, size, efficiency, and ownership have been found to be main determinants of bank performance (e.g. Molyneux and Thornton, 1992; Miller and Noulas, 1997; Demirguc-Kunt and Huizinga, 2000). Bank profitability can also be quite persistent (Athanasoglu et al, 2008) implying a certain level of concentration and market power in the banking industry, both in input and output markets.

In terms of macroeconomic variables, researchers have found a link between inflation, interest rates, and profitability as well as the business cycle and bank performance (e.g. Demirguc-Kunt and Huizinga, 2000; Flamini et al, 2009). Banks are typically able to adjust interest rates if (expected) inflation increases, which might feed back into higher revenues and profits. The link in the Gulf Cooperation Council (GCC) countries might be somewhat different since the exchange rate peg to the US dollar implies that inflation is imported from abroad (given that monetary policy is geared towards maintaining the peg).

The empirical academic literature on differences in commercial and Islamic banks is very scarce and mainly touches upon financial stability (Cihak and Hesse, 2008) and does not examine their relationship with oil – the main revenue source for government in these oil-exporting countries. Conceptually, since Islamic banks often tend to fund themselves with sukuk besides shariah-compliant deposits, and higher oil prices are associated with higher liquidity and therefore deposit inflows that can be intermediated into lending, a positive relationship between oil prices and bank performance for Islamic banks seems likely. But with oil prices having fallen from their peak of $140 a barrel, the reduced oil liquidity has not only hit Islamic banks but also their conventional peers, so the differential impact is not clear a priori. One would expect that investment banks, with their typically wholesale funded business models and higher leverage than their conventional and Islamic banking peers, would be hit by the liquidity squeeze.

New evidence

In Poghosyan and Hesse (2009), we empirically investigate the relationship between oil price shocks and bank performance in MENA countries (Algeria, Bahrain, Iran, Kuwait, Libya, Oman, Qatar, Saudi Arabia, Sudan, United Arab Emirates and Yemen) using bank-level data for the period 1994-2008 and dynamic panel methods. As far as we know, no study has explicitly looked at oil-exporting countries and bank profitability. Including oil price changes and shocks as a systemic variable into this framework is novel and by using different definitions for the shocks ensures robustness of the results. Since the business models of commercial, investment, and Islamic banks are likely to exhibit differences, we also explore the impact of bank specialisation on bank profitability.

Our findings suggest that oil prices affect bank profitability indirectly, via macro channels. Specifically, the main macro channels appear to be the fiscal stance, inflation, and (partly) the real GDP growth of a country. In terms of different bank types, we find that investment banks have the highest exposure and sensitivity to oil price shocks, which is likely to be driven by their buoyant advising, fee, trading, etc. income during oil price booms and bolstered by excess oil-related liquidity entering the financial system. However, this result should be interpreted with some caution, since we do not control for the impact of house prices (due to lack of data), which might be a very influential determinant of profitability for commercial and Islamic banks. In addition, given the heterogeneity of bank balance sheet data across the countries, we might not be fully capturing this relationship between bank type and oil price shocks. We also find some tentative evidence that the global financial crisis has diminished the positive impact of oil price shocks on bank profitability. In terms of bank-specific variables, more liquid, efficient, and capitalised banks have higher profits, while there is some persistence in the profitability over time.

Policy implications

Our results have interesting policy implications, since they provide the first evidence of a systemic importance of oil price shocks for bank performance in oil-exporting countries. There has been anecdotal evidence of this link, but it has not been tested formally in an empirical setting. In particular, these findings suggest that oil price shocks could be used for macro-prudential regulation purposes in MENA countries, since oil prices are easier to monitor than commonly used measures of business cycle (such as deviations of GDP from its potential level). For instance, tying bank capitalisation to oil price shocks could help mitigate pro-cyclical bank lending and allow banks to use their capital cushions created during boom periods for lending purposes during downturns.

References

Athanasoglou P., S. Brissimis and M. Delis (2008). “Bank-specific, industry-specific and macroeconomic determinants of bank profitability,” Journal of International Financial Markets, Institutions, and Money 18, pp. 121-136.

Cihak, M. and H. Hesse. (2008). “Islamic Banks and Financial Stability: An Empirical Analysis.“ IMF Working Paper WP/08/16. Washington, D.C.

Demirguc-Kunt, A. and H. Huizinga (2000). “Financial structure and bank profitability.” Policy Research Working Paper Series 2430. The World Bank.

Flamini, V., C. McDonald and L. Schumacher (2009). “The determinants of commercial bank profitability in Sub-Saharan Africa.” IMF Working Paper WP/09/15. Washington, D.C.

International Monetary Fund (2009). Regional Economic Outlook: Middle East and Central Asia, May 2009. Washington, D.C.

Miller, S.M. and Noulas, A.G. (1997). “Portfolio mix and large-bank profitability in the USA”. Applied Economics 29, 505–512.

Poghosyan, T. and H. Hesse (2009) “Oil Prices and Bank Profitability: Evidence from Major Oil Exporting Countries in the Middle East and North Africa.” IMF Working Paper 09/220. Washington, D.C.

Molyneux, P. and J. Thornton (1992). “Determinants of European Bank Profitability: A Note,” Journal of Banking and Finance 16, 1173-1178.

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Topics:  Energy Financial markets

Tags:  oil, banks, Middle East and North Africa