Academic journal article International Journal of Business and Society

On the Nexus between Risk Taking and Profitability: Evidences from Indonesia

Academic journal article International Journal of Business and Society

On the Nexus between Risk Taking and Profitability: Evidences from Indonesia

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1.INTRODUCTION

Recent developments in the company performance evaluation, such as economic value added (EVA) and return adjusted risk of capital (RAROC), has been applied to provide new insight on how a bank operates and performs in competitive environment (Saha, Ahmad and Yeok: 2016). However. Traditional financial ratios and profitability indicators such as return on average assets (ROAA) or return on average equity (ROAE) are still regarded as the most reliable bank's performance measure especially among regulators. Rodríguez-Ruiz, Rodríguez-Duarte and Gómez-Martínez (2016) support the use of ROAA for bank performance as market based performance is not superior than accounting based. Further, Agarwal and Taffler (2008) confirmed that the accounting-based approach yield significant economic benefit over modern method known as market-based model.

The purpose of this study is to review performance indicators of different banks in comparison to their risk preferences using simultaneous regression (Two Stage Regression-2SLS). According to Maddala (2001), this technique can directly estimate the interrelationship between risk taking and performance. As risk taking serves as instrumented variables, the results correlate with the error term (endogenous) implies the traditional Ordinary Least Square (OLS) is not suitable. From risk perspectives, Greuning and Bratanovic (2009) suggest that analysis of bank profitability should be embedded with risk-taking perspective. We replicate the approach of Booth, Fung and Leung (2016) who use a risk return framework to investigate the momentum-reversal phenomenon using U. S. stock returns. We adapt the approach for the banking industry in Indonesia. Using risk taking principle, we recognise the possibility or the choices of bank manager may bring negative effects such as loss or danger to the bank but it also produces higher profits either.Endogeneity of risk and profit is essential in the banking as banks serve as intermediation players. As intermediary, banks serve as size transformation, maturity transformation and risk transformation. Commercial banks by effectively appraising credit requests can channel funds into productive uses. According to Bhattacharya and Thakor (1993), benefits provided by financial intermediaries consist of reducing information and transaction costs, granting long-term loans, providing liquid claims and pool risks. It means, financial intermediary such as banking, generating profit from the risks they take.

Many papers discussed the determinant profitability based on macroeconomic, microeconomics or both that try to link the risk position to profitability. For example, Dietrich and Wanzenried (2011) using microeconomics and macroeconomic variable to investigate the determinant of bank profitability especially on the impact of global financial crisis (GFC). Petria, Capraru and Ihnatov (2015) apply risk as a determinant of bank profitability using linear regression. Similar work is done by Mongid and Tahir (2011) for ASEAN banking. However, their approaches are not yet considering the endogeneity of risk taking and profitability.

The problem of the research is whether there is a positive relationship between bank's risk taking position and profitability when bank specific variables and economic condition where the bank operating areembedded. Freixas and Rochet (2008) suggest banks operate in different economic condition own different preferences in risk taking and profitability. Most of previous studies (González, 2005; Dietrich and Wanzenried, 2011; Srairi, 2013; Petria, Capraru and Ihnatov, 2015) defined risk as ex post meaning the risk is measured using risk event data such as non-performing loan (NPL) or loan loss provision (LLR). Thispaper looks at the risk from different perspective (ex-ante) and measured as a summation of credit and operational risk. We exclude market risk due to data availability. …

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