Determinants of profitability of financial institutions in Latin America and the Caribbean

The Caribbean and Latin American countries are often treated as a single homogenous bloc. This frequently results in similar policy prescriptions for both regions—this can be problematic if the two regions are not in fact homogenous. First, the paper investigates if the characteristics of financial institutions (FI) in the Caribbean countries are different from their Latin American counterparts. Second, the paper delves into the relationships between the source of revenues and balance sheet composition, the profitability of these deposit taking financial institutions, and changes in the internal and external environments, by exploring the following research questions: (i) Do differences in the internal and external environments in which the FI operate affect its profitability? (ii) Do changes in the composition of revenues and balance sheet impact the FIs’ profits? This paper utilizes financial statement data and proxy variables that measure the internal structure from the Bankscope database of over 400 deposit taking financial institutions in the Caribbean region from 1998–2013. Macroeconomic data (measuring the external environment) were obtained from the World Bank’s World Development Indictors database. The dataset was organized as panel data with the stratification variable as the financial institution. Multiple regressions with fixed and random effects are used to determine how profitability, as measured by return on assets and return on equity, is impacted by the institution’s sources of revenues and expenses, its balance sheet composition, and its internal and external environments. Descriptive data showed that Caribbean financial institutions are smaller, less profitable, but have lower nonperforming loans than their Latin American counterparts. Profitability varied with the internal structure of the institutions, the external environment, and during the period prior to 2007, which was recorded as the most profitable years. Further analysis revealed that balance sheet composition and sources of revenues (and expenses) were highly significant in explaining differences in the institutions’ profitability. Specifically, profitability, as measured by return on equity and return on assets, is higher for financial institutions (i) that engage in nontraditional banking activities and (ii) that operate in less stable macroeconomic environments (higher inflation rates and depreciating currencies). The major implication from this study is that the ability of these financial institutions to achieve greater profitability is dependent on factors that are primarily within their control and not because they are significantly constrained by their external environment. Thus, banking regulators should focus on managerial capabilities in maintaining the institutions’ profitability to ensure safety and soundness in the financial system.