The factors affecting the performance of financial institutions in the UK

Abstract

This research project aims to determine which factors affect the financial performance of financial institutions in the UK. In order to achieve this objective, a group of factors have been selected based on literature that might affect the financial performance of these institutions and a quantitative study model has been developed as will be discussed in the Research Methodology section. The following hypotheses will be tested in the study;
H1: Interest rate fluctuations, loans and advances granted to other financial institutions, and deposits with other banks have a significant impact on the Return on Assets (ROA) of these institutions in the UK
H2: Interest rate fluctuations, loans and advances granted to other financial institutions, and deposits with other banks have a significant impact on the Return on Equity (ROE) of these institutions in the UK
H3: Interest rate fluctuations, loans and advances granted to other financial institutions, and deposits with other banks have a significant impact on the Earnings per share (EPS) of these institutions in the UK
Introduction

The financial services industry of the UK has been one of the greatest contributors to the economic growth of the country and despite a negative impact of the Brexit, the impact of this industry remains of invaluable significance. For instance, the 6.9% of the total economic output has been produced by the sector in 2018 even in light of uncertainty over the fallout from the Brexit (House of Commons Library, 2019). With regards to its peers, the UK financial sector has been ranked as the 7th largest in the Organisation for Economic Co-operation and Development (OECD) region with 1.1 million jobs across the sector. In respect to the surplus/deficit of the sector, the UK financial sector created a 44 billion GBP trade surplus in 2017 again highlighting the importance of the sector for the economy of the country.
Many sectors affect the performance of the financial sector companies and this project aims to investigate which factors are important in the sector. The main financial performance indicators have been selected as ROA, ROE and EPS as these indicators are watched by almost all industries unanimously (Avadhanam, et al., 2012). Financial institutions are engaged in various business activities in the UK. Some institutions are both in investment banking and retail banking. Therefore, a wide range of factors have been selected so that both the factors affecting investment banks as well as retail bank divisions of these financial institutions can be captured.
The aim of the research is to identify which factors affect the financial performance of the UK financial institutions significantly.

Literature Review

The literature review section looks into the studied phenomena in other contexts. Many of the studies concentrate on investigating the impact of interest rate changes on the financial performance of commercial banks (Khan, 2014). One of these studies investigated the effect of interest rate changes on the profitability of commercial banks in Pakistan. A period of 2008-2012 has been used for this purpose (Khan, 2014). It was identified that frequent variations in interest rates in the country, had a negative effect on savings and investment. In order to test the effect of interest rates on the profitability of banks in Pakistan, a Pearson’s correlation has been used. Hence, it was identified that there is a positive and strong correlation between bank profitability indicators and interest rates in Pakistan (Khan, 2014).
Another study similarly investigates the effect of interest rate changes on the performance of commercial banks but this study divides the banks into two categories, small banks and big banks (Ifeoma, 2012). It was revealed, however, that small banks are affected more than big banks and the net worth of these banks are also exposed to a greater risk from interest rate fluctuation.
A research was conducted in the context of Sri-Lankan commercial banks in order to identify the factors that affect financial performance of banks. 12 commercial banks have been included in the study and it covered a period of 2011-2015 (Kawshala & Panditharathna, 2017). Dependent variables were bank size, capital, deposits and liquidity whereas, independent variables were profitability indicators such as ROA. This study did not include interest rates as a variable affecting profitability though. In summary, it was revealed that bank size, capital ratio and deposit ratio are significant influencers with regards to the profitability of commercial banks. In addition, liquidity was found to be insignificant in the case of Sri-Lankan commercial banks (Kawshala & Panditharathna, 2017).
Factors affecting the financial performance of commercial banks have also been investigated in Kyrgyzstan. A wide range of indicators have been included in the study that might have potentially affected the profitability of banks. The findings of the research indicated that earnings quality reduced profitability of commercial banks which was related to expenditure management of banks. As a result, a better management of expenditures were suggested (Myktybekovich, 2013). Furthermore, a negative correlation between bad debt levels and profitability has been identified as well. Finally, capital adequacy has also been found to have a positive impact on net interest margin of banks.

Methodology

Research methodology is composed of steps that have to be completed in order to conduct research. Research philosophy, approach, strategy, methods, time horizon, data collection and data analysis are the main stages of the research process (Wilson, 2010).
Research philosophy is an approach to the collection of data and the way it is analyzed in order to answer the question of the research. In other words, the purpose of the selection of a particular research philosophy is to convert the believed things into known things and positivist and interpretivist approaches are the main philosophical approaches in research (Wilson, 2010). Positivist research philosophy is a belief in the stability of reality and applying this philosophy means that one research can be repeated by many researchers without a loss of reliability. Interpretivist philosophy, on the other hand, is a subscription to the idea of a subjective reality and how it might change based on the beliefs of the researcher. This study adopts a positivist approach based on the accepted approach in the literature with regards to learning performance of institutions (Bajpai, 2011). The impact of the selected variables on the performance of financial institutions is an objective study design and will be approached from the prism of positivist research philosophy.
The main approaches to conducting research are deductive and inductive. Deductive approach uses the already developed theoretical framework in the literature by other researchers (Newsome, 2015). This framework is referred to and new data are used for confirming or rejecting the validity of this framework in a particular setting. Inductive research, in contrast, uses the data to build a new framework or interpret a particular phenomenon (Newsome, 2015). This approach does not rely on the existing relationships in the theory. The investigation of factors that explain the financial performance of financial institutions in the UK rely on the existing frameworks. There has been a considerable body of research in the area looking into various factors that affect financial performance across countries and within different types of institutions. Referring to this research, it is possible to identify common factors in the case of the UK financial institutions as well. Thus, this research also looks into common factors explaining the financial performance of financial institutions across the world and develops a model for the same types of institutions in the UK.
With regards to research strategies, experiment, survey, case study, grounded theory, action research and ethnography can be distinguished (Bajpai, 2011). Experiment seems to fit the purpose of this research better than other strategies. This strategy isolates variables into dependent and independent variables and measures the effect of one or more variables on others in a controlled way which allows the researcher to identify which variables explain the variability in the dependent variables. This strategy resembles a natural experiment closely.

Regarding methods of the research, the study is quantitative in nature and adopts a mono-method research (Myers, et al., 2013). The impact of independent variables on dependent ones will be identified using a regression analysis and this tool is quantitative. Therefore, the research is considered quantitative.
Time horizon of the research is usually classified as cross sectional and time series. Cross sectional research focuses on the variables at a particular point in time and time series research process concentrates on the change of variables over some period of time (Myers, et al., 2013). The investigation of the factors that affect the financial performance of banks has been conducted using a time series approach in order to explain the dynamics of variables better. A 5 year time period from 2014 to 2018 will be used to review the financial performance of banks and the variability in the factors which are tested. Therefore, this study is considered as a time-series research.
The sample has been selected using stratified sampling. In general, sampling methods allow the research to select the most representative and convenient data set for the study (Bajpai, 2011). In order to investigate how the UK financial institutions are affected by different common factors, it is necessary to select a representative sample of institutions. Therefore, among the most commonly used sampling methods of simple random sampling, systematic sampling, stratified sampling and cluster sampling, stratified sampling has been deemed as the most suitable. In this methodology of sampling, the researcher divides the data into several strata or groups from which samples are drawn in order to obtain the representation of different strata in the selected sample (Myers, et al., 2013). It should be noted that upon the identification of the strata, a simple random sampling is applied to the groups in the majority of cases. In this research, the financial institutions list has been obtained from the list provided by Bank of England. The Bank of England list has 120 constituents and they have been divided by the researcher into small, medium and big financial institutions based on the size of total assets. Subsequently, 15 institutions have been picked from each bucket and in total, 45 institutions have been in the selected list for the study. Hence, 45 financial institutions in the UK will be studied in order to determine factors that affect their financial performance.
With respect to data, primary and secondary data are the two possible sources of data for researchers. Primary data are collected by the researcher for the first time whereas secondary data are collected from sources where it has been deposited by others prior to the researcher (Myers, et al., 2013). In the case of financial performance analysis, the data on the factors and financial performance of financial institutions have already been available on the financial reports of these institutions. Therefore, the researcher will download and collect the necessary data from the websites of these institutions. In some cases, the calculation of ratios will be done manually (such as ROA, ROE).

Data analysis will be conducted using R statistical software package. It can be used in a wide variety of statistical analysis and this research will use R for descriptive as well as inferential statistical analysis. For descriptive analysis, the various indicators of the descriptive statistical analysis will be presented in order to learn more about the variables (Newsome, 2015). In the next stage, a multiple regression analysis will be conducted using R. A multiple regression analysis is used to analyse how one or more variables affect the variability of the other. In other words, the statistical significance of the impact of independent variables on the dependent variables will be studied. If there is a statistically significant relationship between the two variables, then it will be concluded that the relevant independent variable is a significant determinant of the pertinent dependent variable (Wilson, 2010).

References

Avadhanam, P. K., Achanta, R. & Manthena, R., 2012. Financial Performance Analysis. London: Lap Lambert Academic Publishing .
Bajpai, N., 2011. Business Research Methods. London: Pearson.
House of Commons Library, 2019. Financial services: contribution to the UK economy. [Online] Available at: https://researchbriefings.parliament.uk/ResearchBriefing/Summary/SN06193
[Accessed 20 February 2020].
Ifeoma, E., 2012. MARKET INTEREST RATE FLUCTUATIONS: IMPACT ON THE PROFITABILTY OF COMMERCIAL BANKS, Johannesburg: UNIVERSITY OF THE WITWATERSRAND .
Kawshala, H. & Panditharathna, K., 2017. The Factors Effecting on Bank Profitability. International Journal of Scientific and Research Publications, 7(2), pp. 212-216.
Khan, A. W., 2014. Impact of Interest Rate Changes on the Profitability of. International Journal of Accounting and Financial Reporting, 4(1), pp. 2162-3082.
Myers, J., Well, A. & Lorch, R., 2013. Research Design and Statistical Analysis: Third Edition. London: Routledge.
Myktybekovich, S. T., 2013. Factors Affecting the Profitability of Banking System in Kyrgyzstan, Gazimağusa: Eastern Mediterranean University.
Newsome, B., 2015. An Introduction to Research, Analysis, and Writing: Practical Skills for Social Science Students. London: SAGE Publications.
Wilson, J., 2010. Essentials of Business Research: A Guide to Doing Your Research Project. London: SAGE.