Do equity investments affect banks profitability?. Evidence from OECD countries. Francisco Gonzlez* University of Oviedo Abstract This paper analyzes the influence of equity investments on banks profitability in a panel data of 24 OECD countries. The results suggest a positive influence ofbanksequityinvestmentsonbanksinterestratemarginandbanksnet incomethatisnotoutweighedbyadditionalrequirementsofprovisionsand capital that supervisory authorities establish to control bank risk. The positive effectequityinvestmentshaveonbanksinterestmarginisconsistentwith thebanksabilityasshareholderstoobtainbenefitsinthelending relationship they also keep with firms. Keywords:equityinvestments,bankprofitability,regulation,bankingand commerce, panel data. JEL Classification: G21, G24, G28. * The author acknowledges the financial support provided by the Spanish Ministry of ScienceandTechnology,projectBEC2000-0982.Correspondenceto:Francisco GonzlezRodrguez,DepartmentofBusinessAdministration,UniversityofOviedo. AvenidadelCristoS/N,33071.Oviedo.Spain.Tel.:+34985103698.e-mail: fgonzale@uniovi.es. 1 Do equity investments affect banks profitability?. Evidence from OECD countries. Abstract This paper analyzes the influence of equity investments on banks profitability in a panel data of 24 OECD countries. The results suggest a positive influence ofbanksequityinvestmentsonbanksinterestratemarginandbanksnet incomethatisnotoutweighedbyadditionalrequirementsofprovisionsand capital that supervisory authorities establish to control bank risk. The positive effectequityinvestmentshaveonbanksinterestmarginisconsistentwith thebanksabilityasshareholderstoobtainbenefitsinthelending relationship they also keep with firms. Keywords:equityinvestments,bankprofitability,regulation,bankingand commerce, panel data. JEL Classification: G21, G24, G28. 2Introduction Oneofthesubjectsarousinggreatinterestanddebateinfinancialsystem designisthedegreeofseparationthatshouldexistbetweenbankingand commerce(Saunders,1994).Themainbenefitsindicatedfortheaffiliation betweenbankingandcommerceincludereducingtheconflictsofinterests and information asymmetries between the shareholders of the borrowing firm andtheirdebtholders.Offsettingthesebenefits,defendersofseparating bankingandcommercearguethatenablingbankstoholdsharesin borrowingfirmswouldincreasetheinstabilityofthebankingsystemupon increasingthelevelofbankrisk.Bank'srisk-shiftingincentivescausedby depositinsurance,whentheinsurancepremiumdoesnotreflectabanks risk,havelongbeenrecognized1.Theriseofbankingriskwhenequity investmentsareallowedobligesauthoritiestomonitorbanksandincreases the supervision costs and the probability of bank runs.Followingtheschemeofbenefitsandcostsassociatedwiththeaffiliation betweenbankingandcommerce,thepreviousliteraturecontainsbasically theoretical models focused on analyzing the socially optimal equity stake as a trade-off between the increase in the risk of the bank's asset portfolio and the increaseinefficiencyofthefirmsinvestmentsuponloweringtheconflict betweendebtholdersandshareholders(Boydetal.,1998;Johnetal.,1994; Park, 2000). Atthesametime,thedifferentpointofviewthatnationalregulatorshold abouttheimportanceofcostsandbenefitshashinderedaninternational coordinationofnationalregulationsdealingwiththeaffiliationbetween bankingandcommerce.However,therearesomecommonpatternsbetween countriesontheregulationsaboutbanksownershipofnon-financialfirms. These regulations usually limit a banks investment in the equity of a firm to a certainpercentageofthebankscapitaland/orimposealimitonabanks investment inthe equity ofafirmtoa certain percentage of either the firms capitaloritsvotingrights.Forexample,bankequityinvestmentsmaynot exceed45%ofbankscapitalinBelgiumorItaly,60%inFinland,France, Germany,Greece,PortugalorSpain,the25%inCzechRepublicorPoland. Examples of the limits in the percentage of firms capital owned by a bank are 50%inNorway,25%inPortugal,10%inCanadaandFinland,and5%in Belgium,Japan,theNetherlands,andSweden.Germany,Spainand 1 See Kareken and Wallace (1978), Merton (1977,1978) and Dothan and Williams (1980). 3Switzerlandareexamplesofcountrieswherebanksarenotsubjecttothis latter type of regulation. As a result, banks in these countries can be the sole ownerofnon-financialfirms.Ontheotherhand,intheUSbankingand commercehavebeentraditionallyseparatedsincetheGlassSteagallActof 1933 which meant that equity investments can only be made by bank holding companiesprovidedthattheydonotrepresentmorethan5%ofafirm's votingshares.Recently,theGramm-Leach-BlileyFinancialServices ModernizationActof1999hasloosenedrestrictionsonbankownershipof equityinnon-financialfirms,althoughthelawcarefullymaintainsthe separationofbankingandcommercebylimitingthetimethatbanksmay hold such equity stakes and the amount of such holding relative to the banks capital2. Despitethedifferencesinlegallimitsonbankequityinvestments,countries havetwobasicmechanismstokeeptheadditionalriskderivedfromequity investmentsundercontrol,no matterwhatthemaximumlegallimitofthem is.These two basic mechanisms are provisions and the capital adjusted-risk ratio.Regulatorsimposefundprovisioningonbankstocompensatefuture capital loss. Moreover, the adoption of the capital adjusted-risk ratio for most ofthecountriesafter1993followingthe1987BasleAccordonCapital Standards3alsorepresentsacontinuousmechanismofkeepingtheeffectof equityinvestmentsonbankriskundercontrol.Asequityinvestmentsare consideredriskyinvestments,bankswithgreaterequityinvestmentsare required to have a higher capital. Although theoretical literature has agreed that the affiliation between banking and commerce has consequences for both the bank-owned firm and the owner bank,mostoftheempiricalliteraturehasfocusedonanalyzingthe consequences for the efficiency of borrowing firms. However, the ability of the ownerbanktoextractafirmssurplusortransferringfundsfromthefirm forces us to complete the analysis of the effect on the firms profitability with thatoftheeffectonbanksprofitabilityinordertoevaluateallofthe consequencesoftheaffiliationbetweenbankingandcommerce4.However, 2SeePecchioli(1987),Schuijer(1992)orBarthetal.(2002)foradescriptionofthe regulationsontheassociationbetweenbankingandcommerceinseveralcountries.A historical perspective on changes in the US system is given in Berger et al. (1995). 3Anexampleofthewideestablishmentoftheminimumrequiredcapital-to-assetratio according to the Basle guidelines is the fact that a hundred out of the one hundred and seven countries analyzed by Barth et al. (2001b) have adopted it. 4Inspiteofagreementofthetheoreticalworksonforecastinganimprovementonthe firmsefficiencywiththebankshareholding,theavailableevidenceisnotconclusive. 4only very recently Barth et al. (2001a, 2002) have analyzed in a sample of 60 and107countriesrespectively,theeffectsthatdifferentnationalregulations ontheabilityofbankstoownandcontrolnonfinancialfirmshavebothon financial sector performance and banking system stability in these countries. Using country-level data they do not find beneficial effects from restricting the mixingofbankingandcommerce.Despitenotfindingareliablerelationship between the restrictions on mixing banking and commerce and the level of the bankingsectordevelopment,theyconcludethatthosecountriesthatrestrict banksfromowningnonfinancialfirmshaveamuchhigherprobabilityof suffering a major banking crisis.In this paper, we provide additional empirical evidence analyzing the influence of the banks investments in the equity of firms on banks interest rate margin andonbanksnetincomeusingacountry-levelpaneldataof24OECD countries.IncontrasttoBarthetal.(2001a,2002),weusetherealratioof banks equity investments to total banks assets in each country instead of an index, ranging from 1 to 4, of the national restrictions on the ability of banks toownandcontrolnonfinancialfirms.Wealsotakeintoaccountthe unobserved country heterogeneity using a panel database from 1987 to 1997. Intheregressionswealsocontrolforotherbanksbalance-sheetvariables, macrovariablesandvariablesofthebankingandfinancialmarket development in the country. Evenafterconsideringbanksprovisionsandcapitalrequirementswefinda positiveinfluenceofbanks'equityinvestmentsonbanks'profitability.This resultsuggeststhatthecontrolofbankriskwhichiscarriedoutbythe authorities under provision and bank's capital regulations does not outweigh thehigherreturnsobtainedfrominvestmentsintheequityofnonfinancial firms. The positive influence of bank equity investments in banks interest rate marginalsosuggeststhatbankshareholdingallowsthebanktotake advantageofitslendingrelationshipwiththefirm.Infact,thisisthemain benefitofthebankequityinvestmentbecausewedonotobservedifferences

AlthoughthereareworkscarriedoutinJapan,GermanyandSpain,theresultsare contradictoryevenwithinthosedoneinthesamecountry.Amongtheworkswhichfind evidenceofapositiveeffectofbankshareholdingonthefirmsefficiencywehaveKim (1991),Hoshi et al. (1991) and Pushner (1995) all in Japan, Cable (1985) and Gorton and Schmidt(2000)inGermanyinthe1970sandZoido(1998)inSpain.Nevertheless,the positiverelationshipbetweenbankshareholdingandthefirmsefficiencyisneither observed by Weinstein and Yafeh (1998) in Japan, nor by Gorton and Schmidt (2000) in Germany in the 1980s nor by Bergs and Snchez del Villar (1991) in Spain.5inbanksprofitabilitycausedbycapitalgainsorlossesderivedfromequity transactions. The rest of the paper is structured as follows: Section 2 describes the theory behindourempiricalstudyinmoredetail.Section3dealswiththe characteristicsofthedatabaseandthemethodologyusedandtheempirical results are analyzed in Section 4. Finally, Section 5 presents the conclusions. 1.Theoretical Background The financial literature does not predict a clear effect of equity investments on banksprofitability.First,theportfolio theorysuggeststhatsinceinvestment inequityisriskierthaninvestmentindebt,thosebanksincreasingthe proportionoftheirinvestmentsinequitysecuritiescanexpecttheirportfolio to bring higher profits and with it higher risk. The mere reference to the high varianceofreturnonequityinvestmenthasbeentakenasevidenceofits incrementaleffectuponthebanksportfolio.Basedonthisidea,regulators fromcertaincountriesjustifytheregulationthatseparatesbankingfrom commerceasatooltoreducetheinstabilityinthebankingsystemandthe probability of a banking crisis. However, economists have long recognized that the introduction of any assets into the allowable investment set may improve theportfoliosrisk-returnefficiency.Aslongasthenewassetislessthan perfectlypositivelycorrelatedwiththeexistingportfoliocomponents,its addition may prove mean-variance improving (Langohr and Santomero, 1985). Apartfromasimplesubstitutionofdebtformoreriskyassetsinthebank's asset portfolio, the presence of a bank in the ownership of the borrowing firm can modify the firms investment decision and give rise to additional increases on the expected return and bank's risk on the originally suggested by portfolio theory.Park(2000)takesintoaccounttheagencyconflictswhichtakeplace between the bank, the firm and the regulator in order to prove that the bank's ownership of a commercial firm may also increase the bank's profitability and risk.Theconsequenceofanimprovementinthefirmsinvestmentefficiency once the problems of under-investment and over-investment in the firm have beenreducedwouldbeanincreaseinthebank'sprofitability.The consequence of a higher banks incentive to allow the firm to undertake risky projectswouldmeananincreaseinthebank'srisk.Theparticipationinthe surplusexpectedfromriskyprojectscanchangetheinitialpositionthata 6bank would have to avoid funds transfers when it is an only a firm's creditor (SmithandWarner,1979).Sincethefirmisallowedtoundertakeriskier projects,boththeequityanddebtofthefirmmaybecomeriskierand consequently the banks asset portfolio, too. On the other hand, Boyd et al. (1998) also suggest an additional reason for a positiveinfluenceofequityinvestmentsonbanksprofitabilitybasedonthe ideathatbankequitypositionsonnonfinancialfirmsstrengthenthebanks abilitytoextractsurplusfromborrowers5.Thus,ownerbankscanalso increasetheirprofitabilitynotonlybythehigherexpectedreturnsofriskier investments but also by the fact that a larger portion of the surplus generated by externally financed investments accrues to banks, and less accrues to the originating investor. Although, Boyd et al. (1998) agree with Park (2000) when pointingoutthepositiveinfluenceofequityinvestmentsonbank's profitability, they do not agree on the consequences on the firm's efficiency. In Boyd et al.'s (1998) model, nonbanking shareholders have fewer incentives to strive for due to the funds' expropriation carried out by the shareholder bank and the consequence is a reduction of the firms efficiency. Contrarytothepreviousarguments,Santos(1999)statesthatbankequity investmentsdonotincreasebanksprofitabilityandrisk. Hisview is thatby limiting the banks ability to use equity, the regulator forces the bank to use moredebtinordertochannelthenecessaryfundsintothefirm.This outweighs the effects of the reduction of the banks stakes in the firms capital and, insome cases,itmight evencreatethenegative effect ofincreasingthe banksriskoffailurebecauseheassumesthatdebtisthebank'spreferred financialinstrumenttoencouragethefirmtoincreasetheriskofits investment projects. This effect is more significant when firms depend largely on banks to raise external funds or on bank oriented systems, and when the regulationlimitsbanksequityinvestmentstoacertainpercentageofthe firms capital. Therefore, Santos (1999) suggests that there is no relationship betweenbanksequitypositionsincommercialfirmsandthebanks profitabilitybecausethebankoutweighsanydifferenceintheequity investment in order to reach the banks mean-variance target by means of the lending decision. 5Thebanksabilitytoobtainsurplusfromfirmswhenthebankonlyhasalending relationshipwiththefirmhasalsobeenanalyzedbyRajan(1992)andVonThadden (1995). 7Nevertheless,allthepreviouspredictionsaboutbanksprofitabilityandrisk donottakeintoaccountthesupervisoryactivitydevelopedbyauthoritiesto controlbankrisk.Thus,differencesinrisk-returnbankportfolioscausedby differencesinthelevelofequityinvestmentsbeforeconsideringsupervisory activity could disappear after this is considered. In this sense, two of the main mechanismsofbankssupervisionaretheminimumrequirementsofbanks capital and provisions. On the one hand, the highest risk of the asset portfolio inbankswithagreaterproportionoftheirassetsinvestedinequityof nonfinancial firms could be compensated for by a higher percentage of capital entailedbytherisk-adjustedbank'scapitalrequirement.Thehighercostof equity compared to cost of debt for banks will have negative consequences for bank'sprofitabilitythatcanoutweighthehigherexpectedreturnsofequity investments.Ontheotherhand,similartocapitalregulation,ifbankswith higherequityinvestmentsareobligedtosupplyhigherprovisions,theymay loseafterprovisionstheexpectedhigherprofitabilitythatequityinvestments originatebeforeprovisions.Therefore,thedifferencesinbanksprofitability beforeconsideringprovisionsandcapitalrequirementscoulddisappearafter considering the effect of both types of legal requirements.Usingprovisionsandcapitalrequirementsasvariablestocontroltheriskof bankassetportfolioimplicitlyinvolvesusingtheriskmeasuredevelopedby thenationalsupervisorwhenfixingtheminimumlevelsforprovisionsand capital.Ifweassumethatnationalsupervisoryauthoritieshavemore informationaboutbanksthananyotheroutsideinvestor,measuringriskin this way would be better than using risk measures defined on the basis of the banks account statements. Thedifferenthypothesesdiscussedinthissectiondonotclearlysuggest whicheffectofequityinvestmentsmadebybanksshouldprevail.Hence,we shallnotformulateahypothesisonaprevailingeffect.Instead,weexamine the data to ascertain which effect prevails. We have estimated the relationship inOECDcountriesbetweentheproportionoftotalbanksassetinvestedin equityofnonfinancialfirmsandbanksnetinterestincomeandbanksnet income.Wehavealsotakenintoaccounttheconsequencesofequity investments on banks risk adopting the method of risk measurement used by supervisoryauthorities.Thus,wehaveincludedintheregressionsas independentvariablesthetwobasicinstrumentsthatauthoritiesuseto controlbank'srisk:provisionsandcapitalratios.Additionally,wehavealso included control variables related to the financial development of the country, macro variables and other banks variables. 8 2.The dataWe have used time series and cross-country data derived from balance sheets and income statements of commercial banks in OECD countries, as available from the Bank Profitability database published by the OECD. Although some OECDcountrieshavestate-ownedandcooperativebankswehaveonly considered commercial banks in each country to avoid confusing effects from thetype ofbank ownership.Initially, the datasetcovers all OECDcountries (29)from1987to1997.Togetherwiththeinformationobtainedfrombanks' financialstatementswehaveobtainedadditionalinformationaboutthelevel ofinflationandgrowthofeachcountryfromtheOECDHistoricalStatistics. Informationaboutthefinancialdevelopmentandstructureofeachcountry wasobtainedfromtheFinancialStructureDatabasecompiledbyBecketal. (2001). Table 1 summarizes the variables used in this paper and their source. Insert Table 1` Thefinalstudywascarriedoutin24OECDcountriessinceinformationon banks equity investments (EQUINV) for Canada, the Czech Republic, Poland, theUKandtheUSwasnotavailable.Asinformationonthevariablesused was not available in each country for all years from 1987 to 1997 we have an unbalanced panel.Wehaveusednetinterestincome(NETINTER)andbanksnetincome (NETINC) to total bank assets as measures of banks profitability. Net interest incomeorbanksinterestmarginistheinterestincomeminusinterest expense over total assets and it captures the profitability of the intermediation activity of banks. Its potential relationship with banks equity investments will show whether banks use their shareholders position to increase their benefits on the lending relationship through higher interest margins Net income is net interest income plus non-interest earnings minus overhead costandprovidesameasureofbankprofitsbeforeprovisionsandtaxes.As the capital gains or losses and dividends of firms' shares are included in the net income but not in the net interest income, the relationship between banks 9equity investments and banks net income would depict not only the effect on thebanks lendingrelationshipbutalsoonthedirectyields(capitalgainsor losses,dividends)thatbanksgetfromtheinvestmentinthefirmsequity. When comparing both estimations we can separate both effects. Inordertoanalyze whetherthebank's risk control mechanisms designedby theregulators(provisioningandbankcapitalrequirements)decreasethe differencesthatequityinvestmentscouldcauseinbank'sprofitabilitywe includetheprovisions(PROVIS)andbankcapitalratios(CAPITAL)inthe regressions.Weincludetotalbankprovisions(provisionsonloansand securities)insteadofonlyprovisionsonsecuritiesbecausethepotential effects of the banks equity investments on the lending relationship that banks alsokeepwiththefirmscanalsoproducesomeinfluenceonprovisionsfor loans. Moreover, separate information of provisions for loans and securities is not available for most of the countries, which prevents us from including both variables independently of each other in regressions. FollowingDemirgc-KuntandHuizinga(2001)wealsoincludeotherbank characteristics that along with equity investment could give rise to differences in banks profitability, such as LOANS, non-interest earnings (NONINTER) and banksoverheadcost(OVERHEADC).Totalbanksassetsdivideallthese previous banks variables in each year. We include the annual growth rate of real GDP per capita (GROWTH) and the inflation rate (INFLATION) since they are macro variables potentially affecting banks'profitabilityineachcountry.Additionally,Demirgc-Kuntand Huizinga(2001)haveshowntherelevanceoffinancialdevelopmentoverthe financialstructureofthecountryinorderto explainthebanksprofitability. In a sample of developed and developing countries they found that banks have both higher profits and interest margins in underdeveloped financial systems andoncetheycontrolfortheleveloffinancialdevelopment,financial structure,i.e.therelativedevelopmentofbanksversusmarkets,doesnot haveanindependenteffectontheirprofitabilityorinterestmargins.To controlthedevelopmentofthefinancialsystemweincludethevariables proposedbyBecketal(2001)formeasuringthevolumeandactivityofthe bankingsectorandthestockmarket.Tomeasurethesizeofthebanking sectorweusetheratioofthetotaldomesticassetsofdepositmoneybanks divided by GDP (BANKASSET). The size of the stock market is proxied by the ratioofthestockmarketcapitalizationdividedbyGDP(MAKTCAP).To measureactivity,weusethecredittotheprivatesectorbydepositmoney 10banksdividedbyGDP(PRIBC)toproxythecreditactivityofthebanking sector while the total value of stocks traded divided by GDP (SMTVT) is of the stock market activity. To measure national regulatory restrictions we use the index of restrictions on banksowningnon-financialfirmselaboratedbyBarthetal.(2001b) (RESTRICT).Thisindexrangesfrom1to4withahighervalueindicating higherrestrictionsintheabilityofbankstoownandcontrolnon-financial firms. The grading scale of the index is the following: (1) Unrestricted- a bank may own 100% of the equity in any non-financial firm. (2) Permitted- a bank may own 100% of the equity in a non-financial firm, but ownership is limited based on banks equity capital. (3) Restricted-abankcanonlyacquirelessthan100%oftheequityina non-financial firm. (4) Prohibited-abankmaynotacquireanyequityinvestmentinanon-financial firm. Inoursamplethereisnocountrywherebanksarenotallowedtoacquire equityinnon-financialfirms,whichiswhytheindexinOECDcountries ranges from 1 to 3. Table2providesthelistofcountriesincludedinthisstudyandthemean values of the country-level variables used in the empirical work. Insert Table 2` The correlations matrix of variables used in the empirical analysis is shown in Table3.FocusingonthecorrelationsofEQUINVweobservethatitis positivelycorrelatedwiththetwovariablesofbanksprofitability(NETINTER andNETINC).EQUINVandLOANScorrelatenegatively,whichisconsistent with the fact that equity and debt securities are alternative investments, and thereforethehighertheequityinvestment,thelowertheproportionofbank total assets invested in loans. Moreover, as the equity investments are riskier thanotherassets,bankswithhigherequityinvestments(andlowerloans) 11also have higher provisions and higher capital requirements. Thus, EQUINV is positively correlated with PROVIS and CAPITAL. MacrovariablesalsocorrelatewithEQUINV.Theannualgrowthrateofreal GDP per capita has a positive correlation coefficient while the annual inflation hasanegativeone.Regardingfinancialdevelopmentvariables,EQUINV correlatesnegativelywiththesizeofthestockmarket(MAKTCAP)but positively with their activity level (SMTVT).However,thereisnocorrelationbetweentheindexofrestrictionsonbanks owningnon-financialfirmselaboratedbyBarthetal.(2001)andthe percentage of equity investments undertaken by banks to total bank assets in eachcountry.Theabsenceofcorrelationbetweenthesetwovariables indicates that regulatory restrictions on banking and commerce affiliation are not binding and that other variables are the main determinants of the equity investmentactivityofbanksineachcountry.Inthiscase,usingthereal values of banks' equity investments can be more suitable than using an index of the range of legal restrictions in each country when we aim to analyze the consequencesonbanks'profitabilityduetotheaffiliationbetweenbanking and commerce. Insert Table 3` 3.Multivariate analysis3.1.Methodology Theavailabilityofapaneldataenablesustocorrectcountry-specificand time-specificeffects.TheBreuschandPagan(1980)Lagrangemultipliertest (LMtest)rejectsthenullhypothesisthaterrorsareindependentwithin countries, i.e., the country effects are relevant and OLS estimations would be biased. The country effect can be fixed or at random. It is clear that the fixed effectsmodelisaparticularcaseoftherandomeffectsmodelwhenthe variablerepresentingthecountryeffectsisnon-stochastic.However,as pointedoutbyHsiao(1986),whentheindividualeffectsarecorrelatedwith theregressors,therandomeffects'modelproducesbiasedestimationsof coefficients. In such cases, considering these effects as fixed leads to the same 12results as when such a correlation is explicitly included in the model. In this case, we use the Hausman _2 to test the null hypothesis that the random and fixedeffectsmodelsarenotsignificantlydifferent.Inalltheestimationsthe Hausmans test rejects the null hypothesis and only the results obtained with thefixedeffectsGLSestimationarereported.Weestimateatwo-wayfixed effectmodelbecausewealsoincludetimedummyvariablesforeachyearto captureanyunobservedmacroeconomictimeeffectnotincludedinthe regression that is country invariant. The equations estimated to analyze the influence of banks equity investments on banks profitability are as follows6: | | 1FD M B it i it it it q o | o + + + + + = it INwhere INit is the dependent variable (either NETINTER or NETINC) for country iinyeart,Bitarebanksvariablesforcountryiinyeart,Mitrepresentsthe macro variables, FDit are the financial development variables,i is a country-specific effect and qit is a white-noise error term. As theabove estimationsassume exogeneityofthe explanatoryvariables, we alsouseinstrumentvariablesmodelstocontrolforpotentialbiasesdueto endogeneityandtochecktherobustnessoftheresults.Weconstruct instrumentsforthebalancesheetandincomestatementvariablesofthe right-hand-side.Inparticular,weuselaggedvaluesofthesevariablesas instruments.Weworkwithtwolagstoavoidcasesinwhichtheremightbe first-order autocorrelation of the residuals. This technique assumes that past valuesoftheexplanatoryvariablesarenotcorrelatedwiththe contemporaneous values of the explanatory variables. 6 Demirgc-Kunt and Huizinga (2001) use a similar specification to analyze the impact of financial development and financial structure on bank profits and margins in a sample of banksfromdevelopedandunderdevelopedcountries.However,theydonotconsider the influenceofbankequityinvestmentsandtheydonotcontrolforcountry-specificand time-specific effects as they use mean values for each variable over the sample period or betweenestimations.However,wetakeadvantageofourpaneldatabasetocontrolfor unobserved country heterogeneity using within estimations. 133.2.Results Theresultsoftwo-wayfixedeffectsorwithinestimationsontheinfluenceof equityinvestmentsonthenetinterestincomeareshownintable4.Table5 showsthetwo-wayfixedeffectsestimationswithinstrumentsforbanks' variables. EQUINVhasapositiveandstatisticallysignificantcoefficientinallthe models.Thisresultisconsistentwithbanks'usageoftheirshareholder positiontoincreasetheirinterestmarginsandtoobtainbenefitsinthe lendingrelationshipstheyalsokeepwithfirms.Thispositiveinfluenceof equity investments on banks' net interest income remains after controlling for theprovisionsandcapitalratiosrequiredbythenationalsupervisory authoritiestocontrolbankrisk.Thus,thepositiveeffectofbankequity investmentsonnetinterestincomeisnotoutweighedbytheadditional requirements(provisionsandcapitalratios)thatsupervisorsestablishto controlthepotentialhigherriskofbankequityinvestments.Moreover,this positiveinfluenceisobtainedbothinthewithin(table4)asininstrumental variables (table 5) estimations. ThecoefficientsofPROVISarepositiveandstatisticallysignificantinall specifications. CAPITAL also has positive coefficients in the within estimations while it does not have statistically significant coefficients in the instrumental variablemodels.ThepositivecoefficientsofPROVISandCAPITALmay indicatethathighernetinterestincomesareassociatedwithriskier investment portfolios that also oblige banks to have higher capital ratios and provisions.Nevertheless,ashasjustbeenshown,thepositivecoefficientof EQUINV remains statistically significant after including PROVIS and CAPITAL in the regressions. Thepercentageofloansontotalbankassetsdoesnotappeartohavea statistically significant effect on banks interest margin. Non-interest earnings arenegativelyrelatedtonetinterestincomesinallestimationssuggestinga possiblesubstitutioneffectbetweenthesetwotypesofbankincomes. However, the overhead cost variable has positive coefficients in the fixed effect estimations.ThiseffectisconsistentwiththeresultsobtainedbyDemirgc-KuntandHuizinga(2001)forasampleofcountrieswithdevelopedand underdevelopedfinancialsystemsindicatingthatbankscanpassonthese coststotheircustomers.However,whenweuseinstrumentalvariablesin Table5tocorrectpotentialproblemsof endogeneity,thenegative effectdoes 14not remain and we do not obtain significant coefficients for OVERHEADC. The macrovariables(GROWTHandINFLATION)arepositiveandstatistically significant indicating that banks have greater interest margins in inflationary and growing environments.UnlikeDemirgc-KuntandHuizinga(2001),thefinancialdevelopment variablesusedasacontrolarenotstaticallysignificantinanyspecification. Although not reported in the paper, we have included the variables measuring thesizeandtheactivityofthebankingsectorandthestockmarket simultaneously.Wehavealsoincludedalternativevariablesoffinancial developmentsuchasthestockmarketturnoverratio.Nevertheless,the resultsdidnotchange.Thisnon-significanteffectoffinancialdevelopment variablesinOECDcountries,contrarytotheresultsobtainedbyDemirgc-kuntandHuizinga(2001)forasampleofdevelopedandundeveloped countries, may be the result of the higher similarity of financial development among OECD countries. Insert Table 4` Insert Table 5` In addition to the effect on banks' interest margin we also look at the effect of equity investments on bank's profitability when analyzing banks' net income. Asthisbankprofitabilityvariableincludesnetinterestincomeandthenon-interestearningswearealsocapturingothereffectsofequityinvestments additionaltothoseinthelendingrelationship.Theresultsofthese estimationsareshownintables6and7.Resultsarebasicallyanalogousto those shown in tables 4 and 5. Insert Table 6` Insert Table 7` 15 EQUINVhaspositivecoefficientsinallspecificationssuggestingthatthe positiveinfluenceofequityinvestmentsonbanksinterestmarginremains whenweincludethecapitalgainsorlossesofequityinvestmentsandother non-interest earnings in the measure of bank profitability analyzed. CAPITAL andPROVISalsokeeptheirpositivecoefficientsinthewithinestimations whereasPROVISdoesnothavestatisticallysignificantcoefficientswhenwe usetwolagsasinstrumentsofbanks'variables.Thus,equityinvestments have a positive effect on overall bank profitability after taking into account the requirementsthatsupervisoryauthoritiesimposetocontroltheadditional bank risk that can derive from higher bank equity investments. Non-interest earning variable, NONINTER, has positive coefficients consistent with its contribution to bank profits. Likewise, as overhead costs are expenses includedinthebanknetincome,theyhaveanegativeinfluence.Macro variables (GROWTH and INFLATION) have the same positive influence shown in tables 4 and 5, and the variables of the development of the financial system donothavestatisticallysignificantcoefficientsasinthenetinterestincome regressions. Although not shown in the paper we have also tested additional specifications to check the robustness of the results. Thus, we have also analyzed the effect ofequityinvestmentsonbanks'profitbeforetaxes.Inthiscase,thehigher provisionsforwhichahigherpercentageofequityinvestmentsareneeded have been directly deduced from the dependent variable and PROVIS has not beenincludedasanindependentvariable.Wealsousedependentvariables adjusted by risk. The net interest income and the net income in each year are divided,respectively,bythestandarddeviationofNETINTERandNETINC overthe1987-1997period.TheresultsdidnotchangeandEQUINVshows positive and statistically significant coefficients in all these specifications. 4.Conclusions Thispaperusesapanelcountry-dataof24OECDcountriesinorderto analyze the influence of equity investments on banks' profitability. The results showthatbankequityinvestmentshaveapositiveeffectonnetinterest 16incomeandonnetincome.Thispositiveinfluenceremainsthesameafter controllingforthepotentialincreaseofbankriskthathigherequity investments can originate. Thus, the highest profitability that portfolio theory suggestsforbankswithhigherequityinvestmentsdoesnotdisappearafter consideringthehighestprovisionsandcapitalratiosthatthesebanksare obliged to keep. The positive influence on net interest income is consistent with the view that bankscanusetheirshareholderpositioninnon-financialfirmstoobtain benefits in the lending relationship that they usually keep with firms in which they also take equity. In fact, the positive influence on banks interest margin is the main benefit of the bank equity investments because we do not observe differencesinbanks'profitabilitycausedbycapitallossesorgainsderived from equity transactions. Thebank'sabilitytotakeadvantageofthebenefitsthatbankshareholding canhaveonthefirm'sefficiencyalsopreventsempiricalworkswhichonly analyze the effect on the firm's performance from being a complete measure of theconsequencesonbusinessefficiencythatthetheoreticalliteraturehas suggested for the affiliation between banking and commerce. 5.ReferencesBarth, J.R., G. Caprio Jr. and R. Levine, 2001a, Banking systems around the globe:doregulationsandownershipaffectperformanceandstability?,in FredericS.Mishkin,Editor:Prudentialsupervision:Whatworksandwhat doesnt, University of Chicago Press. Barth,J.R.,G.CaprioJr.andR.Levine,2001b,Theregulationand supervisionofbanksaroundtheworld:anewdatabaseinRobertE.Litan andRichardHerring,Editors,Integratingemergingmarketcountriesintothe globalfinancialsystem,Brookings-WhartonPapersonFinancialServices, Brookings Institution Press. Barth,J.R.,G.CaprioJr.andR.Levine,2002,Bankregulationand supervision: What works best? World Bank Research. 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Huizinga, 1999, Determinants of commercial bank interestmarginsandprofitability:someinternationalevidence,Worldbank economic review 13, 379-408. Demirgc-Kunt,A.andH.Huizinga,2001,Financialstructureandbank profitability, in Financial Structure and Economic Growth, edited by Demirgc-Kunt, A. and R. Levine, The MIT Press, Cambridge, Massachusetts, London. Dothan, U. and J. Williams, 1980, Banks, bankruptcy, and public regulation. Journal of banking and Finance 4, 65-88. Gorton, G. and F.A. Schmid, 2000, Universal banking and the performance of German firms, Journal of Financial Economics 58, 29-80. Hoshi, T., A. Kashyap and D. Schafstein, 1991, Corporate structure, liquidity and investment: Evidence from Japanese industrial groups, Quarterly Journal of Economics, February, 33-59. Hsiao,C.,1986,Analysisofpaneldata.EconometricSocietyMonograph11, Cambridge University Press, Cambridge. John, K., T.A. John and A. Saunders, 1994, Universal banking and firm risk-taking, Journal of Banking and Finance 18, 307-323. Kareken, J.H. and N. Wallace, 1978, Deposit insurance and bank regulation: A partial-equilibrium exposition, Journal of Business 51, 413-438. Kim, S., 1991, The use of equity positions by banks: The Japanese evidence, Economic Review of the Federal Reserve Bank of San Francisco, Fall, 41-55. Langohr,H.andA.M.Santomero,1985,Theextentofequityinvestmentby European banks, Journal of Money, Credit, and Banking 17, 243-252. Merton,R.C.,1977,Ananalyticderivationofthecostofdepositinsurance and loans guarantees, Journal of Banking and Finance 1, 512-520. 18Merton,R.C.,1978,Onthecostofdepositinsurancewhenthereare surveillance costs, Journal of Business 51, 439-452. Park, S. 2000, Effects of the affiliation of banking and commerce on the firms investmentandthebanksrisk,JournalofBankingandFinance24,1629-1650. Pushner,G.1995,Equityownershipstructure,leverageandproductivity: Empirical evidence from Japan, Pacific-Basin Finance Journal 3, 241-256. Pecchioli, R.M., 1987, Prudential supervision in banking. OECD, Paris. Rajan,R.G.,1992,Insidersandoutsiders:thechoicebetweeninformedand arm`s length debt, Journal of Finance 47, 1367-1400. Santos, J., 1999, Bank capital and equity investment regulations, Journal of Banking and Finance 23, 1095-1120. Saunders, A., 1994, Banking and commerce: An overview of the public policy issues, Journal of Banking and Finance 18, 231-254. Saunders,A.andL.Schumacher,2000,Thedeterminantsofbankinterest ratemargin:aninternationalstudy,Journalofinternationalmoneyand finance 19, 813-832. Schuijer, J., 1992, Banks under stress. OECD, Paris. Smith, C.W. and J.B. Warner, 1979, On financial contracting: an analysis of bond covenants, Journal of Financial Economics 7, 117-161. VonThadden,E.L.,1995,Long-termcontracts,short-terminvestmentand monitoring, Review of Economic Studies 62, 557-575. Weinstein, D.E. and Y. Yafeh, 1998, On the cost of a bank-centered financial system:evidencefromchangingmainbankrelationsinJapan,Journalof Finance 53, 635-672. Zoido,M.E.1998,Unestudiodelasparticipacionesaccionarialesdelos bancosenlasempresasespaolas,InvestigacionesEconmicasXXII,427-467. 19Table 1 The variables This table describes the variables collected for the 29 OECD countries. We present the description and the sources from which each variable is collected. VariableDefinition Banks Characteristics EQUINVBanksequityinvestmentsovertotalbanks'assets.Bank Profitability (2000), OECD Publications. NETINTERInterestincomeminusinterestexpenseovertotalassets.Bank Profitability (2000), OECD Publications. NETINCGrossincome(netinterestincomeplusnon-interestearnings) minusoperatingexpensesovertotalassets.BankProfitability (2000), OECD Publications. PROVISProvisionsovertotalassets.BankProfitability(2000),OECD Publications. CAPITALBookvalueofequityovertotalassets.BankProfitability(2000), OECD Publications. LOANSTotalloansovertotalassets.BankProfitability(2000),OECD Publications. OVERHEADCPersonnelexpensesandsomeothernon-interestexpensesover total assets NONINTERNet profit or loss on financial operations, net fees and commissions and other non-interest earnings over total assets. Bank Profitability (2000), OECD Publications. Macro Indicators GROWTHAnnualgrowthrateofrealGDPpercapita.OECDHistorical Statistics (2001), OECD Publications. INFLATIONThe annual inflation from consumer price indices. OECD Historical Statistics (2001), OECD Publications. Financial Development BANKASSETTotalassetsofdepositmoneybanksdividedbyGDP.Becketal. (2001): Financial structure database. PRIBCPrivatecreditbydepositmoneybankstoGDP.Becketal.(2001): Financial structure database. MAKTCAPStockmarketcapitalizationtoGDP.Becketal.(2001):Financial structure database. SMTVTStockmarkettotalvaluetradedtoGDP.Becketal.(2001): Financial structure database. RESTRICTIndexofcountryrestrictionsonbanksowningnonfinancialfirms constructedbyBarthetal.(2001).Thisindexrangesfrom1to4 with a higher value of the index indicating higher restrictions in the ability of banks to own and control nonfinancial firms. 20 Table 2 Bank country-level characteristics This table shows the mean values of the country-level variables used in the empirical work over the 1987-1997 period. EQUINVNETINTERNETINCPROVISCAPITAL LOANSNONINTEROVERHEADC Australia3.9252.5561.5010.4669.08757.3991.8042.858 Austria3,0251.7470.8670.4804.52350.0870.8661.744 Belgium1,0891.4300.6260.2853.03133.6550.4931.298 CanadaN.A2.6961.530.5565.18170.8621.3412.508 Czech RepublicN.A2.8680.971.44710.18747.15010.27312.178 Denmark3.5972.9011.4931.2307.34143.5160.8892.297 Finland2.371.8810.0500.1755.87558.7321.8073.636 France3.0131.3640.7190.4283.97238.4970.7691.414 Germany2.7442.0450.9720.3933.88254.8680.6121.683 Greece4.1951.9341.5960.4784.85329.9702.3052.643 Hungary3.5124.8080.303-0.3128.97341.112-0.6733.832 Iceland2.2374.4491.9531.3837.48572.5052.1694.663 Ireland0.4472.3901.5250.1356.27054.3301.1702.032 Italy2.1812.8051.3330.6496.36843.0960.9692.443 Japan3.9281.2470.4440.2373.02959.1080.1560.959 Korea2.3722.1281.1021.1066.98051.3811.2662.292 Luxembourg0.5770.8410.7560.3452.95923.7190.3860.472 Mexico1.5255.1712.6371.5746.72061.4842.0754.610 Netherlands1.0191.9800.9440.2874.13958.5520.8911.927 New Zealand0.7362.7241.3840.2074.92371.6681.6132.955 Norway1.9073.1061.3340.9425.24475.2240.9822.752 PolandN.A5.1753.2310.7728.40638.1362.0333.978 Portugal2.9062.9531.6830.9269.77242.0640.9552.223 Spain3.1723.4391.6470.6758.70444.9300.9062.699 Sweden2.2982.1530.744-0.0645.76147.5811.3632.773 Switzerland2.6761.3811.3020.6956.03256.5771.5471.591 Turkey4.8908.1144.3291.2265.00039.9860.4494.235 UKN.A2.6821.5960.6934.47657.1641,7182.804 United statesN.A3.5741.9150.6347.18863.2951.8603.519 21 Table 2 (continuation) Bank country-level characteristics This table shows the mean values of the country-level variables used in the empirical work over the 1987-1997 period. All variables are divided by total bank assets. GROWTHINFLATIONBANKASSETPRIBCMAKTCAPSMTVTRESTRICT Australia2.2923.7230.6470.5660.5840.2522 Austria2.0662.4251.1990.8780.0970.0601 Belgium2.1382.1080.9240.4390.3190.0463 Canada1.4922.7230.5770.5090.5270.2263 Czech Republic-0.14414.7300.8200.5560.2670.0973 Denmark1.4312.6460.5460.4150.2870.1072 Finland1.8423.0330.7350.7150.2390.0851 France1.7542.2150.9780.8470.2640.1252 Germany1.5612.2921.1600.9020.2280.2641 Greece1.33312.6750.4300.2060.1040.0351 Hungary2.32520.3150.3730.3180.0390.009N.A Iceland1.4008.2690.4460.4200.1100.0073 Ireland5.8502.5500.3560.2730.2650.1411 Italy1.7544.4380.7060.5070.1530.0603 Japan2.2541.1691.2571.1080.8300.4303 Korea5.8545.7300.5190.4930.3030.3483 Luxembourg4.5851.9770.3130.2972.3330.0211 Mexico1.13936.1690.1990.1570.2010.0883 Netherlands2.3611.9771.0190.8110.5650.3251 New Zealand2.1083.7690.6260.5520.4610.1052 Norway2.2463.4000.6840.5450.2030.1072 Poland3.53313.4250.3530.0710.0280.0292 Portugal3.7547.0610.7770.5810.1040.0322 Spain2.9314.5380.9190.6580.2470.1601 Sweden1.4084.0000.5340.4460.5300.2363 Switzerland0.7002.3001.6671.5530.8591.0303 Turkey1.94672.6150.1950.1350.1010.0973 UK2.1614,1460.9630.9310.9640.4681 United states2.1853.2770.7570.6620.6900.5013 22Table 3 Correlations This table shows the correlation between the country-level variables used in the empirical work over the 1987-1997 period EQUINVNETINTERNETINCPROVISCAPITAL LOANSOVERHEADCNONINTERGROWTH INFLATIONBANKASSETPRIBCMAKTCAPSMTVT NETINTER0.321**____ NETINC0.287**0.783**____ PROVIS0.170**0.379**0.476**____ CAPITAL0.203**0.337**0.295**0.237**____ LOANS-0.154** 0.068-0.0080.0840.073____ OVERHEADC0.210** 0.481**0.221**0.264**0.436**0.147**____ NONINTER-0.052-0.0670.0390.198**0.323**0.0880.760**____ GROWTH -0.199** -0.0240.113*-0.154**0.067-0.137*-0.147**-0.065____ INFLATION0.388**0.829**0.710**0.263**0.065-0.190**0.307**-0.128**-0.160**____ BANKASSET0.027-0.503**-0.402**-0.170**-0.189**0.181**-0.342**-0.041-0.154**-0.443**____ PRIBCIT0.026-0.471**-0.379**-0.147**-0.164**0.333**-0.296**-0.011-0.144*-0.428**0.943**____ MAKTCAP-0.203**-0.306**-0.153**-0.116**-0.232**-0.132*-0.313**-0.0660.155**-0.224**0.0780.179**____ SMTVT0.143*-0.144*-0.019-0.088-0.0140.228**-0.0980.0650.117-0.172**0.423**0.519**0.304**____ RESTRICT0.1070.253**0.218**0.188**0.124*0.172**0.223**0.121*-0.130*0.246**-0.089-0.053-0.0910.155** ** Significant at 1 % level* Significant at 5 % level 23Table 4 Effect of equity investments on bank net interest income (Fixed effects) Thistableshowstheresultsofatwo-wayfixedeffectmodel.Thedependentvariableisthebanksnetinterest income. As independent variables we include banks, macro and country financial development variables. Banks variablesaretheproportionofequityinvestments(EQUINV),thecapitalratio(CAPITAL),theprovisions (PROVIS),theproportionofLOANS,thenon-interestearnings(NONINTER)andtheoverheadcosts (OVERHEADC). All these variables are divided by the total bank assets in the country. The annual growth rate of real GDP per capita (GROWTH) and the annual inflation for consumer prices indices (INFLATION) are the macro variables. Total assets of deposit money bank assets to GDP (BANKASSET) and the stock market capitalization (MAKCAP)areintroducedtomeasurethesizeofthebankingsectorandthestockmarketrespectivelyinthe country.Finally,theprivatecreditbydepositmoneybankstoGDP(PRIBC)andthestockmarkettotalvalue tradedtoGDP(SMTVT)areincludedtomeasuretheactivityofthebankingsectorandthestockmarket respectively. The standard errors are corrected for autocorrelation, and the corresponding t-statistics are given in parentheses below. Dependent variable: Net Interest Income (NETINTER) (1)(2)(3)(4)(5)(6)(7)(8) INTERCEPT2.210*** (4.37) 2.040*** (4.05) 1.770*** (3.52) 1.413*** (2.87) 2.081*** (3.96) 1.931*** (3.68) 1.592*** (3.07) 1.254** (2.47) EQUINV0.145*** (3.10) 0.144*** (3.16) 0.114** (2.49) 0.106** (2.44) 0.117** (2.50) 0.120*** (2.64) 0.087* (1.92) 0.086** (2.00) CAPITAL 0.127*** (3.62) 0.156*** (4.61) 0.137*** (3.93) 0.164*** (4.88) PROVIS 0.205*** (3.29) 0.262*** (4.38) 0.209*** (3.31) 0.265*** (4.43) LOANS0.000 (0.00) -0.003 (-0.37) -0.004 (-0.51) -0.008 (-1.11) 0.007 (0.75) 0.003 (0.33) 0.002 (0.25) -0.003 (-0.41) NONINTER-0.874*** (-14.60) -0.901*** (-15.28) -0.915*** (-15.57) -0.956*** (-16.85) -0.883*** (-14.50) -0.911*** (-15.21) -0.929*** (-15.62) -0.969*** (-16.96) OVERHEADC0.442*** (6.86) 0.511*** (7.73) 0.461*** (7.40) 0.555*** (8.81) 0.449*** (6.85) 0.518*** (7.74) 0.468*** (7.45) 0.560*** (8.87) GROWTH0.067*** (4.15) 0.073*** (4.60) 0.065*** (4.19) 0.073*** (4.88) 0.063*** (3.70) 0.069*** (4.10) 0.061*** (3.75) 0.068*** (4.37) INFLATION0.023*** (2.91) 0.021*** (2.76) 0.020** (2.54) 0.017** (2.26) 0.025*** (3.20) 0.023*** (2.98) 0.021*** (2.76) 0.017** (2.39) BANKASSET -0.279 (-0.98) -0.193 (-0.70) -0.237 (-0.87) -0.118 (-0.45) MAKTCAP-0.005 (-0.06) -0.014 (-0.16) -0.015 (-0.18) -0.027 (-0.34) PRIBC -0.642 (-1.51) -0.488 (-1.17) -0.536 (-1.32) -0.310 (-0.79) SMTVT 0.295 (1.15) 0.278 (1.12) 0.309 (1.26) 0.291 (1.25) R2 overall75.23%79.76%76.54%79.80%77.96%81.81%78.77%80.99% F24.83***25.43***26.02***28.38***24.74***25.48***26.42***29.00*** LM _2202.35***83.05*** 82.21***56.37***206.01***85.41***76.31***55.13*** Hausman _2182.54***166.54***55.45***42.77***49.49***48.57***744.73***48.09*** # observations200198200198198196198196 # countries2424242424242424 *** Significant at 1 % level** Significant at 5 % level*Significant at 10% level 24Table 5 Effect of equity investments on bank net interest income (Fixed effects with instrumental variables) Thistableshowstheresultsofatwo-wayfixedeffectmodelwithinstrumentsforbanks'variables.Thedependent variable is the banks net interest income. As independent variables we include banks, macro and country financial developmentvariables.Bankvariablesaretheproportionofequityinvestments(EQUINV),thecapitalratio (CAPITAL),theprovisions(PROVIS),theproportionofLOANS,thenon-interestearnings(NONINTER)andthe overheadcosts(OVERHEADC).Allthesevariablesaredividedbythetotalbankassetsinthecountry.Weuseas instruments two lags of each one of these banks' variables. The annual growth rate of real GDP per capita (GROWTH) andtheannualinflationforconsumerpricesindices(INFLATION)arethemacrovariables.Totalassetsofdeposit money bank assets to GDP (BANKASSET) and the stock market capitalization (MAKCAP) are introduced to measure the size of the banking sector and the stock market respectively in the country. Finally, the private credit by deposit money banks to GDP (PRIBC) and the stock market total value traded to GDP (SMTVT) are included to measure the activityofthebankingsectorandthestockmarketrespectively.Thestandarderrorsarecorrectedfor autocorrelation, and the corresponding t-statistics are given in parentheses below. Dependent variable: Net Interest Income (NETINTER) (1)(2)(3)(4)(5)(6)(7)(8) INTERCEPT2.398*** (3.12) 2.165*** (2.83) 2.413*** (3.09) 2.148*** (2.75) 2.595*** (3.13) 2.262*** (2.72) 2.595*** (3.07) 2.214** (2.60) EQUINV0.254*** (4.60) 0.220*** (3.87) 0.254*** 84.57) 0.220*** (3.86) 0.245*** (4.42) 0.209*** (3.68) 0.245*** (4.40) 0.210*** (3.68) CAPITAL -0.007 (-0.12) 0.008 (0.13) 0.000 (0.00) 0.017 (0.27) PROVIS 0.198** (2.19) 0.200** (2.19) 0.207** (2.24) 0.210** (2.25) LOANS-0.001 (-0.11) 0.000 (0.00) -0.001 (-0.08) -0.000 (-0.03) -0.008 (-0.56) -0.004 (-0.30) -0.008 (-0.55) -0.005 (-0.35) NONINTER-0.308*** (-3.29) -0.316*** (-3.41) -0.306*** (-3.22) -0.318*** (-3.38) -0.308*** (-3.24) -0.314*** (-335) -0.308*** (-3.19) -0.318*** (-3.34) OVERHEADC-0.131 (-1.29) -0.111 (-1.10) -0.130 (-1.28) -0.0112 (-1.11) -0.124 (-1.18) -0.102 (-0.99) -0.124 (-1.17) -0.103 (-0.99) GROWTH0.074*** (3.01) 0.077*** (3.15) 0.075*** (2.89) 0.076*** (2.95) 0.078*** (3.05) 0.080*** (3.17) 0.078*** (2.85) 0.077*** (2.86) INFLATION0.043*** (3.33) 0.047*** (3.60) 0.044*** (3.21) 0.046*** (3.41) 0.046*** (3.52) 0.049*** (3.79) 0.046*** (3.33) 0.048*** 83.51) BANKASSET -0.274 (-0.66) -0.265 (-0.65) -0.281 (-0.67) -0.257 (-0.62) MAKTCAP-0.019 (-0.15) -0.004 (-0.03) -0.019 (-0.15) -0.004 (-0.03) PRIBC -0.142 (-0.23) -0.178 (-0.29) -0.142 (-0.23) -0.164 (-0.27) SMTVT -0.154 (-0.40) -0.040 (-0.10) -0.154 (-0.39) -0.021 (-0.05) R2 overall58.18%64.66%58.20%64.70%53.65%61.91%.53.65%62.06% F7.44***7.48***7.01***7.06***7.42***7.48***6.98***7.07*** LM _295.73***51.88***22.43***15.39***88.45***52.16***18.37***13.70*** Hausman _2129.58***54.06***216.90***59.6341.58***20.3862.96***36.14*** # observations194194194194192192192192 # countries2424242424242424 *** Significant at 1 % level** Significant at 5 % level*Significant at 10% level 25Table 6 Effect of equity investments on bank net income (Fixed effects) This table shows the results of a two-way fixed effect model. The dependent variable is the banks net income. As independent variables we include banks, macro and country financial development variables. Banks variables are the proportion of equity investments (EQUINV), the capital ratio (CAPITAL), the provisions (PROVIS), the proportion ofLOANS,thenon-interestearnings(NONINTER)andtheoverheadcosts(OVERHEADC).Allthesevariablesare divided by the total bank assets in the country. The annual growth rate of real GDP per capita (GROWTH) and the annualinflationforconsumerpricesindices(INFLATION) arethemacrovariables.Totalassetsofdepositmoney bankassetstoGDP(BANKASSET)andthestockmarketcapitalization(MAKCAP)areintroducedtomeasurethe size of the bankingsector and the stock market respectivelyin the country. Finally,the privatecredit by deposit money banks to GDP (PRIBC) and the stock market total value traded to GDP (SMTVT) are included to measure the activityofthebankingsectorandthestockmarketrespectively.Thestandarderrorsarecorrectedfor autocorrelation, and the corresponding t-statistics are given in parentheses below. Dependent variable: Net Income (NETINC) (1)(2)(3)(4)(5)(6)(7)(8) INTERCEPT2.242*** (4.41) 2.069*** (4.09) 1.798*** (3.57) 1.435*** (2.90) 2.067*** (3.94) 1.915*** (3.66) 1.573*** (3.04) 1.234** (2.43) EQUINV0.150*** (3.21) 0.149*** (3.27) 0.119*** (2.59) 0.111** (2.55) 0.120** (2.55) 0.123*** (2.69) 0.089* (1.97) 0.088** (2.05) CAPITAL 0.128*** (3.65) 0.158*** (4.65) 0.138*** (3.96) 0.165*** (4.92) PROVIS 0.209*** (3.34) 0.267*** (4.45) 0.210*** (3.33) 0.266*** (4.46) LOANS-0.001 (-0.10) -0.004 (-0.48) -0.005 (-0.62) -0.009 (-1.24) 0.007 (0.75) 0.003 (0.33) 0.002 (0.25) -0.003 (-0.41) NONINTER0.125** (2.08) 0.097* (1.65) 0.084 (1.42) 0.042 (0.74) 0.116* (1.90) 0.088 (1.47) 0.070 (1.18) 0.029 (0.52) OVERHEADC-0.553*** (-8.55) -0.482*** (-7.26) -0.533*** (-8.53) -0.438*** (-6.94) -0.550*** (-8.39) -0.481*** (-7.18) -0.531*** (-8.45) -0.439*** (-6.98) GROWTH0.066*** (4.08) 0.072*** (4.54) 0.065*** (4.13) 0.072*** (4.82) 0.064*** (3.73) 0.069*** (4.13) 0.062*** (3.78) 0.069*** (4.41) INFLATION0.022*** (2.80) 0.020*** (2.64) 0.019** (2.43) 0.016** (2.14) 0.025*** (3.17) 0.023*** (2.95) 0.021*** (2.72) 0.017** (2.35) BANKASSET -0.286 (-1.00) -0.200 (-0.72) -0.244 (-0.89) -0.123 (-0.47) MAKTCAP-0.002 (-0.02) -0.011 (-0.13) -0.012 (-0.14) -0.024 (-0.30) PRIBC -0.638 (-1.51) -0.484 (-1.17) -0.532 (-1.31) -0.304 (-0.78) SMTVT 0.320 (1.25) 0.303 (1.22) 0.334 (1.36) 0.316 (1.36) R2 overall12.76%22.77%15.69%26.51%20.59%30.12%22.58%30.67% F7.32***7.94***8.18***9.63***7.51***8.17***8.61***10.15*** LM _2197.91***81.68***81.71***56.66***206.19***86.02***76.96***55.98*** Hausman _278.08***163.11***55.46***231.23***50.46***31.69***1277.36***62.51*** # observations200198200198198196198196 # countries2424242424242424 *** Significant at 1 % level** Significant at 5 % level * Significant at 10% level 26Table 7 Effect of equity investments on bank net income (Fixed effects with instrumental variables) This table shows the results of a two-way fixed effects model with instruments for banks' variables. The dependent variableisthebanks'netincome.Asindependentvariablesweincludebanks,macroandcountryfinancial developmentvariables.Banksvariablesaretheproportionofequityinvestments(EQUINV),thecapitalratio (CAPITAL),theprovisions(PROVIS),theproportionofLOANS,thenon-interestearnings(NONINTER)andthe overheadcosts(OVERHEADC).Allthesevariablesaredividedbytotalbankassetsinthecountry.Weuseas instrumentstwolagsofeachoneofthesebanks'variables.TheannualgrowthrateofrealGDPpercapita (GROWTH) and the annual inflation for consumer prices indices (INFLATION) are the macro variables. Total assets of deposit money bank assets to GDP (BANKASSET) and the stock market capitalization (MAKCAP) are introduced tomeasurethesizeofthebankingsectorandthestockmarketrespectivelyinthecountry.Finally,theprivate creditbydepositmoneybankstoGDP(PRIBC)andthestockmarkettotalvaluetradedtoGDP(SMTVT)are included to measure the activity of the banking sector and the stock market respectively. The standard errors are corrected for autocorrelation, and the corresponding t-statistics are given in parentheses below. Dependent variable: Net Income (NETINC) (1)(2)(3)(4)(5)(6)(7)(8) INTERCEPT0.327 (0.52) 0.298 (0.47) 0.167 (0.26) 0.116 (0.18) 0.083 (0.12) -0.017 (-0.03) -0.139 (-0.21) -0.283 (-0.41) EQUINV0.122*** (2.71) 0.117** (2.51) 0.125*** (2.80) 0.119** (2.5) 0.091** (2.03) 0.080* (1.72) 0.096** (2.15) 0.082* (1.78) CAPITAL 0.078 (1.58) 0.080 (1.62) 0.089* (1.79) 0.095* (1.90) PROVIS 0.025 (0.33) 0.039 (0.52) 0.062 (0.82) 0.080 (1.05) LOANS0.023** (2.27) 0.023** (2.28) 0.018* (1.78) 0.019* (1.79) 0.030*** (2.69) 0.031*** (2.77) 0.026** (2.31) 0.027** (2.40) NONINTER0.067 (0.88) 0.066 (0.87) 0.049 (0.64) 0.047 (0.61) 0.081 81.06) 0.079 (1.03) 0.060 (0.78) 0.056 (0.73) OVERHEADC-0.169** (-2.04) -0.166** (-2.00) -0.176** (-2.14) -0.173** (-2.09) -0.147* (-1.73) -0.140* (-1.65) -0.153* (-1.82) -0.145* (-1.72) GROWTH0.056*** (2.78) 0.056*** (2.79) 0.45** (2.16) 0.045** (2.16) 0.057*** (2.78) 0.058*** 82.80) 0.044** (1.99) 0.043** (1.98) INFLATION0.013 (1.26) 0.014 (1.29) 0.008 (0.76) 0.009 (0.79) 0.019* (1.76) 0.020* 81.84) 0.012 (1.13) 0.013 (1.19) BANKASSET -0.192 (-0.57) -0.191 (-0.56) -0.111 (-0.33) -0.106 (-0.31) MAKTCAP-0.034 (-0.32) -0.032 (-0.30) -0.033 (-0.32) -0.030 (-0.29) PRIBC -0.602 (-1.21) -0.613 (-1.23) -0.524 (-1.06) -0.533 (-1.08) SMTVT 0.385 (1.23) 0.419 (1.33) 0.475 (1.51) 0.525* (1.65) R2 overall25.22%27.41%20.14%23.41%36.02%38.95%32.12%35.83% F2.65***2.50***2.67***2.54***2.85***2.73***2.91****2.82*** LM _2124.34***51.14***38.70***16.51***129***58.34***39.93***18.38*** Hausman _219.6821.17750.32***31.89***14.0914.0953.19***47.65*** # observations194194194194192192192192 # countries2424242424242424 *** Significant at 1 % level** Significant at 5 % level * Significant at 10% level