The role of the control variables deposits and GDP are also interesting. The effect of GDP of the economy is negative on the profitability of the banks. This implies that as the economy strengthens, the banking industry is becoming more lucrative and is attracting more banks in the economy. This makes the market more competitive. While this might be in the interest of the customers, the banks certainly face stronger competition in capturing the markets thereby losing on the profitability. It might also point to the fact that in an attempt to get more assets, the banks are failing to perform appropriate due diligence due to which their ROA and ROE suffer.
When the banks do not perform the appropriate KYC (Know Your Customer) or due diligence on their customers, they inherently misjudge the riskiness of the customers. In these cases, the customers often become delinquent and the corresponding asset becomes non-performing. These issues lead to a decline in the profitability of the banks and often weaker balance sheets. Although this is expected to be short-term because as the competitors in the market increase, or as the banks start facing bad loans, the lucrativeness of the sector declines, thereby reducing the risk appetite of the banks. It may also happen that as the GDP increases, the banks in hope of better behaviour from the customers start lending more without appropriate due diligence which leads to sub-standard and later non-performing assets.
However, the effect of deposits turns out to be positive. As the deposits in the banks increase, their ROA and ROE are also expected to increase. This is an indicative of the faith of the customers in the banks. With higher deposits banks have more money to convert into assets. The downside here is that due to regulatory norms, the reserves that the banks have to keep aside in liquid form also increase with the deposits. Nonetheless, when banks have more deposits, only a fraction of it goes down into deposits as security either with themselves or with the central banks. Despite that, what is more important here is that with increasing deposits, banks lend more and have better opportunities to increase their profitability.