On the nexus between risk taking and profitability: Evidences from Indonesia

Abstract

This paper test interrelationship between risk taking and profitability (ROAA) using two stage regression. We study 150 bank sample for 2008-2014 from Indonesia. Instrumented variable is total risk taking (RT) and the instruments are asset size, equity to total asset, loan asset ratio, loan loss reserve, efficiency, liquidity. For macroeconomic variables, we use economic growth, Central bank -rate (CBDR) and inflation rate (CPI). We find a positive relationship between risk taking (RT) and bank profitability (ROAA). Further, the relationship between risk taking (RT) and profitability (ROAA) is endogenous. The result confirms that bank’s motivation to take more risk is to earn higher profit. In addition, capital ratio is negative to risk taking (RT) and profitability (ROAA). Interestingly, credit risk taking is negative due to the high correlation with a problem loan (LLRGL). The cost inefficiency is negative to bank’s profitability. Finally, for improving profitability, bank’s manager should manage the operation better such as reducing problem loan and improving cost efficiency as these actions are more effective than taking more risk taking (RT).