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A study of determinants of intellectual capital performance in banks: the UK case
Magdi El-Bannany
Liverpool Business School, Liverpool, UK
Abstract
Purpose – The purpose of this paper is to investigate the determinants of intellectual capital performance in the UK banks over the period 1999-2005. Design/methodology/approach – Multiple regression analysis is used to test the relationship between the intellectual capital performance as a dependent variable and certain independent variables. Findings – Results indicate that the standard variables, bank profitability and bank risk, are important. The results also show that investment in information technology (IT) systems, bank efficiency, barriers to entry and efficiency of investment in intellectual capital variables, which have not been considered in previous studies, have a significant impact on intellectual capital performance. Research limitations/implications – More evidence is needed on the determinants of intellectual capital performance before any generalisation of the results can be made. In addition, the empirical tests were conducted only on the Major British Banks Group over the period 1999-2005 and hence the results of the study cannot be assumed to extend beyond this group of banks or to different study periods. Practical implications – The study might help the banking regulators in addressing the factors affecting intellectual capital performance to take actions towards developing their performance and in turn maximise their value creation. Originality/value – This paper adds to the literature on the determinants of intellectual capital performance in banks. In particular, it tests the theories that investment in IT systems, bank efficiency, barriers to entry and efficiency of investment in intellectual capital have impact on intellectual capital performance. Keywords Intellectual capital, Human capital, Systems analysis, Banks, United Kingdom Paper type Research paper

Intellectual capital performance 487

Introduction Human capital, as an intellectual capital component, is one of the most important resources which companies rely on to improve their efficacy and efficiency, and hence gain a competitive advantage as argued by de Pablos (2003). Nielsen et al. (2006) argued that human capital, represented by the company’s stock of, e.g. skilled employees, knowledge and management philosophy, helps to improve the company’s performance. This makes studying the determinants of intellectual capital performance a key challenge. In addition, the results of this study might help the banking authorities to formulate and implement strategies to develop intellectual capital and guide banks to benchmark themselves in order to improve their value creation as argued by Goh (2005).
The author is grateful to Professor Ken Holden of Lancaster University in the UK for his helpful and valuable comments on earlier drafts of this paper.

Journal of Intellectual Capital Vol. 9 No. 3, 2008 pp. 487-498 q Emerald Group Publishing Limited 1469-1930 DOI 10.1108/14691930810892045

] for countries in the vanguard of the world economy. Production requires both physical and intellectual capital as argued by Goh (2005). This will lead it to gain a competitive advantage in the market which allows maximizing the profit of the company (maximizing the value creation). . this will be reflected in better performance for company (A) compared to company (B). . . Employees. physical rather than intellectual capital is more important in the process of wealth creation. capital and organizing to create value to the economy) to a knowledge driven economy (depending on factors such as creativity and employees’ skills to create value to the economy) as argued by Goh (2005). p. if the skills of the staff of company (A) are better than the skills of the staff of company (B) which is performing the same services. 20) stated that “knowledge is our most powerful engine of production”. play a crucial role in creating value through increasing efficiency. .] today’s most technologically advanced economies are truly knowledge-based. p. Mavridis (2004. new production methods. This is because the staff of company (A) might adopt certain strategies. (which relies mainly on knowledge). Usoff et al. So. This is the reason for choosing the banking sector rather than other sectors for the present study. 93) stated “the banking sector in general offers an ideal area of intellectual capital research because the business nature of the banking sector is intellectually intensive”. e. Alliance & Leicester Commercial Bank plc. known as human capital.3 488 In 1998. skilled. Alliance & Leicester plc. They gain an advantage which allows them to compete in the market. intellectual rather than physical capital is more important in the process of wealth creation. But in other sectors. whereas the proposed cost of obtaining skilled staff who are supposed to have a critical role in improving efficiency. The Major British Banks Group (MBBG) has been chosen as a study sample based on the assumption of the potential role of human capital of these large banks is expected to be clearer than other medium or small sized banks. World Bank (1998) stated: [. So. labour. World Bank (1999.JIC 9. in a knowledge driven economy such as the UK. The MBBG and its abbreviations are represented as follows: (1) Alliance & Leicester Group (AL): . p. Also.g. 9) stated “knowledge has become the key economic resource and the dominant and perhaps even the only source of competitive advantage”. e. . Also. the UK as a country and the years from 1999 to 2005 as a period are convenient for the present study. is assumed to be high and affordable only by the major banks. In the agricultural and industrial sectors (which rely mainly on the traditional inputs of land and labour). .g. That is. Public (1998) stated “in a knowledge based economy the responsible party for the achieved market results are definitely the employees”. In addition. Additionally. (2002. the UK Ministry of Trade and Industry adopted strategies to transfer the economy from an input-driven (relying on the traditional inputs of land. the balance between knowledge and resources has shifted so far towards the former that knowledge has become perhaps the most important factor determining the standard living [. which might lead to reduction in the production cost of the services and in turn allow this company to offer a lower price and hence make the company more efficient than company (B). banking.

AMC Bank Ltd. section D formulates the hypotheses. . . Capital Bank plc. . . HSBC Bank plc. Ulster Bank Ireland Ltd. HSBC Trust Company (UK) Ltd. (9) The Royal Bank of Scotland Group (RBS): . section E covers the research method used. Intellectual capital performance 489 . Bank of Scotland.(2) Abbey Group (AN): . Barclays Private Bank Ltd. Abbey National Treasury Services plc. (6) HSBC Bank Group (HSBC): . . . Lloyds TSB Bank plc. . section F presents the empirical results. . . (8) Northern Rock plc (NR). and section G provides the conclusions. Barclays Bank plc. . The Royal Bank of Scotland plc. . Abbey National plc. Coutts & Co. . Cater Allen Ltd. . section C considers the measurement of intellectual capital. The remainder of this paper is structured as follows: section B discusses the definition of intellectual capital and its components. Halifax plc. Ulster Bank Ltd. (5) HBOS Group (HBOS): . HBOS Treasury Services plc. . Lloyds TSB Scotland plc. . Barclays Bank Trust Company Ltd. (7) Lloyds TSB Group (LT): . (3) Barclays Group (B): . . (4) Bradford & Bingley (BB). . Cheltenham & Gloucester plc. Adam and Company plc. . Scottish Widows Bank plc. National Westminster Bank plc. Tesco Personal Finance Ltd. Lloyds TSB Private Banking Ltd. .

3).3 490 Definition of intellectual capital and its components Many definitions in the literature for intellectual capital and some of these are: . which allows it constantly to adapt to changing conditions” as stated by Mouritsen (1998. p. information. 305). . “Given to the combined intangible assets which enable the company to function” as stated by Brooking (1996. relationships. and general capabilities that individuals bring to bear on behalf of the firm through the employment relation”. 462). 201) stated that human capital can be considered as “such factors as employees’ knowledge. Measurement of intellectual capital performance As discussed above. 217) stated that “human capital generates innovation – whether of new products and services or improving business processes”. assume that business man (A) decides to establish an IT company and recruit two highly skilled IT engineers to run the company. . copyrights and franchises” as stated by Brennan (2001. . That is. information. It covers the knowledge and experience which skilled staff can use to gain a competitive advantage for the company through applying some creative strategies as discussed above. “Encompasses intangibles such as patents. p. 43). “An intangible asset with the potential to create value for the enterprise and the society itself” as stated by Mavridis (2005. both physical and intellectual capital are important for creating value to the company. Riahi-Belkaoui (2003. p. In turn. Of these. p. . 423). p. p. p. (2004. capability. it might lead to a competitive advantage in the market and hence a higher value for the company. skill. We can conclude that human capital is an important production tool in rising the quality of services provided to customers. 12). . measuring the intellectual capital performance is based on the assumptions that the existence of the physical capital is essential to allow the human capital to contribute to creating added value. Human capital cannot act without the physical capital (the initial investment to buy the core components of the business) so this part cannot be ignored in constructing an index of intellectual capital performance. human capital is assumed to be the most important component for the present study. So. Several types of intellectual capital components have been addressed in the literature. Galunic and Anderson (2000. In the present study. Chen et al. p. knowledge applied to work to create value” as stated by Edvinsson and Malone (1997. These two engineers will . “Broad organisational knowledge unique to a firm. 3) stated that human capital can be defined as “the know-how. intellectual property and experience that can be put to use to create wealth” as stated by Martinez and Garcia-Meca (2005. “Information.JIC 9. intellectual property rights. “The knowledge. 87) stated that human capital can be defined as “the individual knowledge stock of an organisation as represented by its employees”. p. and attitudes in relation to fostering performances which customers are willing to pay for and the company’s profit comes from”. intellectual capital is an intangible asset. p. Bontis et al. (2000.

it can be argued that there is a negative impact of investment in IT systems on the employees because it reflects the intention of the management to fire a number of staff. The value added intellectual capital (VAIC) method explained by Public (1998) will be used to measure the intellectual capital performance because it is more convenient than others in implementing the above theoretical argument as follows: Output ¼ Gross income Input ¼ Operating expenses ðExcluding personal costsÞ VA ¼ Output 2 Input HC ¼ Personal cost ðConsidered as investmentÞ CA ¼ Physical capital VA of human capital ðVAHCÞ ¼ VA HC VA CA Intellectual capital performance 491 VA of physical capital ðVACAÞ ¼ VA intellectual capital ðVAICÞ ¼ VAHC þ VACA Formulation of hypotheses In the banking literature.not be able to show their brilliance without the availability of IT facilities in the company (which will be reflected in the initial physical capital for company). bank profitability and bank risk. These two groups of IT systems can be considered as a threat to the employees. (2) IT Systems for external use which can be defined as the IT resources allocated to serve customers of the bank such as electronic distribution channels including ATMs and online banking. . Holden and El-Bannany (2004) found that investing in ATMs by the MBBG over the period 1976-1996 led to reduction in the number of staff of the bank. efficiency of investment in intellectual capital. specially the unskilled ones and hence. some factors which can be considered as determinants of intellectual capital performance are: investment in information technology (IT) systems. Investment in IT systems In general. barriers to entry. IT systems can be classified into two groups: (1) IT systems for internal use which can be defined as the IT resources allocated mainly to serve the purposes of the management of the company such as different types of computers and their related software. The published data on computing cost will be used as a measure of investment in information technology systems. So it might be acceptable to consider the physical capital value added (VA) as a part of the VA intellectual coefficient. bank efficiency.

Depoers (2000) argued that there are several ways of measuring obstacles to entry have been considered in the banking literature. represented by the ratio of fixed assets to total assets. competence. This situation might lead in turn to motivate the bank’s staff (the human capital) to continue in innovating (e. It can be assumed that if bank efficiency is associated with human capital. the amount of investment necessary to enter the sector. 389) stated that human capital can be defined as “the accumulated value of investments in employee training. p. Therefore. Based on the above discussion. there should be a positive correlation between human capital performance and the market shares of the banks. e. There is a negative relationship between barriers to entry in a firm’s sector and intellectual capital performance. appears more appropriate than others in representing the notion of barrier to entry. the first hypothesis is: H1. There is a negative relationship between the levels of investment in information technology and intellectual capital performance. But it is better to measure bank efficiency in terms of the comprehensive measure. than using a partial measure. because there are different sources for efficiency. Bank efficiency Based on the discussion in section B above. Barriers to entry It can be argued that firms that are protected from competition in their sector by heavy barriers to entry are much more likely not to encourage and motivate their staff to generate innovation and this situation might have a negative impact on the performance of the staff (human capital). human capital as an investment (represented by the staff cost) is expected to contribute to value creation for the company 492 . total assets. and future”.JIC 9. Based on the above discussion. intangible assets.g. will be used to represent the level of bank i’s investment in IT in year t for the reasons discussed in Section 6.3 The logarithm of the computing cost for bank i’s in year t (LOGITINVit). In the banking literature. new products or services) or improving business processes to keep the increase in the market share. two measures of market share are used for bank efficiency: in terms of deposits or assets. it can be argued that human capital plays an important role in lowering the production cost of the bank (giving a cost advantage) and differentiates its products (hence gaining a competitive advantage) which should be reflected in increasing the market share of the bank through attracting more customers.g. As discussed in Section 2 above. Efficiency of investment in intellectual capital Kannan and Aulbur (2004. the third hypothesis is: H3. There is a positive relationship between bank’s relative efficiency and intellectual capital performance. the second hypothesis is: H2. Here. The ratio of fixed assets to total assets for bank i in year t will be used to reflect barriers to entry to the market.

Patton and Zelenka (1997. This suggests the fourth hypothesis of this study: H4. There is a positive relationship between bank risk and intellectual capital performance. It can be argued that increasing the percentage of intangible assets might give the impression to the human capital (as intangible assets) that they are important in contributing to the success of the company and motivate them to continue in innovating. e. the sixth hypothesis is: H6. which are making profits. The individual bank i annual net profit before taxation divided by shareholders equity in year t will be used to represent the bank profitability. Based on the above argument.(represented by the ratio of staff cost to total revenues of bank i in year t). The ratio of staff cost to total revenue for bank i in year t will be used to represent the efficiency of investment in human capital.g. Intellectual capital performance 493 . which is making loss. Based on the above argument. making profits can be considered as the usual financial results and leave the directors to undertake other useful activities for the company such as encouraging staff to innovate which might increase profits. e. the fifth hypothesis is: H5. If. Bank risk is measured as the ratio of intangible assets to total assets of bank i in year t. There is a positive relationship between bank profitability and intellectual capital performance. a positive association between bank profitability and human capital performance is expected. the directors have to spend time clarifying the reasons for losses they will have less time to undertake useful activities for the company such as encouraging innovation which might lead to increased profitability of the company. Bank profitability In general. the more efficient investment is. As a result. There is a positive relationship between the staff costs ratio and intellectual capital performance. and negative results. new products or services or improving business processes to achieve more benefit to the company. Losses can be considered unusual financial results and hence the directors need to be cautious when dealing with them. Losses might require time to be spent by the directors of the company to investigate the reasons for them.g. new products or services or improving business processes to keep the efficiency of the investment in intellectual capital as it is or better. a positive association between bank risk and human capital performance is expected. On the other hand. Therefore. Bank risk It is well known that there is a positive relationship between the level of risk and rate of return. p. 611) stated that “the percentage of intangible assets is a proxy for the extent to which a firm’s future performance depends on risky assets”. Therefore. the financial results of any company can be classified positive results. the greater the contribution of that investment to the value creation and this in turn should motivate the bank’s staff (the human capital) to continue innovating.

JIC 9. uit.] if the choice of whether the variables should be included in the basic equation in linear form. is not clear from the theory then the approach which can be adopted is to choose the form which best fits the data. 64) stated that: [. .. I found that log of a positive variable represented by investment in information technology systems (LOGITINit) is the best performing variable and as a result the study variables are as in the regression model shown in Section 5 above.2.77 of the maximum value representing the intellectual capital performance and the mean for the intellectual capital performance is 10. . a0 ¼ constant. a1. The mean intellectual capital performance for the sample banks throughout the study period varies from 4. the dependent variable – VAIC for bank i in year t. coefficients of the independent variables.3 Research methods The regression model used in this study is shown as follows: VAICit ¼ a0 þ a1 LOGITINit þ a2 HASSit þ a3 FASSit þ a4 SREVit þ a5 ROEit þ a6 ITAGASSit þ uit where VAICit.80. disturbance term – that is the usual error term. Descriptive statistics Table II reports the descriptive statistics for the intellectual capital performance and independent variables selected in this study. 494 Hence. . p. measured as explained in Section 3 above.3.52 to 29. details of the definitions of the independent variables are given in Table I. Description of independent variables and expected signs Natural logarithm of total cost of hardware and software of computing systems for bank i in year t Bank’s relative efficiency (HASSit) The ratio of bank i assets divided by total banking market assets in year t Barriers to entry (FASSit) The ratio of fixed assets to total assets for bank i in year t The ratio of staff costs to total Efficiency of investment in revenue for bank i in year t intellectual capital (SERVit) Individual bank i annual net profit Bank profitability (ROEit) before taxation divided by shareholders equity in year t Bank risk in terms of the ratio of The ratio of intangible assets to intangible assets to total assets total assets for bank i in year t (ITAGASSit) Source: Annual reports þ þ 2 þ þ 2 2 þ þ þ . The independent variables represented by Variable and abbreviation Investment in information technology systems (LOGITINit) Measurement Expected sign Actual sign 2 2 Table I. . Analysis of the results El-Bannany (2006. after conducting several experiments. or in non-linear form such as logarithms or square roots.

000 0.710 * * 0. Neter (1985) stated: [.69 0.52 1.investment in information technology systems.17 0.701 * * 0.03 20.99 (it is 0.390 20.06 0. Variable Intellectual capital performance (VAICit) Investment in information technology systems (LOGITINit) Bank’s relative efficiency (HASSit) Barriers to entry (FASSit) Efficiency of investment in intellectual capital (SERVit) Bank profitability (ROEit) Bank risk in terms of the ratio of intangible assets to total assets (ITAGASSit) Note: N ¼ 60 observations Mean 10.000 – FASSit 0.695 * * 0.23 0.05 0. Intellectual capital performance 495 Moreover.45 0. bank efficiency in terms of assets.831 20.07 0. which means that the multicollinearity should not be considered a serious problem as argued by El-Bannany (2002).000 – ROEit 20. Test for multicollinearity Multicollinearity exists when independent variables correlate significantly with each other.00 Max 29.137 0.00 0.256 20.06 0.58 0. .02 0. * *0. in general.873 * * 0.028 0. barriers to entry. Muticollinearity in the data set was investigated by the correlation matrix of the independent variables shown in Table III. provided these inferences are made within the region of observations. bank profitability and bank risk all vary as well and this should increase the confidence level in the results as argued by Naser and Al-Khatib (2000). inhibit our ability to obtain a good fit nor does it tend to affect inferences about mean responses or predictions of new observations. efficiency of investment in intellectual capital.80 3.720 * * 0.297 – ITAGASSit 0. Neter (1985) stated that “deleting some variables to reduce multicollinearity reduces the model’s explanatory power and may lead to specification errors”.91 0. The two-tailed significance level is shown in parentheses Table III.000 – SERVit 0.23 0. Furthermore.12 0.01 level (two-tailed).890 * * 0.01 0.10 0.01 Min 4.000 0.599 * * 0.690 * * 0.090 0.000 2 0.64 0.492 – Notes: Correlation is significant at the *0.15 0. The correlation coefficient matrix for the independent variables .01 SD 6.] the fact that some or all independent variables are correlated among themselves does not.00 0.77 3.02 0.89).000 0.113 0.000 0.04 Table II.651 * * 0.000 0. The highest correlation coefficient value is between FASSit and ITAGASSit and is less than 0.000 0. . Descriptive statistics for the dependent and independent variables Independent variables LOGITINit HASSit FASSit SERVit ROEit ITAGASSit LOGITINit – HASSit 0.149 0.05 level (two-tailed).521 * * 0.

This suggests that increasing the percentage of intangible assets might give the impression to the human capital (as intangible assets) that they are important in contributing to the success of the company and motivate them to carry on performing innovative activities to achieve more benefit to the company.09 2114. N ¼ 60 observations .40 285. F ¼ 0. Regressor Intercept LOGITINit HASSit FASSit SERVit ROEit ITAGASSit Coefficient 39.3 So.86.000 0. Bank profitability is significant with the expected positive sign. Regression results and discussion The results presented in Table IV show that the regression model is significant and explains 85 per cent of the relationship between the intellectual capital performance and the independent variables and this indicates that the model is well specified.06 181. Conclusions This study provides empirical evidence relating to the determinants of intellectual capital performance for the MBBG over the period 1999-2005.32 t-Ratio 13.90 2.JIC 9. bank profitability and bank risk are statistically significant.000. sig.31 2. bank efficiency. efficiency of investment in intellectual capital. 59) ¼ 55. represented by profits. the more efficient a bank is. Bank risk is significant with the expected positive sign.77 8.025 0. The coefficients of investment in information technology systems.33 25. motivates bank directors to encourage staff to perform better. caution is needed while implementing and interpreting the results for multicollinearity test.85.07 27. Efficiency of investment in intellectual capital is significant with the unexpected negative sign. which will lead in turn to increasing in the financial return. This suggests that investing in IT systems can be considered as a threat because it might reflect the intention of the management to fire a number of staff and hence affect negatively on the performance of the staff (human capital). barriers to entry. Therefore.000 0. F(6.030 0.99. This might be because the innovative activities which are the main reflection of intellectual capital are not only due to human capital. Investment in information technology systems is significant with the expected negative sign.020 496 Table IV. This suggests that firms that are protected in their sector by heavy barriers to entry are less likely to encourage and motivate their staff to innovate because of the absence of competition and this situation might have a negative impact on the performance of the staff (human capital).49 22. This suggests that at good financial performance. The regression results: dependent variable VAICit Notes: R 2 ¼ 0. Barriers to entry is significant with the expected negative sign. the better the performance of the staff (human capital). ¼ 0. Bank efficiency is significant with the expected positive sign.000 0.92 71.41 Probability 0.000 0.77 4.23 29.

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