Banking industry of pakistan

ABSTRACT

The main goal of this paper is to study the impact of interest rates changes on bank profitability of commercial banks operating in Pakistan. By analyzing the financial statement for five major banks for the period 2003 - 2008. As banking sector efficiency is considered as a precondition for macroeconomic stability, monetary policy execution and economic growth. Interest spread of the Pakistan banking industry on the rise from few years. The changes in interest rate ultimately discourages the savings and investment on the one hand, and raises concern on the effectiveness of bank lending channel of monetary policy on the other. Variable were found, based on previous studies. In this model independent variables are interest rate, Loan and Advances and Earning Assets has been chosen. Regression model is tested to determine the interest rate fluctuations have a significant impact on banks profitability and expected result would be that there is a significant effect of interest rate changes on bank profitability.

CHAPTER 1: INTRODUCTION

1.1: Banking industry of Pakistan

Over the years, banking system in Pakistan shown enormous growth and potential. The performance and stability indicators showed significant improvement in the profitability of banking system. After enormous amount of growth now banking sector facing some though pressures from 2008. Such as liquidity crunch and solvency problem have significant impact on the performance of banking sector and economy. The financial institution could have managed the situation without any trouble if they have sufficient amount of liquidity available to fulfill their obligation. Since, they are operating in a very tight market conditions. They are forced to pay attractive rates to depositors to attract liquidity. Although the State Bank of Pakistan reduced the Cash Reserve Requirement (CRR) and Statutory Liquidity Requirement (SLR) on demand and Time Liabilities to ease the liquidity in the market. The government instead of developing its own recourses empowers banks to generate money and then borrow from banks. The huge amount of borrowing from banks by the government is alarming the economy. The government not only curtails its borrowing from banks but also put some sort of check on power of money.

All these factors have combined to set a stage where lending rates are high and having great amount of burden on banks financials. The amount of non performing loans increased at rapid speed despite of heavy amount of provision created by the bank in recent years. The increasing asset quality concerns would force the banks to book heavy provisions for non performing loans (NPLs).

The stability of the banking system is conditional upon the stability of overall economy. A stable macroeconomic environment contributes to effective and efficient growth of saving and investment decision. Appropriate macroeconomic measures should support the functioning of the banking system more specifically in the areas of financial stabilization, transparent fiscal policy and monetary policy. The major contributor role of effective and efficient growth in the economy is played by the State Bank of Pakistan and provides guideline to the financial institution to play their role in the development by mobilizing the resources of the economy and facilitating the investors.

The success of a bank also depends on the ability to forecast and avoid risk, to cover the losses brought about by the arisen risk. Profit is the important requirement of a competitive banking institution and the cheapest source of funds. It is essential to see it not simply as a result, but also a necessity for successful banking in a growing competition on financial market. These important facts together are the reason for this to focus on the current topical issue of banks profitability. Which are influencing on banks effectiveness and efficiency to manage their portfolio such as assets and liabilities in aiming at to achieve profitability and identify the areas where it might have possible room for raising the bank profitability? Banks assets are grouped into two categories - earning assets and non earning assets. Earning assets means those on which banks earns interest income and non earning assets means those which are used for the purpose of reserve requirement, fixed assets to run day to day operational activities. In this study we have focused on earning assets. This includes Placements, lending to financial institution, investment in securities and loan & advances. These assets are the major source of income for bank. Therefore, it is apparent that average income generation ability of these assets has a decisive influence on the banks profitability.

As financial intermediary, banks play a vital role in the operation of most economic development. The efficiency of financial intermediation can also affect the economic growth. Banks are different from other firms in that they provide financial services, the reward to which is an interest rate, and the most of the funding are financed by the deposits or borrowing, the expense of which is also an interest rate. Interest margin, the difference between what a bank has earned on its earning assets and what is paid to depositor. It has been on upward trend during the last decade. An increase in the spread would affect the depositor or the borrower or both stand loose at same time. The lack of alternate avenues of financial intermediation aggravates the adverse impact of spread. For example, if the State Bank of Pakistan based on the monetary policy change the interest rate. The change in interest rate influences the cost of capital that in turn affects the level of consumption and investment decision. If the increase in the spread is due to decrease the rate to depositors then this discourage the saving, and alternatively if due to increase the rate it would have adverse impact on investment. Therefore, these changes in the interest rate have important implication on the economy.

Banks are more sensitive to interest rate changes than most of the other institutions. The effect of interest rate changes on banks profitability has been an important issue for banking system. It has been argued that bank exposure to interest rate risk perhaps the most important issue in participating the saving and investment crises.

1.2: Problem Statement

The rapid fluctuations in interest rate have significant impact on the economy. The impact of interest rates changes affect individual level and corporate level. Interest rate volatility discourages the saving & investment decision and also affects the development and growth of the economy.

1.3: Research Question

What are the affects of interest rate movement on banks profitability?

1.4: Objective

The aim of this study is to evaluate and analyze the impact of interest rate changes on banks profitability based on the following variables.

  • Interest rate
  • Balances with other banks - Deposit accounts
  • Lending to Financial Institution
  • Investments
  • Loan & Advances

1.5: Research Scope and Limitation

The scope of this study provides valuable insight to the factors that affecting the interest rate movements and its impact on banks profitability. There are some limitations in this research. Such as;

  • The basis for calculation of income is KIBOR rate. The Pakistan banking system starts practicing KIBOR rate as benchmark from 2002 onward. Therefore, the study period is 2003 - 2008.
  • The sample size consists of Pakistan five major banks. This covers the 57% market share of the Pakistan banking industry.

1.6: Chapter Summary

The banking sector had shown enormous potential in previous years. Banking sector achieved high profitability and economy was stable. From 2008 onward banking sector had been going through a financial crises such as liquidity and solvency problem. The uncertainty condition in the country should be control. The central bank reduces the Cash Reserve Requirement and Statutory Liquidity Requirement. So, banks have more liquidity to fulfill their obligations. On the other hand Central Bank increases the discount rate to control the money supply in the market. This results in higher interest rates. Due to the increase in interest rate and financial crises borrowers default ratio increase and financial institution suffer large amount of losses during the period. This increasing amount of asset quality concerns would force the bank to book heavy provision for non performing loans (NPLs). The stability of the banking system is dependant on the economy. A stable macroeconomic condition will contribute to effective and efficient growth of saving and investment. Banks play as role of financial intermediary in the development of economy. If the central bank made any change in the monetary policy it will affect the performance of financial institution. Then the changes in the interest rate will affect the saving and investment. If the spread increases due to decrease in the rate to depositor then it will discourage the depositor and alternatively if due to increase in the rate to borrower then it will affect the investment decision. Therefore, banks are more sensitive to interest rate.

1.7: Research Structure

This research structure based on five chapters as follows:

  • Introduction about Pakistan banking sector and their role in the economy.
  • The literature review provides theoretical background of the research and cites author those who have previously researched on the topic of impact of interest rate changes on banks profitability.
  • Interest rate policy implication on banks performance and economy.
  • The methodology chapter includes adopted data sources, collection and interpretation.
  • The conclusion and recommendation section provides the final logical analysis.

CHAPTER 2: LITERATURE REVIEW

The study of Flannery, (1981) showed that “large banking organizations (1978 assets greater than $2 billion) are well hedged against interest rate fluctuations”. The large banks made necessary adjustment to avoid interest rate fluctuation by revising the repayment schedule rate as per the agreement with customer to minimize their interest rate risk. The some of the borrower pay quarterly, half yearly and annual payments. So, as per the agreement schedule bank revise the rates which minimize the risk of bank.

When market rate change, the large banking organization made necessary adjustments to avoid interest rate volatility in revenue and cost. The mostly organization have mis matched balance sheet such as they borrow from customer and financial institution at shorter period or maturity and give lending to customer and financial institution at longer period. It would create mismatch between assets and liabilities. Therefore, banks are exposing to interest rate risk and liquidity risk. To avoid the liquidity risk the banks develop relationship with financial institution to overcome their liquidity problem on immediate basis and for interest rate they minimize the risk by revising the interest rate of the contract as per the agreement.

The study of Flannery, (1983) showed that “most bank posses a sufficient range of assets and liabilities choices to avoid the risk. This study employs annual data from the federal Reports of Income and Condition on individual insured banks in continuous existence from 1960 through 1978. Twelve banks were chosen at random from the national population in each of five asset size categories (based on year-end 1978 assets): less than $25 million, $25- 25-49.9 million, $50-99.9 million, $100-299.9 million, and greater than $300 million. Holding company subsidiary banks were excluded from the first four size million, $100-299.9 million, and greater than $300 million. Holding company subsidiary banks were excluded from the first four size groups; 3 banks above $300 million were included regardless of their subsidiary status, since large independent banks may not be representative of the population”. In this study data collected from the federal report of income and condition from 1960 to 1978. Population of Twelve banks randomly chosen for analysis and break into 5 different assets size categories on the basis of 1978 assets: less than $25 million, greater than $25 and less than $49.9 million, greater than $50 and less than $99.9 million, greater than $100 and less than $299.9 million and greater than $300 millions. In this study holding company's subsidiary excluded from first four groups and greater than $300 million includes the subsidiary banks of holding company and regression techniques had been used in the analysis. The result of the study showed that commercial banks groups are substantial exposed to interest rate risk and individual bank choose alternatives to avoid such risk. Bank possess sufficient amount of funds available in the form of assets and liabilities to minimize those risk and try to get productive results.

The study of Barajas et.al (1999) showed that “a key variable in the financial system is the spread between lending and deposit interest rates. When it is too large, it is generally regarded as a considerable impediment to the expansion and development of financial intermediation, as it discourages potential savers with low returns on deposits and limits financing for potential borrowers, thus reducing feasible investment opportunities and therefore the growth potential of the economy”. The key point of financial institution is the spread between Loan and deposits rate differences. When the lending rate is high and deposits rate is low then which results in higher the profitability for the financial institution but on the other hand it will discourage the depositor. Because the depositors getting low return on their savings and also discouraging for the borrowers because the financial institution charging high interest rate. If the financial institution doing the same then it would reducing the saving confidence on depositor and borrower will try to avoid to borrow from financial institution. Which resulting in reducing the investments opportunities because the saving money not contributing to the economy. Financial system of developing countries showing larger spread difference as compare to the developed countries. Based on the balance sheet and profit & loss information the author derived two data base. Data base was developed on basis of quarterly from 1974-1988 and on the other hand of monthly from 1991-1996. In the period 1974-1980 the spread between loan and deposits increasing steadily and then start decreasing during the period 1981-1988 reached to 19 percent and again decreased during the period of 1991-1996. The evidence provided by the author clearly suggested that in the period of 1974-1980 spread increased and then during the 1981-1990 significantly decreased. This showed that the loan quality during the period remained stable and reserve ratio requirement decreased and consistent spreads and cost lower the productivity of the state bank.

A study of Maisal, Robert (1978) showed that “financial markets is the degree and rapidity with which financial institution react to new information and shift funds among asset and liability classes so as to equalize marginal cost and returns. Many analysts assume that markets are efficient, that transaction and information costs are negligible or unimportant, and that borrowing and lending hedging and arbitrage are simple and available at or close to risk free rates. As a result, they believe that they can successfully predict the results of all types of markets actions and reactions without concern for institutional forces”. The financial markets are so efficient that they get rapidly information and on the basis of information they are making quick decision regarding the fund management such as assets, liability, cost and income. When all the information readily available then it reduces the cost and increase efficiency of transaction such as hedging and arbitrage without taking any risk on the basis of available information analyst predict their results of any market without considering the forces. The study conducted by author on the basis of cost and revenue of cross section banks during the period 1962-1975 estimation made on the basis of net rate of income and cost of book value of assets. The net rate is the difference between the gross revenue from assets minus cost of asset and rates are net of servicing, processing and overhead cost. The result showed that major shift occurred during the period of 1970-1975. Net returns of assets considerably differ when computed on the basis of average.

The study of Demirgüç-Kunt, Harry (1999) showed the “differences in interest margins and bank profitability reflect a variety of determinants: bank characteristics, macroeconomic conditions, explicit and implicit bank taxation, deposit insurance regulation, overall financial structure, and underlying legal and institutional indicators. A larger ratio of bank assets to gross domestic product and a lower market concentration ratio lead to lower margins and profits, controlling for differences in bank activity, leverage, and the macroeconomic environment. Foreign banks have higher margins and profits than domestic banks in developing countries, while the opposite holds in industrial countries. Also, there is evidence that the corporate tax burden is fully passed onto bank customers, while higher reserve requirements are not, especially in developing countries”. The study showed that variation between spreads and profitability comprised of various determinants, such as economic conditions, regulations and financial structure. As the banks have a high ratio of asset with respect to gross domestic product and have small profit margin and banks profits because of debts and economic conditions. Foreign banks usually have greater margin of profits as compare to the local or domestic bank in the developing countries and different outcome for industrial countries. This study also evidence that corporate tax had a direct burden on the bank customer because bank transfer the tax burden to their customer while reserve requirement of central bank doesn't not have a significant effect on banks. The data collected at the level of banks for 80 institutes and period comprised of 1988-1995 on the size and decomposition of banks spreads and profits. Regression technique had been used to find out the determinate of interest rate spreads and banks profitability. Taxation and regulation have big impact on bank customer and overall bank position. The banking system varies from country to country around the world in size and composition and structure. All banks have different influence of macroeconomic conditions, regulation and market conditions. Several countries data had been used for analysis to find out the bank characteristics and conditions which affect the banks performance such as interest margins and profitability. Some variable have positive relationship with each other and some of them have a negative relationship with each other i.e. reserve ratio to profitability.

The study of Samuelson Paul A, (1945) showed that the “banking system as a whole is not really hurt by an increase in the whole complex of interest rates. It is left tremendously better off by such a change. If a bank were a university, nobody would doubt that it would be made better off by an increase in the interest rate. At worst, it could continue to hold all existing gilt-edge securities to maturity and be no worse off. As these matured, the proceeds could be invested at higher rates with a resulting increase in income. It would be better off in the sense that ceteris paribus it could hire more teachers per year, spend more money on buildings and stadia, and engage in more research. The only exception would be in the limiting and unrealistic case where all its money was invested in perpetuities. But even here it would be no worse off. In every other case it would be better off”. The increase in the interest rates usually not affects the performance of bank, its actual effect on the borrower. When the interest rate increases then borrower will bear the effect of increase interest rate. But it would not affect the bank performance .The reason is that the bank pay low return to depositors and charge more to borrower as interest rate increases. So, both depositor and borrower will bear the cost. In this article author taken the example of university. If this loan given to the university it certainly impact on the university performance because of increase in the interest rates. As the interest rates increases it would become more costly for the university and difficult to pay to the bank on time. The increase in the interest rates would not hurt university as its decreases capital value. This change would have a better impact on university.

The study of Coleman George W, (1945) showed that the “banking system would recover these losses over a period of time, the length depending upon the maturity distribution. During that period, it would be "frozen in" to a given maturity pattern. The earnings of the banking system upon the existing portfolio would increase. He states that "immediately after interest rates have risen and capital values have scaled down, all parts of the portfolio, old as well as new, began to earn the higher rates”. The rise in the interest rates bank can come up with some loss on the portfolio such as investing in the securities of longer period. The bank can recover this cost over the period of time and get desired returns and also increase in the capital of the bank. When the investment is carried at cost then it would amortize cost. It means banks amortize the investments over the period of agreement until it becomes zero. When the interest rate rise it would have immediate effect and bank re-prices the portfolio on the current interest rate and gets benefit of the opportunity. The objective of the study to find that increase in interest rate would not a sufficient impact on banks. Its directly influence on the saver or borrower. Which ultimately result in decrease in saving and investment? The management of bank continuously monitoring and updating their portfolio policies to minimize such risk.

The study of Khawaja, Musleh, (2007) showed that “Interest spread of the Pakistan's banking industry has been on the rise for the last two years. The increase in interest spread discourages savings and investments on the one hand, and raises concerns on the effectiveness of bank lending channel of monetary policy on the other”. The interest rate spreads in banking sector on the upward move. When the interest rate increases it discourages the depositor and borrower, such as saving and investments. Banks giving low returns to depositors which results in discouragement and getting high return from borrower by charging high interest rates inclusive of spreads. Spreads are much high in Pakistan. When spreads taken into account ultimately the interest increase and banks gets high returns on lending and investments. The depositor not has any other option to save his money and also the strict requirement of SBP capital requirement. The industry has rapidly merger and acquisition. This results in decrease in the option for saving. In this study author used data of 29 banks. Variant model had been used to check variables relationship. The results showed that inelasticity in deposits supply have positive impact on interest rate spreads. To lower the spread margin central bank play a vital role to reduce the spread and other alternative would be the financial intermediary which lower the spreads.

The study of Chirwa, Montfort, (2004) highlighted the importance of “financial liberalization in facilitating economic development and growth. While there is no complete agreement on the removal of financial repression, usually characterized by control of interest rates, imposition of credit ceilings, and credit rationing, leads to significant amelioration of growth prospects, the dominant view is that financial liberalization and growth usually go together”. Financial liberalization had a great influence on improving the economy and increasing growth. There is no certain agreement made on the financial repression. The management made certain tool and polices to control the interest rate impact on credits. Such as by applying tool of checking limits and there purpose of credit extension. The good control over the interest rate would have a significant on the performance of economy and growth of the country. Financial liberalization and growth of the economy work to gather and run head to head and boost the development of economy. The determinants of markup spread and bank profit have been used in the model. The portfolio bank is trying to maximize their good portfolio. This maximizes the profitability of the banks. Bank usually made feasible choice of assets and liabilities with respective tenor interest rate. This study used monthly panel data from banking system between 1989-1999.the findings of that study showed that the after liberalization the interest rate significantly increased. The main cause of that increase was the increase in nonfinancial cost, provision for doubtful debts, taxation and variation in the inflation rates.

The study of Marisel Peter, (2002) showed that in the “world of endogenous money, the central bank's role in monetary policy is reduced to the setting of a very short term official rate of interest, which indicates the price at which it will make liquidity available to the banking system. However; it is changes in market rates that affect behavior; and so the ability of the central bank to influence anything at all depends, first, on the interaction between official and market rates. In this paper, we use a vector autogressive error correction model to explore the response to changes in the central bank rate of three short-term market rates that have been featured previously in this journal in debates about the demand for endogenous money”. The main responsibility of the state bank is to control or reduce the rates which affect the price and liquidity of the banking system and affect the availability of liquidity of the banking organizations. The fluctuation in the market interest rates will affect the function of the banking system and as well as the behavior of the consumer and economy. In this study autoregressive correction model had been used by the author to find out the responses of interest rates changes and its effect. When spread between Corporate - Government bond increases then the market assume that the risk on the bond increases. When they see then they try to predict the coming slowdown and recession in the economy. After testing they have found that it would have a positive effect on the economy. They have used the Autoregressive model to test the fluctuation in prices and interest rates. The result of the paper showed that the short term interest rates have a significant impact on the banking system as compare to the long term interest rates. Short term interest rates were the major instrument of the monetary policy of the central bank. In monetary policy central bank advice the interest rates which would affect the banking system as well as the overall economic activities of the country.

The study of Flannery, (1981) showed that “exposure to financial intermediary firms to market interest rate risk has become a significant concern of regulators, investors and managers throughout the financial sector. The regression specification used to determine the short and long run effects of market interest rates on bank revenue and empirical conclusion showed that no evidence exist to support the presumption that commercial banks as a group are dangerously exposed to interest rate risk”. The bank plays the role of financial intermediary in the economy. Interest rate movement is the major concern for the regulators authority, investors and managers. How to avoid such risk? To check the interest rate volatility the author has used the regression technique to predict the small banks profitability. The impact of interest rate have significant short run affect on pretax profit. This effect reduces overtime, as the different asset and liabilities maturities. Surprisingly, the result of showed no significant evidence that interest rate fluctuation pose serious impact on commercial banks. They remarkably well hedged against interest rate changes. Usually, banks borrow funds for a shorter period and lend for a longer period. Banks with significant long run movement in the interest rate benefits from higher rate.

The study of Samuel, Laura (2006) showed that “macroeconomic imbalances are generally associated with high bank spreads. Instability in the macro economy is likely to increase the probability of default by bank debtors. For example exchange rate instability and high and variable inflation can constrain corporation, households' ability to meet their loan obligations, if it adversely affects their balance sheets. Balance sheet data were utilized for estimating the determinants of bank spreads. Both ex ante and ex post measures of spreads were used. The evidence proved that spreads in Barbados are higher than predicted by its macroeconomic environment”. Macroeconomic stability is associated with bank spreads. If the spreads are too much high. Then it will increase the bad debts and capital control also affects the spreads. Capital control directly effect on spreads by decreasing the return on fix income instruments. But also affect the spreads by decreasing the return on deposits. Bank size and market concentration not affect the spreads. It is often note that larger banks able to diversify their portfolio face lower defaults. To control the interest rate fluctuation central bank uses the tool of monetary policy. Financial sector efficiency increases when countries introducing market based instrument of monetary policy.

The study of Hester, John (1966) showed that “the rate of return, positive and negative, which a bank realizes from its assets and liabilities are important determinants of banks portfolio composition. The relevant rates of return on earning assets, of course are not easily observed nominal rates; servicing and processing costs must be deducted. Similarly, the relevant rates for liabilities are not observable interest payments per dollar; servicing cost net of service charges to depositors must be added. Regression method are utilized to allocate revenue and cost among the elements of bank portfolios. Ten district banks data used for the analysis on an accrual accounting basis”. Interest rate either positive or negative affects the portfolio performance. Banks portfolio comprises of asset and liabilities. Asset includes current and fixed assets. While liabilities included short term and long term in nature. Bank portfolios have direct relationship with earnings. For example, if the bank earning assets increases it would also have positive impact on earnings of the bank. Usually banks allocate their revenue and cost according to their segment. Such as bank treasury department borrowing from financial institution and lending to other financial institution. Then the borrowing cost and revenue would be allocated to treasury department. If treasury department revenue greater then cost. Then it will be treasury department profit otherwise loss. Regression model used to find out the allocation of revenue and cost to bank portfolios.

The study of Agha et al, (2005) showed that “the monetary tightening leads first to a fall in domestic demands, primarily investment demand financed by bank lending, which translate into gradual reduction in price pressures that eventually reduces the overall price level with a significant lag. In addition to the traditional interest rate channel, the results point to a transmission mechanism in which banks play an important role. We have also found an active assets price channel”. The transmission mechanism basically concerned with the relationship between money supply and level of output. There are different channel through which money supply affect the output level of the economy. Theses channel varies country to country based on the financial market conditions. The transmission mechanism process begins with open market operations to money market and demand and supply. Vector auto regression model used to examine the monetary transmission mechanism of Pakistan. There are several channel used such as 1- Bank lending channel, 2- Exchange rate channel, 3- Asset price channel and 4-Direct interest rate channel. The role of bank lending in Pakistan is prominent because no other option. Such as non bank sources of finance. Bank role also enhanced because of financial reforms, market based credit allocation.

The study of Favero et al, (1999) showed that “central bank tightens monetary policy by squeezing bank reserves; it can generate a corresponding reduction in the supply of bank loans. There are two ways in which a bank can prevent this from happening. It can change the composition of its liabilities by issuing instruments not subject to a reserve requirement. Alternatively it can sell bonds. If this does not happen, and the supply of loans is reduced, the monetary contraction will affect the real economy. The central bank uses the tool of monetary policy to control the money supply in the market by increasing reserve requirement. When central bank increases the reserve requirement will decrease the bank lending to corporate or consumer level. Sufficient amount of fund place with central bank to meet the liquidity requirement. The banks may issue instruments which does not requirement any reserve requirement. Such as in the form of issuance of bonds. Which does not required any central bank requirement.

2.1: Chapter Summary

The impacts of interest rate changes have a significant impact on the bank profitability. When interest rate changes it would result in increase or decrease in the interest income. The Pakistan banking industry use Karachi Interbank Offered Rate (KIBOR) for earning assets to find out the interest income. The major portfolio reprise on 6 M KIBOR rate. Bank is exposing to interest rate risk. But usually bank hedge against interest rate risk to minimize its impact on bank performance. The major impact of interest rate changes would affect the depositors and borrowers. Because when interest rate changes it would discourage the saving and investment decision.

CHAPTER: 03 INTEREST RATE IMPLICATIONS AND POLICY RESPONSE

The mechanismof monetary policy is to bring discipline and efficiency in the financial sector, developing a conducive environment for economic growth. The central bank pursuing a tight monetary policy past few years. There are several objective of monetary policy to inflation, government borrowing and interest rate. In Pakistan, rising inflation and interest rate are the most common phenomenon. Rising lending rates harms the economy and consumer. It is a fact that high lending rates are regularly linked to high inflation.

The changes in interest rates affect consumption and savings decisions of households, corporate level and also affect the output and investment decision throughout the economy. The central bank set the interest rate at which bank lends money to financial institution and consumer. This measure will help in controlling the monetary pressure associated with the economy.

3.1: Decrease in interest rates

As a general rule, the decrease in interest rate is best for the economic environment. When consumer can afford to borrow funds because they don't have to pay high interest rate on borrow funds. The benefit from low rate includes: 1). House loans 2) Personal loans 3) Credit Cards 4) Auto loans and 5).Investment in Stock Market. Interest rate as a means of controlling economic growth. When the economy grows rapid pace then it will experience inflation. Prices rise to a high level and no one can afford changes in real interest rate. Which affects the public demand for goods and services due to altering the availability of bank loans? For example a low real interest rate decreases the borrowing cost; that leads to the investment spending and encourage people to spend in various forms consumer durables.

Low interest rate will provide corporate level opportunity to take new capital investment spending and increase the firm confidence by make heavy investment in growing sector and generating heavy revenue. Which result in stabilizing the economy and providing employment opportunities? The other aspect of low interest rate will decrease the default risk of counter party. It means that people have more disposable income to pay their borrow funds and take saving decisions. Cause depreciation in the exchange rate and increase demand for domestic producers those who sell goods and services global markets. The rise in the growth of exports will increase the aggregate demand and boost the economy and increases the factor incomes of those in work. This should lead to an increase in the level of national income.

3.2: Increase in interest rates

The increase in rate will increase the cost of property which results in different of property. Conversely, fall in the interest rate increase the demand and increase pressure on mortgage prices. This will increase the spending associated with mortgage buying and increase in prices will increase the total wealth.

The increase in interest rate opening the door of increasing non performing loans. Despite of heavy provision made by the banks. As inefficient and corrupt borrower try to find out and easy exit way to avoid repayment. This problem is going to be worse due to low recovery rate of bad debts.

3.3: Chapter Summary

The global industry incurring losses but Pakistan banking industry has earned profit. The major difference is the spreads. The widening spreads indicates that the depositors are not compensated and incurring losses due to the high inflation. The high interest rate system may be leading to the default culture in Pakistan. Bad debts increasing very sharply. In Pakistan, nearly all the banks work on the interest rate based system.

The significant increase in the interest rate will tighten the monetary policy. It is also worth stressing that some firms are more affected by rate changes than others and some firms of the economy are more exposed to interest rate risk .The impact of interest rate volatility is not uniform throughout the economy. Interest rate volatility affects the interest rate risk and alters the cost of borrowing linked to repayment capacity of the borrower and have significant amount of impact on the economy and growth.

CHAPTER 04: METHODOLOGY

4.1: Data Collection Technique

There are two types of sources available for data collection i.e. primary and secondary data. In this research secondary data have bee used. Secondary data is gathered from journal articles and electronic media. The annual financial information extracted from selected financial institution web site. Such as annual statements and six month average KIBOR rates.

4.2: Sample Size

This study period consist of six years from (2003-2008). The main reason for short study period was the amendments in practice. Before, 2003 banking industry used the PKRV rates. After changes the benchmark rate, the banks start practicing KIBOR rate as benchmark to find out the profitability. Pakistan's five major banks selected from total population thirty four of the banking industry. These five major banks cover 56.6% market share of Pakistan banking industry. The selection of five banks is made on the basis of total assets for the period ended December 31, 2008.

4.3: Characteristics of Variables;

4.3.1: Dependent Variable

Interest income: is defined as the income earned on earning assets. Such as deposits with other banks, lending to financial institution, investments and loan & advances at the prevailing interest rate.

4.3.2: Independent Variable

  • Interest rate: in simple term as cost of borrowing. In this research six month average KIBOR rate used for the analysis.
  • Balances with other banks - deposit accounts: Banks place excess liquidity with different financial institution in order to earn profit. These placements have no fixed maturity period.
  • Lending to financial institution: Bank places excess funds with different banks to earned profit. These placements have fixed maturity period.
  • Investment: is defined as bank purchase the certificates from issuer by providing financial assistance. When borrower repay the borrow funds then bank sell the certificate to the borrower.
  • Loan & Advances: is defined as funds provide the customer to full fill their commitment and obligations.

4.4: Statistical Test

The data were analyzed by using regression model to find out the relationship between bank profitability and interest rates, balances with other banks - deposit accounts, lending to financial institution, investments and loan & advances.

InI =α+b1IR+ b2BWOB + b3LF +b4INV+b5LA+℮

InI= Interest Income

IR= Interest Rate

BWOB= Balances with other banks - deposit accounts

LF= Lending to Financial Institution

INV= Investments

LA= Loan & Advances

4.5: Data Analysis and Findings

The data analysis and its findings based on the statistical analysis.

Descriptive Statistics

Mean

Std. Deviation

N

Interest Income

28236.091

16813.530

30

Interest Rate

7.811

3.798

30

Deposits with other Banks

15135.597

14661.258

30

Lending to FI's

15132.321

7979.746

30

Investments

103857.869

43654.240

30

Loan & Advances

250856.303

115103.000

30

The value of mean show the average values; standard deviation shows the variability in the values and N represents number of cases in the model.

Correlations

Interest Income

Interest Rate

Deposits with other Banks

Lending to FI's

Investments

Loan & Advances

Pearson Correlation

Interest Income

1.000

0.788

0.434

-0.046

0.641

0.950

Interest Rate

0.788

1.000

-0.031

-0.091

0.158

0.661

Deposits with other Banks

0.434

-0.031

1.000

0.000

0.568

0.592

Lending to FI's

-0.046

-0.091

0.000

1.000

-0.073

-0.083

Investments

0.641

0.158

0.568

-0.073

1.000

0.682

Loan & Advances

0.950

0.661

0.592

-0.083

0.682

1.000

Sig. (1-tailed)

Interest Income

.

0.000

0.008

0.405

0.000

0.000

Interest Rate

0.000

.

0.436

0.316

0.202

0.000

Deposits with other Banks

0.008

0.436

.

0.500

0.001

0.000

Lending to FI's

0.405

0.316

0.500

.

0.351

0.332

Investments

0.000

0.202

0.001

0.351

.

0.000

Loan & Advances

0.000

0.000

0.000

0.332

0.000

.

N

Interest Income

30

30

30

30

30

30

Interest Rate

30

30

30

30

30

30

Deposits with other Banks

30

30

30

30

30

30

Lending to FI's

30

30

30

30

30

30

Investments

30

30

30

30

30

30

Loan & Advances

30

30

30

30

30

30

The correlations table displays correlation coefficients, significance values, and the number of cases. Correlation coefficient represents the association between the variables. These values of correlation coefficient range from -1 to +1. The sign of correlation coefficient indicates the direction of the relationship either positive or negative. The value of correlation coefficient indicates the strength and values indicate the nature of relationship either strong or weak. Interest rate, investments and loan & advances absolute value shows strong relationship. While, deposits with other banks shows weak correlation and lending to financial institution shows no correlation with interest income. The correlation coefficients on main diagonal are always 1, because each variable have a perfect and positive relationship with itself. The significant level or P value is the probability of obtaining results as extreme. The significant level very small (less than 0.05) except for lending to financial institution that shows correlation is significant and variables are linearly related. The significant level of lending to financial institution is large (greater than 0.05). This shows that there no significant correlation and variable are not linearly related.

Variables Entered/Removed

Model

Variables Entered

Variables Removed

Method

1

Loan & Advances, Lending to FI's, Deposits with other Banks, Investments, Interest Rate

.

Enter

2

.

Deposits with other Banks

Backward (criterion: Probability of F-to-remove >= .100).

3

.

Lending to FI's

Backward (criterion: Probability of F-to-remove >= .100).

The above table displays that variables entered or removed from method. Two variables have been removed from the method on the basis of not relationship with interest income.

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

1

.983a

0.966

0.958

3430.689

2

.983b

0.966

0.960

3361.684

3

.981c

0.963

0.959

3416.282

This table displays R, R squared, adjusted R squared and the standard error. R is the multiple correlation coefficient, is the relationship between the independent variables and dependant variable. Here, we have large value of R 0.981. This indicates that there is strong relationship. R squared is the proportion of variation in the dependant variable explained by the independent variables. R squared value is 0.963 or 96 percent. This indicates that 96 percent variation in the dependant variable explained by the independent variable and remaining un-explained. Large values indicate that the model fit the data well. Adjusted R squared attempts to correct R squared to more closely reflect the goodness of fit of the model. Here, standard error of the estimate is considerably lower as compare to standard deviation.

ANOVA

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

7916000000

5

1583000000

134.510

.000a

Residual

282500000

24

11770000

Total

8198000000

29

2

Regression

7916000000

4

1979000000

175.110

.000b

Residual

282500000

25

11300000

Total

8198000000

29

3

Regression

7895000000

3

2632000000

225.479

.000c

Residual

303400000

26

11670000

Total

8198000000

29

This table summarizes that regression output displays information about the variation accounted for by the model. While, residual indicates that information not accounted for by the model. The model with large regression sum of squares indicate that the model account for most of variation in the dependent variable. The degree of freedom is the number of cases minus 1.The mean square is the sum of squares divided by the degree of freedom. The F statistics is the regression mean square divided by the residual mean square. Here, significant value of F statistics is small (smaller than 0.05) then the independent variables do a good job explaining the variation in the dependent variable.

Coefficients

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

Collinearity Statistics

B

Std. Error

Beta

Tolerance

VIF

1

(Constant)

-15536.753

2518.301

-6.170

0.000

Interest Rate

1762.837

359.973

0.398

4.897

0.000

0.217

4.606

Deposits with other Banks

0.005

0.076

0.004

0.066

0.948

0.323

3.095

Lending to FI's

0.107

0.080

0.051

1.331

0.196

0.987

1.014

Investments

0.079

0.024

0.206

3.324

0.003

0.372

2.686

Loan & Advances

0.080

0.017

0.547

4.742

0.000

0.108

9.275

2

(Constant)

-15511.249

2438.811

-6.360

0.000

Interest Rate

1746.659

259.784

0.395

6.724

0.000

0.400

2.498

Lending to FI's

0.107

0.079

0.051

1.361

0.186

0.988

1.013

Investments

0.079

0.023

0.206

3.423

0.002

0.382

2.621

Loan & Advances

0.081

0.012

0.553

6.994

0.000

0.221

4.531

3

(Constant)

-13606.312

2029.376

-6.705

0.000

Interest Rate

1721.312

263.324

0.389

6.537

0.000

0.402

2.485

Investments

0.077

0.023

0.201

3.297

0.003

0.383

2.612

Loan & Advances

0.081

0.012

0.555

6.919

0.000

0.221

4.528

The estimated model equation is InI = -13606.312+1721.312 IR+0.77 INV+0.81 LA+E

The equation has three results:

  • One percent increase in interest rate, there would be an increase in interest income by 1721.312 million.
  • One unit increase in investments, there would be increase in interest income by 0.077 million.
  • One unit increase in loan & advances, there would be increase in interest income by 0.081 million.

Often the independent variables are measures in different units. The standardized coefficient is an attempt to make the coefficient more comparable. Before transformation the data to z score. We will get unstandardized coefficient. The t statistics determine the relative importance of each variable in the model. Here, t value of constant below -2 and independent variable above 2.

Collinearity Diagnostics

Model

Dimension

Eigen

value

Condition Index

Variance Proportions

(Constant)

Interest Rate

Deposits with other Banks

Lending to FI's

Investments

Loan & Advances

1

1

5.154

1.000

0.000

0.000

0.000

0.010

0.000

0.000

2

0.430

3.464

0.010

0.010

0.230

0.080

0.000

0.000

3

0.257

4.478

0.000

0.050

0.030

0.430

0.000

0.010

4

0.096

7.342

0.080

0.080

0.140

0.160

0.290

0.000

5

0.052

9.936

0.710

0.000

0.120

0.320

0.200

0.030

6

0.011

21.472

0.200

0.860

0.470

0.000

0.510

0.960

2

1

4.507

1.000

0.000

0.000

0.010

0.000

0.000

2

0.271

4.075

0.000

0.030

0.520

0.010

0.020

3

0.139

5.688

0.000

0.270

0.020

0.190

0.000

4

0.063

8.474

0.680

0.000

0.420

0.000

0.120

5

0.019

15.272

0.310

0.700

0.030

0.800

0.860

3

1

3.744

1.000

0.010

0.000

0.000

0.000

2

0.143

5.125

0.020

0.300

0.150

0.000

3

0.094

6.316

0.660

0.000

0.050

0.110

4

0.020

13.777

0.320

0.690

0.800

0.890

This table determines if there is any problem with collinearity. Eigen value indicates dimensions among independent variables. If Eigen values are close to zero. This shows that variables are highly intercorrelated. Small changes in data values may lead to large changes in the estimates of the coefficients. Condition indices are the square root of the ratios of the largest Eigen value to each of successive Eigen value. If condition index greater than 15 indicates a possible problem. Here, condition index shows 1 to 14 indices. The variance proportion is the variance of estimate accounted for by each principle component associated with each of the Eigen value.

Excluded Variables

Model

Beta In

t

Sig.

Partial Correlation

Collinearity Statistics

Tolerance

VIF

Minimum Tolerance

2

Deposits with other Banks

.004a

0.066

0.948

0.014

0.323

3.095

0.108

3

Deposits with other Banks

.007b

0.104

0.918

0.021

0.323

3.092

0.108

Lending to FI's

.051b

1.361

0.186

0.263

0.988

1.013

0.221

This table displays information about the variable not in the model at each step. The partial correlation is correlation of each independent variable with the dependent variable. Collinearity is the correlation among independent variable is very strong. Tolerance is the proportion of variables variance not accounted for by other independent variable in the model. Deposits with other banks have small tolerance. This will contribute to the model and cause computational problem. While, lending to financial institution have high tolerance. The variance inflation factor is reciprocal of the tolerance. The large value of VIF indicates the multicollinearity.

Residuals Statistics

Minimum

Maximum

Mean

Std. Deviation

N

Predicted Value

-2298.448

58974.508

28236.091

16521.327

30

Residual

-6592.705

7283.055

0.000

3120.959

30

Std. Predicted Value

-1.848

1.861

0.000

1.000

30

Std. Residual

-1.922

2.123

0.000

0.910

30

The predicted value is the value predicted by the model and residual indicates difference between observed value of dependent variable and the predicted values by the model. Standardized predited values are predicted values have mean 0 and standard deviation 1. Standardized residual have mean 0 and standard deviation 1.

The shape of histogram approximately follow the shape of normal curve. This inidates the fulfil ment of normality assumption.

The PP plot also approximately follow assumption of linearity.

4.6: Hypothesis Testing

Coefficients

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

Collinearity Statistics

B

Std. Error

Beta

Tolerance

VIF

1

(Constant)

-15536.753

2518.301

-6.170

0.000

Interest Rate

1762.837

359.973

0.398

4.897

0.000

0.217

4.606

Deposits with other Banks

0.005

0.076

0.004

0.066

0.948

0.323

3.095

Lending to FI's

0.107

0.080

0.051

1.331

0.196

0.987

1.014

Investments

0.079

0.024

0.206

3.324

0.003

0.372

2.686

Loan & Advances

0.080

0.017

0.547

4.742

0.000

0.108

9.275

2

(Constant)

-15511.249

2438.811

-6.360

0.000

Interest Rate

1746.659

259.784

0.395

6.724

0.000

0.400

2.498

Lending to FI's

0.107

0.079

0.051

1.361

0.186

0.988

1.013

Investments

0.079

0.023

0.206

3.423

0.002

0.382

2.621

Loan & Advances

0.081

0.012

0.553

6.994

0.000

0.221

4.531

3

(Constant)

-13606.312

2029.376

-6.705

0.000

Interest Rate

1721.312

263.324

0.389

6.537

0.000

0.402

2.485

Investments

0.077

0.023

0.201

3.297

0.003

0.383

2.612

Loan & Advances

0.081

0.012

0.555

6.919

0.000

0.221

4.528

H1: There is no significant relation between interest rate and interest income

Result: Since the significant value of interest rate is 0.000, which is less then 0.05. We reject the null hypothesis. This means that the interest rate have a significant relation with interest income.

H2: There is no significant relation between balances with other banks - deposit accounts and interest income

Result: Since the significant value of balances with other banks - deposit accounts is 0.918, which is greater then 0.05. We accept the null hypothesis. This means that the balances with other banks - deposit accounts have no significant relation with interest income.

H3: There is no significant relation between lending to financial institution and interest income

Result: Since the significant value of lending to financial institution is 0.186, which is greater then 0.05. We accept the null hypothesis. This means that the lending to financial institution have a significant relation with interest income.

H4: There is no significant relation between investments and interest income.

Result: Since the significant value of investment is 0.003, which is less then 0.05. We reject the null hypothesis. This means that the investment have a significant relation with interest income.

H5: There is no significant relation between loan & advances and interest income

Result: Since the significant value of loan & advances is 0.000, which is less then 0.05. We reject the null hypothesis. This means that the loan & advances have a significant relation with interest income.

CHAPTER: 05 CONCLUSION & RECOMMENDATION

5.1: Conclusion

The objective of this paper is to evaluate the impact of interest rate changes on banks profitability. The bank interest income is significantly affected by the interest rate, investments and loan & advances. The regression technique also proves these findings. This means that profitability of banks dependant on interest rate that is the tool of monetary policy. Interest income, investments and loan & advances are significantly related to the interest rate. Interest income is highly associated with interest rate.

Specifically, in a higher interest rate environment, an increase in lending rates usually larger than the increase in deposit rates, which result in pushing up the bank, spreads. On the other side, in a lower interest rate scenario, the opposite likely to be happen. When interest rate increases, lending rates tend to adjust more quickly as compare to deposit rates. While, in a declining situation deposit rates adjust faster then lending rates.

It is feared that further increase in the interest rate will slow the growth of advances and increase in the bad debts. The Paid up capital requirement of Rs. 7 billion until 2010 by the SBP also encourage further consolidation in the banking sector. It used for decrease the impact of risk, conservative growth in advances and deposits, bringing downward advances to deposits ratio. But the major concern is the interest rate movement which damaging in great deal. It will very difficult for individual to save money and made investment in the economy.

5.2: Recommendation

  • The banks can decrease their risk with out involvement of funds by developing their focus on non interest income.
  • Bank must take conscious measure about capital adequacy ratio and abrupt changes in the interest rate.
  • The central bank should play their role in standardization of interest spreads.
  • There has been a gap of 5 to 8 percent between what the banks in Pakistan were paying to the deposit holders and what they were charging to borrowers, which is not in line with the international level. Banks management should logically focus on improving the quality of their banks profitability by providing better return to depositors and charge less interest rate to borrowers for the development of economy.

 

comments powered by Disqus