TABLE OF Contents TITLE PAGE . 1 PROJECT APPROVAL...2 LETTER OF TRANSMITTAL..3 LETTER OF AUTHORIZATION.4 ACKNOWLEDGEMENT5 TABLE OF CONTENT .6 ABSTRACT...7 INTRODUCTION..

.8 LITERATURE SURVEY.13 OVERVIEW OF COMMERCIAL BANKS IN PAKISTAN20 HOW INTEREST RATES EFFECT YOU.24 FUTURE PROSPECTS..27 PROBLEM STATEMENT..27 THEORETICAL FRAMEWORK.27 HYPOTHESIS.27 METHODOLOGY...27 POPULATION AND SAMPLE SIZE..28 DATA COLLECTION METHOD. .... . . 28 DATA ANALYSIS....28 SAMPLE CHARACTERISTICS.. ...28 CHARACTERISTICS AND MEASURES...28 DATA ANALYSIS METHOD.....29 DATA FINDINGS30 CONCLUSION33 RECOMMENDATION.34 ANNEXURE-135 ANNEXURE-237 ANNEXURE-338 ANNEXURE-439 ANNEXURE-540

ABSTRACT

The main goal of this paper is to study the impact of interest rates changes over banks profitability of commercial banks operating in Pakistan. By analyzing the financial statement using balance panel data for 12 banks for the period 1998-2007. As banking sector efficiency is considered as a precondition for macroeconomic stability, monetary policy execution, and economic growth. Interest spread of the Pakistans 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. Variables were found, based on previous studies. In this model independent variable, which was interest rate (6-month T-bills rate) has been chosen and its effect on CBs profitability has been analyzed. Due to the limitations and constraints, data has been collected for last ten years; much remains to be done to understand the impact of the attributes that may affect CBs profitability. Regression model are tested to determine if rate fluctuations have a significant impact on banks profitability. There is a significant effect of interest rate on the profitability of commercial banks, means the profitability of commercial banks depend on the tool of monetary policy that is interest rate.

INTRODUCTION Over the years, banking system of Pakistan has transformed into a robust, resilient and stable banking system. All of the performance and stability indicators witnessed significant improvement during the last ten years. High profitability and strengthened solvency remained the hallmark of our banking system in recent years. In regional perspective, the Pakistani banking system has been placed among the top ten of the emerging market economies in terms of profits, whereas the capital position has been ranked among the first half of these economies. The stability of the banking sector as a whole is conditional upon the overall stability of the economic environment in applying the basic principles of a market economy and the principles of managing a modern democratic society. A stable macroeconomic environment contributes to the effective growth of savings, sound investment decisions and consequently also to economic growth. Appropriate macroeconomic policy should support the correct functioning of the banking sector mainly in the areas of financial stabilization, transparent fiscal policy and monetary policy support. An important role in ensuring banks stability at the macro- and micro-level is played by the central bank, which through monetary policy and the application of suitable monetary instrument parameters can positively influence the banking sector's stability. The success of a bank also depends on its ability to foresee and avoid risks, possibly to cover losses brought about by risks arisen. Profit is the essential prerequisite of a competitive banking institution and the cheapest source of funds. It is necessary to see it not merely as a result, but also as a necessity for successful banking in a period of growing competition on financial markets. These facts together are the reason for this articles focus on the currently topical issue of bank profitability. In it, we will identify problem areas negatively influencing banks effectiveness to manage their assets and liabilities in aiming to achieve a profit and highlight areas where it might be possible to find room for raising banks profitability. Bank assets are grouped into two main categories fixed and revenue generating assets. One of the basic characteristics of a commercial bank is the rate of creating 3

revenue generating assets from funds obtained. This is an evaluation of the share of revenue generating assets in total assets, which defines the revenue generation ability of assets, where the standard level for revenue generating assets as a share of total assets is taken to be more than 90%. In connection with achieving bank profitability expressed as balance-sheet profit, another particularly important fact is the structure of revenue generating assets. Revenue generating assets mean those asset operations that bring an interest income. These assets are the main source of income for commercial banks. Loans, inter bank assets and securities operations all have an important position in the structure of a bank's assets. It is therefore obvious that the average revenue generation ability of these assets has a decisive influence on a commercial bank's profitability. As financial intermediaries, banks play a crucial role in the operation of most economies. The efficacy of financial intermediation can also affect economic growth. Banks are different from other commercial firms in that they produce financial services, the reward to which is an interest rate, and most of their operations are financed by borrowings, the cost of which is also an interest rate. Interest spread, the difference between what a bank earns on its assets and what it pays on its liabilities, has been on an upward trend during the last few years. An increase in the interest spread implies that either the depositor or the borrower or both stand to loose. In the context of developing economies, the lack of alternate avenues of financial intermediation aggravates the adverse impact of increase in spread. Interest spread also has implications for the effectiveness of the banklending channel. For example, with a commitment to market based monetary policy, the central bank influences the yield on treasury bills (T. bill hereafter) that in turn affects the deposit and lending rates. The change in these rates influences the cost of capital that in turn affects the level of consumption and investment in the economy. If the pass through of the changes in yield on T. bill rate to the deposit and lending rates is asymmetric then this changes the spread, for better or worse, depending upon the nature of asymmetry. If the increase in spread is due to lower return to depositors then this discourages savings; alternatively if it is due to higher charge on loans, investment decisions are affected. In either case the increase in spread has an adverse bearing upon the effectiveness of bank lending channel of monetary policy and has therefore important implications for the economy. Banks are therefore more sensitive to interest rate fluctuations than most other businesses. The effect of interest rate changes on banks profits has been an important issue for the banking industry in recent years. It has been argued that banks exposure to interest rate risk was perhaps the most important factor in precipitating the savings and loans crisis. Whether higher market

interest rates hurt or benefit banks, will have crucial implications for monetary policy and government regulation of interest rates. To date, there is no consensus on whether higher interest rates hurt or help the banking industry. In fact, whether banks are at all sensitive to changes in interest rates is an unresolved issue argued that banks should benefit from rising interest rates, while some have found no significant effect of interest rate changes on bank profitability. Crucially, financial intermediation affects the net return to savings and the gross return for investment. The spread between these two return mirrors the bank interest margins, in addition to transaction costs and taxes borne directly by savers and investors. This suggests that bank interest spreads can be interpreted as an indicator of the efficiency of the banking system. In this research, we investigate how bank interest spreads effect the profitability of CBs. This report extends the existing literature in several ways. First, using financial statements of CBs from FY1998 to FY2007, to collect the summary statistics on the size and decomposition of banks net interest margins and profitability. Second, we use regression analysis to examine the underlying determinants of CBs profitability. Our results show that wellcapitalized banks have higher net interest margins and are more profitable. This is consistent with the fact that banks with higher capital ratios tend to face a lower cost of funding due to lower prospective bankruptcy costs. In addition, a bank with higher equity capital simply needs to borrow less in order to support a given level of assets. This moral hazard problem and the associated risks can lead bank creditors to demand a higher interest rate. Also, for a given risk deposit insurance may lead banks to lend money more cheaply than they otherwise would, depressing net interest margins and profitability. Even banks that do not engage in risky lending strategies themselves may experience a downward effect on interest margins on account of bank competition. Further, high real interest rates are associated with higher interest margins and profitability. The spread or margin between lending and deposit interest rates is a key variable in the financial system. It reflects the additional cost of borrowing related to intermediation activities performed by banks in linking borrowers with the ultimate fund lenders. When it is too large, it 5

can contribute to financial disinter mediation as it discourages potential savers with too low returns on deposits and limits financing for potential borrowers, thus reducing feasible investment opportunities and therefore the growth potential of the economy. A number of factors have motivated researchers to investigate the level and determinants of interest rate margins. Firstly, there has been the need for a better understanding of the behavior of interest rates following the mixed experiences of Scheduled Banks with interest rate liberalization. There has also been the concern that in Pakistan the level and structure of interest rates remained inflexible with high interest rate margins during the post-liberalization period. The use of interest rate margin as a parameter of bank profitability, intermediation cost and financial market efficiency gave impetus to further research. Financial systems in Pakistan normally exhibit significantly and persistently larger intermediation spreads on average than in developed countries. These high spreads have generally been attributed to high operating costs, financial taxation, lack of competition and high inflation rates. Rise in discount rate, CRR and SLR has resulted into increase in lending rate. Basically, CRR is tasked to control excess liquidity in the market. This time simultaneous bps gaining to SLR has also stopped banks from liquidating their investments, which they use to ease flight of liquidity. Compounded with spike in CRR and SLR trenches, liquidity management may become difficult for banks following impending application of ceiling on rate of returns and they would less likely be in a position to offset additional profit loss in any way. On the other hand growth in advances despite draw down in consumer financing and up trend of high interest rate will be able to keep hooked at 10%. Too, this may be because of demand pressure of prospective and ongoing projects that require credit. Also, the research insinuated that in short term banks would be getting higher returns on KIBOR linked advances after rise in discount rate. Concurrently, in long term, it maintained, upward revision of interest rate may have produced fallout in credit flight to 8% in 2009 in contrast to initial projection of 10 % in 2008. Discount rate increased by 150 basis points to 12.0 percent. Increase in CRR for all deposits up to on year maturity by 100 basis point to 9 percent while keeping the CRR for deposits by over one year maturity unchanged at 0 percent. SLR requirement is increased by 100 basis points to 19 percent of the total time and demand liabilities. Bank to pay a minimum profit of 5 percent to the saving account holders. The governments, instead of creating their own money, empower banks to generate credit-based money and then borrow from 6

them. This process continues in definitely making the banks stronger and stronger. The huge government borrowings during the current fiscal year and its disturbing influence on country economy in now talk of the town. The government should not only curtail its borrowing from the banking system but should also put a check on banks powers to create credit-based money. The banking sector has grown due mainly to the favorable environment created partly by the international events and partly by the controlling bodies failure to regulate the banks. The atmosphere is now changed and the banks will no more be able to operate on their own terms in total disregard of the canons of equity and justice. The expected budgetary raise in the government saving schemes profit rates will put further pressure on banks when a sizeable portion of bank deposits will find exit to these scheme. The interest insensitive deposit accounts as proxy for the inelasticity of deposit supply to the banking industry. We view, deposit accounts, other then deposits of fixed maturities as interest insensitive. Thus the ones considered interest insensitive are Current Account, Savings Account and other accounts. The current account does not pay any interest and is thus obviously interest insensitive. The account holder deposits money in this account for features other than generation of interest income. These features include the option to withdraw large sums of money at no or very short notice and the use of banks clearing facilities to execute monetary transactions. A customer may like to have a current account in one or the other bank due to difference, in service quality and location etc. among the banks, but given his reasons for depositing, he cannot take money out of the banking system. Thus for the industry as a unit the supply on this count is inelastic. Savings Account offers relatively low rate of interest as compared to Fixed Deposit Accounts, but allows the depositor to withdraw his money at will without any penalty being charged. The depositors placing money in Savings Account are, typically, small account holders who cannot predict as to when they would have to withdraw. The uncertainty about the timing of withdrawal, short period for which the depositor wants to place money in the bank and smaller amount of money that is available for placement, extremely limits depositors alternate options for placement of funds. This is especially true for Pakistan where capital markets are insufficiently developed, investment in securities traded at stock market is perceived very risky, given the fluctuations in stock prices and other investment opportunities are considered less liquid. In sum, again, for the banking industry as a single unit the supply of deposit in savings 7

account is more or less inelastic. Other deposit accounts constitute a negligible percentage of the total deposits and their inclusion on either side is not likely to alter the results. Interest insensitive and hence their supply to banks as inelastic. Market share of each bank is the banks total deposit as percentage of the total industry deposits. Liquidity is measured as the ratio of liquid assets to total assets. Inelasticity of deposit supply is a major determinant of interest spread whereas industry concentration has no significant influence on interest spread. One reason for inelasticity of deposits supply to the banks is the absence of alternate options for the savers. Banks are raising deposits and offering loans, but there is a difference of spread between the two and it is causing problems and losses to both loan seekers and depositors. Banks have earned on unprecedented profit during the last few years. Some of the banking sector experts say that the average lending rates are not as high as being stated by certain quarters. Banks have lent money even below Kibor in the past. As such interest rates are linked with risk involved, higher the risk higher the interest rate. The lending to blue chip companies below Kibor was a distress move because banks are sitting on tons of money. SBP has increased the reserve requirement percentage with the purpose of reducing the money supply by requiring a larger percentage of banks, and depository institutions, thus taking them out of supply. Due to this increase, banks have lesser money to offer to their clients hence typical demand-supply theory applies here with the lesser money to offer, banks will have to increase lending rates to discourage the borrowers to borrow money from them. Thus, to the extent that the determinants of the spread are distortionary, these problems can be redressed so as to permit interest rate spreads to narrow with positive effects on economic growth and efficiency of resource allocation. Despite the growing consensus about the factors that influence interest rate spreads, there is a dearth of literature quantifying the impact of the various known influences. This study seeks to investigate the issue for the case of Scheduled Banks Incorporated in PakistanOverall with a view to quantifying the influence of various determinants of interest rate spread in Scheduled Banks Incorporated in Pakistan-Overall.

LITERATURE SURVEY A number of studies have examined the determinants of banks interest margin and profitability in many countries around the world. In this literature review Demergu-Kunt and Huizingha (2001) and Demergu-Kunt et al. (2004) papers which constitute our sources of inspiration for the methodology used in this study. They indicate that the best performing banks are those who have maintained a high level of deposit accounts relative to their assets and finally, those who have been able to reinforce their equity. The emergence of fast paced dynamic environment in business world in general and financial services banking sector in particular, has highlighted the significance of competition and efficiency. Banking industry acts as life-blood of modern trade and commerce acting as a bridge to provide a major source of financial intermediation. Thus, appraisal of its efficiency is vital in context of an efficient and competitive financial system. Efficiency of financial service firms and the strategy being followed by them is largely reflected through the information condensed in their balance sheets and profit and loss accounts. That is used for financial ratio analysis there are diverse ways of measuring efficiency of banks. Berger and Humphrey (1997) provide an extensive account of 130 studies that applied different frontier efficiency analysis for 21 countries. The

traditional method of approaching the efficiency measurement issue is the financial ratio analysis. But there is lack of agreement on the relative importance of various types of input or output under this method (Chen and Yeh, 1998, p. 402). This method also does not consider the value of management actions and investment decisions that will affect future as opposed to current performance. It is a short run measure and may be inappropriate for describing the actual efficiency of a bank in the long run (Oral and Yolalan, 1990). Financial ratios give only a restricted, incomplete picture of the process and fail to account for the interactions between the different factors, leading to contradictory results (Mukherjee et al. 2002, p. 124). Bernanke and Gertler (1989). Argue that inelasticity of deposit supply to banks or the interest insensitivity of deposits is also a determinant of spread. Theoretically, changes in T-bill rate are passed on to the deposit and lending rates of the banks. Greater the inelasticity of deposits the less compelled a bank would be to pass on the increase in T-bill rate to deposits, thereby increasing the interest spread. Fixed deposits as percentage of industry deposits have been declining with the decline in interest rate [T.bill rate] The observed negative relationship of interest spread with real output, is in accordance with the business cycles effect The positive relationship of the spread with liquidity is due the fact that as the liquidity increases, the banks appetite for deposits decreases therefore the bank pays less on deposits thereby raising the spread discussed by Barnanke and Gertler (1989). In this backdrop, a visible rise in margins/banking spreads of the banking sector in Pakistan over the last three years should be interpreted with caution. High levels of banking spreads accompanied with the all time high profitability of the banking sector have raised important policy issues related to the efficiency and the degree of competition in the industry. High banking spreads also have strong implications for the stability of the overall financial sector. Low returns to savers have a negative impact on incentives to save, which in turn affects the fund mobilization capacity of the financial sector. On the other hand, high lending rates have negative implications for investment activities in the economy. Brock and Suarez (2000) and Koeve (2003) High net interest margin and profitability tend to be associated with banks that hold a relatively high amount of capital, and with 10

large overheads. On the other hand, we found that macroeconomic variables have no impact on Tunisian banks profitability. Interest rate liberalization has contrasting effect on net interest margins. In fact, partial liberalization has a negative impact on the interest margin whereas complete liberalization strengthens the ability of Tunisian banks to generate profit margin. Tunisia in the 1980-2000 period (Ben Naceur and Goaied) macroeconomic variables does not seem to influence the bank margins. Barajas et al. (1999). While Banks may enjoy deposit inflows if short-term rates continue to be low or get lower, banks may not gain. Since banks borrow short-term funds from depositors and lend for longer terms, their profit margins on loans typically benefit. Bank margins can suffer under low short-term interest rates, though to a lesser extent because banks can lend at longer horizons and to moderate-risk borrowers. This restraining effect on bank profits could have a minor impact on the economy. Owing to low shortterm market interest rates, banks are under pressure to raise fees or minimum balance requirements on short-term accounts. Conceivably, banks might not lower loan rates one-for-one with any further market interest rate declines if their margins are narrowed by a zero bound on deposit rates. Instead, they might tighten credit standards or not ease standards as much as they would have otherwise, which would hurt some less highly rated borrowers. Primarily, interest margin, defined as the difference between incomes from loans and costs of deposits, is the key determinant of the profitability of the local banking industry. Meanwhile, it is expected that interest rate movements will influence interest incomes from loans and interest payments to depositors, and hence the growth of interest margin. The main purpose of this paper is to examine this relationship. Thus the rising interest rates would support the growth of interest margin as well as the profitability of banking sector. Traditional deposit and lending businesses are still the dominant banking activities, and the net interest income (i.e. the difference between interest incomes generated from loans and expenditures on interest payments to depositors) continues to be the major source of profits. Its contribution to bank profits, however, started to diminish in the late 1990s (Cheang 2004). The objective of this paper is to investigate the relationship between interest margin and interest-rate movements in Pakistan techniques such as regression analysis.

11

Interest margin, i.e. the difference between interest income and interest expenses, mirrors the profitability of banks especially when the banks emphasis on traditional deposit and lending businesses. Interest rates are thus one of the key determinants of bank profits. Needless to say, profitability of banks is also responsive to banks specific as well as macroeconomic factors. Jiang et al. (2003) point out that real interest rates are one of the significant positive contributors to profits of banks. The deregulation of the Interest Rate Rules, which reduces the ability of banks to manipulate their lending and deposit margins, have intensified competition and hence add pressure on profitability in Pakistans banking sector. Generally, the higher the net interest margin, the higher are the profit margin. Another empirical study as regards the impact of interest rates on the performance of the Hong Kong banking sector also shows movements in interest rates one of the determinants of the sectors profitability. Peng et al. (2003) indicate that a rise in the Hong Kong dollar risk premium, which is measured by the spread between Hong Kong Dollar and US Dollar interest rates, would influence banks profitability through several channels. One of these channels is net interest margin, which plays a dominant role in retail banks pre-tax return in Hong Kong. According to the estimates on data from 1992 to 2002, it is found that the net interest margin decreases in response to the hikes in risk premium because the deposit interest rates are more sensitive to changes in the risk premium than the lending rates. Financial deregulation is nothing uncommon in most developed countries. European countries have gone through numbers of deregulations. For instance, the privatization of banks has substantially increased competition within the sector. The banking deregulation has also aroused the urge to restructure banks. The banking sector in Portugal, during the late 1980s, witnessed considerable changes when its inflation and interest rates were reduced to levels comparable with those of other European Union members. Reductions in net interest margin for Portuguese banks were observed while the increased interest-rate volatility also caused interest incomes, and hence bank profits, to become more volatile. From a bank's point of view, interest rate margin is a reward for the risk the bank bears. Not only does it compensate for loan default, but also for the risk related to cost of funding. Banks usually borrow short-term funds from depositors and lend longterm loans. Therefore, interest rate margins should cover both spot and future cost of funds. The margin may move up or down depending on the predictions of future short-term interest rate.

12

The principal source of banking fragility is credit risk: the risk of loss resulting from counter party default. According to the related literature, interest rate volatility is a significant determinant of the movement in interest margin. The purpose of this paper is to study the relationship between the changes in loan and deposit interest rates and the change in interest margin in banking sector. The change in interest margin is positively dependent on the spread monetary policy actions that have asymmetric effects on the returns of commercial banks and bank holding companies across different monetary policy and business environments. The effectiveness of monetary policy depends on the states of the economy. However, monetary policy affect the returns of commercial banks It is also observed that the returns of commercial banks and bank holding companies are affected by the direction of surprise monetary policy changes. The interest rate channel of monetary transmission mechanism emphasizes that the changes in monetary policy first affect the bank lending rates and short-term interest rates. These changes are then transmitted to long-term interest rates that then affect business investments and consumer spending. Commercial banks also play an important role in the financial system because they can solve the asymmetric information problem in the credit market. According to the credit view of monetary transmission mechanism (specially the bank lending channel), monetary policy affect bank deposits and loans which in turn affects business investment and consumer spending. The bank-lending channel of the credit view implies that the changes in monetary policy affect both the cost of bank funds and the profitability of the banks. Because of the importance of commercial banks in the monetary transmission mechanism, banks continue to receive special attention from researchers. The overwhelming evidence suggests that bank equity returns are inversely related to interest rate changes. The evidence points to an inverse relationship between monetary policy indicator and bank equity returns. In particular, returns of commercial banks and bank holding companies are more sensitive to monetary policy actions in a concretionary monetary policy environment compared to an expansionary monetary environment. Second, evidence is presented that shows monetary policy actions have asymmetric effects across different states of the economy. Returns of commercial banks and bank holding companies are more sensitive to monetary policy in good business conditions compared to bad business conditions. 13

Financial intermediaries, especially banks are engage in asset transformation function by lending long and borrowing short. The mismatched asset-liability structures make bank stock returns more exposed to interest rate surprises than other types of firms. Flannery and James (1984), Bae (1990), Choi, Elyasiani and Kopecky (1992), Mansur and Elyasiani (1995) among others observe negative relation between bank equity returns and market interest rates. Several studies found out the relationship between changes in monetary policy and market interest rates. Roley and Troll (1984), Smirlock and Yawitz (1985), Cook and Hahn (1988), Dueker (1992) observe positive relation between market interest rates and discount rate. Determinants of interest spread including: (i) market structure of the industry; (ii) bank specific factors; (iii) macroeconomic variables; and (iv) financial regulations. The industrial organization literature predicts that an oliogopolistic market structure may result in higher spreads [Samuel and Valderrama (2006)], though the empirical evidence on this count is mixed. Hannan and Liang (1993) and Barajas, Steiner, and Salazar (1999), among others, suggest that industry concentration may lead to higher spread. However, Classens, and Laeven (2004) argue that a better measure of competition is contestability, proxied by Panzar and Rosse (1987) measure of bank behavioral response. The authors find that contestability is enhanced by free entry and lesser regulations. Ho and Saunders (1981) view the bank as a dealer, a demander of deposit and supplier of loans. According to this study, bank interest margin depends on four factors: (i) the degree of banks management risk aversion; (ii) market structure of the industry; (iii) average size of bank transactions; and (iv) the variance of interest rates. The authors also make the point that a number of imperfections and regulatory restrictions have an impact upon spread. They consider the probability of loan defaults and opportunity cost of holding mandatory reserves as additional variables that influence the spread. Given market power a bank would pay relatively less on its liabilities and earn more on its assets, thereby increasing the spread. Efficient-structure hypothesis on the other hand asserts that concentration is the consequence of the efficient operations of the leading firms in the industry. Because of their efficient operations these firms earn economic or Ricardian rent. To the extent that efficiency is represented by lower marginal cost of producing output of a given quality, banks in concentrated markets should find it advantageous to offer higher interest on loans and charge lower interest on deposits, thereby decreasing 14

the spread. Thus if the efficient-structure hypothesis holds then the coefficient on the concentration variable has a negative sign. The two hypotheses have been tested extensively for the banking industry as well [see Berger and Hannan (1989]. Given that interest spreads can be influenced by macroeconomic environment we control for real output, inflation and the policy interest rate (T. bill rate). Real output growth is included to capture the affect of business cycles discussed by Bernanke and Gertler (1989). The authors argue that borrowers creditworthiness is countered cyclical. The reason is that slowdown in economic activity affects borrowers fortunes and hence their creditworthiness. The change in creditworthiness would affect the lending rate charged to the borrower that would be reflected in the changed spread. Inelasticity of deposit supply has a positive and significant impact on spread whereas concentration does not cause a statistically significant influence upon interest spread. Very high level of inelastic deposit supply leaves little incentive to the bankers to adopt competitive practices and therefore the concentration ratio, which captures the level of competition, fails to exercise an influence upon spread. During recession the creditworthiness of the borrower declines and therefore he can borrower only at a higher interest rate, and this raises the spread. Therefore a negative relationship between spread and real output. The positive relationship of the spread with liquidity is due the fact that as the liquidity increases, the banks appetite for deposits decreases therefore the bank pays less on deposits thereby raising the spread. Finally the positive relationship of the spread with market share implies that higher market share gets translated into higher market power thereby enabling the bank to raise the spread to the detriment of its customers. Its noteworthy here that an ambiguous sign on market share because increase in market share may allow the bank to reap scale economies and thereby allow the bank to transfer some of the benefits to its customers in the shape of lower spread. The fact that the sign on market share is not negative implies that scale economies perspective is not valid in case of Pakistans banking industry. Banking mergers and acquisitions under the purview of antitrust authority. Given the specific features of banking industry in Pakistan such as the non-existence of financial intermediaries that can serve as an alternative to banks for small savers, inelasticity of deposit supply to banks as a determinant of interest spread. The results show that inelasticity of deposit supply has a positive and significant impact on spread whereas concentration does not cause a statistically significant influence upon interest spread. The very high level of inelastic deposit 15

supply leaves little incentive to the bankers to adopt competitive practices and therefore the concentration ratio, which captures the level of competition, fails to exercise an influence upon spread. The emergence of alternate financial intermediaries is essential for lowering the spread. Meanwhile, the regulator can perhaps play some role in lowering the spread. Another possibility in explaining the asymmetric effect of monetary policy on the returns of commercial banks and bank holding companies across different monetary policy environments is that the interest rate on liabilities may adjust faster than the interest rates on assets for commercial banks and bank holding companies in response to a decrease in the funds rate, leading to a significant policy response of commercial banks and bank holding companies in the concretionary policy period. The findings of Hannan and Berger (1991) are that the deposit rates are significantly more rigid when the stimulus for a change is upward, rather than downward. In addition, there are a number of studies explaining the trend and pace of change in interest rates as a function of the market concentration and interest elasticity of deposit and advances (Neumark and Sharpe 1992). Similarly, there are findings that the spread tends to widen when interest rates rise and narrow when interest rates fall (Hutchison 1995). Here it is essential to recall that when in Pakistan the benchmark interest rates were falling, i.e., during FY03 and FY04, the banking spread was squeezing as the fall in lending rates was sharper compared with the fall in deposit rates. There is a relation between competition in the financial sector and monetary policy, which are worth flagging. Competition in the financial sector appears to be a little more complicated than in the non-financial sector. It has been enhanced in both banking and Non-banking financial sectors has been gradually introduced through a dynamic mix of private and public as well as domestic and foreign ownership along with deregulation or adaptive regulations. Simultaneously regulation and supervision of banks financial markets and infrastructure were improved to align them with international Standards and best practices. The implications of enhanced competition in financial Sector for monetary policy are: First is the positive impact on both growth and price stability especially due to the competitive pressures in the banking sector. Bank finance still dominants the financing of the 16

corporate sector through loans and advances, subscription to corporate bonds as also assisting in overseas operations in several ways, both in trade and investment. Second in view of the enhanced competition there is a clear evidence of improved monetary transmission mechanism both through interest rate and credit channels. Third increasingly competitive financial markets are playing enhanced feedback role in the financial system. They help us not in terms of information content on yield curves, but also in gauging market expectations and designing better communications. The widespread notion that commercial bank borrow short and lend long implies that sharp market interest rate increase may induce a significant number of banking failures. Regression models are tested to determine if market rate fluctuations have a significant impact on bank profitability. The conclusion is negative: large banks have effectively hedged themselves against market rate risk by assembling asset and liability portfolios with similar average maturities. (Mark J. Fiannery). The role of ordering the structure of assets and liabilities is to manage the net interest margin, mitigate the risk of interest rate changes, where presently these are one of the most serious risks to which commercial banks are exposed. The sensitivity of assets and liabilities to interest rate changes is an important issue. This sensitivity enables a bank to change the structure of its assets and liabilities so as to minimize the negative effect of a change in interest rates, or, conversely, to exploit positive changes fully. Assets sensitive to interest rate changes include those reaching maturity in the near future, assets with reprising, and a part of assets that are amortized over a defined time period. Sensitive liabilities, on the other hand, include those payable in the near future, liabilities with reprising, and those liabilities, which it is assumed, will be withdrawn, as well as for example a part of deposits without any term of notice. As regards assets and liabilities sensitive to interest rate changes denotes the ratio of these assets to liabilities as an indicator of the risk of a fall in profits. Sensitivity of liabilities is characterized as negative also due to the fact that the management of liabilities is more complex. Often market influence is stronger than a bank's capacities. Conversely, in the case of asset operations a bank can change its structure more easily. In the case that liabilities sensitive to interest rate changes are greater than assets correspondingly sensitive, a rise in interest rates has a negative 17

effect on profits, since the increase in the cost of funds, i.e. those concerning liabilities sensitive to interest rate changes, will be greater than the revenues gained through the increase in interest on sensitive assets. If, however, a fall in interest rates is expected, then such a structure is appropriate. The opposite situation occurs where assets sensitive to interest rate changes are greater than sensitive liabilities. In this case a rise in interest rates is more advantageous for the bank than their fall. The structure of bank assets and liabilities sensitive to interest rate changes influences the development of the net interest margin and thereby also a bank's profitability. Therefore it is important for a bank to adjust the structure of its assets and liabilities in accordance with the expected development of interest rates, which will have a positive influence on its profitability. The profitability of a commercial bank is influenced also by its interest rate policy. Here the decisive factor is a bank's ability to set such an interest rate for asset deals that meets costs of outside funds, operating costs, as well as the required rate of profitability and ensures that the predicted risk of these assets is covered. The significance of interest is influenced also by the fact that revenue-generating assets represent a decisive part of the assets and outside funds comprise a substantial part of the banking sector's liabilities. The relationship between interest income and interest expenses is described as the interest rate margin. A more precise indicator is the net interest margin. This indicator gives a more precise economic depiction of a banks profit environment. The net profit margin describes the bank's ability to create assets from funds that lead to the creation of revenues enabling it to cover costs ensuing from the bank's activity. Its normal level is 4.5%. A fall below this level means a risk that the mutual interrelationship of the decisive revenue items (interest incomes) and costs (interest expenses) in the current creation of other revenues and costs will probably be reflected in a loss. With regard to the high share of interest incomes and expenses in a bank's total revenues and costs, managing the net interest margin is key to a bank's ability to achieve a profit. J. Makch (1996). OVERVIEW OF COMMERCIAL BANKS IN PAKISTAN The banking system has further consolidated its resilience against adverse shocks during September 2007 quarter on the back of strong capital base. In addition, continued healthy profitability of the banking system helped to absorb the additional burden of incremental non-performing loans (NPLs) 18

during the quarter. The Return on Assets (ROA) remained healthy at 2.0 percent, whereas, the Return on Equity (ROE) of the banking system marginally declined to 20.0 percent, as compared to 20.6 percent in Jun-07 at the back large increase in paid up capital of the banks. The assets of the banking system witnessed modest decline during Sep-07 quarter, though the JanSep 2007 cumulative increase in the assets of the banking system remained above the increase recorded in the corresponding periods of CY04-CY06. The slowdown in loans and advances continued, as a result, their share in the total assets decreased marginally to 50.4 percent in Sep-07 quarter, bringing the Jan-Sep 07 cumulative decline to 5.4 percentage points. In fact, the loans and advances component has decreased in absolute terms; due to persistent deceleration in credit to the private sector primarily coming from slowdown in consumer loans and decrease in working capital and commodity financing. On the other hand investment portfolio of the banking system continued to enhance its weight during Sep-07 quarter. The share of investment in total assets rose by 2.8 percentage points during Sep-07 quarter, reached 26.6 percent; bringing the cumulative Jan-Sep 07 increase to 7.3 percentage points. Overall, operating performance of the banking system further strengthened during Jun-07 quarter. Both the core and non-core income contributed to the healthy profits. The before and after tax profits reached Rs102.8 billion and Rs68.4 billion respectively in Sep-07 and constitute 83 percent and 81 percent of CY06 fullyear profits. After tax ROA maintained the last quarter level of 2 percent. Further, ROE declined marginally by 0.6 percent to 20 percent. The profit & loss composition of commercial banks (CBs) has witnessed a slight change. The share of net interest income in the gross income, which registered a slight decline of 2.5 percent to 70.5 percent in Sep-07, was counterbalanced by the corresponding rise in the other non-interest income by 2.6 percent to 12.5 percent in Sep-07. Particularly, other non-interest income almost doubled during the quarter from Rs13 billion to Rs25.9 billion in Sep-07. The slow increase in interest income may be attributed to declining interest rate spread between the weighted average rates on incremental loans and fresh deposits. The spread dropped down to 4.4 percent in Sep-07 from 5.0 percent in Jun-07. The return on fresh deposits increased to 6.0 percent as compare to 5.3 percent in Jun-07. The future growth projections of the economy suggest that the current growth momentum in the banking system may prevail in the near future. The deposits are expected to maintain their previous growth trend on the back of steady flow of workers remittances and substantial foreign exchange inflows in the form of FDI. Loans 19

may follow growth trends of major sectors of the economy and would heavily depend upon the demands of both the corporate and consumer sectors and also the movements in interest rates. In terms of profitability of the banking system, the year 2006 proved to be yet another milestone. The profits, before and after tax, kept their pace of growth on the back of growing levels of high yield earning assets coupled with the well supporting noninterest income. As a result, pre-tax profit of the banking system crossed the Rs100 billion mark and reached to Rs123.6 billion in CY06. Similarly, after-tax profit also increased to Rs84.1 billion compared to Rs63.3 billion in CY05. The rapid development in computer and telecommunication technologies is transforming the present branch banking into highly integrated next generation multi-channel online banking. The e-banking technology has enabled the institutions to offer their services 24/7, cross border and in any currency. Banks in Pakistan have started offering their services through alternate delivery channels of e-banking such as Automated Teller Machines (ATM), Point of Sale (POS), Internet, Call Center, Interactive Voice Recognition (IVR), Mobile telephone, and Real Time Online Banking. The growth in e banking witnessed in last 6 years both in terms of numbers and value is phenomenal and this has made the banking sector more attractive for market. CY06 proved to be another good year in terms of growth in e-banking activities thus increasing the number of banks and online branches offering e-banking solution. Out of 39 banks, 30 banks are offering ATM service, 26 banks provide online banking facility, 16 have POS terminals, 10 are offering call center banking and 12 banks have internet banking programs. Numbers of on-line branches have increased significantly to around 4 thousand in CY06 Commercial banks have been exposed and withstood several types of pressure since 1997. Some of these are: 1) multiprolonged reforms introduced by the central bank, 2) freezing of foreign currency accounts, 3) continued stagnation in economic activities and low growth and 4) drive for accountability and loan recovery. All these have brought a behavioral change both among the borrowers as well as the lenders. The risk aversion has been more pronounced than warranted. Commercial banks operating in Pakistan can be divided into four categories: 1) Nationalized Commercial Banks (NCBs), 2) Privatized Banks, 3) Private Banks and 4) Foreign Banks.

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The banking sector has gone through massive changes during the last decade. Marked with shift in ownership from public to private sector, mergers and acquisitions, significant improvement in the quality of human resource base, huge technological up gradation, and introduction of variety of products and services; the banking industry is consolidating its profitability. Maintaining the strong growth momentum of the preceding years, deposits increased by Rs441 billion surpassing the growth of Rs430 billion in CY04. Resultantly, the system did not encounter any serious liquidity drain because of the continuing tight monetary policy stance of SBP to check high inflation rate. Thus, the banking system was able to finance high credit demand by the various sectors, which is expected to help the economy to get near the targeted GDP growth rate for the current fiscal year. Strong earnings and profitability profile of banks reflects the ability to support present and future operations. More specifically, this determines the capacity to absorb losses, finance its expansion programme, pay dividend to its shareholders and build up adequate level of capital. Being front line of defense against erosion of capital base from losses, the need for high earnings and profitability can hardly be overemphasized. Although different indicators are used to serve the purpose, the best and most widely used indicator is return on assets (ROA). Net interest margin is also used. Since NCBs have significantly large share in the banking sector, their performance overshadows the other banks. However, profit earned by this group resulted in positive value of ROA of banking sector during 2000, despite losses suffered by ABL. Pressure on earnings was most visible in case of foreign banks in 1998. The stress on earnings and profitability was inevitable despite the steps taken by the SBP to improve liquidity. Not only did liquid assets to total assets ratio declined sharply, earning assets to total assets also fell. T-Bill portfolio of banks declined considerably, as they were less remunerative. Foreign currency deposits became less attractive due to the rise in forward cover charged by the SBP. Banks reduced return on deposits to maintain their spread. However, they were not able to manage the decline in ROA due to declining stock and remuneration of their earning assets. The weighted average lending rates have improved due to general increase in interest rates. Over the years there has been a declining trend both in lending and deposit rates. Downward trend in lending rates was due to SBP policy. The realized trend in lending rates was in line with monetary objectives of SBP, 21

though achieved with lags following the sharp reduction in T-Bill yields in year 1999, needed to induce required change in investment portfolio of banks. Downward trend in deposit rates was almost inevitable. One can argue that banks should have maintained, if not increased, their deposit rates to arrest declining growth in total deposits. However, this was not possible at times of eroding balance sheet, steady earnings were of prime importance. Consequently banks tried to find creative ways of mobilizing deposits at low rates. However, due to inefficiencies of the large banks, the spread has remained high. Fiscal year 200405 witnessed a gradual shift in monetary policy stance, as rising inflation-attracted response from the SBP. Although it raised interest rates until March 2005, monetary policy largely remained accommodative to support economic recovery; the weighted average lending rates remained negative in real terms and private sector credit rose by a record Rs. 428.8 billion during the year. The sharp pick up in inflation in April 2005 changed the SBPs monetary policy stance from measured to aggressive tightening a policy still being pursued. The weighted average lending rates of commercial banks have declined from 14.0 percent in June 2001 to 9.36 percent by February 2003 as a result of the cut in SBP discount rate of 650 basis points to 7.5 percent. At the same time, the weighted average deposit rate has also declined from 6.2 percent to 3.0 percent during the same period. Thus, 68 percent cut in lending rate was made possible by cutting deposit rate by commercial banks. The discount rate cuts to the extent of 650 basis points have yet to produce desirable result in bringing the spread (the difference between the average lending and deposit rates) down to an acceptable level of 3.0 percent. It is, nevertheless, encouraging to note that banking spread has declined from 7.8 percent in June 2001 to 6.32 percent by February 2003. The spread is expected to come down further owing to declining NPLs and pressures on banks to cut lending rate and lend more to the private sector in view of the very low yields on government papers. Fiscal year 2004-05 witnessed a gradual shift in monetary policy stance, as rising inflation-attracted response from the SBP. Although it raised interest rates until March 2005, monetary policy largely remained accommodative to support economic recovery; the weighted average lending rates remained negative in real terms and private sector credit rose by a record Rs 428.8 billion during the year. The sharp pick up in inflation in April 2005 changed the SBPs monetary policy stance from measured to aggressive tightening a policy still being pursued. The rising interest rates 22

will severely effect industrial production and to directly hit economic growth of the country. The year 2005 has been a very profitable year for the banking industry in the back drop of rising interest rates and healthy growth in lending to the private sector across all sectors; industry, agriculture and services. The banking sector has not only benefited from substantial growth in the economy during the past few years but has also been an engine of growth, Confidence in the economy coupled with low interest rates and accommodative monetary policy in the last few years has improved investment and credit intake.

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HOW INTEREST RATES EFFECT YOU Interest rates are kind of like mood rings: When they're low, you feel all warm and radiant. But when they rise, the whole world grows dark and cold. Especially if you're big on using credit cards. As a general rule, lower interest rates are best for the economy. When people can afford to borrow money because they don't have to pay a high interest rate, they tend to do just that. Youve got to spend money to make money. Spending money helps the economy grow. A few of the financial transactions that benefit from a low-interest rate environment include: 1). Mortgage loans 2). Home equity loans and lines of credit 3). Credit card purchases 4). Car loans 5). Stock market investments. They affect how much more you have to pay a credit card company above and beyond the amount you charged. They make your house payments rise and fall. They make your investments rise and fall. But what makes interest rates rise and fall. Interest rates as a means of controlling economic growth. If the economy grows too fast, it will experience inflation. That's when prices rise so high that no one can afford anything. Changes in real interest rates affect the public's demand for goods and services mainly by altering borrowing costs, the availability of bank loans, the wealth of households, and foreign exchange rates. For example, a decrease in real interest rates lowers the cost of borrowing; that leads businesses to increase investment spending, and it leads households to buy durable goods, such as autos and new homes. In addition, lower real rates and a healthy economy may increase banks' willingness to lend to businesses and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks. Lower real rates also make common stocks and other such investments more attractive than bonds and other debt instruments; as a result, common stock prices tend to rise. Households with stocks in their portfolios find that the value of their holdings is higher, and this increase in wealth makes them willing to spend more. Higher stock prices also make it more attractive for businesses to invest in plant and equipment by issuing stock.

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In the short run, lower real interest rates also tend to reduce the foreign exchange value, which lowers the prices of the produced goods we sell abroad and raises the prices we pay for foreignproduced goods. This leads to higher aggregate spending on goods and services produced. The increase in aggregate demand for the economy's output through these different channels leads firms to raise production and employment, which in turn increases business spending on capital goods even further by making greater demands on existing factory capacity. It also boosts consumption further because of the income gains that result from the higher level of economic output. Changing the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation. The SBP set an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy. A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers and firms cash flow a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased. Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing homeowners to extend their mortgages in order to finance higher consumption. Higher share prices raise households wealth and can increase their willingness to spend. Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the Pakistan relative to overseas would give investors a higher return on assets relative to their foreign-currency equivalents, tending to make Pakistan assets more attractive. That should raise the value of PKR, reduce the price of imports, and reduce demand for PK goods and services abroad. However, the impact 25

of interest rates on the exchange rate is, unfortunately, seldom that predictable. Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers expectations of inflation an important consideration for the eventual settlement. The impact on output and wages feeds through to producers costs and prices, and eventually consumer prices. Some of these influences can work more quickly than others. And the overall effect of monetary policy will be more rapid if it is credible. But, in general, there are time lags before changes in interest rates affect spending and saving decisions, and longer still before they affect consumer prices. We cannot be precise about the size or timing of all these channels. But the maximum effect on output is estimated to take up to about one year. And the maximum impact of a change in interest rates on consumer price inflation takes up to about two years. So interest rates have to be set based on judgments about what inflation might be the outlook over the coming few years not what it is today. While lower interest rates are fueling the local housing market and promoting greater capital spending among businesses, there's a downside: Some of larger banks have begun to notice a pinch on their profits. It's always a mixed bag as far as the banking industry is concerned Lower interest rates certainly contribute to higher corporate profits. That's the good news. On the other hand, it clearly puts pressure on a bank's margin." That is, rates paid to depositors are being pushed down as a result of lower interest rates. Ultimately, a bank's profits could be affected by the rate reduction. There has not been much difference between short-term and long-term rates. Typically, the long-term loans are those that have the highest rates, and short-term, the lowest. Yet recent rates have, at times, nearly mirrored one another. Low short-term rates and long-term rates go higher as the time frame (or yield) goes out"(But) there have been points in time where 10-year rates were lower than three-month rates." And while lower interest rates may have a negative side, all agree it also lends itself to more business. "The lowering of rates impacts the portfolio of business you have, but I think it also may stimulate new business opportunities."

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FUTURE PROSPECTS Considering the minimum capital requirements of SBP, it is foreseen that quite a number of banks would merge in order to comply with regulatory requirements and bring operating efficiency into their midst. PROBLEM STATEMENT

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In Problem statement, first of all I would like to discuss impact of interest rate changes over banks profitability. In first hypothesis I would analyze relation between interest rate & net interest margin. In which I will take T-bills rate and Net interest margin. And in second hypothesis just simply I will find out the relation between interest rate and return on assets. In which I take T-bills rate and Return on Assets. And in last hypothesis I analyze relation between interest rate and return on equity. In which I take T-bills rate and Return on Equity. This three hypothesis are main ingredients to measure banks profitability. This will help me to conclude my final result. THEORETICAL FRAMEWORK Various measures have been used to find out impact of interest rate changes over banks profitability? HYPOTHESIS The hypothesis to be tested are: H0-1: There is no significant relation between interest rate & net interest margin. H0-2: There is no significant relation between interest rate and return on assets of CBs. H0-3: There is no significant relation between interest rate and return on equity of CBs. METHODOLOGY The methodology to be adopted for the subject study would be as follows:

POPULATION AND SAMPLE SIZE The population for the subject study would be all the financial statements of CBs. The sample size would be 28

ten-year financial statements of 12 CBs, 15 articles from the Journal of Finance, SBP Publications and other related material on Internet. DATA COLLECTION METHOD The subject study would be based on secondary sources. Annual reports, Books, statistical periodicals and Internet have been used for collecting the required data. DATA ANALYSIS The data collected would be studied in detailed for inferring the accurate result. SAMPLE CHARACTERISTICS Financial statements for ten different years of 12 CBs and SBP publications are used for collecting the data and its analysis. Data has been collected from FY1998 to FY07. The selection of these years based on purposeful sampling. These years represent the trend almost during the last decade. CHARACTERISTICS AND MEASURES Several measures have been used to find out the impact of interest rate on the profitability of CBs. Interest rate T-bill rate (6 months) 6 months T-bill rate has been taken because banks generally invest in short terms securities and make advances for long terms. It has been concluded from the literature survey. Profitability measures: Net interest margin in %: Net interest income divided by interest income multiply by 100 is the formula to find out the net interest margin. Return on assets in %:

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Earning before taxation divided by total assets multiplies by 100 is the formula used to find out ROA. . Return on equity in %: Earning before taxation divided by total equity multiplies by 100 is the formula used to find out ROE. DATA ANALYSIS METHOD The data were analyzed by using the following model. THE REGRESSION MODEL This research study uses the simple regression analysis. The data has been collected for the last Ten years on interest income and net interest income for twelve banks. Then Interest income and net interest income has been taken to find out the net interest margin of overall CBs. 6 months T-bill rate has been taken as independent variables. Simple regression analysis has been applied on the data to find relationship between interest rate and CBs profitability. DATA FINDINGS After comprehensive calculations of the collected data, the findings are:

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FOR NET INTEREST MARGIN: SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square 0.743666746 0.55304023 0.497170258

Standard Error 12.3025496 Observations 10

ANOVA df Regression Residual Total Significance SS MS F F 1498.19562 1498.1 9.89870 0.01367623 1 7 96 26 8 1210.82181 151.35 8 3 27 9 2709.01744

Coefficien Standard ts Error t Stat P-value 77.356185 4.319EIntercept 65 9.654594435 8.01237 05 3.6968331 - 0.013676 X Variable 1 98 1.175007713 3.14622 2

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X- TBR = Independent variable Y - NIM = Dependent variable It has been analyzed from the result given above that there is substantial relationship between T-bill rate and net interest margin. P value is 0.01, which is lower than the alpha that is 0.05 reject the null hypothesis. The Coefficient for the variable Treasury bill rate is -3.696, which shows the negative relationship between the two variables. R2 is 0.55 that shows that the model is fit for the analysis and variable X has explained 55% variation in variable Y. The result rejected HO-1 H0-1: There is no significant relation between interest rate & net interest margin.

FOR ROA: SUMMARY OUTPUT

Mod el 1

Adjuste Std. Error R dR of the R Square Square Estimate .798(a) .636 .575 .57905

ANOVA

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Mode l 1

Sum of Square s Regress ion Residua l Total 3.517 2.012 5.529

df 1 8 9

Mean Square 3.517 .335

F 10.489

Sig. .018(a)

Mod el

Unstandardized Coefficients Std. B Error (Consta nt) tbr 2.430 -.151 .428 .047

Standardi zed Coefficien ts Beta

Sig.

5.677 -.798 -3.239

.001 .018

The result given above shows that the coefficient of determination is 0.636 & according to the value of R 2, the fitness of the model is not that much high and beta value is 0.798. It means there is negative co-relation between Return on Asset and Treasury bill rate. The Coefficient value of variable Treasury bill rate is 0.151 that means if T-bill rate increases and Return on Asset decreases. Standard error is 0.047 that means TBR is significant determinant of CBs profitability. The result rejected H0-2 2 H0-2: There is no significant relation between interest rate and return on assets of CBs.

FOR ROE: SUMMARY OUTPUT

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Regression Statistics Multiple 0.630891055 0.398023523 0.322776463 12.04059874 10

R Square Adjusted R Square Standard Error Observatio ns

ANOVA df Regressio n Residual Total 1 8 9 SS MS F Significanc eF

766.8587 766.8587 5.289555 0.05047844 416 42 8 1 1159.808 144.9760 145 18 1926.666 886

Intercept X Variable 1

Coefficient s 38.860169 66 2.6448635 98

Standard Error 9.449024 912 1.149988 975

t Stat P-value 4.11261 0.003378 162 4 2.29990 34 0.01

The R2 is 0.39, which indicates that about 39% of the variation on the dependent variable is explained by the independent variable, which is slightly stronger. The result given above shows that there is significant relationship between Treasury bill rates and 34

ROE. The P- value is 0.01 that is lower than the alpha that is .05, also prove are finding. On the basis of findings, the null hypothesis is rejected. The value of Coefficient is 2.644, which shows the negative relationship between ROE and TBR. The result rejected H0-3 H0-3: There is no significant relation between interest rate and return on equity of CBs.

CONCLUSION The objective of this paper has been to evaluate the effects of interest rate in the profitability of CBs. It has been concluded that interest rate specially 6 months Tbills rate is significantly related to the profitability of the commercial banks. The regression analysis also proves the findings. All the measures of profitability are significantly affected by the interest rate. There is positive correlation (that is 0.2867) between spread and T-bill. So as T-bill rate increases, spread also increases. A short-term interest (T-bill) rate is one of the determinants of CBs profitability. There is a significant effect of interest rate on the profitability of commercial banks, means the profitability of commercial banks depend on the tool of monetary policy that is interest rate. This alarming fact reveals that monetary policy which is announced by the Central Bank SBP; take decision about profitability of commercial banks. SBP announces interest rate because the Pakistani financial market is not running in perfect market economy. Net interest margin, Return on Assets and Return on equity of all Commercial Banks are significantly related to the 6 months T-bill rate. If through monetary policy, profitability of CBs can be altered then it means that government can easily take corrective measures to make the other financial markets profitable. Net interest margin is highly associated with interest rate. Finding shows that markup income is based on interest rate. This trend is highly risky. Specifically, in an increasing interest rate environment, a rise in lending rates is generally larger than the rise in deposit rates, which results in pushing up the banking spread. On the other hand, in a declining interest rate scenario, the opposite is likely 35

happen. Besides these changes in banking spread due to base effect, the magnitude of spread is also affected by different adjustment lags of lending and deposit rates. Specifically, when interest rates are rising, lending rates tend to adjust more quickly (in terms of time) than the deposit rates, while in a declining interest rate scenario, deposit rates adjust faster than the lending rates. The lack of competition in the banking sector is too much. The mergers are more likely to take place essentially in small banks. Even if mergers do take place between small and big banks, cost will reduce with out conferring any monopolistic power to these banks. This will also help in stability of the financial sectors, which is one of the concerns of SBP. So the best policy option for SBP is to encourage mergers, while keeping a check on interest spread, so the benefits from reduction in cost due to mergers are passed on the depositors and borrowers.

RECOMMENDATIONS: CBs can decrease unsystematic risk through diversification & focusing on non-interest income. Bank can reduce their dependability through focusing on other factors like improving bank credit standards. Bank can change the situation by adjusting the spread. Government should transform the economy into market economy gradually and slowly; it can reduce the effect of interest rate on the CBs profitability. Bank must be conscious about capital adequacy ratio to bear the shock in case of abrupt changes in interest rates. Moderate Credit standards are preferable to avoid failure in banking sectors It is feared that a further increase in the discount rate and augmented SLR and CRR requirements are likely to add to the cost of deposits, slow down advances growth and marginally lower lending spreads. Paid up capital requirement of Rs.6 billion until 2009 by the SBP shall encourage further consolidation in the sector.

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Instruments with higher returns are likely to be a threat to banks deposit base. Lending rates and yield on earnings assets are likely to average around 9.8 and 8.6 per cent during 2006-2011. Deposit rates and cost of interest liabilities both are expected to average around 6.9 per cent during the 2006-2011 period. Money supply is expected to grow by an average of 12.8 per cent during 2006-2011. The presence of rising ratio of advances to deposits, and mismatches in the maturity profile of assets and liabilities shall continue to radiate higher liquidity risk. Demand for higher returns on deposits due to the launch of government instruments with higher returns is likely to be a threat to banks deposit base. For lessening the impact of this risk, conservative growth in advances and deposits has been taken; bringing down the ADR to a sustainable level of 68.8 per cent by 2011. Commercial Banks in Pakistan really witnessed a boom during the last 6/7 years-thanks to Shaukat Aziz pro-elite economic policies. He was a banker by profession and during 5 years tenure be may have destroyed the economy of the country for overwhelming majority of the people. But give the devil his due, as a banker he has made the banking as on of most prosperous industry of Pakistan. The CBs in Pakistan multiplied their profits during the last 6/7 years by exploiting their depositors through cartel like behavior. There has been a gap of 7 to 8 percent between what the banks in Pakistan were paying to the depositors and what they were charging from their borrowers, which has no parallel in the world. Banks management should logically focus on improving the quality of managing their bank profitability. It seems the extended honeymoon period for CBs is over.

(ANNEXURE-1) REFERENCES: Afanasieff T., P. Lhacer and M. Nakane. 2002. The determinants of bank interest spreads in Brazil , Banco Central di Brazil Working Papers.

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Abdul Qayyum, Sajawal Khan. X-efficiency, Scale Economies, Technological Progress and Competition: A Case of Banking Sector in Pakistan Ali Awdeh. Domestic banks and foreign banks profitability: Differences and their determinants Asli Demirg-Kunt and Harry Huizinga. Determinants of commercial bank interest margins and profitability: some international evidence Archer, David (2005), Central Bank Communication and the Publication of Interest Rate Projections, manuscript, Bank of International Settlements. Bali, T., 2003, modeling the stochastic behavior of short-term interest rates: Pricing implications for discount bonds, Journal of Banking and Finance. Jose A. Lopez, Miguel A. Ferreira Evaluating Interest Rate Covariance Models within a Value-at-Risk Framework. Glenn D. Rudebusch, Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections. Gilbert, R. Alton, and Robert H. Rasche, 1980, Federal Reserve Bank membership, Effects on bank profits, Journal of Money, Credit and Banking Hanson, J. A., and R. R. Rocha (1986). High Interest Rates, Spreads, and the Cost of Intermediation: Two Studies, World Bank Industry and Finance Mark J.FLANNERY, Market Interest Rate and Commercial Bank Profitability. An Empirical Investigation Margarida abreu, commercial bank interest profitability: evidence for some Eu countries. margins and

Samy ben naceur, mohamed goaied. The determinants of Commercial bank interest margin and profitability: evidence from Tunisia Ing. Viktria Bobkov, csc. Raising the profitability of Commercial banks.

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Idrees Khawaja, Musleh-ud Din Determinants of Interest Spread in Pakistan. Dr. Shamshad Akhtar, Pakistan - Economic Outlook and Prospects Pakistan Research Daily Call (ALFALAH SECURITIES). Iftekhar Hasan, Bank Of Finland Discussion Papers. Aharony, J.Saunders, A.; and Swary, I.1986 Journal of Monetary Economics. K. Jankee. Bank of Mauritius Annual Report.

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(ANNEXURE-2) END NOTES 1) 2) 3) 4) 5) CBs: Commercial Banks ROA: Return on assets. ROE: Return on equity. TBR: T-bill rate NIM: net interest margin

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(ANNEXURE-3) Banks Included in the Study 1. Allied Bank of Pakistan 2. Askari Bank Limited 3. Al-Habib Bank Limited 4. Habib Bank Limited 5. Alfalah Bank Limited 6. Muslim Commercial Bank 7. National Bank of Pakistan 8. Soneri Bank Limited 9. United Bank Limited 10. Faysal Bank Limited 11. Bank of Punjab 12. PICIC Commercial Bank

41

(ANNEXURE-4)

80 72.11 68.01 67.32 70 59.01 54.32 60 48.21 50 41.23 32.29 40 27.65 30 25.41 20 7.38 7.68 7.82 8.49 9.52 4.71 5.46 6.02 5.14 5.3 10 0

NIM spread

98

99

00

01

03

04

05

06
5.81

02

20

20

20

20

20

19

19

20

20

15 10

13.45

12.87 11.16 9.53 6.81 7.23 5.58 3.35 2.1 1.77 4.23 10.95

20

5 0

4.96

2001 2002 2003 2004 2005 2006 2007

07

Lending rate Deposit rate

42

80 70 60 50 40 30 20 10 0
25.41 11.87 27.65 32.29 48.21 41.23 67.32

72.11

68.01 59.01 54.32

TBR NIM
8.25 1.76 2.52 8.53 8.96

10.1

10.96

7.93

4.32

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

(ANNEXURE-5) DATA:
1998 T-bills rate Spread 1999 2000 2001 2002 2003 2004 2005 2006 2007

11.87 7.38

10.1 7.68

10.96 7.82

7.93 8.49

4.32 9.52

1.76 4.71

2.52 5.46

8.25 5.3

8.53 6.02

8.96 5.14

MARK-UP/ RETURN/INTEREST EARNED

1 2 3 4 5 6 7 17,033,2 15,385,8 10,369,9 9,083,86 17,756,2 25,778,0 31,786,5 MCB 25 69 94 3 32 61 95 26,738,4 23,956,1 19,049,9 18,198,7 31,041,8 42,152,5 50,481,0 HBL 46 14 14 25 63 20 21 4,754,34 3,046,24 2,074,61 2,753,45 6,338,05 9,728,04 11,610,7 FAYSAL 220318118536962291575 7 6 1 1 1 6 81 2,590,95 2,776,41 2,403,48 2,432,10 4,935,62 7,857,74 9,945,87 AL-HABIB 213562618786101961055 7 7 9 6 6 5 2 8,276,83 7,497,08 4,984,60 5,244,71 9,892,05 17,215,5 21,201,4 ABL 605906072874328,115,062 6 1 7 0 1 07 22 3169937 3127704 31,290,5 27,126,8 19,452,3 20,947,3 33,692,6 43,788,6 50,569,4 NBP 1 7 29677937 84 39 17 33 65 28 81 1,046,52 1,776,50 1,869,08 2,336,41 4,171,89 5,795,97 6,999,88 PICIC 702311 11100701009074 6 1 3 2 0 9 8 11,468,0 11,020,0 8,944,26 9,233,88 20,158,8 3299160 41,045,5 UBL 8699226986167610416460 51 35 0 1 60 3 43 98 99 0 1719780 1575599 5 0 14126332 2480777 2385520 4 9 25407135

43

ASKARI BOP SONERI ALFALAH MARKUP INCOME

4,250,91 4,858,25 4,073,71 4,487,20 8,780,69 1259692 15,143,2 6 1 5 6 8 1 41 2,172,95 2,069,55 1,664,46 2,555,03 6,125,09 1164396 17,539,0 225960822607701934794 6 5 4 9 3 3 94 1,893,16 2,137,24 1,713,97 1,947,65 3,680,95 6,271,63 152717816483401815658 8 4 1 7 6 5536098 9 3,391,93 4,630,49 4,033,38 5,620,20 12,246,8 2119147 25,783,8 162535219058082298527 5 4 0 3 11 0 71 8519354.8 9,575,66 8,856,72 6,719,48 7,070,04 13,235,0 19,689,7 24,031,5 85326598503732 3 2 1 4 9 66 12 37 347542133501313178649

NET MARK-UP / INTEREST INCOME

4 5 6 7 7,026,22 14,974,7 23,921,06 61327426404043 6902382 9,488,328 9,311,187 3 64 21,252,702 2 11,303,90 12,375,68 13,726,5 24,301,0 57590125859262 8021374 2 3 87 03 29648284 31327064 1,635,33 3,026,48 122680 -264345 341326 890,616 878,576 3 4 3638791 4151389 1,469,98 2,792,11 520627 435404 467423 784,295 800,784 7 6 3779545 4181115 4,450,60 7,867,39 769089 334426 1736539 3,244,371 3,769,937 5 2 10422406 11182418 1037137 12,413,33 12,428,33 14,387,9 23,370,8 8784046 1 8778999 7 2 35 97 30153716 33629470 1,268,76 2,110,00 66060 305807 324425 292,868 479,310 541,541 5 1 2265650 2003933 7,055,91 7,501,12 14,112,9 17103802353119 3675592 5,120,836 5,640,600 1 1 12 20864794 24109356 2,694,10 3,370,00 4,502,32 964750 864335 921925 1,348,410 1,841,392 6 0 4 5619608 6,457,617 1,180,26 1,835,96 3,456,35 504165 757534 851451 1,059,805 1,071,906 2 5 4 4070241 3,599,717 1,195,38 1,667,09 381319 366374 424695 438,283 624,801 924,326 1 4 1767775 1,937,281 2,004,80 3,185,74 5,041,81 311788 431465 574486 876,861 1,518,181 3 4 9 5958584 9,162,908 4,532,29 5,087,80 8,935,26 12,971,94 21688882351566 2751718.08 3,938,493 4,228,391 5 4 3 11,620,175 4 0.25418 0.27653 0.4113023 0.674500 0.719627 0.675120 0.59016479 0.5397883 7 3 0.32299606 79 0.4774217 45 82 404 3 6 25.4186 27.6533 41.130237 67.45004 71.96278 67.51204 59.0164793 53.978836 7 5 32.2996065 93 47.742172 53 21 043 4 2 98 99 0 1 2 3 7,437,30 1 13,603,5 74 1,128,12 6 1,271,15 6 3,829,69 4 12,716,7 38

MCB HBL FAYSAL AL-HABIB ABL NBP PICIC UBL ASKARI BOP SONERI ALFALAH Net markup income NIM NIM%

PROFIT/ (LOSS) BEFORE TAXATION

99 0 1 2 3 4 5 6 7 121053 2,101,17 3,101,02 3,612,92 4,057,71 13,018,4 18,500,6 21,308,0 MCB 947003 9 1321795 6 0 4 6 87 70 35 122996 530886 2,224,23 4,088,02 5,469,16 7,247,44 13,162,9 20,502,8 15,144,6 HBL 5 5 1074525 0 6 8 0 38 02 17 1,254,57 2,745,27 2,207,47 3,968,86 3,870,34 2,697,82 FAYSAL 637237 428595 -223320 924,857 4 2 0 7 0 7 AL1,512,99 1,039,17 2,022,00 2,689,38 3,052,22 HABIB 444742 372728 403128 551,006 619,726 2 9 8 1 7 ABL 169592 71098 -839,266954,059 481,702 4,834,19 6,661,09 5,953,07 4,491,70 1,586,70 5 4 6

98

44

0 4 213538 3,015,62 6,044,81 9,008,70 12,025,1 19,056,0 26,310,5 28,060,5 NBP 2 519862 1032400 9 1 8 58 28 77 01 1,126,38 1,905,62 1,279,21 PICIC 125692 231153 116746 295,837 509,067 825,071 5 0 5 571,207 660055 125305 5,728,18 2,731,30 4,326,71 4,889,72 9,481,64 14,291,7 13,004,9 UBL 1 9 1645497 2 8 6 8 8 56 73 1,008,49 1,244,02 1,901,80 2,842,74 2,859,08 3,346,85 2,299,78 ASKARI 854134 712446 751588 8 2 0 0 1 5 5 1,001,65 1,735,94 3,164,95 4,768,72 4,845,72 BOP 135615 124739 319639 421,275 431,844 8 3 7 1 2 1,046,56 1,400,03 1,448,90 1,476,68 SONERI 335200 382316 393922 551,234 621,176 813,512 6 2 1 5 ALFALA 3,505,68 1,653,73 2,563,29 2,565,94 4,535,55 H 67736 354415 400350 524,164 894,653 0 4 0 5 2 66060. 42092. 228714. 1,662,79 2,973,13 3,362,81 6,453,09 8,853,02 8,579,18 EBT 6 1 167 420,872 4 0 3 6 1 4

45