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Back ground/ introduction

We are doing research on an issue that discuss does interest rate risk effect the performance and profitability of the bank.Interst rate risk varies time to time. Every bank offer its on interest rate. The fluctuation in the different interest rate and its impact on the performance and profitability of the banks. In our research the main focus is to identify the impact of interest rate risk variation on the performance and profitability of the banking sector of Pakistan. We will also discuss how a bank earns profit by using interest rate risk. The interest rate risk is the risk to earning or capital from movement of interest rates. The interest rate risk are influence the profitability growth of the bank. The interest rate risk indicates the changing in the timing of rate and of cash flow. Interest rate risk affects the bank earning by changing in the following factor, 1. Net interest income 2. The market value of the trading accounts 3. Other interest sensitive income and expense (mortgage and servicing fees) The changing in the interest rate also affects the economic value of the bank (Assets, liability, future cash flow). The price risk is risk to earning. The risk that the value of the securities will decline in the future. The position taking activities for interest rate, foreign exchange, equity and commodity market. In the banking sector the exposure of interest rate risk influence the each transaction of the bank. Each bank seeks to reduce the interest rate risk level. Such banks are not carefully considering take position to get advantage from particular movement in the interest rate. These banks always try to compare its assets and liabilities to the maturity and reprising dates. Some bank attempts to centralize management of interest rate risk and restrict position taking to certain discretionary portfolio such as the money market, investment, and Eurodollar.

These banks often use a fund transfer pricing system to isolate the interest rate risk management and position in the treasury unit of bank (fund transfer pricing system appendix H). Some bank use decentralize approach they manage the risk in particular limits same as in the target zone arrangement (financial system).the bank can also use some other alter to reduce the interest rate risk such as use of swap and derivatives, managing the cash flow or future cash flow instruments. To take a decision about interest rate risk the bank will also carefully consider the assets, liabilities, and liquidity of the assets. The ability of the bank to meet the short term and long term loan and earning. If the bank has long term fixed assets funded by the short term liabilities may less able to response new business opportunities duo to their deprecation in its assets. Many banks consider the term transformation represent solidly of the interest income. This term transformation strongly related to the small and medium sized banks. They are in traditional commercial banking. Bank has critical about the opportunities and risk they are related to term transformation. For survival the bank have manage the interest rate risk and their banking behavior.

Literature review
Mandos and solis (2009) the analysis of maxican banking sector about net interest income in the period of 1993 to 2005.In this study the mandos get sample of 43 commercial banks with 289 annual observation of unbalance panel data to under the behavior of banking spreads including various factor . The factor they directly affect the interest rate including ,operating costs, volatility of interest rate quality of management credit risk degree of risk aversion market risk,transation size, liquidity cost of gross income, GDP growth, and inflation rate. These all factor are influence the interest rate of the banking sector. English (2002) study about the relationship between the net interest margin and term transformation. In their study they find out the much evidence of the net earnings from transformation and interest margin. Ho and Saunders (1981) analysis the banking sector as a dealer. They mention four different factors they affect the banks interest margin. The factor including the degree of bank management risk aversion, market structure of industry, average size of bank transaction and variance of interest rate. Wood bridge Williams (2003) according to the Australian experience argue the increase in value, efficiency, bargaining power, as a result of under taken mergers. The mergers are increase the value and efficiency of the bank. Its means the different mergers are undertake to increase in the efficiency. Rajan 1992; Petersen and Rajan (1995) a negative relationship exists between the firm access to external financing and degree of banking system competition. The more competitive banking system may less financing to the firm because they have less incentive to invest in close relationship with firm. Dale and Haldane (1993, P3) the central bank is the main monitoring body in any country. In Pakistan the state bank of Pakistan control all the commercial bank in the country. The policy of

state bank related to interest rate is affecting the commercial banks of the country. when the state bank change the interest rate strictly, the refinancing rate at which liquidity is made available to banking sector it is only in the market for reserves that the banks is the monopoly suppliers and only in the market that it can determine price directly. International banking system, if the interest rate is low then people would not want to invest more money in banks. If the interest rate is highly then the short term invest will increase in that particular countery.when investment increase then the value of the currency will also increase. So the interest rate also has great influence with the value of the currency. Monetary policy committee (1999) the change in the interest rate is directly affects the import price. The change in the interest rate work mainly through demand, (in United Kingdom). Alper and Anbar (2011) According to their study they find that ROA is positively affects by the assets size, noninterest income, real interest rate. ROA is negative effect on the loan. The profitability of the bank are not affected much by the capital ratio, net interest margin, GDP, and inflation. Bank capital requirements for market risk (darryll hendrich and Beverly hirtk) for market riskThe market risk is risk of loss from adverse movement in the market value of assets, liabilities, or off balance sheet position. The market risk was arising from banks trading activates, so duo to that the market risk is more visible and easily measured within the trading portfolio. Svenssn (1993) normally two type of interest rate exist in the market. One is nominal interest rate and other is real interest rate. The nominal interest rate id without inflation adjusted, on other hand the real interest rate is inflation adjusted. According to svenssn when the nominal interest rate is use its means the inflation expectation has recently give wide popularity. The simple assumption about real interest rate is instance use forward rate to adjust the inflation. This method is recently use among other then central bank of England and Sweden (bank of England 1994 and soveriges risk bank 1995).

The inflation and interest rate are change time to time in the economy. Amita and Brtra (bank profitability with hybrid profit function the case of India) It is very difficult to evaluate the bank profitability, because the output of the bank is not easily quantified in an any unique manner, the other reason is that the industry of banking sector a multiple output industry. Rangarajan and mampilly (1972) In 1972 rangarajan and mampilly analyze that a use of a simple cost function to compute average and marginal cost to determine the optimal bank size. Seshadri (1980) they analyze the bank profitability and size. In their analysis they are use both linear and log linear methods, in their finding he take profitability as a profit deflated by size. He was also considering all Indian banks as a consolidated group. Campbell R. Harvey (interest rate based forecasting on German economic growth) Interest rate has a close relationship with the economic growth. Interest rates are at which the people are willing to invest their money. The investor want to invest in a stable economy, stable economy mean the economy where the interest rate fluctuation is less. The investor are want to minimize the risk at all, for this purpose the investor are reduce the risk level by using different technique such as swap, hedging etc. Fisher (1907) the people would like to transfer their income from today to future. The interest rate is the main reason for this move; the people want to increase their wealth. The people think that they get more from future as compare to today. The concept of time value of money also include in this case. Campbell R. Harvey (interest rate based forecasting on German economic growth) two type of investor are exist in the market, one is risk averse and other is risk taker. In the case risk avers investor they forecast the future growth of economy on the base of today interest rate. The interest rate interest rate of today gives a some idea about future economic growth.

Back and hesse (2009) they analyze the bank regarding to the interest rate spreads. The data they are use are panel data, the sample size are 1390 banks from 86 different countries. According to their finding the difference in the interest rate spreads are more the 6% between different countries. To analyze the high fluctuation in the interest rate margin between different countries, for this purpose they are use following different factor like, bank size, exchange rate, deprecation, real t-bill rate, liquidity ratio, concentration, institutional development, GDP growth, overhead cost, inflation. Khawaja and Din (2007) to conduct a study about interest rate spreads in the Pakistan, during the period of 1998 to 2005. (BIS 1997, for a survey of monetary policy tacticeand Borio, 1997, for a survey of central bank operation procedure) As a result of emerging the monetary policy in 1970, most country has regular increase in the market orientation. The monetary policy effect removal of direct control. The importance of interest rate will also increase; the operating target and its maturities rate are directly involved. Interest rate reform in (South Africa) the interest rate reform in the south Africa was removed the many barriers related to interest rate. This remove make bank more flexible and visible. Duo to the management of interest rate the competition will also increase in the banking industry. This reform make able to the banks to change the rates charged to borrowers according to the cost of the funds. Interest rate reform in (Tanzania) this reform is divided into three different periods. The first period was start from 1961 to 1966, in this period they dispatch the interest rate with the London financial market. In second period they are set a fixed interest rate and start from 1967 to 1985. The third period starts from 1986 to present, in this era they follow the deregulated interest rate policy. Mckinnons complementarity hypothesis: mckinnons conduct a research and explain how the interest rate impact on the saving, investment, growth. They give there different assumption, first to undertake investment all the economic agent are confined to self finance. Second the

investment expenditure is more visible then the consumption expenditure. The form of capital is discrete and heterogeneous. There third assumption is that gives the more credit to the modern urban and export industry. De mello and tybout (1986) according to their arguments when the interest rate released ( free) from Government the two various type of improvement are begin, the first is saving have increase ( large volume of investment can be financial) . The second expected return are below the new market clearing rate will be drop out.

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