RESEARCH REPORT NO. 162

The Pro'fitabilityof the Banking Sector of Pakistan

Rehana Siddiqui Sellior Research EcoJ/ol/lisl. !'akistall/llslitllie

(~rl>£'J'elopl/lclI(F;COIIOl/lics,Islal/labad

and

Rizwana Siddiqui Research ECOIIOlllist, Pakistall Illstitute (~r/)el.e!°plIlf;nt Econolllics,

Islal/labad

The PIDE Research Report Series offers an up-to-date )sition of various economic, demographic-, and anthropological cts of the development process in developing countries Tal1y and in Pakistan particularly. Its wide dissemination is ~d at providing a firm foundation for useful policy-making in tion to encouraging academic interaction. The n1ajor areas of research addressed by the Series are roeconomics and sectoral issues, international trade, labour

(et issues, demographic patterns, anthropological approaches, v'th, and distribution. Manuscripts submitted for publication in Series are r~viewed by the PIDE Research Report Com1nittee published from time to time.

PIDE Research Report COlnmittee lr Mahmood

Naushin Mahmood

Zafar Iqbal

N 969-461-070-2

ghts rescrvcd. No pan of this publication may be. reproduced, stored in a retricval system or nitted in any form or by any mcans-e.lectronic, mcchanical. photocopying, rccording or ,vise-without Plior permission of the author and or the Pakistan Institute of Development )l11ics, P. O. Box 1091, Islamabad.

kistan Institutc of Dcvelopmcnt IJlHlmics,1998

CONTENTS Poge

Executive Summary 1. Introduction

. 3 4

II. The Indicators of Profitability (a) Determinants of Bank Advances

4

(b) Determinants of Banking Deposits

6

(c) Determinants of Differences Rates of Return

8

in the 10

(d) Determinants of Liquidity Ratio

III. Determinants of Private Investment

10

IV. Policy hnplications

12

(a) Impact of Open Market Operati"onsand ChanQ:es in Bank Assets on B~mks Profitability v

.

13

V. Conclusions

16

Abstracts

20

(i i i )

List of Tables Page Table 1. Determinants

of Banks'

Advances 5

(Adv.) Table 2. Determinants (Dep.)

of

Banks'

Deposits 7

Table 3. Determinants of Differences in Rates of Return: (Spl~ead) Table 4. Determinants. of Private Investment:

9 II

(PI)

Table 5. Elasticity Estimates Table 6. Ilnpact of Open Market Operations

14

and Reduction in Banks' Assets in Pakistan on Bank Advances by ] une 1996

IS

Appendix Table 1. Recent Policy Actions of State Bank of Pakistan

17

Appendix Table 2. Indicators of Profitability Banking Sector

18

of

the

Appendix Table 3. Determinants of Profitability (a)

19

Appendix Table 4. Determinants of Profitability (b)

19

EXECUTIVE SUMMARY The main objective of the pi'esent study is to exarnine the determinants of the profitability or the banking sector in Pakistan. For this purpose we take the level of bank advances, the level of bank deposits, the difference between the rate 'of i-eturn on advances and the rate of return on deposits (often referred as 'spread'), and the ,

liquidity ratio as the main indicators of the profitability of the banking sector. The analysis presented here shows that the intensity of economic activity is the main determinant of the profitability of the banking sector because an intensification of the economic activity increases bank advances and bank deposits. Interestingly, both the level of advances and level of deposits are sensitive to changes in the. liquidity ratio: bank advances decline and bank deposits go up as the liquidity ratio rises- which is seen as an incre%e in the credibility of the banking system. Since the positive effect on the level of deposits is lower than the negative impact on the level of advances the net impact of changes in liquidity, depending on the level of advances and deposits, may be a decline in advances, .

The 'spread' is positively affected by the level of economic

activity. However, the data, presented in this study, show that the spread declined during late 1980s but increased during 1990s; which may indicate changes in the profitability of the banking sector; but, it may also reflect the increase in risk and rising operating cost in the banking sector. There is a two-way relationship between the performance of

the banking sector and the private saving and investment. In order eX~lmine the' impact of chdl1ges in the rin~lI:cjJj sector (in the r~\tc

(0 0'1"

2 investment in the physical assets we estimate an investment function also. It turns out that rise in economic activity is strong determinant of investment in physical assets as well. However, as the level or private deposits in the banks rises the private investment in the physical assets goes down; which indicates that, on the average,

financial assets have substituted for the private investment in physical assets, The last section of the study examines the impact or recent Open Ivlarket Operation COMOs) by the State Bank or Pakistan on the level of bank advances in the country. Based on our elasticity estimates, we can say. that the impact of the OMOs on the profitability is gojng to be substantial if we take into account its impact on the assets position and the liquidity positions of the banks. Furthermore, th~ impact will be higher in the long run, as it.will take into account the adverse effects on the level of economic activity and also on the level of fixed capital formation.

1. INTRODUCTION Recently, the State Bank of Pakistan (SSP) has taken a number

of steps to control the rate of monetaryexpansion in the country (see Appendix Table I).'

These actions will inevitably modify the

profitability of the banking sector as they affect the level of advances, the level of bank deposits, the difference in the rates or return on advances and deposits, and the liquidity position of the banking sector.:: During 1980-95, the bank advances increased at a rate of 16.78 percent per annum whereas the growth rate or bank deposits was 17.02 percent per annum. But the difference between the rate of return on advances (ra) and rate or return on deposits (rei). referred to here-in-after as the 'spread', changed a great deal during 1980--95; and especially during the 1990s. A1so, the liquidity ratio has varied significantly over time (see Appendix Table 2). Thus, while the bank advances and deposits have been growing at the same rate the spread of the rates of return has changed significantly over time:\ In this paper we discuss the factors which are expected to influence bank advances, bank deposits, the size of the spread: and private fixed capital formation.4 As an exanlple of the specific IThe central banks can control monetary expansion by changing the following bank rate: 0.) 'reserve rcquircments: ratilJ:

(6)

credit

ceiling:

and

(7)

valiablcs: (I) the

(3) the discount rate: (4) sectoral allocation of funds: (5) liquidity open

market

operations.

In

Pakistan.

recently

government

has

concentrated mainly on the last option. "Here lhe b:{nking sector includes 'Scheduled Banks' only.

'The diiTerence between rate of relurn on advances (ra) and I~lte of return on deposits (i'd) is often called as :'spread". -1111 most studies dealing with the banking sector. the.saving behavior is analyzed as compared to tl1\: private investment behavior. dir'-'\.'Ily afkl'k'(\

In this study we concentrate on the pliv:\te investment behavior. as it.is

by Ih\.' h:1I1k's\.';Ip:I\.'itytl) giw

CI\'dil.

4 monetary policy

instrument we also try to see how the. rccent

increase in the frequency of the Open Market Operations (OMOs hcreinafter) and the changes in the asset position of the banks may affect the profitability

of the banking sector.

A few concluding

remarks are made at the end of the paper.

II. TfIE INDICATORS OF PROFITABILITY In order to analyze the effects of the many actions taken by the State Bank of Pakistan on the banking system, the profi.tabiJity of the banks must be appropriately measured, which can be defir1cd in a number of ways. This can be done by focusing on: (1) the level of bank advances and level of deposits; (2) the size of the spread; (3)

the ratio of banks liquid assetsto liabilities (LR);5 (4) the assets position of the banks; and fina!]y, (5) the ability of the management to deploy its finances where the yield and efficiency of resource use is high. Each of these indices is reported in Appendix Table 2. (a) Detenninants

of Bank Advances

To analyze the determinants of the !evel of bank advances

CAdv) we regrcss it on the rate of j-eturnon advances(ra), the bank assets (ast), bank investment in government bonds and. securities

(gbs), the Jagged gross domestic product (GDP), advances (Adv(-l» can write it as:

lagged bank and the time trend (t). In an equation form we

Adv =f (ra, ast, gbs, GDP( -1), t, Adv (- I))

( 1)

An increase in the rate of return on advances is expected to lower the demand for bank advances; while an increase in the bank assets. is expected to provide a wider base for credit expansion. .Therefore, the advances are likely to go up as the asset position of the banks strengthens. An increase in bank investment in the government ~A lower liquidity ratio lower:; public confidence in the banking system whereas a higher

liquidity r;nio ::dn~r~c!yaffects the credit now in the economy and lowers the over all profitability of the banh.

5 securities and treasury bills, which is the main policy instrument llsed by the government to control the level of liquidity in the economy, is expected to affect the bank advances positively as it curtails the supply of advances in the open market. The level of' economic activity is expected to make a positive impact on bank advances as it not only increases the demand for advances but the supply of loanable funds as well. And, finally, bank advances lagged .by one year are expected to expand the rate of advances as they reflect the adjustment between the d.esired and actual level of advances. The

regression results of the two best equations are reported in Table 1.6.7 .

The table shows that, as expected, the level of economic acti\;ity significantly affects the level of banks' advances positively. The effect of monetary policy on the bank advance$ is determined o'n the Table 1 Determinants of Banks , Advances (Adv.)

c

ra

2.67

-OAG

(4.75)

ast

gbs

GDP

F

R~'1SE

0.9~5

39~

0.OS5

0.995

236

0.()()4

(I R.8)

3.27 -0.006 0.227 -0.087, «WI)

R-squ

1.125

(I.]J)

(2.23)

LR

Aclv(-I)

(1.73)

(2.49)

0.564 (2.X4)

0.026 -0.197 (0,26)

(0.54)

i\'o/{!s: !-\'allll:S are reported in parentheses. .'\cl\', = level of bank advances. ra

= rate of relurn

on banks' :1dvances.

ast =!e\'d of banks' assets. gbs

=banks'

GDP

= gross

invcstment in go\'crnmcnt treasury bills and seclIlitics. domestic product.

Adv(..:.1) =previous year's advances.

= time trend, LR = liquidity

t

ratio.

C = intercept.

{'All equations are estimated in double-log form, estimates,

70nly selected equations arc repol1ed in Table I.

Therefore. the coefficients ar~ also ebslicity

6 basis of coefficients of the bank assets and the bank investment in' government securities and treasury bil1s.x The estimated equation shows that a tight monetary policy-e.g.,

an increase in bank

investment in government bonds and securities-adversely