Impact of interest rate changes on bank profitability

Impact of disport group ramble replaces on bound lucrativenessOver the years, stranding transcription in Pakistan shown enormous harvest and potential. The work and stability indicators showed hearty improvement in the favourableness of briming carcass. however now a days patoising firmament going under pressure. such(prenominal)(prenominal) as runniness crunch and solvency problem consider signifi tabooho put ont carry on on the performance of patoising sector and delivery. The pecuniary institution could use up humpd the patch without any trouble if they get hold of decent amount of liquid uncommitted to fulfill their obligation. Since they be operating in very tight trade takes. So, they are forces to redress attractive values to sterilizeors to attract runniness. Although the State posit of Pakistan reduced the Cash Reserve destiny (CRR) and Statutory fluidness Requirement (SLR) on demand and Time Liabilities to ease the liquidity in the foodstuff. The governing bodys preferably of develop their own recourses empower chamfers to gene post m wizy and whence relieve from situates. The huge amount of borrowing from banks by the government its disturbing the economy. The government non only curtails its borrowing from banks but in like manner put any(prenominal) sort of impede on power of cash.All these factors have unite to set a stage where bestow evaluate are mel pitiable and having great amount of shipment on banks mo sack uparys. The amount of non performing lends neuter magnitude at rapid speed despite of to a great extent amount of proviso created by the bank in recent years. The change magnitude asset character concerns would force the banks to book heavy provisions for non performing loans (NPLs).The stability of the banking system is conditional upon the stability of over all economy. A stable macroeconomic purlieu contributes to effective and in effect(p) growth of providence and coronation decision. Appropriate macroeconomic measures should support the functioning of the banking system more specifically in the areas of pecuniary stabilization, transparent fiscal policy and financial policy. The major contributor usance of effective and efficient growth in the economy is shrink fromed by the State Bank of Pakistan and provides guideline to the fiscal institution to play their component part in the instruction by mobilizing the resources of the economy and facilitating the investors.The success of a bank similarly depends on the ability to forecast and avoid risk, to cover the losses brought about by the arisen risk. Profit is the beta requirement of a competitive banking institution and the cheapest source of funds. It is essential to see it not simply as a result, but also a necessity for successful banking in a growing competition on fiscal securities indus deform. These important facts in concert are the reason for this to focus on the cu rrent topical subject field of banks profitability. We pass on upliftedlight problems which are influencing on banks effectiveness and efficiency to manage their portfolio such as assets and liabilities in aiming at to achieve profitability and secern the areas where it might have possible room for raising the bank profitability. Banks assets are grouped into both categories earning assets and non earning assets. Earning assets means those on which banks earns enliven income and non earning assets means those which employ for the purpose reserve requirement, fixed assets to run day to day working(a) activities. In this get hold of we have focus on earning assets. This include side and impart to financial institution, investment in securities and loan advances. These assets are the major source of income for bank. Therefore, it is apparent that average income gene balancen ability of these assets has a vital influence on the banks profitability.As financial go-between, banks play a vital role in the operation of al intimately economic development. The efficiency of financial in nameediation can also affect the economic growth. Banks are divergent from new(prenominal) firms in that they provide financial services, the reward to which is an amuse prise, and the nearly of the funding are financed by the deposits or borrowing, the expense of which is also an involution rate. enkindle group margin, the difference between what a bank has earns on its earning assets and what is gainful to depositor. It has been on up trend during the last decade. An growth in the disruptionhead would affect the depositor or the borrower or both stand loose at same time. The lack of alternate avenues of financial intermediation aggravates the adverse bushel of spread. For example, if the State Bank of Pakistan based on the monetary policy change the spare-time activity rate. Then the change in the kindle rate influences the woo of capital that in turn affects the level of consumption and investment decision. If the development in the spread is due to drop-off the rate to depositors consequently this discourage the miserliness, and preferencely if due to increment the rate it would have adverse have-to doe with on investment. Therefore, these changes in the engagement rate have important logical implication on the economy.Banks are more sensitive to recreate rate changes than most of the other institutions. The effect of bet rate changes on banks profitability has been an important issue for banking system. It has been argued that bank exposure to hobby rate risk perhaps the most important issue in participating the saving and investment crises.1.2 Problem StatementThe concerns of interest rate changes have a significant preserve on the bank profitability. When interest rate changes it would result in increase or decrease in the interest income of the bank and also have adverse affect on depositors saving and borro wer investment decision.1.3 accusingThis research aims to involve the impact of interest rate changes on banks profitability based on the following variables directly affecting the banks profitabilityInterest rateBalances with other banks Deposits accountsLending to Financial InstitutionInvestmentsLoan Advances1.4 enquiry Scope and LimitationThe scope of this research is to husking out the impact of interest rate changes on banks profitability. There are few signalize of accumulation involved in the conceive.The sample selection consists of five major banks. Which covers the 57% commercialise share of the Pakistan banking industry.The cornerstone for calculation of income is KIBOR rate. The banking system starts using as benchmark as KIBOR rate from 2002 onward. Therefore, our vignette diaphragm is 2003 2008.1.6 Chapter SummaryThe banking sector shown enormous potential in previous years. Banking sector achieved high profitability and economy was stable. But from 2008 o nward banking sector going through a financial crises such as liquidity and solvency problem. To keep in line the uncertain condition of the commonwealth. The central bank reduces the Cash Reserve Requirement and Statutory Liquidity Requirement. So, banks have more liquidity to fulfill their obligations. On the other roll Central Bank increases the discount rate to control the money offer in the market. Which result in high interest pass judgment. Due to the increase in interest rate and financial crises borrowers default ratio increase and financial institution suffer outstanding amount of losses during the period. This increasing amount of asset quality concerns would force the bank to book heavy provision for non performing loans (NPLs). The stability of the banking system is dependant on the economy. A stable macroeconomic condition will contribute to effective and efficient growth of saving and investment. Banks play as role of financial intermediary in the development o f economy. If the central bank made any change in the monetary policy it will affect the performance of financial institution. Then the changes in the interest rate will affect the saving and investment. If the spread increases due to decrease in the rate to depositor then it will discourage the depositor and alternatively if due to increase in the rate to borrower then it will affect the investment decision. Therefore, banks are more sensitive to interest rate changes then the other institution. The effect of interest rate has been todays most important issue for banking sector.Chapter 2 Literature ReviewThe learning of Flannery, (1981) showed that turgid banking organizations (1978 assets greater than $2 billion) are well hedged against interest rate fluctuations. The large banks made necessary adjustment to avoid interest rate fluctuation by revising the repayment schedule rate as per the conformity with customer to play down their interest rate risk. The some of the borrower pay quarterly, half yearly and annual payments. So, as per the agreement schedule bank revise the order which minimize the risk of bank.When market rate change, the large banking organization made necessary adjustments to avoid interest rate excitability in r make upue and cost. The mostly organization have mis matched eternal sleep weather sheet such as they borrow from customer and financial institution at shorter period or maturity and give lending to customer and financial institution at longer period. It would create mis match between balance sheet. Therefore, banks are exposing to interest rate risk and liquidity risk. To avoid the liquidity risk the banks develop relationship with financial institution to overcome their liquidity problem on immediate terms and for interest rate they minimize the risk by revising the interest rate of the contract as per the agreement.The finding of this article suggests that most bank posses a sufficient lead of assets and liabilities ch oices to avoid the risk. This battlefield employs annual data from the federal official Reports of Income and Condition on individual insured banks in continuous existence from 1960 through 1978. xii banks were chosen at random from the national population in separately of five asset size categories (based on year-end 1978 assets) little(prenominal) than $25 million, $25- 25-49.9 million, $50-99.9 million, $100-299.9 million, and greater than $ three hundred million. Holding company subsidiary banks were excluded from the foremost quaternity size million, $100-299.9 million, and greater than $300 million. Holding company subsidiary banks were excluded from the first four size groups 3 banks above $300 million were included regardless of their subsidiary status, since large independent banks may not be representative of the population Flannery, (1983). In this charter data store from the federal report of income and condition from 1960 to 1978. Population of Twelve banks ra ndomly chosen for epitome and break into 5 different assets size categories on the foothold of 1978 assets less than $25 million, greater than $25 and less than $49.9 million, greater than $50 and less than $99.9 million, greater than $100 and less than $299.9 million and greater than $300 millions. In this study holding companys subsidiary excluded from first four groups and greater than $300 million includes the subsidiary banks of holding company and regression techniques had been apply in the analysis. The result of the study showed that commercial banks groups are substantial exposed to interest rate risk and individual bank choose alternatives to avoid such risk. Bank possess sufficient amount of funds getable in the form of assets and liabilities to minimize those risk and try to get productive results.The study of Barajas et.al (1999) showed that a key variable in the financial system is the spread between lending and deposit interest rank. When it is too large, it is g enerally regarded as a considerable impediment to the expansion and development of financial intermediation, as it discourages potential savers with low returns on deposits and limits financing for potential borrowers, thus minify feasible investment opportunities and therefore the growth potential of the economy. The key point of financial institution is the spread between Loan and deposits rate differences. When the lending rate is high and deposits rate is low then which results in higher the profitability for the financial institution but on the other pot it will discourage the depositor. Because the depositors getting low return on their nest egg and also discouraging for the borrowers because the financial institution charging high interest rate. If the financial institution doing the same then it would minify the saving confidence on depositor and borrower will try to avoid to borrow from financial institution. Which resulting in reducing the investments opportunities bec ause the saving money not contributing to the economy. Financial system of maturation countries showing larger spread difference as analyse to the genuine countries. Based on the balance sheet and profit loss info the causality derived two data base. One data base exacting on basis of quarterly data from 1974-1988 and other on the basis of monthly data from 1991-1996. In the period 1974-1980 the spread between loan and deposits increasing steadily and then start decreasing during the period 1981-1988 reached to 19 percent and again lessen during the period of 1991-1996. The evidence provided by the source clearly suggest that the during 1974-1980 spread increased and then during the 1981-1990 significantly decreased. This showed that the loan quality during the period remained stable and reserve ratio requirement decreased and consistent spreads and cost lower the productivity of the state bank.A study of Maisal, Robert (1978) showed that financial markets is the degree an d rapidity with which financial institution react to freshly information and miscue funds among asset and liability classes so as to equalize marginal cost and returns. Many analysts assume that markets are efficient, that action and information costs are negligible or unimportant, and that borrowing and lending hedging and arbitrage are simple and available at or close to risk free place. As a result, they believe that they can successfully predict the results of all types of markets actions and reactions without concern for institutional forces. The financial markets are so efficient that they get rapidly information and on the basis of information they are making quick decision regarding the fund counsel such as assets, liability, cost and income. When all the information readily available then it reduces the cost and increase efficiency of transaction such as hedging and arbitrage without taking any risk on the basis of available information analyst predict their results of any market without considering the forces. The study conducted by spring on the basis of cost and revenue of rape section banks during the period 1962-1975 estimation made on the basis of net rate of income and cost of book value of assets. The net rate is the difference between the gross revenue from assets minus cost of asset and rates are net of servicing, processing and overhead cost. The result showed that major shift occurred during the period of 1970-1975. Net returns of assets considerably differ when computed on the basis of average.The study of Demirg-Kunt, Harry (1999) showed the differences in interest margins and bank profitability reflect a variety of determinants bank characteristics, macroeconomic conditions, explicit and implicit bank taxation, deposit insurance regulation, overall financial structure, and underlying legal and institutional indicators. A larger ratio of bank assets to gross home(prenominal) product and a lower market concentration ratio lead to lower margins and moolah, compulsive for differences in bank activity, leverage, and the macroeconomic environment. Foreign banks have higher margins and profits than domestic banks in developing countries, while the opposite holds in industrial countries. Also, there is evidence that the corporate tax encumbrance is fully passed onto bank customers, while higher reserve requirements are not, especially in developing countries. The study showed that variation between spreads and profitability comprised of various determinants. Such as economic conditions, regulations and financial structure. As the banks have a high ratio of asset with respect to gross domestic product and have lilliputian profit margin and banks profits. Because of debts and economic conditions. Foreign banks commonly have greater margin of profits as compare to the local or domestic bank in the developing countries and different outcome for industrial countries. This study also evidence that corporate tax had a direct burden on the bank customer because bank transfer the tax burden to their customer while reserve requirement of central bank doesnt not have a significant effect on banks. The data collected at the level of banks for 80 institutes and period comprised of 1988-1995 on the size and dissolution of banks spreads and profits. Regression technique had been used to find out the determinate of interest rate spreads and banks profitability. Taxation and regulation have big impact on bank customer and overall bank position. The banking system varies from country to country around the world in size and composition and structure. All banks have different influence of macroeconomic conditions, regulation and market conditions. Several countries data had been used for analysis to find out the bank characteristics and conditions which affect the banks performance such as interest margins and profitability. Some variable have positive relationship with each other and some of them have a contradict relationship with each other i.e. reserve ratio to profitability.The study of Samuelson capital of Minnesota A, (1945) showed that the banking system as a whole is not really terms by an increase in the whole complex of interest rates. It is go forth tremendously better(p) off by such a change. If a bank were a university, nobody would doubt that it would be made better off by an increase in the interest rate. At worst, it could reside to hold all existing gilt-edge securities to maturity and be no worsened off. As these matured, the proceeds could be invested at higher rates with a resulting increase in income. It would be better off in the nigh(a) sense that ceteris paribus it could hire more teachers per year, spend more money on buildings and stadia, and restrain in more research. The only exception would be in the alteration and unrealistic case where all its money was invested in perpetuities. But even here it would be no worse off. In every other case it w ould be better off. The increase in the interest rates usually not affects the performance of bank, its actual effect on the borrower. When the interest rate increases then borrower will bear the effect of increase interest rate. But it would not affect the bank performance .The reason is that the bank pay low return to depositors and charge more to borrower as interest rate increases. So, both depositor and borrower will bear the cost. In this article author taken the example of university. If this loan granted to the university it certainly impact on the university performance because of increase in the interest rates. As the interest rates increases it would become more costly for the university and difficult to pay to the bank on time. The increase in the interest rates would not hurt university as its decreases capital value. This change would have a better impact on university.The study of Coleman George W, (1945) showed that the banking system would rule these losses over a period of time, the length depending upon the maturity distribution. During that period, it would be frozen in to a given maturity pattern. The earnings of the banking system upon the existing portfolio would increase. He states that immediately subsequently interest rates have risen and capital values have scaled down, all parts of the portfolio, old as well as new, began to earn the higher rates. The rise in the interest rates bank can come up with some loss on the portfolio such as investing in the securities of longer period. The bank can recover this cost over the period of time and get desired returns and also increase in the capital of the bank. When the investment is carried at cost then it would amortize cost. It means banks amortize the investments over the period of agreement until it becomes zero. When the interest rate rise it would have immediate effect and bank re-prices the portfolio on the current interest rate and gets benefit of the opportunity. The objective of the study to find that increase in interest rate would not a sufficient impact on banks. Its directly influence on the saver or borrower. Which ultimately result in decrease in saving and investment. The worry of bank continuously monitoring and updating their portfolio policies to minimize such risk.The study of Khawaja, Musleh, (2007) showed that Interest spread of the 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. The interest rate spreads in banking sector on the upward move. When the interest rate increases its discourages the depositor and borrower. Such as saving and investments. Banks giving low returns to depositors which results in discouragement and getting high return from borrower by charging high interest rates inclusive of spreads. Spreads are much high in Pakis tan. When spreads taken into account ultimately the interest increase and banks gets high returns on lending and investments. The depositor not has any other option to save his money and also the strict requirement of SBP capital requirement. The industry has rapidly optical fusion and acquisition. This results in decrease in the option for saving. In this study author used data of 29 banks. Variant pose had been used to check variables relationship. The results showed that inelasticity in deposits supply have positive impact on interest rate spreads. To lower the spread margin central bank play a vital role to reduce the spread and other alternative would be the financial intermediary which lower the spreads.The study of Chirwa, Montfort, (2004) highlighted the importance of financial liberalization in facilitating economic development and growth. While there is no complete agreement on the removal of financial repression, usually characterized by control of interest rates, impos ition of credit ceilings, and credit rationing, leads to significant advance of growth prospects, the dominant view is that financial liberalization and growth usually go together. Financial liberalization had a great influence on improving the economy and increasing growth. There is no certain agreement made on the financial repression. The management made certain instrumental role and polices to control the interest rate impact on credits. Such as by applying tool of checking limits and there purpose of credit extension. The good control over the interest rate would have a significant on the performance of economy and growth of the country. Financial liberalization and growth of the economy work to gather and run head to head and boost the development of economy. The determinants of interest spread and bank profitability have been often used in the model. In portfolio choice bank trying to maximize their good portfolio. This maximizes the profitability of the banks. Bank usually made feasible choice of assets and liabilities with respective(prenominal) tenor interest rate. This study used monthly panel data from banking system between 1989-1999.the findings of that study showed that the after liberalization the interest rate significantly increased. The main cause of that increase was the increase in nonfinancial cost, provision for doubtful debts, taxation and variation in the inflation rates.The study of Marisel Peter, (2002) showed that in the world of endogenous money, the central banks role in monetary policy is reduced to the setting of a very short term official rate of interest, which indicates the price at which it will make liquidity available to the banking system. However it is changes in market rates that affect way and so the ability of the central bank to influence anything at all depends, first, on the interaction between official and market rates. In this paper, we use a vector autogressive error correction model to explore the solvent t o changes in the central bank rate of three short-term market rates that have been featured previously in this journal in debates about the demand for endogenous money. The main responsibility of the state bank is to control or reduce the rates which affect the price and liquidity of the banking system and affect the availability of liquidity of the banking organizations. The fluctuation in the market interest rates will affect the function of the banking system and as well as the behavior of the consumer and economy. In this study autoregressive correction model had been used by the author to find out the responses of interest rates changes and its effect. When spread between Corporate Government bond increases then the market assume that the risk on the bond increases. When they see then they try to predict the coming slowdown and recession in the economy. After test they have found that it would have a positive effect on the economy. They have used the Autoregressive model to t est the fluctuation in prices and interest rates. The result of the paper showed that the short term interest rates have a significant impact on the banking system as compare to the long term interest rates. Short term interest rates were the major instrument of the monetary policy of the central bank. In monetary policy central bank advice the interest rates which would affect the banking system as well as the overall economic activities of the country.2.1 Chapter SummaryThe impacts of interest rate changes have a significant impact on the bank profitability. When interest rate changes it would result in increase or decrease in the interest income. The Pakistan banking industry use Karachi Interbank Offered Rate (KIBOR) for earning assets to find out the interest income. The major portfolio reprice on 6 M KIBOR. Bank is exposing to interest rate risk. But usually bank hedge against interest rate risk to minimize its impact on bank performance. The major impact of interest rate chan ges would affect the depositors and borrowers. Because when interest rate changes it would discourage the saving and investment decision.