Determinants Of Development Of Banking Sector

ABSTRACT

The objective of this paper is to examine the determinants of development of banking sector from the perspective of Real GDP, Discount rate, Trade openness and Financial Liberalization by using annual data from 1970 to 2007. In this study, Liquid Liabilities, Private sector credit and Domestic credit are used as indicator of banking sector development. The finding of this research shows negative relationship between Trade openness and development of banking sector development. Discount rate is having a significant impact on banking sector development when Private sector credit and Domestic credit is used as the indicator while Real GDP is found significant when Liquid Liabilities and Domestic credit is used as indicator of Banking sector Development. Generalized form of data has been used in this study.

Keywords: Banking Sector development, Real GDP, Trade openness, Discount Rate, Financial Liberalization

INTRODUCTION

The financial sector of Pakistan has shown a substantial growth in past few years, however there is still need for continuous development. The financial sector of Pakistan consists of a variety of specialized financial institutions – commercial banks, DFIs, NBFCs, micro finance banks, Islamic banks, Modarbas, Stock Exchange and Insurance companies. Thus the whole financial sector of Pakistan offers a wide range of products and services to its customers.

(Zaidi, 2005) states that growth of financial sector is significantly related with economic growth therefore, country needs well developed financial sector in order to fully utilize the financial resources. Banking system has a significant importance in financial market.

Banking Sector of Pakistan is an important financial intermediary and responsible for the economic growth in the country. In 1990, Denationalization of Government owned banks have changed the overall scenario of the banking sector of Pakistan. After the amendments in banking companies’ ordinance, Muslim Commercial Bank (MCB) and Allied bank Limited (ABL) were denationalized in 1991 and 1993 respectively. The process of denationalization remains suspended for numbers of years and was restarted in early 2000s, when United Bank Limited (UBL) was privatized. In 2004, Habib Bank Limited (HBL) was also denationalized and due to which, the asset share of public sector banks was reduced to 25% at that time. In the last decade, state bank of Pakistan has made several efforts in promoting the Islamic modes of financing. In 2002, the first Islamic bank was established under the name of Meezan bank. Since then, the number of Islamic banks has been opened. Various traditional banks are now opening Islamic specialized branches. At the end of 2009, total assets of the Islamic banking have reached to 366.3 billions and the deposits in Islamic banks have reached to 282.6 billions [1] . At the end of calendar year 2009, there are 9522 total branches of banks in Pakistan which shows an increase of 376 branches in banking sector from the 3rd quarter of 2009. Moreover, the asset base of banking sector has shown a growth of 7 percent over the last quarter.

(Yasmin, Jehan, & Chaudhary, 2006) explains that after independence in 1947, Pakistan avoided trade openness because of weak industrial structure. In 1960’s, industrial base was laid and manufacturing industry expanded widely in Pakistan. However, industrial expansion face setback in 1970’s due to nationalization of industries. In 1980’s, IMF and World Bank provided facilities to the Pakistan in order to initiate the financial restructuring in country. A loan of $150 million and $200 Million was provided for this purpose under “Financial sector adjustment loan? in 1989 and 1997 respectively. Another project named as financial sector deepening and Intermediation project was initiated in 1995. The estimated worth of that project was $216 million. (Hanif, 2002)

Despite of the remarkable performance since last two decades, the banking sector of Pakistan is less developed and remains small in relation to the economy, when it is compared to the other banking sectors of the world. This shows that a number of financial and banking needs are still ignored and that much of the economic potential of Pakistan is not achieved yet.

Highlights of banking sector of Pakistan

Following is the highlight of banking sector of Pakistan from 2005 to 2009.

(Rs. Billion)

2005

2006

2007

2008

2009

Total Assets

3,660

4,353

5,172

5,672

6,529

Net Investment

800

833

1,276

1,080

1,753

Net Advances

1,991

2,428

2,688

3,183

3,428

Deposits

2,832

3,255

3,854

4,217

4,787

Equity

292

402

544

563

662

Profit after tax

63

84

73

43

54

Source: State Bank of Pakistan

LITERATURE REVIEW

(Christopoulos & Tsionas, 2004) states there is no one opinion of economist on the issue of financial development and growth of economy. (Pagano, 1993) describes that savings are mobilized towards the productive investment due to financial deepening which helps in improving corporate governance. (Khan & Qayyum, 2007) says there are three major channels through which financial development can affect economic growth (i) marginal productivity of capital can be increased (ii) savings are directed towards the investment (iii) level of private saving rate can be increased.

The relationship of economic growth and financial development was first discussed by (Goldsmith, 1969), (McKinnon, 1973) and (Shaw, 1973). Their study shows that there is a positive relationship between financial development and the level of output i.e. when the financial market will increase the credit level, the investment will increase thus, showing that real income and real interest rate is a positive function of financial development. (Yu & Gan, 2010) study shows that due to positive real interest rate, the mobilization of savings of banks increases and it also increases the growth with the increase in volume and productivity of capital.

(Yanikkaya, 2003) argues that trade openness has a significant impact on the GDP share. In developing countries, trade openness creates new opportunities to increase the growth process and hence the unemployment level decrease. (Jin, 2000) states that trade openness facilitates in establishing the development process. Moreover, local technology and production process can be improved through trade liberalization.

One school of thoughts is of view that the financial liberalization is also a major contributor towards the financial development in developing countries. “Financial liberalization means the deregulation of domestic financial markets and liberalization of the capital account.? (Attaullah, Cockerill, & Le, 2004) empirically shows that the effectiveness of banking sector is improved following the financial liberalization. (Bekaert, Harvey, & Lundblad, 2005) Suggests that there is a significant relationship between financial liberalization and economic growth. However, (Stiglitz, 2000) argues that increase in financial liberalization enhances the macro economic vulnerability of nations and chances of crises becomes significant. The study of (Gong, Lee, & Chen, 2004) supported the fact that increase in financial liberalization can cause crisis. (Wyplosz, 2001) suggested that financial liberalization is effective if the objective is to increase the competition and decrease the monopoly powers. However, financial liberalization is quite risky for developing countries. Many developing countries in Asia and Europe have grown faster even with strong financial restraints.

MODEL SPECIFICATION

Based on the above literature, we can propose that in Pakistan, banking sector development is a function of real Gross Domestic Products (RGDP), Discount date (DR) and Trade openness (TO) and Financial Liberalization (FL). This can also be shown as

BSD Pak = f (RGDP, RI, TO, FL)

Where, BSD Pak = Banking Sector Development of Pakistan

In this study, we have used following models which are estimated by using least square techniques. In model 1, we will use Liquid liabilities as the indicator of banking sector development. In model 2, Private Sector Credit will be used as the indicator of banking sector development where as in model 3, domestic credit will be used as the indicator of banking sector development. (Yu & Gan, 2010)

ln LL= βo+β1ln RGDP+ β2 DR + β3TO+ β4FL + e

ln PRI= βo+ β1ln RGDP+ β2 DR + β3 TO+ β4FL+ e

ln DC= βo+β1ln RGDP+ β2 DR + β3 TO+ β4FL+ e

where,

ln LL= Natural logarithm of liquid liabilities

ln PRI= Natural logarithm of Private sector Credit

ln DC= Natural logarithm of Domestic Credit

Data source:

We have used annual data from 1970 to 2007 in this study. The data is obtained from the World Bank database and international financial statistics. However, Financial Liberalization Index of Pakistan, constructed by (Waliullah, 2010) is used in this study. Real GDP (RGDP) is calculated by using following formula

EMPIRICAL METHODOLOGY

In this study, Ordinary Least Square (OLS) technique has been used. In order to run the OLS model, order of integration of every variable is determined. There are two methods to examine the order of integration i.e. Augmented Dickey-Fuller (ADF) test and Phillps-Perron test. In this study, we will use ADF test for examining weather the data is stationary or non-stationary. We will run co-integration test when all variables becomes stationary at same level. The generalized form of data has been used in this study.

Empirical Results of Model 1 – Liquid Liabilities

Table 1. OLS Results of Model 1

Dependent Variable: LL

Method: Least Squares

Date: 01/24/11 Time: 16:07

Sample: 1970 2007

Included observations: 38

Variable

Coefficient

Std. Error

t-Statistic

Prob.

RGDP

2.390212

0.071527

33.41707

0.0000

TO

-0.246367

0.046986

-5.243445

0.0000

DR

0.030429

0.104158

0.292144

0.7720

FL

0.035323

0.009594

3.681828

0.0008

C

-0.000353

0.000128

-2.758942

0.0094

R-squared

0.998745

Mean dependent var

-0.000415

Adjusted R-squared

0.998593

S.D. dependent var

0.020655

S.E. of regression

0.000775

Akaike info criterion

-11.36561

Sum squared resid

1.98E-05

Schwarz criterion

-11.15014

Log likelihood

220.9465

F-statistic

6564.172

Durbin-Watson stat

1.489120

Prob(F-statistic)

0.000000

In model 1, liquid liabilities have been used as an indicator of banking sector development. Table 1 show that Real GDP, Financial Liberalization and Trade openness are statistically significant and Discount rate is not statistically significant to the development of banking sector in Pakistan. However, Trade openness is inversely related with liquid liabilities which means that increase in trade openness will eventually affects the development of banking sector. While, Real GDP and Financial liberalization have a significant impact on the banking sector development i.e. higher Real GDP and Financial Liberalization in Pakistan will leads towards development of banking sector. R square is (.99) which shows substantial explanation of independent variables in dependent variables.

Table 2. OLS Results of Model 2 (Private Sector Credit)

Dependent Variable: PRI

Method: Least Squares

Date: 01/24/11 Time: 16:16

Sample: 1970 2007

Included observations: 38

Variable

Coefficient

Std. Error

t-Statistic

Prob.

RGDP

-7.684614

5.715274

-1.344575

0.1879

TO

-7.525119

3.603842

-2.088082

0.0446

DR

25.87713

9.222809

2.805775

0.0084

FL

-0.204028

1.108112

-0.184122

0.8550

C

0.033118

0.090551

0.365739

0.7169

R-squared

0.343149

Mean dependent var

0.041883

Adjusted R-squared

0.263531

S.D. dependent var

0.648747

S.E. of regression

0.556741

Akaike info criterion

1.788644

Sum squared resid

10.22868

Schwarz criterion

2.004116

Log likelihood

-28.98424

F-statistic

4.309923

Durbin-Watson stat

1.880175

Prob(F-statistic)

0.006483

In model 2, we have used Private sector credit as an indicator of development of banking sector in Pakistan. Results of table 2 indicate that discount rate and trade openness have significant impact on the development of banking sector. However, Trade openness is inversely related to the banking sector development. Financial liberalization and Real GDP are not found statistically significant. R square of model 2 is (.34) which shows that independent variables are explaining 34 % of the dependent variable.

OLS Results of Model 3 (Domestic Credit)

Dependent Variable: DC

Method: Least Squares

Date: 01/24/11 Time: 16:20

Sample: 1970 2007

Included observations: 38

Variable

Coefficient

Std. Error

t-Statistic

Prob.

RGDP

0.289400

0.002316

124.9755

0.0000

TO

-0.007190

0.001983

-3.626526

0.0010

DR

0.014020

0.005240

2.675496

0.0115

FL

0.001211

0.000307

3.938439

0.0004

C

-6.23E-06

4.61E-06

-1.351692

0.1857

R-squared

0.999939

Mean dependent var

-1.15E-05

Adjusted R-squared

0.999931

S.D. dependent var

0.003380

S.E. of regression

2.80E-05

Akaike info criterion

-18.00387

Sum squared resid

2.59E-08

Schwarz criterion

-17.78840

Log likelihood

347.0735

F-statistic

134392.7

Durbin-Watson stat

1.559156

Prob(F-statistic)

0.000000

In model 3, we have used domestic credit as an indicator of banking sector development. Results of table 3 indicate that all variables are statistically significant to the development of banking sector of Pakistan. R square of model 3 is (.99) which shows that independent variables have a significant impact on the dependent variable. (Goldsmith, 1969)

As mentioned above, generalized form of data has been used in this study and numbers of tests have been applied on these three models and there is no serial correlation, heteroscedasticity.

CONCLUSION AND DISCUSSION

The results of this study shows that Trade openness is inversely related to the development of banking sector in Pakistan in all three models which validates the findings of (Siddiqui & Iqbal, 2005) that Trade openness negatively affects the economic growth of a country. However these results are not according to the findings of (Miller & Upadhyay, 2000) which states that trade openness leads to the development of financial sector. Moreover this study also does not support the findings of (Yu & Gan, 2010) which states that trade openness have no impact on the development of banking sector.

In case of Liquid liabilities as indicator of banking sector development, it is clear that Real GDP and Financial liberalization have the significant impact on the development of banking sector of Pakistan. This result is according to the findings of (Yu & Gan, 2010) and (Attaullah et al, 2004) which show that Real GDP and Financial Liberalization significantly impact the banking sector development. It means that increase in Real GDP and Financial Liberalization will lead the banking sector of Pakistan towards prosperity.

In case of Private sector credit as the indicator of banking sector development, it is found that discount rate is statistically significant to the banking sector development. It means that increase in discount rate will lead towards increase in private sector credit which will eventually results in financial sector development. However, financial liberalization was found inversely related to the banking sector development and Real GDP was not found significant which is against the findings of (Yu & Gan, 2010) which identifies that Real GDP has a significant impact on the development of financial sector of Pakistan when Private sector credit is taken as indicator of banking sector development.

In case of Domestic credit as indicator of development of banking sector, results shows that all four variables are statistically significant to the financial sector development which are according to the findings of (Rajan & Zingales, 1998), (Cetorelli & Gambera, 2001) which states that Financial Liberalization and Real GDP significantly impact the development of financial sector.

PRACTICAL IMPLEMENTATIONS FOR BANKING SECTOR

On the basis of the findings of this study, we can conclude that trade openness is having inverse relationship with the banking sector development. As a result of Trade openness, the less developed banking sector of Pakistan faces tough competition from the developed financial sector of other countries. Moreover, increase in trade openness increases the country’s exposure to international shocks i.e. if any economy faces will suffer a crisis, there will be more chance of transferring crisis in Pakistan.

Discount rate is also found significant in this study when Private sector credit and Domestic credit was used as an indicator of banking sector development. When the discount rate will be high, financial institutions will be encouraged to get loan from state bank of Pakistan. Banks usually uses discount rate as benchmark interest rate when they further lend the money to borrowers. So increasing the discount rate will eventually lead the banking sector to development.