Chapter 1 - Introduction

The financial system of the Pakistan is characterized by the dominant role of the banking sector, banking sector is considered as one of the most important source of financing for most businesses and evaluation of profitability of banks is indeed difficult and complicated, that there is no single yardstick to measure bank performance. The general assumptions, which support to measures profitability of the banking sector like measuring asset management, net interest margin, operating efficiency, return on equity and return on assets out of these profitability performances this study is to measure only return on assets (ROA) of banking sector.

In Pakistan banking industry continuously evolves, changes in industry composition and the macroeconomic environment have a direct impact on the aggregate performance of the industry. (SBP, 2007 -08)

The first group of studies for profitability of banking system include Short (1979), examines the relation between the profit rates of 60 banks and concentration in the ‘home' banking market of each. Other determinants found to be significant are whether the bank is government owned an alternate for profit rates throughout each country, and the rate of growth of individual banks' assets. The evidence supports the view that greater concentration leads to higher profit rates and Bourke (1989) examines the internal and external determination of profitability of banks in twelve countries in Europe.

A more recent study in this group is Athanasoglou et al. (2008), gave the systematic study for determining the bank profitability of Greek banks that covers the period 1985-2001 in which they conclude bank-specific determinants significantly affect bank profitability in the anticipated way with the exception of liquidity and there is significant relation between concentration and bank profitability, and bank reforms with bank profitability.

Similarly Athanasoglou et al. (2006), examined the profitability behavior of bank-specific, industry-related and macroeconomic determinants, using an unbalanced panel dataset of South Eastern European (SEE) credit institutions over the period 1998-2002 where they conclude with the exception of liquidity, all bank-specific determinants significantly affect bank profitability in the anticipated way and found inflation as a strong effect on profitability, while bank profits are not significantly affected by real GDP per capita fluctuations.

The banks are an important source of financing for most businesses. The common assumptions are that increasing financial profitability will lead to improved functions and activities of the organizations. There are five major variables to impact profitability of banks; the bank size, its credit risk, Capital, Operating expenses management and the Size of the bank.

Main focus of study is to analyze the financial statements and examine the impact of above factors on bank profitability. In order to evaluate the internal performance of a scheduled bank, financial indicators are constructed from the bank financial statements. Financial ratios like ROA, liquidity risk, credit risk, capital and operating expenses ratio are calculated.

This paper investigates, in a single equation framework, the effect of bank-specific determinants on bank profitability. The group of the bank-specific determinants of profitability involves liquidity, credit risk, capital, operating expenses management and size. So the research hypothesis tested in this report is that bank profitability increase due to better managed bank-specific/internal variables.

Data has been taken from the Pakistani banking sector over a relatively long period (2003-2008). To test the bank-specific variables, all balance sheet and income statement data have been taken from unconsolidated financial statements form each bank and confirmed from the data base of state bank of Pakistan.

1.1 Problem and Justification of Research

In past few years banking activities and performance have attracted the attention of business people, bankers, practitioners, policy makers, and researchers alike, making the investigation of bank profitability in the Pakistan a more relevant issue today than in earlier times. Banks are finings the ways to improve their performance and increase profitability. To help these findings, different studies have been carried out to check the relationship between performance and customer satisfaction and profitability with respect to cost efficiency. In Pakistan literature shows the gap that what major determinants affect the profitability of banks in Pakistan. So, the main objective set for this study is to identify the major determinants of bank's profitability in Pakistan and their linkage with bank's profitability.

1.2 Purpose of the Study

The purpose of this study seeks to examine the effect of bank-specific variables on the profitability of the Pakistan banking industry. And to identify what are major factors which affect bank profitability in Pakistan. And this study focuses to provide the systematic research in Pakistan to test the internal determinants of bank profitability.

1.3 Scope/Limitation of Research

There are number of limitations in this study like data collection which is totally based on secondary data through State Bank of Pakistan (SBP), primary research was quiet difficult to access because of time and lot of Scheduled Domestic and Foreign Banks are existing in Pakistan. Due to the unavailability of the time and restricted access to the accurate data, the study is limited to the last six years from year 2003 to 2008.

This paper includes sample of scheduled commercial banks, and exclude investment banks, micro-finance banks and development banks. Data set involve scheduled commercial banks of Pakistan, listed in Karachi Stock Exchange (KSE 100-Idex) for the period of 2003 - 2008 ; all banks has been excluded from study which have been came in existence after year 2003 due to unavailability of data from preceding year. Another limitation set for this thesis is that it is going test only internal/bank-specific determinants of bank over ROA.

1.4 Definition of Terms

Bank

Organization, typically a corporation, that acknowledges deposits, makes loans, pays checks, and executes related services for the public. The Bank Holding Company Act of 1956 defines a bank as any depository financial institution that accepts checking accounts (checks) or makes commercial loans, and its deposits are insured by a federal deposit insurance agency. A bank acts as a middleman between suppliers of funds and users of funds, substituting its own credit judgment for that of the ultimate suppliers of funds, collecting those funds from three sources: checking accounts, savings, and time deposits; short-term borrowings from other banks; and equity capital. A bank earns money by reinvesting these funds in longer-term assets. A Commercial Bank invests funds gathered from depositors and other sources principally in loans. An investment bank manages securities for clients and for its own trading account. In making loans, a bank assumes both interest rate risk and credit risk; market rates may raise above the Net Interest Margin a bank earns on its loan portfolio and investments, and borrowers may default.

Dependable Variable

Return on Assets (ROA)

ROA, which have been the most commonly used profitability indicators in the previous literature, is used as the dependent variables in regression model. ROA measures the profit earned per rupee of assets and reflect how well bank management use the bank's real investments resources to generate profits. The ratio return on assets (ROA) is calculated as net profit after tax divided by average total assets.

Bank-specific Determinants (Independent Variables)

Liquidity (LA)

Liquidity risk concerns the ability of a bank to anticipate changes in funding sources. This could have serious consequences on a bank's capacity to meet its obligations when they fall due. Effective liquidity management seeks to ensure that, even under adverse conditions, a bank will have access to the funds necessary to fulfill customer needs, maturing liabilities and capital requirements for operational purposes.

The ratio of loans (Total Liabilities not including equity) to Total assets (LA), serving as a proxy for liquidity following the study of Athanasoglou et al. (2006)

Credit risk (Loan Loss Provisions / Loans - LLP)

Poor enforcement of creditor rights, weak legal environment, and insufficient information on borrowers expose banks to high credit risk. At the macroeconomic level, weak economic growth adds to risk as it promotes the deterioration of credit quality, and increases the probability of loan defaults. Miller and Noulas (1997) point out that credit risk should unleash a negative impact on profitability since the higher the level of high-risk loans, the higher the level of unpaid loans. Poor asset quality and low levels of liquidity constitute the two main causes of bank failure. To proxy this variable this research uses the loan-loss provisions to total loans ratio (Allowance for doubtful debt over total loans (PL)). Theory suggests that increased exposure to credit risk is normally associated with decreased firm profitability and, hence, a negative relationship between ROA and PL is expected. Banks would, therefore, improve profitability by improving screening and monitoring of credit risk and such policies involve the forecasting of future levels of risk. According to Athanasoglou et al. (2005) credit risk should be modeled as a predetermined variable.

Capital (Equity / assets - EA)

Capital means the long-term funds contributed to a bank, primarily by its owners, consisting of common and preferred equity, reserves and retained earnings. The proxy to capital is taken as equity to total assets. Equity will be taken as sum of share capital, reserves and unappreciated profits. Capital reflects a bank's ability to absorb unexpected losses. As such, the strength and quality of capital will influence a bank's relative profitability. The capital reserves of the banks under review vary significantly. In this thesis, the ratio of equity to assets (EQ/AS) has been used to approximate the capital variable when adopting ROA as the profitability measure. Similar proxies are used in the existing literature, suggesting a positive relationship between capital and profits (Athanasoglou et al, 2006).

Operating expenses management (OEA)

One of the most important internal factors that can be constructed from the income statement is the efficiency in expenses management. As conventional wisdom suggests, the higher the expense of a bank, the lesser the bank's profitability will be.

Such a negative relation between expenses and profitability has been supported by studies of Bourke (1989) and Athanasoglou et al. (2006), implying that profitable banks are able to operate at lower cost. The expense management variable, which is defined as the ratio of non-interest/operating expenses to total assets, provides information on variations in operating costs. The effect of the variable on banking performance is mixed.

On the one hand, a negative relationship implies that efficient banks are able to operate at lower costs. On the other hand, a positive coefficient may be found if banks are able to transfer a portion of their operating costs to their borrowers and depositors.

Size (S)

The final determinant is the bank's size, measured by its total assets. Large bank size might result in scale economies with reduced costs, or scope economies that result in loan and product diversification, thus providing access to markets that a small bank cannot entry.

Size is used to capture the fact that larger banks are better placed than smaller banks in harnessing economies of scale in transactions to the plain effect that they will tend to enjoy a higher level of profits. Consequently, a positive relationship is expected between size and profits. Molyneux and Thornton (1992), Athanasoglou et al. (2006) and Goddard et al. (2004), all find size to be positively related to profitability.

Size signals specific bank risk, although the expected sign is ambiguous. To capture the relationship between size and bank profitability, proxy to bank size is taken using the logarithm of total assets following the study of Athanasoglou et al. (2006)

1.5Outline Of The Study

This study is organized into five chapters in order to examine the above mentioned research.

  • Chapter One, the Current chapter, provides a general overview/introduction of the study.
  • Chapter Two presents The Literature review, previous studies related to the topic.
  • Chapter holds the detailed description of analytical method used in the report. Further the hypothesis and the sample data are also shown in it.
  • Chapter Four describes the statistics summary of the panel data that we use to test our hypotheses. Later analysis and empirical results are presented.
  • Chapter five sum up the conclusion of the thesis report.

Chapter 2 - Review of Literature

There is a huge amount of literature is available that seeks to identify the determinants of bank performance. Where some studies focus on the understanding of bank profitability in a particular country, others focus their analysis on a panel of countries. In the literature, bank profitability, usually measured by the return on assets (ROA) and/or the return on equity (ROE), is typically expressed as a function of internal and external determinants. Internal determinants are causes that are mainly influenced by a bank's management decisions and policy objectives. Such profitability determinants are the level of liquidity, credit risk, capital adequacy, operating expenses management and bank size. On the other side, the external determinants, macroeconomic, are variables that reflect the economic environment where the credit institution operates.

Internal determinants of bank performance can be defined as variables that are influenced by a bank's management decisions. Such management effects will definitely affect the operating results of banks. Although an excellence management leads to a better bank performance, it is difficult, if not impossible, to assess management quality directly. In fact, it is absolutely assumed that such a quality will be reflected in the operating performance. As such, it is not uncommon to examine a bank's performance in terms of those financial variables found in those financial statements. Of those statements, the balance sheet and income statement are the two principal ones.

The balance sheet is an integral part of financial statements that highlights the financial position of a bank at a single point in time. It reflects the bank's management policies and decisions in the allocation of resources. Balance sheet items are direct indicators of the earning power and the cost of banks. From the financial statement, a variety of variables capable of influencing the bank's performance can be discerned. The determinants that receive most attention in the banking literature are costs, asset and liability composition and size. As a measure of bank costs, the capital ratio has long been a valuable tool for assessing capital adequacy and should capture the general safety and soundness of banks. It is generally believed that well-capitalized banks face lower expected costs of financial distress and such an advantage will then be translated into high profitability

Levine & Zervos (1998) Using data on 49 countries from 1976 to 1993, studied the empirical relationship between various measures of stock market development, banking development, and long-run economic growth. In which they conclude that stock market liquidity and banking development are both positively and robustly correlated with contemporaneous and future rates of economic growth, capital accumulation, and productivity growth. This research concluded positive relation between economic growth and financial development the results suggest that financial factors are an integral part of the growth process.

Goddard, Phil John (2004), in mid-1990s tested a sample of commercial, savings, and co-operative banks on growth and profit equations from five major European countries and explained that current profit is a main requirement for future expansion, because profit is the crucial basis of finance for expansion. But on the other side, undue current growth can have damaging impact to future profit, due to a managerial limitation on the pace at which a bank can go up without reasoning its profitability to decline. The growth regression recommend as banks became superior in relative terms, their growth performance be apt to improve further. There is no such evidence, but, relationship between bank size and growth. Largely, there is less likely or even no mark of mean-deterioration in bank sizes. Banks that sustain high capital- assets ratio is likely to grow at a reserved rate and the growth of banks included a tendency to be directly linked to macroeconomic conditions.

Berger (1995) concluded the positive coefficient estimate for the ratio of equity to total assets indicates an efficient management of banks' capital structure. Hence, result suggests that a bank's performance can be improved if it is well-capitalized and borrows less to finance their operations. Though banks tend to be more profitable when they are able to undertake more lending activities, yet due to the credit quality of lending portfolios, a higher level of provision is needed. Such a high level of provisions against total loans in fact depresses banks' return on assets significantly. In addition to the above characteristics, the negative sign on bank size suggests that larger banks achieve a lower ROA than smaller ones. This shows that the interbank market is competitive and efficient since banks with a large retail deposit-taking network do not necessarily enjoy a cost advantage against other banks. Therefore, rather than size, efficiency is more important in affecting bank profitability.

Bourke (1989) explained that one would expect a positive relationship between liquidity and profitability. Liquidity risk, arising from the possible fund increases on the assets' side of the balance sheet or incapability of a bank to accommodate decreases in liabilities, is considered an important determinant of bank profitability. Especially firms and households, these loans markets have a greater expected return than other bank assets and are equally risky.

Alexiou & Voyazas (2009) using the empirical framework to include the traditional Structure-Conduct- Performance (SCP) hypothesis, examined the effects of bank-specific and macroeconomic determinants of bank profitability. For the purposes of econometric modeling, quarterly balance sheet data for six major Greek banks and macroeconomic data over the period 2000 - 2007 were used. The result shows that the inflation rate appears to have a positive but slight effect on bank profitability. This positive relationship between profitability and inflation may also be influenced by the fact that interest rates on deposits usually decrease at a faster rate than those on loans. Inevitably, the profitability of commercial banks is sensitive to economic conditions. Despite the fact that banks' loan portfolios have grown (in line with increased demand for credit), it appears that increased competition within the Greek banking sector has played a key role in compressing net interest margins.

As for the bank-specific variables, the coefficient of the size variable as measured by the logarithm of banks' assets found to be positive and highly significant, reflecting the advantages of being a large company in the financial services sector. The estimated coefficient showed that the effect of bank size on profitability was positive. Furthermore large banks are generally able to secure financing for their operations at a lower cost than their smaller competitors. (Alexiou & Voyazas, 2009)

The value of the credit risk coefficient was negatively and significantly related to bank profitability. It appears that Greek banks implement risk-averse strategies in their attempt to maximize profits, mainly through systematic controls and monitoring of credit risk. The banks under scrutiny, as well as the whole banking sector in Greece, have significantly higher level of non-performing loans than most other banks in the Europe. Furthermore, non-performing loans tend to remain on the banks' balance sheets longer than is the case in other European countries. Advanced risk management techniques, strict lending policies reinforced by reliable monitoring systems and non-performing loan restructuring appear to have had a direct impact on reducing the banks' provisions for loan defaults which in turn boosts profitability. (Alexiou & Voyazas, 2009)

The sign of the coefficient indicates that the higher the credit risk assumed by a bank, the higher the accumulation of defaulted loans. In turn, the higher the level of loans in default, the greater the negative impact on bank profitability. Alexiou & Voyazas (2009) measured bank productivity as by the ratio of assets over personnel has a negative and significant effect on profitability.

The next calculated parameter by Alexiou & Voyazas (2009) was efficiency as measured by the cost to income ratio. Results suggest a negative and highly significant effect on profitability. This implies that efficient cost management is a prerequisite for improving the profitability of the Greek banking system. Typically the most competitive financial institutions have low efficiency ratios meaning that they have low expenses for a given level of output.

With respect to bank liquidity, as measured by the ratio of loans over deposits, a negative and significant relationship with profitability was confirmed by; the estimated coefficient corresponding to this particular proxy suggests that an increase in liquidity will cause a decline in profitability. These findings highlight the trade-off between liquidity and profitability. The more resources that are tied up to meet future liquidity demands, the lower the bank's profitability. The problem of ensuring adequate liquidity while not negatively impacting, performance requires skilful management. (Alexiou & Voyazas, 2009)

Molyneux and Thornton (1992), found a negative and significant relationship between the level of liquidity and profitability. Low levels of liquidity and poor asset quality are two major sources of bank failure. The requirement for risk management in the banking sector is natural in the banking business. During periods of enlarged uncertainty, financial institutions may make a decision to diversify their portfolios and/or raise their liquid holdings in order to decrease their risk. In this way, risk can be divided into credit and liquidity risk.

Athanasoglou et al. (2006) explained effect of bank-specific variables is in line with expectations, with the remarkable exception of the liquidity risk variable (LA), which is positive but insignificant. The justification may be that the South Eastern European (SEE) banking system still be short of the resources to meet the liquidity standards of the developed banking systems, maintaining an illiquid situation to avert failures.

Cooper et al., (2003), conclude performance of the institution may change with the modification in credit risk which reflects changes in the strength of a bank's loan portfolio. Duca and McLaughlin (1990), conclude increased exposure to credit risk is normally associated with decreased firm profitability so that deviations in bank profitability are largely attributable to variations in credit risk. This cause an argument concerning not the volume but the worth of loans made. In this way, Miller and Noulas (1997), conclude that more the accumulation of unpaid loans and the lower the profitability so this way more financial institutions are exposed to high-risk loans.

The credit risk variable (LLP) is negatively and significantly related to bank profitability, Athanasoglou et al. (2006), studying the SEE banks suggest that banks should focus more on credit risk management, which has been confirmed problematic in the recent past. Severe banking problems have started from the failure of banks to be familiar with impaired assets and create reserves for writing-off these assets. A huge help towards smoothing these anomalies would be provided by improving the transparency of the financial organizations, which in turn will help banks to evaluate credit risk more effectively and avoid problems associated with hazardous exposure.

In further studying Greek banking system Athanasoglou et al. (2008) suggest that f firstly, confirm that capital is better modeled as an endogenous variable and credit risk as a predetermined variable. And than test this by running the same model twice, the first time with the two variables treated as strictly exogenous and the second time as endogenous and predetermined respectively. The outcome support the hypothesis that capital is healthier modeled as an endogenous variable and credit risk as predetermined (as the theory also suggests) since the Sargan-test for over-identifying restrictions indicates that this hypothesis is rejected in the first case, while it is strongly accepted in the second

Bourke (1989) observed a significant positive relation between capital adequacy and profitability. Bourke (1989) concludes that the higher the capital ratio is, the more profitable a bank will be. Likewise, the studies of Berger (1995) result in that banks which are well-capitalized are more profitable than the others in the USA.

Molyneux and Thornton (1992), in the study of banking profitability across eighteen European countries for the period 1986-1989, also found that the capital ratio impacts banks' performance positively although such relationship is confined to just the state-owned banks. The positive relation between the capital ratio and profitability is not limited to the US banking industry. In addition to the capital ratio, researcher includes the asset and liability composition ratios as internal determinants of bank performance. Deposits and loan are considered to be the most important balance sheet indicators because they represent a sign of traditionalism of banking activities. Although bank loans are the main source of revenues and are expected to affect profits positively, findings from various studies are not conclusive. While the study by Abreu and Mendes (2000) documents a positive relationship between the loan ratio and profitability, studies show that a higher loan ratio actually impacts profits negatively. The later study notices that banks with more non-loan earnings assets are more profitable than those that rely heavily on loans.

Further supporting their first study Athanasoglou et al. (2008) concludes capital is important in explaining bank profitability and that increased exposure to credit risk lowers profits, as they found expected results, that credit risk is negatively and significantly related to bank profitability. This implies that in the Greek banking system managers also attempting to maximize profits seem to have adopted a risk-averse strategy, mainly through policies that improve screening and monitoring credit risk.

Flamini, Calvin and Liliana (2009) studied the determinants of bank profitability determined by credit risk, bank size, activity diversification, and private ownership. Research measured credit risk using the ratio of loans to deposits and short-term funding since this provide a forward-looking measure of bank exposure to default and asset quality deterioration. Flamini, Calvin and Liliana (2009) conclude credit risk has a positive and significant effect on profitability. This suggests that risk-averse shareholders target risk adjusted returns and seek larger earnings to compensate higher credit risk. Further explanation is that there is clear evidence that credit risk can be lowered through the increase of credit information sharing. This would lower net interest margins, thus boosting credit expansion and financial. This would lower net interest margins, thus boosting credit expansion and financial intermediation.

Capital should be an important variable in determining bank profitability, although in the existence of capital requirements, it may alternate risk and also regulatory costs. In imperfect capital markets, well-capitalized banks require borrowing less in order to support a given level of assets, and tend to face lower cost of funding due to lower prospective bankruptcy costs. (Flamini, Calvin and Liliana, 2009)

Also, in the presence of asymmetric information, a well-capitalized bank could provide a signal to the market that a better-than-average performance should be expected (Athanasoglou et al., 2008 and Berger, 1995). Athanasoglou et al., 2008, concluded capital variable as positive and highly significant, reflecting the sound financial condition of Greek banks. A bank with a strong capital position is able to practice business opportunities more effectively and has more time and flexibility to deal with problems occurs from unexpected losses, thus achieving increased profitability.

Several bank profit studies use alternates for risk, collectively liquidity ratios and capital-assets, to detain the conception that a bank's ability to absorb unforeseen losses influences its performance. Comparatively high capital-assets ratio could show that a bank is working with over care and paying no attention to potentially profitable diversify- caution or other opportunities. In the same way, a bank investment in a high proportion of liquid assets is not likely to earn more profits, furthermore less exposed to risk (Bourke, 1989).

Goddard, Phil and John (2004), used dynamic panel to test growth and profit equations for a sample of savings, co-operative, and commercial banks from five main European Union countries for the period of the mid-1990s. Banks that sustain high capital-assets or liquidity ratios are likely to record relatively low profitability.

Research concludes that there is more reliable evidence of an inverse correlation between a bank's growth and capital-assets ratio. A high capital-assets ratio as a result comes into view that it associated with a comparatively cautious growth policy. In addition banks that cannot recognize areas into which to rise will naturally tend to accumulate additional capital. As a result banks that give more attention to assets, growth appears likely to operate at comparatively low liquidity ratios.

Goddard, Phil and John (2004), concluded that riskier banks apt to generate more profits, according to portfolio theory. Banks that sustain a high capital- assets ratio are likely to grow up at a reserved rate and the growth of banks apt to be directly linked to macroeconomic conditions. Where as, there emerge to be only some if any added variable that have a strong or systematic control on bank growth.

Berger (1995) found that capital adequacy ratio affected ROE of USA banks positively in 1983-1989 and negatively in 1989-1992. Based on these results, Berger argued that the relationship between capital adequacy ratio and profitability depended on the specific circumstances of the time periods observed. According to the results of the study, a high capital adequacy ratio positively affects profitability when financial situation of banks is perceived as risky and it negatively affects profitability in normal situations due to alternative cost of capital. The main problem in benefiting from this result is the difficulty of determining an optimal level for the capital adequacy ratio.

Sayilgan, Onur (2009) studied determinants of return on assets (ROA) and return on equity (ROE) for banks in Turkey was explored in 2002-2007 period using monthly data and aggregate balance sheet of the banks, through multi-variable single-equation regression method. Sayilgan & Onur (2009) conclude ROA was positively affected by capital adequacy. Turkish banking sector had huge crises in the 1990s and early 2000s. The strengthened capital structure increased the confidence in the sector which have contributed to a better profitability performance through lower cost of financing. According to Sayilgan & Onur (2009) on the micro independent variables front, profitability seems to have been positively affected by capital adequacy in broad terms and negatively by growing off-balance sheet assets.

Flamini, Calvin and Liliana (2009) took sample from 41 countries for 389 banks to study the determinants of ban profitability. Their model was estimated by treating capital and credit risk as predetermined variables. They test the suitability of this assumption by rerunning the model with all the variables strictly exogenous. In order to get a deeper understanding of the relationship between capital and profits, they use Granger causality tests to see how each variable affects future changes in the other variable. The coefficient of equity is positive and highly significant, meaning that well-capitalized banks experience higher returns.

The coefficient on the first lag of equity is negative and significant, meaning that stronger capitalization help predict a lower future ROA. This result confirms the evidence derived from contemporaneous regression, and reflects the different timing of adjustment in the prices of deposit and loans following a capital increase. In an imperfect capital market, a higher capital ratio tends to lower the equilibrium deposit rate required by depositors as well as the equilibrium expected return on assets required by shareholders. Due to the short term characterization of deposits, however, deposit rates adjust quickly, thus instantly increasing banks' expected earnings. This explains the positive contemporaneous correlation between equity and returns. (Flamini, Calvin and Liliana, 2009)

Capital also displays positive and significant conditional serial correlation at first lag, while there is no evidence of causation in the Granger sense from ROA to capital until the third lag which shows a positive and significant coefficient. This suggests the abnormal returns earned by SSA banks are not immediately reinvested in the system to increase capital ratios and financial stability, and if any reinvestment occurs, this only happens with a substantial lag. (Flamini, Calvin and Liliana, 2009)

Even though leverage (overall capitalization) has been demonstrated to be important in explaining the performance of financial institutions, its impact on bank profitability is ambiguous. As lower capital ratios suggest a relatively risky position, one would expect a negative coefficient on this variable (Berger, 1995). Moreover, an increase in capital may raise expected earnings by reducing the expected costs of financial distress, including bankruptcy (Berger, 1995). Indeed, most studies that use capital ratios as an explanatory variable of bank profitability (e.g. Bourke, 1989; Molyneux and Thornton; 1992) observe a positive relationship.

To make sure that the relation Flamini, Calvin and Liliana (2009) are capturing is not spurious, they rerun the test with the complete set of controls incorporated in their main model, including dummies for every time period. Results indicate that capital Granger-causes returns with negative coefficient, while the causation from earnings to capital only occurs at the third lag with positive sign. These findings indicate that the negative causation running from capital to earnings and the delayed positive response of capital to past returns are indeed robust and does not capture spurious effects. Further findings evidence that profits are reinvested, but with a significant lag. The evidence that returns are reinvested in capital with a significant lag gives a little sustain to a policy of striking higher capital requirements to strengthen financial stability in SSA.

Sayilgan, Onur (2009), determines of return on assets (ROA) and return on equity (ROE) for banks in Turkey was explored in 2002-2007 period using monthly data and aggregate balance sheet of the banks, through multi-variable single-equation regression method. Onur concluded ROA was positively affected by capital adequacy. The strengthened capital structure increased the confidence in the sector which might have contributed to a better profitability performance through lower cost of financing.

Well-capitalized banks are, in this regard, less risky and profits should be lower because they are perceived to be safer. In this case, negative association between capital and profits has been observed. However, if regulatory capital represents a binding restriction on banks, and is perceived as a cost, an expected positive relationship to the extent that banks try to pass some of the regulatory cost to their customers. Profits may also lead to higher capital, if the profits earned are fully or partially reinvested. Substitute for capital with the ratio of equity to total assets, and, based on the above considerations, it model as a predetermined rather than strictly exogenous variable (Flamini, Calvin and Liliana, 2009).

Bank net interest margins and profitability which is examined through macroeconomic and financial structure indicators to check the impact of bank's characteristics

Naceur (2003) studied the Tunisian banking industry for the period of 1980-2000 and examined bank net interest margins and profitability through macroeconomic and financial structure indicators to check the impact of bank's characteristics. And use overhead, loan, liquidity ratio and capital ratios as replacement for internal determinants. An extensive part of the within-country variation in bank interest margins and net profitability are clarified by individual bank characteristics. Banks that keep a comparatively increased amount of capital and with large overheads are likely to have high profitability and net interest margin

Naceur (2003) expect that the higher equity-to-asset ratio, the lower the need to external funding and therefore higher profitability. It also a sigh that well capitalized bank face lower costs of going bankrupt and then cost of funding is reduced. And confirms the positive relationship whether it use interest margin or return on assets as a dependant variable and in all specifications. This may indicate that well-capitalized banks support lower expected bankruptcy costs for themselves and their costumers, which reduce their cost of capital.

Bank's interest margins, bank loans are other important internal factors which have a positive and significant impact. A negative and significant coefficient on the net interest margins is found to be size. The size of bank is also included to account for size-related economies and diseconomies of scale. Size is a result of a bank strategy, but the variable alone does not guarantee the earning of excess returns. Banking performance study, conclude that an inverse relation exists between size and profitability. Naceur (2003) implying that larger bank achieve a lower level of profits than smaller one. The former shows that firm size impacts banking profitability negatively for large banks but positively for small ones. Medium-sized banks earn the highest return followed by small banks. This may suggest that inter-bank market is competitive and efficient since banks with a large retail deposit-taking network do not necessarily gain a cost advantage. Naceur (2003) suggested at the bank level, the improvement of the profitability of commercial banks need to be conducted by a reinforcement of the capitalization of banks through national regulation programs, by reducing the proportion of non-interest bearing assets to the benefit of bank loans and by reducing the size of large banks to optimal levels.

One of the most important internal factors that can be constructed from the income statement is the efficiency in expenses management. As conventional wisdom suggests, the higher the expense of a bank, the lesser the bank's profitability will be. Such a negative relation between expenses and profitability has been supported by studies of Bourke (1989) and Jiang et al. (2003), implying that profitable banks are able to operate at lower cost.

On the contrary, Molyneux and Thornton (1992) find that the expense variable affects European banking profitability positively. They propose that high profits earned by firms in a regulated industry may be appropriate in the form of higher salary and wage expenditures. Their findings support the efficiency wage theory, which states that the productivity of employees increases with the wage rate. This positive relationship between profitability and expenses is also observed in Tunisia by Naceur, 2003). The proponents argue that these banks are able to pass their overheads to depositors and borrowers in terms of lower deposit rates and/or larger lending assets.

Apart from overhead expenditures, banks are also subject to direct taxation through corporate tax and other taxes. Although the tax rate on corporate profits is not a choice for banks, yet the bank management should be able to allocate its portfolio to minimize its tax. Since consumers face an inelastic demand for banking services, most banks are able to pass the tax burden to the consumers. Such a positive relationship between the tax variable and profitability is confirmed by Jiang et al. (2003).

Bank expenses are also essential determinant of profitability, closely related to the notion of efficient management. There has been a large literature based on the thought that an expenses-related variable should be incorporated in a profit function. For instance, Bourke (1989) and Molyneux and Thornton (1992) found a positive relationship between better-quality management and profitability.

The most part, the literature argues that reduced expenses enhance the efficiency and hence raise the profitability of a financial institution, implying a negative relationship between an operating expenses ratio and profitability (Bourke, 1989). However, Molyneux and Thornton (1992) observed a positive relationship, suggesting that high profits earned by firms may be appropriated in the form of higher payroll expenditures paid to more productive human capital.

Athanasoglou et al. (2006) conclude that the operating expenses variable presents a negative and significant effect on profitability. This implies a lack of competence in expenses management, since banks pass part of increased cost to customers and the remaining part to profits, possibly due to the fact that competition does not allow them to “overcharge”. Clearly, efficient cost management is a prerequisite for the improved profitability of the banking system (the high elasticity of profitability to this variable denotes that banks have much to gain if they improve their managerial practices), as this sector has not reached the maturity level required to link quality effects pending from increased spending to higher bank profits. Athanasoglou et al. (2008) in their further study explain operating expenses as an important determinant of profitability. Whereas operating expenses are negatively and strongly linked to it, viewing that cost decisions of bank management are helpful in influencing bank performance.

Athanasoglou et al. (2008) concluded that the effect of bank size on profitability is not important. A justification for this may be that small-sized banks generally try to grow faster, even at the expense of their profitability. In addition to this, recently established banks are not particularly profitable (if at all profitable) in their first years of operation, as they place better emphasis on increasing their market share, instead on improving profitability. Along with the effect of size, the ownership position of Greek banks appears to be insignificant in affecting their profitability. In spite of this development, privately-owned banks do not appear comparatively more profitable, possibly denoting that the effects of M&As on bank profitability have not yet arisen.

Bank size in general used to capture potential economies or diseconomies of scale in the banking sector. This variable controls for cost differences and product and risk diversification according to the size of the credit institution. The first factor could lead to a positive relationship between size and bank profitability, if there are significant economies of scale (Bourke, 1989; Molyneux and Thornton, 1992), while the second to a negative one, if increased diversification leads to lower credit risk and thus lower returns. Other researchers, however, conclude that few cost savings can be achieved by increasing the size of a banking firm, especially as markets develop (Athanasoglou et al., 2008). Eichengreen and Gibson (2001), suggest that the effect of a growing bank's size on profitability may be positive up to a certain limit. Beyond this point the effect of size could be negative due to bureaucratic and other reasons. Hence, the size-profitability relationship may be expected to be non-linear.

The estimated equations when ROA is the dependent variable show that the effect of bank size on profitability is usually positive and statistically significant; while the relationship is linear (the square of bank assets is negative but insignificant). This provides evidence for the economies of scale theory. (Athanasoglou et al., 2008)

There is no evidence that bank size has a positive effect on performance. Banks subject to a foreign acquisition or public listing demonstrate better pre-event performance but bank size, foreign acquisition, and/or listing have little impact on return on assets (ROA), return on equity (ROE), the cost to income ratio and non-performing loans to total assets. The size coefficient, measured by total assets, is significantly negative in the ROAA/ROAE regressions, suggesting smaller banks perform better. The fixed effects model yields the same result, suggesting size is not important in explaining performance, nor can performance differences among the four types of banks be attributed to size effects. (Heffernan et al. (2008)

Flamini, Calvin and Liliana (2009), find that returns on assets are linked with greater bank size. The positive and significant coefficient of the size variable gives support to the economies of scale market-power hypothesis. Larger banks make efficiency gains that can be captured as higher earnings due to the fact that they do not operate in very competitive markets. The marginal statistical significance of the regression coefficient, on the other hand, adds further evidence to the hypothesis that, thanks to some degree of market power, banks manage to pass on to depositors and borrowers potential inefficiencies without affecting profits in an important way.

According to Flamini, Calvin and Liliana (2009), size signals specific bank risk, although the expected sign is ambiguous. To the extent that governments are less likely to allow big banks to fail, a risk approach to size would predict that bigger banks would require lower profits. However, if larger banks have a greater proportion of the domestic market, and operate in a non-competitive environment, lending rates may remain high (while deposit rates for larger banks are lower because they are perceived to be safer) and consequently larger banks may enjoy higher profits. This would imply lower costs for larger banks that they may retain as higher profits if they do not operate in very competitive environments.

Goddard et al. (2004) highlights no evidence of any relationship between bank size and profitability in the pooled estimations. The cross-sectional and dynamic panel estimations, however, suggest there are some significant size-profit relationships within the data set. These rather varied cross sectional and dynamic panel results are not contradictory, since they reflect different aspects of the size-profitability relationship: the cross-sectional estimation compares the average profitability of banks in different size bands, while the dynamic panel estimation reflects the direction of change in profitability for a given change in size for any individual bank from year to year. Nevertheless, overall the evidence for any consistent or systematic relationship between size and profitability is unconvincing.

Where as a positive relationship between size and profit explained by several factors. Large banks may benefit from scale or scope economies. In addition, large banks may be able to exert market power through stronger brand image or implicit regulatory (too-big-to-fail) protection. Abnormal profits obtained through the exercise of market power in wholesale or capital markets may also contribute to a positive size-profitability relationship. Alternatively if large banks encounter diseconomies of scale, the size-profit relationship could be negative. (Goddard et al., 2004)

There is some evidence of a significant size-profitability relationship in some of the estimations, but overall the evidence for any systematic relationship between size and performance is unconvincing. The results are consistent with those of much of the previous empirical banking literature, suggesting that efficiency is to be expected to be a more significant factor of performance than revenues. (Goddard et al., 2004)

A widely used alternative for the effect of the macroeconomic environment on bank profitability is inflation. Most studies (e.g. Bourke, 1989; Molyneux and Thornton, 1992) observe a positive relationship between inflation and bank performance.

Athanasoglou et al. (2008) confirmed expected inflation, positively and significantly affects profitability, possibly due to the ability of Greek banks' management to satisfactorily, though not fully, forecast future inflation, which in turn implies that interest rates have been appropriately adjusted to achieve higher profits. This could also be taken as the result of bank customers' failure (in comparison to bank managers) to fully foresee inflation, implying that above normal profits could be gained from asymmetric information. Literature also suggests macroeconomic control variables, such as inflation and cyclical output, clearly affect the performance of the banking sector. The result of the business cycle is asymmetric because it is positively correlated to profitability only when output is above its trend.

Athanasoglou et al. (2006) concluded inflation is positively and significantly affects profitability. This implies that, bank income boost up more than bank costs due to inflation, which may be viewed as the result of the failure of bank customers (comparative to bank managers) to forecast future inflation.

Finally, with respect to the macroeconomic variables, inflation has a strong effect on profitability, while bank profits are not significantly affected by real GDP per capita fluctuations, probably owing to the small sample period. However, as financial systems develop and the reform process ends, both the current and future rates of economic growth are likely to have an enhanced impact on bank profitability.

Kunt et al. (1998) found that inflation is linked with higher profitability and higher realized interest margins. Inflation involves higher costs - more dealings, and generally higher income from bank proposes more and also extensive branch networks. The positive relationship between inflation and bank profitability implies that bank income increase faster than the bank cost due to inflation.

Further, high real interest rates are associated with higher interest margins and profitability, especially in developing countries. This may reflect that in developing countries demand deposits frequently pay zero or below market interest rates.

The percentage change in the GDP deflator, or inflation, is estimated to increase the net interest margin and bank profitability, although significance of the coefficients in the profitability regressions is low. This may reflect that banks obtain higher earnings from float, or the delays in crediting customer accounts, in an inflationary environment. Inflation cause bank costs generally also rise. A larger number of transactions may lead to higher labor costs, and result in a higher bank branch per capita ratio. On net, however, the regression results suggest that the impact of inflation on profitability, while not very significant, is positive throughout. (Kunt et al., 1998)

Sayilgan, Onur (2009) conclude results related to the macro independent variables; the profitability (ROA and ROE) of the banking sector seems to have increased along with declining inflation rate, consistently increasing industrial production index and improving budget balance.

Flamini, Calvin and Liliana (2009) account for macroeconomic risk by controlling for inflation, as measured by the current period CPI growth rate, the price of fuel and the price of a commodity index that excludes fuel. While they expect a positive effect of commodity prices on bank profitability, the extent to which inflation affects bank profitability depends on whether future movements in inflation are fully anticipated, which, in turn, depends on the ability of firms to accurately forecast future movements in the relevant control variables. An inflation rate that is fully anticipated raises profits as banks can appropriately adjust interest rates in order to increase revenues, while an unexpected change could raise costs due to imperfect interest rate adjustment.

Flamini, Calvin and Liliana (2009) concluded Macroeconomic variables significantly affect bank profitability in Africa. In particular, inflation has a positive effect on bank profits, which suggest that banks forecast future changes in inflation correctly and promptly enough to adjust interest rates and margins.

In other words, the effect of inflation on the nominal interest rates on loans and deposits does not cancel out due to the cross product term, implying a positive effect of inflation on interest rate spreads. Assuming that net interest margins (NIM) are major components of bank returns, this translates into a positive effect of inflation on bank returns, absent any attempt by banks to adjust interest rates in response to inflation shocks.

Macroeconomic policies are important. Inflation reduces credit expansion by contributing to higher net interest margins. Therefore, policies aimed at controlling inflation should be given priority in fostering financial intermediation. Since the output cycle matters for bank profits, fiscal and monetary policies that are designed to promote output stability and sustainable growth are good for financial intermediation.

Vong and Hoi (2009) examines the impact of bank characteristics on the performance of the Macao banking industry, utilizing bank level data for the period 1993-2007, and adopt the panel data regression to determine the important factors in achieving high profitability.

Among the internal determinants total assets, loans to assets ratio, provision to total assets ratio and bank size show a significant impact on bank profitability.

Hence, Vong and Hoi (2009) result suggests that a bank's performance can be improved if it is well-capitalized and borrows less to finance their operations. As for the loan-to-total assets ratio, rather than affecting profitability positively, it actually reduces the return on assets. The inverse relationship between LOTA and ROA supports the finding that severe competition in the credit market and interbank placement of idle funds abroad has jointly reduced the profitability of banks. This is especially true in Macao where banks rely on traditional lending activities. The provision to total loans ratio is found to have a significant negative impact on banks' return on assets. Asset quality is reflected in the ratio. Though banks tend to be more profitable when they are able to undertake more lending activities, yet due to the credit quality of lending portfolios and the general practice in Macao, a higher level of provision is suggested. Such a high level of provisions against total loans in fact depresses banks' return on assets significantly.

Vong and Hoi (2009) in addition the negative sign on bank size suggest that larger banks achieve a lower ROA than smaller ones. This shows that the interbank market is competitive and efficient since banks with a large retail deposit-taking network do not necessarily enjoy a cost advantage against other banks. Therefore, rather than size, efficiency is more important in affecting bank profitability. Among the external determinants, only the inflation rate shows the strongest impact on banks' return on assets.

Banks with more equity capital are perceived to have more safety and such an advantage can be translated into higher profitability. On the other hand, Vong and Hoi (2009) results reveal that a higher loan-to-total assets ratio may not necessarily lead to a higher level of profits. Due to the competitive credit market condition and the successive cuts in interest rate, the interest spread, i.e. the important determinant of profitability, becomes narrower. A lower spread together with a higher loan-loss provisions lead to lower profitability. Therefore, instead of loan size, it is the spread and the quality of the loan that matter. Lastly, study shows that smaller banks, on average, achieve a higher return on assets than larger ones.

Singh & Sakshi (2009) focuses on India's banking sector, which since 1991 when a streamlined financial reform program was launched is attracting attention. The period covered under the study is from 2000-01 to 200-07. It evaluates whether chosen bank-specific determinants have significantly influenced profitability of Indian banks. The influence of bank specific determinants and selected macroeconomic determinants on profitability of banks has been assessed by working out simple linear regression analysis using yearly data on operating profit as dependant variable and bank specific determinants and macro economic determinant separately as independent variables on 5% level of significance. Singh & Sakshi (2009) concluded that most of the selected indicators significantly impact banks in India. The investments of public and private banks have significant impact on profitability. Where as the advances deposits and assets of individual banks have insignificant impact on profitability of public sector banks in India. These factors have significant impact on profitability of private sector banks and foreign banks in India. But in all cases one unit change in these variables are able to clarify very little change in profitability of respective banks. Thus, it is concluded that profitability of banks in India has risen significantly over the years and the selected macro economic determinants exert a significant impact on profitability of banks. The profitability moves in consonance with the selected macro economic determinant. On the basis of results Singh & Sakshi (2009) concluded, it can be inferred that the revolution of the Indian banking division with a high level of technology, variety and complexity in products and services and enhanced efficiency. Indian banking division is quickly moving towards international standards with growing competence, transparency and enthusiasm. The broad-based improvement had made the banking division aggressive and have placed it well to support maintain economic growth.

Sayilgan, Onur (2009) using monthly data and aggregate balance sheet of the banks, determines return on assets (ROA) for banks in Turkey was explored in 2002-2007 period, through multi-variable single-equation regression method. The results of the empirical study show that the profitability function of Turkish banking sector changed compared to pre-2002 period in many dimensions. According to the results related to the macro independent variables; the profitability (ROA and ROE) of the banking sector seems to have increased along with declining inflation rate, consistently increasing industrial production index and improving budget balance. On the micro independent variables front, profitability seems to have been positively affected by capital adequacy in broad terms and negatively by growing off-balance sheet assets. The regression results demonstrate that ROA tended to rise as the budget balance improved. This empirical study determined that ROA was positively affected by capital adequacy. The strengthened capital structure increased the confidence in the sector which might have contributed to a better profitability performance through lower cost of financing. The final statistically significant independent variable is the first difference of ratio of off balance sheet assets to total assets. The negative relationship between this variable and ROA was an expected outcome mainly due to the cost of hedging. Derivative transactions used to hedge risks increased rapidly. Nevertheless, derivative transactions have hedging and transaction costs. Besides, non-cash credits that are also classified as off-balance sheet assets have costs due to legal requirements such as provisions and the need for extra capital and liquidity. Further studies might include more specific bank variables such as foreign ownership or to be listed in the stock exchange or not. However, this kind of expansion of variables necessitates available monthly data and a panel data analysis. Bank specific variables are released quarterly, so this might also decrease the number of observations which are limited due to the length of the period beginning from 2002.

Tanna et al. (2005) investigates the impact of bank-specific characteristics, macroeconomic conditions and financial market structure on UK owned commercial banks' profits, during the period 1995-2002. The results show that the capital strength of these banks has a positive and dominant influence on their profitability; capital strength creates a significant role to the profitability of the UK banks, as the relatively high coefficient of the equity to assets ratio shows. The ratio was positive and significant for return on assets, and its effect remains dominant whether it include the external factors or not, it is also the main determinant of UK banks profits providing support to the argument that well capitalized banks face lower costs of external financing, which reduces their costs and enhances profits. Coefficient of the cost to income ratio found negative and significant, suggesting that efficiency in expenses management is a robust determinant of UK bank profits. The results concerning liquidity were mixed.

The other significant determinants are cost-to-income ratio and bank size, both of which impact negatively on bank profits. This ratio liquidity has a positive effect on return on assets, which show that the effect of liquidity on UK bank profits is not clear-cut, and varies with the measure of profitability used. Next, Tanna et al. (2005) found an inverse relationship between bank size and profitability, significant, suggesting that larger banks tend to earn lower margins and profits. This is suggesting either economies of scale/scope for smaller banks or diseconomies for larger banks. The impact of loan loss reserves is also not clear-cut, negative and insignificant on return on assets.

Considering the recent financial crisis, labeled as the worst crisis since the Great Depression, has underscored the fact that a sound and lucrative banking sector is best able to absorb negative shocks and contribute to the stability of the financial system. Ramlall (2009), analyses determinants of profitability for the Taiwanese banking system using bank-specific, industry-specific and macroeconomic factors, under a quarterly dataset, for the period 2002 to 2007. Results show that the main determinant of profitability for Taiwanese banks rests on credit risk, captured by allowance for doubtful debts, entailing the highest effect not only in terms of statistical but also in terms of economic significance that credit risk triggers a negative impact on profitability, capital tends to consolidate profits. Credit risk generates the highest economic significance among the statistically significant variables. Indeed, a 1% change in credit risk entails about -94% changes in profitability. This clearly shows that a rise in loan loss provisions as a preemptive measure instantly gnaws at the profitability of banks.

It also transpired that capital positively impact on profits, though the economic significance is significantly less than that of credit risk. Capital trails behind a positive impact with a 1% change in capital triggering about 8% change in profitability. The positive effect of capital in profitability shows that by having more capital, a bank can easily extend loans to thereby reap higher profits. Besides, capital acts as a safety net should unforeseen contingencies manifest.

The main implication of the Ramlall (2009) study is that, from the perspective of financial stability, it may be difficult to diminish the procyclicality of bank profitability in case of a well-diversified banking system. Procyclicality manifests in case bank profits move in tandem with upswings and downswings of the business cycles. Consequently, by increasing the level of allowance for doubtful debts in good times and reducing them in bad times, such procyclicality may be curbed. A well-diversified banking system, such provisions may further gnaw at the profitability of banks so that in extreme cases, it may cause some banks to close down.

Chapter 3 - Methodology and empirical data

This chapter holds the detailed description of analytical method used in the report. Further the hypothesis and the sample data are also shown in it.

3.1Research Method

This paper investigates, in a single equation framework, the effect of bank-specific determinants on bank profitability. The group of the bank-specific determinants of profitability involves liquidity, credit risk, capital, operating expenses management and size.

The methodology is based on Casual - Comparative Research. To test the relationship between bank profitability and the bank-specific, a Multiple Linear Regression Model is used. Sensitivity of hypothesis is checked on the 95% confidence interval. Reason to test hypothesis on 95% is suggested by literature including the major study by Athanasoglou et al. (2006).

3.2 Variables of the Study

Bank Profitability is the dependent variable, and measured by return on assets (ROA)

The independent variables of this study are the following:

  • Liquidity risk

    (LA) measured by ratio of loans (Total Liabilities not including equity) to Total assets

  • Credit risk

    (PL) measured by the loan-loss provisions to total loans ratio (Allowance for doubtful debt over total loans)

  • Capital

    (EA) is measured by the ratio of equity to assets (EQ/AS)

  • Operating expenses

    (OEA) is measured by ratio of non-interest/operating expenses to total assets

    ·Bank Size

    (S) is measured by using the logarithm of total assets

    3.3Econometric Model

    ROA = 0 β + 1β*LA + 2 β *LLP + 3 β *EA + 4 β *OEA + 5 β *S + εit (1)

    Where ROA is the dependant variable, 0 β is the constant term and the independent variable include liquidity (LA), credit risk (LLP), capital (EA), operating expenses (OEA) and size (S) and εit is the error term.

    Ramlall (2009), Athanasoglou et al. (2006), Athanasoglou et al. (2008) and Vong and Hoi (2009) used same model to examine relationship between ROA with bank-specific/internal, industry related and macro economic variable but as the objective of this thesis has been set to check the major bank-specific determinants of bank profitability, so model has been shorten/restricted to only internal variables.

    Athanasoglou et al. (2006), found liquidity risk variable (LA), positive but insignificant where as the credit risk variable (LLP) is negatively and significantly related to bank profitability. Further Athanasoglou et al. (2006) concluded capital as positive and highly significant coefficient and the operating expenses variable presents a negative and significant effect on profitability. And the effect of bank size on profitability was found to be positive and statistically significant.

    3.4Hypothesis

    Below hypotheses are tested in this thesis, all hypotheses are based on pervious research by Athanasoglou et al. (2006) on South Eastern European (SEE) Region

    H1:

    There is a negative and significant relationship between bank profitability and liquidity risk

    H2:

    There is a negative and significant relationship between bank profitability and credit risk

    H3:

    There is a positive and significant relationship between bank profitability and capital

    H4:

    There is a negative and significant relationship between bank profitability and operating expenses

    H6:

    There is a positive and significant relationship between bank profitability and bank size.

    3.5

    Data Collection

    To test the bank-specific variables, all balance sheet and income statement data have been taken from unconsolidated financial statements form each bank and to confirm from the state bank of Pakistan, The study have gathered six year financial data of all the banks operating in Pakistan.

    This paper includes sample of scheduled commercial banks of Pakistan listed in KSE; exclude investment banks, micro-finance banks and all data used in this thesis is based on secondary data. Convenience based sampling technique is used in this research where data for given time period was available for all given banks. On the basis of study requirement and sampling technique this study includes the sample of scheduled commercial banks of Pakistan, presently listed in Karachi Stock Exchange (KSE 100-Idex) for the period of 2003 - 2008 ; all banks has been excluded from study which have been came in existence after year 2003 due to unavailability of data from preceding year.

    The scheduled KSE listed Pakistani banks include the Allied Bank Ltd (ABL), Askari bank, Bank Alfalah, Bank Al-Habib, Bank of Khyber, Bank of Punjab, Faysal Bank, First Woman Bank Ltd (FWBL), Habib Bank Ltd (HBL), KASAB, Khushali Bank, MCB Bank, Meezan Bank, My Bank, National Bank (NBP), NIB Bank, Samba Formerly Cresent Bank, Saudi Pak Bank, SME Bank, Soneri Bank, Standard Chartered Bank(SCB)and United Bank Ltd (UBL).

    3.5.1.Reliability

    To ensure the reliability of thesis report, financial data has been confirmed from reliable source State bank of Pakistan. Furthermore, selected explanatory attributes and used regression model have taken from most prominent research studies in the area of bank profitability. Results are shown with used data for providing validity and are ensured by showing the related research work on determinants of bank profitability.

    Chapter 4 - Analysis and Empirical results

    This chapter first describes the statistics summary of the panel data that we use to test our hypotheses. Later analysis and empirical results are presented.

    4.1Data Analysis

    To test our hypotheses we perform the regression test and results are as follows:

    4.2Data interpretation

    On the basis of the data analysis we made following equation:

    ROA = - 5.214 - 0.109*LA - 0.843 *LLP + 0.134 *EA - 0.035 *OEA + 0.874*S --- (2)

    The R value .708 indicates that as credit risk increases the ROA decreases and this is a negative correlation where as if size increase ROA also increases which show positive relationship with ROA.

    The R Square value in the Model Summary table shows the amount of variance in the dependent variable that can be explained by the independent variable.

    And Adjusted R Square value .493 suggests that there is 49.3% variation in bank ROA due to its linear relationship with credit risk and size, which is 49.3% explained.

    The ANOVA table suggests that credit risk and bank size explain a significant amount of the variance in the ROA. In above table p<.05 and therefore can conclude that the regression is statistically significant.

    Coefficient output table gives us the regression equation and un-standardized Coefficients B column gives the value of intercept for the constant row and the slope of the regression line from credit risk and size row. It gives the following regression equation.

    ROA = - 5.214 - 0.843 *LLP + 0.874*S ---------------------------------------------- (3)

    4.3Hypothesis Analysis

    Dependant Variables

    Variable

    Measure

    Notation

    Hypotheses

    Regression Coefficient

    Sig

    Empirical Conclusion

    Profitability/ Return on Assets

    Net Profits (Before Taxes) / Assets

    ROA

    Determinants/ Independent Variables

    Bank-specific

    Liquidity

    Loans / assets

    LA

    H1:

    There is a positive and significant relationship between bank profitability and liquidity risk

    -0.109

    0.113

    Rejected

    Credit risk

    Loan loss provisions / loans

    LLP

    H2

    : There is a negative and significant relationship between bank profitability and credit risk

    -0.843

    0.000

    Accepted

    Capital

    Equity / assets

    EA

    H3:

    There is a positive and significant relationship between bank profitability and capital

    0.134

    0.56

    Rejected

    Operating expenses management

    Operating expenses / assets

    OEA

    H4:

    There is a negative and significant relationship between bank profitability and operating expenses

    -0.035

    0.674

    Rejected

    Size

    ln (real assets)

    S

    H5:

    There is a positive and significant relationship between bank profitability and bank size

    0.874

    0.000

    Accepted

    4.4Empirical Analysis

    Liquidity

    The coefficient of liquidity (LP) variable is negative and is insignificant. This result contradicts with various finding by different researchers; Athanasoglou et al. (2006)found liquidity risk variable (LA), positive but insignificant and Molyneux and Thornton (1992) and Alexiou & Voyazas, 2009, found a negative and significant relationship between the level of liquidity and profitability.

    1% change in liquidity risk entails about -10.9% changes in profitability. The estimated coefficient corresponding to this particular proxy suggests that an increase in liquidity will cause a decline in profitability. The more resources that are tied up to meet future liquidity demands, the lower the bank's profitability. The problem of ensuring adequate liquidity while not negatively impacting, performance requires skilful management. (Alexiou & Voyazas, 2009)

    Low levels of liquidity and poor asset quality are two major sources of bank failure. The requirement for risk management in the banking sector is natural in the banking business. During periods of enlarged uncertainty, financial institutions may make a decision to diversify their portfolios and/or raise their liquid holdings in order to decrease their risk. In this way, risk can be divided into credit and liquidity risk. (Molyneux and Thornton, 1992)

    Credit Risk

    The coefficient credit risk (LLP) variable is negatively and significantly related to bank profitability. These results confirms with the result of Athanasoglou et al. (2006), Ramlall (2009) and Alexiou & Voyazas (2009). Indeed, a 1% change in credit risk entails about -84.3% changes in profitability, which is significant at 1%. That shows that a rise in loan loss provisions as a preemptive measure instantly gnaws at the profitability of banks.

    Capital

    The coefficient capital (EA) variable is positive but is not significantly related to bank profitability. 1% change in credit risk entails about 13.4% changes in profitability, which is insignificant at 5.6%.

    This result opposes with various finding by different researchers; Athanasoglou et al. 2006 & 2008, Molyneux and Thornton (1992), Sayilgan, Onur (2009), Ramlall (2009) found capital variable positive and highly significant coefficient for bank profitability. Where as Berger (1995) found that capital adequacy ratio affected profitability of USA banks positively in 1983-1989 and negatively in 1989-1992. Based on these results, Berger argued that the relationship between capital adequacy ratio and profitability depended on the specific circumstances of the time periods observed. According to the results of the study, a high capital adequacy ratio positively affects profitability when financial situation of banks is perceived as risky and it negatively affects profitability in normal situations due to alternative cost of capital.

    Operating Expenses

    The coefficient operating Expenses (OEA) variable is negative and is not significantly related to bank profitability (ROA). 1% change in credit risk entails about -3.5% changes in profitability, which is insignificant at 64.7%.

    This result contradicts with various finding by different researchers; Molyneux and Thornton (1992), Naceur, (2003), who found positive relationship between profitability and expenses

    On other hand (Bourke, 1989), Athanasoglou et al. (2006 & 2008) conclude operating expenses variable presents a negative and significant effect on ROA. As per Athanasoglou et al. (2006) negative relationship to ROA implies lack of competency in expenses management, as banks pass element of increased cost to customers and the remaining part to profits, in spite of the fact that competition doesn't allow them to “overcharge”. In a same way, well-organized cost management is a requirement for the better profitability of the Pakistani banking system.

    Size

    The coefficient size (S) variable is positive and significantly related to bank profitability (ROA). 1% change in credit risk entails about 87.4% changes in profitability, which is insignificant at 1%.

    This result is consistent with result of Athanasoglou et al. (2006), Alexiou & Voyazas (2009) but contradicts with results of Athanasoglou et al. (2008) concluded that the effect of bank size on profitability is not important. And gave justification for this may be that small-sized banks generally try to grow faster, even at the expense of their profitability, in same way (Heffernan et al. (2008)found no evidence that bank size has a positive effect on performance. Where as Naceur (2003) conclude size is a result of a bank strategy, but the variable alone does not guarantee the earning of excess returns. Naceur (2003) implying that larger bank achieve a lower level of profits than smaller one. This shows that firm size impacts banking profitability negatively for large banks but positively for small ones. Medium-sized banks earn the highest return followed by small banks.

    Chapter 5 - Conclusion

    The main objective of this thesis was to identify the internal determinants of Pakistani bank profitability; the sample covers 21 scheduled commercial banks of Pakistan, presently listed in Karachi Stock Exchange (KSE 100-Index) for the period of 2003 - 2008.

    Though, all internal variables were considered to be in line with the empirical literature, however, based on regression coefficients showed by many variables along with dependency problem, the final model comprised of bank size and credit risk as independent variables.

    Results show that the main determinants of profitability for Pakistani banks rests on credit risk and size, as the value of the credit risk coefficient was negatively and significantly related to bank profitability.

    It appears that Pakistani banks implement risk-averse strategies in their attempt to maximize profits, mainly through systematic controls and monitoring of credit risk. But Banks with higher size is perceived to have more safety and such an advantage can be translated into higher profitability.

    On the other hand, results reveal that a higher liquidity ratio may not necessarily lead to a higher level of profits in spite liquidity have negative affect to ROA that suggests that an increase in liquidity will cause a decline in profitability. Whereas operating expenses are negative and insignificant to ROA, showing that cost decisions of bank management are instrumental in influencing bank performance.