Impact Of Capital On A Banks Earning
The main goal of the research was to study the impact of Capital on Banks Earning. The purpose of this research is to examine closely the capital-earnings relationship to try to determine which among the probable explanations of the relationship appear to be important in banking sector operating in Pakistan.. By analyzing the financial statements for five major banks. Close relations between Capital and Earning may develop an increase in capital tended to be followed by increase in earning and vice versa.. Variable were found, based on previous studies. In this model independent variables are Capital Asset Ratio and Dependent variable is Return on Equity. Regression model is tested to determine the capital have a significant impact on banks earning.
CHAPTER 1: INTRODUCTION
Overview of Banking Industry In Pakistan
Over the years, banking sector of Pakistan showed massive growth and potential. The performance and strength indicator represents significant improvement in the success of banking system of Pakistan. The banking sector of Pakistan had faced pressures as of 2008 onward after gigantic amount of growth. Such as the liquidity crisis and solvency hitch had significantly affect the performance of banking economy and sector. The financial institution possibly will have managed the situation well devoid of any trouble if adequate amount of liquidity vacant to fulfill the requirement. Since the banks were working in a very tight market conditions and enforced to pay attractive rates to the depositors to attract liquidity. The central banks have reduced the Cash Reserve Requirement (CRR) and Statutory Liquidity Requirement (SLR) on Time Liabilities and demand to simplicity the liquidity in the market. The government required to develop its own empowers banks and the resources to generate the money. The huge sum of borrow by the government lay distraught on the economy. The government not obligatory only to limit its borrowing from the banks but also place some sort of checks on the money power. All of these factors had pooled to set a stage where the lending rates were far above the ground and having huge amount of burden on the banks financials. In recent years the huge amount of provision created b the bank and due to this the amount of nonperforming loans increased at rapid speed. The heavy provisions for non performing loans (NPLs) is due to the the enforced of banks by rising asset quality concerns. The stability of overall economy was based upon the stability of the banking system. The effective and efficient growth of saving and investment decision contributes to a stable macroeconomic environment. Furthermore in the areas of financial stabilization, transparent fiscal policy and monetary policy the appropriate macroeconomic measures support the functioning of banking system more specifically. The major role was played by the State Bank of Pakistan for the efficient and effective growth in the economy. The guideline provided by the State Bank of Pakistan to the financial institution to take part in the development by mobilizing the resources of the economy and facilitating the investors.
The achievement of banks lying on the ability to predict and avoid risk to cover up the losses brought by arisen risk. Generally the important necessity of a competitive banking institution and the cheapest source of funds were profit making. For successful banking in a growing competition financial market the profit was the essential and requirement. These main specifics together were the reason to focus on the current issue of banks profitability. These are the factors that were influencing the banks efficiency and effectiveness to manage the portfolio. Assets intended to achieve profitability and identify the areas that might have possible room for raising the profitability.
The Bank’s assets were group into two categories, the non earning assets and the earning assets. Earning assets means that the assets on which banks had earned the non earning assets and the interest income, it means the assets which be used for the point of reserve requirement, i.e. fixed assets used to run day to day operational activities. These assets were the main source of income for banks. Therefore regular returns generation ability of these assets had a significant influence on the banks profitability and performance. The study had focused on return on equity and the equity to asset ratio. The return on equity measures how much the shareholder’s earned for their investments in the company. Equity to asset ratio expresses the proportion of total assets financed by the owner’s equity capital, it indicates the finance and profitability of the company. These were the major source of income for banks. Therefore income generation ability of these assets had a vital influence on the banks earnings, performance and profitability.
1.2. Problem Statement
To investigate the study of the impact of capital on the banks earnings.
There is a significant relation between Capital Assets Ratio and Return on Equity.
1.4. Outline of the Study
The research structure based on five chapters as follows:
Introduction about the Banking sector of Pakistan and role in economy.
The literature review had provided theoretical background of the research and cites author those who had previously researched on the topic of impact of capital on banks earning.
The research methods chapter included method of data collection, statistical technique and hypothesis development.
The results chapter had included findings and interpretation of the results.
The conclusion, discussions, implications and recommendation section provided the final logical analysis.
Return on Equity
This ratio indicate how beneficial a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
Capital to asset ratio is define as ratio of equity to assets, both are same. Equity-to-asset ratio expresses the proportion of total assets financed by the owner`s equity capital. The equity to assets ratio indicates the finance and profitability of the company. It shows what proportion of total assets is financed by equity, and hence what proportion is financed by loans and non-equity shares. A low equity to assets ratio means much of the business is financed by loans, or non-equity shares, whereas a high equity to assets ratio means that most or all of the long-term capital is equity. Under the same conditions, the more higher, the more better, it shows the good finance and profitability.
CHAPTER 2: LITERATURE REVIEW
The explanation of this paper is to observe personally the capital-earnings association to try to conclude which between the possible explanations of the association appear to be important. We use annual data 1983-1989 in addition three years of lags on book standards of capital earnings, and a quantity of other variables. Data from the Report, almost insured U.S. commercial bank used, yielding an unusually huge data set of over 80,000 bank-year report (Berger, 1995).
The U.S. tax system imparts a benefit to debt finance throughout its management of interest payments as a tax-deductible expenditure. Debt in this framework refers mostly to deposits. Even though the tax system also encourages use of subordinated debt over equity, banks are partial by regulation in the quantity of debt that they may employ as capital and subordinated debt constituted only 0.57 percent of total bank debt in 1978. Deposit finance is further optimistic by the level fee structure charge for deposit insurance by the FDIC, which permit the bank to boost the value of the insurance, and thus its own value, by increasing its leverage (Marcus, 1983).
Study in banking literature and in more broad industrial organization literature find a positive statistical connection between profitability and way of market construction either concentration or market share. On earliest blush, this might recommend with the purpose of the present wave of amalgamation activity in the banking industry is encouraged by the potential benefits from superior market power created by growing the attention or market shares of the reconciliation firms. The conventional structure conduct performance hypothesis (SCP) assert with the aim of this finding reflect the setting of prices just before are less favourable to customers (lower deposit rates, higher loan rates) in further concentrated markets because of the product of competitive imperfections in these market. A related assumption be the relative-market- power hypothesis (RMP), state that basically firms among huge market shares and well differentiated goods are able to implement market power in pricing products and receive supernormal profits (Shepherd 1982).
Common liquidation costs more or less certainly enlarged significantly in the 1980s. The outlook of bank failure enhanced as the quantity of failure increase from ten or fewer per year as delayed as 1981 and to larger than two hundred per year from 1987 to 1989. These stages also coincide by means of industry declines suitable in the direction of the loss of market power from the overturn of regulatory deposit rate ceiling and financial market innovation that preferred nonbank competitors. In adding together, opposition for bank products improved for the reason of the removal of a number of interstate banking limitations, liberalized bank charters, as well as globalization of banking markets. Supporting conclusion institute a turn down within bank charter values through 1986 with determined through the reason of decline an important reason of the increase in bank failure (keeley, 1990).
Prior experimental study has furthermore focused more on book values rather than market values of debt and equity, even though market values offer improved estimates of the security afforded by investment. The preparation may exist somewhat reasonable by means of the interest rewarded to book values by bank regulator. On the other hand, the rising use of qualitative factor the same as well as a book ratio in capital regulation indicates with the purpose of regulators conscious of deficiencies in book values. Several of the so-called qualitative consideration is exactly the factor that distinguishes market as of book value (Marcus, 1983).
Investment could moreover influence earnings throughout operating costs. If banks be not entirely cost efficient, a change in CAR may possibly influence the force on management to control costs. If investment is highly expensive compared to debt at the margin, at that time the increase in capital precipitate by regulator power, increase pressure on banks to lessen operating costs to help offset the higher financing costs. On the other hand, the reduction in debt servicing load could reduce short-term pressures to set aside on operating costs to provide resources to reimburse debt holders or acquire away from debt holders the organize require in the occurrence of agency costs (Jensen, 1986; Harris and Raviv, 1990).
One more complexity with this narrative is with the purpose of the implication of the ES hypotheses about the things of effectiveness on market structure having certainly not been experienced. An essential condition for the ES hypotheses on the way to be true is the effectiveness is positively associated to attentiveness and/or market share. Once more, direct method of efficiency is required for this task (Berger, 1995).
In this study, the optimistic profit-market share association may support ESS, beneath which scale efficiencies are completely linked to both variables. Still in several of the study that does manage for scale, ESS possibly will be the primary explanation of the data. This is for the reason that does not directly measures scale efficiencies but have often been particular that do not allow for U-shaped standard cost curves (described below). Obviously, this literature cannot differentiate in the middle of the various hypotheses devoid of including shortest measures of both X-efficiencies as well as scale efficiencies (Berger, 1995).
The relationship between CAR and ROE in the simplest possible case and then relax assumptions one at a time. Consider a one-period model of a bank under the assumptions of perfect capital markets, that is, value-maximizing behavior, no bankruptcy costs, no barriers to entry, no taxes, and no deposit insurance. Assume also that bank management has no private information, so that debt and equity investors are symmetrically informed with management about bank in-vestment payoffs. Nonnegative amounts of equity and debt are chosen at the beginning of the period, and a random cash flow to be split between equity and debt holders occurs at the end of the period. In this simple model, market and book rates of return are identical. Here, an increase in CAR by substituting additional equity for debt reduces the risk on both instruments, and therefore lowers the markets required expected rate of return on both, as long as investors are risk averse and can-not completely diversify away the bank's risks. Thus, in the one-period, perfect markets, symmetric information case, we expect a negative correlation between CAR and ROE (Berger, 1995).
An alternative theory of the positive Granger-causation from capital to earnings is the "signalling hypothesis." Here, we relax the symmetric information assumption and allow bank managers to have private information about the future cash flows. Management may be able to signal this information through capital decisions (Acharya, 1988).
The positive Granger-causality as of earnings to capital is steady with the hypothesis to facilitate banks retain several of their marginal earnings in the shape of equity increase. This judgment is not surprising. We pay main attention, on the other hand, to the positive Granger-causality since capital to earnings, which is quite astonishing. This result is also the most applicable to the strategy debate over capital standards, and the individual that most directly challenges conservative wisdom. More evidence suggests that higher capital is follow by advanced earnings mainly throughout reduced interest rates on uninsured purchase funds. These conclusions are powerful for banks with low capital and high portfolio risk to decrease their portfolio risks as well as improved capital positions comparative to what they or else would have been. These results are reliable with the hypothesis for the reason that of factors production banks riskier in the 1980s, some banks may had larger than optimal risk of bankruptcy and the related deadweight liquidation costs, and as a effect paid very high risk premier on uninsured funds and suffer lower earnings. Banks that react by growing capital rapidly appear to have paid lesser uninsured debt rates and had higher earnings than individuals that did not respond in this means (Berger, 1995).
The capital-earnings relationship may also be affected by portfolio decisions. Banks that increase capital may choose portfolios with different risk and return pro- files. This is especially relevant when banks raise capital because they are required to do so by regulators. Desired portfolio risk may either increase or decrease when capital is increased involuntarily. In some cases, regulators may force relatively risky banks to reduce their portfolio risks as well. Under most circumstances, the expected value of revenues would move in the same direction as portfolio risk (Berger, 1995).
Former studies have experienced the MP hypotheses individually by investigative the price concentration connection, again lacking the assistance of efficiency variables. Prices are regress next to attention and/or market share, and a result of less favourable prices for customers of firms in more intense markets or with larger market shares are occupied as support for the suitable MP hypothesis (Berger and Hannan, 1989; Hannan, 1991).
Bank capital is the sum of equity plus debt subordinated to deposits. Capital provides a cushion that protects the bank from insolvency when the value of its assets falls; a bank can meet its obligations to depositors as long as losses on its asset portfolio do not exceed its capital. The ratio of capital to total assets in U.S. commercial banks has fallen dramatically in the last two decades, dropping from 11.7 percent in 1961 to 5.7 percent in 1978, the lowest level since World War I (Marcus. 1983).
On the other hand, such test are also challenging because the disqualified efficiency variables possibly will be related with equally prices and market structure. Beneath the ES hypotheses, prices may be comparatively positive for customers of firm in intense markets or with large shares for the reason that of the disqualified efficiency variables, so that the coefficients of attentiveness and share in such a price equation can represent a net result of the different hypotheses. An irrelevant market structure coefficient cannot be use to differentiate between cases in which mutually MP and ES effects and neither are functioning. A potentially more severe trouble is at hand if effectiveness is unenthusiastically related with focus or market share. This may probably occur in banking because the maximum concentration and largest shares are regularly in country markets where firms may possibly be of less than capable scale or everywhere organization or other factors of construction may be of moderately poor quality. In such cases, awareness and split negatively related to scale efficiencies or X-efficiencies plus regressions that do not manage for these efficiencies are partial toward results less approving prices associated with concentration and market share, imperfectly supporting the MP hypotheses (Berger, 1995).
The advantages of deposit finance are offset by two factors. First, bankruptcy is costly to owners because it entails the loss of the bank charter as well as other direct costs. Second, regulatory pressure for adequate capital results in additional auditing costs, regulatory interference, and, in extreme cases, loss of FDIC deposit insurance. The bank thus maximizes its value by increasing equity to the point at which the marginal value of reduced regulatory pressure and potential bankruptcy costs equals the marginal tax disadvantage of equity finance (Marcus, 1983).
At this point, the optimistic profit-structure connection is false, slightly than of direct origin, with competence driving both profits and market structure. Below the scale effectiveness report of the efficient arrangement hypothesis (ESS), firms have basically equally good management and technology, but a number of firms simply produce at more well-organized scales than others, and as a result have lesser unit costs and superior unit profits. These firms are theoretically having large market shares that may possibly result in high levels of absorption, again yielding a positive profit structure association as a forged outcome (Lambson 1987).
The market power (MP) hypothesis has fundamentally different implication from the two efficient-structure (ES) hypotheses for amalgamation and antitrust policy. To the degree that the MP hypotheses are accurate, mergers may be motivated by requirements to set prices that are less constructive to consumers, which decrease total customer plus producer surplus. To the degree that the ES hypotheses are correct, this merger may be motivated by capability deliberation that would increase total surplus. Therefore, advocate of the MP hypotheses lean to see antitrust enforcement as generally favourable, while ES advocates tend to see strategy that hold back mergers as socially costly (Berger, 1995).
The facts also prove that the positive Granger-causality from capital to earnings do not hold for the 1990-1992 time stage. This suggest that banks may have "overshot" their best possible capital ratios in the early l990s because of decline in bank risk that lower optimal capital ratios, and because of narrow changes and unexpectedly high earnings that raise capital above these best levels (Berger, 1995).
The result also disagree with several opinion supposed to validate distance requirements for instance, that free of charge banks grip too a small number of reserves and too dangerous portfolio (Cothren, 1987)
Reserve needs are required because of the ethical hazard problem linked with deposit insurance. The results propose not only deposit insurance and lender of last resort be not inevitably mandatory to prevent panic but, without reserve requirements, "superior" banks have incentive to grasp reserves to indicate their superiority (Freeman, 1988)
Moreover theoretical input, paper provide official test of bank signaling. The nonexistence of central bank or lender of last resort during 1964-65 serves as a test whether "free" banks signaled to avoid contagious runs. The experimental result supports the signaling hypothesis. Ultimately, this paper propose empirical measures also appropriate in testing other signaling hypotheses, mainly multi-signaling (Kam Hon Chu, 1999)
on the other hand, one quarrel in opposition to free banking be it will fall down because of externalities due asymmetric informational "It is tremendously complicated to differentiate between a comparative far above the ground rate of return that is accessible because of greater efficiency and single is presented because the establishment is also tasking much riskier strategy" (Goodhart, 1988)
Though, information asymmetries do not involve that marketplace forces fail to make sure high-quality banking practice. On other hand confirmation that earlier to the institution of the FDIC depositors and note holder cares about banks' financial circumstances and carefully scrutinizes balance sheets (Kaufman, 1988).
Initial, it shows bank's deposit rate and risk-free resources investment can be a shared signal of bank quality. At the same time as deposit rates single-handedly may be a "noisy" indicator, depositors know how to supplementary use accessible information to monitor banks. In a unscrambling equilibrium, a good bank signals its superiority by contributing a lower deposit rate and investing a higher proportion of liquid, risk-free asset as a bad bank. This bank information may eradicate banking panics even in a non-Diamond banking system that is even everywhere individual banks can not completely expand and around are no secondary markets for bank loans, equity, and deposits (Gorton and Haubrich, 1987).
Such separating balance means that asymmetric in sequence does not unavoidably lead to contagious bank runs. It should be strained, however, that the signal at this time rules out contagions base on wrong attributions of “bad" banking only. Contagions possibly will still arise if depositors anticipate bank loans to go unpleasant for reason independent of bank quality. Consequently, a role motionless exists for former supplementary panic devices, such as delay contracts (Kam Hon chu, 1999)
It always lead to free-rider and an externalities problem as well as contagious bank runs because depositors, mostly small ones, cannot distinguish between "strong" and "trouble" banks. As a result, conveniently there is no guarantee that competitive stress would implement "good" banking training, and a central bank is mandatory to correct market failure to in sequence asymmetry (kam Hon Chu, 1999)
Banks is confidential into diverse type’s base on the banker’s excellence, which vary because of differences in guidance, managerial skills, experience, and specialized ethics. A bank's kind is denoted by an arbitrary variable 0, where 0 E (), the set of all doable types. Bank excellence affects the expected net return on assets the loan scheme is reduced in cost by the higher the value of 0, the lower is the bank's quality. At the opening of the game, Nature determines the type of banks in the industry. For ease, presume only two types "good" and "bad." After 0 is realize, banks offer deposit contract to depositors. Base on their own type, banks decide deposit rates, to make the most of their expected profits. The contract is fixed rate and not state contingent for the reason that of costly state substantiation (Townsend, 1979).
But the preliminary stability is separating; bank cannot be communicable for the reason that depositors can recognize good banks by the signal. If a run occur, it will be a getaway to quality. Comparable to bank capital, the responsibility of the signal here is for good quality banks to rule out contagions. Bank runs play a significant role by given those incentives for depositors to observe banks and also for banks to signal their excellence. This differ from the cases of deferment of convertibility (Gorton, 1985; Selgin, 1993)
In addition, even though the latter plans ideally give out as a signal as well as a beneficial measure to re-establish stability when a panic has begun, their position in practice is still debatable. Experiential evidence is consequently needed to settle on whether banks actually sign and, if so, what signal they use (Friedman and Schwartz, 1963)
CHAPTER 3: RESEARCH METHODS
The chapter formed the core of the research work. The research methods chapter illustrated the detail information regarding data collection technique, sample size and also the tools that had been used in the study. The statistical tool also mentioned to give clear idea about the data collected and its treatment.
3.1. Method of Data Collection
There were two types of sources available for data collection i.e. primary and secondary data source. In the research secondary data source had been used. Secondary data were gathered from annual reports of the company and remaining data collected by using the formula of studied variables return on equity ratio and capital asset ratio. The annual financial information extracted from selected financial institution web site. Such as annual statements.
3.2. Sampling Technique
The study period was consists of six years from (2004-2009). The main reason for short study period was the availability of the relevant data. Ten major banks in Pakistan were selected from total population of thirty three in the banking industry. These ten major banks covered 78% market share of Pakistan banking industry. The selection of banks made on the basis of total assets for the period ended December 31, 2009.
3.3. Sampling size
Sample size used for this study was 10 different banks on the basis of the market share and the companies where proper finance departments exist.
3.4. Instrument of Data Collection
There are two types of sources available for data collection i.e. primary and secondary data. In this research secondary data is used. Secondary data is gathered from annual reports of the company and remaining data calculated by using the formula of studied variables.
3.5. Statistical Technique
In this research coefficient of correlation was used. The reason of using this statistical tool was that this test run compares the two variables to check the relation between two variables.
CHAPTER 4: RESULTS AND ANALYSIS
H1: There is a significant relation between Capital Assets Ratio and Return on Equity.
Interpretation of Table 4.1.1
The value of mean shown the average values, Standard deviation shown the variability of each dependant and independent variable and N represented the number of cases in the analysis. Each bank have average return on equity ratio is 0.211123 and Variability in the return on equity is 0.11277 Which shows that return on equity increased during six years and major contribution is from big Ten nationalized banking industry. Average CAR during six years is 0.0733 percent. While variation appeared is 0.35692 percent,. It is clearly shows that the important variable for the return on equity is CAR and it is clear shows that the increase in the CAR would increase in the return on equity.
Interpretation of Table 4.1.2
Coefficient of correlation represents the association between the variables. These values of coefficient of correlation range from -1 to +1. The sign of coefficient of correlation indicates the direction of relationship either positive or negative. The value of coefficient of correlation indicates the relationship strength. The Pearson correlation coefficient measures the linear association between two scale variables The value of coefficient of correlation indicates the relationship strength. The Pearson correlation coefficient measures the linear association between two scale variables. This table showed that there is a negative correlation between ROE and CAR which is -0.483.
Interpretation of Table4.1.3
Adjusted R Square
Std. Error of the Estimate
R Square Change
Sig. F Change
R Square, the coefficient of determination, is the squared value of the multiple correlation coefficients. Here, we have low value of R 0.483. This indicates that there is week relationship. R squared is the proportion of variation in the dependant variable explained by the independent variables. Adjusted R squared value is 22.0%. This indicates that 22.0 percent variation in the dependant variable explained by the independent variable and remaining un-explained. With the linear regression model, the error of your estimate is considerably lower, about 0.0996
Sum of Squares
Interpretation of Table 4.1.4
The ANOVA table tests the acceptability of the model from a statistical perspective. The significance value of the F statistic is less than 0.05, which means that the variation explained by the model is not due to chance. While the ANOVA table is a useful test of the model's ability to explain any variation in the dependent variable, it does not directly address the strength of that relationship.
The regression and residual sums of squares are not equal, which indicates that about 1/4th of the variation in return on equity is explained by the model.
Significance value is <0.05 that is 0.001 which mean model is fit and regression is required.
Co linearity Statistics
Interpretation of Table4.1.5
It states that the expected return on equity is equal to -1.525(CAR)
Even though the model fit looks positive, the first section of the coefficients table shows that there are two predictors in the model. There is one non-significant coefficient, indicating that this variable does not contribute much to the model, which is Dividend because significance value of Dividend is >0.05
Use of more than one independent variable in the analysis may cause of multi-co linearity problem. The multi-co linearity is measured by tolerance and variance of inflation factor (VIF). The tolerance is defined as the proportion of variation in the dependent variable not explained by the model. The tolerance and VIF value shows that there is not much multi-co linearity problem among independent variables. Which shows that overall model is good.
Multiple Regression Analysis Assumptions
Normality of error term distribution
The normality is check by normal probability plots. In this method, the normal distribution makes a 45 degree straight line, and plotted residual are compared with the diagonal. As presented in the figure 01, the values of the residual fall along the straight line with not much difference. The figure concludes that the residual structure is normal.
CHAPTER 5: DISCUSSION, IMPLICATIONS, LIMITATION, FUTURE RESEARCH AND CONCLUSION
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