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Literature Review On The Role Of Depository Institutions

For any developing country, banks act as an important institution to enhance the economic growth of the economy. Developing countries require an efficient and strong banking system for growth in the important sectors of the economy. The way the banking system has revolutionized in the recent years, its importance in stimulating economic growth is increasing day by day. Now banking system has been revolutionized by the latest and rapid technologies which have emerged in the form of E banking. The use of electronic and computerized systems made the banking system more efficient and strong.

How the banks can serve as an important institution for growth in the developing countries? The answer lies in the operations performed by the banks. Today, the banks are providing funds for investments in new enterprises by issuing short term and long term loans to the investors. These investors then make investments in different sectors of the economy which boosts the economic activity of the economy. Banks increase the capital formation in the country. Banks accepts deposits from its customers, in a way banks act as a store of wealth for a country. These wealth resources are then made available to the businessman for making investments which further boosts the economic growth in a country. Banks are more important for any developing country especially for Pakistan because Pakistan is an agricultural country and the economy of Pakistan depends a lot on the agricultural sector which is a source of living for large proportion of the population. Banks are promoting agricultural development by issuing agricultural loans to farmers which then are used to buy improved instruments for agricultural purposes. In this way there is an increased use of technically improved instruments and techniques which then improves the crop yield and agricultural productivity. Moreover the banks improve the trade in an economy which is an important source of reserves for an economy. Banking services like letter of credit, guarantees, cheques, bills of exchange etc are promoting the trade sector of the economy and developing countries like Pakistan needs these type of institutions for rapid growth economic growth. These type of banking services has been benefiting the trade sector at both national and international levels. Banks are heavily involved in credit creation in an economy by providing credit to the customers. Moreover the rate of interest is also charged and determined by the banks along with monitoring of central bank of an economy. Banks play a vital role in implementing the monetary policy of the central bank of an economy which then is used to stabilize the prices in the economy and to promote the economic activity as soon as possible. Finance in an economy causes growth by stimulating the economic activity in the form of funds provided by the banks which then is used as investments by investors for businesses.

The major role of depository institutions in a developing country like Pakistan is to mobilize the funds in the economy. Finance in the base of the economic activity in an economy due to its important uses described earlier. Banks can control money supply as they keep the 80% of the cash with them in the form of deposits (annual reports by state bank Pakistan). Banks provide liquidity to the country for growth in the various sectors.

While with special reference to Pakistan, banks are promoting economic activity by issuing loans to different sectors which are then becomes a part of the economic growth in the form of investments made by the investors or creditors. Pakistan’s economy is facing its worst era of the 60 year history. Economy has been hit hard by the terrorism, foreign investment id declining year by year. Foreign investors are no making investments in Pakistan as they don’t feel secure due to lapse of security in Pakistan. Poverty, inflation, budget deficits, food shortages, power shortages, oil and gas shortages are the major problems currently faced by the economy of Pakistan. In all these crucial economic and financial conditions, banks can play an important role in the revival of the economy.

Defining the profitability of banks: interest rate spread

Banks make their profits by the spread they earn from their core operation of lending and borrowing. The interest spread is defined as the difference between the interest bank charges on the loans and the interest rate which it gives to the depositors or the cost of borrowing. Bank maker loans to different sectors and they earn interest on it. Banks then gives interest to the depositors which is basically a cost to the bank. The interest rate spread in the basic earning source for any bank. Although in the recent years the banks has indulged in different off balance sheet activities and they have started providing services for which they charge fees which also a source of revenue for a bank but the core activity if of borrowing and lending. The interest spread is of a great importance for any bank.

In Pakistan the banking interest spread has remained high for the last few years. This is the reason why foreign banks are attracted towards banking sector of Pakistan. In the recent past a lot of banks came in Pakistan due to it higher spreads. The banking industry of Pakistan is performing quite efficiently. It is making high profits and expanding its business areas in the Pakistan. Although economic and financial crisis is creating problems for the Pakistan but banks are doing their job quite up to the mark. They are providing funds to both the sectors of economy i-e private and public. Each year the performance has been improving of the banks in Pakistan.

According to the report by the state bank of Pakistan, interest spread of banks remained quite high. Spread was around 7.31 in the February 2010. Over the past few years the banking industry is maintaining the interest spread of above 7 percent. Whereas the financial markets are facing crisis in the whole world but banks in Pakistan are still performing relatively better.

Due to its important role especially in a country like Pakistan there is a need to investigate the different sectors within the banking industry to provide more enhanced and detailed view of banking sector in Pakistan. The literature concerned was on the different areas of banking sectors (loans, E banking, consumer banking, borrowings, lending, interest rates) but the most important domain of banking sector which I came across was the profitability of banking sector in Pakistan due to which the banking industry attracts international banks towards Pakistan. To investigate more deeply regarding this issue, few research works was concerned and some of them focused especially Pakistan’s economy and its economic and financial health.

Impact of different variables on bank’s net interest margin

Interest spread of banks is affected by different variables at different levels. At macro levels the interest spread is affected by the real GDP, inflation and interest rates. Some more variables which have been included in this research paper are non performing loans, credit creation capacity, effect of IMF conditions on Pakistan, concentration of banks, administrative cost of banks and rate of investment in the economy. these variables affect the interest rate spread in different ways.

When GDP of a country increases the creditworthiness of creditor increases and the interest charged by the banks on loans fall as the creditors are now less riskier and this results in a low interest spread. Inflation however is crucial to any economy, higher inflation rates are reflected in the form of increased lending rates charged by the banks. So, higher inflation leads to higher interest spreads. Administrative cost is positively related to the banking interest spread because if administrative cost increases, this increased cost is passed on to the customers in the form of increased spread. Concentration of banks affects the interest spread quite importantly. Because in Pakistan the concentration of the banking industry is towards the top five or six banks which are controlling majorly the banking industry. They have the highest shares in deposits, advances, assets etc. These major banks include Habib bank limited, Muslim commercial bank limited, allied bank limited, National bank limited, united bank limited. The higher concentration leads to higher spread in the banking sector.

Regarding the banking spread in Pakistan we find a few research work done on this issue. The most important research work which I found was of Idrees Khwaja and Musleh-ud din and both are working in Research department of “Pakistan institute of development economics”. The research work done by these researchers focused on the “determinants of Banking spread in Pakistan” while considering the variables which affect interest rate spread on macroeconomic level, bank level and the whole banking industry level. During the research work they found that the banking spread can be lowered by bringing more alternate financial intermediaries which can serve as an alternate source to banks for small savers. They also concluded that Mergers and acquisitions should be brought under antitrust review as there is no law exists in this respect in Pakistan at present.

The research study by Anthony sanders and Liliana Schumacher “the determinants of bank interest rate margins: an international study” explores the determinants of on net interest margin/ interest spread in six countries of Europe including 614 banks. They used two step process to analyze the determinants of interest rate margins. First step was to control for the factors that cannot be built directly into the models like implicit interest rates, opportunity cost of reserves etc and second step includes the analysis of cross country and time varying determinants of these interest spreads. They used OLS regression to analyze the effects of various determinants on the interest spreads.

In a study by M.M.G Fase “the demand for commercial bank loans and the lending rate” he focuses on the lending rates on commercial loans and its determinants. They run regression analysis to analyze the impact of various factors on lending rates of commercial loans and they found that the interest rate elasticity of loan demand is significant and another finding was that the loan rate which a bank charges is a range rather than a point.

Literature consulted on the problem also includes a study “the determinants of bank rates in local consumer lending markets: comparing market and institution – level results” by Robert M. Feinberg. In this research work the role played by the credit unions in determining the banking rates. According to this research there is a strong competitive role for credit unions on bank loan pricing and they concluded that greater the local market share of credit unions and the greater the state level membership penetration, lower would be the bank loan rates. In addition to this conclusion the results shown by the regression analysis supports the importance of local markets in consumer banking sector.

In a study “banking market conditions and deposit interest rates” by Richard J. Rosen analyzes the impact of market structure on bank deposit rate and according to this research the impact is complex, both market size structure and multimarket bank presence have independent effects on rates. Mega banks have become more aggressive competitors due to their rapid growth in recent time period. They also concluded that more similar the banks are in size in a market, higher would be the deposit rates. Furthermore the shifting of deposit from single market and small banks to multimarket and mega banks has an impact on deposit rates.

In another study “multimarket bank pricing : An empirical investigation of deposit interest rates” by Timothy H, Hannan and Robin A. Prager, determinants of deposit rates which are offered by large, geographically diversified banking organizations have been analyzed. They found that these large organizations offer lower deposit rates then smaller banks and also found that interest rates are negatively related to the number of local banking markets in which an organization operates. The research also led to the finding that state level concentration of banks are more related to deposit rates as compared to the weighted average of local market concentration. Furthermore they also examined that whether large banks which have funding advantage causes small banks to offer low deposit rates but there was no evidence regarding this statement.

Another study by Idrees Khawaja and Musleh-ud Din “banking: Interest spread, inelastic deposit supply and Mergers” examined and found that inelasticity of depose supply influences the interest spread positively. Moreover they found that mergers and acquisition should be brought under antitrust review.

In a study at international level on almost 80 countries “Determinants of commercial banks interest margins and profitability” by Asli Demigriic – kunt and Harry Huizinga the determinants of banks profitability/ spread has been analyzed and this study includes variables according to the bank characteristics, macroeconomic conditions, explicit and implicit bank taxes, Regulation of deposit insurance, General financial structure and several underlying institutional and legal indicators. They found that all of the variables affect the interest rate spread in one way or the other. Some factors influence banking spread more than the other. The regression is detailed one so I am just mentioning their work because they also incorporated the variables like corruption and taxation which I have used in this research but I used it specifically for the conditions and environment of Pakistan and they used it for 80 countries across.

The research work done by David Tennant and Abiodun Folawewo “Macroeconomic and market determinants of banking sector interest rate spreads: Empirical evidence from low and middle income countries” analyzed the effect of macroeconomic and market specific determinants on interest rate spreads in low and middle income countries. They concluded that most of the variables which are critical in determining interest rate spread are not affected by size of the banking sector spreads in developing countries. Exchange rate a macroeconomic instability came out to be statistically insignificant and indicated that exchange rate volatility does not lead to a high inflation rates.

In another analysis done on the state bank of Pakistan’s annual reports from CY 97 to CY06 “Efficiency of financial intermediation: An analysis of banking spreads” the determinants of banking spread mentioned includes administration costs, provisions against NPLs, non-interest income, ownership structure and competition in the banking sector. This analysis focuses that how banking spread has increased and what were the trends in the determinants of interest spreads which I mentioned above and what trends had been observed in those factors affecting the interest spreads.

Banking industry in Pakistan

When Pakistan came into being, it did not have any kind of defined banking system. In 1947 the state bank of Pakistan was established. Then after the formation of state bank of Pakistan, the banking sector witnessed a rapid growth in this sector and it was flourishing at a very rapid rate. But the nationalization of commercial banks in the seventies was a sudden upset for the banking industry. That industry which was flourishing at a rapid pace went into troubles. All the commercial banks were then bound to the political persons. The bureaucracy became strong in the banking industry and rather continuing the business concerns, banks went into bureaucracy. This change affected the banks in a strong negative manner. Loan issued under the political pressure exerted by the political persons in the economy. these resulted in an increase in nonperforming loans, the administrative cost of banks rose to a high level. But in the nineties, much importance was given to banking sector, increased power of state bank lead to improvements in the banking sector of Pakistan. In nineties, there was a massive privatization of banks and MCB was the first bank to privatize followed by ABL and recently HBL has been privatized. Moreover national bank is the leader in the financial market and banking market. National bank has remained outstanding in Pakistan. It was the first bank to introduce to the foreign exchange company in Pakistan and it has also been awarded the different awards on the performance of banks.

State bank of Pakistan also monitor the monetary policy of the country as the other central banks in the world do. During the State bank of Pakistan was given complete autonomy in 1993. The main purpose was to give independence to state bank to make important decisions regarding the macro economy of the country. This increase in powers of state bank of Pakistan increases the authority to make policies regarding the credit and money in the economy.

Banking industry of Pakistan is performing very good and is very attractive for the foreign investors and the it evident from the history of banking industry that foreign banks have been incorporating in Pakistan due to the favorable conditions and high profits made by banks of Pakistan. Some specialized banks are also working in public sector like zarai taraqqiati bank limited and various others.

Credit creation capacity of banks in Pakistan

Credit creation is basically the capacity to increase the amount of money in the economy or we can say “money creation”. The credit creation can be done by different tools like money can be created by printing money, it can also be created by lending loans to the customers by banks. The credit creation capacity tells the ability of the bank to increase the money in the economy. This capacity can be measured by “money multiplier”. Money multiplier is the inverse of reserve ratio and reserve ratio is the amount which banks needs to keep with state bank. So, in this way there is a direct effect of the state bank policy on the money creation capacity of the banks as state bank sets the reserve requirement for the banking industry.

In Pakistan the banking sector has shown good performance in the creation of money. And it is evident from the historical analysis that banks kept on increasing their money creation capacity. If state bank lowers the reserve requirement or the reserve ratio, the ability of banks to create money or credit creation capacity increases. In nineties when privatization took place in the banking sector, the money multiplier kept on increasing till now and recently it is around 3.41 (banking statistics, state bank of Pakistan). Banks are trying to improve their credit creation capacity so they can lend more and earn more spread form the high money creation in the economy. More lending means more interest earned and more will be the spread. Banks also emphasize more on lending the money and keep a lesser amount with them (deposits) for the customers to pay them on demand.

Economic growth is also affected by the capacity of money creation by the banks. If banks increase the lending to the creditors, the rate of investment in the economy rises and economic activity also increases in the economy. Capital formation indicates the rate of investment in an economy. If money is being created rapidly and at large scale then economy grows much rapidly. These entire phenomenons have affects on one another. However focus is the economic growth in the developing countries like Pakistan. The case of Pakistan being a developing country is more important because the economy is facing a lot of problems currently. And the economy of Pakistan needs investment and investor’s confidence to revive the economy of the country. High rates of lending ad credit creation can be helpful to revive the economy of the Pakistan and it can put the economy on the way of progress.

Central bank regulations and IMF conditions.

In Pakistan the state bank of Pakistan is acting as the central bank. All the issues regarding the banking sector of Pakistan are being dealt by the state bank of Pakistan. State bank make policies for the banking industry of Pakistan, the monetary policy, interest rates in economy and various other financial duties in the economy. The amount of money being printed or created in the economy is also one of the key functions of state bank.

State bank of Pakistan maintains several rules and regulations for the all the banks in Pakistan. Like reserve requirements are set by the state bank of Pakistan. These matters or policies are very crucial to the growth and development of the economy. Like if reserve ratio increases or decreases the amount of money being created in the economy can increase or decrease. There is a negative relation between credit creation and reserve requirements. Another important function which is getting importance is the credit ratings of the financial institutions. These credit ratings are issued by the state bank of Pakistan on the basis of different criteria. These ratings provide a comprehensive view of the institution o the investors so the investors can make decision whether to invest in the particular institution or not. Firms and institution get rated each year by the state bank of Pakistan.

Being a developing country, one of the major problems of Pakistan has been heavy debts. Pakistan faces large budget deficits and it takes loans from the IMF to fulfill its required amount of budget. In doing so, the conditions set by the IMF have to be fulfilled by Pakistan in order to get the money drawn from the IMF. These conditions sometimes are helpful or in sometimes they are bad for the economy. During the musharraf regime, Pakistan did sign only one agreement with IMF in 2000. But after that no agreements were signed till 2008. In 2008 another agreement was signed. As compared to 2000 onwards, in nineties Pakistan signed agreements almost each year with IMF. I have incorporated to see the effect of these conditions on the interest rates in the economy and ultimately on the interest spread by the banks.

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