Impact Of Interest Rate Changes On Banks Profitability Finance Essay - Free Essay Example

Use of more than one independent variable in the analysis may cause of multicollinearity problem. The multicollinearity is measured by tolerance and variance of inflation factor (VIF). Tolerance is the proportion of variation in the dependent variable not explained by the model. The tolerance and VIF value showed that there is not much multicollinearity problem among independent variables. Which showed that overall model is good. 4.2: Multiple Regression Analysis Assumptions 4.2.1: Normality of error term distribution The normality is checked by normal probability plots. In the method, the normal distribution made a 45 degree straight line, and plotted residual are compared with the diagonal. As presented in the figure 4.1 the values of the residual fall along the straight line with not much difference. The figure concludes that the residual structure is normal. Figure 4.1: Normal P-P Plot of Regression Standardized Residual Another method used to check the normality by histogram. The shape of the histogram in figure 4.2 showed that the figure closed to the shape of normal curve. Figure 4.2: Histogram 4.2.2: Linearity of the phenomenon measured The linearity of the relationship between dependent variable and independent variable represented the degree to which the change in the dependent variable is associated with independent variable. The figure 4.3 did not reflect any nonlinear pattern to the residual. Which shown that the overall relationship between variables is linear. Figure 4.3: Scatter Plot Interest Income Figure 4.4: Partial Regression Plot Interest Income and Interest Rate Figure 4.5: Partial Regression Plot Interest Income, Loan and Advances 4.2.3: Constant variance of error term The residual plots also showed that the presence of equal variance. This fulfilled the assumption of multiple regression model. 5.2.4: Independent of the error terms In regression each predicted value was independent of any other prediction. There were no sequenced by any variable from residual plot. 4.3: Reliability and Validity 4.3.1: Reliability The reliability is defined as the degree to which the observed values measure the true values, error free and consistent. The overall results were in line with the practices applicable in Pakistan. But the difference is appeared when the results of Pakistan compared with international practices. In high interest rate environment Pakistan banking getting high returns on the other hand the at global level interest rate were low. That clearly indicates the major differences in returns at Pakistan and international level. 4.3.2: Validity The validity is defined as the degree to which the measure is accurately represents what it is supposed to. The instrument has been used to predict the variation explained by the independent variable in interest income. The regression model used in the analysis and all the assumption has been fulfilled. 4.4: Hypothesis Testing H1: There is a significant and positive impact of interest rate on interest income. Result: Since the significant value of interest rate is 0.000, which was less than 0.050 and regression coefficient value 852.617 was also positive. That means interest rate had a significant and positive impact on interest income. That accepts the hypothesis H1. The reason for significant and positive impact was that rate increases and interest income increases. H2: There is a significant and positive impact of balances with other banks deposit accounts on interest income. Result: Since the significant value of balances with other banks- deposit accounts is 0.209, which was greater than 0.050 and regression coefficient value 0.057 was also negative. That means balances with other banks deposit accounts had no significant and positive impact on interest income. That rejects the hypothesis H2. The reason for no significant and positive impact was balances with other banks cover only the small portion of the banks earning assets. H3: There is a significant and positive impact of lending to financial institution on interest income. Result: Since the significant value of lending to financial institution is 0.917, which was greater than 0.050 and regression coefficient value 0.003 was also negative. That means lending to financial institution had no significant and positive impact on interest income. That rejects the hypothesis H3. The reason for no significant and positive impact was lending to financial institution cover only the small portion of the banks earning assets. H4: There is a significant and positive impact of investments on interest income. Result: Since the significant value of investments is 0.186, which was greater than 0.050 and regression coefficient value 0.079 was also positive. That means investment have no significant but had positive impact on interest income. That rejects the hypothesis H4. The reason for no significant but positive impact was that interest income not much dependent on investment. If the investment increases then interest income also increases but in small proportion. H5: There is a significant and positive impact of loan and advances on interest income. Result: Since the significant value of loan and advances is 0.000, which was less than 0.050 and regression coefficient value 0.118 was also positive. That means loan and advances have a significant and positive impact on interest income. That accepts the hypothesis H5. The reason for significant and positive impact was that as the portfolio increases the interest income increases. Table 4.6: Hypothesis Assessment Summary Hypothesis Independent Variables t value sig. Comments There is a significant and positive impact of interest rate on interest income. Interest Rate 6.474 0.000 Accepted since there was a significant and positive impact of interest rate on interest income. There is a significant and positive impact of balances with other banks deposit accounts on interest income. Balances with other banks deposit accounts -1.270 0.209 Rejected since there was an insignificant and negative impact of balances with other banks- deposit accounts on interest income. There is a significant and positive impact of lending to financial institutions on interest income. Lending to Financial Institution -0.105 0.917 Rejected since there was an insignificant and negative impact of lending to financial institutions on interest income. There is a significant and positive impact of investments on interest income. Investments 1.338 0.186 Rejected since there was an insignificant and positive impact of investments on interest income. There is a significant and positive impact of loan and advances on interest income. Loan and Advances 28.368 0.000 Accepted since there was a significant and positive impact of loan and advances on interest income. Dependent Variable : Interest Income Sig. Value: (0.05) 4.5: Chapter Summary The chapter included the results, interpretation, assumption in the multiple regression and hypothesis tested. The overall results are positive and significant. CHAPTER FIVE DISCUSSIONS, IMPLICATIONS, FUTURE RESEARCH AND CONCLUSIONS 5.1: Conclusion The objective of the study was to evaluate the impact of interest rate changes on banks profitability. The interest rate and loan and advances had a significant and positive impact on interest income. In the context of Pakistan interest rate and loan and advances had major impact on the banks interest income. The other significantly important variable was the loan and advances. As the portfolio of the loan and advances increases the banks interest income increases. Both the independent variable was directly related to interest income. The statistical result also showed that both the variable has significant and positive impact on the banks interest income. The regression technique also proved these findings. That means that profitability of bank dependant on interest rate, loan and advances. Specifically, in a higher interest rate environment, an increase in lending rates usually larger than the increase in deposit rates, which result in pushing up the bank, spreads. On the other side, in a lower loan and advances scenario, the opposite likely to be happen. When interest rate increases, lending rates tend to adjust more quickly as compare to deposit rates. While, in a declining situation deposit rates adjust faster then lending rates. Banks were more sensitive to interest rat risk as compare to the other financial institution. It is feared that further increase in the interest rate would slow the growth of advances and increase in the bad debts. Short term interest rate changes was a serious issue among shareholders, managers and analysts and most of the banks represent no serious threat on long term interest rate. That would affect the performance and credit rating of financial institution. The Paid up capital requirement of Rs. 7 billion until 2010 by the SBP also encourage further consolidation in the banking sector. It used for decrease the impact of risk, conservative growth in advances and deposits, bringing downward advances to deposits ratio. But the major concern was the interest rate movement which damaging in great deal. It would be very difficult for individual to save money and made investment in the economy. The findings clearly suggested that main determinant of banks profitability are interest rate, loan and advances. The only way to increase banks profitability by way of having good quality portfolio in terms of assets, check and balance system developed to monitor closely such default risk and interest rate risk. Usually Banks have different polices in place to monitor the customer credit worthness in the form of KYC, AML, watch list, credit rating and electronic credit information bearue (ECIB). Banking was about how to managing its risk and return. Success in banking system is dependent on how well organization manages its risk and return. The nature of banks business was to identify, evaluate and manage risk effective and efficiently. 5.2: Discussions and limitations There were some limitations in the research. Such as; The basis for calculation of interest income was KIBOR rate. The Pakistan banking system started practicing KIBOR rate as benchmark from 2002 onward. Therefore, the study period is 2003 2008. The sample size consists of ten major banks in Pakistan. That covered 76% market share of the Pakistan banking industry. 5.3: Implications and Recommendation 5.3.1: Implications The mechanism of monetary policy was to bring discipline and efficiency in the financial sector and developing a favorable environment for economic growth. The central bank pursued a tight monetary policy from past few years. There are several objective of monetary policy to control inflation, government borrowing and interest rate. In Pakistan, rising inflation and interest rate was the most common phenomenon. Rising lending rates harms the economy and consumer. It is a fact that high lending rates are regularly linked to high inflation. The changes in interest rates affect consumption and savings decisions of households, corporate level and also affect the output and investment decision throughout the economy. The central bank set the interest rate at which bank lends money to financial institutions and consumer. This measure will help in controlling the monetary pressure associated with the economy. 5.3.1.1: Decrease in interest rates As a general rule, the decrease in interest rate is best for the economic environment. When consumer can afford to borrow funds because customers dont have to pay high interest rate on borrow funds. Interest rate used as a tool for controlling the economic growth. When the economy grows rapid pace then it will experience inflation. Prices rise to a high level and no one can afford changes in real interest rate. That affects the public demand for goods and services due to altering the availability of bank loans. A low real interest rate decreases the borrowing cost that leads to the investment spending and encourage people to spend in various forms consumer durables. Low interest rate provide corporate level opportunity to take new capital investment spending and increase the firm confidence by making heavy investment in growing sector and generating heavy revenue. That result in stabilizing the economy and providing employment opportunities. The other aspect of low interest rate was that it will decrease the default risk of counter party. It means that people have more disposable income to pay their borrow funds and take saving decisions. Cause depreciation in the exchange rate and increase demand for domestic producers those who sell goods and services global markets. The rise in the growth of exports would increase the aggregate demand. 5.3.1.2: Increase in interest rates The increased in rate will increase the cost of property. Conversely, fall in the interest rate increase the demand and increase pressure on mortgage prices. That would increase the spending associated with mortgage buying and increase in prices had increase the total wealth. The increase in interest rate opens the door for increasing non performing loans. Despite the fact that heavy amount of provisioned made by the banks. Inefficient and corrupt borrowers try to find out an easy exit way to avoid repayment. That problem was going to be worsted due to low recovery rate of bad debts. 5.3.2: Recommendations The banks can decrease their risk with out involvement of funds by developing their focus on non interest income. Bank must take conscious measure about capital adequacy ratio and abrupt changes in the interest rate. The central bank should play their role in standardization of interest spreads. There has been a gap of 5 to 8 percent between what the banks in Pakistan were paying to the deposit holders and what charging to borrowers, which was not in line with the international level. Banks management should required to logically focus on improving the quality of their banks profitability by providing better return to depositors and charge less interest rate to borrowers for the development of economy. APPENDICES Appendix A Data Sheet Period 2003 2004 2005 2006 2007 2008 Interest Rate 2.4588 3.3384 8.1853 9.9159 10.1640 12.8018 S.No Bank Year Interest Income Balances with Other Banks Deposit Accounts Lending to FIs Investments Loan and Advances 01 ABL 2003 4,984.607 1,607.460 15,361.240 40,972.690 49,986.980 02 ABL 2004 5,244.710 1,183.920 16,175.000 57,631.300 69,948.840 03 ABL 2005 9,846.657 2,329.190 5,777.380 45,068.120 119,506.010 04 ABL 2006 17,215.507 460.830 19,050.240 47,274.640 151,705.420 05 ABL 2007 21,201.422 18,419.240 84,209.830 178,524.360 06 ABL 2008 30,570.540 15,793.180 86,560.780 223,639.780 07 AB 2003 4,373.715 2,370.460 5,770.840 20,421.220 46,341.070 08 AB 2004 4,487.206 4,194.420 2,324.840 16,602.370 71,718.490 09 AB 2005 8,780.698 4,949.270 10,172.240 24,447.030 88,395.860 10 AB 2006 12,596.921 6,019.030 8,392.950 27,094.960 102,724.880 11 AB 2007 15,143.241 2,697.120 14,444.140 39,196.290 108,188.770 12 AB 2008 18,393.313 2,847.660 4,479.750 37,077.250 139,830.970 13 BAF 2003 4,033.380 138.920 7,437.730 28,603.260 50,372.330 14 BAF 2004 5,620.203 1,195.210 35,346.540 90,291.460 15 BAF 2005 12,246.811 7,714.610 27,050.490 57,445.250 120,416.990 16 BAF 2006 21,191.470 9,929.260 12,456.650 57,152.550 152,235.780 17 BAF 2007 25,783.871 14,695.660 3,452.060 88,568.460 175,678.810 S.No Bank Year Interest Income Balances with Other Banks Deposit Accounts Lending to FIs Investments Loan and Advances 18 BAF 2008 31,046.583 12,815.470 3,315.500 77,655.480 198,811.850 19 BAH 2003 2,403.489 303.650 469.630 14,109.220 35,543.980 20 BAH 2004 2,432.106 3,952.270 2,471.000 14,413.790 47,536.980 21 BAH 2005 4,935.626 377.170 3,352.750 19,502.320 55,526.000 22 BAH 2006 7,857.745 536.820 6,578.800 20,949.460 71,036.210 23 BAH 2007 9,945.872 262.700 4,112.430 35,240.220 79,446.700 24 BAH 2008 14,604.237 2,513.210 295.400 48,360.340 101,422.780 25 HBL 2003 19,049.914 17,049.800 22,595.490 158,870.810 216,380.740 26 HBL 2004 18,198.725 28,962.540 3,755.040 132,354.980 292,398.010 27 HBL 2005 32,343.206 27,558.480 12,272.250 107,678.120 350,424.900 28 HBL 2006 43,685.740 29,301.390 6,550.130 120,077.020 371,364.540 29 HBL 2007 50,481.021 22,865.310 1,628.130 178,463.740 403,478.900 30 HBL 2008 63,305.033 35,810.250 6,193.790 146,668.940 484,451.900 31 HMB 2003 2,684.887 195.090 3,896.280 17,958.900 32,637.090 32 HMB 2004 2,783.812 1,695.490 4,132.230 15,559.830 40,599.290 33 HMB 2005 4,358.556 381.790 5,462.580 22,003.310 44,039.160 34 HMB 2006 7,289.123 4,665.010 5,447.110 39,252.460 84,142.090 35 HMB 2007 11,983.551 2,175.450 3,989.250 61,656.770 91,044.060 36 HMB 2008 15,873.445 1,537.310 98.180 55,347.780 110,391.360 37 MCB 2003 10,569.994 290.360 10,430.450 125,635.810 104,011.100 38 MCB 2004 9,083.863 3,972.120 10,965.300 66,220.990 144,010.170 39 MCB 2005 17,756.232 548.150 9,998.830 68,261.030 188,139.680 40 MCB 2006 25,778.061 2,531.000 21,081.800 62,178.080 206,847.500 S.No Bank Year Interest Income Balances with Other Banks Deposit Accounts Lending to FIs Investments Loan and Advances 41 MCB 2007 31,786.595 571.810 1,051.370 111,816.630 229,732.870 42 MCB 2008 40,043.824 696.010 4,100.080 102,168.650 273,222.330 43 NBP 2003 19,452.317 19,979.670 29,937.860 168,280.530 188,958.770 44 NBP 2004 20,947.333 47,412.390 10,511.320 146,984.970 250,494.740 45 NBP 2005 33,692.665 28,068.920 16,282.940 120,471.490 299,422.810 46 NBP 2006 43,788.628 39,662.610 23,012.730 114,093.350 348,370.460 47 NBP 2007 50,569.481 30,356.200 21,464.600 180,431.770 374,732.030 48 NBP 2008 60,942.798 35,021.680 17,176.030 167,708.330 457,828.030 49 NIB 2003 172.372 347.580 951.960 6,791.960 50 NIB 2004 803.542 118.860 1,812.910 1,329.410 12,349.390 51 NIB 2005 1,716.917 1,400.000 2,270.000 5,205.170 20,181.320 52 NIB 2006 3,499.278 1,100.000 2,600.000 6,677.110 31,874.850 53 NIB 2007 6,999.888 535.720 4,753.110 40,593.510 92,586.340 54 NIB 2008 15,201.691 12,459.620 37,663.870 97,322.480 55 UBL 2003 9,269.494 17,959.120 23,096.030 53,841.740 114,897.000 56 UBL 2004 9,660.563 22,801.880 16,262.500 52,906.600 166,488.950 57 UBL 2005 20,687.373 13,262.180 17,867.550 61,236.540 239,613.350 58 UBL 2006 33,627.533 18,164.960 29,572.070 65,571.650 282,322.910 59 UBL 2007 41,045.543 2,583.690 24,781.720 115,967.140 334,120.160 60 UBL 2008 52,253.361 3,056.020 22,805.340 126,129.800 410,665.880 Appendix B Banks included in the study with legend S.No Legend Bank 1 AB Askari Bank Limited 2 ABL Allied Bank Limited 3 BAF Bank Al Falah Limited 4 BAH Bank Al Habib Limited 5 HBL Habib Bank Limited 6 HMB Habib Metropolitan Bank Limited 7 MCB MCB Bank Limited 8 NBP National Bank of Pakistan 9 NIB NIB Bank Limited 10 UBL United Bank Limited Appendix C SPSS Results Table 4.1: Descriptive Statistics Mean Std. Deviation N Interest Income 18,772.105 16,092.870 60 Interest Rate 7.811 3.766 60 Deposits with other Banks 9,089.759 12,244.525 60 Lending to FIs 10,296.928 8,376.489 60 Investments 68,035.369 49,741.048 60 Loan and Advances 165,419.474 122,548.000 60 Table 4.2: Correlations Interest Income Interest Rate Deposits with other Banks Lending to FIs Investments Loan and Advances Pearson Correlation Interest Income 1.000 0.581 0.617 0.363 0.811 0.961 Interest Rate 0.581 1.000 0.031 0.024 0.201 0.436 Deposits with other Banks 0.617 0.031 1.000 0.318 0.703 0.723 Lending to FIs 0.363 0.024 0.318 1.000 0.431 0.412 Investments 0.811 0.201 0.703 0.431 1.000 0.862 Loan and Advances 0.961 0.436 0.723 0.412 0.862 1.000 Sig. (1-tailed) Interest Income . 0.000 0.000 0.002 0.000 0.000 Interest Rate 0.000 . 0.408 0.429 0.062 0.000 Deposits with other Banks 0.000 0.408 . 0.007 0.000 0.000 Lending to FIs 0.002 0.429 0.007 . 0.000 0.001 Investments 0.000 0.062 0.000 0.000 . 0.000 Loan and Advances 0.000 0.000 0.000 0.001 0.000 . N Interest Income 60 60 60 60 60 60 Interest Rate 60 60 60 60 60 60 Deposits with other Banks 60 60 60 60 60 60 Lending to FIs 60 60 60 60 60 60 Investments 60 60 60 60 60 60 Loan and Advances 60 60 60 60 60 60 Table 4.3: Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1 .961a 0.924 0.923 4,477.355 2 .978b 0.956 0.955 3,428.556 Table 4.4: ANOVA Model Sum of Squares df Mean Square F Sig. 1 Regression 14,120,000,000 1 14,120,000,000 704 .000a Residual 1,163,000,000 58 20,050,000 Total 15,280,000,000 59 2 Regression 14,610,000,000 2 7,305,000,000 621 .000b Residual 670,000,000 57 11,750,000 Total 15,280,000,000 59 Table 4.5: Interest Income Model Unstandardized Coefficients Standardized Coefficients t Sig. Collinearity Statistics B Std. Error Beta Tolerance VIF 1 (Constant) -2107.823 976.321 -2.159 0.035 Loan and Advances 0.126 0.005 0.961 26.537 0.000 1.000 1.000 2 (Constant) -6878.423 1049.738 -6.553 0.000 Loan and Advances 0.115 0.004 0.874 28.368 0.000 0.810 1.235 Interest Rate 852.617 131.700 0.200 6.474 0.000 0.810 1.235 Table 4.6: Excluded Variables Model Beta In t Sig. Partial Correlation Collinearity Statistics Tolerance VIF Minimum Tolerance 1 Interest Rate .200a 6.474 0.000 0.651 0.810 1.235 0.810 Deposits with other Banks -.164a -3.404 0.001 -0.411 0.477 2.096 0.477 Lending to FIs -.041a -1.024 0.310 -0.134 0.830 1.205 0.830 Investments -.068a -0.957 0.343 -0.126 0.258 3.883 0.258 2 Deposits with other Banks -.057b -1.270 0.209 -0.167 0.377 2.652 0.306 Lending to FIs -.003b -0.105 0.917 -0.014 0.800 1.250 0.648 Investments .079b 1.338 0.186 0.176 0.220 4.549 0.186 Figure 4.1: Normal P-P Plot of Regression Standardized Residual Figure 4.2: Histogram Figure 4.3: Scatter Plot Interest Income Figure 4.4: Partial Regression Plot Interest Income and Interest Rate Figure 4.5: Partial Regression Plot Interest Income, Loan and Advances