Background on the 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 from 2008 onward after gigantic amount of growth. Such as the liquidity crisis and solvency hitch had significantly affected the performance of banking and economy. The financial institution possibly managed the situation well devoid of any trouble. The adequate amount of liquidity had vacant to fulfill the requirement. Since the banks were working in a very tight market conditions and enforced to pay attractiveness rates to the depositors to attract liquidity. The government required to extend own resources to generate the money. The huge amount of borrowed funds by the government lay troubled on the economy. The government major responsibility was to regularize borrowed funds from the banks but also place some sort of control on money generation. All of the 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 by the bank and due to the amount of nonperforming loans increased at rapid speed. The heavy provisions against bed debts had put burned on the bank financials. 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. 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 bank had 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. The main specifics reason to focus on the current issue of banks profitability. The factors were influencing the banks efficiency and effectiveness to manage the portfolio. Assets intended to achieve profitability and identify the areas where possible room for raising the profitability available.

The Bank's assets were group into two categories, the non earning assets and the earning assets. Earning assets means the assets on which banks had earned the non earning assets and the interest income, means the assets which to be used for the point of reserve requirement, i.e. fixed assets used to run day to day operational activities. The assets were the main source of income for banks. Therefore regular returns generation ability of the 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 shareholder's earned for investments in the company. Equity to asset ratio expresses the amount of the total assets financed by the owner's equity capital, indicates the finance and profitability of the company and was the major source of income for banks. Therefore income generation ability of assets had a vital influence on the banks earnings, performance and profitability. The return on equity reveals that how greatly the profit corporations earned in association to the total amount of the shareholder equity originate on the balance sheet. The shareholders equity that equals to the total assets less the total liabilities. The shareholders equity was the formation of the accounting that represents the assets that were created by the retained earnings of the business and the paid in capital of the owners. Business with higher return on equity was expected to be the one that capable of generating cash internally. The return on equity figures takes into account that the retained earnings from the preceding year that tells the investor that how effectively capital being re invested.

1.2 Problem Statement

The rapid fluctuation in share prices and interest rate had a significant impact on capital as well on banks earning. As the prices and interest rate deviate the capital move both ways or vice versa. Which ultimately affect the banks earning.

1.3 Hypotheses

There was a significant and negative impact of capital to assets ratio on 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 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.

1.5 Definitions

1.5.1 Return on Equity

The ratio indicates how beneficial a company by comparing net income to average shareholders' equity. TheA rate of return measures how much shareholders earned for the investment in a company. The higher the ratio percentage, the more efficient management was in utilizing equity base and the better return to investors.

1.5.2 Capital to Asset Ratio

Capital to asset ratio was defined as ratio of equity to asset. Equity to asset ratio indicates the amount of the total assets financed by owner's equity capital. The equity to asset ratio indicates the finance and profitability of the company.

CHAPTER 2: LITERATURE REVIEW

The explanation of the research was to observe personally the capital-earnings association to try to conclude which between the possible explanations of the association appear to be important. 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 management of interest payments as a tax-deductible expenditure. Debt in that framework refers mostly to deposits. Even though the tax system also encourages use of subordinated debt over equity, banks were partial by regulation in the quantity of debt employ as capital and subordinated debt constituted only 0.57 percent of total bank debt in 1978. Deposit finance was further optimistic by the level fee structure charge for deposit insurance by the FDIC, which permits the bank to boost the value of the insurance and own value, by increasing 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, that recommend with the purpose of the present wave of amalgamation activity in the banking industry was 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 that finding reflect the setting of prices less favourable to customers (lower deposit rates, higher loan rates) in further concentrated markets because of the product of feasible imperfections in the market. A related assumption be the relative-market- power hypothesis (RMP), state basically firms among huge market shares and well differentiated goods were able to implement market power in pricing products and receive supernormal profits (Shepherd, 1972).

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. 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 studies were 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 exists 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 was exactly the factor 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 influence the force on management to control costs. Investment was highly expensive compared to debt at the margin, the time of increase in capital precipitate by regulator power. On the other hand, the decrease 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 organization costs (Jensen, 1986; Harris and Raviv, 1990).

One more complexity with narrative was 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 was the effectiveness was positively associated to attentiveness and/or market share. Once more, direct method of efficiency was required for the task (Berger, 1995).

In the study, the optimistic profit-market share association support ESS, the scale efficiencies completely linked to both variables. Still in several studies does manage for scale, ESS possibly be the primary explanation of the data. The reason does not directly measures scale efficiencies but had often been particular do not allow for U-shaped standard cost curves. Obviously, the 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 positive earnings to capital was steady with the hypothesis to facilitate banks retain several marginal earnings in the shape of equity increase. The judgment was not surprising to pay main attention, on the other hand, to the positive since capital to earnings, which was quite astonishing. The result was also the most applicable to the strategy debate over capital standards, and the individual most directly challenges conservative wisdom (Berger, 1995).

Former studies were experienced the MP hypotheses individually by investigative the price concentration connection, again lacking the assistance of efficiency variables. Prices were 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 were occupied as support for the suitable MP hypothesis (Berger, Hannan, 1989 and Hannan, 1991).

Bank capital was the sum of equity plus debt subordinated to deposits. Capital provides a cushion to protect the bank from insolvency when the value of assets falls; a bank can meet obligations to depositors as long as losses on asset portfolio do not exceed the capital. The ratio of capital to total assets in U.S. commercial banks had 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 was also challenging because the disqualified efficiency variables possibly be related with equally prices and market structure. Beneath the ES hypotheses, prices comparatively positive for customers of firm in intense markets or with large shares the reason of the disqualified efficiency variables, so 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 neither functioning. A potentially more severe trouble was at hand if effectiveness was unenthusiastically related with focus or market share. Probably occur in banking because the maximum concentration and largest shares were regularly in country markets where firms possibly of less capable scale or everywhere organization or other factors of construction were moderately poor quality (Berger, 1995).

The advantages of deposit finance were offset by two factors. First, bankruptcy was costly to owners 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 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 that point, the optimistic profit-structure connection was 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 basically equally good management and technology, but a number of firms simply produce at more well-organized scales than others, and as a result lesser unit costs and superior unit profits. The firms theoretically having large market shares 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 had fundamentally different implication from the two -structure (ES) hypotheses for amalgamation and antitrust policy. To the degree the MP hypotheses were accurate, mergers motivated by requirements to set prices were less constructive to consumers, which decrease total customer plus producer surplus. To the degree the ES hypotheses were correct, merger motivated by capability deliberation increase total surplus. Therefore, advocate of the MP hypotheses lean to see antitrust enforcement as generally favourable, while ES advocates tend to see strategy hold back mergers as socially costly (Berger, 1995).

The result also disagree with several opinion supposed to validate distance requirements for instance, the free of charge banks grip too a small number of reserves and too dangerous portfolio (Cothren, 1987).

Reserve needs were 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 incentive to grasp reserves indicate the superiority (Freeman, 1988)

Moreover theoretical input, research 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, the paper proposes empirical measures also appropriate in testing other signaling hypotheses, mainly multi-signaling (Chu, 1999).

on the other hand, one quarrel in opposition to free banking a fall down because of externalities due asymmetric informational "It was tremendously complicated to differentiate between a comparative far above the ground rate of return accessible because of greater efficiency and single was presented because the establishment was also tasking much riskier strategy" (Goodhart, 1988).

Though, information asymmetries do not involve marketplace forces fail to make sure high-quality banking practice. On other hand confirmation earlier to the institution of the FDIC depositors and note holder cares about banks' financial circumstances and carefully scrutinizes balance sheets (Kaufman, 1988).

Initially, showed 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 a "noisy" indicator, depositors know how to supplementary use accessible information to monitor banks. In a unscrambling equilibrium, a good bank signals superiority by contributing a lower deposit rate and investing a higher proportion of liquid, risk-free asset as a bad bank. The bank information eradicate banking panics even in a non-diamond banking system was even everywhere individual banks can not completely expand and no secondary markets for bank loans, equity, and deposits (Gorton and Haubrich, 1987).

Such separating balance means asymmetric in sequence does not unavoidably lead to contagious bank runs. However, the signal at time rules out contagions base on wrong attributions of “bad" banking only. Contagions possibly 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 (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 was no guarantee competitive stress had implement "good" banking training, and a central bank was mandatory to correct market failure to in sequence asymmetry (Chu, 1999).

Banks was 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 was 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 was reduced in cost by the higher the value of 0, the lower was 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 0was realize, banks offer deposit contract to depositors. Base own type, banks decide deposit rates, to make the most of the expected profits. The contract was fixed rate and not state contingent for the reason of costly state substantiation (Townsend, 1979).

But the preliminary stability was separating; bank cannot be communicable for the reason depositors can recognize good banks by the signal. A run occur for getaway to quality. Comparable to bank capital, the responsibility of the signal here was for good quality banks to rule out contagions. Bank runs play a significant role by given incentive for depositors to observe banks and also for banks to signal excellence. The difference from the cases of deferment of convertibility (Gorton, 1985; Dowd, 1988 and 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 was begun, the position in practice was still debatable. Experiential evidence was consequently needed to settle on whether banks actually sign and signal had used (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 had been used in the study. The statistical tool also mentioned to give clear idea about the data collected and 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. The 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 the study was 10 different banks on the basis of the market share. The 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.

3.4 Instrument of Data Collection

There were two types of sources available for data collection i.e. primary and secondary data. In the research secondary data was used. Secondary data was gathered from annual reports of the company and remaining data calculated by using the formula of studied variables.

3.5 Research Model Developed

ROE =α+β1CAR+a‚

α = Regression Constant - Alpha

β = Regression Coefficient - Beta

ROE = Return on Equity

CAR = Capital to Asset Ratio

a = Error

3.6 Statistical Technique

The data were analyzed by using regression model to find out the impact of capital to asset ratio on return on equity.

CHAPTER 4: RESULTS

4.1 Data Analysis and Findings

Table 4.1: Descriptive Statistics

Mean

Std. Deviation

N

ROE

0.211

0.113

60

CAR

0.073

0.036

60

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 banks average return on equity ratio was 0.211percent and Variability in the return on equity was 0.113 percent. The result showed return on equity increased during six years and major contribution was from big five nationalized banking industry. Average CAR during six years was 0.073 percent. While variation appeared was 0.036 percent.

Table 4.2: Summary of Regression Result

R

R Square

Std. Error of the Estimate

0.483

0.233

0.100

The table 4.2 displayed R, R Squared and the standard error. R represented the multiple correlation coefficients and the relationship between the independent variables and dependant variable. Low value of R 0.483 in model summary table. Indication was weak relationship. R squared value was the proportion of variation in the dependant variable explained by the independent variables. With the linear regression model, the error of estimate was considerably lower, about 0.100.

Table 4.3: ANOVA

Sum of Squares

Df

Mean Square

F

Sig.

Regression

0.175

1

0.175

17.633

0.000

Residual

0.575

58

0.010

Total

0.750

59

The table 4.3 summarized regression output displayed information about the variation accounted for by the model. While, residual indicated information not accounted for by the model. The model with large regression sum of squares indicated the model accounted most of variation explained by the independent variables in the dependent variable. The significance value of the F statistic was less than 0.05, which means the variation explained by the model was not due to chance. While the ANOVA table was a useful test of the model's ability to explain any variation in the dependent variable.

Table 4.4: Return on Equity

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

(Constant)

0.323

0.030

10.920

0.000

CAR

-1.525

0.363

-0.483

-4.199

0.000

The estimated model equation was = 0.323-1.525 CAR+a

The impact of significant variable had been mentioned below:

One percent increase in capital to asset ratio had decreased the return on equity by 1.525 percent and constant represent the amount when the capital to asset ratio equal to zero. Which was equal to return on equity.

The standardized value of capital to asset ratio increase by 1 percent then standardized value of return on equity decreased by 0.483 percent.

4.2 Hypotheses Assessment Summary

4.5: Hypotheses Assessment Summary

Hypothesis

Independent Variables

t value

sig.

Comments

There was a significant and negative impact of capital to asset ratio on return on equity.

Capital to Asset Ratio

-4.199

0.000

Accepted - since there was a significant and negative impact of capital to asset ratio on return on equity.

Dependent Variable : Return on Equity

CHAPTER 5: DISCUSSION, IMPLICATIONS, LIMITATION, FUTURE RESEARCH AND CONCLUSION

5.1 Conclusions

The objective of the study was to evaluate the impact of capital on banks earnings. Banks efficiency considered the main pillar to run the economy of any country and Pakistan stability and growth mainly dependant on the banking sector. Capital and earnings always been the major building block of any bank for there operations and generation on money. The study period was consists of six years from (2004-2009). The 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.

In the research two variables were used based on previous studies. The independent variable was capital to asset ratio and dependent variable was Return on Equity. Regression technique was used to determine the impact of capital to asset ratio on return on equity and finding of the research showed that there was a significant and negative impact of capital to asset ratio on return on equity. The return on equity measures how much shareholder's earned for investments in the company. Equity to asset ratio expresses the amount of the total assets financed by owner's equity capital, indicates the finance and profitability of the company and was the major source of income for banks. Therefore income generation ability of assets had a vital influence on the banks earnings, performance and profitability. The return on equity reveals that how greatly the profit corporations earned in association to the total amount of the shareholder equity originate on the balance sheet. The shareholders equity that equals to the total assets less the total liabilities. The shareholders equity was the formation of the accounting that represents the assets that were created by the retained earnings of the business and the paid in capital of the owners. Business with higher return on equity was expected to be the one that capable of generating cash internally. The return on equity figures takes into account that the retained earnings from the preceding year that tells the investor that how effectively capital being re invested.

The finding of the study showed that there was a significant and negative impact of capital to asset ratio on return on equity. As the capital asset ratio increases the return on equity decreases and as capital asset ratio decreases the return on equity increases. Which resulted in pushing up the banks profitability and goodwill.

5.2 Discussions and limitations

There were some limitations in the research. Such as;

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.

The sample size was consisting of ten major banks in Pakistan. The covered 78% market share of the Pakistan banking industry.

5.3 Implications and Recommendation

The current study based on the ten banks. The recommendation was that the study based on all the banks operating in Pakistan. Which provide better judgment and comparison with the international level.

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