Impact of Interest Rate Changes on Banks Profitability Finance Essay

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.

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.

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.

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.

The residual plots also showed that the presence of equal variance. This fulfilled the assumption of multiple regression model.

DISCUSSIONS, IMPLICATIONS, FUTURE RESEARCH AND CONCLUSIONS

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.

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.

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.

As a general rule, the decrease in interest rate is best for the economic environment. When consumer can afford to borrow funds because customers don't 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.

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.

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.

 

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