Chapter 1

Introduction
Banking sector of Pakistan has revealed huge growth and likely over the years. There is a
weighty increase in the profitability of banking sector established by performance and
strength indicators. From 2008 later the huge progression, the banking sector of Pakistan
is in visible of some pressures like liquidity and solvency problems which has effect on
the performance of banks. If Bank has sufficient amount of liquidity to respond to their
commitments then they can manage the circumstances simply. To easiness the liquidity in
the Economy SBP has decreased the liquidity Requirement on demand and cash reserve
requirement and time liabilities. Bank using monetary policy to control flow of cash in
the economy.
As an additional form of developing its own recourses the government permits the banks
to produce money and subsequently take advance from the banks. The big amount of
government advancing from banks is dreadful for the economy. The government not only
has to limit its borrowings from banks as well as place certain kind of check on balance
of money. Now a days banking sector providing different kind of services like
remittances services, car loan, business loan etc. The fee paid by someone for the use of
somebody elses money is known as interest. When money is lent Interest received and
paid when money is borrowed. When the debtor pays advance, he also pay the principal
amount as well pay interest which arisen on the principal amount. By ignoring to the
interest; investors wouldnt be interested to delay their expenditure as well as financier to
loaned money. In our routine life, interest rate plays an important function. It can

considerably influence purchasing power of people. Therefore, as depositor it is essential

to focus on these trends in interest rate because the common trends in interest rate can
have a major influence on savings of people. The major variation in these trends makes it
essential to examine the existing investment opportunities and potential opportunities.
The changes in interest rate have significant impact on banks. The major part of bank
revenue comes from the difference in the interest rate that it charges from and pays to
customers. Previously, in the commercial bank operations interest rates have become
slight element. To accomplish the stability in the overall economy by managing foreign
trade rates and by controlling the inflation, the SBP uses interest rate as a tool.
Typically interest rate is expressed in yearly percentage. E.g. for one year somebody
borrows PRs. 1000 and interest amount is Rs.100 (10%) Interest received percent on
annual basis. It mean while he pays off the advance he has to pay PRs.1100 where 1000
is principal amount and PRs.100 is interest on the principal amount.
The banks take money from one house holds at low interest rate and this money give
another households at higher interest rate, the difference between higher interests to lower
are bank revenue. So the Interest rate is very important factor for bank, the rate are
increasing and decreasing time to time. The fluctuation of interest rate may effect bank
profitability we discussed as under.
1.2. Problem statement
The focus of this study is to find out the interest rate changes on the profitability of six
major commercial banks which are operating in Pakistan only. The problem of the study
therefore is to investigate some key determinants of profitability and the extent to which

they impact on profitability in the banking sector of Pakistan this study focus only six
banks and the independent variable interest rate only.
1.3 Study limitations
The desire scope of the study review includes the specific factors with an impact on the
profitability related with commercial banks in Pakistan. This study is covering 5 year
period (2009-2014). The sample size is six (6) major commercial banks of Pakistan. To
calculate the effect of interest rate changes on the profitability of conventional banks
functioning in Pakistan, Students took an average of annual profits of the six major
commercial banks from annual reports. But this study do not covers the complete banking
sector which operating in Pakistan. This study do not covers the entire time periods from
the start of commercial banks in Pakistan to present.
1.4 Objective of the study
The objective of the study is to determine the how the interest rate effect bank
profitability that influence profitability of Bank in Pakistan.
i. To examine the effect of increasing of interest rate on the profitability of six
commercial bank in Pakistan.
ii. To examine the effect of decreasing of interest rate on the profitability of six
commercial bank in Pakistan.
1.6 Significant of study
Profitability is a significant factor for all organization. It has become imperative that bank
managers understand the variables that significantly relate to the profitability of their

business. The interest rate is a strongly independent variable which effect bank
profitability. Interest rate play very vital rule in banking sector as well economy of a
country this study will be a helpful for bankers, students and investors.

Chapter 2
Literature Review:
There are number of studies has been done in this area and this field. To check the effect
of changes in interest rate on commercial banks profitability in Pakistan, in these study
students explain the profitability of commercial banks and interest rate with the review of
previous literature on this topic. Interest rate is defined the certain amount of cash
compensate by someone on the use of funds for a specific time period. (Buiter &
Panigirtzoglou, 2003). Furthermore when a debtor rewards to creditor with the

amount of cash for the use of creditors funds for a particular time period is called interest
rate. Creditors charge the interest rate as percentage of the sum of funds lent. (Boulier,
Huang &Taillard, 2001; Laubach, 2009) similarly, the institution like banks pays

interest rate to the depositor for the use of money. Profitability of bank is defined as
income by interest or non-interest and after tax profits which are calculated as an amount
of revenue (both interest & non-interest) after the deduction of provisions and operating
costs (Albertazzi & Gambacorta, 2006).

Financial system is serving as back-bone in a country and a good facilitator for financial
institutions. Ahmad, Raza, Amjad, & Akram, (2011) said that institutions are components
of a good financial system and they assist the investors for investment to attain an
efficient capital and money market in a country. State Bank of Pakistan (SBP) as well as
Securities and Exchange Commission of Pakistan (SECP) is also working for the
development of a good financial system (Alam, Raza, & Akram, 2011). Therefore,
Commercial banking sector as a major component of financial system has an ample

share in the financial and economic growth of a country. Aburime, (2009) said that a
lucrative and profitable commercial banking sector is capable to tolerate the adverse
distress and adds the strength and power in the economic system. A profitable and sound
commercial banking sector is at a better point to endure adverse upsets and adds
performance in financial system (Athanasoglou, Brissimis & Delis, 2008).
The sensitivity of loan loss provisions to interest rates should be expected to be especially
high at very low interest rates. This is because, given central banks typical reaction
function, such low rates are likely to prevail following financial crises, when banks as
well as their customers balance sheets are in bad shape. This can make banks especially
reluctant to accept further losses and hence to evergreen the loans, ie extend and
pretend (eg Barseghyan (2010)). This effect comes in addition to the lower probability
of default linked to lower debt service burdens. There is considerable evidence for this
mechanism, some of it going back to the post-bubble experience in Japan during the
1990s (eg Caballero et al (2008)) and some relating to the post-crisis experience in
Europe (eg Albertazzi and Marchetti (2010), Enria (2013) and Bank of England (2010)).
2.2 Interest Rate
An interest rate that changes from time to time in relation to an index
Payments may increase or decrease accordingly (McCracken & Todd E.
Clark, 2003) Interest is a payment to debtor to the lender as a form of
reward for the usage of the assets. (Steven Sheffrin.M, 2003).
Due to the competition among the banks interest rate remains in
an equivalent range. For tracing and treatment the important growth

interest rate is to be give a lecture an important economic problem

(Boulier, Huang & Taillard, 2001; Laubach, 2009).
Instead, in the profit and loss statement interest rate also involve in
handling the interest component entirely (Buiter & Panigirtzoglou,
2003)
Interest rate is also defined as fee charged by a lender to a borrower
for the use of borrowed money, usually expressed as an annual
percentage of the principal, the rate is dependent upon the time value
of money, the credit risk of the borrower, inflation rate among others
Brock & Rojas (2000) defined interest rate spread as margin between
interest income and interest expense as a percentage of total earning
assets. Spread is defined by market microstructure characteristics of
the banking sector and the policy environment. Risk-averse banks
operate with smaller spread than risk-neutral banks since risk aversion
raises the banks optimal interest rate and reduces the amount of
credit supplied. Emmanuelle (2003) argued actual spread, is influenced
by monetary and fiscal policy.
In addition, the interest rate also summarizes the system of whole
business debt summary, including the receipt of debt, excellence of the
debt, expectations of visions participation proportions and fixed
uncontrolled mixture of the debt ( Brigo & Mercurio, 2006; Einav,
Jenkins, & Levin, 2008).

It is calculated by dividing the amount of interest by the amount of principal.

Interest rates often change as a result of inflation and Federal Reserve Board.
For example, if a bank charges a customer Rs.100 in a year on a loan of Rs.1000, then the
interest rate would be 100/1000 *100% = 10%. (Babazadeh & Farrokhnejad, 2012)
From a consumer's viewpoint, the interest rate is expressed as annual percentage yield.
For example, deposit or savings account, credit card, and a loan, the interest rate is stated
as annual percentage rate. Despite important regulatory concern funded to the interestrate risk that banks face (OCC (2004); Basel Committee on Banking Supervision (2004)
2.2.1 Increasing Effect
When interest rate rises up, business man and other households or people pay more In
other words their cost of taking loan increases which decreases their profitability and
other side paying high interest rate attract investors and households to invest money.
(Genay.H ,1992 ; Einav, Jenkins, & Levin, 2008 ; Ahmad , & Waseem 20013)
The study of Samuelson Paul A, (1945) presented that when interest rate increases it
actually effect to debtors but it dont disturb the banks performance. The borrower is
tolerating the effect of high interest rate whereas the performance of bank would not be
affected by high interest rates. The bank charges more to borrower than the return it pays
to depositors when interest rates rising. So, both the borrower and depositor are tolerating
the cost. According to the study of Khawaja, Musleh, (2007), when rise in interest rate
also fall the value of corporate bond.
2.2.2 Decreasing Effect
Accordingly (Athanasoglou et al., 2006) Lower interest rates make it economical to
borrow. This tends to encourage spending and investment. This sign to highest aggregate

demand and economic growth. This increase in aggregate demand can also reason
inflationary forces.
2.3 Bank Profitability
The profitability of bank is usually is performed of interior and external surfaces
determinants. The interior determinants are called micro or standard bank specific bases
of profitability since they are commenced from bank accounts like balance sheet or
income statement. The other hand the surface determinants are the variables which might
be not in the handle of banks management. These variables reflect the permitted and
economic environment which can affect the procedure and performance of economic
body. For instance Bourke (1989) and Molyneux and Thornton (1992) discovered an
encouraging association among profitability and better-quality management. Gelos
(2006) studies the determinants of bank interest margins in Latin America using bank and
country level data. The study of Short (1979) is from one of the few studies contributing
cross country evidence of direct inverse correlation among private organization and the
profitability of banks. The final set of the determinants of banks profitability works with
macro-economic control variables. The issue of the association among inflation and
banks profitability has been introduced by Revell (1979). He noted that the consequence
of inflation on the profitability of banks depends upon whether wages and other operating
expenses of banks are increasing faster than the inflation.
The operating efficiency has an effect on the bank size. Pilloff and Rhoades (2002) said a
positive relationship exist between the profitability and bank size. Sufian (2009);
Molyneux and Seth (1998); Ramlall (2009) also found an affirmative relation of bank
size and examine the dependence of bank size upon economies of scale because smaller

banks were less profitable than larger banks. Whereas Koasmidou, (2008); Spathis,
Koasmidou & Doumpos, (2002) found empirically a negative relation exist between bank
size and profitability.
Bank size and financial ratios such as efficiency / profitability ratios, liquidity ratios,
capital / leverage ratios and asset quality ratios are effective tool to classify the public and
private banks and these ratios are also suggested by SBP statistical bulletin to evaluate
the financial performance of banks. Financial measures such as return on assets (ROA),
interest margins (IM), and capital adequacy (CA) has positive relation with customer
service quality (Elizabeth & Elliot 2004). Raza, Farhan, & Akram, (2011) classified the
investment banks in his study using return on total assets (ROA) and return on owners
equity (ROE). Effectiveness and effeciency are the independent factors (Tarawneh,
2006); (Raza, Farhan, & Akram, 2011). There is no boundness that efficient bank also has
effectiveness always.

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