Session 2012-2014

AHMAR RAZAS4F12MCOM0070SECTION (B)

MASTERS OF COMMERCE

PUNJAB COLLEGE OF COMMERCEUNIVERSITY OF CENTRAL PUNJABLAHORE, PAKISTAN

Determinants of Commercial Banks Profitability

A THESIS SUBMITTED TOTHE PUNJAB COLLEGE OF COMMERCE(UNIVERSITY OF CENTRAL PUNJAB)IN FULFILLMENT OF THE REQUIREMENTFOR THE DEGREEMASTERS IN COMMERCE (ACCOUNTING AND FINANCE)BYAHMAR RAZAMASTERS OF COMMERCE

PUNJAB COLLEGE OF COMMERCEUNIVERSITY OF CENTRAL PUNJAB2014RESEARCH COMPLETION CERTIFICATECertified that the research work contained in this thesis titled, Determinants of commercial banks profitability has been carried out and completed by Ahmar Raza. Reg. No. S4F12MCOM0070 under my supervision during his masters of commerce.

____________PrincipalDate: ___________Punjab College of CommerceUniversity of Central PunjabResearch Supervision: __________Lahore, PakistanCERTIFICATE OF EXAMINERSCertified that the quantum and quality of the research work contained in the thesis titled, Determinants of Commercial Banks Profitability, adequate for the award of degree of Masters of Commerce.

Internal ExaminerExternal ExaminerSignature: ______________ Signature: ______________ Name: _________________ Name: _________________Date: __________________Date: __________________

PrincipalSignature: ______________ Name: _________________ Date: __________________DECLARATOIONI, Ahmar Raza. Reg. No. S4F12MCOM0070, student of Masters of Commerce during the session of 2012-2014, hereby declare that the matter printed in the dissertation titled, Influence Of Key Elements On Dividend Payout Of Banking Sector In Pakistan, is my own work and has not been printed, published and submitted as research work in any form in any university, research institute etc, in Pakistan or abroad.

Dated: _______________

Signature of Deponent: _______________DEDICATIONThis thesis is dedicated to my loving parents, who have raised me to be the person I am today. You have been with me every step of the way, through good times and had. Thank you for all the unconditional love, guidance, and support that you have always given me, helping me to succeed and instilling in me the confidence that I am capable of doing anything I put my mind to. Thank you for everything.

ACKNOWLEDGEMENTI acknowledge that, it is an excellent while working on thesis research study. As it is a biggest target to do work on the banking sector.From the formative stages of this thesis, to the final draft, I owe an immense debt of gratitude to my supervisor, Prof. Faisal Abbas. His sage advice, insightful criticisms, and patient encouragement aided the writing of this thesis in innumerable ways. I would also like to thank my teachers; those steadfast supports of this project was greatly needed and deeply appreciated. I also want to thank my all friends to being so corporative while I was doing this research report.

Table of ContentsCHAPTER 18Introduction81.1-Humble beginnings, 1947 197081.2-A legacy of public control, 1970 198081.3-Business as usual, 1980-199091.4-Ushering in the reforms, 1997 200691.5-The post-reform era, 2006 present101.6-Banking in Pakistan the long journey ahead10Chapter 219Literature Review192.1-Net advances a percentage of total assets.192.2-Time and savings deposits as a percentage of total deposits202.3-Total expenditures as a percentage of total assets202.4-Loan to deposit ratio20Chapter 3..28Data Collection and Methodology283.1 Dependent Variable283.2 Independent Variables283.3 Share Capital to total assets (SETA):-293.4 Bad debts to total assets (BDTA):-29Chapter 432Result and Discussion32Chapter5 Bibliography35

AbstractA significant constituent of the micro-prudential analysis is the study of banking sector profitability. Using bank level data this paper analyzes the profitability of commercial banks in Pakistan over the period from 2006 to 2009 using an empirical framework. To account for profit perseverance, this paper has applied multivariate regression analysis by formulating two regression models. The estimation results show that Gearing ratio, NPLs ratio and asset management are found to have significant affect on the profitability of commercial banks in both models. While size of the banks is a significant indicator for profitability where return of assets is used as proxy for measuring banks profitability and insignificant relation where return on equity is used as proxy to measure the profitability of commercial banks.Keywords: Profitability Determinants; Profitability Indicators; Commercial banks; Pakistan CHAPTER 1 Introduction1.1-Humble beginnings, 1947 1970Our financial sector evolved very differently from banks in the developed world. For nearly a year after partition, Pakistan had no central bank. Habib Bank established in 1941 filled this gap initially, until the State Bank of Pakistan (SBP) was set up in 1948 under quasi-government ownership. The role of domestic banks was particularly limited at the time, accounting for only 25 of the total 195 bank branches in the country. Therefore, the SBP was initially mandated to develop commercial banking channels, and maintain monetary stability so trade and commerce could flourish in the newly-created state. Subsequently, Habib Bank, Allied Bank and National Bank were amongst the first to start operations with strong support from the central bank.1.2-A legacy of public control, 1970 1980Commercial banking grew favorably in Pakistan until 1974. Under the nationalization policy implemented by Zulfiqar Ali Bhuttos government, thirteen banks were brought under full government control, and consolidated into six nationalized banks. The Pakistan Banking Council was set up to monitor nationalized banks, marginalizing the SBPs role as a regulator. These measures were meant to improve lending to prioritized industries. However, while directed lending was viewed favorably at the time, little can be said of the long-term gains that have been achieved.1.3-Business as usual, 1980-1990Over time, the financial sector grew to serve primarily large corporate business, politicians and the government. Board of Directors and CEOs were not independently appointed. Lending decisions were not always commercially motivated, and many billions of rupees were unsurprisingly funneled out of the financial system as bad loans. Banks were essentially not in control of their destinies during this period.Privatization, 1990 1997By 1991, the Bank Nationalization Act was amended, and 23 banks were established of which ten were domestically licensed. Muslim Commercial Bank was privatized in 1991 and the majority ownership of Allied Bank was transferred to its management by 1993. By 1997, there were still four major state-owned banks, but they now faced competition from 21 domestic banks and 27 foreign banks. More importantly, administered interest rates were streamlined, bank-wise credit ceilings removed and a system of auctioning government securities was established, forcing the government to borrow at market determined rates.1.4-Ushering in the reforms, 1997 2006After privatization, transformational reforms were pushed through. The central banks regulatory powers were restored via amendments to the Banking Companies Ordinance (1962) and the State Bank of Pakistan Act (1956). Subsequently, corporate governance, internal controls and bank supervision was strengthened substantially. Legal impediments and delays in recovery of bad loans were streamlined in 2001. Furthermore, the scope of prudential framework set up in 1989 was enhanced, allowing banks to venture into hitherto untapped business segments. Lending to small and medium enterprise had previously been neglected, whereas consumer and mortgage finance had not developed prior to reforms.1.5-The post-reform era, 2006 presentBuoyed by the spirit of liberalization, the sectors landscape has changed significantly. By 2010, there were five public commercial banks,25 domestic private banks, six foreign banks and four specialized banks. There are now 9,348 bank branches spread throughout the country, catering to the needs of some 28 million deposit account-holders.1.6-Banking in Pakistan the long journey aheadMuch still remains to be accomplished. In the absence of sustainable economic growth, banks will remain vulnerable to business cycle fluctuations. As recently as 2008, non-performing loans increased sharply in response to the preceding years of easy credit and risky consumer lending practices, Moreover, strong regulation will continue to be required so as to maintain the delicate balance between industry concentration and competition. Presently, the top five banks account for about 50% of the sector, measured in terms of total advances.Finally, the benefits of financial liberalization must trickle down to the common man. Banks are proactively exploring new business models to make this happen such as branchless banking. But more headway needs to be made before existing deployments such as Tameer Banks Easy paisa or UBL Omni reach a critical mass of users. Reforms have helped banks come a long way, but unless the central bank remains autonomous, and continues to err on the side of caution, liberalization may quickly become a bitter pill to swallow.Banks are financial institutions that play intermediary role in the economy through channeling financial resources from surplus economic units to deficit economic units. In turn, they facilitate the saving and capital formation in the economy. Bank for International Settlements/BIS (2008) defines liquidity as the ability of bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Hence, liquidity risk arises from the fundamental role of banks in the maturity transformation of short-term deposits into long-term loans. Therefore, banks have to hold optimal level of liquidity that can maximize their profit and enable them to meet their obligation. Over the past years, the subject of bank liquidity creation has become more and more in focus of research in financial intermediation. The widely accepted view today is that banks create liquidity on both the asset and liability side of their balance sheets by transforming maturities of balance sheet items. This process allows banks to hold illiquid monetary items for the non-bank public and give out liquid monetary items to both depositors and borrowers. Banks profitability indicates the ability to finance its transaction efficiently. If the bank is unable to do this it is known as the liquidity risk. As this risk increases the bank is considered unable to meet its obligations (such as deposits withdrawal, debt maturity and funds for loan portfolio and investment). Bank for International Settlements (BIS, 2008) explains liquidity as banks ability to finance increases in assets and meets its obligations without losses. A bank should acquire proper profit abilities when needed immediately at a sensible cost. Though sustaining the optimal level of profit is a real art of banks management. The whole banking system is particularly reliant on the satisfactory degree of liquidity because if a single bank registers the liquidity crisis it will affect the whole financial institutions framework through the contagion effect (mainly because of interbank dependencies) and may ultimately raise the level of systemic risk.Financial sector play a vital role in the economic development of any country. As banking sector is part of financial sector. So, banking sector of any country must be sound and well functioning for economic development. Banks help other sectors of the economy in various 150 JBSQ 2012. Banking sector of Pakistan comprises of both local, foreign banks and Islamic banks. Some specialized and public sector banks are also operating in Pakistan. Banking sector of Pakistan has witnessed drastic change in terms of growth and development over the period of 64 years. After the independence, banking sector of Pakistan had to face shortage of resources and uncertainty due to political and various other reasons. To develop financial sector of Pakistan the state bank of Pakistan was established on 1st July 1948 as central bank of the country. Afterwards through SBP ACT 1956 regulatory and various amendments were made for the development of banking sector. In 1974 nationalization of all private banks took place by government and this nationalization further deteriorated the performance of banking sector due to poor quality of banking products and services. In the decade of 1990s banks were again privatized under the reform policy of banking sector. Now forty banks operating all over Pakistan by the end of June 2010 according to report of state bank of Pakistan and out of these forty banks only four banks are owned by public sector and their total number of branches were one thousand six hundred and twenty one only. Total numbers of local private banks were twenty five and their total numbers of branches were six thousand eight hundred and fifty only. Moreover total numbers of foreign banks were seven and their total numbers of branches were eighty. Specialized banks were four having five hundred and thirty six branches. All statistics given above have been taken from state bank of Pakistan. Pakistani banking sector has shown substantial growth in recent financial years. Since 1980 total assets of banking have been increasing rapidly despite huge challenges to banking sector.The tendency of banking sector of Pakistan over the last few years was towards introduction and betterment of Islamic banking, privatization, competition, deregulation and mergers. Such sorts of changes in the sector have increased scope of competition and choices for consumers have also been increased. The changes mentioned posed greater challenges to banking sector of Pakistan because these rapid changes in operating environment ultimately affected the performance of banks. However, irrespective of such considerable changes in structure and substantial increase in competition, the banking sector of Pakistan had been remained under research to bring innovation, betterment in service and improved quality of product. The major reforms started in banking sector of Pakistan in earlier 1990s. As the basic purpose of these reforms was to bring such change that could make them efficient and sound Following major changes occurred due to reforms in the banking sector. Privatization of sector brought significant betterment in the quality of service through professionalism. Secondly, due to lack of innovative products and poor quality of service during nationalism era, banks were losing substantial part of profit to foreign banks. Privatization witnessed huge upward trend in profits due to more innovative product. Thirdly, due to reforms, strict measures had been considered for the appraisal of loans, as a result default ratio of borrowers was reduced. The present study uses panel data to study profitability of commercial banks in Pakistan because the banking system in Pakistan has undergone technological improvements like the introduction of ATM, Credit Cards, Online Banking, and Privatization overtime. So in order to capture any increased profitability that may occur overtime as technological improvements that are made in the banking industry, we need to use time series data along with cross-section data. This will allow us to separate the impact of technological improvements from other factors. In effect, the panel data set allows us to study both the changes in profits of a single bank over time and the variation in profits of whole banking industry at a given point in time. Many banks struggled to maintain adequate liquidity during global financial crisis. Unprecedented levels ofProfitability support were required from central banks in order to sustain the financial system. Even with such extensive support, a number of banks failed, were forced into mergers or required resolution. Commercial banks were heavily exposed to maturity mismatch both through their balance sheet and off-balance sheet vehicles and through their increased reliance on repo financing. In response to the freezing up of the interbank market, the European Central Bank and U.S. Federal Reserve injected billions in overnight credit into the interbank market.Most of the studies concluded that internal factors explain a large proportion of bank profitability along with many external factors. However, these relations are not same everywhere. Relationship among these factors differs across countries. Therefore, wearing this argument further research is required to investigate relationship. The rest of the paper is structured as follows: Section 2 is about literature review, Section 3 is about describing the nature of variables and their measurements that have been selected to measure performance Pakistani banks. Section 4 is about the methodology select to find out statistical results. Section 5 is about the presentation of empirical results and their analysis and Section 6 is about concluding remarks recommendations and future directions.The development of international financial markets and rising variety of financial instruments has increased the possibility of banks' achievement to financial resources at an extensive level. Under such conditions, the market are rapidly developed and some opportunities are provided to design new products and present more services. Although it seems that the speed of such changes is different from a country to another country, but the banks generally compete with each other to develop and expand the new financial instruments and services. Bank's profit is usually one of the main resources to accumulation of asset. The safety of banking system is depending on theprofitability and capital adequacy of banks. Profitability is a parameter which shows management approach and competitive position of bank in market-based banking. This parameter helps the banks to tolerate some level of risk and support them against short-term problems. Banking in fact is primitive as human society, for ever since man came to realize the importance of money as a medium of exchange; the necessity of a controlling or regulating agency or institution was naturally felt. Perhaps it was the Babylonians who developed banking system as early as 2000 BC. IT is evident that the temples of Babylon were use National Bank of Pakistand as Banks because of the prevalent respect and confidence in the clergy. The partition plan was announced on June 3, 1947 and August 15, 1949 was fixed as the date on which independence was to take effect. It was decided that the Reserve bank of India should continue to function in the dominion of Pakistan until September 30, 1948 due to administrative and technical difficulties involved in immediately establishing and operating a Central Bank. At the time of partition, total number of banks in Pakistan were 38 out of these the commercial banks in Pakistan were 2, which were Habib Bank Limited and Australia Bank of India. The total deposits in Pakistani banks stood at Rs.880 million whereas the advances were Rs.198 million. The Governor General of Pakistan, Muhammad Ali Jinnah issued the order for the establishment of State Bank of Pakistan on 1st of July 1948. In 1949, National Bank of Pakistan was established. It started with six offices in former East Pakistan.The term liquidity risk includes two types of risk: funding liquidity risk and market liquidity risk. Funding liquidity risk is the risk that the bank will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a bank cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption. Profit can be measured by two main methods: This gap is the difference between assets and liabilities at both present and future dates. At any date, a positive gap between assets and liabilities is equivalent to a deficit. Profitability ratios are various balance sheet ratios which should identify main liquidity trends. These ratios reflect the fact that bank should be sure that appropriate, low-cost funding is available in a short time. Banking industry is perhaps most crucial financial intermediary in any country as it facilitate in two major services, liquidity in monitoring services and information creator (Diamond & Dybvig, 1983). The behind reason of economic growth of any nation depends upon the services provided by banking sector. Banks raise funds from suppliers, lend money to customers, work as a major actor in primary market and ultimately work as a backbone in the development of any economy.Organizations competitiveness depends upon its competitive advantage, as there are two different views the Industrial organizational view and Resource based view. The industrial organizational view interpret that competitiveness can be achieved how a company respond to external opportunities and threats as competition, technological changes and economic changes etc. It means that an organization has competitive advantage if it is capable of exploit any opportunity in the market or respond to any external threat timely. Whereas resource based view says that competitiveness can be achieved through how the organization is internally strong and its internal policies, procedures and systems are so strapping which enable an organization to gain competitive advantage. In this contemporary era the strategic approach articulated that the organization will only be able to gain competitive advantage if such polices, procedures, system, and internal resources are rare, dear, peerless, and no substitutable. So in our study we are focusing both the internal and external factors as determinants of organizations success. Unique services are being provided by most of banks therefore there is a great competition in market. The current study is focusing which factors actually affect the organization performance in banking sector of Pakistan.As this risk increases the bank is considered unable to meet its obligations (such as deposits withdrawal, debt maturity and funds for loan portfolio and investment). Bank for International Settlements (BIS, 2008) explains liquidity as banks ability to finance increases in assets and meets its obligations without losses. A bank should acquire proper liquidities when needed immediately at a sensible cost. Though sustaining the optimal level of liquidity is a real art of banks management. The whole banking system is particularly reliant on the satisfactory degree of liquidity because if a single bank registers the liquidity crisis it will affect the whole financial institutions framework through the contagion effect (mainly because of interbank dependencies) and may ultimately raise the level of systemic risk.Achieving the optimum level of liquidity is extremely dependent on various properties such as: size, characteristics, nature and level of complexity of activities of a bank. Greuning and Bratonovic, (2004) explains the management of liquidity as the bank has to follow a decisional structure for managing liquidity risk; an appropriate strategy of funding, the exposure limits and a set of rules for arranging liquidities in case of need. Every bank must have a well-defined liquidity management policy that is communicated in the whole organization. There must be a liquidity control strategy that specifies certain rules regarding management of assets, liabilities and liquidity The role of banking industry is crucial in an economy for its economic growth and development. Over the past years there came significant changes (such as number of commercial banks, technological changes and increased competition) in the financial institution sector of Pakistan. These changes require the increased performance to sustain and compete in the industry. On the other hand the banking sector of Pakistan also has a significant part of market capitalization in the KSE-100 index which is the index of top 100 companies of the country. So the banking sector also works as one of the market movers of Karachi stock exchange (KSE). If the banking industry is disrupted it may harm the entire capital market. For this reason the accurate functionality of financial institutions is needed to evade disorder of any financial service. Optimum level of liquidity is greatly linked with the efficient banking operations. If the liquidity not adequately managed it may lead to insolvency (in case of low liquidity) or low profitability (in case of high liquidity) and ultimately destroy the wealth of shareholder and breakdown of entire financial institutional framework due to strong integration.1. To examine the impact of firm specific and macroeconomic variables on theCommercial bank liquidity.2. To examine the impact of Asian financial crisis (2008) on the commercial bankLiquidity.The financial sector in Pakistan comprises of Commercial Banks, Development Finance Institutions (DFIs), Microfinance Banks (MFBs), Non-banking Finance Companies (NBFCs) (leasing companies, Investment Banks, Discount Houses, Housing Finance Companies, Venture Capital Companies, Mutual Funds), Modarabas, Stock Exchange and Insurance Companies. Under the prevalent legislative structure the supervisory responsibilities in case of Banks, Development Finance Institutions (DFIs), and Microfinance Banks (MFBs) falls within legal ambit of State Bank of Pakistan while the rest of the financial institutions are monitored by other authorities such as Securities and Exchange Commission and Controller of Insurance (State Bank of Pakistan, 2009).The financial system of Pakistan is dominated by the commercial banks. The structure of banking system in Pakistan underwent significant changes after 1997 when the banking supervision process was aligned with international best practices. Privatization of public sector banks and the ongoing process of merger/consolidation brought visible changes in the ownership, structure, and concentration in the banking sector. The objective of this paper is to examine Banks profitability in the context of top 10 Pakistani banks, by using cross-national time series data from 2004-2008. The hypothesis of the study is:i. To estimate whether there is a trade-off between total assets and Banks profitability.ii. To estimate whether there is a relationship between total deposits and total equity overBanks profitability.iii. To estimate whether loans contribute to banking profitability.During the said period i.e., from 2004-2008 is very important in terms of mergers and acquisition in the banking industry. Therefore, this study focuses primarily on the internal factors of banks profitability. Future research will carried out with some external factors on banks profitability in Pakistan, which would assess the impact of South Asian Free Trade Agreements (SAFTA) and general globalization of markets on banking system. For this reason, top 10 banks have been selected for data collection in our research, as these banks covers almost 75% of the total asset base of overall banks in Pakistan. The factors considered for analysis include ROA as dependent variables and equity to total assets, loans to total assets, deposits to total assets and total assets have been taken as independent variables.Organizations competitiveness depends upon its competitive advantage, as there are two different views the Industrial organizational view and Resource based view. The industrial organizational view interpret that competitiveness can be achieved how a company respond to external opportunities and threats as competition, technological changes and economic changes etc. It means that an organization has competitive advantage if it is capable of exploit any opportunity in the market or respond to any external threat timely. Whereas resource based view says that competitiveness can be achieved through how the organization is internally strong and its internal policies, procedures and systems are so strapping which enable an organization to gain competitive advantage. In this contemporary era the strategic approach articulated that the organization will only be able to gain competitive advantage if such polices, procedures, system, and internal resources are rare, dear, peerless, and non substitutable. So in our study we are focusing both the internal and external factors as determinants of organizations success. Unique services are being provided by most of banks therefore there is a great competition in market. The current study is focusing which factors actually affect the organization performance in banking sector of Pakistan.According to the best knowledge of authors this is the first study to investigate the determinant of profitability by using panel data in Pakistan. A profitable banking sector is better able to withstand negative shocks and contribute to the stability of the financial system. The profitability of a financial institution is affected by numerous factors. These factors include elements internal to each financial institution and several important external forces shaping earnings performance. This exercise brought about a landmark change in the number of Pakistani banks as the banking system shrank to only twenty-five banks from a whopping eighty nine banks before the consolidation exercise. It is therefore important to understand the determinants of banking sector profitability in Pakistan. This is essentially important in the light of the above notable changes that have occurred in the operating environment of banks in Pakistan. There is a wide body of studies and literature looking at the determinants of bank profitability. This paper contributes to literature in a unique way. Our dataset, made up of 147 bank level observations consist of 71.43% of banks operating in Pakistan.

Chapter 2 Literature Review

Commercial banks profitability determinants can be grouped namely into internal factors which are under the management control as well as the external factors which are ahead of the management control. The internal determinants give a reflection how the management policies and decisions are different regarding the assets composition which means proportion of investment in current and non-current assets, capital adequacy which is the debt to equity ratio we are considering because the debt financing and capital financing vary with respect to risk and return, deposit composition interprets the proportion of current and fixed deposit, expense efficiency means how efficiently the organization is managing and controlling its operative expenses, and how much they depend on the debt leverage and liquidity management. These management induced determinants on the commercial banks performance can be analyzed through comprehensive analysis of statement of financial position and through statement of comprehensive income of the commercial banks. These internal determinants which are under the management control we are considering in this study are similar to those determinants and factors other researchers considering on the profitability of commercial banks.2.1-Net advances a percentage of total assets.An important explanatory variable of bank performance is liquidity which is measured as a ratio of current assets to fixed assets investments. Meeting the decreases in liabilities or to accommodate the current need of cash by the bank, liquidity is very important for commercial banks profitability. There is a negative relationship between liquidity and profitability means higher the liquid firm, more funds are kept in current assets such as cash and cash equivalents, and less investment in advances and loans by the bank leads to lower return and profitability. Because there is a negative relationship between liquidity and net advances as a percentage of total asset the ratio which we have used for explanatory variable higher the ratio less the liquidity results in higher profitability.2.2-Time and savings deposits as a percentage of total depositsThe current deposits as a percentage of total deposits are the business current liabilities whereas the time and saving deposits as a percentage of total deposits are the business long term liabilities when the ratio of long term liabilities are high and ratio of short term liabilities is low mean high liquidity of the business and higher the liquidity is associated with less profitability of the business.2.3-Total expenditures as a percentage of total assetsAnother internal aspect that can be projected to have significant outcome on profitability is efficiency in expenses management. It is very straight forward that there is inverse relationship between expense ratio and profitability suggested by many researchers such as (Abdullah, 2012) however it is not necessary that expenditures reduce the profit, because more expenditure reflects greater activities in business and ultimately increase in revenues. So in order to access the efficiency of banks at expense-management it is necessary to mention the activity level as well. To this extent in line with (Allen, 2005)the banks total expenditures would be deflated by total assets to measures the firm specific expense management efficiency by measuring the cost incurred per monetary units of assets this ratio will be then total expenditures as a percentage of total assets hence it is expected that when the total expenditure as a percentage of total assets will be high it will affect the profitability negatively.2.4-Loan to deposit ratioAs commercial banks major profits are from interest income so the fourth internal factor which we have included in the study is loan as a percentage of total deposit. High ratio is expected to have a positive relationship with commercial banks profitability because high ratio of loan from total deposits of the bank actually generates the return for bank.External determinantsSuch factors which are beyond the management control namely external determinants those are the firms specific determinants and environmental determinants. These includes firm size, inflation rate, market growth, market interest, market share and sate bank of Pakistan regulations for commercial banks. Such determinants are as much important for our study as the internal determinants of commercial bank profitability after the literature reviewed the most researchers include in their study these variables determine the performance of commercial banks profitability. Transactions costs might be an influencing determinant of capital structure decision and the results were consistent with existing theories. Another study on testing the static trade off theory and pecking order theory was done by Cassar and Holmes, (2003) and the results of regression analysis showed that the asset structure, profitability and growth were important factors which affected the debt equity ratio of the firms. Size and risk showed weaker influences on the debt financing of the firms. Their results were consistent with the static trade off, pecking order and agency cost theories.They experienced that ownership oriented firms preferred equity financing due to lower tax shields and higher bankruptcy costs (Bunda, 2008)analyzed that the debt equity ratio was related to a number of country specific factors such as bond market development, protection of creditors right and growth rate of gross domestic product. Although many foreign researchers have studied the attributes affecting the choice of debt and equity of firms in developed countries, few of them researched on firms in developing countries.The issues related to bank liquidity creation are given importance and a massive theoretical literature is developed in a few past years on financial institutions liquidity supply. (Diamond, 1983) are the first who gave the theoretical explanation for the presence of credit holding bodies and they provided the justifications for the importance of banks role in creating liquidity.The results showed that there is a significant relationship between the liquidity and theresources sufficiency. (Lucchetta, 2007) showed that in a chaotic economic era the liquidity position is that much concerned that any changes in it may change the whole banking network. Their study showed that backing of liquidity is stable and often decreased in tumult phase so it is necessary to consider the liquidity management.Moreover liquidity is very important for both predictable and unpredictable losses. It deals with cash and cash equivalents, investment in securities and placement with other banks. It can help to reduce losses and enhance the chances of banks profitability thatswhy liquidity is a very essential measure. Comparisons between bank and market liquidity are explained by (Vodova, 2011) who said that the origin of market distress is closely matched to the banking distress. For the financial and economic stability its important to understand the joint behavior of market contributors and the inter-reliance between market restraints and individual financial institutions.The lender of last resort issues arise at first place through the predictive externality that a weakening bank may create on the real economy and the financial institutions as well because of asymmetric information context. Central banks mediations comprise of the emergency provision of short-term loans for commercial banks that are facing severe liquidity problems, on the basis of particular stress condition. Therefore the bank liquidity also relies on the core of central bank strategic issues.To summarize the decision about the provision of liquidity support for the sudden needs to maintain the financial stability, pivots on the indebtedness of the social charge specifically linked with the bank failures, bank dreads and contagion effects. Some empirical studies suggest that the central bank functionality may help to evade costly bank dreads.The internal factors include capital ratio, credit risk, productivity growth and size of the bank. In the study of (Vong, 2006), he found an important positive relation between the capital adequacy and profitability. He illustrated that higher the capital ratio, more the bank will be profitable. (Staikouras, 2003)conduct a more comprehensive study which examines the determinants of banking performance for 80 countries, both developed and developing, during the period 1988-1995.They conclude that foreign banks have higher profitability than domestic banks in developing countries, while the opposite holds in developed countries. Nevertheless, their overall results show support for the positive relationship between the capital ratio and financial performance.(Borio, 2004) use panel and cross-sectional regressions to estimate growth and profit equations for a sample of banks for five European countries over the 1990s. The growth regressions suggest that, as banks become larger in relative terms, their growth performance tends to increase further, with little or no sign of mean reversion in growth. (Berger, 1995) finds positive causation in both direction between capital and profitability. Another comparative study by (Bourke, 1989)on the profitability of Islamic and conventional banking in GCC countries examines the profitability of Islamic and conventional banks in GCC countries over the period of 1997-2004. He considered, both internal and external factors as determinants of ROA, ROE and NIM, and suggested that asset quality of conventional banks is better than Islamic banks. And interest free lending relates to profitability in Islamic banks and total expenses affect conventional bank profitability negatively. Bank profitability in the South eastern European region, considering the credit institutions for the period 1988-2002, suggested some implementation of the findings. They found that all bank specific determinants (the internal factors) have significant affect on banks profitability. No positive result was found between banking reforms and profitability and macroeconomic determinants shows mixed affect. According to the research by (Claessens, 1998) on the commercial banks industry of the OECD (Organization for Economic Co-operation and Development) countries shows that a higher leverage ratio helps to get better profitability. Similarly, lower overheads ratio also improve profitability by reducing the type of costs, which is generally considered a signal of efficiency.It reveals that capital (ratio of equity to assets) is very important in explaining bank profitability and that increased exposure to credit risk lowers profits. (Gilbert, 1984)investigate the impact of internal and external factors of banks on the Macao Banking industry for 15-year period. Their results show that with greater capitalization, there is a low risk and high profitability for the bank. Moreover, the large banking network attains higher profitability than the smaller banking network. They found that loan-losses provisions affect banks profitability unfavorably. (Levine, 1998) studies the determinants of bank net interest rate margins in 10 SSA countries.Although, a lot of work has been carried out for the evolution of commercial banks efficiency in the world but very little work has been carried out on the banking sector of Pakistan. There are few studies which evaluate the performance of banking sectors in Pakistan. (Levine, 1998) made a comparative analysis of commercial banks in India and Pakistan during 1988-1998. They found that the efficiency score in loan based model was much higher as compared to the income based model. Both countries banks have needed to improve their efficiency. (Molyneux, 1992) analyzed the impact of financial reforms on the efficiency of state, private and foreign banks of Pakistan by using data of 40 banks for the period 1991-2000. They found a positive impact of banks size, interest income to earning assets and loans to deposit ratio on estimated efficiency scores. The profitability of European banks during the 1990s was investigated by (Short, 1979) using cross-sectional, pooled cross-sectional time-series and dynamic panel models. Their model for the determinant of profitability incorporates size, diversification, risk and ownership type, as well as dynamic effects. They found that despite intensifying competition there is significant persistence of abnormal profit from year to year. The evidence for any consistent or systematic sizeprofitability relationship is relatively weak. The relationship between the importance of off-balance-sheet business in a banks portfolio and profitability is positive for the UK, but either neutral or negative elsewhere. The relationship between the capitalassets ratio and profitability is positive.In another dimension, (Rodriguez, 1993) examined the relationship between bank-specific and macro-economic characteristics over bank profitability by using data of top fifteen Pakistani commercial banks over the period 2005 to 2009. The paper used the pooled ordinary least square (POLS) method to investigate the impact of assets, loans, equity, deposits, economic growth, inflation and market capitalization on major profitability indicators that is, return on asset (ROA), return on equity (ROE), return on capital employed (ROCE) and net interest margin (NIM) separately. The empirical results showed strong evidence that both internal and external factors have a strong influence on the profitability.In banking industry, liquidity risk has an opposite effect on profitability. Some studies such as (Allen L. (., 1988)and (Bonin, 2005)supported the positive effect of risk on the profitability; while some studies such as (Zopounidis, 2009)and (Lloyd-Williams, 1994)believed in its negative effect. Liquidity risk is usually measured as liquidity ratio which is practically calculated in two different forms. In first type, liquidity is adjusted by size which includes the ratio of cash asset to total asset (Williams, 2003); (Habibullah, 2010), the ratio of cash asset to deposits (savings) Second type includes the adjusted loan by the size which includes the ratio of total asset and/or the ratio of net loan to total asset (Smirlock, 1985)In first type, the higher is the liquidity ratio, the higher is the liquidity level, and therefore, it is less vulnerability against bankruptcy. In contrast, in second type, the higher are the values of ratios, it will represent that banks will undergo higher liquidity risk. Financial gap ratio introduced by (Kwan, 2008)is used in this study. They expressed that liquidity risk criterion is determined based on financial gap. Bank managers mostly assume core deposits as stable source of funds which can permanently finance the supply of banking loans. Generally, core deposits are regarded as loan resources with the least cost. Financial gap is defined as the difference between loan and bank's core deposits. If financial gap is positive, the bank should fill this gap by its cash funds through selling cash assets and borrowing from money market. Therefore, financial gap can be estimated by subtracting the borrowed funds from the cash assets. This financial gap represents financial needs of the bank after selling its cash assets. When the economy is under stagnation and financial market increasingly demands for Cash funds, it is when the banks are more exposed on liquidity risk. Therefore in this study, it seems that financial gap is a more appropriate alternative for liquidity risk of the bank. For standardization of financial gap, the variable of financial gap is divided by total asset.conducted research to find out determinants of profitability of commercial banks in Malaysia concluded that efficiency in managing the expenses of banks and market interest rate plays vital role to determine profitability of commercial banks. Further they concluded that to increase the profit and to reduce expenses banks must increase current account deposit on which no interest is applicable. While advancing loans to any one, commercial banks must be extremely careful and must have vigilant eyes on the business risk indicators. argued that profitability of banks can be enhanced through efficient asset management and through economic growth. Further they argued that high credit risk of advances result in lower profitability of banks. As micro variable GDP has positive impact on the profitability of banks. As micro indicators profitability of banks is positively affected by size of bank, operating efficiency and profitability is negatively affected by credit risk. concluded that net interest margin of banks in not affected by interest rate risk where as it more affected by default risk and this higher interest margin leads towards higher profitability of banks. The banks that have small scale of operations they are affected by both default risk and interest rate risk this ultimately affect their results. Discussed that how commercial banks profit is affected by some factors that are considered as determinants of profitability of domestic and foreign banks. Banks solvency chances increases due to higher default and interest rate risk that have an adverse impact on the economy as well and reduces the profits of banks. Equity and assets growth both have positive impact on the profitability of both domestic and commercial banks. Further, cost impact on return on assets was significant and negative for both foreign and domestic banks. The relationship of size of operations was negative to for both the domestic and foreign banks and this relationship also give support to this concept that larger operation for financial institution result in diseconomies of scale. The GDP and inflation have positive and significant impact on the return on assets of both foreign and domestic banks. conducted research and concluded that huge amount of overheads earnings and huge capital has positive impact on the profitability of banks. The net interest margin and loans advances by bank have significant and positive impact on the profitability of banks. Further, from the macroeconomic indicators size and growth have a negative impact on the profitability of commercial bank. Financial markets developments also have significant impact on the profitability of commercial banks. concluded that banks which are well capitalized and have less operating cost earn higher return on assets. Bank size only matters when macroeconomic variable are included in the model. Concluded that creating provision about the loan loss reverse is amongst the most important factors that affect the profitability of banks. Loan loss provision provides true picture to the stake holders about the profits/losses to the banks. If loan loss provision will not be created than profits will be overstated. Loan loss ratio must be maintained by keeping in mind all micro and macro factor rather than depending upon past trends. and concluded that some of the important variables that explain banks profitability are ratio of loans to assets, ratio of equity to assets and personal operating expense of banks. These variables are also directly considered as in relation of directly to strategic planning. Further, economies of scale have positive impact on the profitability of banks and bank size is considered as economies of scale. As an external variable the size of the market is considered as having positive impact on the profitability of banks. The ownership is not significantly associated with the profits of banks. Capital to assets is measure of strength of ratio of banks and increases the profitability of banks. Liquidity ratio is also positively associated with profitability of banks. (Bonin, Bank performance, efficiency and ownership in transition countries, 2005) banks profitability is highly associated with how much cash bank holds. Banks advances to total assets have positive impact on the profitability of banks where as size of banks has negative significant impact on the profitability of banks. Banks profitability is also affected by stock markets because if stock market will grow then demand of advances will increase.In banking industry, liquidity risk has an opposite effect on profitability. Some studies such as (Levine R. (., 1997)and (Kosmidou, 2005)supported the positive effect of risk on the profitability; while some studies such as (Abdullah, 2012) and (Hassan, 2003)believed in its negative effect. Liquidity risk is usually measured as liquidity ratio which is practically calculated in two different forms. In first type, liquidity is adjusted by size which includes the ratio of cash asset to total asset (Kosmidou K. F., 2003); the ratio of cash asset to deposits (savings) Second type includes the adjusted loan by the size which includes the ratio of total asset and/or the ratio of net loan to total asset (Demirguc-Kunt, 1999).In first type, the higher is the liquidity ratio, the higher is the liquidity level, and therefore, it is less vulnerability against bankruptcy. In contrast, in second type, the higher are the values of ratios, it will represent that banks will undergo higher liquidity risk.Financial gap ratio introduced by (Claessens S. D.-K., 1998) is used in this study. Liquidity risk criterion is determined based on financial gap. Bank managers mostly assume core deposits as stable source of funds which can permanently finance the supply of banking loans. Generally, core deposits are regarded as loan resources with the least cost. Financial gap is defined as the difference between loan and bank's core deposits. If financial gap is positive, the bank should fill this gap by its cash funds through selling cash assets and borrowing from money market. Therefore, financial gap can be estimated by subtracting the borrowed funds from the cash assets. This financial gap represents financial needs of the bank after selling its cash assets. When the economy is under stagnation and financial market increasingly demands for Cash funds, it is when the banks are more exposed on liquidity risk. Therefore in this study, it seems that financial gap is a more appropriate alternative for liquidity risk of the bank. For standardization of financial gap, the variable of financial gap is divided by total asset.

Chapter 3 Data Collection and MethodologyThe accord generally reflected from the literature on commercial bank profitability was that the most fitting is Stata regression model. (Bonin, Bank performance, efficiency and ownership in transition countries, 2005) had considered an array of other models but arrive at conclusion that the stata regression gives outcome as reliable and fine as any other form of model. Hence we have also considered a multiple Stata regression model to analyze the cross sectional time series data to determine the commercial bank profitability in Pakistan. ROA=C+1ETI+3SETA+2BDTA+4LIQ Selected Variables and Measurement Five characteristics of a commercial bank have been used as internal determinants of performance. The variables chosen to measure the performance of banks are followings: Dependent Variable Return on Assets (ROA):-The ROA stands for return on total assets of the banks. In line with earlier studies that examined the determinants of the banks profitability, accounting ratios have also been used as measures of performance in this study as well. The first ratio is the return on average assets (ROA), calculated as net profit after tax divided by average total assets.Independent Variables The four variables that are used as internal determinants of performance and as independent variable are as following: Expense to total income (ETI):- This is the ratio expense to income. This ratio is used to have an idea of the information on the efficiency of the management because it tells expense to revenue generated by firms. Therefore, higher ratios means management is less efficient or vice versa. Expense to income (ETI). It measures the overheads or costs of running the bank, including staff salaries and benefits, occupancy expenses and other expenses such as office supplies shown by Total Non-Markup/Interest Expenses as a percentage of total Markup plus Non Markup income.

Share Capital to total assets (SETA):-Banks capital is the ultimate line of defense against the risk of banks technical insolvency. The ratio of share capital as a percentage of total assets (SETA) is considered the best ratio for capital strength. It is expected that the higher the equity to assets ratio, the lower the need to external funding and the higher the profitability of the bank. SETA is used as to measure the strength of capital and it is calculated as equity relative to total assets. Bad debts to total assets (BDTA):-Bad debts to advances ratio provides information about portfolio that how much of the total portfolio has been used as a measure of banks asset liquidity and risk that were provided for but not charged off. If the result of ratio will be higher due to this quality of loans will be poorer and loan portfolio will be highly risky or vice versa. Further, the ratio Bad debts to advances (BDTA) is also a measure of quality of assets of Banks.

Liquidity (LIQ):- LIQ is used as a measure for liquidity and it is calculated as liquid assets to short term funding and liquid assets to customers. This is a measure of liquidity calculated as liquid assets to customer and short term funding. Higher answer of the ratio will be indicator of higher liquidity or vice versa. Low liquidity positively affects the profitability of banks. The ratio of liquid assets to customer plus short term funding is used in this study as a measure of liquidity (LIQ)

Chapter 4 Result and Discussion

ROACoefStd. Err.tP>|t|95% Conf Interval

ETI-.0082668.0032548-2.540.012-.0147061-.0018276

SETA-.7763382.0693323-11.200.000-.9135037-.6391726

BDTA.0001337.00229570.060.954-.0044081 .0046755

LIQ.0007134.00029832.390.018 .0001233 .0013036

_cons.748664.029404625.460.000 .6904904 .8068375

Summarize ROA ETI SETA BDTA LIQVariable0bsMeanStd. DEV.MinMax

ROA135.57538070.2884910.9085

ETI1353.7439186.094729057.55

SETA135.2027274.26667980.9316

BDTA1351.4352798.399528-43.8962.19

LIQ13520.8289259.14910586.8107

Correlate ROA ETI SETA BDTA LIQ(obs=135)ROAETISETABDTALIQ

ROA1.0000

ETI0.00021.0000

SETA-0.6812-0.24501.0000

BDTA0.1154-0.3702-0.06931.0000

LIQ0.17560.0030-0.0417-0.01941.0000

Regression results indicate that slop coefficient is 0.748664 and beta coefficient 1 is -.0082668, 2 is .0010634, 3 is -.7763382, 4 is 0.0007134 which means that change in one unit of X1 will change i with -0.0047934+-0.716895+0.0010634+5.10e-10 units being other things remain constant. T-test is applied to test for the statistical significance of the parameter estimated of the regression. When degree of freedom ranges from 7 to 12 values of t more than .0137238 indicate the statistical significance of parameter. Prob greater than t is the probability of observing a value of t at least as large as we did given that null hypothesis is true. Normally prob greater than t does not exceed 0.10 for statistical significance of parameter. Therefore, it can be concluded that X1, X2, X3 and X4 are statistically significant 10% because t value is 25.46 and P > ltl is 0.000. R square indicates the good fit of the data in such a manner that what fraction of the sample variation in y1 that is explained by X1 . X value shows the significance of model fit using R square normally value of f more than 15 indicates good fit of model prob. > f is a probability of observing a value of f at least as large as we did, given that the null hypothesis is true. Normly prob > f does not exceed .10 for good fit of model. Here it can be concluded that model is good fit at 10% because R square is 0.5150 f value is 34.51 and prob. > f = 0.0000. ConclusionThis study examines the determinants of banks liquidity and also tested the impact of Asian financial crisis 2008 on liquidity of commercial banks. The study concludes that the bank specific fundamentals must be monitored and optimized; such as the greater liquid assets are required as the bank size increases. The central bank regulations also greatly affect the liquidity position of commercial banks, which means that a tight monetary policy is needed to control the undesirable effects of inflation on liquidity.Stata regression analysis exposes that the ROA has negative and significant coefficient with L1. Besides ETI and SETA negatively and significantly correlated, BDTA and LIQ are positively and significantly correlated with L2. L1 and L2 are negatively correlated with each other. Furthermore the co relational analysis does not indicate the problem of multicollinearity. Afterwards the regression equations are estimated. The results of model 1 indicate that the bank specific fundamentals and monetary policy interest rate positively determine the bank liquidity whereas inflation has a negative impact. Additionally bank liquidity is also negatively affected by the financial crisis measured by L1.The study concludes that the bank specific fundamentals must be monitored and optimized; such as the greater liquid assets are required as the bank size increases. The central bank regulations also greatly affect the liquidity position of commercial banks, which means that a tight monetary policy is needed to control the undesirable effects of inflation on liquidity. Besides, the financial crisis showed a negative impact on banks liquidity which also indicates that the banks were not ready enough to absorb the crisis shock. It suggests that banks must forecast the liquidity requirements to fulfill the requirements of anticipated events.

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