IMPACT OF BANK SIZE ON PROFITABILITY: EVIDANCE FROM PAKISTAN

Volume 2, 2013, Page 98-109 IMPACT OF BANK SIZE ON PROFITABILITY: EVIDANCE FROM PAKISTAN Muhammad Arif 1, Muhammad Zubair Khan 2, Muhammad Iqbal 3 1 Islamabad Model Postgraduate College of Commerce, H-8/4-Islamabad, For correspondence: 2 Hajvery University, Lahore 3 Department of Statistics, University of Peshawar. iwu2005@yahoo.com ABSTRACT This study empirically investigates the impact of various measures used in research for bank size on the profitability of Pakistani banks. In Pakistan debt market is not capacitated to cater the financing needs of corporate sector. Banks are thus the major source of debt financing for business and non-business enterprises. Therefore the stability of banking sector is of paramount importance to the financial system. Quarterly data (2005-09) of all domestic scheduled banks for last five years is extracted from the quarterly statements of the banks. The banks are divided into the three size categories on the basis of assets. Descriptive analysis and linear regression is run separately for each group for comparison purpose. On the basis of results it is found that all the measures of size used in research have positive impact on profitability of commercial banks. It is concluded that commercial banks in Pakistan can maximize their profitability if they manage to increase size by expansion strategies and restructuring. KEY WORDS: profitability, commercial banks, bank size 1. INTRODUCTION As financial intermediaries, banks play an important role in the operation of an economy. This is particularly true in the case of Pakistan where banks are the major providers of funds, and their stability is of paramount importance to the financial system. As such, an understanding of determinants of their profitability is essential and crucial to the stability of the economy. Like other developing economies, the Pakistani Banking sector has also benefited from the macroeconomic stability. The overall assets of the banking sector increased from Rs. 3.6 trillion in December 2005 to Rs. 5.5 trillion by June 2008 (Pakistan 10 years strategy paper for the banking sectors reforms: SBP) Merger, acquisitions and expansions are taking place and the

Volume 2, 2013, Page 99-109 structure and size of banking institutions are changing. As compared to the past, the banking sector has become more competitive. In banking literature, the determinants of profitability are empirically well explored, although, the definition of profitability varies among studies. Whatever the measure of profitability, most of the researchers have noticed that the capital ratio, loan loss provisions and expense control are important factors in achieving high profitability. However there are number of studies conducted around the world, found a significantly positive relation between bank size and its profitability. The investors in commercial banks are of various levels and their number is the largest in any other sectors of the economy. Therefore, looking at the interest of a larger number of investors, it becomes worthwhile important that the factors responsible for effecting profitability of commercial banks should be identified. The aim of this study is to analyze the sensitivity of profitability in terms of total assets, advances and deposits in the domestic commercial banks of Pakistan. The study employed bank-level data which are rarely used by analysts who study determinants of profitability. Most of the researchers focus on macroeconomic factors. Therefore, the paper extends the literature on the subject by relying only upon the bank specific variables. Arby (2003) studied the impact of structure of banks on the performance of commercial banks in Pakistan. Another study Efficiency analysis of commercial banks in Pakistan conducted by Tanvir (2007). The studies included both bank specific and external factors as independent variables. 2. DATA AND METHODOLOGY Domestic schedule commercial banks operating in Pakistan during the period 2005 to 2009 is population of this study. The total number of these commercial banks is twenty five. Foreign commercial banks and Islamic banks are excluded. The reason for exclusion of foreign commercial banks is that most of the branches of these banks operate in a different environment. The sources of origination of interest and non-interest income of domestic and foreign banks are different therefore; making comparison of two may lead to somewhat unrealistic conclusions. Islamic banks are not included in the population on the basis of different structure of its assets and the special laws governing these banks. Data set used in this study is based on the information collected from the quarterly financial statement of commercial banks operating in Pakistan over the period of July 2005 June 2009. Procedure for selection of the sample was that first log of the book value of all commercial banks

Volume 2, 2013, Page 100-109 (Both nationalized and private) were calculated. Then on the basis of natural log of book value of assets, banks with natural log of 20 and above, 18-19 and 17-18 were classified as large, medium and small size banks respectively. Quarterly financial statements are obtained from the web site of association of Pakistani banks and SBP. Indranarain (2009) used quarterly data obtained from 31 banks operating in Taiwan during the period from March 2002 to December 2007. Model: it = α + β it + ε it = Profitability in terms of return on assets (ROA) of firm i at time t. = Intercept it = Slope of independent variable. = Random error 3. DATA ANALYSIS All the analysis is performed using SPSS, like descriptive statistics, linear regression etc. Table-1 shows the average values of variables. As the average returns of larger banks are the highest and that of the medium size banks is the second highest. The ROA and ROE of small banks is the lowest of the three groups. Devinaga (2010) concluded that in terms of return on assets and returns on equity medium size banks are in general, the most profitable. Table-1: Average financial ratios of large, medium and small size banks: Natural log of Natural log of Natural log of Banks Assets Advance Deposits ROA ROE Large Banks 20.150 19.331 19.713 0.012 0.098 Medium Banks 18.979 18.313 18.634 0.005 0.062 Small Banks 17.031 16.282 16.692-0.003-0.113 For finding empirical evidence of relationship between the dependent and independent variables, two tailed Pearson correlation with the significance level of 10% is been used Pearson Correlation: Assets Advances Deposits Profits

Volume 2, 2013, Page 101-109 Assets Pearson Correlation 1.556 **.774 **.280 ** Sig. (2-tailed).000.000.000 Advances Pearson Correlation.556 ** 1.820 **.308 ** Sig. (2-tailed).000.000.000 Deposits Pearson Correlation.774 **.820 ** 1.444 ** Sig. (2-tailed).000.000.000 Profits Pearson Correlation.280 **.308 **.444 ** 1 Sig. (2-tailed).000.000.000 The Pearson correlation reveals that the relationship between bank size in terms of total assets, advances and deposits with profitability is.280**.308** and.444** the relationship between the three independent variables with the dependent variable is positive significant at.01 significance levels. The results of the correlation analysis are in accordance with results derived by Eward (1976), Sudin (1996), and Vallenina et al (1996) e.tc. Pearson correlation further reveals that the independent variables are not highly correlated i.e less than.85 with each other. The correlation between, assets, advances is.556**, assets and deposits is.774** and deposits and advances is.820**. 4. REGRESSION ANALYSIS For evaluating the effect of size on profitability, nine dummy coded variables A, A1, A2, for assets, Ad, Ad1, Ad2, for advances and D, D1 and D2 were used for deposits of the three groups of banks i.e. large, medium and small respectively. In the first step individual independent variables were entered, and in the second step first dependent variable (Profit before tax) were entered. For analyzing the impact of size on profitability for the three groups of banks separately, two dummy variables representing large and medium size group of banks were used as independent variable and dummy variable representing small size group of banks was used as

Volume 2, 2013, Page 102-109 control variable. In the second step, dummy variables representing medium and small size group of banks were entered and dummy variable for large size group of banks was used as control variable. Impact of all the three independent variables was first evaluated on the dependent variable (Profit before tax). The following results were obtained from the regression analysis: Table-2 Model Summary Model RE R Square Adjusted R Square Std. Error of the Estimate 1.208 a.043.036.02225 a. Predictors: (Constant), A1, A The model summary represented by table-2, indicates the R Square.043 which in insignificant. It reveals that size in terms of total assets caused only 4.3 percent change profitability. Table-3 a Standardized Unstandardized Model B Std. Error Beta t Sig. 1 (Constant).000.003 -.300.765 A.011.004.239 2.862.005 A1.002.004.048.577.565 a. Dependent Variable: ROA The coefficients table reveals that large size banks used their assets more efficiently as the impact of assets on ROA of large size banks is significant which is reflected by β=.239 and p < 0.05. For medium size group of banks impact of assets on profitability is insignificant which is reflected by beta.048 and p > 0.05. The regression results for medium and small size banks, when the large size banks group has been used as control variable, are as under. Table-4

Volume 2, 2013, Page 103-109 Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1.207 a.043.036.02225 a. Predictors: (Constant), A2, A1 The model summary represented by table-4, indicates the R Square 0.043. It reveals that size in terms of total assets caused only 4.3 percent change profitability. Table-5 a Standardized Unstandardized Model B Std. Error Beta T Sig. 1 (Constant).010.002 5.264.000 A1 -.008.003 -.169-2.717.007 A2 -.011.004 -.176-2.835.005 a. Dependent Variable: ROA Table-5 contains coefficients of the regression analysis, which reveals that the impact of assets on ROA in medium size banks is negative and significant which is reflected by (β = - 2.717 p < 0.05). The impact of assets on ROA for small size banks is also negative and significant as (β = - 0.176 and p < 0.05) Results for Impact of bank size in terms of advances on ROA for the three groups of banks are as under: Table-6 Model Summary Model R R Square Adjusted R Square d. Error of the Estimate.335 a.112.105 2143 a. Predictors: (Constant), Ad1, Ad

Volume 2, 2013, Page 104-109 The model summary represented by Table-6, indicates the R Square 0.112 which reveals that size in terms of Advances caused only 11.2 percent change profitability for large and medium size banks. The group of small size banks was used as controlled variable. Table-7 a Standardized Unstandardized Model B Std. Error Beta T Sig. 1 (Constant) -.005.002-1.936.054 Ad.020.003.398 5.817.000 Ad1.010.003.013.212.832 a. Dependent Variable: ROA of the analysis reveal that the impact of advances on profitability for both large and medium size banks is positive but for medium size banks the impact is insignificant the results show that β= 0.398 and p < 0.05 for large size banks and β= 0.212 and p > 0.05 for medium size banks. Table-8 Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1.325 a.106.099.02151 a. Predictors: (Constant), Ad2, Ad1 Table-8, shows R Square 0.106 which reveals that size in terms of Advances caused 10.6 percent change profitability for medium and small size banks the group of large size banks was used as referring variable. Table-9

Volume 2, 2013, Page 105-109 Standardized Unstandardized Model B Std. Error Beta t Sig. 1 (Constant).015.002 6.093.000 Ad1 -.009.003 -.194-2.839.005 Ad2 -.019.003 -.385-5.639.000 a. Dependent Variable: ROA of the analysis reveal that the impact of advances on ROA of medium and small size banks is negative and significant. For medium size banks, β= - 0.194 and p < 0.05 while for small size banks β = - 0.385 and p < 0.05 The impact of deposits on profitability is depicted by the regression results given below: Table-10 Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1.254 a.064.057.02200 a. Predictors: (Constant), D1, D For groups of large and medium size banks, the R Square = 0.064, it reveals that 6.4 percent change in profitability is caused by change in the volume of deposits.

Volume 2, 2013, Page 106-109 Table-11 a Standardized Unstandardized Model B Std. Error Beta t Sig. 1 (Constant).000.003 -.117.907 D.013.004.278 3.570.000 D1.002.004.041.521.603 a. Dependent Variable: ROA Table-11 containing coefficients, reveals that for large banks the impact of deposits on profitability is positive and highly significant, the regression analysis for large banks reveal that β = 0.278 and p < 0.05. For large banks the impact of deposits on profitability is although positive but insignificant. For the group of medium size banks, the beta is Β = 0.041 and p > 0.603. Table-12 Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate 1.251 a.063.056.02201 a. Predictors: (Constant), D2, D1 The percent change in profitability caused by change in deposits for the group of small and medium size banks is 6.3 percent. Table-13 a Standardized Unstandardized Model B Std. Error Beta t Sig. 1 (Constant).012.002 5.846.000

Volume 2, 2013, Page 107-109 D1 -.011.003 -.234-3.619.000 D2 -.013.004 -.227-3.520.001 a. Dependent Variable: ROA Analysis of coefficients revealed by table-13 shows that for both group of banks, i.e. small and medium size, the impact of deposits is negative and significant. For D1 which represents group of medium size banks, β= - 0.234 and p < 0.05 and for small size banks represented by D2, β= - 0.227 and p < 0.001. 5. RESEARCH FINDINGS AND DISCUSSION The study contemplated some of the concerns and questions raised by other researchers, regarding the impact of bank size measured in terms of total assets, advances and deposits of commercial banks on their profitability. This study aimed at identifying the bank specific determinants of bank profitability. Table-1 shows that the ROA ratio of large, medium and small size banks are 0.012, 0.005 and - 0.003 respectively. The return on assets ratios indicate that bank size has a positive impact on profitability of commercial banks in Pakistan. The regression analysis also reveals a positive and significant impact of bank size in terms of total assets on profitability for the group of large size commercial banks. Whereas, for medium size commercial banks the impact of bank size in terms of total assets on profitability is positive but insignificant. The regression analysis revealed that the impact of bank size in terms of total assets on profitability for the group of small size commercial banks is negative and significant. The relevant financial ratio i.e. ROA and the regression analysis indicate that size is a significant determinant of profitability of commercial banks in the country. Other researchers like Panayiotis et al (2005), Sudin (1996) and Valentina et al (2009) has also found a positive impact of bank size in terms of total assets on profitability of commercial banks. Results for Impact of bank size in terms of advances on ROA for the three groups of banks reveal that bank size in terms of Advances caused only 11.2 percent change profitability for large and medium size banks. Results obtained from the regression analysis revealed that the impact of advances on profitability for both large and medium size banks is positive but for medium size banks the impact is insignificant. Whereas for the group of small size commercial banks, the impact of bank size in terms of advances is negative and significant.

Volume 2, 2013, Page 108-109 The regression results revealed that for groups of large size banks the impact of deposits on profitability is positive and highly significant, (β = 0.278 and p < 0.05.). It indicates that deposits contribute positively to profitability for the group of large size commercial banks. For medium size group of banks the impact of deposits on profitability is although positive but insignificant (β = 0.041 and p > 0.05). For the group of small size commercial banks, the impact of deposits on profitability is negative and significant (β = - 0.227 and p < 0.05.). Other researchers like Arby (2003) suggested that deposits of banks also play a crucial role in affecting the profitability of banks. The researcher indicated that deposits play dual role in effecting banks revenue. The researcher concluded that the net impact of deposits was negative on their profitability. Edward (1976) conducted a study of all insured commercial banks in United States for the period from 1954-74. The researcher found a positive relationship between the bank size in terms of deposits and bank profitability. The results indicate that the bank size in terms of deposits has a positive impact on profitability of commercial banks and therefore H 3 is rejected. It is concluded that commercial banks in Pakistan can maximize their profitability if they manage to increase size by expansion strategies and restructuring. Commercial bank managers and investors can use the results of this study. The result can be useful while making decision about expansions, granting loans and collecting deposits. Book value of total assets has a significant impact on profitability. So while making expansion decisions, this information can help the decision makers in giving thought to this aspect of the impact of decision. Association between advances and the dependent variable is also positive and significant so, while making decision regarding credit growth, this aspect should be contemplated. Generally management believes that the macro economic factors are the major determinants of profitability and pays little attention on the bank specific factors. REFERENCES o Arby, M. Farooq. (2003). Structure and Performance of Commercial Banks in Pakistan. Munich Personal RePEc Archive Working paper 4983, 1-24 o Devinaga Rasiah. (2010). Theoretical framework of profitability as applied to commercial banks in Malaysia. European Journal Of Economics, Finance And Administrative Sciences, 19, 75-96 o Edward C. Gallick. (1976). Bank profitability and bank size. Monthly Review, 76, 11-16 o Indranarain Ramlall. (2009). Bank specific, industry-specific and Macroeconomic determinants of profitability in Taiwanese banking system: Under panel data estimation. International research journal of finance and economics 34, 160-167

Volume 2, 2013, Page 109-109 o Sudin Haron. (1996). Competition and other external determinants of the profitability of Islamic banks. Islamic economic studies, 4, 50-65. o Valentina Flamini Calvin McDonald, and Liliana Schumacher. (2009). The determinants of commercial bank profitability in Sub-Saharan Africa. IMF working Paper 09/15, 2-32.