DETERMINANTS OF PROFITABILITY: A CASE OF COMMERCIAL BANKS IN PAKISTAN

Purpose of the study: This study aims to investigate the impact of bank-specific and macro-economic factors on commercial banks profitability in Pakistan. Methodology: This study uses both internal and external factors as independent variables. Internal factors are inclusive of capital adequacy, operational efficiency, deposit ratio, liquidity, leverage, number of branches, and bank size, while external indicators are pertaining to GDP, rate of inflation, interest rate, and rate of foreign exchange. Return on assets, return on equity, and net interest margin is employed as proxies for measuring profitability. Balanced panel data of 25 commercial banks over a period ranging from 2009 to 2018 is analyzed through descriptive statistics and fixed effects regression model. Main Findings: The empirical findings revealed that among internal factors, capital adequacy ratio, deposit ratio, leverage ratio, liquidity ratio, and bank size significantly affect the return on asset, while in the case of macro-economic factors, inflation rate, exchange rate, and GDP have a significant impact on return on asset. On the other hand, return on equity is significantly affected by deposit ratio, leverage ratio, and operational efficiency, whereas among macro-economic factors, only the inflation rate had a significant effect on return on equity. Furthermore, in the case of net interest margin, among internal factors, capital adequacy ratio, deposit ratio, bank size, and the number of branches have a significant impact on net interest margin, whereas, among macro-economic factors, interest rate, inflation rate, and exchange rate significantly affected net interest margin. Applications of this study: This study has greater importance for government, bank managers, investors, academicians, and scholars. Originality/Novelty: In this study, the number of branches is taken as a novel factor in Pakistan's case and bridges the gap in the banking literature of Pakistan. 25 banks is selected for this study based on purposive sampling technique for some time from 2009 to 2018. A balanced panel data is utilized because of the study's objectives and the advantages that it has over cross-sectional or time series. Panel data gives more information, lessens co-linearity among the variables, more variability, higher degrees of freedom, and higher efficacy (Baltagi, 2005; Gujarati, 2012). Bank-level data is taken from each bank's financial statement and Pakistan's state bank (sbp.org.pk). Macro-economic level data is retrieved from the World Bank database.


INTRODUCTION
Banks are considered the lifeblood of an economy. The banking industry plays the role of locomotive for an economy which ultimately boosts financial development and strengthens overall economic growth (Levine, 1997). An advanced and lucrative banking industry facilitates access to finance at competitive rates and, therefore, provides the momentum for economic growth in an economy (Petria et al., 2015;Peng, 2019). The banking sector assumes a critical function in developing the financial sector and contributing a major portion to the financial development of a nation; therefore, it is important to observe the performance of the banks.
The banking industry of Pakistan plays a greater role in its financial and economic growth. Several reformations had taken place in the Pakistani banking sector to boost financial performance. To ensure growth and sustainability in banking performance, in 1990, the government announced the decentralization of banks (Shair et al., 2019). In the post-privatization period, the banking sector experienced massive development. Banking reforms attracted private and foreign banks to enhance the quality of banking products and services. It prompted competition in the banking industry which further brought about internal improvement, effectiveness and lessened the cost of lending to safeguard the accessibility of finance to the middle class. This progressiveness of the financial institution sector requires improved performance to maintain and contend in the business (ABBAS, 2019).
This paper attempts to identify the profitability of commercial banks operating in Pakistan by utilizing inner components such as "bank size, capital adequacy, deposit, operational efficiency, number of branches, leverage and liquidity" and macroeconomic variables such as GDP, interest rate, inflation rate and exchange rate on various performance measures like Return on Assets (ROA), Return on Equity (ROE) and Net Interest Margin (NIM). The internal and external determinants both affect the financial institution's performance in terms of profitability (Abdur Rahman, 2020; Gul et al., 2011). 1. What is the impact of bank-specific factors on commercial banks' profitability?

LITERATURE REVIEW
Bank profitability is of utmost importance within the current context, and its determinants have been, hence, evaluated and represented in the empirical papers of numerous scholars. Most of the researchers employed both internal and external indicators to determine bank profitability (Abdelaziz et Zampara et al., 2017). Ensuing the previous works done in this paper, profitability is taken as an explained variable, whereas internal/bank-specific and external/macroeconomic indicators are employed as explanatory variables. Three proxies (ROA, ROE, and NIM) are used to measure the profitability of commercial banks.

Bank Specific Factors
The larger the size, the more efficient the bank is in regarding operating costs. Or in other words, if a bank grows in its size, it gives additional strength and capability to a bank in managing its operating costs efficiently, which in turn leads to economies of scale and scope (Ayano & Ponnala, 2016;Dasig et al., 2017).). The profitability of banks is positively affected by the size of banks (Almaqtari et al., 2019;De Silva et al., 2019). Furthermore, it is substantiated that increase in firm size can be translated to cost reduction, which comes as the result of economies of scale. It is also concluded that larger banks have better opportunities in raising capital and financing their operations with a reasonable capital cost. On the contrary, it is concluded that the profitability of banks is negatively influenced by size Batten & Vo, 2019). It is observed that banks having a large size are facing difficulties in controlling and managing efficiently. When larger banks grow as compared to smaller banks, their costs increase and ultimately result in lower profits (ur Rehman et al., 2018).
There is consistency in empirical works done regarding operating efficiency, and it is concluded that operational efficiency hurts banking performance (Al-Homaidi et al., 2020; Supriyono & Herdhayinta, 2019). It is clarified, if bank management can efficiently manage its operating costs, this will increase banking performance.
The capital ratio can work as a safeguard for financial distress and represents funds that are retained and owned by a bank. It will be realized throughout the financial crises that how bank profits are affected by the poor quality of capital ratio and unpredicted losses. Lardic and Terraza (2019) and Abdelaziz et al. (2020) found a negative association between profitability and ratio of capital adequacy. Contrary to the above arguments, it is observed that capital adequacy enhances banking performance and exerts a positive effect on profitability (Le & Nguyen, 2020;Shair et al., 2019). Berger (1995) clarified that banks with higher amounts of capital are in a less risky stance than those with lesser amounts of capital. However, the greater extent of riskiness will be translated into higher profitability. Having a large amount of capital enables a bank to reduce the effect of unpredicted losses, make a bank to use its internal financial resources and does not rely on further borrowings, brings down borrowing cost, and there will be sufficient resources that could be used for advances to increase interest income and can be utilized in other profitable investment opportunities (Gul et al., 2011;Tan & Floros, 2012;Chang, 2016.) Performance of banks decreases when leveraging ratio increases, and it may be due to the reality that equity is less expensive compared to that of debts; as a result, using a higher LEV ratio tends to decline bank performance (Yadollahzadeh et al., 2013). Al-Homaidi et al. (2018) and Ali (2015) concluded that leverage ratio exerts a negative effect on bank profitability.
In present global scenarios, it is essential for businesses to have a sufficient amount of liquid assets to guarantee the stability of the firm in the long term (Ayele, 2012). There will arise a risk of insolvency if the firms are not in a position to fulfill a reasonable benchmark of working capital. So, it does have positive consequences on the profitability of the firm and its stability when a firm can set up its liquidity to an optimal level (Karakuza, 2017; Osra, 2017). Organizations having enough cash can easily grab profitable investment opportunities (Arnold, 2008). On the contrary, it is stated that firms having higher liquidity are facing many financial problems. This is the likely elucidation that the firms with higher amounts of circulating assets that need conservation or maintenance costs ultimately considerably reduce the profitability (Neto, 2003).
The economic theory describes, that the association between profitability and risk is positive. Hence, if the liquidity level tends to increase, the risk exposure will decrease, and it sparks a negative impact on firm profitability. In such conditions, the working capital strategy remains less risky in context. Conversely, if a firm has less working capital, it significantly increases the risk of being insolvent. However, the firm shall have increased profitability (Abebe, 2014). The liquidity ratio negatively affects banking performance.

Macroeconomic Factors
If banks can accurately anticipate the rate of inflation, their profitability will increase because they will have the ability to bring such changes in interest rate which help to boost bank's turnover; on the other hand, if inflation is not accurately expected, it will increase the cost. After all, banks will not be in a position to adjust the interest rate in a way that could enhance revenue. When banks' income increases more swiftly compared to their costs, in such a case, the inflation rate is likely to positively impact banks' profits and vice versa (Ayele, 2012). The rate of inflation negatively affects banking performance. On the contrary, it is concluded that the rate of inflation negatively affects banking profitability ( The critical point to concentrate on is banks' ability to set interest rates that easily cover funding costs, operational costs, and the required rate of return. It is anticipated that the rate of interest positively affects banking performance in lending long and borrowing short slogans (Vong & Chan, 2009). On the contrary, interest rate and bank profitability have a negative relationship because it causes a real burden on borrowers to increase and deteriorate the quality of assets, diminishing banking profitability. Rate of interest rate and profitability negatively associated Banks with assets or liabilities in foreign currencies face foreign exchange rate risk, affecting bank capital and profitability due to fluctuating movements in exchange rates. Exchange can be moved in either upstream or downstream irrespective of considering predictions and estimates. These ambiguous movements posing a risk to the capital and turnover of a bank, when these movements are in contradiction to the desired goals. Exchange rate depreciation positively and significantly affects profitability when management is good enough to accurately predict fluctuations taking place in exchange rates and ultimately results in achieving profits on foreign currency transactions (Davydenko, 2010). The rate of exchange negatively affects banking performance (Hasan et al., 2020; Almaqtari et al., 2019). On the contrary, a positive association between the rate of exchange and performance of the bank is reported by (Caliskana & Lecunab, 2020;Shuremo, 2016).
The aim of the study conducted by ur Rehman et al. (2018) conducted a study in Pakistan, covering a time span from 2007 to 2015. For analysis, the fixed effect regression model was adopted to investigate micro and macro-economic indicators on bank performance. Bank-specific factors include capital adequacy ratio, asset composition, funding source, quality of the asset, size, cost ratio, tax ratio, fee-based services, and market volume. Macro-economic indicators include GDP, real interest rate, and Herfindahl-Hirschman Index (HHI). The profitability of the bank is proxied by ROA. The study's empirical results demonstrate that only asset composition and size, out of micro indicators, are substantial elements that contribute to banking performance. Concerning external factors, GDP and real interest rate are significantly affecting profitability.
In Pakistan, from the period 2007 to 2017, an investigation was executed by Shair et al. (2019) to evaluate the bank profitability by using the generalized method of moment and taking 26 banks. It is concluded that liquidity, capital adequacy, size, taxation, and GDP positively affected banks' profitability, whereas competition and credit risk demonstrate an inverse association with bank performance. Furthermore, it is reported that operating cost has a positive link with NIM, but negative relation with ROA. In Pakistan, banks are needed to be involved in traditional loaning activities to utilize their liquid assets because having an increased amount of liquid assets reduces profitability. It is reported that size does not contribute to Pakistani banks' profitability, and it harms profitability and could be due to diseconomies of scale. Furthermore, it is reported that the capital adequacy ratio plays a significant role in accelerating a bank's profitability, and it positively impacts profitability.

Conceptual Framework
In order to accomplish the aim of the present work, it is considered essential to include both internal and external indicators.
Accordingly, it is inspected in the following schematic diagram.

RESEARCH DESIGN AND METHODOLOGY
Currently, in Pakistan, 33 banks are working, consisting of 20 private business banks, 4 foreign-owned banks, 5 state-owned business banks, and 4 specialized banks, and these specialized banks also work under government possession. The target population for the present work is 29 commercial banks working in the country. From the 29 commercial banks, a sample of

Dependent Factor Independent Factors Independent Factors
25 banks is selected for this study based on purposive sampling technique for some time from 2009 to 2018. A balanced panel data is utilized because of the study's objectives and the advantages that it has over cross-sectional or time series. Panel data gives more information, lessens co-linearity among the variables, more variability, higher degrees of freedom, and higher efficacy (Baltagi, 2005;Gujarati, 2012). Bank-level data is taken from each bank's financial statement and Pakistan's state bank (sbp.org.pk). Macro-economic level data is retrieved from the World Bank database.

Model Estimation and Selection
In order to identify the indicators that affect the profitability of banks, it is better considered to employ panel data analysis. Panel data models which evaluate the effect of internal and external indicators on commercial bank profitability are given below: Fixed effect model (FEM) and random effect model (REM) are the most pronounced models which are used for panel data analysis (Brooks, 2019    For the regression analysis accuracy, it is important to relax some of the basic OLS assumptions. Thus, before running regression analysis, it is considered essential to address the issues of multicollinearity, heteroscedasticity, and autocorrelation. Multicollinearity issue is checked through the variance inflation factor (VIF) portrayed in  in table 8 for ROA, ROE, and NIM models respectively, lie between the range of (1 to 3), show the absence of serial correlation problem in this study. This figure is high as a contrast with the factors that are in the table that implies that the information focuses on the number of branches (NoB) that has widely spread around its mean.

Correlation Matrix
Based on correlation coefficients shown in table 7, the relationship of operational efficiency, deposit ratio, leverage, bank size, GDP, and the exchange rate is negative with ROA. at the same time, the capital adequacy, liquidity, number of branches, inflation, and rate of interest have a positive association with ROA. Regarding ROE, the relationship of operational efficiency, capital adequacy, liquidity, inflation, and interest rate is negative with ROE, while the number of branches, deposit ratio, leverage, bank size, GDP, and the exchange rate is in line with the direction of profitability (ROE). Concerning NIM, the relationship of operational efficiency, deposit ratio, leverage, bank size, GDP, and the exchange rate is negative with NIM, while the capital adequacy, liquidity, number of branches, inflation, and interest rate move in the same direction with the NIM.

Regression Analysis
Based on the given results in table 8, as profitability is measured    indicates that INTR has a substantial impact on NIM. The positive relationship recommending that when banks advancing loans to their clients, they charge a higher rate in contrast when they pay on deposit or on other liabilities or shortly it can be concluded that saving rate is lesser than that of lending rate, ultimately the positive spread helps the bottom-line to increase. This finding is steady with the result of (Al-Harbi, 2019).

CONCLUSION
The present work's primary purpose was to identify the indicators of profitability of the commercial banking industry of Pakistan. Based on the past work done in an attempt to determine the indicators which affect profitability, and including this study, it is clarified that profitability can be influenced by either indicator (micro and macro-economic). By using internal factors inclusive of capital adequacy, operational efficiency, deposit ratio, liquidity, leverage, number of branches, and bank size with the macro-economic indicators pertaining to GDP, rate of inflation, interest rate, and rate of foreign exchange, this paper seeks to identify the indicators of profitability concerning commercial banking industry working in Pakistan covering a time span from 2009 to 2018 and taking 25 commercial banks. Data analysis is carried out with descriptive statistics, correlation analysis, and a fixed-effect model. In view of the study's outcome, the explanatory factors explained 77%, 69%, and 82% variations in ROA, ROE, and NIM, respectively. It is perceived that there are some other outer and interior factors (bank class, market fixation, charge rate, industry development, bank proprietorship, bank age, government guideline, innovation, and so on) that could impact the benefit of business banks in Pakistan. Thus, for future studies, it could be suitable to include the above factors. Furthermore, it could be possible to conduct comparative studies between the countries or between the banking industries like private vs public banks.

LIMITATIONS AND FUTURE RESEARCH DIRECTIONS
The limitations of the research include the fact that it was restricted to listed commercial banks. Also, only such determinations were tested in Pakistan. Future research should include all commercial banks, including non-listed ones.
Besides, considerations can also be made to analyze the variations in profitability determinants between small and big or high and low profitability banks.

POLICY IMPLICATIONS
 Implications for Government: Based on the empirical results reported in this investigation, among macro-economic indicators, inflation has a substantial and negative impact on ROA, ROE, and NIM. The government is needed to put in action such as macroeconomic approaches and systems that are fit for controlling dramatic changes in inflation rates. The government may consider those approaches and systems which help and facilitate the financial exercises in the country.
 Implications for Bank Managers: As inflation is a critical indicator, bank supervisors are needed to foresee inflationary ups and downs precisely. As reported in the results, DPER has a substantial and positive effect on ROA, ROE, and NIM. Banks may increase their deposits because it is the economical funding source for banking businesses, and this is argued that increased deposit liabilities provide credit opportunities and other profitable investments. During rising economic growth rates, banks may boost their profitable investment opportunities by utilizing their surplus funds.
 Implications for Investors: The results also assist people or investing class in perceiving productivity indicators and making the pertinent investigation of fiscal summaries to settle on educated and valued equity investing choices.