FINAL PROJECT

Submitted By: Muhammad Ali Haider

Roll Number: 0948-BH-BAF-19
Course Name: Financial Econometrics
Course Code: BAF-4201
Semester: 8th
Submitted To: Sir Safyan Majid
Title of the Research Article:
DETERMINANTS OF PROFITABILITY OF ISLAMIC BANKS OF PAKISTAN – A CASE STUDY ON PAKISTAN’S
ISLAMIC BANKING SECTOR

Introduction:

The dataset on which the commands on STATA software have been run is from
an article the name: Determinants of profitability of Islamic banks in Pakistan.

The aim of this study is to identify the factors that influence Islamic banks in
Pakistan. Data from five Islamic banks in Pakistan were gathered by the author
during a ten-year period, from 2006 to 2015. The dependent variable was
Return on Asset, while the independent variables were GDP, Size, Inflation,
and Liquidity. Making use of STATA software and using panel regression, the
researcher discovered that the size of Islamic banks and liquidity are the only
two significant variables at 5% in the fixed model effect. Size has a detrimental
impact on the profitability of Islamic banks, although liquidity has a beneficial
one. The findings will assist the Islamic banking sector formulate appropriate
policies.

Question No#1:

Research Questions in the article:

These were the research question on which this study is entirely based on:

1. What are the key determinants of profitability for Islamic banks

operating in Pakistan's Islamic banking sector?
2. To what extent do macroeconomic factors, such as GDP growth,
inflation, and interest rates, impact the profitability of Islamic banks in
Pakistan?

Question No#2:

Which variables are used as dependent, independent, endogenous,

exogenous, and instrumental variables?

Dependent Variable:
In this study the researcher has selected the profitability as a dependent
variable. However, profitability is a term which can be signified using various
variables but in this study the researcher opted to use ROA as the dependent
variable

ROA is an abbreviation of Return on Assets. It is determined by dividing net

revenue by the total value of the assets. Banks have primarily used ROA as a
metric of profitability. How much income a company generates from its assets
can be used to determine how efficient that company is.

Independent Variable:

Four independent variables—two financial and two macroeconomic—have

been chosen by the researcher. Below are the specifics of each independent:

1. GDP: GDP stands for Gross Domestic Product. Total production and
services over specified fiscal period.
2. Inflation: an increase in an economy's overall price level for products
and services.
3. Size: The total assets of the company can be used to measure the size of
the bank. The most crucial tool for any company to increase its profit is
its assets. It is not a given that if one company has more assets than
another, they will also make more money. Strategies and policies also
have a crucial influence.
4. Liquidity: Any company's liquidity is its capacity to pay all of its
obligations when they become due. Total loans to deposit ratio is a
liquidity variable used by the author.

Question No#3:

Sampling technique and sample size:

There are five Islamic banks in Pakistan, which are working under Shariah
Compliant mode, taken as sample. These are the strategies used to locate
data, gather data from information sources, and evaluate information. The
information for the financial and economic variables (dependent and
independent variables) is gathered from secondary sources, such as reports
from the State Bank of Pakistan, final reports that have been made public or
financial statements that have been posted online by banks, reports from the
Pakistan Statistics Bureau, and reports from the Economic Survey of Pakistan.

The author gathers information from secondary sources by downloading

reports from numerous sources' websites in both hard copy and soft copy.
Hence it can be said that a convenient sampling approach has been adopted by
the researcher to collect data from open sources.

Question No 4:

What is the type of data? How did you identify it?

The type of data that the researcher used in this study is panel data

We used the following method to ascertain whether the data used in the study
is panel data:

Analysis of Panel Data: Panel data analysis, often referred to as longitudinal or

cross-sectional time series data analysis, is created especially to handle data
gathered across a variety of time periods and across a variety of entities. With
the help of this method, you may look at the dataset's cross-sectional and time
series variance.

Panel data analysis has a number of benefits, including the ability to effectively
handle endogeneity problems, capture individual-level variability, and
compensate for time-invariant unobserved components. Several frequently
used methods for panel data analysis include:

Fixed Effects Models: These models include entity-specific fixed effects,

accounting for individual heterogeneity across the entities in the panel data.

Random Effects Models: These models consider entity-specific random effects,

which capture unobserved heterogeneity that is uncorrelated with the
explanatory variables.

First Differences and Fixed Effects: This approach involves differencing the data
to remove time-invariant heterogeneity and estimating the effects using fixed
effects models.
Dynamic Panel Data Models: These models incorporate lagged dependent
variables or other dynamic specifications to account for the temporal
dependencies within the panel data.

By employing panel data analysis techniques, you can effectively analyze the
determinants of profitability in the Islamic banking sector of Pakistan while
accounting for both time and cross-sectional variation within the dataset.

Question No#5:

Type of analysis techniques used in the research paper.

The researcher used the regression analysis technique in order to develop

relationship between the dependent and the independent variables. Moreover
the researcher used several tests such as serial test to check autocorrelation
which might be making the results to not be efficient. To ensure that the panel
regression analysis's presumption was met, the author applied the log variable
transformation equation. It is a crucial solution to the heteroscedasticity
problem in the panel analysis data. Before conducting panel regression
analysis, the researcher must eliminate autocorrelation and heteroscedasticity
from the data that we analyzed since if we don't, the conclusions aren't
expected to be true.

Question No#6:

What is the estimation technique employed to conduct the analysis?

In panel data analysis, the fixed effects model is a statistical technique often
used in econometrics to address variances among individual entities. It is
especially useful for analysing data gathered over time from many entities. The
focus of the fixed effects model is on capturing entity-specific effects, which
persist over time yet vary between entities. These consequences could result
from several elements that are connected to each entity. The author
discovered that the size of Islamic banks and liquidity are the two significant
variables at 5% in the fixed model effect. Here, the profitability of Islamic banks
is positively correlated with liquidity but negatively correlated with size.

The author then applies a random effect to the model of Islamic banks. The
author once more discovered that size and liquidity are strongly related to the
profitability of Islamic banks when using a random effect model. Both factors
have a 5% significance level. Size and liquidity have opposing effects on each
other. It is crucial to use the Hausman Test to choose the best model. The
author chose the most suitable model from both of them using the same test.
The P-value came less than 0.05 which suggests that fixed model is more
suitable than random effect model.

Question No#7:

What is the econometric specification of the model?

For this work, the Islamic bank model equation was created. All variables,
including the macroeconomic and financial ones, are supported by pertinent
theories and earlier research. The equation of model is as below:

Equation:

PF = Bo + B1GDP + B2INF + B3LQ + B4SZ + σ

Where, PF = Profitability of Islamic banks

GDP = Gross Domestic Product

INF = Inflation

SZ = Size of Islamic banks

LQ = Liquidity of Islamic banks

σ = Error Term

The author has used log variable transformation equation in order to fulfill
assumption of panel regression analysis. After using the log variable
transformation the following equation emerges:

(Log)PF = Bo + B1(Log)GDP + B2(Log)INF + B3(Log)LQ + B4(Log)SZ + σ

Question Number 8:

What are the assumptions of the estimation technique?

To ensure the accuracy of their estimates, researchers frequently make specific

assumptions while doing regression analyses. Although I do not have access to
the particular study you cited, the following are some typical hypotheses that
researchers frequently take into account when utilizing regression analysis:

1. Linearity: The researcher expects that the dependent variable and the
independent factors have a linear relationship. This presumption states
that a straight line or a linear combination of variables can appropriately
depict the relationship.
2. Independence: It is assumed that each observation in the dataset is
unrelated to the others. This presumption suggests that none of the
observations are affected by or connected to one another.
3. Normality: It is assumed that each observation in the dataset is
unrelated to the others. This presumption suggests that none of the
observations are affected by or connected to one another.
4. Homoscedasticity: All levels of the independent variables are considered
to have the same variance of the residuals. The spread of the residuals,
in other words, ought to be comparable across the range of values for
the independent variables.
5. No Multicollinearity: It is presumed that there is no correlation between
the independent variables employed in the regression model. Coefficient
estimates can become unstable and incorrect due to multicollinearity,
which develops when independent variables are strongly connected.

Question No#9:

Critically evaluate the econometric techniques.

In order to investigate the factors that affect Islamic banks' profitability in

Pakistan, the author employed panel regression analysis. The panel regression
models were estimated using STATA software, and conclusions were drawn
from the study. A critical analysis or a critical evaluation of the used
econometric methods is provided below:

Panel Regression Analysis: Panel data, which includes observations on

numerous entities throughout time, can be examined using panel regression. It
enables the management of both time- and person-specific effects. The author
successfully employed panel regression to account for cross-sectional and
time-series changes while capturing the effects of independent variables on
the dependent variable (profitability).
Fixed Effect Model: The fixed effect model, used by the author, is predicated
on the idea that individual-specific effects are associated with the independent
variables. Unobserved heterogeneity between banks is taken into account by
this approach. It is crucial to keep in mind that fixed effects may not fully
account for all forms of endogeneity and can only capture time-invariant
heterogeneity.

Transformation of Variables: Heteroscedasticity and autocorrelation problems

were addressed by the author using log transformations of the data. By using
this strategy, linearity may be attained and the error term's variance can be
stabilized. However, because coefficients on log-transformed variables indicate
elasticities rather than marginal effects, it is crucial to take this into account
when interpreting them.

Hausman Test: To decide between the fixed effects and random effects
models, the author used the Hausman test. The Hausman test evaluates the
relationship between the independent variables and the effects that are
unique to each individual. The test implies that the individual-specific effects
are unrelated to the independent variables if it reveals that the random effects
model is suitable.

Robust Standard Errors: To take into account heteroscedasticity and probable

correlation within the panel data, robust standard errors were used. More
trustworthy standard errors are produced by this correction, which enables
reliable statistical inference. When estimating panel regression models, robust
standard errors are essential.

Model Specification and Interpretation: The researcher specified the model

with a set of independent variables, including GDP, inflation, size, and liquidity,
based on relevant theories and previous studies. The interpretation of
coefficients suggests the direction and magnitude of the relationships between
the independent variables and profitability.

Overall, the econometric methods utilized in the study, including panel

regression analysis, fixed effect models, log transformations, Hausman tests,
and robust standard errors, offer a rigorous framework for analysing the
factors influencing profitability in Islamic banks. These methods improve the
validity of the results by addressing potential endogeneity, heteroscedasticity,
and autocorrelation problems. It is crucial to keep in mind that the evaluation
of the methodology is only based on the data presented in the abstract, and a
more detailed evaluation would necessitate a careful review of the entire
research report.

Question No#10:

Why do you think the research has chosen the specific methodology? Do you
think that there are other estimation/analysis techniques which shall align
with the data type and research question.

Based on the information provided in the article, the research has chosen
panel regression analysis as the methodology for several reasons:

Panel Data Nature: The study makes use of panel data, which are observations
made over time on numerous organisations (banks). In order to analyse both
cross-sectional and time-series variations, panel regression analysis was
created specifically to handle this kind of data. The researcher can accurately
capture the dynamics of profitability in Islamic banks over time and take
individual-specific impacts into account by utilizing panel regression.

Controlling for Unobserved Heterogeneity: The fixed effect model is employed

in the analysis to control for unobserved heterogeneity across banks. This
approach is appropriate when there are time-invariant factors that vary across
entities (banks) and can affect profitability. By including fixed effects, the
researcher aims to account for such unobserved factors, which may include
bank-specific characteristics that are constant over time, such as managerial
quality, corporate governance practices, or brand reputation.

Robustness of Results: The robustness of the findings is improved by using

panel regression analysis with strong standard errors. More accurate standard
errors are produced and proper statistical inference is ensured by robust
standard errors, which account for heteroscedasticity and probable correlation
in the panel data. By employing this method, the researcher can get precise
estimates and draw conclusions regarding the connection between the
independent factors and profitability in Islamic banks with more assurance.

While panel regression analysis appears to be a suitable methodology for the

research question and data type, there may be other estimation/analysis
techniques that could align with the data and research question as well. Some
alternative techniques include:

Random Effects Model: The research article employs the fixed effect model,
but an alternative approach could be the random effects model. The random
effects model assumes that individual-specific effects are uncorrelated with
the independent variables. If the Hausman test had indicated that the random
effects model is appropriate, it would have been another valid choice.
However, the researcher in this study determined that the fixed effect model
was more suitable based on the results of the Hausman test.

Dynamic Panel Data Models: Dynamic panel data models, such the Arellano-
Bond or the system GMM (Generalised Method of Moments) estimator, may
be taken into account if the research topic entails studying the dynamics and
temporal lags in the relationship between the independent variables and
profitability. These models offer more accurate estimates when serial
correlation is present because they take into account both the fixed effects and
any endogeneity resulting from lagged dependent variables.

Instrumental Variable (IV) Approach: An instrumental variable technique could

be used to address this problem if endogeneity issues are a concern. The bias
brought on by reverse causality or omitted variable bias can be lessened with
the use of instrumental factors. The researcher can establish a causal
relationship between the independent variables and profitability by identifying
appropriate instruments. However, it would be important to carefully assess
the availability of reliable instruments and the identification strategy.

Question No#11:

Conclusion:

In order to examine the relationship between several characteristics and

profitability in Islamic banks, the research study uses panel regression analysis
with fixed effects and robust standard errors. Due to the study's use of panel
data, which enables the examination of both cross-sectional and time-series
variations, this methodology was chosen. Fixed effects' inclusion aids in
reducing unobserved bank-level heterogeneity, and the conclusions'
robustness is increased by robust standard errors. The chosen methodology
seems appropriate for addressing the study objectives, even though other
estimating strategies, such as the random effects model, dynamic panel data
models, or instrumental variable approach, could align with the data and
research topic. In the end, the methodology selected will depend on the
precise research question, underlying assumptions, and intended outcomes.

Appendix:

.xtset COMPANYNAMES1 YEARS,yearly

panel variable: COMPANYNAMES1 (unbalanced)

time variable: YEARS, 2006 to 2015, but with gaps

delta: 1 year

------------------------------------------------------------------------------

. xtreg lnROA lnliquidity lnsize lngdp lninflation , fe

------------------------------------------------------------------------------

lnROA | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lnliquidity | 2.011519 .8405947 2.39 0.022 .3112553 3.711782

lnsize | -.6842416 .2498151 -2.74 0.009 -1.18954 -.1789427

lngdp | -.0185074 .3665933 -0.05 0.960 -.7600124 .7229975

lninflation | -.4785313 .8727629 -0.55 0.587 -2.243861 1.286798

_cons | 3.147271 3.392723 0.93 0.359 -3.71516 10.0097

-------------+----------------------------------------------------------------

sigma_u | 1.5247605

sigma_e | 1.8525438

rho | .40385097 (fraction of variance due to u_i)

------------------------------------------------------------------------------
F test that all u_i=0: F(4, 39) = 5.44 Prob > F = 0.0014

. estimates store fix

------------------------------------------------------------------------------

. xtreg lnROA lnliquidity lnsize lngdp lninflation , re

------------------------------------------------------------------------------

lnROA | Coef. Std. Err. z P>|z| [95% Conf. Interval]

-------------+----------------------------------------------------------------

lnliquidity | 2.181193 .8208816 2.66 0.008 .5722943 3.790091

lnsize | -.5560853 .2382232 -2.33 0.020 -1.022994 -.0891764

lngdp | .042169 .3686038 0.11 0.909 -.6802812 .7646192

lninflation | -.4186151 .8869643 -0.47 0.637 -2.157033 1.319803

_cons | 2.247411 3.432535 0.65 0.513 -4.480234 8.975057

-------------+----------------------------------------------------------------

sigma_u | 1.1170932

sigma_e | 1.8525438

rho | .2666552 (fraction of variance due to u_i)

------------------------------------------------------------------------------

. estimates store ran

------------------------------------------------------------------------------

hausman fix ran

---- Coefficients ----

| (b) (B) (b-B) sqrt(diag(V_b-V_B))

| fix ran Difference S.E.

-------------+----------------------------------------------------------------

lnliquidity | 2.011519 2.181193 -.1696742 .1809771

lnsize | -.6842416 -.5560853 -.1281563 .0752151

lngdp | -.0185074 .042169 -.0606764 .

lninflation | -.4785313 -.4186151 -.0599163 .

------------------------------------------------------------------------------

b = consistent under Ho and Ha; obtained from xtreg

B = inconsistent under Ha, efficient under Ho; obtained from xtreg

Test: Ho: difference in coefficients not systematic

chi2(4) = (b-B)'[(V_b-V_B)^(-1)](b-B)

= 218.30

Prob>chi2 = 0.0000

(V_b-V_B is not positive definite)

------------------------------------------------------------------------------

. xttest2

Correlation matrix of residuals:

__e0 __e1 __e2 __e3 __e4

__e0 1.0000

__e1 0.1494 1.0000

__e2 -0.4308 -0.3027 1.0000

__e3 -0.2110 -0.3814 0.2449 1.0000

__e4 -0.1708 -0.5662 0.5649 -0.0021 1.0000

Breusch-Pagan LM test of independence: chi2(10) = 9.748, Pr = 0.4629

Based on 8 complete observations over panel units

-------------------------------------------------------------------------------

. xttest3

Modified Wald test for group wise heteroskedasticity in fixed effect regression
model

H0: sigma(i)^2 = sigma^2 for all i

chi2 (5) = 6.72

Prob>chi2 = 0.2420

---------------------------------------------------------------------------------

. xtserial lnROA lnliquidity lnsize lngdp lninflation

Wooldridge test for autocorrelation in panel data

H0: no first-order autocorrelation

F( 1, 4) = 0.539

Prob > F = 0.5036

End