An Empirical Analysis of Market and Industry Factors in Stock Returns of Pakistan Banking Industry

Article excerpt

Banks in Pakistan are the major stakeholders of the financial sector of the country, and their operational and stock market performance is considered to be the real reflector of financial and economic conditions. The purpose of this study is to examine the relationship of stock returns of Pakistan banking industry to selected market and industry variables by applying multi-factor model. The model consists of four market and industry variables, which would affect stock returns of banking firms. This paper attempts to discover which, if any, of the market and industry variables are of use in explaining the variability of banking stock returns. The 15 banks selected for this analysis were on the basis of data availability, profitability and performance on the Karachio Stock Exchange (KSE) 100 index. The stock prices data for the selected banks and market and industrial variables were obtained for the period July 1998-June 2006. Multi-factor regression models were used to carry out the data analysis. This paper concludes that the return on the KSE 100 index is the only independent variable significant at 0.05 level, while the other macroeconomic as well as industry variables are insignificantly related to the stock returns of banking industry but they do increase the explanatory power of the model.

INTRODUCTION

Only efficient banks with competent management, a reasonably large branch network and consumer focus should excel in the future banking industry scene. For a little over a decade now, the Pakistani banking sector has been undergoing a profound transformation, and if the existing scenario is any indication, the next 10 years are likely to be just as exciting. Burgeoning non-performing loan portfolios, antiquated infrastructure and poor customer service had created a dire need, during recent years, to reform the nationalized commercial banks. Thus, in order to resolve these problems the government initiated a flurry of activity on the privatization front, whereby it off-loaded its interests in a number of banks. Privatization of nationalized banks, as well as the establishment of separate private banks, is likely, to continue to give the sector a more shareholder based, and hence morc efficient orientation. The decision by the government to increase private, ownership in the banking sector was a necessity, not a luxury, since inefficiencies and wasteful expenditure plagued the nationalized commercial banks. Recognizing the need to reform the situation, the government started to privatize the nationalized banks in 1991, and allowed the establishment of separate privately owned banks. As can be expected, this process has already led to a marked increase in competition and hence efficiency in the sector over the years.

All these facts emphasize on the importance of banking industry of Pakistan, and hence it becomes a very lucrative investment for investors. Investing in stocks has become very popular trend in Pakistan in recent years. People opt to invest in stocks so that they get return on them. The return on stocks is dependent on a number of factors, and the exact number of factors is not yet known: Two theories are very important and common in explaining the relationship between industry and market factors and stock returns of some company: one is called' Capital Asset Pricing Model (CAPM) and the other is known as Arbitrage Pricing Theory (APT) (Bishop, 2004).

There has been a long history in the empirical capital market research literature to analyze and explain the factors that determine stock returns. In addition to the traditional equilibrium based model Capital Asset Pricing Model, a number of multi-factor asset pricing models have been developed, e.g., arbitrage-based model, Arbitrage Pricing Theory. These models are based on the assumption that the stock returns are generated by a limited number of economic variables or factors (Opfer and Bessler, 2004).

The APT assumes that returns on securities are generated by a number of industry-wide and market-wide factors. …