Profit Efficiency and Risk Management in the Banking Sector of Pakistan: A Comparative analysis using Stochastic Frontier Approach

Abstract

This study investigates the relationship among risk management, profit efficiency using capital adequacy ratios as a risk management proxy of banks in Pakistan. In the first part, the efficiency of Banking sectors was evaluated and compared using the Stochastic Frontier Approach. In the second stage, Efficiency scores along with other banks' specific and macroeconomic variables were used as a determinants of Risk management using panel regression analysis. Data was collected from a sample of 25 commercial banks operating in Pakistan from the year 2010 to 2019. The average profit efficiency of Pakistani banks is 57% on an overall basis and is also showing an increasing trend over the study period. Likewise, large banks have the highest profit efficiency (73%) compare to medium (58%) and small (45%) banks, whereas Islamic banks (36%) are less profit efficient relate to conventional banks (61%). Moreover, public banks (50%) are the least efficient banks in Pakistan followed by private (57%) and foreign banks (67%). Results from the second stage concluded that overall profit efficiency has a positive impact on risk management whereas medium, private and conventional banks model also shows the same result. Credit risk has a negative effect on risk management, whereas, in public, foreign, medium and small banks credit risk does not have any relationship with risk management, while in large, private and conventional banks, decrease in credit risk is a signal of improving risk management whereas in Islamic it has a positive impact on risk management. Moreover, liquidity risk is positively related to risk management especially in private, public, and small banks. Return on assets turns out to be the mixed trend factors as it is negatively related to CAR in all banks model, medium, small, foreign, and conventional banks but positively related to risk in large, private, and public models. This indicates that higher profitability leads to better risk management in large, private, and public banks of Pakistan. Similarly, bank size is negatively related to risk management, this indicates that it is difficult to manage risk as banks grow up and expand in size. The findings would help regulatory authorities to set better regulations for improving efficiency, credit, and liquidity quality of banks in Pakistan. This study may also provide useful guidelines to bank managers to maintain an adequate level of bank capital.