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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
Lecture # 18
Asset composition
Assets of banking sector, as per cent of GDP, have been on the decline. Slowdown in asset
growth was also accompanied by changing share of different groups. Negative growth in the
assets of foreign banks during 1998 and 1999 was the prime reason behind declining growth
in overall assets of the banking sector. Share of NCBs have been decreasing since private
banks were allowed to operate in 1992. In terms of asset share, private banks are now as
large as foreign banks.
Problem bank management
The central bank is the sole authority to supervise, monitor and regulate financial
institutions. It is also responsible to safeguard the interest of depositors and shareholders of
these institutions. Lately, SBP took actions against two private banks which became a threat
to viability of the financial system in the country. These were Indus Bank and Prudential
Commercial Bank. On the basis of detailed investigations, the license of Indus Bank was
cancelled on September 11, 2000. After successful negotiations, management and control of
Prudential Bank handed over to Saudi-Pak group.
Commercial banks have been going through the process of restructuring. There are efforts
to reduce lending rates. The SBP has been successful in implementing its policies. Most of
the banks have been able to adjust to new working environment. The proposed increase in
capital base will provide further impetus to financial system in the country.
In the post September 11 era, the GoP borrowing from SBP and commercial banks is
expected to come down substantially and private sector borrowing to increase. However, a
temporary decline in repayment ability of borrowers may increase provisioning for the year
2001. The situation is expected to improve in year 2002. Unless efforts are made by banks
to shrink spread, depositors will not be able to get return which corresponds with the rate of
inflation in the country. Privatization of NCBs is expected to be delayed due to external
factors. However, it is an opportunity for the banks to further clean their slate. Pakistan's
banking sector like many other developing countries had been faced with several problems
and difficulties such as:
(1) Most of the financial assets and deposits were owned by nationalized commercial banks
(NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable
branches and poor customer service.
(2) NCBs along with specialized banks such as ADBP, IDBP and Development financial
institutions such as NDFC had a high ratio of non-performing loans.
(3) Banking industry faced a high tax rate, which affected its profitability and attractiveness
for new entrants.
(4) There was a proliferation of banks and some of them were undercapitalized, poorly
managed with a scanty distribution network.
(5) Agriculture, small and medium enterprises, Housing sectors were underserved and the
middle class and low income group had limited access to bank credit.
Management of Financial Institutions - MGT 604
(6) Banks had typically focused on trade and corporate financing with a narrow range of
products and had not diversified into consumer and mortgage financing for which there is
an ample unsatisfied demand.
(7) Poor quality of human resources, weak internal controls, non-merit based recruitments,
high administrative costs and undue interference of unions in decisions making process
affected the performance of public sector financial institutions adversely.
Banking sector reforms were aimed at addressing these and other constraints. Although
there is no room for complacency and a lot needs to be done it is fair to say that substantial
progress has been made to improve the health and soundness of the banking sector in recent
years. There are still few weak and vulnerable institutions but overall the banking sector in
Pakistan is much stronger today compared to five years ago or in comparison to other
countries in the region. What are the factors responsible for this improvement? A large
number of reforms have either been undertaken or under way.
(i) Privatization of NCBs
The nationalized commercial banks are being privatized and their domination of the
banking sector is likely to be reduced from almost 100 percent in 1991 to about 20 percent
by December 2003. The shares of Muslim Commercial Bank are all in the private sector.
United Bank has been sold to a consortium of private investors. Privatization of Habib Bank
Ltd., is under way and is scheduled to be completed by end December, 2003. 23.5 percent
of shares of National Bank have been floated through Stock Market mainly aimed at small
retail investors. The NCBs have been restructured and professional management inducted
which works under the supervision of independent Boards of Directors drawn from the
private sector.
(ii) Corporate governance.
Strong corporate governance is absolutely essential if the banks have to operate in a
transparent manner and protect the depositors' interests. The SBP has taken several
measures in the last four years to put in place good governance practices to improve internal
controls and bring about a change in the organizational culture. The salient features of this
structure are:
a. Banking license of one of the commercial banks which was found in violation of the
prudential regulations and norms was cancelled for the first time in the history of Pakistan
after following the due process. This decision was upheld by Peshawar High Court.
b. Ownership and management were changed at two private commercial banks, one of
which had committed breach through unauthorized transfer of funds from the bank to
associated companies.
c. A number of cases of willful bank defaulters were referred to National Accountability
Bureau (NAB) for taking legal actions and recovering the amounts due.
d. The appointments of Board members, Chief Executive Officers and key Executives of all
banks have to be screened so that they meet the fit and proper test prescribed by the SBP.
Management of Financial Institutions - MGT 604
e. Family representation on the Board of Directors of the banks where they hold majority
ownership has been limited to 25 percent of the total membership of the Board.
f. To avoid possible conflict of interest and use of insider information the Directors,
executives and traders working in Brokerage companies will no longer serve on the Boards
of Directors of the banks.
g. External auditors are evaluated annually and classified in various categories based on
their performance and other prescribed criteria. Two large audit firms were debarred from
auditing the banks and only after showing improvement in their performance placed in a
category lower than they originally belonged to.
h. A detailed set of guidelines for the Board of Directors to effectively oversee the
management of the banks and develop policies has been issued. A training course on
Corporate Governance was organized for the members of the Boards of banks and their
Chief Executives.
i. The disclosure requirements for banks have been strengthened and now they are required
to prepare their annual financial statements in accordance with the International Accounting
Standards. They are also required to publish quarterly and half-yearly accounts to provide
information to their stakeholders for taking well informed decisions.
j. In order to institutionalize the decision making process and to provide guidance to staff,
the banks are required to formulate and implement well-defined policies in credit,
investment, recovery of write-offs, human resources, audit and compliance, risk
management, etc. k. To provide guidance to banks in identifying, measuring, monitoring
and controlling various risks and to make them proactive, a detailed set of guidelines on risk
management has been issued.
(iii) Capital Strengthening.
Capital requirements of the banking sector have to be adequate in relation to the risk
weighted assets and conform to the Basle Accord. To further strengthen their competitive
ability, both domestically and internationally and to encourage the economies of scale, the
minimum paid-up capital requirements of the banks have been raised. The banks were
required to increase their paid-up capital from Rs 500 million to Rs 1 billion by 1st January
2003 failing which they will no longer be allowed to carry out full banking activities as
scheduled banks. This has resulted in mergers and consolidation of many financial
institutions and weeding out of several weaker banks from the financial system.
(iv) Improving Asset quality.
The stock of non-performing loans (NPLs) has been tackled in several ways. The gross
NPLs amount to Rs 252 billion and account for 22 percent of the advances of the banking
system and DFIs. However, there has been aggressive provisioning carried out during the
last three years. More than 60 percent of the NPLs are fully provided for and net NPLs to
net advances ratio has thus declined to less than 10 percent. Efforts are being made to
further reduce this ratio through the active involvement of Corporate & Industrial
Restructuring Corporation (CIRC) and the Committee on Revival of Sick Units (CRSU).
The settlement reached between loss category loan holders and banks under State Bank
circular No.29 will further reduce the volume of NPLs and allow the sick industrial units to
revive while at the same time enable the banks to clean up their balance sheets. The positive
Management of Financial Institutions - MGT 604
development is that the quality of new loans disbursed since 1997 has improved and
recovery rate is 95 percent.
(v) Liberalization of foreign exchange regime
Pakistan has further liberalized its foreign exchange regime and ensured partial Capital
account Convertibility by allowing foreign exchange companies to operate and Pakistani
Corporate sector to acquire equity abroad.
(vi) Consumer Financing
The State Bank has removed restrictions imposed on nationalized commercial banks for
consumer financing. The positive experience of auto financing gives a lot of hope that the
middle class of this country will be able to access consumer durables through banks. This
will at the same time boost the manufacturing of TVs, air-conditioners, VCRs, washing and
drying machines, deep freezers etc. in the country. Credit and Debit Cards are also gaining
popularity and the numbers of card holders have doubled during the last two years.
(vii) Mortgage Financing
A number of incentives have been provided to encourage mortgage financing by the banks.
The upper limit has been raised from Rs 5 million to Rs 10 million. Tax deduction on
interest payments on mortgage have been allowed up to a ceiling of Rs.500,000. The new
recovery law is also aimed at expediting repossesssion of property by the banks. The banks
have been allowed to raise long term funds through rated and listed debt instruments like
TFCs to match their long term mortgage assets with their liabilities.
(viii) Legal Reforms
Legal difficulties and time delays in recovery of defaulted loans have been removed through
a new ordinance i.e. The Financial Institutions (Recovery of Finances) Ordinance, 2001.
The new recovery laws ensures expeditious recovery of stuck up loans by the right of
foreclosure and sale of mortgaged property with or without intervention of court and
automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission
is reviewing, revising and consolidating the banking laws and drafting new laws such as
bankruptcy law.
(ix) Prudential Regulations
The prudential regulations in force were mainly aimed at corporate and business financing.
The SBP in consultation with the Pakistan Banking Association and other stakeholders has
developed a new set of regulations which cater to the specific separate needs of corporate,
consumer and SME financing. The new prudential regulations will enable the banks to
expand their scope of lending and customer outreach.
(x) Micro financing
To provide widespread access to small borrowers particularly in the rural areas the licensing
and regulatory environment for Micro Credit and Rural financial institutions have been
relaxed and unlike the commercial banks these can be set up at district, provincial and
national levels with varying capital requirements. There is less stringency and more
facilitative thrust embedded in the prudential regulations designed for this type of
institutions. Khushali Bank and the First Microfinance Bank in the private sector have
Management of Financial Institutions - MGT 604
already started working under this new regulatory environment. Khushali Bank has already
reached a customer base of 125,000 mainly in poorer districts of the country and its
recovery rate is above 95 percent.
(xi) SME Financing.
The access of small and medium entrepreneurs to credit has been a major constraint to
expansion of their business and up gradation of their technology. A Small and Medium
Enterprise (SME) Bank has been established to provide leadership in developing new
products such as program loans, new credit appraisal, and documentation techniques, and
nurturing new skills in SME lending which can then be replicated and transferred to other
banks in the country. Program lending, for example, can help up gradation of power looms
to shuttle less looms in Faisalabad area and contribute to the achievement of goal set under
Textile Vision 2005. The new
Prudential regulations for SMEs do not require collateral but asset conversion cycle and
cash flow generation as the basis for loan approval. The State Bank is also contemplating to
develop capacity building among a select group of banks for SME lending. This will
revitalize the lending to SMEs particularly export oriented ones.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday