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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
Lecture # 17
Public perceptions of banks
In United States history, the National Bank was a major political issue during the
presidency of Andrew Jackson. Jackson fought against the bank as a symbol of greed
and profit-mongering, antithetical to the democratic ideals of the United States.
Currently, many people consider that various banking policies take advantage of customers.
In Canada, for example, the New Democratic Party has called for the abolition of user fees
for automated teller transactions. Other specific concerns are policies that permit banks to
hold deposited funds for several days, to apply withdrawals before deposits or from greatest
to least, which is most likely to cause the greatest overdraft, that allow backdating funds
transfers and fee assessments, and that authorize electronic funds transfers despite an
In response to the perceived greed and socially-irresponsible all-for-the-profit attitude of
banks, in the last few decades a new type of bank called ethical banks have emerged, which
only make socially-responsible investments (for instance, no investment in the arms
industry) and are transparent in all its operations.
In the US, credit unions have also gained popularity as an alternative financial resource for
many consumers. Also, in various European countries, cooperative banks are regularly
gaining market share in retail banking.
Large banks in the United States are some of the most profitable corporations, especially
relative to the small market shares they have. This amount is even higher if one counts the
credit divisions of companies like Ford, which are responsible for a large proportion of
those companies' profits.
In the past 10 years in the United States, banks have taken many measures to ensure that
they remain profitable while responding to ever-changing market conditions. First, this
includes the Gramm-Leach-Bliley Act, which allows banks again to merge with investment
and insurance houses. Merging banking, investment, and insurance functions allows
traditional banks to respond to increasing consumer demands for "one-stop shopping" by
enabling cross-selling of products (which, the banks hope, will also increase profitability).
Second, they have expanded the use of risk-based pricing from business lending to
consumer lending, which means charging higher interest rates to those customers that are
considered to be a higher credit risk and thus increased chance of default on loans. This
helps to offset the losses from bad loans, lowers the price of loans to those who have better
credit histories, and offers credit products to high risk customers who would otherwise been
denied credit. Third, they have sought to increase the methods of payment processing
available to the general public and business clients. These products include debit cards, pre-
paid cards, smart-cards, and credit cards. These products make it easier for consumers to
conveniently make transactions and smooth their consumption over time (in some countries
with under-developed financial systems, it is still common to deal strictly in cash, including
carrying suitcases filled with cash to purchase a home). However, with convenience there is
also increased risk that consumers will mis-manage their financial resources and accumulate
excessive debt. Banks make money from card products through interest payments and fees
charged to consumers and transaction fees to companies that accept the cards.
Management of Financial Institutions - MGT 604
The banking industry's main obstacles to increasing profits are existing regulatory burdens,
new government regulation, and increasing competition from non-traditional financial
Society for Worldwide Interbank Financial Transactions
("SWIFT") operates a worldwide financial messaging network. Messages are securely and
reliably exchanged between banks and other financial institutions. SWIFT also markets
software and services to financial institutions, much of it for use on the SWIFT Network,
and ISO 9362 bank identifier codes are popularly known as "SWIFT codes". The majority
of international interbank messages use the SWIFT network. As of April 2006 SWIFT
linked almost 8,000 financial institutions in 205 countries. SWIFT does not facilitate funds
transfer. Financial institutions would need a corresponding banking relationship for
financial transactions.
SWIFT is a cooperative society under Belgian law and it is owned by its member financial
institutions. SWIFT has offices around the world. SWIFT headquarters are located in La
Hulpe, Belgium, near Brussels.
It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to
establish common standards for financial transactions and a shared data processing system
and worldwide communications network. Fundamental operating procedures, rules for
liability etc., were established in 1975 and the first message was sent in 1977.
SWIFT Services
There are four key areas that SWIFT services fall under within the financial marketplace,
Securities, Treasury & Derivatives, Trade Services, and Payments & Cash Management.
The banking sector in Pakistan has been going through a comprehensive but complex and
painful process of restructuring since 1997. It is aimed at making these institutions
financially sound and forging their links firmly with the real sector for promotion of
savings, investment and growth. Although a complete turnaround in banking sector
performance is not expected till the completion of reforms, signs of improvement are
visible. The almost simultaneous nature of various factors makes it difficult to disentangle
signs of improvement and deterioration.
Commercial banks have been exposed and withstood several types of pressure since 1997.
Some of these are:
1) Multipronged reforms introduced by the central bank,
2) Freezing of foreign currency accounts,
3) Continued stagnation in economic activities and low growth and
4) Drive for accountability and loan recovery. All these have brought a behavioral change
both among the borrowers as well as the lenders. The risk aversion has been more
pronounced than warranted.
Commercial banks operating in Pakistan can be divided into four categories:
1) Nationalized Commercial Banks (NCBs),
Management of Financial Institutions - MGT 604
2) Privatized Banks,
3) Private Banks and
4) Foreign Banks.
While preparing this report efforts have been made to evaluate the performance of each
group which enjoy certain strengths and weaknesses as per procedure followed by State
Bank of Pakistan (SBP). The central bank has been following a supervisory framework,
CAMEL, which involves the analysis of six indicators which reflect the financial health of
financial institutions.
These are:
1) Capital Adequacy,
2) Asset Quality,
3) Management Soundness,
4) Earnings and Profitability,
5) Liquidity and
6) Sensitivity to Market Risk.
Capital adequacy
To protect the interest of depositors as well as shareholders, SBP introduced the risk based
system for capital adequacy in late 1998. Banks are required to maintain 8 per cent capital
to Risk Weighted Assets (CRWA) ratio. Banks were required to achieve a minimum paid-
up capital to Rs 500 million by December 31, 1998. This requirement has been raised to one
billion rupee and banks have been given a deadline up to January 1, 2003 to comply with
The ratio has deteriorated after 1998. However, it was fallout of economic sanctions
imposed on Pakistan after it conducted nuclear tests. The shift in SBP policy regarding
investment in securities also led to a fall in ratio. However, most of the banks have been
able to maintain above the desired ratio as well as direct their investment towards more
productive private sector advances. Higher provisioning against non-performing loans
(NPLs) has also contributed to this decline. However, this is considered a positive
Asset quality
Asset quality is generally measured in relation to the level and severity of non-performing
assets, recoveries, adequacy of provisions and distribution of assets. Although, the banking
system is infected with large volume of NPLs, its severity has stabilized to some extent. The
rise over the years was due to increase in volume of NPLs following enforcement of more
vigorous standards for classifying loans, improved reporting and disclosure requirements
adopted by the SBP.
In case of NCBs this improvement is much more pronounced given their share in total
NPLs. In case of privatized and private banks, this ratio went up considerably and become a
cause of concern. However, the level of infection in foreign banks is not only the lowest but
also closes to constant.
The ratio of net NPLs to net advances, another indicator of asset quality, for all banks has
declined. Marked improvement is viable in recovery efforts of banks. This has been
remarkable in the case of NCBs, in terms of reduction in the ratio of loan defaults to gross
advances. Although, privatized banks do not show significant improvement, their ratio is
much lower than that of NCBs. Only exception is the group of private banks for which the
Management of Financial Institutions - MGT 604
ratio has gone up due to bad performance of some of the banks in the group. However, it is
still the lower, except when compared with that of foreign banks.
Management soundness
Given the qualitative nature of management, it is difficult to judge its soundness just by
looking at financial accounts of the banks. Nevertheless, total expenditure to total income
and operating expenses to total expenses help in gauging the management quality of any
commercial bank.
Pressure on earnings and profitability of foreign and private banks caused their expenditure
to income ratio to rise in 1998. However, it started tapering down as they adjusted their
portfolios. An across the board increase in administrative expenses to total expenditure is
visible from the year 1999. The worst performers in this regard are the privatized banks,
mostly because of high salaries and allowances.
Earnings and profitability
Strong earnings and profitability profile of banks reflects the ability to support present and
future operations. More specifically, this determines the capacity to absorb losses, finance
its expansion program, pay dividend to its shareholders, and build up adequate level of
capital. Being front line of defense against erosion of capital base from losses, the need for
high earnings and profitability can hardly be overemphasized. Although different indicators
are used to serve the purpose, the best and most widely used indicator is return on assets
(ROA). Net interest margin is also used. Since NCBs have significantly large share in the
banking sector, their performance overshadows the other banks. However, profit earned by
this group resulted in positive value of ROA of banking sector during 2000, despite losses
suffered by ABL.
Pressure on earnings was most visible in case of foreign banks in 1998. The stress on
earnings and profitability was inevitable despite the steps taken by the SBP to improve
liquidity. Not only did liquid assets to total assets ratio declined sharply, earning assets to
total assets also fell. T-Bill portfolio of banks declined considerably, as they were less
remunerative. Foreign currency deposits became less attractive due to the rise in forward
cover charged by the SBP. Banks reduced return on deposits to maintain their spread.
However, they were not able to contain the decline in ROA due to declining stock and
remuneration of their earning assets.
Movement in liquidity indicators since 1997 indicates the painful process of adjustments.
Ratio of liquid assets to total assets has been on a constant decline. This was consciously
brought about by the monetary policy changes by the SBP to manage the crisis-like
situation created after 1998. Both the cash reserve requirement ((CRR) and the statutory
liquidity requirement (SLR) were reduced in 1999. These steps were reinforced by declines
in SBP's discount rate and T-Bill yields to help banks manage rupee withdrawals and still
meet the credit requirement of the private sector.
Foreign banks have gone through this adjustment much more quickly than other banks.
Their decline in liquid assets to total assets ratio, as well as the rise in loan to deposit ratio,
are much steeper than other groups. Trend in growth of deposits shows that most painful
part of the adjustment is over. This is reflected in the reversal of decelerating deposit growth
into accelerating one in year 2000.
Management of Financial Institutions - MGT 604
Sensitivity to market risk
Rate sensitive assets have diverged from rate sensitive liabilities in absolute terms since
1997. The negative gap has widened. Negative value indicates comparatively higher risk
sensitivity towards liability side, while decline in interest rates may prove beneficial.
Deposit Mobilization
Deposit mobilization has dwindled considerably after 1997. Deposits as a proportion of
GDP have been going down. Growth rate of overall deposits of banks has gone down.
However, the slow down seems to have been arrested and reversed in year 2000.
Group-wise performance of deposit mobilization is the reflection of the varying degree with
which each group has been affected since 1998. Foreign banks were affected the most due
to their heavy reliance of foreign currency deposits. They experience 14 per cent erosion in
1999. However, they were able to achieve over 2 per cent growth in year 2000. Similar
recovery was shown by private banks.
Deposit mobilization by NCBs seems to be waning after discontinuation of their rupee
deposit schemes linked with lottery prizes. Growth in their deposits was on the decline.
Despite the decline NCBs control a large share in total deposits. Aggressive posture of
private banks in mobilizing more deposits in year 2000 is clearly reflected in their deposit
growth, from 1.9 per cent in year 1999 to 21.7 per cent in year 2000. This has also helped
them in increasing their share in total deposits to over 14 per cent in year 2000.
Due to the shift in policy, now banks are neither required nor have the option to place their
foreign currency deposits with the SBP. Although, the growth in foreign currency deposits
increases the deposit base, it does not add to their rupee liquidity. The increasing share of
foreign currency deposits in total base is a worrying development. In order to check this
trend, SBP made it compulsory for the banks not to allow foreign currency deposits to
exceed 20 per cent of their rupee deposits effective from January 1, 2002.
Credit extension
Bulk of the advances extended by banks is for working capital which is self-liquidating in
nature. However, due to an easing in SBP's policy, credit extension has exceeded deposit
mobilization. This is reflected in advances growing at 12.3 per cent in year 1999 and 14 per
cent in year 2000.
Group-wise performance of banks in credit extension reveals three distinct features.
1) Foreign banks curtailed their lending,
2) Continued dominance by NCBs and
3) Aggressive approach being followed by private banks. Private banks were the only group
that not only maintained their growth in double-digit but also pushed it to over 31 per cent
in year 2000. With this high growth, they have surpassed foreign banks, in terms of their
share in total advances in year 2000.
Banking spreads
Over the years there has been a declining trend both in lending and deposit rates. Downward
trend in lending rates was due to SBP policy. The realized trend in lending rates was in line
with monetary objectives of SBP, though achieved with lags following the sharp reduction
Management of Financial Institutions - MGT 604
in T-Bill yields in year 1999, needed to induce required change in investment portfolio of
Downward trend in deposit rates was almost inevitable. One can argue that banks should
have maintained, if not increased, their deposit rates to arrest declining growth in total
deposits. However, this was not possible at times of eroding balance sheet; steady earnings
were of prime importance. Consequently banks tried to find creative ways of mobilizing
deposits at low rates. However, due to inefficiencies of the large banks, the spread has
remained high.
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