Management of Financial Institutions - MGT604

MGT604 - Management of Financial Institutions - Lecture Handout 01

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Financial Environment & Role of Financial Institutions

The economic transformation under way in the former centrally planned economies (FCPEs) was motivated in part by the recognition that central planning has failed to allocate financial and real resources efficiently. This paper addresses the question of what kind of financial system should replace central planning in allocating capital and maintaining effective corporate governance during the transformation period. Financial sector reform has, at times, been portrayed as a question of adopting either a bank-based or a (securities) market-based model. In the bank-based model, commercial banks, often licensed as universal banks, take the lead in financing enterprise restructuring and investment. Proponents of the market-based model argue that the structural problems in the banking sector cannot be overcome easily; so firms will have to look to equity and bond markets for sources of new capital. Equity and bond markets in the FCPEs are not sufficiently well developed to support significant issues of new securities or to provide a mechanism for corporate control. They lack adequate liquidity, regulatory oversight, information disclosure, and clearing and payment systems. The important role of banks in maintaining the payment system and in providing credit to market participants to support trading and settlement means that until banks are restructured and recapitalized, securities market development will be constrained.

Investment funds emerging from mass privatization schemes may create concentrations of equity ownership that would allow them to play an important role in corporate control and perhaps, too, in finding sources of investment capital. They are a relatively recent innovation, however, and it remains to be seen how active they will be in financing and managing privatized enterprises.

The authorities should first establish a healthy banking sector, because it is the banks that are the most promising source of working capital and corporate control. This does not mean that securities market development should be ignored, only that it should not be a priority use of scarce government resources at the present time.

Many observers recommend that banks be given the power to act as universal banks, combining lending with securities market operations and equity investment. The potential problems associated with such a model in the FCPEs during the transformation period outweigh any potential benefits. It is recommended, therefore, that commercial banking and
investment banking activities be separated, at least until banks have demonstrated competence in their commercial lending operations.

MGT604 - Management of Financial Institutions - Lecture Handout 02

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FINANCIAL INSTITUTIONS

In financial economics, a financial institution acts as an agent that provides financial services for its clients. Financial institutions generally fall under financial regulation from a government authority.

Types of Financial Institutions

Common types of financial institutions include banks, Insurance Co, Leasing Co, Investment Co, and Mutual Funds.

Banks

A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money, and processing transactions and the creating of credit.

Central Bank

Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system).

MGT604 - Management of Financial Institutions - Lecture Handout 03

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CENTRAL BANK

A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country or of a group of member states, such as the European Central Bank (ECB) in the European Union or the Federal Reserve System in the United States of America. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system).

It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently. A central bank is usually headed by a governor, but the titles are president, chief executive, and managing director respectively for the European Central Bank the Hong Kong Monetary Authority and the Monetary Authority of
Singapore.

In most countries the central bank is state owned and has a minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. An "Independent central bank" is one which operates under rules designed to prevent political interference; examples include the US Federal Reserve, the Bank of England (since 1997), and the Bank of Canada, the Reserve Bank of Australia, the Banco de la República de Colombia, and the European Central Bank.

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

Implementing the basis of monetary policy
Monopoly on the issue of banknotes
Controls the nation's entire money supply
The Government's banker and the bankers' bank ("Lender of Last Resort")
Manages the country's foreign exchange and gold reserves and the Government's stock register
Regulation and supervision of the banking industry
Setting the official interest rate - used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms.

MGT604 - Management of Financial Institutions - Lecture Handout 04

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POLICY INSTRUMENTS

The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest-rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International
Settlements, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves (usually in the form of government bonds) and official gold reserves. It will often have some influence over any official or mandated exchange rates: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest Rates

By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified
banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited. Other central banks use similar mechanisms.

MGT604 - Management of Financial Institutions - Lecture Handout 05

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BALANCE OF TRADE

The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period of time.
A positive balance of trade is known as a trade surplus and consists of exporting more than is imported;
A negative balance of trade is known as a trade deficit or, informally, a trade gap.

Physical balance of trade

Monetary balance of trade is different from physical balance of trade (which is expressed in amount of raw materials). Developed countries usually import a lot of primary raw materials from developing countries at low prices.
Often, these materials are then converted into finished products, and a significant amount of value is added

Factors that can affect BOT

Exchange rates
Trade agreements or barriers
Other tax, tariff and trade measures
Business cycle at home or abroad.

Balance of Payment

The Balance of Payments (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year.
The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).

MGT604 - Management of Financial Institutions - Lecture Handout 06

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STATE BANK OF PAKISTAN

The State Bank of Pakistan (SBP) is the central bank of Pakistan. While its constitution, as originally lay down in the State Bank of Pakistan Order 1948, remained basically unchanged until January 1, 1974, when the bank was nationalized, the scope of its functions was considerably enlarged. The State Bank of Pakistan Act 1956, with subsequent amendments, forms the basis of its operations today. The headquarters are located in the financial capital of Pakistan, Karachi with its second headquarters in the capital, Islamabad.

History

Before independence on 14 August 1947, the Reserve Bank of India (central bank of India) was the central bank for what is now Pakistan. On 30 December 1948 the British Government's commission distributed the Bank of India's reserves between Pakistan and India - 30 percent (750 M gold) for Pakistan and 70 percent for India.

The losses incurred in the transition to independence were taken from Pakistan's share (a total of 230 million). In May, 1948 Muhammad Ali Jinnah (Founder of Pakistan) took steps to establish the State Bank of Pakistan immediately. These were implemented in June 1948, and the State Bank of Pakistan commenced operation on July 1, 1948.

Functions

Under the State Bank of Pakistan Order 1948, the state bank of Pakistan was charged with the duty to "regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in Pakistan and generally to operate the currency and credit system of the country to its advantage".

MGT604 - Management of Financial Institutions - Lecture Handout 07

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STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS

Agricultural Credit Department

Established under Section 8(3) of SBP Act 1956, is mainly responsible to meet credit needs of agriculture that being the mainstay of Pakistan’s economy generates nearly one fourth of the total out put and 44% of total employment and is the major source of foreign exchange earning.

To operate as a focal point in SBP for all agriculture and rural finance policies, programs and projects.
To assess/estimate the credit needs of farm & non farm sector in rural areas.
To review the issues and challenges faced and developments taking place in agriculture and rural finance both in the country and elsewhere to develop an adequate knowledge and information base for policy formulation etc
To formulate agri & rural finance policies in consultation with stakeholders to ensure adequate flow of institutional credit in rural areas.
To monitor growth and trends in agri /rural finance portfolio of banks & financial institutions.
To collect periodical agri/rural finance data for analysis, policy formulation and dissemination to general public.
To advise Federal and Provincial Governments, Banks, Cooperative Banks & agriculture chambers on agri & rural finance issues.
To initiate and undertake information dissemination and awareness building programs for farmers and special training programs for commercial banks.
To build SBP rural and agriculture finance capacity
To operate as a Secretariat for Agriculture Credit Advisory Committee (ACAC)

MGT604 - Management of Financial Institutions - Lecture Handout 08

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STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Islamic Banking Department

Islamic Banking Department was established on 15th September, 2003 and has been entrusted with the huge task of promoting & developing the Shariah Compliant Islamic Banking as a parallel and compatible banking system in the country.
State Bank of Pakistan wants to develop a progressive and sound Islamic banking system that is in line and compatible with the global financial sector, providing innovative Shariah compliant products and services so as to achieve equitable economic growth.
One of the biggest challenges being faced by this growing industry is the dearth of professional Islamic Bankers and capacity building in this regard is one of the top most priorities for the promotion of Islamic Banking.
In order to play our regulatory and supervisory role more efficiently we are working on the areas like Risk Management, Corporate Governance, Prudential Regulations, Accounting & Shariah Standards etc. regarding Islamic Banking

Islamic Banking Department consists of following four divisions:

Policy Division
Shariah Compliance Division
Business Support Division
Shariah Board Secretariat

Islamic Banking is one of the emerging field in global financial market, having tremendous potential and growing at a very fast pace all around the world.

MGT604 - Management of Financial Institutions - Lecture Handout 09

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STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Banking Surveillance Department

Health of an economy depends on the degree of safety and stability of its banking and financial system. A sound, stable, and robust banking and financial system is a pre-requisite for economic well being of a country and its populace. In Pakistan, ensuring the stability and soundness of the banking system is a statutory responsibility of State Bank of Pakistan. The banking supervision departments viz. Banking Policy and Regulations Department (BP&RD), Banking Surveillance Department (BSD), Off-Site Supervision and Enforcement Department (OSSED) and Banking Inspection Department have been assigned this important function to work jointly and severally to ensure the soundness of individual banks and of overall banking industry. The Department is responsible to supervise financial institutions in the country. The department ensures effective adherence to regulatory & supervisory policies, monitors risk profiles, evaluate operating performance of individual banks/DFIs & the industry as a whole while issuing guidelines for managing various types of risks. It also ensures that banks are adequately capitalized & have policies & systems in place to assess various risks. The department is also responsible for the implementation of the Basel II Accord in Pakistan. The function & activities of Credit Information Bureau also falls within the domain of Banking Surveillance Department. The CIB collect credit data,
under section 25A of the Banking Companies Ordinance 1962, maintain its database & disseminate credit information to financial institutions online to facilitate their credit appraisal process.

MGT604 - Management of Financial Institutions - Lecture Handout 10

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STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)

Exchange Policy Department

(EPD) one of the core departments of the State Bank is responsible for overall stability of the foreign exchange market and is engaged in the process of policy formulation and implementation. It reviews on continuous basis, the existing rules and regulations, to facilitate foreign exchange activities in the country. Foreign exchange business in Pakistan is governed / regulated under Foreign Exchange Regulations Act, 1947 (FERA, 1947). Exchange Policy Department is structured into three divisions namely:

1. Policy Division:

Policy Division is responsible primarily for dealing with policy matters in the areas of export/ import transactions, issuance of Authorized Dealer’s license, Foreign Exchange Exposure Limits, Foreign Currency Accounts Scheme, Exchange Risk Cover Fee on Medium & Long Term Loans, etc

2. Investment Division:

This division primarily facilitates implementation and compliance of policy of the Government for investments in Pakistan and abroad. This is carried out by offering feedback on matters of varied natures, reviewing and updating of investment related policies and activities and operational management

3. Exchange Companies Division:

Policy formulation for establishing Exchange Companies & ensuring adequate framework for licensing, operating, effective supervision & monitoring thereof are the prime responsibilities of Exchange Companies Division. These activities are carried out in close coordination with other the Field Offices of SBP-BSC and concerned government functionaries etc. It also organizes training and development activities for the respective financial institutions and concerned bodies.

MGT604 - Management of Financial Institutions - Lecture Handout 11

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MAJOR DRIVERS OF FINANCIAL INDUSTRY

MACRO ECONOMIC PERFORMANCE OF A COUNTRY

National Income

People of any country produce a specific quantity of different goods and services from the natural resources by the help of capital goods with in a specific period, usually one year and this is called income of a country

Concepts of National Income

Gross National Product “GDP” or Gross National Income “GNI” GDP or GNI is defined as “the total market value of all the final goods and services produced in a year.”
Net National Product “NNP” or Net National Income “NNP” “It means net value of all the goods and services produced in a country during a year is called Net National Income.”

Difference b/w GDP & GNP

GDP is the value of goods and services in the country during a year minus the value of inputs.
GNP represents GDP plus net factor income payments from abroad.

MAJOR DRIVERS OF FINANCIAL INDUSTRY

Regulating risk and the importance of risk management

Key challenge for regulators is to find ways to manage risks adequately. They have to ensure the prudential soundness of financial institutions and the stability of the system at large. But they also have to avoid stifling innovation and limiting the growth potential of the institutions concerned.

MGT604 - Management of Financial Institutions - Lecture Handout 12

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INTERNATIONAL FINANCIAL INSTITUTIONS

World Trade Organization

(WTO) is an international organization designed to supervise and liberalize international trade. The WTO came into being on January 1, 1995, and is the successor to the General Agreement on Tariffs and Trade (GATT), which was created in 1947, and continued to operate for almost five decades as a de facto international organization. The WTO is governed by a Ministerial Conference, which meets every two years; a General Council, which implements the conference's policy decisions and is responsible for day-to-day administration; and a director-general, who is appointed by the Ministerial Conference. The WTO's headquarters are in Geneva, Switzerland.

Criticism on WTO

Although the stated aim of the WTO is to promote free trade and stimulate economic growth, some believe that globally free trade results in the rich (both people and countries) becoming richer, while the poor are getting poorer. Martin Khor, Director of the Third World Network, argues that the WTO does not manage the global economy impartially, but in its operation has a systematic bias toward rich countries and multinational corporations, harming smaller countries which have less negotiation power. He argues that developing countries have not benefited from the WTO Agreements of the Uruguay Round, because (among other reasons): market access in industry has not improved; these countries have no
gains yet from the phasing out of textiles quotas; non-tariff barriers such as anti-dumping measures have increased; domestic support and export subsidies for agricultural products in the rich countries remain high. Other critics have characterized the decision making in the WTO as complicated, ineffective, unrepresentative, and non-inclusive, and they have proposed the establishment of a small, informal steering committee (a "consultative board") that can be delegated responsibility for developing consensus on trade issues among the member countries.

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PAKISTAN ECONOMIC AID & DEBT

The Asian Development Bank will provide close to $ 6 billion development assistance to Pakistan during 2006-9. The World Bank unveiled a lending program of up to $6.5 billion for Pakistan under a new four-year, 2006-2009, aid strategy showing a significant increase in funding aimed largely at beefing up the country's infrastructure. Japan will provide $500
million annual economic aid to Pakistan.

The major causes of poverty in Pakistan

Lack of employment opportunities, which in the rural setting is caused by the absence of rural-urban linkages.
A slowdown in the pace of economic growth in the 1990s
With the burgeoning debt obligations, a decline in the public sector development program.

Key challenges facing the Government of Pakistan

Restoring economic growth-constrained further by a drought-affected agriculture sector
Managing the large debt burden with international financial institutions.
Promoting domestic and foreign investors' confidence
Increasing exports to generate foreign exchange,
Maintaining a level of social development spending to stem the deteriorating social indicators.
Law and Order, or Terrorism

Future Prospects for Pakistan's Economy

Pakistan's long term prospects will depend upon the interplay of evolution in political and social developments, economic policies to be pursued, the quality of governance and institutions, and most important investment in the human capital. It has become quite obvious from both Pakistan's own history and the experience of the developing countries that sustained economic growth and poverty reduction cannot take place merely on the strength of economic policies. Political stability, social cohesion, supporting institutions, and good governance are equally important ingredients coupled with both external environments for achieving economic success.

MGT604 - Management of Financial Institutions - Lecture Handout 14

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INCREASING FOREIGN DIRECT INVESTMENT

Pakistan must increase Foreign Direct Investment, if it intends to enhance the growth of its economy. The experience of the developing countries is that FDI is directly related to economic growth. Two recent examples from the developing world are China and India.

The following factors have proven to be critical for attracting foreign investment:

World-class physical infrastructure
A secure law and order situation
Skilled and productive labor
Innovative capacities
Agglomeration of efficient suppliers, competitors
A well-developed institutional infrastructure

Foreign Interest in Local Financial Markets

With the rapid growth in Pakistan's economy, foreign investors are taking a keen interest in the corporate sector of Pakistan. In the recent years, majority stakes in many corporations have been acquired by multinational groups.

Enhancing and Sustaining a Growing GDP

There have been two problems with the GDP growth rate in Pakistan. First, Pakistan has not been able to sustain growth over the long term. Sometimes Pakistan grows at a rate of around 7 percent and sometimes it retreats to a 3 percent growth rate.
Second, the growth rate of the economy in Pakistan has not been linked to improvement in human development factors. Basic indicators like education, health, poverty, safe drinking water, etc., have been neglected in Pakistan. The "trickle down theories" and market forces of the 1970s and 1980s have failed to provide relief for the general public. A need exists to link the growth rate of the economy to improvement in human development. The basic argument is that a higher growth rate is of limited utility if it does not benefit the population as a whole, including the poor.

MGT604 - Management of Financial Institutions - Lecture Handout 15

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ROLE OF COMMERCIAL BANKS

A bank is a commercial or state institution that provides financial services, including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit

A commercial bank accepts deposits from customers and in turn makes loans, even in excess of the deposits; a process known as fractional-reserve banking. Some banks (called Banks of issue) issue banknotes as legal tender. A commercial bank is usually defined as an institution that both accepts deposits and makes loans; there are also financial institutions
that provide selected banking services without meeting the legal definition of a bank. Many banks offer ancillary financial services to make additional profit; for example, most banks also rent safe deposit boxes in their branches. Currently in most jurisdictions commercial banks are regulated & require permission to operate. Operational authority is granted by bank regulatory authorities who provide rights to conduct the most fundamental banking services such as accepting deposits and making loans.

Purpose of a bank:

Banks have influenced economies & politics for centuries. Historically, the primary purpose of a bank was to provide loans to trading companies. Banks provided funds to allow businesses to purchase inventory, and collected those funds back with interest when the goods were sold.

Commercial Lending:

For centuries, the banking industry only dealt with businesses, not consumers. Commercial lending today is a very intense activity, with banks carefully analyzing the financial condition of their business clients to determine the level of risk in each loan transaction.

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ROLE OF COMMERCIAL BANKS

Types of investment banks

Investment banks "underwrite" (guarantee the sale of) stock and bond issues, trade for their own accounts, make markets, and advise corporations on capital markets activities such as mergers and acquisitions.
Merchant banks were traditionally banks which engaged in trade financing. The modern definition, however, refers to banks which provide capital to firms in the form of shares rather than loans. Unlike Venture capital firms, they tend not to invest in new companies

Banks in the Economy

Role in the money supply

A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a capital market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits.

Bank reserves are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy.

Note that under Basel I (and the new round of Basel II), banks no longer keep deposits with central banks, but must maintain defined capital ratios

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ROLE OF COMMERCIAL BANKS

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 overdraft.

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.

Profitability

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.

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ROLE OF COMMERCIAL BANKS

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.

Outlook

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:
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.

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ROLE OF COMMERCIAL BANKING

12. 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.

13. Taxation

The corporate tax rates on banks were exorbitantly high in Pakistan thus adversely affecting their profitability and attractiveness as an avenue for investment and new equity injection. The Government has already reduced the tax rate from 58 percent to 44 percent during the last three years and it is envisaged that the rate will be reduced gradually and brought at par with the corporate tax rate of 35 percent in the next three years. This will in turn help in reducing the spread between the deposit rate and lending rate and benefit financial savers.

14. Agriculture Credit

A complete revamping of Agriculture Credit Scheme has been done recently with the help of commercial banks. The scope of the Scheme which was limited to production loans for inputs has been broadened to the whole value chain of agriculture sector. We have, with the grace of Allah, become a surplus country in food grains, livestock etc. and thus the needs of agriculture sector have also expanded. The SBP has included financing for silos, god-owns, refrigerated vans, agro processing and distribution under the cover of this scheme. This broadening of the scope as well the removal of other restrictions have enabled the commercial banks to increase their lending for agriculture by a multiple of four times compared to FY 1999-00 thus mainstreaming agriculture lending as part of their corporate business. Unlike the previous years when they were prepared to pay penalties for under performance they have set up higher targets for this year. The private commercial banks have also agreed to step in and increase their lending to agriculture.

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BRANCH BANKING IN PAKISTAN

A branch, banking centre or financial centre is a retail location where a bank or financial institution offers a wide array of face to face service to its customers.

Remittances:

Demand Draft

It’s a written order, drawn by one branch of a bank upon another branch of the same bank, upon other bank under special arrangement to pay a certain sum of money to or to the order of a specified person.”

Parties Involved

Purchaser
Issuing Branch
Drawee Branch
Payee/ Beneficiary

Pay Order

A Pay Order is a written authorization for Pmt, Made in a receipt from issued & Payable by the bank, to the person named & addressed therein on his giving a proper discharge thereon.

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ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR

Microfinance in its broadest terms can be defined as provision of a range of financial services such as deposits, loans, payment services, money transfers and insurance to poor and low income households, and their micro enterprises (Source: Asian Development bank report on microfinance development strategy). While a commercial bank is a financial institution that offers a broad range of deposit accounts, including checking, savings, and time deposits, and extends loans to individuals and businesses.

The decision as to whether the commercial banks be involved in microfinance is a sensitive and debatable issue which requires a deep analysis of many factors.

Primarily, the microfinance customers are large in number, scattered in far-flung areas with very minute transaction sizes. Only government or state bank alone cannot reach out to millions of potential Microfinance beneficiaries; a whole well knitted network with almost doorstep reach is required, which is only possible when the commercial banks will be involved in microfinance. In Pakistan it is estimated that as many as 5.6 million households need microfinance services but these services reach only to less than 1 percent, most probably because of the absence of commercial banks from the microfinance sector. (Source: Pakistan microfinance Network PMN) This way a poor person just need to visit his local commercial bank to get access to microfinance benefits, which will help reduce many economic problems.
One criticism over involving the commercial banks in microfinance is that commercial banks will charge higher interest rates, further lower the standard of living and will exploit the public. The ground realities are totally different; empirical evidence has demonstrated that participants in microfinance programs have improved their living standards at both the

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Mutual funds

What are mutual funds?

An investment vehicle which is comprised of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market securities, and similar assets. Mutual funds are operated by money mangers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual
fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

In business encyclopedia

Mutual funds belong to a group of financial intermediaries known as investment companies, which are in the business of collecting funds from investors and pooling them for the purpose of building a portfolio of securities according to stated objectives. They are also known as open-end investment companies. Other members of the group are closed-end
investment companies (also known as closed-end funds) and unit investment trusts. In the United States, investment companies are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940.

Mutual funds are generally organized as corporations or trusts, and, as such, they have a board of directors or trustees elected by the shareholders. Almost all aspects of their operations are externally managed. They engage a management company to manage the investment for a fee, generally based on a percentage of the fund's average net assets during
the year. The management company may be an affiliated organization or an independent contractor. They sell their shares to investors either directly or through other firms such as broker-dealers, financial planners, employees of insurance companies, and banks. Even the day-to-day administration of a fund is carried out by an outsider, which may be the
management company or an unaffiliated third party.

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Mutual Funds

Criticism of managed mutual funds

Historically, only a small percentage of actively managed mutual funds, over long periods of time, have returned as much, or more than comparable index mutual funds. This, of course, is a criticism of one type of mutual fund over another.

Another criticism concerns sales commissions on load funds, an upfront or deferred fee as high as 8.5 percent of the amount invested in a fund (although the average upfront load is no more than 5% normally). *(Mutual Funds have to qualify to charge the maximum allowed by law, which is 8.5% and most of them DO NOT qualify for
this.)
In addition, no-load funds typically charge a 12b-1 fee in order to pay for shelf space on the exchange the investor uses for purchase of the fund, but they do not pay a load directly to a mutual fund broker, who sells it.
Critics point out those high sales commissions can sometimes represent a conflict of interest, as high commissions benefit the sales people but hurt the investors. Although in reality, "A shares", which appear to have the highest up front load, (around 5%) are the "cheapest" for the investor, if the investor is planning on 1) keeping the fund for more than 5 years, 2) investing more than 100,000 in one fund family, which likely will qualify them for "break points”, which is a form of discount, or 3) staying with that "fund family" for more than 5 years, but switching
"funds" within the same fund company. In this case, the up front load is best for the client, and at times "outperforms" the "no load" or "B or C shares".
High commissions can sometimes cause sales people to recommend funds that maximize their income. This can be easily solved, buy working with a "registered investment advisor" instead of a "broker", where the investment advisor can charge strictly for advise, and not charge a "load, or commission" for their work, at all.

This is a discussion of criticism, and solutions regarding one mutual fund over another.12b- 1 fees, which are found on most "no load funds”, can motivate the fund company to focus on advertising to attract more and more new investors, as new investors would also cause the fund assets to increase, thus increasing the amount of money that the mutual fund
managers make.

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Mutual Funds

Balanced Funds

The basic objectives of balanced funds are to generate income as well as long-term growth of principal. These funds generally have portfolios consisting of bonds, preferred stocks, and common stocks. They have fairly limited price rise potential, but do have a high degree of safety, and moderate to high income potential.

Investors who desire a fund with a combination of securities in a single portfolio, and who seek some current income and moderate growth with low-level risk, would do well to invest in balanced mutual funds. Balanced funds, by and large, do not differ greatly from the growth and income funds described above.

Growth Funds

Growth funds are offered by every investment company. The primary objective of such funds is to seek long-term appreciation (growth of capital). The secondary objective is to make one's capital investment grow faster than the rate of inflation. Dividend income is considered an incidental objective of growth funds.

Growth funds are best suited for investors interested primarily in seeing their principal grow and are therefore to be considered as long-term investments - held for at least three to five years. Jumping in and out of growth funds tends to defeat their purpose. However, if the fund has not shown substantial growth over a three - to five-year period, sell it (redeem your shares) and seek a growth fund with another investment company. Candidates likely to participate in growth funds are those willing to accept moderate to high risk in order to attain growth of their capital and those investors who characterize their investment temperament as "fairly aggressive.

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Mutual Funds

Cost of Ownership

1. Management Fee

All mutual funds, including no-load funds, have certain fixed expenses that are built into their per share net asset value. These expenses are the actual costs of doing business.

They are deducted from the assets of the fund. It is advisable to check the prospectus to determine the percentage of the fund's total net assets that is paid out for expenses.

Additionally, shareholder services provided by the fund, investment adviser's fees, bank custodian fees, and fund underwriter costs also come out of the fund's assets. These charges vary from fund to fund; however, they are clearly spelled out in the prospectus.

On a per-share basis, however, management expenses are usually quite small, because they are spread over the tens of thousands, or the millions, of shareholders in the fund.

The formula for determining the cost of a fund's management expenses is simple: From the current value of the fund's total assets subtract liabilities and expenses, and divide the result by the number of outstanding shares. The fund's prospectus and /or annual reports often provide this data. Management fees and expenses are usually expressed as a ratio of expenses paid out to total assets. Generally, the prospectus will show these expense ratios.

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Mutual Funds

Navigating the Investing Frontier: Where the Frauds Are

Many fraudsters rely on the telephone to carry out their investment scams. Using a technique known as cold calling (so-called because a caller telephones a person with whom they have not had previous contact), these fraudsters will hound you to buy stocks in small, unknown companies that are highly risky or, sometimes, part of a scam. In recent years, the Internet has also become increasingly attractive to fraudsters because it allows an individual or company to communicate with a large audience without spending a lot of time, effort, or money.

You should be skeptical of any offers you learn about from a cold caller or through the Internet. Here's what you need to know about cold calling and Internet fraud.

Cold calling

For many businesses, including securities firms, cold calling serve as a legitimate way to reach potential customers. Honest brokers use cold calling to find clients for the long term. They ask questions to understand your financial situation and investment goals before recommending that you buy anything.

Dishonest brokers use cold calling to find "quick hits." Some set up "boiler rooms" where high-pressure salespeople use banks of telephones to call as many potential investors as possible. Aggressive cold callers speak from persuasive scripts that include retorts for your every objection. As long as you stay on the phone, they'll keep trying to sell. And they won't
let you get a word in edgewise. Our advice is to avoid making any direct investments over the phone.

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Mutual Funds

Investing In International Mutual Funds

Investing in international mutual funds has two faces:

First is buying funds from US based companies that buy and manage portfolio in internationally listed stocks/securities. These companies are governed by regulations of SEC (Securities and Exchange Commission)
Second is buying mutual funds from international non US companies.

A word of caution before investing even in best international mutual funds - Unlike domestic mutual funds investment, international investments entail additional risk factors such as economic and political in addition to risk of FOREX value (simply put: foreign currency exchange value) fluctuations.

Why Should You Invest In International Opportunities?

The number of funds in international investing is on the rise. We can cite a few reasons for this.

Removal of trade barriers and expanding of economies have sparked off growth in many non-US companies.
Some of the major industries of the world are dominated by non US companies.
Over 72% of the world stocks are listed out side US.
Greater and true diversification and opportunity to capitalize on best overseas companies.

Investing in international mutual funds is gaining popularity for various reasons. Rising political stability merging or opening of borders and currencies are some of the reasons. Vibrant and upcoming economies and non US corporations becoming financially stronger by the day are some of the reasons. In addition you get true diversification, balance and
opportunities.

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Role of Investment Banks

Investment banks

It helps companies and governments (or their agencies) raise money by issuing and selling securities in the capital markets (both equity and debt).

Almost all investment banks also offer strategic advisory services for mergers, acquisitions, divestiture, or other financial services for clients, such as the trading of derivatives, fixed income, and foreign exchange, commodity, and equity securities.

Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is referred to as "sell side."

The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing public who consume the products and services of the sell-side in order to maximize their return on investment. Many firms have both buy and sell side components.

Organizational structure of an investment bank

The main activities and units

The primary function of an investment bank is buying and selling products both on behalf of the bank's clients and also for the bank itself. Banks undertake risk through proprietary trading, done by a special set of traders who do not interface with clients and through Principal Risk, risk undertaken by a trader after he or she buys or sells a product to a client
and does not hedge his or her total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet.

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Letter of Credit

Commercial Letter of Credit

Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves.

Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between banks, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.

Elements of a Letter of Credit

A payment undertaking given by a bank (issuing bank)
On behalf of a buyer (applicant)
To pay a seller (beneficiary) for a given amount of money
On presentation of specified documents representing the supply of goods
Within specified time limits
Documents must conform to terms and conditions set out in the letter of credit
Documents to be presented at a specified place

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Letter of Credit and International Trade

A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honor (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.
cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank, and the confirming bank, if any). However, the applicant is not a party to the letter of credit. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheque. Typically, the documents a beneficiary has to present in order to avail him of the credit are commercial invoice, bill of lading, insurance documents. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped.

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Foreign Exchange & Financial Institutions

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the
global forex and related markets currently is over US$ 3 trillion. Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks, and are subject to forex scams.

Market size and liquidity

The foreign exchange market is unique because of

its trading volume,
the extreme liquidity of the market,
the large number of, and variety of, traders in the market,
its geographical dispersion,
its long trading hours: 24 hours a day (except on weekends),
The variety of factors that affect exchange rates.
the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

According to the BIS, average daily turnover in traditional foreign exchange markets is estimated at $3,210 billion. Daily averages in April for different years, in billions of US dollars, are presented on the chart below:

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Foreign Exchange

Factors affecting currency trading

Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions, and market psychology.

Economic factors

These include economic policy, disseminated by government agencies and central banks, economic conditions, generally revealed through economic reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and"cost" of money, which is reflected by the level of interest rates).

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Leasing Companies

A lease or tenancy is a contract that transfers the right to possess specific property. In law, there are two types of property: historically, land is the more important because, under normal circumstances, it holds the highest value in economically developed societies. Ownership of land is an aspect of the system of real property or realty in common law systems.
When structured as an operating lease, this is a form of financing that avoids the down payment usually required for the purchase of equipment. Because leased equipment is not owned by the company, it does not appear on the balance sheet. A financing lease does appear on the balance sheet.
Don't be intimidated! For most people, leasing is an unfamiliar concept and therefore a little scary, but leasing isn't any more difficult than purchasing a car. Fully understanding how the leasing process works is the first step toward a positive leasing experience.

Leasing a vehicle is similar to renting a car, just for a longer time period. Like renting a car, a person who leases pays a pre-determined rate to drive a vehicle for a pre-determined amount of time. You never own the vehicle and return it when your lease is up. A person who leases enjoys the benefits of driving a car without assuming the up-front costs, and many of the risks of ownership.

Basic Purpose of Leasing

Bargain Purchase Option

A lease provision allowing the lessee, at its option, to purchase the equipment for a price predetermined at lease inception that is substantially lower than the expected fair market value at the date the option can be exercised.

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The Leasing Sector in Pakistan and its Role in Capital Investment

From the Third World perspective where a major source of economic capital is a form of foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80’s, when Pakistan floated its first leasing company, the characteristic of ‘asset-based’ financing made it a more ‘Islamic’ form of lending. (Asset based lending is a permitted form of debtfinancing
in Islam). From the perspective of developmental finance, Leasing provided an alternative to interest based debt.

Leasing as investment indicator

Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in time, would indicate the amount of incremental and fresh capital investment in a year. Hypothetically, we may ignore ‘leakages’ such as rescheduling and duplicate leasing.

The aggregate figure for ‘Investment in Leasing’ for the leasing sector in Pakistan has been ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics regarding the exact percentage of new investment in plant and machinery or other income generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery. Of-course, the AIL is only indicative of new capital investment if compared with the same over the previous year. A fairly rough estimate of incremental capital investment would therefore be an average of Rs3billion per year. This does not mean all new investment in a year. That would be much higher since part of the AIL would be paid back, depending on the life of the lease contract.

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Role of Insurance Companies

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is the company that sells the insurance. Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

Principles of insurance

Commercially insurable risks typically share seven common characteristics.

A large number of homogeneous exposure units. The vast majority of insurance policies are provided for individual members of very large classes. Automobile insurance, for example, covered about 175 million automobiles in the United States in 2004.[2] The existence of a large number of homogeneous exposure units allows insurers to benefit from the so-called “law of large numbers,” which in effect states that as the number of exposure units increases, the actual results are increasingly likely to become close to expected results. There are exceptions to this criterion. Lloyd's of London is famous for insuring the life or health of actors, actresses and sports figures. Satellite Launch insurance covers events that are infrequent. Large commercial property policies may insure exceptional properties for which there are no ‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like these are generally considered to be insurable.
Definite Loss. The event that gives rise to the loss that is subject to insurance should, at least in principle, take place at a known time, in a known place, and from a known cause. The classic example is death of an insured on a life insurance policy. Fire, automobile accidents, and worker injuries may all easily meet this criterion. Other types of losses may only be definite in theory. Occupational disease, for instance, may involve prolonged exposure to injurious conditions where no specific time, place or cause is identifiable. Ideally, the time, place and cause of a loss should be clear enough that a reasonable person, with sufficient information, could objectively verify all three elements.
Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable.

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Role of Insurance Companies

Types of insurance

Any risk that can be quantified can potentially be insured. Specific kinds of risk that may give rise to claims are known as "perils". An insurance policy will set out in detail which perils are covered by the policy and which is not.

Below is a (non-exhaustive) list of the many different types of insurance that exist. A single policy may cover risks in one or more of the categories set forth below. For example, auto insurance would typically cover both property risk (covering the risk of theft or damage to the car) and liability risk (covering legal claims from causing an accident). A homeowner's insurance policy in the U.S. typically includes property insurance covering damage to the home and the owner's belongings, liability insurance covering certain legal claims against the owner, and even a small amount of health insurance for medical expenses of guests who are injured on the owner's property.
Automobile insurance, known in the UK as motor insurance, is probably the most common form of insurance and may cover both legal liability claims against the driver and loss of or damage to the insured's vehicle itself. Throughout most of the United States an auto insurance policy is required to legally operate a motor vehicle
on public roads. In some jurisdictions, bodily injury compensation for automobile accident victims has been changed to a no-fault system, which reduces or eliminates the ability to sue for compensation but provides automatic eligibility for benefits. Credit card companies insure against damage on rented cars.
Aviation insurance insures against hull, spares, deductible, hull war and liability risks.
Boiler insurance (also known as boiler and machinery insurance or equipment breakdown insurance) insures against accidental physical damage to equipment or machinery.
Builder's risk insurance insures against the risk of physical loss or damage to property during construction. Builder's risk insurance is typically written on an "all risk" basis covering damage due to any cause (including the negligence of the insured) not otherwise expressly excluded.
Business insurance can be any kind of insurance that protects businesses against risks. Some principal subtypes of business insurance are (a) the various kinds of professional liability insurance, also called professional indemnity insurance, which are discussed below under that name; and (b) the business owners policy (BOP), which bundles into one policy many of the kinds of coverage that a business owner needs, in a way analogous to how homeowners insurance bundles the coverage that a homeowner needs.

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Role of financial Institutions in Agriculture Sector

Which banks are authorized for providing agricultural credit to farmers/growers?

All banks can provide agricultural credit to Farmers / growers. SBP does not restrain any bank from providing agricultural credit. However, under the Agricultural Credit Scheme indicative targets are given to 21 banks on annual basis. These include; two specialized banks (ZTBL & PPCBL), five major commercial banks (ABL, HBL, MCB, NBP & UBL) and 14 domestic private commercial banks; 1) Askari Com. Bank, 2) Bank Al-Habib, 3) Bank Al-Falah , 4) My Bank, 5) Faysal Bank, 6) Habib Metropolitan Bank, 7) PICIC Com. Bank, 8) KASB Bank, 9) Prime Com. Bank , 10) Saudi Pak Com. Bank, 11) Soneri Bank, 12) Bank of Khyber, 13) Bank of Punjab and 14)Standard Chartered Bank (Pakistan).

Who is eligible for agricultural credit from the banks?

Any individual (farmers/livestock farmers, fishermen, fish farmers), corporate firms, cooperative societies/self help groups under-taking livestock related activities, fish catching/ processing /packing companies and fish exporters having sufficient knowledge and relevant experience are eligible to draw agricultural credit from banks.

Are the traders and intermediaries engaged in trading/processing of agricultural
commodities eligible for agricultural credit?

Loans to entities exclusively engaged in processing, packaging and marketing of agricultural produce shall not fall under agricultural financing and would be covered under commercial or SME financing. However, agricultural financing can be extended to entities (including corporate farms, partnerships and individuals) engaged in farming activity as well as processing, packaging and marketing of mainly their own agricultural produce, provided 75% of the agriculture produce being processed, packaged and marketed is being produced by the abovementioned entities themselves.

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Agriculture Sector and Financial Institutions of Pakistan

What types of securities/collaterals are acceptable to the banks for providing agricultural credit to farmers/growers?

Agricultural land under the pass book system, urban/rural property, commercial property, Defense Saving Certificates, Special Saving Certificates, Gold & Silver Ornaments, personal surety, hypothecation of livestock and other assets e.g. motor boats / fishing trawlers, etc. are generally accepted by banks as collateral.

Is mark-up rate fixed by SBP on agricultural loans?

SBP does not fix any maximum/minimum mark-up rate to be charged on agricultural loans. Banks’ mark-up is based on their cost structure and risk profile of the borrowers and the sector. However, for benchmarking, Karachi inter-bank Offered Rate (KIBOR) is used by banks for the purpose.

Revolving Credit Scheme was introduced in 2003 in consultation with banks. Under the scheme, banks can provide finance for agricultural purposes on the basis of revolving limits for a period of three years with one-time documentation. The borrowers are required to clear the entire loan amount (including mark-up) once in a year at the date of their own choice.

Multiple withdrawals are allowed and the borrowers are also allowed to make partial repayments. Only the amount utilized by the borrower will attract mark-up. This facility can be availed by the farmers just like “running finance”. The limits under this scheme are automatically renewed on annual basis without any request or fresh application.

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Can Government of Pakistan Lay a Pivotal Role in this Sector?

In the recent past SMEDA stands out as a significant step towards Govt of Pakistan commitment to SME development. Created as an autonomous institution with private sector led governance structure, SMEDA promises to become an important institution spearheading Government’s SME development efforts. However, in absence of a coherent SME development policy framework it is unrealistic to expect a single organization such as SMEDA, to be able to implement aggressive SME development initiatives because:

Issues to be addressed for SME development fall within the purview of a large number of Ministries and Departments at the Federal, Provincial and Local government levels. SMEDA has no institutional jurisdiction or linkage with such institutions; and
SMEDA has limited budget and manpower, posing restrictions on its capacity to launch capital intensive initiatives and extend its outreach Thus to provide a coherent policy mechanism, there is a need to develop a
comprehensive SME Policy for Pakistan that defines the role of concerned public sector institutions. Such a Policy framework will provide the required direction and focus for achieving SME led economic growth resulting in job creation and reduction in poverty. Private sector growth in SME sector (as opposed to the large scale manufacturing) will result in lesser investments per job created, wider geographic and social spread of investments and better income distribution.

SME Policy & Their Objectives

The objective of SME Policy is to provide a short and a medium to long- term policy framework with an implementation mechanism for achieving higher economic growth based on SME led private sector development.

The SME Policy suggests concurrent and specific policy measures in all possible areas of SME development:

Business environment
Access to finance
Human resource development
Support for technology up gradation and marketing

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Financial Crimes

What is Money Laundering?

Defined in non-technical terms, money laundering is the conversion of 'dirty' money into - seemingly - 'clean' money. Dirty money is money that meets the following conditions: (1) it has been derived by illegal means and (2) for an outside observer it is possible to identify that condition (1) applies. Money laundering is the practice of engaging in financial transactions in order to conceal the identity, source, and/or destination of money, and is a main operation of the underground economy. In the past, the term "money laundering" was applied only to financial transactions related to organized crime. Today its definition is often expanded by government regulators to encompass any financial transaction which generates an asset or a value as the result of an illegal act, which may involve actions such as tax evasion or false accounting. As a result, the illegal activity of money laundering is now recognized as potentially practiced by individuals, small and large businesses, corrupt officials, members of organized crime (such as drug dealers or the Mafia) or of cults, and even corrupt states, through a complex network of shell companies and trusts based in offshore tax havens. The increasing complexity of financial crime, the increasing recognized value of so-called "financial intelligence" in combating transnational crime and terrorism, and the speculated impact of capital extracted from the legitimate economy has led to an increased prominence of money laundering in political, economic, and legal
debate.

Process of Money Laundering

Money laundering is often described as occurring in three stages: placement, layering, and integration.

Placement: refers to the initial point of entry for funds derived from criminal activities.
Layering: refers to the creation of complex networks of transactions which attempt to obscure the link between the initial entry point, and the end of the laundering cycle.
Integration: refers to the return of funds to the legitimate economy for later extraction.

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DFIs & Risk Management

Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational,
Compliance / legal / regulatory and reputation risks. Before overarching these risk categories, given below are some basics about risk Management and some guiding principles to manage risks in banking organization.

Risk Management

Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources. The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a
particular risk. Some traditional risk managements are focused on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. Objective of risk management is to reduce different risks
related to a pre-selected domain to the level accepted by society. It may refer to numerous types of threats caused by environment, technology, humans, organizations and politics. On the other hand it involves all means available for humans, or in particular, for a risk management entity (person, staff, and organization). In every financial institution of
Pakistan, risk management activities broadly take place simultaneously at following different hierarchy levels.

Strategic level: It encompasses risk management functions performed by senior management. For instance definition of risks, ascertaining institutions risk appetite, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken.
Macro Level: It encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management or units devoted to risk reviews fall into this category.
Micro Level: It involves ‘On-the-line’ risk management where risks are actually created. This is the risk management activities performed by individuals who take risk on organization’s behalf such as front office and loan origination functions. The risk management in those areas is confined to following operational procedures and guidelines set by management.

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Banking Fraud & Misleading Activities

Bank fraud is a federal crime in many countries, defined as planning to obtain property or money from any federally insured financial institution. It is sometimes considered a whitecollar crime.

• Rogue Traders

A rogue trader is a highly placed insider nominally authorized to invest sizeable funds on behalf of the bank; this trader secretly makes progressively more aggressive and risky investments using the bank's money, when one investment goes bad, the rogue trader engages in further market speculation in the hope of a quick profit which would hide or cover the loss. Unfortunately, when one investment loss is piled onto another, the costs to the bank can reach into the hundreds of millions of dollars; there have even been cases in which a bank goes out of business due to market investment losses.

• Fraudulent Loans

One way to remove money from a bank is to take out a loan, a practice bankers would be more than willing to encourage if they know that the money will be repaid in full with interest. A fraudulent loan, however, is one in which the borrower is a business entity controlled by a dishonest bank officer or an accomplice; the "borrower" then declares
bankruptcy or vanishes and the money is gone. The borrower may even be a non-existent entity and the loan merely an artifice to conceal a theft of a large sum of money from the bank.

• Wire Fraud

Wire transfer networks such as the international SWIFT inter-bank fund transfer system are tempting as targets as a transfer, once made, is difficult or impossible to reverse. As these networks are used by banks to settle accounts with each other, rapid or overnight wire transfer of large amounts of money is commonplace; while banks have put checks and balances in place, there is the risk that insiders may attempt to use fraudulent or forged documents which claim to request a bank depositor's money be wired to another bank, often an offshore account in some distant foreign country.

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The Collapse of ENRON

Only months before Enron Corporations bankruptcy filing in December 2001, the firm was widely regarded as one of the most innovative, fastest growing, and best managed businesses in the United States. With the swift collapse, shareholders, including thousands of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron’s failure already raises financial oversight issues with wider applications. This lecture briefly examines the accounting system that failed to provide a clear picture of the firm’s true condition, the independent auditors and board members who were unwilling to challenge Enron’s management, the Wall Street stock analysts and bond raters who missed the trouble ahead, the rules governing employer stock in company pension plans, and the unregulated energy derivatives trading that was the core of Enron’s business. Formed in 1985 from a merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated
transportation of natural gas to unregulated energy trading markets. The guiding principle seems to have been that there was more money to be made in buying and selling financial contracts linked to the value of energy assets (and to other economic variables) than in actual ownership of physical assets. Until late 2001, nearly all observers – including
professional Wall Street analysts – regarded this transformation as an outstanding success. Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $101 billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and Senate have held or plan to hold hearings related to Enron’s fall. The Justice Department is conducting a criminal investigation. The challenge for financial oversight, however, does not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the swift and unanticipated collapse of such a large corporation suggests basic problems with the U.S. system of securities regulation, which is based on the full and accurate disclosure of all financial information that market participants need to make informed investment
decisions.

MGT604 - Management of Financial Institutions - Lecture Handout 44

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Classic Financial Scandals

"Bankers who hire money hungry geniuses should not always express surprise and amazement when some of them turn around with brilliant, creative, and illegal means of making money." “The quotation is from a speech by the financial thriller writer on the Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam. Barings Bank collapsed when one of the Singapore based employees of London's Barings Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract speculation. Leeson's actions led the oldest merchant bank to default on its debts. The bank's collapse is considered a pivotal turning point in the history of banking and has become a textbook example of accounting fraud.

• Internal auditing

The way that Barings Bank's activities in Singapore were organized between 1992 and 1995 enabled Leeson to operate effectively without supervision from Barings Bank's head office in London. Leeson acted both as head of settlement operations (charged with ensuring accurate accounting) and as floor manager for Barings' trading on Singapore International Monetary Exchange (SIMEX). Normally the positions would have been held by two employees. This concentration of functions placed Leeson in the position of reporting to an office inside the bank which he himself held. Several observers, including Leeson, placed much of the blame on the bank's own deficient internal auditing and risk management practices.

• Corruption

Because of the absence of oversight, Leeson was able to make seemingly small gambles in the futures market at Barings Futures Singapores (BFS) and cover for his shortfalls by reporting losses as gains to Barings in London. Specifically, Leeson altered the branch's error account, subsequently known by its account number 88888 as the "five-eight account," to prevent the London office from receiving the standard daily reports on trading, price, and
status. Leeson claims the losses started when one of his colleagues bought contracts when she should have sold them. By December 1994 Leeson had cost Barings £200 million but he reported to British tax authorities a £102 million profit. If the company had uncovered his true financial dealings then, collapse might have been avoided as Barings had capital of £350 million

MGT604 - Management of Financial Institutions - Lecture Handout 45

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RECAP

1) FINANCIAL ENVIRONMENT &FINANCIAL INSTITUTIONS

Role Of Financial Institutions
Long Run Performance Of Financial Institutions For Economic Growth
Capital market
Commodity markets
Money markets
Derivatives markets
Futures markets
Borrowers of financial markets
Lenders of financial market
Stock markets
Bond markets

2) FINANCIAL INSTITUTIONS

Types of Financial Institutions
Central Bank
Commercial Banks
Investment Bank
Saving Bank
Micro Finance Bank
Islamic Bank
Agriculture Bank
SME Banks
Non-Banking Financial Institutions
Investment Companies
Brokerage Houses
Leasing Companies
Insurance Companies
Mutual Fund
Financial Institution & Their Functions