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MGT604 - Management of Financial Institutions - Lecture Handout 17

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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.


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, prepaid 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 mismanage 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.

The banking industry's main obstacles to increasing profits are existing regulatory burdens, new government regulation, and increasing competition from non-traditional financial institutions.

Society for Worldwide Inter-bank 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 inter-bank 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),
  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 paidup 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 this.

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 development.

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 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 painfulpart of the adjustment is over. This is reflected in the reversal of decelerating deposit growth into accelerating one in year 2000.

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 in T-Bill yields in year 1999, needed to induce required change in investment portfolio of banks.

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.