“Impact of Basel II on Credit Risk in

Pakistani Banks”

By

Sadaf Fayyaz

ABSTRACT

Banking sector today is under immense pressure to sustain

the economy and improve regulatory measures. BASEL I was

introduced but it had its own shortcomings and

limitations. Now State Bank of Pakistan has asked certain

Pakistani banks and DFI to implement BASEL II.

It is a regulatory frame work and State Bank has hired

certain consultants to work on it. The basic motivation

comes from an interest in banking sector and regulatory

reforms.

The scope of the research work is to see aims to see

whether BASEL II would benefit the credit risk in

Pakistani banks or not. The costs of implementation would

be high and certain banks have been asked to increase

their capital ratio. Some banks were taken as sample out

of the whole population and studied. It was found that

some banks may find it difficult to meet the requirements

and may go for restructuring. The banks with higher

capital base did not have any problems.

The research focuses on how Pakistani banks will benefit

from this approach. Certain banks find it difficult to

implement such regulatory measures, as it will drive them

out of competition. In the end the recommendation is that

however costly it is, for banking sector improved

performance, Pakistani banks and DFI will have to go for

this supervisory measure.

ACKNOWLEDGEMENTS

First of all, all my heartiest thanks to the Almighty

ALLAH, whose mercy and blessings helped me to complete

this research work.

Yaseen Anwar (Deputy Governor, State Bank of

Pakistan)

Christian Marlier (Head of CRO Executive Office,

Counsellor to Chief Risk Officer)

David Keefe (Consultant Global Risk Regulator)

Christopher Chu (The Global Consulting Group)

Muhammad Akber

My account of acknowledgement would remain incomplete if

I do not express my gratefulness to my parents. They have

always been a source of inspiration for me.

TABLE OF CONTENTS

CHAPTER I INTRODUCTION

I.1 Background on Research 1

I.2 Research motivation and rational 2

I.3 Problem statement 3

I.4 Population 3

I.5 Element 3

I.6 Sample 3

I.7 Research objectives 6

I.8 Purpose of study 7

I.9 Unit of analysis 7

I.10 Data collection methods 7

I.11 Definition of terms 7

I.11.1 Basel I 7

I.11.2 Basel II 8

I.11.3 Capital Adequacy Ratio 8

I.11.4 Tier 1 Capital 9

I.11.5 Tier 2 Capital 9

I.11.6 Privatized Banks 9

I.11.7 Credit Portfolio (stochastic) 9

I.11.8 Confidence Interval 9

I.11.9 Value at Risk 10

I.11.10 Expected Loss 10

I.11.11 Unexpected Loss 10

I.11.12 Probability of Default 10

I.11.13 Exposure at Default 10

I.11.14 Off-Balance Sheet 11

I.11.15 Internal Based Rating 11

CHAPTER II THE LITERATURE REVIEW 12

CHAPTER III THE RESEARCH METHODOLOGY

III.1 Ten banks sample 23

III.2 The ratings based approach 23

III.3 Determination of risk variables 24

CHAPTER IV RESEARCH RESULTS AND DISCUSSIONS

IV.1 Basel II Process 25

IV.2 Basel II costs 25

IV.3 Impact on Local Banking System 26

IV.4 Challenges for Pakistani Banks 26

IV.5 Banks Qualification for Basel II 27

IV.6 Ratings Approach 27

IV.7 Mitigation of Credit Risk 28

IV.8 Rivalry among Banks 28

IV.9 Tools and Techniques 29

IV.10 Difference in Ratings Approach 29

IV.11 Findings 30

IV.12 Research Results 31

IV.12.1 Difference between Basel I and II 31

IV.12.2 Deadline for Pakistani Banks 31

IV.12.3 Standardized versus IRB Approach 31

IV.12.4 Anticipated Benefits 32

IV.12.4.1 Impact on Competition 32

IV.12.4.2 Better Information Systems 33

IV.12.4.3 Cost Analysis 34

IV.13 Feedback Results 35

IV.13.1 Deadline 36

IV.13.2 The Approach 36

IV.13.3 Slow Process 37

IV.13.3.2 Employee training 38

IV.13.3.1 Expensive Software 38

IV.13.3.3 Experts 38

IV.13.3.4 Need for a Big Investment 38

IV.14 Banks’ Paid-up Capital 39

IV.14.1 An overview 39

IV.14.2 Allied Bank Limited 39

IV.14.3 United Bank Limited 40

IV.14.4 Muslim Commercial Bank 40

IV.14.5 Abn Amro Bank 43

IV.14.6 NIB Bank 43

IV.14.8 Meezan Bank Limited 44

IV.14.7 Citi Bank N.A 44

IV.14.9 Bank Al Falah Limited 45

IV.14.10 Standard Chartered Bank 45

IV.14.11 KASB Bank 46

CHAPTER V CONCLUSION AND RECOMMENDATIONS 51

Bibliography

Appendix A Interview with Yaseen Anwar

Appendix B Interview with David Keefe

LIST OF ABBREVIATIONS

ABL Allied Bank Limited

ADBP Agricultural Development Bank of Pakistan

AIRB Advanced Internal Ratings Based

BCBS Basel Committee on Banking Supervision

BIS Bank for International Settlements

BSRA Banking Supervision Risk Assessment

CAR Capital Adequacy Ratio

ED Exposure at Default

EL Expected Losses

ESOP Employee Stock Option Plan

FSA Financial services Authority

FSF Financial Stability Forum

GDR Global Depository Receipts

GRR Global Risk Regulator

IBP Institute of Bankers Pakistan

ICAP Institute of Chartered Accountants of Pakistan

IRAF Institution Risk Assessment Framework

IRB Internal Ratings Based

JCR Japan Credit Rating

LGD Loss Given Default

MCB Muslim Commercial Bank

PACRA Pakistan Credit Rating Agency

PICIC Pakistan Industrial Credit & Investment

Corporation Ltd

PCBL PICIC Commercial Bank Ltd.

PD Probability of Default

VAR Value at Risk

SCB Standard Chartered Bank Ltd.

SBP State Bank of Pakistan

UBL United Bank Limited

LIST OF FIGURES

Figure IV.1 Risk Class

Figure IV.2 The Anticipated benefits of Basel II

Figure IV.3 Impact on competition

Figure IV.4 Timely Information

Figure IV.5 Costs of Basel II

Figure IV.6 Feed back

Figure IV.7 Rating Approach

Figure IV.8 Excerpt from Balance Sheet

Figure IV.9 Excerpt from Balance Sheet

Figure IV.11 Excerpt from Balance Sheet

Figure IV.10 Excerpt from Balance Sheet

Figure IV.11 Excerpt from Balance Sheet

Figure IV.12 Excerpt from Balance Sheet

Figure IV.13 Excerpt from Balance Sheet

Figure IV.14 Excerpt from Balance Sheet

Figure IV.15 Excerpt from Balance Sheet

Figure IV.16 Excerpt from Balance Sheet

Figure IV.17 Excerpt from Balance Sheet

Figure IV.18 Excerpt from Balance Sheet

Figure IV.19 Excerpt from Balance Sheet

Figure IV.20 Excerpt from Balance Sheet

Figure IV.21 Excerpt from Balance Sheet

Figure IV.22 Excerpt from Balance Sheet

Figure IV.23 Banks’ Earnings after Taxes 2006 & 2007

Figure IV.24 Banks’ return on Equity 2006 & 2007

Figure IV.25 Banks’ assets 2006 & 2007

Figure IV.26 Banks’ loan growth rate

LIST OF TABLES

Table I.1 Pakistani Banks

Table II.1 Credit Rating

Table IV.1 Capital Summary

Table IV.2 Banks’ credit ratings 2007

CHAPTER I INTRODUCTION

I.1 Background on Research

Basel II is the term which refers to a round of

deliberations by central bankers from round the world. In

1988, the Basel Committee in Basel, Switzerland,

published a set of minimal capital requirements for

banks. This is also known as the 1988 Basel Accord, and

was enforced by law in the Group of Ten countries in

1992, with Japanese banks permitted an extended

transition period. Purpose of the original 1988 accord

was two-fold: The guidelines of Basle accord were

originally adopted by the central banking authorities

from 12 developed countries in July 1988. Their

implementation started in 1989 and was completed four

years later in 1993. Basel I served banking industry

quite well since its introduction in 1988 but it delayed

behind the financial market developments and innovation.

It became outdated and flawed as it relied on a

relatively rudimentary method of assigning risk weights

to assets, accentuating mostly on balance sheet risks

relative to multiple risks being faced by financial firms

today. Furthermore, it offered a rigid approach to

capital determination and standard setting which did not

incarcerate fully the range of large and complex banking

operations and the accompanying series of assorted set of

economic risks. Addressing the perceived deficiency and

structural flaws of Basel I, the Basel II Accord offers a

newer and comprehensive approach and methodology for

financial sector dictatorial capital calculation which

recognizes well the advancements and innovations in

banks’ businesses, policies and structures and the

accompanying financial engineering and innovation. The

relevance and significance of Basel II comes from its

ability to recognize effectively the different types of

risks facing industry and the new products as well as

off-balance sheet transactions. Basel I is now widely

viewed as passé, and a more inclusive set of procedure,

known as Basel II is in the process of execution by

several countries.

I.2 Research motivation and rational

The basic motivation is an interest in the field of

banking. The area of interest is credit risk. The other

motivation factor is basic research. The original Basel I

model had its own limitations. The implementation of

Basel II may face some problems for Pakistani Banks. The

capital requirements and other constraints are still

there. There is a need to explore whether Basel II will

bring any improvements in the credit risk of Privatized

Pakistani banks. The total sample space comprises some of

Pakistani banks namely:-

Muslim Commercial Bank www.mcb.com.pk

Allied Bank Limited www.abl.com.pk

United Bank Limited www.ubl.com.pk

ABN Amro Bank www.abnamro.com.pk

Citi Bank Pakistan www.sbp.com.pk

Standard Chartered Bank www.standardchartered.com/pk/

Meezan Bank Limited www.meezanbank.com

Bank Al Falah www.bal.com

NIB Bank www.nibpk.com

KASB Bank www.kasbbank.com

The research study has helped us to know how Pakistani

banks undergo such the process of BASEL II in order to

improve regulatory framework. This would help to see

whether Basel II costs exceed benefits or not. It may be

feasible for large banks whose capital requirements are

enough, as compared to small banks.

I.3 Problem statement

“To what extent has Basel II overcome the potential

difficulties in the field of credit risk in Pakistani

Banks and will the impact be positive?”

For this purpose, ten banks were considered and certain

study was done.

Certain research questions will be answered like:

Will Basel II lead to a jagged playing field between

banks and unregulated competitors?

Will the capital requirements lead to decreased bank

profits?

Will Basel II cost of compliance outweigh its benefits?

Will Basel II lead to threatening behavior in times of

crisis, increasing rather than decreasing systematic

risk?

Does Basel II favor large banks?

How does it relate to CAMELS? The rating system is

efficient or new credit rating systems need to be

developed?

The risk profile of all the banks is same or different?

If so, how does BASEL II fit into that?

I.4 Population

It was overall banking industry of Pakistan.

I.5 Element

Each bank, whether local or foreign, investment or

commercial, was an element of the population.

I.6 Sample

The Pakistani banks were a sample, the mentioned above

ten as well.

Table I.1 Pakistani Banks

Nationalized Commercial banks

National bank of Pakistan

www.nbp.org.pk

Habib Bank Ltd. www.hbl.com.pk

First Women Bank Ltd.

www.fwbl.com.pk

Privatized banks

Allied Bank Ltd. www.abl.com.pk

United bank Ltd. www.ubl.com.pk

Muslim Commercial bank Ltd.

www.mcb.com.pk

Specialized banks

Agricultural Development Bank (ADBP)

www.adbp.org.pk

Industrial Development bank of Pakistan

www.idbp.com.pk

Private Scheduled Banks

Punjab Provincial Co-operative Bank Ltd. (PPCB)

SME Bank Ltd. www.smebank.org

Private Scheduled banks

Askari Commercial bank

www.askaribank.com.pk

Bank Al-Falah Ltd. www.bankalfalah.com

Bank Al-Habib Ltd. www.bankalhabib.com

Bolan bank Ltd. www.mybankltd.com

Faysal Bank Ltd. www.faysalbank.com.pk

Meezan bank Ltd. www.meezanbank.com

Metropolitan Bank Ltd.

www.metrobank.com.pk

Platinum Commercial bank Ltd.

Soneri bank Ltd. www.soneribank.com

Pak Saudi Commercial bank Ltd.

www.saudipakbank.com

The Bank Of Khyber www.bok.com.pk Provincial before

Bank of Punjab www.bop.com.pk Provincial before

Investment Banks

Atlas Investment Bank Limited

www.atlasgrouppk.com

Cresent Investment Bank Limited

First International Investment Bank Limited

www.interbank.com.pk

Jehangir Investment Bank Limited

Orix Investment Bank (Pak) Limited

www.orixbank.com

Trust Investment Bank Limited

www.trustbank.com.pk

I.7 Research objectives

The research is focused towards finding certain answers

to certain questions. Though banks find it helpful,

Pakistani Banks may face some potential implementation

difficulties. Certain issues may prove difficult to

resolve in Pakistani market. These include:

Banks, especially those facing profit challenges, may

find the cost of Basel II execution high-priced.

Many Pakistani banks will have noteworthy system and

process gaps to close.

Delaying the Basel II implementation may blow the

competitiveness of the Pakistani Banking Industry.

Large number of Pakistani banks likely to mean that

reporting is variable in terms of consistency and

quality.

Data availability and relevance identified as key issue

with mergers will complicate system and data

integration.

Potential shortage of core skills to implement Basel

II, especially given large number of banks.

Senior management may not succeed to appreciate the

importance / benefits of the Accord.

The research would further include whether Pakistan has

overcome some of the key challenges, as compared to

other developed countries. SBP has issued BSD circular

2 & 8, 2007 for capital adequacy standards at banks and

DFIs.

I.8 Purpose of study

The purpose of study is descriptive. Since some research

has already been conducted on Basel II, this lies under

descriptive studies. The investigation would be cause-

effect.

I.9 Unit of analysis

(Banking) Banks of Pakistan

I.10 Data collection methods

Interviews and questionnaires are used. Qualitative data

is collected through some focus groups. The Secondary

data sources would include term papers, articles,

addresses, recent publications and case studies. Most of

the data was gathered via State bank of Pakistan. The

consultants on Basel II interviewed and how BASEL II

could help banks maintain proper risk measures. This

included a discussion with the Deputy Governor, State

Bank of Pakistan.

I.11 Definition of terms

I.11.1 Basel I

Basel I chiefly focused on credit risk. Assets of banks

in this framework were classified and grouped in five

categories according to credit risk, carrying risk

weights of zero (for example home country sovereign

debt), ten, twenty, fifty, and up to one hundred percent

(this category has, as an example, most corporate debt).

Banks with international presence are needed to hold

capital equal up to 8 % of the risk-weighted assets.

I.11.2 Basel II

Basel II is the term which refers to a round of

deliberations by central bankers from round the world.

The new Basel Capital Accord puts down new guidelines for

determining the minimum solvency requirements for banks.

The key change in these guidelines is a new structure for

weighting the risks run by banks in their loans to retail

and corporate customers. The objective of Basel II is to

perk up the dependability of the financial system.

I.11.3 Capital Adequacy Ratio

CAR is defined as the ratio that determines the bank’s

ability and capacity in terms of liquidity needs, credit

risk and operational risk factors. It serves as a

“cushion” against the potential losses of the bank, which

save the lenders and depositors both.

CAR is same as leverage, but unlike traditional leverage,

CAR recognizes that different asset classes have

different risk levels. The regulations assign a 0% risk

factor to government bonds, 50% to residential mortgage

loans and 100% to consumer loans and credit cards.

Bank "A" has assets totaling 100 units, consisting of:

Cash : 10 units.

Government bonds: 15 units

Mortgage loans : 20 units

Other loans: 50 units

Other assets: 5 units

I.11.4 Tier 1 Capital

A term used for the capital adequacy of bank. It’s the

core or base capital of the bank. It includes the equity

capital, reserves and shareholder equity too. The

examples are common stock, preferred stock (non-

redeemable and non-cumulative) and retained earnings. It

is the most reliable form of capital.

I.11.5 Tier 2 Capital

The term stands for the second most important and

reliable form of banks capital. These were standardized

with Basel I and come after Tier 1 capital.

I.11.6 Privatized Banks

It’s the repurchase of all of a bank's outstanding stock

by employees or a private investor. As a result of such

an initiative, the company stops being publicly traded.

Sometimes, the company might have to take on significant

debt to finance the change in ownership structure.

Companies might want to go private in order to

restructure their businesses. They might also want to go

private to avoid the expense and regulations associated

with remaining listed on a stock exchange.

I.11.7 Credit Portfolio (stochastic)

It’s a combination of loans i.e. credit.

I.11.8 Confidence Interval

It is a statistical range with a specified probability

that a given parameter lies within the range. A

confidence interval is a range of values computed in such

a way that it contains the estimated parameter a high

proportion of the time. The 95% confidence interval is

constructed so that 95% of such intervals will contain

the parameter.

I.11.9 Value At Risk

A technique which uses the statistical analysis of

historical market trends and it’s a technique volatility

to estimate the likelihood that a given portfolio's

losses will surpass a certain amount.

I.11.10 Expected Loss

It’s the average financial loss or impact that can be

expected for a particular loss even or risk. It is

calculated based on experience and past.

It is the expected value over a specified sphere of

portfolio losses due to default.

I.11.11 Unexpected Loss

The worst case financial loss or blow that a business

could incur due to a particular loss E / I / C or risk

I.11.12 Probability of Default

The Probability of Default is the likelihood that a loan

will not be re-payed and fall into default. This PD will

be calculated for each company who has a loan. The credit

history of the counterparty and nature of the investment

will all be taken into account to calculate the PD

figures. Many banks will use external ratings agencies

such as Standard and Poors. However, banks are also

encouraged to use their own Internal Rating Methods as

well.

I.11.13 Exposure at Default

Exposure at Default or EAD is a parameter used in the

calculation of Economic Capital or Regulatory Capital

under Basel II for banking.

I.11.14 Off-Balance Sheet

This means that assets or liabilities not recorded on the

bank balance sheet. It could have a lease, independent

subsidiary or a liability like letter of credit. It also

has loan commitments, loans sold, futures and forwards.

I.11.15 Internal Based Rating

It is an approach to internal ratings within the

framework of the new Basel accords, which is

distinguished by its basic and advanced methods. The

advanced method may be used only by institutions

satisfying more stringent requirements compared to the

basic approach. In this case, all the estimated input

(PD, LGD, EAD and Maturity) used for credit risk

assessment is done in-house. Instead, in the basic method

the Bank assesses only the PD.

CHAPTER II THE LITERATURE REVIEW

The new Basel II comprises three pillars. Pillar 1

consists of minimal capital requirements. Pillar 2

consists of supervisory review processes and Pillar 3

comprises market discipline (Council of Mortgage Lenders,

2008, p.2). Basel I served banking industry well since its

introduction in 1988 but it could not match the new

developments in markets and put behind the financial

market developments and innovation.(Institute of

Chartered Accountants of Pakistan, 2006, p.1-11).

According to (State Bank of Pakistan, 2007, p.1-32), its

known by its importance and why Basel I increasingly

became outdated and flawed as it relied relatively on a

simple method of assigning risk weights to assets,

highlighted mostly balance sheet risks relative to

multiple risks being faced by financial firms today.

Furthermore, the Basel I offered a rigid agenda that

could not fit in the large set of complex banking

operations and following range of economic risks. Basel

II in some senses “serves as more intelligent solvency

capital redeployment.” Globally there is a deep interest

in Basel II. There is a strong global need for Basel II

standards but it would vary from economy to economy and

bank to bank (Cognos, 2007, [p.1]). Presently, on one

hand there are differences in economy’s and institutions’

risk management procedures, state of technical know-how,

customers’ portfolio, and on the other hand, the state of

development of rating agencies, external auditors, and

above all, the variation of regulators across different

economies (www.globalriskregulator.com).

The standard purpose of Basel Accord has

To promote world financial stability by

coordinating supervisory definitions of capital,

risk assessments and standards for capital

adequacy across countries (Ernst & Young, 2006,

p.8).

To link a bank’s capital requirements

systematically to the risk level of its

activities, including various off-balance-sheet

forms of risk exposure.

The relevance and significance of Basel II comes

from its ability to recognize efficiently the

different types of risks facing industry and the

new products as well as off-balance sheet

transactions. Some distinct characteristics of

Basel II are noteworthy:

@ It aligns capital of banks with their basic

risk profiles,

@ It is elaborate and far superior in terms of

its coverage and details,

@ It has the ability to develop effectively new

frontiers of risk management and gives thrust

to the development of sound risk management

systems, which in turn are predictable to

promote efficiency and more prudent

allocation of resources.(Financial Services

Authority,2007,p.14)

First, while the new Accord maintains the level of

capital adequacy requirements at 8% (Tier 2 capital is

restricted to 100% of Tier 1 capital) consistent with

Basel I, it has shifted emphasis from regulatory to

economic capital framework, while giving appreciation to

new risk alleviation techniques (default protection etc.)

and expounding new trading book capital questions (Bank

For International Settlements, 2006, p.19).

Careful evaluation of these elements proposes that Basel

II is not ideologically about raising as per se capital

requirement but focuses on efficient and effective

capital allocation. Appropriate and sharpened risk

expression and assessment and preserves would result in

reduced capital requirements (Bank for International

Settlements, 2006, p.12). Conversely, the ill-conceived

financial structures with risky counterparties will

attract disciplinary capital requirements. Basel II in

some senses “serves as more intelligent solvency capital

redeployment.”(Basel Committee On Banking Supervision,

2007, p.1-40).

Second, the new Accord has more intensity in its draft

than the older one (Federal Reserve Bank of Boston, 2005,

p.69). Basel II at the very basic level consists of the

Standardized Approach which recognizes and defines

various asset classes and assigns them risk weights in

accordance with the type and nature of corporate issue

and other transactions and passing on its qualitative

assessment to external raters (Pakistan Banks’

Association, 2006, p.3). The matrix of risk pails and

weights is considered to have added unnecessary

complexity for less sophisticated banks. The connection

and delegation of quality assessment to external ratings

lends extreme confidence on the objectivity and

reliability of rating agencies which, in at least

developing countries has only thus far rated a small

proportion of corporate and issues. (Bank For

International Settlements, 2007, p.13).The third

implication of Basel 2 and the Accord cheers banks to

recognize all types of risk and take suitable steps to

alleviate these risks, while providing for adequate

capital. Besides the credit risk, the Accord for the

first time identifies the operational risk, however, the

degree of guidance and complexity in measurement provided

within the framework for these risks varies. The credit

risk is dealt with most lengthily in the Basel II in line

with legacy of the first Accord as well as the banks

customary edge and capability in credit risk assessments

(www.bis.org).

Fourth, the IRB approach is being favored by large global

banks, which already competitively price credit risk. The

key strictures under IRB approach are PD (probability of

Default), LGD (loss given default), M (Maturity) and EAD

(Exposure At default) (Bank For International

Settlements, 2007, p.26).

The banks and financial institutions have greeted Basel

II, but the challenges and fore comings is still a

problem for banking industry. The credit risk is well

determined by mathematical formula:

Equation 1.1 Total Capitals

For example, if a bank holds $875 of risk weighted

assets, and market charge is $10, operational charge is $

20, the bank has to hold at least $100 in capital as

minimum. 875 + (10+20 *12.5) = $1250, 8% * 1250 =$100.

The resolving the outstanding issues of Basel II

regulatory procedures is the most challenging task

(Kashyap, 2004, pp.1-13).

According to (Akhtar, 2007, p.13), the Basel II embodies

a major innovation in advances to financial sector

regulation that would result in stronger and much

reliable banking and financial system. The need is to

implement it to its full potential. Certain key

outstanding issues need to get resolved. (Gestel, 2006,

p.2).

(Global Risk Regulator, 2008, p.2) has laid the

importance of regulatory framework that the Basel

Committee has put forward. The main issue of concern is

the starting dates of implementation for different world

zones. EU has it as 2008, and Pakistan has an

implementation deadline of 2009. The competitive

inefficiencies would develop among countries of different

world zones and these would cause inefficient and

unhealthy competition among the banks (Habib Bank

Limited, 2007, [p.12]).

Basel II forces participant countries to reopen safety-

net bargaining across affected sectors (Kane, 2007).

The accord’s success would primarily lies on the home-

host supervisory link and the right balance between the

two. As far as up-and-coming countries are concerned,

they need to get associated with the international

regulators to adopt a truly global accord. (Global Risk

Regulator, 2008, p.3).

According to Chernih, Vanduffel & Henrad, the Basel II

generates a framework for determining the capital

requirements for credit portfolios. Different businesses

operate in different socio-economic environments and a

capital requirement determination is necessary. The asset

co-relation between the obligors lie between 8-24%.

( Institute of International Finance, 2006, p.12).

Jacobs has spoken of different risk models and Basel II

implementation. Smithson reviews both a top-down and a

bottom-up approach to measuring economic capital. The

first one measures cash flow doubt by analyzing the

historical cash flows of the firm. A measure of cash flow

analysis and assumed CI can be used. For example, use a

99% CI, and the change in annual income is Rs. 300

million, how much capital must be set apart in offsetting

against this? Dividing by the annual risk free rate

creates a risk capital amount which, invested in

perpetuity, will produce the $300 million each year

(Hussain, 2008, p.10). The benefit to this approach is

that it is a comprehensive, total risk measure for a

business unit or firm. This approach suffers from a draw

back of historical data availability (State bank of

Pakistan, 2007, p.12).

Market users need to understand better the structure and

risks of the credit risk transfer (CRT) products in which

they invest, according to the Joint Forum of banking,

insurance and securities market regulators.

A stoppage to understand and handle some of these risks

contributed to the financial market chaos stemming from

the collapse of the US market for subprime credit

lending, the Joint Forum acknowledges in a report

prepared for a meeting in Rome of the Financial Stability

Forum (FSF).  Users need also to understand better how

credit rating agencies assign ratings to specific

instruments and what circumstances would lead them to

downgrade ratings (Keefe, 2008, p.12).

The bottom up approach is used for measuring economic and

regulatory capital. Risks are measured definitely. The

risk break down of large banks is 70% of credit risk, 10%

market risk and 20% operational risk. According to

author, the credit risk is defined as the probability of

default (Bank for International Settlements, 2006, p.1).

Akhtar (2007) speaks of credit risk and two layers of

capital namely tier 1 and tier 2. The tier 1 constitutes

common equity, retained earnings, non-cumulative

preferred stock less good will. The tier 2 capital

comprises allowance for loan and lease losses, perpetual

preferred stocks, hybrid instruments and subordinated

debt. The off-balance sheet items are converted into

balance sheet items and multiplied by the appropriate

risk weight category. For example, a letter of credit

with maturity greater than 1 year lies in 50% range. The

new credit risk models according to Basel II consists of

internal ratings based (IRB), which is further divided

into foundation IRB or A-IRB. The other one is

standardized approach. The corporate credit risk can be

measured under Basel II like:-

Table II.1 Credit Ratings

S&P rating Corporate risk weight

AAA to AA- 20%

A+ to A- 50%

BBB+ to BB- 100%

Below BB- 150%

Unrated 100%

The basic IRB differs from an advanced one in the context

of degree of control. The banks can exercise how much

control over determination of credit risk components.

There are 5 categories of exposure:-

Corporate (debt obligation to a corporation)

Sovereign

Bank

Retail

Equity

Smithson also speaks of the 4 credit risk components

like:-

Probability of Default (PD)

Loss given Default (LGD)

Exposure at default (EAD)

Effective maturity (M)

The main problem with the agency rating systems is that

agency ratings are based on stress scenarios and bank

ratings are based on borrower current conditions. The two

sets of rating criteria are not compatible (Monetary and

Economic Department, 2007, p.128). The quantifications

are unbalanced and unreliable in the time in which data

planning is done. If the mapping is done in good economic

conditions, the banks ratings get slanted to good quality

credit ratings and prejudice the study (Department of

Finance, 2008, p.2).

US banking supervisors hope to provide some more

information in the next month or so about their

expectations for banks’ plans for executing the

controversial Basel II safety rules, according to a top

federal supervisor. US Federal Reserve Board of Governors

member Randall Kroszner said plans by the Basel Committee

of global banking supervisors to enhance the resiliency

of the Basel II framework in the light of the credit

munch “should in no way interfere with institutions’

efforts to meet the process and system requirements in

the US final (Basel II) rule.”(Global Risk Regulator,

2008, p.12).

Wang has spoken on the importance of how capital

requirements influence monetary policy effectiveness. A

strict and conservative capital requirement affects the

lending supply and the balance sheet liquidity of banks

(Institute of Bankers Pakistan, 2007, p.4).

The Achilles' heel remarkably revealed in the Basel II

models by the chaos are a very bright, flashing yellow

light warning us to drive very carefully, Bair told the

Basel summit day of this week’s Risk Minds conference in

Geneva. She noted the turbulence took another twist today

with the announcement by Swiss banking giant UBS that it

is writing off a further $10 billion in losses in the US

subprime lending market. Her views on the Basel II

advanced approaches have often contrasted with those of

officials at the other three federal banking supervisory

agencies jointly involved in developing US policy on the

Basel II rules – the Federal Reserve Board of Governors,

the Office of the Comptroller of the Currency and the

Office of Thrift Supervision. Officials at these agencies

have argued the current problems highlight the need for

large, complex banks to be regulated by the risk-focused

Basel II capital rules, which upgrade the simpler Basel I

rules that date from 1988 (Federal Deposit Insurance

Corporation, 2008, p.14).

The more sensitive capital requirement would reduce the

bank lending in era of decline. He has also argued that

the credit ratings of the borrowers are exaggerated in

recession, leading to greater capital requirements.

(Institute of Bankers Pakistan, 2008, p.2. Power (2004)

has a similar opinion. According to her, a rise in credit

risk may lead to a greater loan supply decrease and Basel

II may have a negative impact on the monetary policy. The

monetary policy would not be used as a inspiring tool

during collapse. Akhtar (2007) has a similar view.

According to her, the weakness in the Basel II model is

that US banking industry is losing the lending market by

$ 10 billion. The large complex banks are facing this

problem. The Basel II credit rating models would fail

because these are not a reliable predictor of credit

responses (Hussain, 2008, p.12). They should never be

used where there is a change in the lending product. The

simpler and standardized approaches work better than

Basel II advanced risk rating systems. The regulators

require a cross risk approach under Basel II. (Institute

of Bankers Pakistan, 2007, p.3).

Basel II described as revolution in risk management,

(Dawn, 2006, p.12), its mentioned that the new accord

would definitely prove a challenge and shape up the

banking industry. The main element for success is the

correct recognition and organization of risk. A higher

capital allocation against the credit risk would be

needed for banks. The small businesses may suffer under

the new regime. The banking industry needs a better

credit rating and monitoring risk assessment system.

The deadline has been extended to July 2008. (Business

Recorder, 2006, p.10).

(Institute of Chartered Accountants of Pakistan, 2006,

p.3) holds a similar opinion. The eccentricity with Basel

II would a bad choice as it would demote the rating of

the banking industry. This would in turn affect the

payment of high risk premium to global financial markets.

Zubyr Soomro, (Gauhar, 2007, p.12) has spoken of how the

Basel II accord aims to lock up the different types of

risks and accordingly requires the level of capital

appropriate for each of those risks, which banks are

facing today. So the fact that banking system is going

from Rs. 3 billion to Rs. 6 billion by the end of 2009,

in line with global trends (Business Recorder, 2008,

p.4).

According to local papers (Business Recorder, 2008, p.6),

the Basel II replaces and overcomes some of the flaws

inbuilt in the Basel I credit risk model.

The BCBS papers shed light on home-host information

sharing and cross border standards and international

capital standards application as a mere reason for

successful Basel II (Qamar, 2006 p.2).

SAS Pakistan works with banks to meet 2008 Basel II

compliance, (Daily News, 2006, p.12); it seems that

Pakistani banks have welcomed Basel II. The future of the

banking industry is further associated with the contract

of software preparation that Net Sol has won (Market

Wire, 2008, p.11).

Pakistan is likely to go for Basel II in 2008(The News,

2006, p.19) and some banks have been qualified as well.

According to (Dawn, 2006, p.20), it would be a great

revolution in Pakistani banking industry.

CHAPTER III THE RESEARCH METHODOLOGY

III.1 Ten banks sample

The research methodology used was the ten banks were

taken from the banking sector of Pakistan. The banks were

taken and how they could adopt to Basel II requirements.

Data from the balance sheets of these banks was taken and

analyzed. Some of these had problems in adopting Basel II

procedures for credit risk measures. Out of these banks,

MCB, ABL and UBL belonged to the privatized banks of

Pakistan, HBL and FWBL belonged to nationalized banks,

Meezan and Al Falah came under private scheduled banks,

and STC, Citi Bank and Abn Amro came under foreign banks

operating in Pakistan with head offices abroad.

III.2 The ratings based approach

The Internal Ratings Based approach used by some banks

was analyzed too. The balance sheets and other statements

showed well how the banks could tackle the problem of

tier 1 and tier2 capital. The minimum capital

requirements needed by the bank were feasible or not.

The banks were taken and samples of the latest financial

data were taken. The annual reports of 2006 and 2007 were

taken for Basel II implication, since the BSD circular no

08 was issued in the year 2007. It’s not mandatory for

all Pakistani banks and DFIs to adopt Basel II, but it

would improve the performance of overall banking sector.

The credit risk is important and the credit portfolio of

the customer/corporate needs to be checked under the

system. What was found from the three banks, UBL is the

first one to opt for Basel II standards?

The risk analysts jobs at the UBL require excel modeling

with Basel II standards.

III.3 Determination of risk variables

The most difficult task was the determination of risk

related variables. The proper risk assessment tools could

not be used since the process is in its infancy stage.

Also the financial data didn’t disclose the quantitative

bank information. The determination of off-balance sheet

items made it further difficult. The data from the annual

reports of the banks was analyzed. The main source of the

analysis came from the bank’s balance sheets and profit

and loss statements. The capital determination was

conducted from the yearly financial data of the three

banks.

CHAPTER IV RESEARCH RESULTS AND DISCUSSIONS

As things were discussed with the deputy governor of

State Bank Pakistan, certain questions were put to him.

The discussions were held on telephone and mail as well.

The certain discussion research questions were asked and

certain answers provided.

The following answers were discussed and reproduced.

IV.1 Basel II Process

The State Bank of Pakistan has issued BSD circular 08,

and asked Pakistani banks and financial institutions to

have the minimum capital requirements. The issue has been

revised 3 times. The banks will be required to operate

and have a standardized internal ratings based approach

in order for the process to succeed. The BSD circular no.

08 of 2006, BSD circular no. 03 0f 2005 and BSD circular

no. 02 0f 2007 pertains to the same Basel II

implementation. Though Pakistani banks are a bit slow in

acquiring Basel II, the system would improve the credit

rating and the market based risk rating systems under

this provision.

IV.2 BASEL II costs

Netsol, a NASDAQ listed company with CMM model 5 has won

the bid of developing the internal credit rating IRB

software for the banks. The software cost may be a little

high like, SAP cost but banks would benefit under this

program and likelihood of probability of default would

reduce too under this system. The costs are still unknown

but Netsol has been doing an excellent job in developing

Basel 2 software in other countries too. The State bank

has strictly asked the Pakistani banks to adopt Basel II.

The famous NASDAQ listed company has been successfully

providing the Basel II services in Asia pacific, Africa,

and UAE region too.

IV.3 Impact on Local Banking System

Certain foreign consultants, who are making careful

analysis of certain things and issues, have been hired by

SBP. The foreign consultants have been working on these

specific issues and how Basel II standards in the

developing economies. Basel II regulations need certain

adaptations in the developing economies. Large banks

usually don’t have enough capital requirements. The

capital needs, like tier 1 and tier 2 requirements are

same. The both should equal 8 % of total capital. The

total capital includes off balance sheet items as well.

Tier 1 needs to be 4 % of the capital, and tier 2 needs

to be 4 % of tier 2 too. Both contribute equally. Certain

small banks do not have maximum capital requirements. The

banks will need to increase the capital base.

IV.4 Challenges for Pakistani Banks

The Pakistani banks are under intense pressure, since the

corporate portfolios of loans are being changed too. The

emerging economies are under more pressure than the

developed ones. The emerging economies are prone to more

shock and risk than the developed ones. Due to

macroeconomic stability, the credit risk profile of

corporate is significantly changing and banks are engaged

in diverse sectors and industries. The credit and market

risk is increasing due to this long exposure. The wide

array of risks that Pakistani banks are prone to now

include, credit risk, market risk, operational risk,

liquidity and macroeconomic risks. The well and much

improved management and mitigation of all these risks is

important for the betterment of banking sector.

IV.5 Banks Qualification for Basel II

The new regulatory framework established by SBP, under

BIS aims towards better managed and well mitigated

regulatory procedure. The minimum capital requirements

ask banks to increase their capital base. The risk

management procedures would improve under this. We have

hired special consultants to work on Basel II. Pakistani

banks may/may not adopt these regulatory procedures, but

the fast coming trends would require banks to do so.

Banks need to increase their capital base to $ 100

million by year 2009. some banks have already qualified

for these standards. The ones, who have found the capital

expansion requirement difficult, are working hard on

capital base expansion. Not only this, the state bank has

asked the banks to change the accounting mechanisms and

reporting formats. Some new financial products have

introduced too. Some special regulatory requirements are

needed in order to foster areas like consumer financing,

treasury, Islamic financing, information technology and

investment banking too.

IV.6 Ratings Approach

State Bank has recently introduced IRAF (Institution Risk

Assessment Framework). The ratings are conducted

according to standards of SBP and come in compliance with

these. The composite rating system gives an onsite and

offsite feedback from the bank’s management. The 360

degree rating procedure is a supervisory rating process

that enables information about the health of different

banks from multiple resources like SBP, Board of

Directors, management and market vigilance too. SBP has

also been in the process of developing banking

supervision Risk Assessment Model. It would improve and

quantify the credit risk in the banks. The method used

would be VAR Value at risk by all the banks. The bank’s

position would be forecasted under the stress scenarios.

The system would extract the data from eCIB, Electronic

Credit Information Bureau. The market and operational

risk would use other date statistics. The BSRA model

would help banks to have better credit and market risk

appetite. The system would allow for corrective and

timely measures, if needed.

IV.7 Mitigation of Credit Risk

The credit risk in an important element of bank lending

and needs to be dealt with care and supervision.

Credit operations are a main source of bank income and

boost economic activity too. Credit does impose a lot of

risk on the banking sector too. The probability of

default is one important thing. The number of consumer

financers has increased in the last 3 years from 2.4% in

2002 to 14.3% in 2006. It depends on the credit portfolio

also. The house financing is merely 2.3% of total loan

financing. Besides capital requirements, the Basel 2

system encompasses a good risk management system. The

basic criterion is that according to the risk profile,

capital should be allocated accordingly. The pillar 1

comes under efficient capital utilization.

IV.8 Rivalry among Banks

Banks are asked to adopt the standardized risk approach

from 2009. In absence of regular rating agencies, the

banks would end allocating more capital than before and

this would generally affect the rate of competition among

the local banks. There is a need for better IT networks

and systems for the new framework to succeed. Secondly

historical data of banks need to be available in order to

make judgmental qualitative analysis.

IV.9 Tools and Techniques

The rating systems are discussed before as well. The

tools used would be either mathematical, statistical

(VAR), benchmarking, and other validation procedures as

well. A combination of both qualitative and quantitative

methods would be used. The most famous models to be used

are probability of default, (PD), exposure at Default

(EAD), Loss Given Default (LPD). The scorecards models

would be used for credit applications. The simulation

models would be used for project financing.

Basel IIdefault

Recovery default

Timeline

Back to non-default level

Riskclass

End-of- year

Timeline

Performingloans

Pas

sSpecial

Uncertain

Doubt

Figure IV.1 Risk Class

IV.10 Difference in Ratings Approach

The standardized rating approach is used by banks with

less complex operations. The IRB approach would be used

by banks with complex books and operations. The PD, LGD

and EAD are under IRB models. An IRB approach is there

for all the asset classes. The standardized approach is

for retail exposure. The Advanced IRB approach is for

whole sale exposure. It compels some small Pakistani

banks to change the capital requirements. Only 8

Pakistani banks have been qualified up till now for Basel

II. The ones which do not qualify would increase the

capital base by the year 2009.

IV.11 Findings

Necessity

The order has been issued by the State Bank. It is

successful in the developing and the emerging economies.

So Pakistani banking sector must not lag far behind than

other nations. It must adopt Basel II Standards too.

Challenges for Pakistani banks

The Pakistani banking industry has seen much regulation

and deregulation in the last few years. It has to face

the new challenge. The business cycles and corporate

behavior has changed a lot. Banks are washed out with

liquidity problems, non-performing loans. The credit risk

profile of different businesses has changed too. Small

banks may face some problem in adopting Basel II.

Expected benefits

The risk areas would concentrate more and the regulatory

requirements would help reduce risk from these 3 areas,

i.e. market risk, credit risk and operational risk also.

Cost benefits analysis

The costs would be in software development, (Netsol) has

already won the consultancy contract for developing

software for Basel II. The training cost would also

incur, as the bank employees need to know it. The

creation of reserves may also impose some additional

cost.

IV.12 Research Results

IV.12.1 Difference between Basel I and II

Basel needs lenders to compute a certain level of minimum

capital requirements. Basel II has 3 pillars. Basel II

goes beyond Basel I in allowing lenders to compute their

own risk measurement models. An IRB risk rating is used

with Basel II. Under pillar 1 of Basel II, the lenders

are required to cater for additional risk, which was not

done by a pillar 1. For example, there may be

dissimilarity between the interest rate of asset and

liability classes.

IV.12.2 Deadline for Pakistani Banks

Up till now, only 8 banks have qualified for Basel II.

The other is striving hard to change the capital

requirements to 100 Million dollars till 2009. BSD

circulars issued by the State bank ask local banks to

adopt Basel II till year 2008.

IV.12.3 Standardized versus IRB Approach

The standardized approach is for banks with more capital

and less complex operations and books. The standardized

approach is just like Basel I. under IRB approach, the

lenders determine their own credit rating and minimum

capital requirements. They determine on their own how

much capital to allocate to what risk class.

The term capital under Basel II means that it includes

shareholder’s funds, debentures, bonds and preference

shares too. Capital needs to be held by banks and

financial institutions, so that it absorbs the loss and

acts as a cushion against the risk. Some borrowers may

not pay the loan or amount lent.

The capital requirement, both of risk adjusted assets, is

8% of total capital. The tier 1 plus tier 2 capital would

count for 8% in all.

IV.12.4 Anticipated Benefits

The new regulatory procedures would bring a substantial

change in the banking world though efficient port folio

management, risk based measures and efficient risk

models.

Basel II has an impact on spread; the risk pricing would

become more proactive. The banks would plan to work and

contribute the capital to risk attribution and

performance management both.

Anticipated Benefits

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Proactive portfolio risk management

Increased use of derivatives forrisk

Move away from buy-hold

Greater specialization

Figure IV.2 Anticipated Benefits of Basel II

IV.12.4.1 Impact on Competition

The positive impact of Basel II would be on competition.

The banks and financial institutions with better risk and

regulatory procedures would definitely get a competitive

advantage. The Basel II changes will allow the business

models that get more timely and accurate risk data. Thus

the competitive and comparative landscape would change a

lot.

Positive Impact

0% 20% 40% 60% 80% 100% 120%

Comprehensive risk information

Proper risk assessment

Changes in product pricing

Changes in competitive landscape

Figure IV.3 Impact on Competition

IV.12.4.2 Better Information Systems

The Basel II would result in better information systems

and better risk management systems. The impact would be

positive on timely and quality risk information. Also,

there would be better understanding of risks profiles in

the organizations. Lastly, it would lead to better

assessment of risk-return.

Timely Information

0% 10% 20% 30% 40% 50% 60% 70% 80%

Better timely andQuality riskinformation

Better riskconcentrationunderstanding

Better risk-returnassessment for

business

Figure IV.4 Timely Information

IV.12.4.3 Cost Analysis

The on-going cost analysis for Basel II is as under. The

diagram shows well the costs to be incurred. These are

development as well as operational costs.

A better terminology would be to use the word

“investment” instead of cost. The development as well as

the operational costs would be higher. The training and

software development costs pertain to the highest of

these. The cost of reserve is another one.

Basel 2 Costs

0% 10% 20% 30% 40% 50% 60% 70% 80%

Data infrastructure

Skilled resources for standards

Maintaining IRB

Compliace with regulators

Disclosure requirements

Maintaining standards

Figure IV.5 Costs of Basel II

IV.13 Feedback Results

The capital allocation procedures under Basel II are more

risk sensitive and deep. This would cause improved risk

management procedures at banks. The implementation is not

a piece of cake in emerging market economies. The risk

assessment and management procedures need to be updated

and transformed into advanced ones. The Pakistani local

banks are in their infancy stage of Basel II standards.

It is more questionable in the developing economies.

The results obtained from some banks showed a positive

response. None of the bank said “no” to Basel II

standards. The DFIs had the same answer. The figure below

shows the obtained results from banks.

IV.13.1 Deadline

Bank response

Banks agreed to 2006 year,

5%, 5%

Banks with no answer , 3%,

3%

Banks agreed to 2008 year ,

49%, 49%

Banks agreed to 2007 year,

43%, 43%

Figure IV.6 Feedback

The above statistics clearly show the feedback obtained

from different banks. Most of the banks were of the view

that Basel II standards should be implemented from year

2008. though the SBP has extended the time line to year

2008. the other finding was that many banks were ready to

adopt the standardized rating approach. The other finding

was the response from the local banks. Almost banks

facing capital problems said yes to Basel standards to

start from 2008.

IV.13.2 The Approach

The local banks were of the view that standardized risk

rating approach would be the best for them. They were

hesitant in adopting the AIRB approach.

Approach

IRB Advanced , 3%

No answer, 4%

IRB Foundation , 3%

Standardised approach, 88%

Figure IV.7 Rating Approach

Some of the banks may need to increase their paid-up

capital as well. Also the banks would need to increase

their capital requirements to charge off against credit

risk. The banks may get the Basel II software also. The

paid-up capital increase would be Rs. 2 billion. There

would be 3 credit rating approaches that the banks would

be using. The standardized approach would be used by the

banks with less complicated operations. The banks with

more complicated operations would be using the IRB

approach. The IRB approach is further divided into the

foundation IRB and the Advanced IRB. Under the AIRB

approach, the banks would be able determine LGD and EAD

and estimates and build better flexibility in collateral

guarantees and credit risk formulas. The capital

allocation is determined by the quantitative and formulas

given by the committee.

IV.13.3 Slow Process

It was certainly found that most of the Pakistani banks,

even those with no capital shortage, are slow in

acquiring Basel II standards. As compared to other Asia

Pacific countries, the process is much slower in the

Pakistani banks. The reasons for the slow process

include:-

IV.13.3.1 Expensive Software

The expensive cost of Basel II software has made the

process a bit slower.

IV.13.3.2 Employee training

The high cost on employee train on software usage has

also caused the process to slow down.

IV.13.3.3 Experts

The job descriptions or hiring of professional may

include Basel II experts. It may take more time than

estimated. Since, it’s not that easy to find people from

a pool of banking and finance, who are well aware of the

Basel II standards.

IV.13.3.4 Need for a Big Investment

Adopting Basel II standards needs big investments in

human resource and IT software, systems and

specifications. In most of Pakistani banks, the risk

management function is still regarded as a requirement

laid by IBP. In order to implement Basel II and risk

management should not be looked at separately; rather,

instilling a prudent and proactive risk management

environment will inevitably lead towards a smooth

transition to Basel II compliance.

In a span of the next 3 years, the Pakistani banks have

to increase the capital from Rs. 2 billion to 6 billion.

This may get some small banks disappear. Up till now,

only eight banks have qualified for the capital

requirements. The rest are meeting or trying to reach the

capital requirement threshold. This may cause 2 small

banks to merge with other small bank to have more

capital. The problem only lies with the local banks. The

foreign banks like Abn Amro and Standard Chartered would

definitely be expected from this restriction if their

head offices have $100 million capital.

IV.14 Banks’ Paid-up Capital

IV.14.1 An overview

The State Bank of Pakistan has extended the Basel II

implementation deadline to year 2009 now. The central

bank has asked to increase the capital requirement from

Rs. 2 billion in 2007, and to increase by Rs. 1 billion

each year, to reach Rs. 6 billion in 2009. The commercial

banks were required to increase their capital up to Rs. 4

billion till 2007.

The paid-up capital target has to reach a minimum

threshold level of Rs. 6 billion by the end of 2009. The

paid up capital for First Women bank Limited is not is

meager. Such banks may go for restructuring or merging.

IV.14.2 Allied Bank Limited

The Allied Bank has currently a paid-up capital of above

Rs. 4.4 billion. So it need not worry. The paid-up

capital increased from 4.4 billion in 2006 to 5.38

billion in 2007.

Figure IV.8 Excerpts from Balance Sheet

Figure IV.9 Excerpt from Balance Sheet

Also, the long term credit rating is AA and the short

term is A1-. The credit ratings show the low expectation

of credit risk. A1- ratings support the highest capacity

for timely payments.

IV.14.3 United Bank Limited

The UBL has a paid-up capital of Rs. 6.47 billions. It

has increased its capital in 2005 from 5.1 billion to

6.47 billion in 2006. There is a better future associated

with Basel II. The Bank assets (loans in all) have also

increased from 21.6 billion to 29.863 billion. The bank

also has a credit rating of AA in the long term. The

short term rating is A-1+, which shows good credit

quality. The Pakistani government plans to sell GDR of

UBL in June. This would further increase the capital

base.

Figure IV.10 Excerpt from Balance Sheet

The data for 2005 and 2006 is as follows:

Figure IV.11 Excerpt from Balance Sheet

The paid-up capital did not increase but the net assets

increased.

IV.14.4 Muslim Commercial Bank

It has a paid-up capital of Rs. 5.4 billions.

Figure IV.12 Excerpt from Balance Sheet

Also, the long term credit rating is AA+ and short term

is A1+. The ratings reflect MCB's strong capacity to

endure the banking environment, arising from its

extensive franchise supported by an efficient technology

platform. The ratings recognize the improving asset

quality having positive impact on the bank's risk

absorption capacity. The MCB experienced high deposit

ratio in 2006 and planned to increase it till 75%. The

GDR issue in 2005 led to a high CAR. The deposit ratio

was 46% in 2003, 62% in 2004, and 79% in 2005. It came to

a level of 75% in 2006 and then 75% in 2007. The

subsidiary of MCB asset management led Rs. 300 million

capitals injected. The estimated target of MCB in the

next 3-5 years is to have 30-35 % consumer lending.

The bank of Khyber would not be able to meet the capital

requirements till next year. It may require a deadline

extension. The First Women Bank Limited has it as:-

Figure IV.13 Excerpt from Balance Sheet

PACRA gives a similar view of the bank in maintaining the

capital needs. With its paid-up capital well short of the

statutory requirement and uncertainty regarding its

future, the bank is finding it difficult to maintain the

momentum. Its rating is BBB+.

My Bank has prepared itself for the new capital

requirements. The latest data from 2007 annual report

shows:

Figure IV.14 Excerpt from Balance Sheet

From the above financial data, it’s obvious that the

increased capital does not cause bank assets (loans) to

decrease. In case of ABL, the capital did not increase

from 4.4 billion in 2005 to 2006, but assets increased

from 14.54 to 17.64 billion. The % increase is of 21.59%.

The capital has increased from 4.4 to 5.3 billion. The

assets increased from 17.64 to 19.87 billion. The %

increase in capital during 2006-07 was 20%. The growth in

assets in 2006-07 was 12.64%. The loans increased, but at

a decreased rate.

In case of UBL, the paid-up capital did not increase from

5.18 billion in 2004-05. The assets grew by 24.67%. The

capital increased from 5.18 to 6.47 billion. The assets

grew by 37.85%.

In case of MCB, the five year historical data was

available. The paid up capital kept growing till 5.4

billion till the end of 2006. The assets grew similarly.

IV.14.5 Abn Amro Bank

Figure IV.15 Excerpt from Balance Sheet

From the above financial data for the years 2005 and

2006, it is obvious that the foreign bank is already

exempted from Basel II compliance. The head office has a

capital base touching the 6 billion targets and there is

an increase in the capital base of the bank from 2005 to

year 2006. Also, the assets grew from 4.1 billion Rs. to

4.8 billion Rs. The bank has no problem with its capital

base, and can endure in the banking industry. Currently

Abn Amro is using the Delta, VAR and OCP model to manage

its market risk, and MDDR and OBSI to manage its credit

risk. The CAR of the bank declines from 12.37% in 2005 to

11.69% in 2006. Abn Amro is currently managing through

ALCO and risk directorates. The bank has recently

acquired Prime Commercial Bank.

IV.14.6 NIB bank

Figure IV.16 Excerpt from Balance Sheet

The above financial data for the years 2006 and 2007

shows that NIB qualifies for Basel II with a high capital

base, though the reserve creation process is slow. There

is an increase in the capital base of the bank, but

reserves show no change. The bank plans to sell its

shares to shareholders of PICIC and PCBL, which would

increase the capital base further. Also, the long term

credit rating of the bank is A+ and the short term is A-.

There is a remarkable increase in the bank assets from 46

billion Rs. to 176 billion Rs. So Basel II is not a

problem. (NIB acquired PICIC and PCBL recently). It is

the second most capitalized bank of Pakistan now. The

shareholders of PICIC bank will get 2.27 shares of NIB as

one of old ones. The 646 million shares will be

introduced and the paid up capital would further increase

from 22 billion to 28 billion, with 6.5 billion swap

capital.

IV.14.7 Citi Bank N.A

Figure IV.17 Excerpt from Balance Sheet

Citi Bank may have to struggle a bit hard to sustain

itself. The capital base is 3.79 billion and increased a

little over the past one year. There is very slight

increase in the capital base and reserves. Citi bank is

planning to buy Soneri bank.

IV.14.8 Meezan Bank Limited

Figure IV.18 Excerpt from Balance Sheet

Figure IV.19 Excerpt from Balance Sheet

The above financial data for the years 2006 and 2007

shows that there is no increase in the capital base,

though some reserves have been created and increased.

According to the requirements by SBP, the bank intends to

increase its capital base by issuing 9.9 million ordinary

shares at Rs. 10 under an Employee Stock Option Plan to

reach the target set by SBP.

IV.14.9 Bank Al Falah Limited

Figure IV.20 Excerpt from Balance Sheet

The bank already qualifies for Basel II targets and

standards. Though, the reserves have declined in year

2007. It is forecasted that the year 2008 and 2009 would

be very profitable for the bank. The bank has announced

to increase its capital base to 15 billion Rs. Also the

long term credit rating is AA and short term is A1+. Also

the bank has maintained a CAR of 8.34 % in 2007.

IV.14.10 Standard Chartered Bank

Figure IV.21 Excerpt from Balance Sheet

The paid up capital is quite high for the bank. This is

the highest capital base for a Pakistani bank. The NIB

bank comes as second most highly capitalized bank of

Pakistan. Also the reserve creation process is quite

high. All the 3 credit rating agencies (JCR-VIS, PACRA

and S&P) have assigned high ratings to the bank.

IV.14.11 KASB Bank

Figure IV.22 Excerpt from Balance Sheet

The above financial data for the 5 years show the great

increase in the capital base. The bank has reached a

target of 4 billion Rs. The reserves have also increased.

Over the past 5 years, the bank has been actively

increasing its capital base and reserves. The bank has

issued right shares and has an Employee Stock Option Plan

for increasing its capital base. There is also an upgrade

in the credit rating of the bank. The long term rating

has been upgraded to A- whereas the short term is A2. The

improved ratings show a low expectation of credit risk.

Table IV.1 Capital Summary

Bank Year 2006 capital

(in billions PKR)

Year 2007 capital

(in billions PKR)

Reserves

2006

Reserves

2007

ABL 4.4 5.38 6.133 6.05

UBL 5.18 6.47 8.2 ------

MCB 4.2 5.3 24.6 ------

FWBL 0.2 0.2 0.175 ------

Abn Amro 4.11 4.8 ------

NIB 3.2 22.3 0.719 0.719

Citi bank 3.74 3.79 ------ ------

Meezan Bank 3.779 3.779 0.528 0.728

Bank Al Falah

5 6.5 2.749 2.414

Standard Chartered

38.715 38.715 1.11 1.92

KASB bank 2.2 3.1 0.11 0.11

Earning After Tax 2006-2007 in billions

4.834

9.707

13.341

2.19

2.594

0.986

2.036

5.5

-0.048

6.661

14.5

18.941

3.044

2.575

0.926

1.907

7.618

0.124

-5 0 5 10 15 20

ABL

UBL

MCB

Abn Amro

Citi Bank

Meezan Bank

Bank Al Falah

Standard Chartered

KASB Bank

Earnings before tax 2006 Earnings before tax 2007

Figure IV.23 Banks’ Earnings after Taxes 2006 & 2007

UBL showed improvement in its after tax profits due to

overall improvement in retail banking, commercial banking

and corporate finance group. MCB showed an improvement in

profits because of its retail and consumer banking. The

increase in SCB profits is associated with the

acquisition of Union Bank.

ROE 2006, 2007

39

44.5

67.8

106.4

43.7

33.9

32.8

68.1

-23.2

41.3

50.5

56.6

67.5

43.9

21

20.2

28.6

6

-40 -20 0 20 40 60 80 100 120

ABL

UBL

MCB

Abn Amro

Citi Bank

Meezan Bank

Bank Al Falah

Standard Chartered

KASB Bank

ROE 2006 ROE 2007

Figure IV.24 Banks’ return on Equity 2006 & 2007

Assets 2006-2007

192.574

358.056

299.712

59.584

76.474

31.224

248.222

113.558

20.471

32.019

252.027

435.89

343.178

71.433

91.316

47.009

275.111

249.796

27.111

46.429

0 50 100 150 200 250 300 350 400 450 500

ABL

UBL

MCB

Abn Amro

Citi Bank

Meezan Bank

Bank Al Falah

Standard Chartered

KASB Bank

NIB

Assets 2006 Assets 2007

Figure IV.25 Banks’ assets 2006 & 2007

annual Loan growth rate 2006-2007

55.6

31.1

20.2

9.6

24.7

48

29.9

60.7

62.7

0 10 20 30 40 50 60 70

ABL

UBL

MCB

Abn Amro

Citi Bank

Meezan Bank

Bank Al Falah

Standard Chartered

NIB

annual Loan growth rate 2006-2007

Figure IV.26 Banks’ loan growth rate

Table IV.2 Banks’ Credits ratings 2007

Banks Rating Agency Ratings assigned

Short Term Long Term

ABL JCR-VIS

PACRA A1+

A+

AA

UBL JCR-VIS A-1+ AA+

MCB PACRA A1+ AA+

Abn Amro

Pakistan

PACRA A1+ AA

Citi Bank Standard & Poor ---------- -----------

Meezan Bank JCR-VIS A-1 A+

Bank Al Falah PACRA A1+ AA

STC PACRA A1+ AAA

JCR-VIS

A-1+

AA+

NIB PACRA A1 A+

KASB PACRA A1 A

CHAPTER V CONCLUSION AND RECOMMENDATIONS

In the light of things and issues discussed above, it’s

obvious that the changing banking environment and

paradigm has increased the complexity of operations and

business. The businesses have increased their portfolio

risk and operational risk too. Also the Pakistani banking

industry is under the intense pressure of changing

governmental and other operations. The central bank

operations may be affected and the banking industry has

to handle the enhanced exposures to not only the

corporate risk, but also the household sector.

The following is recommended for some banks:

Banks like ABL, UBL, MCB, NIB, STC, KASB, and Meezan

have no problem with their capital base. They can

simply go for Basel II standards. (It is estimated

that these banks will have increased capital for

year 2008).MCB announced its GDR which can increase

capital. NIB after acquiring PICIC has increased its

capital base. Bank Al Falah would have no problems

since it has already announced to increase its

capital base to Rs. 15 billion in 2008.

Citi Bank has achieved little growth in its capital

base and reserves for the last one year. It may

acquire some local bank or can either merge with

some stronger bank to increase its capital base.

Citi Bank may find it difficult to meet Basel II

requirements.

Abn Amro has sufficient capital base but has to make

it to 6 billion. Also, the bank needs to change its

credit rating procedures from MDDR and OBI to Basel

II. Basel II covers all the three kinds of risks

(i.e. market, credit and operational. The STC is

using three different models i.e. Delta, VAR and

OCB for market risk, and MDDR, OBI for credit risk).

FWBL will have to merge with a stronger bank or get

acquired by some other bank to maintain the Basel II

standards. Also My bank may fall prey to mergers if

it doesn’t increase its capital base. Provincial

banks like Bank of Khyber would see a difficult time

in 2008-2009.

The SME and microfinance exposures also require better

risk management procedures. The SBP has taken a proactive

initiative in the regulation of the local banks. The

sound increased growth and diversity of businesses need

better regulatory and supervisory procedures now. The

macroeconomic pressures also make the adoption of Basel

II important. The results from differ banks show that

they would be prone to more credit and operational risk

during the next decade. The credit risk weight has been

quite high in the last decade and some regular capital

needs to be assigned against it.

In the short run, local banks would have to continue the

risk management procedures through better understanding

of market and credit risk both. It may be a bit costly

for some banks to adopt the Basel II regulatory

procedures, but this should be considered as an

investment. A more fundamental credit risk ratings

approach needs to be adopted. Also a change is required

in the risk methodology and procedures too. The new and

advanced credit risk rating procedures need to be adopted

to ensure better banking supervision. The SBP would

continue to take the initiative and recommend banks to

adopt the standards. It would continue its alignment with

the local banks and make sure that the banking industry

prospers more under the surveillance of SBP, under the

compliance of international supervision procedures.

So it’s recommended for banks with more complex

operations to adopt the standardized credit rating

approach. The local banks with more complicated

operations would go for IRB credit rating approach.

The data showed from different banks that some of the

local banks usually have strived well increasing their

capital base. Some banks have already qualified for the

Basel II standards. The capital requirements are aligned

with the Basel II minimum capital requirements. Some

banks are in the process of reaching the desired level of

capital requirements and would be able to attain it by

the end of 2009. The capital requirements may drive some

players out of the competition or may result in their

disappearance. A better standard for such small banks

would be consolidation or merger. A merger would help in

small banks achieve the capital standards and hence

continue their existence too.

The Basel II capital increase requirement would certainly

drive out some small banking industry players out of the

competition. This may result in complete ebb. The small

banks with weak credit rating and meager capital base

seriously need to do something. Its visible that in order

to meet the capital needs, some small players would need

to merge and lot of consolidations would take place in

the banking sector in the next few years. The number of

banks may increase, since consolidations would take

place. The local banking industry has already seen about

twenty five mergers in the last six years. The most

famous acquisition is of PICIC by NIB and Union Bank by

Standard Chartered Bank. The Samba Financial Group of

Saudi Arabia would be acquiring Crescent Commercial Bank,

and ABN Amro has already acquired Prime Commercial. Citi

Bank is also in the process of acquiring Soneri Bank.

The banking sector would definitely be taking a new

shape. It’s recommended also. The banking sector needs to

fulfill the capital requirements of Basel II. Mergers and

acquisitions is the only solution that can let banks

sustain themselves. This would create some synergistic

benefits too. Mergers may have their own pros and cons

but it ensures survival of small banks too.

The strengthening of the financial and banking sector is

only ensured by mergers and acquisitions. This would also

affect and shrink the banking industry. The large pie

which was divided into 10 pieces would be now divided

into 5 pieces only. One most recent development is that

Barclays group is taking keen interest in acquiring stake

in banking sector in Pakistan.