“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 www.nbp.org.pk

Pakistan

Habib Bank Ltd. www.hbl.com.pk

First Women Bank www.fwbl.com.pk

Ltd.

Privatized banks

Allied Bank Ltd. www.abl.com.pk

United bank Ltd. www.ubl.com.pk

Muslim Commercial www.mcb.com.pk

bank Ltd.

Specialized banks

Agricultural www.adbp.org.pk
Development Bank
(ADBP)

Industrial www.idbp.com.pk
Development bank
of Pakistan

Private Scheduled Banks

Punjab Provincial
Co-operative Bank
Ltd. (PPCB)
SME Bank Ltd. www.smebank.org

Private Scheduled banks

Askari Commercial www.askaribank.com.pk

bank

Bank Al-Falah www.bankalfalah.com

Ltd.

Bank Al-Habib www.bankalhabib.com

Ltd.

Bolan bank Ltd. www.mybankltd.com

Faysal Bank Ltd. www.faysalbank.com.pk

Meezan bank Ltd. www.meezanbank.com

Metropolitan Bank www.metrobank.com.pk

Ltd.

Platinum
Commercial bank
Ltd.

Soneri bank Ltd. www.soneribank.com

Pak Saudi www.saudipakbank.com

Commercial bank
Ltd.

The Bank Of www.bok.com.pk Provincial

Khyber before

Bank of Punjab www.bop.com.pk Provincial

before

Investment Banks

Atlas Investment www.atlasgrouppk.com

Bank Limited

Cresent
Investment Bank
Limited
First www.interbank.com.pk
International
Investment Bank
Limited

Jehangir
Investment Bank
Limited

Orix Investment www.orixbank.com

Bank (Pak)
Limited

Trust Investment www.trustbank.com.pk

Bank Limited

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.
 Doubt
Pas
Specia
Performi
Uncerta
Basel
Recovery
Back
End-of-
Timeline
Risk to non-
Timeline
l ng
IIs n
iyear
default
class
loans level
default

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

Greater specialization

Move away from buy-hold

Increased use of derivatives for

risk

Proactive portfolio risk management

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

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

Changes in competitive landscape

Changes in product pricing

Proper risk assessment

Comprehensive risk information

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

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

Better risk-return
assessment for
business

Better risk
concentration
understanding

Better timely and

Quality risk
information

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

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

Maintaining standards

Disclosure requirements

Compliace with regulators

Maintaining IRB

Skilled resources for standards

Data infrastructure

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

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 with no
answer , 3%,
3% Banks agreed
to 2006 year,
5%, 5%
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
No answer, 4%

IRB Advanced ,
3%
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 Year 2007 Reserv Reserves

capital capital es 2007
(in billions (in billions 2006
PKR) PKR)

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 3.779 3.779 0.528 0.728

Bank

Bank Al 5 6.5 2.749 2.414

Falah

Standard 38.715 38.715 1.11 1.92

Chartered

KASB bank 2.2 3.1 0.11 0.11

 Earning After Tax 2006-2007 in billions

Bank 0.124
KASB -0.048
7.618
Standard Chartered 5.5

1.907
Bank Al Falah 2.036

0.926
Meezan Bank 0.986

Citi Bank 2.575

2.594
3.044
Abn Amro 2.19

18.941
MCB 13.341

14.5
UBL 9.707

6.661
ABL 4.834

-5 0 5 10 15 20

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

KASB Bank 6
-23.2

Standard Chartered 28.6

68.1

Bank Al Falah 20.2

32.8

Meezan Bank 21
33.9

Citi Bank 43.9

43.7

Abn Amro 67.5

106.4

MCB 56.6
67.8

UBL 50.5
44.5

ABL 41.3
39

-40 -20 0 20 40 60 80 100 120

ROE 2006 ROE 2007

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

Assets 2006-2007

NIB 46.429
32.019
KASB Bank 27.111
20.471
Standard Chartered 249.796
113.558
Bank Al Falah 275.111
248.222
Meezan Bank 47.009
31.224
Citi Bank 91.316
76.474
Abn Amro 71.433
59.584
MCB 343.178
299.712
UBL 435.89
358.056
ABL 252.027
192.574

0 50 100 150 200 250 300 350 400 450 500

Assets 2006 Assets 2007

Figure IV.25 Banks’ assets 2006 & 2007

 annual Loan growth rate 2006-2007

NIB 62.7

Standard Chartered 60.7

Bank Al Falah 29.9

Meezan Bank 48

Citi Bank 24.7

Abn Amro 9.6

MCB 20.2

UBL 31.1

ABL 55.6

0 10 20 30 40 50 60 70

annual Loangrowthrate2006-2007

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 A+

PACRA A1+ AA

UBL JCR-VIS A-1+ AA+

MCB PACRA A1+ AA+

Abn Amro PACRA A1+ AA

Pakistan

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.