COMMERCIAL BANKING

CAPITAL RISK MANAGEMENT

ASKARI BANK AND BANK ALFALAH

BAHRIA UNIVERSITY ISLAMABAD

CAMPUS
Submitted To:

Submitted By:

ACKNOWLEDGEMENT
First and foremost we are thankful to Allah for giving us the mind to think,
heart to fell and strength to complete this report.
We would also like to thank our course instructor, Maam Huma Ayub for her
advice and suggestions to this report. Without the assistance of her, it would
have been difficult and stupendous for our group with meager resources at
its disposal to accomplish it
We are thankful to the respectable personnel of Askari Bank Limited and
Bank Al-Falah bank for their time and effort to provide us the essential
information, which helped to complete our project successfully. We are
especially thankful to the following employees of the respective banks
Askari Bank:

Mr. Khalil Chaudary (VP-Head Credit Risk)

Mr. Haider

Mr. Burhan Iftikhar

Ms. Huma Khalid

Bank Al-Falah

Mr. Zeeshan Tanveer

Mr. Zia Hanf

TABLE OF CONTENTS
INTRODUCTION................................................................................................
1
INTRODUCTION................................................................................................1
PROBLEM STATEMENT......................................................................................
3
STATEMENT......................................................................................3
LITERATURE REVIEW........................................................................................
4
REVIEW........................................................................................4
METHODOLOGY..............................................................................................
10
METHODOLOGY..............................................................................................10
FINDINGS.......................................................................................................
11
FINDINGS.......................................................................................................11
ASKARI BANK..............................................................................................
11
BANK..............................................................................................11
BANK ALFALAH............................................................................................
17
ALFALAH............................................................................................17
RECOMMENDATIONS......................................................................................
23
RECOMMENDATIONS......................................................................................23
CONCLUSION..................................................................................................
25
CONCLUSION..................................................................................................25
BIBLIOGRAPHY...............................................................................................
26
BIBLIOGRAPHY...............................................................................................26

TABLE OF FIGURES

Figure 1 Risk Management Framework.............................................................

Framework.............................................................ii
Figure 2: Components of Regulatory Capital of ABL.........................................
ii
ABL.........................................ii
Figure 3 Capital Adequacy Ratio.....................................................................
iii
Ratio.....................................................................iii
Figure 4 Credit Risk Exposure.........................................................................
iv
Exposure.........................................................................iv
Figure 5 Loan Classifcation And Provisioning.................................................
iv
Provisioning.................................................iv

INTRODUCTION
A commercial bank acts an intermediary between surplus units (entities
having excess of fund) and defcit units (entities in need of funds). The
essentiality of a commercial bank for a country cannot be described enough
as it plays various roles, for instance it also plays an important role in
enhancing economic conditions of the country by allowing people to engage
in various economic activities using borrowed funds. Banks are a
fundamental component of the fnancial system, and are also active players
in fnancial markets. Therefore it is important to ensure safety and soundness
of fnancial system of the country by putting up parameters for banks.
Capital risk is closely tied to the asset quality and a bank's overall risk
profle. Banks and fnancial institutions are faced with long-term future
uncertainties, which they intend to account for. It is in this context that the
Basel Accords were created, aiming to enhance the risk management
functions of banks and fnancial institutions. Basel II provides directives on
the regulatory minimum amount of capital that banks should hold against
their risks, such as credit risk, market risk, operational risk and others.
Basically, capital provides a cushion for banks to absorb losses and also
provides ready access to fnancial markets, guards against liquidity
problems. The more risk taken, the greater is the amount of capital required.
To hold more capital means forcing banks to have more of their own funds at
risk. Even a bank's dividend policy affects its capital risk by influencing
retained earnings. So managing the capital risk through different techniques
is the important concern of the bank.
Basel II is the second of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking
Supervision. The purpose of Basel II, which was initially published in June
2004, is to create an international standard that banking regulators can use
when creating regulations about how much capital banks need to put aside
to guard against the types of fnancial and operational risks banks face.
Advocates of Basel II believe that such an international standard can help
protect the international fnancial system from the types of problems that
might arise should a major bank or a series of banks collapse. In practice,
Basel II attempts to accomplish this by setting up rigorous risk and capital
management requirements designed to ensure that a bank holds capital
reserves appropriate to the risk the bank exposes itself to through its lending
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and investment practices. Generally speaking, these rules mean that the
greater risk to which the bank is exposed, the greater the amount of capital
the bank needs to hold to safeguard its solvency and overall economic
stability.
Financial stability exists when the fnancial system is resilient to a wide range
of economic and fnancial shocks, and able to absorb fnancial crisis losses
with least disruption. It cannot be emphasized enough that the soundness
and efficiency of banks to manage various risk including the capital risk
which is important as it matters a lot for fnancial stability. Therefore, in
Pakistan, Basel Accords recommendations are enforced by State Bank of
Pakistan in their guidelines that are provided to the banking industry so that
commercial banks can tailor their operations accordingly. We can see that
this system is effective in many ways.
The purpose of this project is to see implementation of Basel II in form of SBP
regulations in commercial banks and see how it effectively manages its
capital by mitigating the risks associated with all bank businesses with
special emphasis on credit risk. We have chosen two banks that are
successfully working with risk management framework as prescribed by SBP:
Askari Bank Limited and Bank Al-Falah. We will look into their capital
management techniques with thorough study of their credit risk mitigation.

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PROBLEM STATEMENT
To fnd out how Askari and Alfalah Bank manages the capital risk
and what type of techniques they uses for credit risk evaluation
and assessment as to mitigate their credit risk exposure

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LITERATURE REVIEW
Risks are usually defned by the adverse impact on proftability of several
distinct sources of uncertainty. While the types and degree of risks an
organization may be exposed to depend upon a number of factors such as its
size, complexity business activities, volume etc, it is believed that generally
the banks face Credit, Market, Liquidity, Operational, Compliance / legal
/regulatory and reputation risks. Before overarching these risk categories,
given below are some basics about risk Management and some guiding
principles to manage risks in banking organization.1
Banks are invariably faced with different types of risks that may have a
potentially negative effect on their business. Risk management in bank
operations includes risk identifcation, measurement and assessment, and its
objective is to minimize negative effects risks can have on the fnancial
result and capital of a bank. Banks are therefore required to form a special
organizational unit in charge of risk management. Also, they are required to
prescribe procedures for risk identifcation, measurement and assessment,
as well as procedures for risk management.
In every fnancial institution, risk management activities broadly take place
simultaneously at following different hierarchy levels.
a) Strategic level: It encompasses risk management functions performed
by senior management and BOD. For instance defnition of risks, ascertaining
institutions risk appetite, formulating strategy and policies for managing
risks and establish adequate systems and controls to ensure that overall risk
remain within acceptable level and the reward compensate for the risk taken.
b) Macro Level: It encompasses risk management within a business area or
across business lines. Generally the risk management activities performed by
middle management or units devoted to risk reviews fall into this category.
c) Micro Level: It involves On-the-line risk management where risks are
actually created. This is the risk management activities performed by
individuals who take risk on organizations behalf such as front office and
loan origination functions. The risk management in those areas is confned to
following operational procedures and guidelines set by management.
1 http://www.sbp.org.pk/riskmgm.pdfDate Visited: May 25th, 2010

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The risks to which a bank is particularly exposed in its operations are:

liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk
and risk from change in market price of securities, fnancial derivatives and
commodities), exposure risks, investment risks, risks relating to the country
of origin of the entity to which a bank is exposed, operational risk, legal risk,
reputational risk and strategic risk.2
NEED OF BASEL 1
From 1965 to 1981 there were about eight bank failures (or bankruptcies) in
the United States. Bank failures were particularly prominent during the '80s,
a time which is usually referred to as the "savings and loan crisis". Banks
throughout the world were lending extensively, while countries' external
indebtedness was growing at an unsustainable rate.
As a result, the potential for the bankruptcy of the major international banks
because grew as a result of low security. In order to prevent this risk, the
Basel Committee on Banking Supervision, comprised of central banks and
supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland.
The Basel Committee consists of representatives from central banks and
regulatory authorities of the Group of Ten countries, plus others (specifcally
Luxembourg and Spain). The committee does not have the authority to
enforce recommendations, although most member countries (and others)
tend to implement the Committee's policies. This means that
recommendations are enforced through national (or EU-wide) laws and
regulations, rather than as a result of the committee's recommendations thus some time may pass between recommendations and implementation as
law at the national level.3
The committee drafted a frst document to set up an international 'minimum'
amount of capital that banks should hold. This minimum is a percentage of
the total capital of a bank, which is also called the minimum risk-based
capital adequacy. In 1988, the Basel I Capital Accord (agreement) was
2 http://www.nbs.rs/export/internet/english/55/55_6/index.htm l Date Visited: May 25th, 2010

3 http://en.wikipedia.org/wiki/Basel_AccordsDate Visited: May 27th, 2010

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created. The Basel II Capital Accord follows as an extension of the former,

and should be implemented in 2007. In this article, we'll take a look at Basel I
and how it impacted the banking industry as it enters the Basel II phase.
The Purpose of Basel I
In 1988, the Basel I Capital Accord was created. The general purpose was to:
1. Strengthen the stability of international banking system.
2. Set up a fair and a consistent international banking system in order to
decrease competitive inequality among international banks.
The basic achievement of Basel I have been to defne bank capital and the
so-called bank capital ratio. In order to set up a minimum risk-based capital
adequacy applying to all banks and governments in the world, a general
defnition of capital was required. Indeed, before this international
agreement, there was no single defnition of bank capital. The frst step of
the agreement was thus to defne it.
Two-Tiered Capital
Basel I defne capital based on two tiers:
1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holders
equity) and declared reserves, such as loan loss reserves set aside to
cushion future losses or for smoothing out income variations.
2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital
such as gains on investment assets, long-term debt with maturity greater
than fve years and hidden reserves (i.e. excess allowance for losses on loans
and leases).
In 1996 the Basel I agreement was revised to incorporate market risk. As a
result, the new defnition of capital ratio is defned as: Market risk includes
general market risk and specifc risk. The general market risk refers to
changes in the market values due to large market movements. Specifc risk
refers to changes in the value of an individual asset due to factors related to
the issuer of the security. There are four types of economic variables that
generate market risk. These are interest rates, foreign exchanges, equities
and commodities. The market risk can be calculated in two different
manners: either with the standardized Basel model or with internal value at
risk (VAR) models of the banks. These internal models can only be used by
the largest banks that satisfy qualitative and quantitative standards imposed
by the Basel agreement. Moreover, the 1996 revision also adds the
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possibility of a third tier for the total capital, which includes short-term
unsecured debts. This is at the discretion of the central banks.
Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main
criticisms include the following:

Limited differentiation of credit risk

There are four broad risk weightings (0%, 20%, 50% and 100%), as
shown in Figure1, based on an 8% minimum capital ratio.
Static measure of default risk
The assumption that a minimum 8% capital ratio is sufficient to protect
banks from failure does not take into account the changing nature of
default risk.
No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity
of a credit exposure.
Simplified calculation of potential future counterparty risk
The current capital requirements ignore the different level of risks
associated with different currencies and macroeconomic risk. In other
words, it assumes a common market to all actors, which is not true in
reality.
Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the
risk reduction through portfolio diversifcation. Therefore, summing all
risks might provide incorrect judgment of risk. A remedy would be to
create an internal credit risk model - for example, one similar to the
model as developed by the bank to calculate market risk. This remark
is also valid for all other weaknesses.
These listed criticisms have led to the creation of a new Basel Capital
Accord, known as Basel II, which adds operational risk and also defnes
new calculations of credit risk. Operational risk is the risk of loss arising
from human error or management failure.4

BASEL II

4 http://www.investopedia.com/articles/07/BaselCapitalAccord.asp Date Visited: May 25th,

2010

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Basel Committee on Banking Supervision (BCBS) fnalized the New Capital

Adequacy framework commonly known as Basel II in June 2004. This new
capital adequacy regime offers a comprehensive and more risk sensitive
capital allocation methodology for major risk categories. Basel II framework
comprises of three parts referred to as three pillars of the Accord; Pillar I,
which is about minimum capital requirement, prescribes the capital
allocation methodology against credit and operational risks. The capital
requirement for Market risk remains the same as envisaged under Basel I in
1996. The risks, which are not captured under pillar I, are covered in pillar II.
Pillar II of the New Accord outlines the supervisory review process of the
capital adequacy of banks. It requires banks to establish a robust risk
management framework to identify, assess and manage major risks inherent
in the institution and allocate adequate capital against those risks. The
supervisor has to review the adequacy of risk management function and
capital allocation mechanism against major risks including those that are not
covered under pillar I i.e. Liquidity Risk, Concentration risk, Interest rate Risk
in Banking Book etc. and ensures it commensurate with the size and nature
of business of the institution. The pillar 3 of the Accord sets out disclosure
requirement depending upon which particular approach of Pillar I the
institutions adopt for calculating Minimum Capital Requirement. The New
Capital Accord is not mandatory even for the member countries of the BCBS.
However, there is consensus among member countries to adopt Basel II
standardized approach by the end of 2006 and advance approaches by 2007.
Among Non Member countries Basel II is expected to be adopted by most of
the economies in 2008 or later on.
Why Basel II?
The Basel I had a number of flaws. For instance, it provided one size ft all
approach and did not differentiate between assets having less risk and
assets having higher risk. There was no capital allocation against operational
risk as well as no consideration was given to other risks such as
concentration risk, liquidity risk etc. The new accord has risk management
embedded in it; so it will be a driving force for bringing improvement in risk
management capabilities of banks. Basel II provides incentive to banks
having good risk management and punishes those that are not managing
their risk profle appropriately by requiring higher capital.
On the basis of foregoing and keeping in view the global response towards
Basel II, SBP has, in principle, decided to adopt Basel II in Pakistan. The
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ensuing pages outline a proposed Roadmap for the implementation of Basel

II in Pakistan. While preparing this Roadmap, the State Bank has conducted a
survey to assess the existing capacity of the banks and their fnancial
position to meet additional capital requirement. The plans of other countries
for adoption of Basel II have also been reviewed. Efforts have been made to
draw a realistic timeline so as to give banks sufficient time to prepare
themselves for meeting the requirement of Basel II.5
TRADITIONAL METHOD TO CREDIT RISK MANAGEMENT
TRADITIONAL APPROACH:
It is hard to differentiate between the traditional approach and the new
approaches since many of the ideas of traditional models are used in the
new models. The traditional approach is comprised of four classes of models
Expert Systems
In the expert system, the credit decision is left in the hands of the branch
lending officer. His expertise, judgment, and weighting of certain factors are
the most important determinants in the decision to grant loans. the loan
officer can examine as many points as possible but must include the fve
Cs these are; character, credibility, capital, collateral and cycle (economic
conditions) in addition to the 5 Cs, an expert may also take into
consideration the interest rate.
Artificial Neural Networks
Due to the time consuming nature and error- prone nature of the
computerized expertise system, many systems use induction to infer the
human experts decision process. The artifcial neural networks have been
proposed as solutions to the problems of the expert system. This system
simulates the human learning process. It learns the nature of the relationship
between inputs and outputs by repeatedly sampling input/output
information.
Internal Rating at Banks
Over the years, banks have subdivided the pass/performing rating category,
for example at each time, there is always a probability that some pass or
5 www.sbp.org.pk/bsd/2005/C3_ROADMAP-Basel.pdf Date Visited: May 17th, 2010

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performing loans will go into default, and that reserves should be held
against such loans.
Credit Scoring Systems
A credit score is a number that is based on a statistical analysis of a
borrowers credit 1report, and is used to represent the creditworthiness of
that person. A credit score is primarily based on credit report information.
Lenders, such as banks use credit scores to evaluate the potential risk posed
by giving loans to consumers and to mitigate losses due to bad debt. Using
credit scores, fnancial institutions determine who are the most qualifed for a
loan, at what rate of interest, and to what credit limits (Wikipedia, 2008). 6
Contingency planning: Institutions should have a mechanism to identify
stress situations ahead of time and plans to deal with such unusual situations
in a timely and effective manner. Stress situations to which this principle
applies include all risks of all types. For instance contingency planning
activities include disaster recovery planning, public relations damage control,
litigation strategy, responding to regulatory criticism etc.

6 http://his.diva-portal.org/smash/get/diva2:2459/FULLTEXT01 Date Visited: May 25th, 2010

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METHODOLOGY
As to conduct our project research, we will use both primary and secondary
data
SAMPLE SIZE

Two banks

SECONDARY RESEARCH

Internet
News Articles

PRIMARY RESEARCH

Interview with Bank Managers.

ASKARI BANK
INTERVIEW WITH KHALIL
CHUADHRY

BANK ALFALAH
INTERVIEW WITH ZEESHAN
TANVEER

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FINDINGS
ASKARI BANK
Askari Bank Limited takes pride in being one of the commercial banks in
Pakistan that is effectively managing risk through an efficient risk
management framework. The Bank strives to to effectively manage and
mitigate all kinds of risks inherent in the banking business. (Risk
management framework can be referred in Annexure; fgure 1)
According to the Annual Report of 2009, Askari Bank enjoys the entity rating:
Long term: AA
Short term: A1+
RISK MANAGEMENT
The Bank has provided an overview of their risk management in their annual
report. Risk Management is a core function at the Bank that performs critical
activities of measuring, monitoring, controlling and reporting credit, market,
liquidity, operational and other risks. The risk management framework of the
Bank covers (i) risk policies and limits structure, (ii) risk infrastructure and
(iii) risk measurement methodologies.
In the Annual Report of 2009, the Bank outlines its Capital Risk management
as follows:
CAPITAL ADEQUACY
Scope of Applications
Standardized Approach is used for calculating the Capital Adequacy for
Market and Credit risk while Basic Indicator Approach (BIA) is used for
Operational Risk Capital Adequacy purpose.
The Bank has two subsidiaries, Askari Investment Management Limited
(AIML) and Askari Securities Limited (ASL). AIML is the wholly-owned
subsidiary of Askari Bank Limited while ASL is 74% owned by the Bank. Both
these entities are included while calculating Capital Adequacy for the Bank
using full consolidation method. The fact that Askari Bank has neither any
signifcant minority investments in banking, securities, or any other fnancial
entities nor does it has any majority or signifcant minority equity holding in
insurance excludes it from a need for further consolidation. Furthermore, the
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Bank does not indulge in any securitization activity that shields it from the
risk inherent in securitization.
The risk-weighted assets are determined according to specifed requirements
of the State Bank of Pakistan that seek to reflect the varying levels of risk
attached to on-balance sheet and off-balance sheet exposures. The total riskweighted exposures comprise the credit risk, market risk and operational
risk.
Types of Exposures and ECAIs used
For domestic claims, ECAIs recommended by the State Bank of Pakistan
(SBP), namely Pakistan Credit Rating Agency Limited (PACRA) and JCR-VIS
Credit Rating Company Limited (JCR-VIS) were used. For foreign currency
claims on sovereigns, risk weights were assigned on the basis of the credit
ratings assigned by Moodys. For claims on foreign entities, rating of S&P,
Moodys, and Fitch Ratings were used. Foreign exposures not rated by any of
the aforementioned rating agencies were categorized as unrated.
Type of exposures for which each agency is used in the year ended 2009 is
presented below

Capital adequacy ratio as at December 31, 2009

The capital to risk weighted assets ratio, calculated in accordance with the
State Bank of Pakistans guidelines on capital adequacy, using Basel II
standardized approaches for credit and market risks and basic indicator
approach for operational risk is presented in Figure 2 & 3 in Annexure. 7

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7 http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf Accessed on:
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Credit Risk

Market Risk Management Department: This department develops and

implements the market risk policy and risk measuring / monitoring
methodology, and reviews and reports market risk against regulatory and
internal limits. Basically this department deals with risk related to banks
investments for e.g. treasury bills, preference shares etc.
Operational Risk Management (ORM) Department: it has been
established to increase the efficiency and effectiveness of the Banks
resources, minimize losses and utilize opportunities. This department deals
with risk related to banks day to day operations such as Account Opening,
Fraud cases etc.
Credit Risk Department is further divided into two departments.
Post Facto Review
Basel Implementation.
The role of the subdivisions will be discussed later in detail as they are main
scope of project.
Policy Department: it is responsible for formulation of policies in light of all
the bank business risks prevailing. These policies are made in discussion and
results are communicated to Country Head for approval. Once the policies
have been approved, these are communicated across the respective
Departments.
ROLE OF POST FACTO REVIEW & BASEL IMPLEMENTATION DIVISIONS
Basel Implementation Division
During the Interviews, this is how the credit risk department views the
signifcance and effectiveness of Basel Accord II: In earlier times, banks were
lending on the basis of deposits: lending ratio, meaning the banks lending
decision and calculations were based on its deposit base. Bank of
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International Settlements (BIS) took the initiative of making lending activities

more sophisticated with more emphasis on risk mitigation in terms of credit
risk; this led to the formulation of Basel Accords.
Basel Accord II is a more conservative method to mitigate credit risk which
requires banks to keep check on credit, operational and market risk to
manage its capital. Basel Accord II restricts the risk to be born by depositors
to minimum level arising from the banks lending activities. It requires banks
to share risk by injecting its own capital when investing in riskier assets in
form of loans and advances.
The type of capital being maintained at Askari Bank Limited is regulatory
capital, and as the name implies, it is regulated by the Central Bank (SBP).
The Bank is required to quantify risk weighted assets and set aside capital
according to the risk bank undertakes.
Basel Implementation Division is responsible for:
Implementation of Basel Accords, mainly Basel Accord II in lending
activities, and
Calculations of Capital Adequacy Ratio based on guidelines of SBP.
When the department receives the report for loan request, the frst step is to
categorize it in any one of the following:
Retail portfolio
Mortgage
Corporate
Public/ sector enterprise (PSE)
Government
Past due exposure
The treatment of each category is uniquely designed by the Bank under the
SBP guideline.
The department then checks the collateral. A few examples of the collateral
taken by the bank as specifed by the SBP are:
Cash margins or deposit
Gold reserves
Government securities
The bank then calculates the Risk Weighted Assets= Exposure Eligible
Collateral. By clubbing all these risk weighted assets, the department
calculates the capital it needs to set aside. The Credit Risk exposure of 2009
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is in fgure 3: Capital Adequacy Ratio is calculated by Standardized method= Total

Regulatory Capital/ RWAs
Post Facto Review Division
This division is responsible for monitory of the loans disbursed. They use
different models to analyze the performance of loans. The models conduct
quantitative analysis by checking profts, trend analysis of Cash Flows and
so, as well as qualitative analysis by checking management practices and
performance. The bank gives more weight age to qualitative measures as it
provides an insight into the character of entity, for e.g., does the borrower
intend to repay the loan.
The Post Facto Reviews for borrowers are done after regular intervals to know
about the current position. Based on the results of various analyses, the
division raises alarm if it cites problems in the loan performance, and future
course of action with the customer is planned. For example, Bank is now
restricting its credit facilities to Textile sector to rare cases, since it has been
moved from low risk to high risk due to greater no. of NPLs arising from
recent events like strikes, decline in textile performance, fluctuating
government policies etc.
PROBLEMS FOR CREDIT RISK MITIGATION EXTERNAL FACTORS
According to Askari Bank, different environmental factors have a direct while
some have indirect impact on credit risk for bank:
Fluctuating Government policies: fluctuations in government policies
hit many sectors badly, rendering them incapable to repay loans,
leading to increase in NPLs.
Energy Crisis: this has led to deterioration in performance of many onetime leading and favorable entities to provide credit like Textile Sector.
Inflation: burden of individuals/ corporations etc. increase, they are
likely to default.
Unemployment: downsizing, limited job opportunities and so leads to
inability to pay off loans.
PROBLEMS FOR CREDIT RISK MITIGATION DUE TO INTERNAL
FACTORS

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As Askari Bank has a decentralized system, problem often arises from

Management Information System to gather data from all sources that leads
to problems in calculating CAR. It may happen that information from some
departments maybe delayed, or reports may have flaws; data collection and
processing of bulk of data takes time, and bank often faces time constraint in
submitting the Capital Adequacy return report required by SBP at required
time due to these factors.
ASKARI BANKS PRACTICE CLASSIFICATION AND PROVISIONING
This is done as per the type of facility and according to SBPs regulation. For
example, if bank has lent credit for auto loans, according to SBP guidelines
the loan shall be classifed and provisioning shall be made according to
Figure 4 in Annexure.
IMPROVEMENTS IN ASKARI BANKS CAPITAL ADEQUACY RATIO
MEASUREMENT
Askari Bank has embarked upon a major initiative of overhauling its
technology infrastructure with the aim of upgrading business and operational
capabilities while improving quality of customer service.
For this purpose, fve new software application products have been acquired
and are currently in different stages of implementation. One of these
includes a Risk Management System.
The bank is in process of
implementing IFLEX Reveleus, risk management software of Oracle
fnancial Services Solution, having the ability to generate live Capital
Adequacy Ratio and at day end generate report.
The key features of this product include:
Pre-confgured reports covering Pillar I and Pillar II reporting
Enables tabular as well as graphical reporting
Drill-through functionality allows for detailed analysis
Risk measures and capital numbers displayed as point in- time values,
trends, heat maps, distributions etc.
Metrics displayed across multiple levels and risk categories8
8 http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf
http://www.oracle.com/us/industries/fnancial-services/046223.pdf
Date Visited: June 7th, 2010

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BANK ALFALAH
Bank Alfalah manages the capital as to safeguard its ability to absorb large
unexpected losses and to protect depositors and other claim holders. It is the
policy of the bank to maintain a strong capital base so as to maintain
investor, creditor, and market confdence and to sustain future development
of the business. PACRA, a premier rating agency of the country, has rated the
bank AA (double A), Entity Rating for long term and A1+ (A one plus) for the
short term.
GOALS OF MANAGING CAPITAL
The goals of managing capital of the Bank are as follows:
To be an appropriately capitalized institution, considering the
requirements set by the regulators of the banking markets where the
Bank operates
Maintain strong ratings and to protect the Bank against unexpected
events
Availability of adequate capital at a reasonable cost so as to enable the
Bank to operate adequately.
RISK MANAGEMENT
Bank Alfalah has in place an approved integrated risk management
framework for managing credit risk, market risk, liquidity risk and operational
risk under risk management policy and risk management and internal control
manual according to SBP prescription. In it, the risk awareness culture is
being encouraged by communicating the principles of proper risk
management to all bank employees.
Following is the governance structure and important policies on risk
management of the bank

The board of directors through sub committee called board risk

management committee (BRMC) oversees the overall risk of bank

Risk Management Division (RMD) is the organizational arm performing

the functions of identifying measuring monitoring and controlling the
various risks and assists other various sub committees in conversion of
polices into action.
Page | 19

As part of its mandate the central management committee is entrusted

with overseeing the operational risk of the bank.

After reviewing the Basel II, the bank has exclusively pursued the
implementation of Basel II with the help of external consultants and
has compiled with all pillars requirements of Basel II.

In the light of SBP circulars and guidelines, signifcant progress has also
been made in respect of advance approaches of Basel II.

The bank has acquired temenos T24 banking system as its core
banking solutions and its risk management system called T-Risk used
for managing credit market and operational risk.

A watch list procedure is also functioning which identifes loans

showing early warning signals of becoming non-performing.

CREDIT RISK MITIGATION

For managing the credit risk under the regulatory capital, Bank Alfalah has
developed a procedural manual and processes that have been set for fnetuning systems and procedures, informational technology capabilities and
risk governance structure as to meet the advanced approaches as well. For
the implementation of Basel II advance approaches, bank is considering
appointment of a consultant frm to assist it in this regard.
Moreover, Credit Risk Department looks after all the aspects of credit risk
and Head of the Credit Risk Department reports directly to the General
Manager (GM) in Risk Management Division.
Following are some measures the Bank Alfalah conducts before accepting the
loan request as to mitigate credit risk.
Know your customer
Purpose of lending
Financial statements including ratio analysis
Working style: whether the customers do business on credit or cash?
As to know the integrity of the customer they check the CIB report
which provide a consolidated picture of a borrower as of a given date
based on the information/data supplied by the banks.
Market reputation
Debt history etc
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Standardized Approach VS Internal Rating Based

Bank Alfalah uses both approaches.
Standardized Approach
The bank, as per State Bank of Pakistans guideline, has migrated to Basel II
as on January 01, 2008, with Standardized Approach. So for the purpose of
estimating credit risk weighted assets, the Bank Alfalah limited is using
standard approach of SBP Basel II accord.

Under the standardized approach, they determined the risk weights by

the category of borrower with risk weights based on the external credit
ratings (with un-rated credits assigned to the 100% risk bucket).
Those external credit assessment agencies (ECAIs) should be authentic and
should be those as prescribed by the State Bank of Pakistan. Namely
PACRA, JCR-VIS, Moodys, Fitch and Standard & Poors.
For exposures with maturity of less than or equal to one year, short term rating given by
approved rating agencies id used where as for long term exposure with maturity of
greater than one year, long term rating is used.
Where there are two ratings available, the lower is considered and where there are three
or more ratings, the second lowest rating is considered.

Types of Exposures and ECAIs used

For foreign currency claims on sovereigns, risk weights were assigned on the
basis of the credit ratings assigned by Moodys. Type of exposures for which
each agency is used in the year ended 2009 is presented below

Internal Rating Based

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A sophisticated Internal Credit Rating System has been developed by the

bank which is capable of measuring counter party risk in accordance with
best practices. The system takes into consideration qualitative and
quantitative factors of the counter party and generates an internal rating of
that counter party. The system has been statistically tested, validated and
checked for compliance with the State Bank of Pakistans guidelines for
Internal Credit Rating. The system is backed by secured database with back
up support and is capable of generating MIS report providing snapshot of the
entire portfolio for decision making. This system supports the Internal Rating
Based Approach.
Under the Internal Rating System, the bank is allowed to monitor risk of
counterparties against different grade/scores ranging from 1-12 (1 being best
and 10-12 for defaulters. Different variables have been identifed according
to which scores are marked. Like business operation, history, legal entity,
market reputation etc.
They have introduced the Internal Rating Based, because of two reasons

Bank Alfalah lends money to the individual, SME, commercial and

corporate frms. It ranges from small to big frms therefore bank is of
the view that not all of the frms or individuals can get rated from
external credit rating agencies as they are very expensive.
Moreover, they cant rely only on the external credit rating agencies.

Collateral
The bank defnes the collateral as the assets or right provided to the bank by
the borrower or a third party in order to secure a credit facility. Alfalah Bank
reduces its exposure under the particular transaction by taking into account
the risk mitigating effect of the collateral.

Value of collateral should be higher than the loan amount.

Generally amount of loan that Bank Alfalah lends should not
exceed the 60% of the value of the collateral.
Collateral is revalued at least every three or six months.

.
Adjustment of Collateral
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Comprehensive Approach
As stipulated in the SBP Basel II guidelines, the bank uses the comprehensive
approach for collateral valuation. Under this approach, the bank reduces its
credit exposure to counterparty when calculating its capital requirements to
the extent of risk mitigation provided by the eligible collateral as specifed in
the Basel II guidelines. In line with Basel II guidelines, the bank makes
adjustment in eligible collaterals received for possible future fluctuations in
the value of the collateral. These adjustments are also referred to as
haircuts.

For example
Bank Alfalah lends Rs 40 million to a particular counterparty, which is
secured by collateral worth Rs 30 million. Rating of the counter part is B+
where as the collateral consists of securities issued by an A-rated company.
So, the risk weight for the counterparty is 150% and the risk weight for the
collateral is 50%.
Under the Comprehensive Approach: Assume that the adjustment to
exposure to allow for possible future increases in the exposure is +10% and
the adjustment to the collateral to allow for possible future decreases in its
value is -15%. The new exposure is:
1.1 X 40 -0.85 X 30 = 18.5 million
A risk weight of 150% is applied to this exposure:
Risk-adjusted assets = 18.5 X 1.5 = Rs. 27.75 M
Types of Collateral
The decision on the type and quantum of collateral for each transaction is
taken by the Credit Approving Authority as per the credit approving
authorization approved by the Board of Directors. Collateral used include:
government of Pakistan guarantees, gold, cash, shares, government
securities, all that fall in eligible collateral.
Bank Alfalah limited determines the appropriate collateral for each facility
based on the type of product and counter party.

In case of corporate and SME fnancing, fxed assets are generally

taken as security for longer tenor loans and current assets for working
capital fnance.
Page | 23

For project fnance, security of the assets of the borrower and

assignment of the underlying project contracts is generally obtained.
Additional securities such as pledge of shares, cash collateral etc may
also be taken. Bank Alfalah markup for shares is 35- 50% and for cash
and all A category securities is 10%.
Moreover in order to cover the entire exposure Personal Guarantee of
Directors is also obtained by the bank.

For retail products the security to be taken is defned by the product

policy for the respective products.

Housing loans and automobile loans are secured by the security of the
property being fnanced. The valuation of the properties is carried out
by an approved valuation agency. Here the Bank Alfalah markup for
property is 40%.

Bank alfalah usually avoid litigation, therefore if the client hasnt payback the
credit then leverage of 3-6months is given, and they check on it.
Proactive credit risk management practices in the form of studies, research
work, internal rating system, integrated bank-wide risk management and
internal control framework, adherence to Basel II accord, portfolio monitoring
are only some of the prudent measures the bank is engaged in for mitigating
risk exposures.

Page | 24

RECOMMENDATIONS
ASKARI BANK

Askari Bank at present requires the entities from smallest (individual)

to largest (MNC) to get ratings from external rating agencies. However,
it may be losing customers for loans as they may not afford the cost of
valuation and documentation. Askari bank does offer services at
charge, therefore burden remains on entities. Askari Bank should form
policies to give relaxation to entities for loan process.

The Bank should make an organization wide networking with a central

database, where information from all the departments from bank is
available and can be used for risk mitigation purposes whenever
needed. It will save time.

Askari Bank can initiate the process of implementing IRB, despite the
time, cost and efforts involved. This would allow the Bank to keep aside
capital as close to the risk it is taking with the exposures.

The bank should implement VAR system for Credit Risk Mitigation as
well, as it is being used for Market Risk management. Basel II is shifting
its focus from regulatory capital to economic capital. Economic capital
requires banks to set aside capital based on actual, expected and
unexpected losses, based on historic data, the system is able to
calculate the possible risk associated with sample set and it would help
the bank also prepare for unexpected loss.

The Bank can formulate policies to provide insurance to the entities

that perform well on an average but may default for loan repayment
due to unforeseen involuntary factors, such as natural disasters. This
will increase banks customer base.

Page | 25

BANK ALFALAH

Bank Alfalah should implement IFLEX Reveleus, risk management

software of Oracle fnancial Services Solution, having the ability to
generate live Capital Adequacy Ratio and its board should review at
least annually its overall credit risk strategy to keep it current with the
global fnancial trends.

The credit strategy of Alfalah should also take into consideration the
countrys economy as well as the shifting in composition and quality of
overall credit portfolio, because of the long term nature of this credit
strategy, periodical amendments should be done, if necessary.

A sound risk management structure should be in place such that the

structure should be in sync with the concerned bank Alfalahs overall
size, complexity and diversifed activities.

Alfalah Bank should not over rely on collaterals but should consider
them only as a buffer that would provide protection incase of default. It
should rather focus on the borrowers debt servicing ability and
reputation in the market

Also Bank Alfalah should make sure that the size of its credit limit
should depend on the strength of the borrower; genuine requirements
of debt, economic conditions and Alfalahs own risk tolerance, credit
limits should be reviewed regularly.

Page | 26

CONCLUSION
Based on our project we can say that the banking system and in turn
fnancial system is safe and sound due to the implementation of Basel
Accord II in SBP regulation. The banks are able to prevent or limit risk to
their capitals by setting aside part of their total capital risk for risk and also
get deposits without depositors fearing loss due to risk from banks activities.
We can see many of its advantages in form of:

Reduction in the level of risk bank creditors are exposed to (i.e. to

protect depositors)
Reduction in Systemic risk reduction, that is reduction in possibilities
that may cause multiple or major bank failures
Avoid misuse of banks for illegal and unethical purposes
Credit allocation -- to direct credit to favored sectors
Increase in the confdence of investors, local and foreigners due to
effective risk mitigation framework in place.

But still bank has to keep themselves up-to-date to the new technologies and
software which can make their procedures and way of managing credit risk
more effective. Now Basel Committee has introduced Basel III, more
concentrating on liquidity risk. Therefore banks have to focus on that too as
credit risk cant be analyzed in isolation.

Page | 27

BIBLIOGRAPHY

Bank alfalfa Annual Report 2009

www.bankalfalah.com/about/download/AnnualReport2009.pdf

Risk management guidelines by SBP

www.sbp.org.pk/riskmgm.pdf

Need for regulation of banking system

http://en.wikipedia.org/wiki/Basel_Accords

Basel II
http://en.wikipedia.org/wiki/Basel_II

Page | 28

ANNEXURE

Page | 29

Figure 1 Risk Management Framework

Source: http://www.askaribank.com.pk/Reports/Askari%20Financials
%202009.pdf

Page | 1

Figure 2: Components of Regulatory Capital of ABL

Source: http://www.askaribank.com.pk/Reports/Askari%20Financials
%202009.pdf

Page | 2

Figure 3 Capital Adequacy Ratio

Source: http://www.askaribank.com.pk/Reports/Askari%20Financials
%202009.pdf

Page | 3

Figure 4 Credit Risk Exposure

Source: http://www.askaribank.com.pk/Reports/Askari%20Financials
%202009.pdf

Figure 5 Loan Classification And Provisioning

Source: http://www.sbp.org.pk/publications/prudential/PRs-Corporate.pdf
Page | 4

QUESTIONS FOR INTERVIEW

1. What entails capital risk for the bank?
2. What are the capital management requirements specifed by SBP?
3. Which approach is the bank following to maintain its regulatory
capital? And why?
4. What are the external and internal factors that may give rise to credit
risk for the Bank?
5. What are the risk mitigation techniques to maintain regulatory capital
with regard to credit risk?
6. What is the Banks policy was getting the entity rating?
7. How does the Bank monitor and formulates action according to
performance of loan?

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