Subject : Management of Financial Institutions

Assignment No. 1
Topic : Commercial banks
Submitted to : Sir Shakeel Sb.
Submitted by : Muhammad Ahsan Raza
Roll No: F-61
M.comIV (morning)




NATIONAL UNIVERSITY OF MODERN LANGUAGES
FAISALABAD
April 24,2014
Definition of 'Commercial Bank'
An institution which accepts deposits, makes business loans, and offers related services.
Commercial banks also allow for a variety of deposit accounts, such as checking, savings,
and time deposit. These institutions are run to make a profit and owned by a group of
individuals, yet some may be members of the Federal Reserve System. While commercial
banks offer services to individuals, they are primarily concerned with receiving deposits
and lending to businesses.

Functions of the commercial banks:
Commercial banks perform various primary functions, some of them are given below:
Commercial banks accept various types of deposits from public especially from its
clients, including saving account deposits, recurring account deposits, and fixed deposits.
These deposits are payable after a certain time period
Commercial banks provide loans and advances of various forms, including an overdraft
facility, cash credit, bill discounting, money at call etc. They also give demand and
demand and term loans to all types of clients against proper security.
Credit creation is most significant function of commercial banks. While sanctioning a
loan to a customer, they do not provide cash to the borrower. Instead, they open a deposit
account from which the borrower can withdraw. In other words, while sanctioning a loan,
they automatically create deposits, known as a credit creation from commercial banks.
Along with primary functions, commercial banks perform several secondary functions, including
many agency functions or general utility functions. The secondary functions of commercial
banks can be divided into agency functions and utility functions.
The agency functions are the following:
To collect and clear cheque, dividends and interest warrant.
To make payments of rent, insurance premium, etc.
To deal in foreign exchange transactions.
To purchase and sell securities.
To act as trustee, attorney, correspondent and executor.
To accept tax proceeds and tax returns.
The utility functions are the following:
To provide safety locker facility to customers.
To provide money transfer facility.
To issue traveller's cheque.
To act as referees.
To accept various bills for payment: phone bills, gas bills, water bills, etc.
To provide merchant banking facility.
To provide various cards: credit cards, debit cards, smart cards, etc.
Technology used in commercial banks and changing trends:
Technological advances are quickly changing the face of the Pakistani banking industry.
Alternative channels are growing quickly and represent a sizable portion of banks revenue
streams as all banks as well as mobile network operators are jumping on the branchless
banking bandwagon.
As I discussed in the previous piece about shrinking spreads, published on November 4, the
business model utilized by commercial banks of collecting deposits and investing in treasury
bills is not sustainable. No single additional revenue stream can completely compensate for the
declining interest income, so banks will have to aggressively pursue revenue expansion from
several diversified streams.
Competition is also expected to intensify in smaller cities as there are many underserved affluent
customers in Hyderabad, Multan, Sukkur, etc. Aggressively growing mid-sized banks such as
Bank Alfalah and Meezan Bank are looking to expand their branch network to these cities.
Given the intense competition and increasingly price-sensitive customers, price increase for
standard banking services, such as cheque book issuance, is unlikely. To generate additional
income, banks will have to develop new and innovative products and cross-sell to increase
products per customer.

Data analytics
As mobile network operators (MNOs) have done, banks too need to establish business
intelligence units which collect and analyse huge volumes of data to drive decision-making
throughout the organisation. In coming days, data and analytics will drive growth, drive better
risk behaviour and reduce costs. Analytics can help sales and marketing success by:
*Identifying profitability of customer segments and helping the business prioritise
relationships/align channels accordingly
*Identifying propensity to buy amongst various customer profiles for more targeted sales efforts
and increased success rate
*Identifying cross-sell opportunities to increase the number of products per customer
*Identifying profitable sub-segments to target with tailoured products/services
*Improving risk management through better credit monitoring and effective early warning
systems
Alternative channels
At the moment, alternative distribution (online banking, call centres, ATMs, debit cards) is the
happening place in retail banking, taking up a major chunk of investment. Banks need to try and
create an ecosystem that captures the customers entire financial universe, enabling them to ring-
fence customers, making them less susceptible to switching over to competition. This can only
be done by providing an integrated multichannel offering, intelligently building alliances and
attractive yet viable loyalty programmes.
More and more customers see the value of accessing their money 24/7 instead of being
constrained by branch banking hours and locations and are signing up for debit cards and internet
banking. As a result, alternative channels are contributing an increasingly higher percentage of
fee income to the bottom line.
Seamless multichannel offering will reduce the burden on the branch network, cutting costs and
improving service quality. Activities like utility bill payments and mobile phone top-ups through
internet or call centres save customers a lot of time and effort while simultaneously reducing
traffic in the branches. Successful banks will focus on shifting less profitable customers to low-
cost channels.
The importance of branches will not decrease as their role will evolve into a sales and service
channel with the bulk of transactions happening through remote channels. This could enable
them to reduce the number of staff and also potentially increase the coverage area per branch.
Branchless banking
With high mobile penetration and low banking penetration (130 million mobile phone users vs
20 million bank account holders), it is clear branchless banking will have a huge role to play in
the future. The number and value of transactions is growing day by day and agent networks are
expanding rapidly. What is less clear is what sort of returns can be forecast for the heavy
investments being made in setting up the infrastructure.
With branchless banking, MNOs have become players in the financial services arena as they tap
into the unbanked population and remittance market. The partnering of banks with a network of
retail outlets (agents) can greatly increase outreach and exponentially increase banking
customers, which is why a number of banks have entered or will soon enter this market.
However, managing this scale of agents and customers will be very complicated as it is hard to
build a network of agents that fulfill the criteria and, unlike the MNOs, banks have no experience
in managing agent networks. Success will depend on the ability to develop and manage an
extensive network of retail outlets.
The fewer partners the better, otherwise, the complexity will be difficult to handle. According to
the McKinsey Quarterly, the experience from across the world is that most efficient operations
involve the partnering of one financial institution with one or few distribution networks.
Currently, the bulk of activity is mostly in CNIC-to-CNIC money transfers. For branchless
banking to really take off and bring about financial inclusion, however, providers need to move
beyond over-the-counter transactions to products that promote a relationship with the customer
and offer mobile wallets, savings products with decent returns and direct deposits (salary/pension
credits, etc). Banks are moving towards this, but in my opinion it is still some years from
fruition.
Balance Sheet of a Commercial Bank

Liabilities Assets
a. Share Capital a. i. Cash in Hand
b. Reserve Funds ii. Cash with the Central Bank (RBI)
c. Deposits iii. Cash with the other banks
i. Fixed Deposits b. Money at short
ii. Saving Deposits c. Bills and securities discounted
iii.Current Deposits d. Investment of bank
iv. Other Deposits e. Loans and Advances given
d. Borrowings f. Other Assets

Bank's Liabilities
Bank's liabilities constitute five major items. The share capital,the contribution which
shareholders have contributed for starting the bank. Reserve funds are the money, which the
bank has accumulated over the years from its undistributed profits. Deposits are the money
owned by customers and therefore it is a liability of a bank. There can be various kinds of
deposits and recurring deposits. Apart from these items a bank can borrow from central and other
commercial banks. These borrowings are also treated as bank's liabilities.
Bank's Assets
Bank's assets comprises cash, money at short notice, bills and securities discounted, bank's
investments, loans sanctioned by the bank, etc. Bank's cash in hand, cash with other banks and
cash with central bank (RBI) are its assets. When a bank makes money available at short notice
to other banks and financial institutions for a very short period of 1-14 days it is also treated as
bank's asset. Apart from these items bank always make money available to people on the form of
loans and advances. They are also become bank's assets.
CAMELS rating system:
What is CAMEL?
The central bank has been following a supervisory framework, CAMEL, which involves the
analysis of six indicators which reflect the financial health of financial institutions. These are:
Capital Adequacy
Asset Quality
Management Soundness
Earnings and Profitability
Liquidity
Sensitivity to Market Risk

Capital Adequacy
To protect the interest of depositors as well as shareholders, SBP introduced the risk-based
system for capital adequacy in late 1998. Banks are required to maintain 8 per cent capital to
Risk Weighted Assets (CRWA) ratio. Banks were required achieving a minimum paid-up capital
to Rs. 500 million by December 31, 1998. This requirement has been raised to one billion rupee
and banks have been given a deadline up to January 1, 2003 to comply withthis.The ratio has
deteriorated after 1998. However, it was fallout of economic sanctions imposed on Pakistan after
it conducted nuclear tests. The shift in SBP policy regarding investment in securities also led to a
fall in ratio. However, most of the banks have been able to maintain above the desired ratio as
well as direct their investment towards more productive private sector advances. Higher
provisioning against non-performing loans (NPLs) has also contributed to this decline. However,
this is considered a positive development.
Asset quality
Asset quality is generally measured in relation to the level and severity of non-performing assets,
recoveries, adequacy of provisions and distribution of assets. Although, the banking system is
infected with large volume of NPLs, its severity has stabilized to some extent. The rise over the
years was due to increase in volume of NPLs following enforcement of more vigorous standards
for classifying loans, improved reporting and disclosure requirements adopted by the SBP. In
case of NCBs, this improvement is much more pronounced given their share in total NPLs. In
case of privatized and private banks, this ratio went up considerably and become a cause of
concern. However, the level of infection in foreign banks is not only the lowest but also close to
constant. The ratio of net NPLs to net advances, another indicator of asset quality, for all banks
has declined. Marked improvement is viable in recovery efforts of banks. This has been
remarkable in the case of NCBs, in terms of reduction in the ratio of loan defaults to gross
advances. Although, privatized banks do not show significant improvement, their ratio is much
lower than that of NCBs. Only exception is the group of private banks for which the ratio has
gone up due to bad performance of some of the banks in the group

However, it is still the lower, except when compared with that of foreign banks.
Management soundness
Given the qualitative nature of management, it is difficult to judge its soundness just by looking
at financial accounts of the banks. Nevertheless, total expenditure to total income and operating
expenses to total expenses help in gauging the management quality of any commercial bank.
Pressure on earnings and profitability of foreign and private banks caused their expenditure to
income ratio to rise in 1998. However, it started tapering down as they adjusted their portfolios.
An across the board increase in administrative expenses to total expenditure is visible from the
year 1999.The worst performers in this regard are the privatized banks, mostly because of high
salaries and allowances.
Earnings and profitability
Strong earnings and profitability profile of banks reflects the ability to support present and future
operations. More specifically, this determines the capacity to absorb losses, finance its expansion
programmer, pay dividend to its shareholders, and build up adequate level of capital. Being front
line of defense against erosion of capital base from losses, the need for high earnings and
profitability can hardly be overemphasized. Although different indicators are used to serve the
purpose, the best and most widely used indicator is return on assets (ROA). Net interest margin
is also used. Since NCBs have significantly large share in the banking sector, their performance
overshadows the other banks. However, profit earned by this group resulted in positive value of
ROA of banking sector during 2000, despite losses suffered by ABL. Pressure on earnings was
most visible in case of foreign banks in 1998. The stress on earnings and profitability was
inevitable despite the steps taken by the SBP to improve liquidity. Not only did liquid assets to
total assets ratio declined sharply, earning assets to total assets also fell. T-Bill portfolio of banks
declined considerably, as they were less remunerative. Foreign currency deposits became less
attractive due to the rise in forward cover charged by the SBP. Banks reduced return on deposits
to maintain their spread. However, they were not able to contain the decline in ROA due to
declining stock and remuneration of their earning assets.
Liquidity
Movement in liquidity indicators since 1997 indicates the painful process of adjustments. Ratio
of liquid assets to total assets has been on a constant decline. This was consciously brought about
by the monetary policy changes by the SBP to manage the crisis-like situation created after 1998.
Both the cash reserve requirement ((CRR) and the statutory liquidity requirement (SLR) were
reduced in 1999. These steps were reinforced by declines in SBP's discount rate and T-Bill yields
to help banks manage rupee withdrawals and still meet the credit requirement of the private
sector. Foreign banks have gone through this adjustment much more quickly than other banks.
Their decline in liquid assets to total assets ratio, as well as the rise in loan to deposit ratio, are
much steeper than other groups. Trend in growth of deposits shows that most painful part of the
adjustment is over. This is reflected in the reversal of decelerating deposit growth into
accelerating one in year 2000.
Sensitivity to market risk
Rate sensitive assets have diverged from rate sensitive liabilities in absolute terms since 1997.
The negative gap has widened. Negative value indicates comparatively higher risk sensitivity
towards liability side, while decline in interest rates may prove beneficial.



Structure of commercial banks in Pakistan:
We will discuss structure of banks in Pakistan, first in terms of number of banks and size of
banks (as measured by assets, deposits, etc), then in terms of concentration ratios(Lorenz curve,
Gini co-efficient, Herfindahl index and Concentration Ratio).In 1990, seven domestic banks and
seventeen foreign banks were doing business in Pakistan. All the domestic banks were owned by
the government. Entry of domestic private sector in the banking business had been banned since
the promulgation of Banks.
Nationalization Act 1974 However, as a part of financial liberalization strategy of 1990s, Privat
sector was allowed to open commercial banks in 1991. At that time fifteen banks were opened.
During the next ten years the process of entering of new banks and exiting of inefficient banks
continued. Moreover, in order to go some step further to make the banking sector competitive,
the government also denationalized a couple of commercial banks. In 1999, there were 19
domestic banks and seventeen foreign banks in Pakistan (see Annex for list). Of the domestic
banks, four were owned by the federal government, two were privatized, two were owned by the
provincial governments and the rest were in the private sector. The government has also
minimized its interventions in the business of its own banks in order to ensure that a competitive
environment prevails in the industry. Along with the growth of banks in numbers, their business
also shows a reasonable growth during 1990s. Total assets of commercial banks grew at a
compound annual growth rate of 15 percent, from Rs 419 billion at the beginning of decade to Rs
1,469 billion by the end of 1999.
Amongst different groups, assets of private banks showed fastest growth during 1990s, followed
by foreign banks. A similar trend is witnessed in the advances and deposits of the banks
Microfinance banking:
Microfinance is a source of financial services for entrepreneurs and small businesses lacking
access to banking and related services. The two main mechanisms for the delivery of financial
services to such clients are:
(1) relationship-based banking for individual entrepreneurs and small businesses;
(2) group-based models, where several entrepreneurs come together to apply for loans and other
services as a group.
In some regions, for example Southern Africa, microfinance is used to describe the supply of
financial services to low-income employees, which is closer to the retail finance model prevalent
in mainstream banking.
For some, microfinance is a movement whose object is "a world in which as many poor and
near-poor households as possible have permanent access to an appropriate range of high quality
financial services, including not just credit but also savings, insurance, and fund transfers. Many
of those who promote microfinance generally believe that such access will help poor people out
of poverty, including participants in the Microcredit Summit Campaign. For others, microfinance
is a way to promote economic development, employment and growth through the support of
micro-entrepreneurs and small businesses.
Microfinance is a broad category of services, which includes microcredit. Microcredit is
provision of credit services to poor clients. Microcredit is one of the aspects of microfinance and
the two are often confused. Critics may attack microcredit while referring to it indiscriminately
as either 'microcredit' or 'microfinance'. Due to the broad range of microfinance services, it is
difficult to assess impact, and very few studies have tried to assess its full impact. Proponents
often claim that microfinance lifts people out of poverty, but the evidence is mixed. What it does
do, however, is to enhance financial inclusion.
Benefits of micro financing:
1. Poor people need not just loans but also savings, insurance and money transfer services.
2. Microfinance must be useful to poor households: helping them raise income, build up
assets and/or cushion themselves against external shocks.
3. "Microfinance can pay for itself."
[24]
Subsidies from donors and government are scarce
and uncertain and so, to reach large numbers of poor people, microfinance must pay for
itself.
4. Microfinance means building permanent local institutions.
5. Microfinance also means integrating the financial needs of poor people into a country's
mainstream financial system.
6. "The job of government is to enable financial services, not to provide them."
[25]

7. "Donor funds should complement private capital, not compete with it."
[25]

8. "The key bottleneck is the shortage of strong institutions and managers."
[25]
Donors
should focus on capacity building.
9. Interest rate ceilings hurt poor people by preventing microfinance institutions from
covering their costs, which chokes off the supply of credit.
10. Microfinance institutions should measure and disclose their performanceboth
financially and socially.
Microfinance is considered a tool for socio-economic development, and can be clearly
distinguished from charity. Families who are destitute, or so poor they are unlikely to be able to
generate the cash flow required to repay a loan, should be recipients of charity. Others are best
served by financial institutions.
1.New kind of relationship between banks and depositors,
2.Integration of financial and real market in financing,
3.Incorporation of ethics and moral values in investment and financing decisions.Islamic Banking brings
economic empowerment to Muslims in the areas of operation. Ithelps Muslim businesspersons,
through financial aid, to remain competitive. It also leads towards the creation of job opportunities for
Muslims as well as Non-Muslims. It is a basis for expansion into the Islamic Economic System since
the establishment of each Islamic Bank is also the creation of another bank to co-operate with
others in the International web of Islamic Banks. Thus also creating a link for international
interests. It provides investors with flexibility in the types of accounts within which they could
channel their investment. It thus links capital to labour and reduces expenditure, to levels,related
with the type of investment, the value thereof and its period. Islamic Banks enable the saving of
monetary resources for the future as shown by the Yusuf(A.S.) and in a methodology approved
by Allah. This thus leads to the protection of wealth. Sponsoring Islamic activity & the
mobilization of resources for International Islamic Support not only investment, but moral as
well, i.e. relief towards Muslim refugees andvictims of war, etc. Islamic Banks facilitate
international and local trade, provide foreign exchange services and profitably invest the Muslim
fraternity's surplus wealth in conformity to Islamic principles through economically acceptable
development and social projects indispensable for the Muslim Ummah.
ISLAMIC MODES OF FINANCING:-
The important modes of financing are
1.Musharakah
2.Mudarabah
3.Murabaha
4.Salam
5.Istisna
6.Ijaraha

Musharakah
Musharakah means a relationship established under a contract by the mutual consent of the
parties for sharing of profits and losses in the joint business. It is an agreement under which the
Islamic bank provides funds, which are mixed with the funds of the business enterprise and
others. All providers of capital are entitled to participate in management, but not necessarily
required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss
is borne by each partner strictly in proportion to respective capital contributions.
A form of partnership where one party provides the funds while the other provides expertise and
management. The latter is referred to as the Mudarib. Any profits accrued are shared between the
two parties on a pre-agreed basis, while loss is borne by the provider of the capital.
Murabaha:
Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which
the seller declares his cost and profit. Islamic banks have adopted this as a mode of financing. As
a financing technique, it involves a request by the client to the bank to purchase a certain item for
him. The bank does that for a definite profit over the cost, which is settled in advance.
Salam:
Salam means a contract in which advance payment is made for goods to be delivered later on.
The seller undertakes to supply some specific goods to the buyer at a future date in exchange of
an advance price fully paid at the time of contract. It is necessary that the quality of the
commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.
The objects of this sale are goods and cannot be gold, silver or currencies. Barring
this, Salam covers almost everything, which is capable of being definitely described as to
quantity, quality and workmanship.

Istisna
It is a contractual agreement for manufacturing goods and commodities, allowing cash payment
in advance and future delivery or a future payment and future delivery. Is tisnacanbe used for
providing the facility of financing the manufacture or construction of houses ,plants, projects,
building of bridges, roads and highways.
Ijaraha
A contract under which an Islamic bank finances equipment, building or other facilities for the
client against an agreed rental together with a unilateral undertaking by the bank or the client that
at the end of the lease period, the ownership in the asset would be transferred to the lessee. The
undertaking or the promise does not become an integral part of the lease contract to make it
conditional. The rental as well as the purchase price are fixed in such manner that the bank gets
back its principal sum along with profit, which is usually determined in advance.
DIFFERENCE BETWEEN ISLAMIC BANKING AND
CONVENTIONALBANKING:-
The Shariah essentially means a way of doing things. This ought to reflect in the working of Islamic
banks at all levels: from doing transactions to record-keeping and the skill-profile of the
manpower. The conventional banks may not move into the turf of the Islamic banks if there are fundamental
differences between the requirements of interest-based banking and Islamic banking. Otherwise,
chances are that interest based banks may give Islamic banks a
run for their money through Islamic windows.
The fundamental difference between Islamic banks and the existing commercial banks is the
avoidance of riba in Islamic banking. Islamic banks are also universal or multi purpose banks
and not purely commercial banks - a cross-breed between commercial banks and investment
banks, investment trusts and investment-management institutions. Since the Islamic bank would
share in the risks of the consignment, venture, business or indemnity, It would need to be more
careful in the evaluation of applications. The activities of the bank will be based on the
commercial transactions allowed in Islam, including mudarabah, ijara,bai bi-tham in ajil and
murabahah.The objectives of these Islamic banks in general have been to promote, foster and
develop the application of Islamic principles, law and tradition to the transaction of financial,
banking and related business affairs. The main principles followed by the Islamic banks are:
(a) prohibition. of interest in all forms of transactions;
(b) undertaking business and trade activities on the basis of legitimate profits; and
(c) giving zakat.


Capital requirements:
i) The minimum Paid up Capital requirements for all locally
incorporated banks has been raised to Rs. 23 billion (net of
losses) to be achieved in a phased manner as under:

ii) Branches of foreign banks operating in Pakistan (FBs) are also required to
increase their assigned capital to Rs. 23 billion (net of losses) within the
above prescribed timelines. However, those FBs, whose Head Offices hold
Paid up capital (free of losses) of at least equivalent to US$ 300 million and
have a CAR of at least 8% or minimum prescribed by their home regulator,
whichever is higher, will be allowed with the prior approval of the State Bank
to maintain the following MCR:
a. FBs, operating with upto 5 branches are required to raise their assigned
capital to Rs. 3 billion latest by 31st December 2010.
b. FBs operating/desirous of operating with 6 to 20 branches are required to
raise their assigned capital to Rs. 6 billion by 31st December 2010.

iii) DFIs will raise their paid up capital (free of losses) to Rs. 5 billion by
December 2008 and Rs. 6 billion by December 2009 as presently required.
3. In addition to the above requirements, all banks are also required to meet
specific condition(s), if any, regarding capital requirement imposed on them
under the Banking license issued by the State Bank of Pakistan.

4. All new banks including branches of foreign banks, licensed after the date
of this Circular will be required to meet the paid up/assigned capital
requirement of Rs. 23 billion before commencement of their operations.

5. The required minimum CAR, on consolidated as well as on standalone
basis has been increased for banks/DFIs to 10%. Those banks/DFIs whose
CAR is at present less than 10% are advised to meet the shortfall latest by
31st December, 2008. Furthermore, all banks/DFIs are required to maintain
variable CAR as under:
i) The variable CAR will now be based on CAMELS-S Rating assigned by the
State Bank to each bank and DFI. The required variable CAR to be
maintained by each bank/DFI will be determined as follows:

ii) Banks/DFIs which, in the opinion of the State Bank, have high risk profile
may be asked to further increase the required CAR by One (1) percentage
point.
Those banks/DFIs whose CAR fall short from the required ratio (determined
on the basis of CAMELS-S) shall meet the shortfall within 6 months from the
assignment of the latest rating.
6. The required MCR and CAR can be achieved by the banks/DFIs either by
fresh capital injection or retention of profits. The stock dividend declared
after meeting all the legal and regulatory requirements, and duly disclosed in
the annual Audited Accounts will be counted towards the required paid up
capital of the bank/DFI pending completion of the formalities for issuance of
bonus shares.

7. Any bank/DFI that fails to meet the minimum paid up capital requirement
or CAR within the stipulated period shall render itself liable to the following
actions:
i) Imposition of such restrictions on its business including restrictions on
acceptance of deposits and lending as may be deemed fit by the State Bank.

ii) Rescheduling of the bank, thereby converting it into a non-scheduled
bank.

iii) Cancellation of the banking license if the State Bank believes that the
bank is not in a position to meet the minimum paid up capital requirement
or CAR.
8. This circular supersedes the instructions issued vide BSD Circular No. 06
dated October 28, 2005.