Impact of Risk Management on Organization Performance: Case Study of UBL VS MCB Bank of Pakistan

Abdul Razzaq Executive Summery

1. Our purpose is to presenting impact of risk management on two major bank performance doing business in
banking sector. Our finding is that how these companies are increasing their wealth and how they satisfied their investors, shareholder & stakeholders and how they meet the obligations of their customers and create best relationship with them. Also we show best performance and judgment of these banks. 2. We used methodologies in this project; general ratios analyses, review of descriptive information, comparison and analyses. 3. Specific portion of Balance sheet and income statements of the UBL and MCB have analyzed for five years. Observations, findings & conclusion of above methodologies have been elaborated. 4. We have also included our recommendations & suggestions to the management of the both banks. Especially for management how they remove their threat and how they increase their business power & decisions not depending on others. We have suggested for owners & investors for maximization of their wealth they have to invest such kind of organizations .

Introduction
Modern business environment introduce many facet and intricate than ever. All organizations have an exposure toward uncertainties and bear losses born from that uncertainty in their daily business operation. No doubt todays volatile business environment impose a hefty threat of risks like market risk, liquidity risk, credit risk, operational risk, interest rate risk etc. all these risk impede the organization performance may not manage effectively. Risks may be categorized as financial risk or non-financial risk. Both of these types of risks need in-depth consideration for managing or reducing their worsening impact. Through this study my focus on financial risk i.e. credit risk. In financial risk credit risk is extensively documented and familiar as the most significant and imperative in nature surrounded by loads of financial risk in front of banks (Sackett 2006) The escalating assortment in the kinds of counterparties i.e. from individuals to governments, and the always mounting diversity in the outlines of obligation i.e. from auto advances to multifaceted derivatives contacts, has supposed that management of credit risk has bound to the front position of risk management strategies carried out by financial services businesses (Fatemi, 2006). Regulations in this regard address, lessen possible losses from non-payment of loans. Financial Sector Development and Economic Development are inter-related. No economy can grow and improve the living standards of its population in the absence of a well functioning and efficient financial sector. Banks in Pakistan account for 95 percent of the financial sector and hence a sound and healthy banking system is directly related to economic growth and development of Pakistan. (Ishrat Husain, 2006)

Financial intermediaries perform five basic functions that affect the real economy. (i) mobilizing savings from domestic households and corporate (ii) pooling and managing risk (iii) acquiring and disseminating information about investment opportunities (iv) monitoring borrowers and exerting corporate control and (v) facilitating the exchange of goods and services (Ishrat Husain, 2006) Financial institution functions within legal and regulatory constraints that limit then risk management alternatives. The State Bank of Pakistan is the regulatory authority of financial institutions operating in Pakistan. SBP become in existence at 1st July, 1948. Near about 29 domestic and foreign banks works under the supervision of SBP. The State Bank through a circular on Risk Management Guidelines for Commercial Banks & DFIS followed by a continuing series of seminars advised the financial institutions in Pakistan to commence setting up independent divisions along the lines stipulated by the Bank for International Settlements (BIS), based in Basel. The gist of the SBP circular is as follows: Risk management involves identification, measurement, monitoring and controlling risks ensuring that, i. The individuals who take or manage risks clearly understand it ii. The organizations risk exposure is within the limits established by its Board of Directors (BOD). iii. Risk taking decisions are in line with the business strategy and objectives set by BOD iv. The expected payoffs compensate for the risk taken v. Risk taking decisions are explicit and clear vi. Sufficient capital as a buffer is available to justify the level of risk exposure. The acceptance and management of financial risk is inherent to the business of banking and banks roles as financial intermediaries. Risk management as commonly perceived does not mean minimizing risk; rather the goal of risk management is to optimize the risk-reward trade-off. Not withstanding the fact that banks are in the business of taking risk, it should be recognized that an institution need not engage in business in a manner that unnecessarily imposes risk upon it: nor should it absorb risk that can be transferred to others. In every financial institution, risk management activities broadly take place simultaneously at the following different hierarchy levels Strategic Level: This encompasses risk management functions performed by senior management and BOD. Macro Level: This encompasses risk management within a business area or across business lines. Generally the risk management activities performed by middle management of units devoted to risk reviews fall into this category. Micro Level: This involves on-the-line risk management where risks are actually created. This covers the risk management activities performed by individuals who take risk on the organizations behalf such as front office and loan origination functions. (Kanwar, 2005)

Here, we look two banks (MCB & UBL) operations through their financial statement accompanied with notes, to assess the level of risk management especially credit risk management and its impact on organization performance and look. Before going further, we briefly discuss both organizations first.

MCB Bank:
MCB has very rich and solid background since 64 years. It is privatized in 1991and succeeding bid placed by Nishat group. It is providing services with 1134 branches and 5 subsidiary companies. It is the first Pakistan bank which got listed at London Stock Exchange. According the financial statements year 2010, bank total capital employed is Rs. 79,204,209,000. MCB offer many products and services, following is a brief list of these products and services. Current account Savings Account Term Deposit MCB Online MCB MNET MCB Cash Management MCB Channel Financing MCB local Drawing Arrangement MCB Corporate Financing MCB Project & Structured Finance MCB Syndicated Loans and Debt Capital Markets MCB Islamic Banking and many more.. MCB introduced proper Risk Management policy in its financial statement 2010 (p-63). Its prominent features are Comprehensive Risk Management framework Complaint with Local and International laws Credit review and Credit Risk Control Market Risk Operational Risk Liquidity Risk Through review of financial statement, try to ascertain the effectiveness of these measures especially Credit Risk and try to gauge the impact of these measures on organization performance.

UBL of Pakistan
United Bank Limited (UBL) is one of the largest commercial banks in Pakistan having more

than 1,100 online branches inside the country. Its 15 branches outside the country are in the United States of America, Qatar, UAE, Bahrain, and Republic of Yemen. It also has representative offices in Tehran, Iran and Almaty, Khazakstan. It owns subsidiaries in the UK (United National Bank Limited), and in Zurich, Switzerland. Agha Hasan Abedi founded the bank in 1959. In 1971 the Government of Pakistan nationalized the bank. In 2002, the Government of Pakistan sold it in an open auction to a consortium of Abu Dhabi Group and Bestway Group. In 2002 the bank merged its operations in the UK with those belonging to National Bank of Pakistan to form United National Bank Limited. United Bank owns 55% of the joint-venture and National Bank of Pakistan owning the remainder (Wikipedia). UBL is a commercial bank, which transacts the business of banking in accordance with the provisions of BCO, 1962. Section 7 of the Act authorizes banks to engage in the prescribed form of business. In the light of this section UBLs functions can be categorized as under: Agency services General Utility Services Underwriting of loans raised by the Government or public bodies and trading by corporations etc. Providing specialized services to customers, and Hajj-related services. UBL management also express its great emphasize on risk management in its policy statement.

Literature Review
Although use of the term risk management dates from the 1950s, the function itself had been recognized earlier. In 1916, Henri Fayol describe six functions of business, in which security function coincides rather closely with our current understanding of risk management and might easily serve as a definition of risk management in a modern textbook.
The purpose of this function is to safeguard property and persons against theft, fire and flood, to ward off strikes and felonies and broadly all social disturbances or natural disturbances liable to endanger the progress and even the life of the business. It is the masters eye, the watchdog of the one-man business, the police or the army in the case of the state. It is generally speaking all measures conferring security upon the undertaking and requisite peace of mind upon the personnel. The object of this (security activity) is to safeguard property and persons against theft, fire and flood, to ward off strikes and felonies and broadly all social disturbances or natural disturbances liable to endanger the progress and event the life of the business.(Fayol, 1916)

The Jarrow-Turnbull model2 was amongst the pioneer studies that had openly arbitrary interest rates at its center. (Barry, Baker and Sanint, 1981) found that impulsiveness in fund accessibility from rural banks added to elevated credit risks. (Deakins and Hussain, 1994) emphasized on

investing in both resources and time during risk assessment process, which in turn makes possible for bank to not only overcome unfair selection but also shows the way to beneficial customer relationship. Moreover there is a sky-scraping risk of malfunction right through the phase of financial stress of banks with elevated credit risk and rigorous portfolios (Barnhill, Papapanagiotou, & Schumacher, 2002). Moreover the study found credit value of banks portfolio the most significant risk factor. (Brown and Wang, 2002) stated that blend of credit spread option and hedging significantly lessen credit risk of sub-investment bond portfolio. (Peter and Peter, 2006) found significant impact of negative equity risk and loan-to-value ratio as drivers of default credit risk while study Australian State housing authorities with main aim to approximate the likelihood of credit default risk. Likewise while studying practices adopted for credit risk management by large US based financial institutions found single most vital underlying principle of credit risk models it to recognize default risk of counterparty (Fatemi&Fooladi, 2006).The pragmatic results points that superior capital adequacy ratio (CAR) appears to lessen the level of problem of non-performing loans (Boudriga, Taktak&Jellouli, 2009). In Corporate Governance (Butt, 2011) describe risk management process is a systematic attempt to analyses and deal with risk. The process can be broke down into five steps: Risk identification Risk assessment Selection of risk management technique Implementation Review Now we discuss these five steps in brief.

Risk identification
Obviously before any thing can be done about the risks an organization faces, it must be fully aware of all that it is exposed to. Many time people are not aware that they are exposed to risk as well as some time they are not aware of exact nature of risk. These two conditions, if not properly identified, may be management is not able to cover or lessen the loss, incur by an eventuality of mishaps.

Risk Assessment
Once management identified possible risks, they exposed, next step is assessing the potential size of loss and the probability that loss is likely to occur and then providing some ranking in order of priorities. It wise before taking a risk, must trade-off between the risks and rewards.

Selection of Risk Management Technique

The next step is to decide what steps to take to eliminate or reduce the impact of risks. There are four basic techniques available for reducing risk, namely: Risk avoidance Loss prevention and control Risk retention Risk transfer

Implementation

Following a decision about how to handle the risks identified, one must implement the techniques selected. The underlying principle in this step of the risk management process is to minimize the costs of implementation.

Review
Risk management is a dynamic feedback process, in which decisions are periodically reviewed and revised. As time passes and circumstances change, new exposures may arise, information about the likelihood and severity of risks may become more readily available, and techniques for managing them may become less costly. Thus, you will probably decide not to purchase life insurance if you are Objectives To post-loss adequacy of resources To minimizing the cost of dealing with credit risk To meet legal and contractual obligations To eliminate worry To ascertain the effectiveness of risk management plan To ascertain the impact of risk management of organization performance

Methodology
Both organizations studied through descriptive study of financial statements over period for five years, to ascertain the credit risk exposure level and impact of risk management on organization performance.

Research design
For this purpose used ratios to compare both organization as well as its own performance year to year period under study. Following procedures used: Net Profit Margin = Net income / Gross interest earned Advances ratio = Net advances / Total Deposits Write off ratio = Write off amount / Net Advance Total NPL Ratio = Non-Performing loan / Net Advance Losses Ratio = Losses portion of NPL /Total Non-Performing Loan

Data Collection
For this research design, collate published studies from different articles, books and journals, and published annual reports of the banks, website of State Bank of Pakistan, and the websites of Karachi, Islamabad & Lahore Stock Exchange is used. Afterwards, the researcher will summarize all the information.

Population and Sample

Population consists of all banks in Pakistan. However our sample for this study is two banks namely MCB vs. UBL bank of Pakistan.

Analysis of Data
In this section we analyze the calculated data.

Net Profit Margin

The net profit margin measures the percentage of each mark-up/return/interest earned rupee remaining after all cost and expenses, including interest, taxes and preferred stock dividend have been deducted. Net Profit Margin calculated as = earnings available for common stock holder / mark-up/return/interest earned The higher the net profit margin, the better.

MCB of Pakistan
2010
30.78

UBL of Pakistan
2007 2006
48.03 47.10

2009
30.02

2008
38.26

2010 2009 2008 2007 2006

18.81 15.11 15.95 20.47 28.70

Net Profit Margin of MCB and UBL was decline through out the period of under review. However, MCB shows very impressive results compare to the UBL even its declining net profit margin is greater than UBL higher net profit margin in 2006.

Return on Total Assets

Return on total assets measures the overall effectiveness of the management in generating profits with its available assets the higher the firms returns on total assets, the better. Calculated as ROTA = EBIT / Total Assets Some times we take average assets for calculations. Some analyst use net profit available for common stock holders. However, we use EBIT because Tax and interest beyond the control of management.

MCB of Pakistan
2010
4.63

UBL of Pakistan
2007 2006 2010
5.19 5.41 2.54

2009
4.55

2008
4.92

2009 2008
2.26 2.29

2007
2.45

2006
3.38

Return on Total Assets of MCB and UBL also on the line of decline over the period understudy. However, MCB shows very impressive results compare to the UBL even its declining Return on Total Assets is greater than UBL higher Return on Total Assets in 2006.

Advances Ratio
Advance ratio calculated to measure the level of advances w.r.t. deposits. Because deposits are the major source of pooling funds from public at large. This measure provides a sense about how much pooled funds disbursed through granting Advances to the business. This category is more sensitive with risk management regard. If management not properly identifies the business financial health with allied requirements, may not be able to assess the risk potential attached with return of advances. It is essential for securing proper and on time return of advances for organization profitability and growth. Financial institutes perform basic function of providing funds to the organization for fulfilling their financial business needs. If funds stuck in some hands, generate a negative cycle for needy business as well as lessen the return for all stakeholders. This ratio calculated through following formula = Net Advances / Total deposits As much this ratio greater low funds available for other purposes like investments etc.

MCB of Pakistan
2010
59.01

UBL of Pakistan
2007 2006
74.96 77.00

2009
68.89

2008
79.49

2010 2009 2008

60.61 71.96 76.75

2007
74.53

2006
73.81

It becomes evident through this ratio major portion of funds disbursed to the business through Advances mechanism. UBL near to 71% of its deposits disbursed through Advances. MCB data depict 72% trend in this regard. On the other hand is also major source of earning for the organization.

Total NPL Ratio (Total Assets)

Total Non-performing loan portion with respect to Total Assets calculated to ascertain the effectiveness of management concern with non-performing loan. With combine to other ratios its provide a better sense for adhering current situation and impact of its on organization performance. Calculation takes place as under: = Total Non-performing loan / Total Assets As much as lower this ratio better for organization growth on performance.

MCB of Pakistan
2010
4.32

UBL of Pakistan
2007 2006 2010
2.61 2.51 6.95

2009
4.56

2008
4.10

2009
6.31

2008
4.60

2007 2006
4.15 3.84

If we look simultaneously these ratios with Return on Total assets ratios, it is evident as Total NPL Ratio increases, Return on Total Assets decreases. This may be not perfect negative linear but results revealed very strong negative correlation between these two parameters. This pattern very significant at MCB compare to UBL. MCB & UBL, NPL ratio increased from 2.51%& 3.84% in FY2006 to 4.32%& 6.95% in FY2010, Return on Total Assets decreased from 5.41%& 3.38% in FY2006 to 4.63%& 2.54% in FY2010 respectively. However, UBLs NPL ratios always stay on higher level, which result lower return of total Assets employed.

Total NPL Ratio (Net Advances)

Total Non-performing Ratio with respect to Advances depicts the portion of advances not in business circle and stuck up in few non responsible business hands. Which impose greater threat for failure not only for its own organization that not repay its obligation, but also contribute in crises for whole financial system. This is calculated as follows: = Total Non-performing loan / Net Advance Active manager always looking for lessen this ratio as possible, is better.

MCB of Pakistan
2010
9.64

UBL of Pakistan
2007 2006
4.90 4.32

2009
9.18

2008
6.96

2010
15.25

2009 2008
11.41 7.69

2007
7.50

2006
6.68

UBL position is very adverse on this measure. Its managers are not smart as MCB managers, to manage or reduce the portion of non-performing loan. Pattern of increase in NPL at UBL is at fast pitch as compare to the MCB. Profitability indicators also support this phenomenon of organization performance.

Losses Ratio
According to rules laid down by the State Bank of Pakistan, organizations must break down it nonperforming loan in three categories. Less then three month default falls under substandard, above three month but less then 6 months called doubtful, above this period, default from due date called losses category. Study revealed most non-performing loans fall under this category. Losses Ratio = Losses portion of NPL / Total NPL Manager always have thrust to lessen this ratio.

MCB of Pakistan
2010
84.77

UBL of Pakistan
2007
75.24

2009
68.56

2008
55.46

2006
87.67

2010
66.22

2009
65.82

2008
56.46

2007
62.01

2006
76.60

This ratio depicts MCB non-performing loans major portion fall under losses category as compare to UBL. This situation may be occurring due to the base amount i.e. total non-performing loan is increased significantly at UBL sheet. However, MCB position also not good on this measure some extent. But, if consider low growth in non-performing loans/ advances with respect to UBL, MCB manager role is look positive.

Conclusion
We have analyzed the specific portion of Balance Sheets and Income Statements of both organizations. We conclude that MCB outperformed UBL on the scale of Net Profit Margin. However, both organization have experience downward trend on this scale. Return of Total assets decline through out the period under study for both organizations. Effective risk management is lessening the loss severity as MCB Vs UBL results depicted. Major portion of income comes from Advances business for both organizations, around to 70%. Both organizations concentrate on Advance sector rather then direct investments. High advances portion may be due to Govt. borrowing. Downward trend in return of total assets and in net profit margin may be due to the Govt. extensive borrowing from financial institutes. Non-performing loans/ Advances portion may be increased due to the constrained in the credit policy. Recession in economy is another cause of impeding the organization performance. Proper evaluation of business cycle is difficult due to the volatility in the country business environment Political pressure and nepotism is the other source of impeding the organization management performance. Management integrity is rear breed in the Pakistan. Organizational support level is very low. Both organizations write off loans. Written off balances charged directly to profit & loss account, as well as some portion to provision account. However, provision account also born from profit and loss account. There is growth trend in non-performing loans indicated in both organizations. Low commitment on the account of credit risk management. Hyper competition in sector imposing threat to achieving targets, also contribute in the compromising on granting loan standard. Internal controls not implemented properly.

Recommendations:
UBL management must take measures to improving its indicators for performance. UBL current position on NPL is revealing its low commitment on the account of Credit Risk Management. Management must introduce strict risk management program, install proper Risk identification controls, risk assessment procedures and risk reduction or retention plans. UBL management must observe professional standards without any fear and accepting any pressure from any quarter. All stakeholders expect trusteeship services on the account of executive managers as well as from BOD. BOD must implement and review credit risk management plan to lowering the NPL portion on balance sheet. Training and integrity plans must be introduced for better future performance. MCB position is better as its competitor. However, growing trend in NPL is need proper intention from BOD. Dynamic and volatile business cycle of country may be imposing new threats, review of credit risk policy is essential on this stage to reducing the NPL. Our analysis shows inverse relationship between profitability on NPL. It is better to take early steps to reduce the NPL portion of Advances.

Limitations:
The financial statements by the business concern are subject to certain limitations, which are as under: They reflect only those factors, which can be measured in monitory terms. They do not indicate non-monitory factors, which definitely affect the financial conditions, operations and operating results. Such factors include o General reputation of directors and managers. o Effects of favorable location. o Cooperation between management and workers. o Efficiency, loyalty and integrity of management and employees. They are essentially interim reports and therefore cannot be final because the actual gain or loss of a business can be determined only when it is used or liquidated. Most of the faces reflected by financial statements are mere estimation e.g. inventory valuation. We are use limited set of data as per study purposes, which are not able to generalize or formed any opinion about both organizations.

References: Ali khizer, M. Farhan Akhtar, Shama Sadaqat Factors Influencing the Profitability of Conventional Banks of Pakistan. Journal of International Research Journal of Finance and Economics - Issue 66 (2011) page.117-124 Ali khizer, M. Farhan Akhtar, Shama Sadaqat Financial and Non-Financial Business Risk perspective: Empirical Evidence from Commercial Banks. Journal of Middle Eastern Finance and Economics issue 11 (2011) page.150-160 finance.gov.pk/survey/chapters/05-Money%20and%20Credit08.pdf ishrathusain.iba.edu.pk/.../Banking_Sector_Reforms_Lesson_from_P...
Vaughan Emmett j. (1997), Risk Management,john Weley & Sons, Inc. New York.

www.sbp.org.pk www.mcb.com.pk www.ubl.com.pk