Course Code: 5479

Level: BS

BANK
OPERATIONS
MANAGEMENT
 BANK OPERATIONS
MANAGEMENT
(BS PROGRAM)

Course Code: 5479 Units: 1–9

DEPARTMENT OF COMMERCE
FACULTY OF SOCIAL SCIENCES & HUMANITIES
ALLAMA IQBAL OPEN UNIVERSITY
ISLAMABAD
 (All Rights Reserved with the Publisher)

First Edition: ........................ 2023

Quantity: .............................. 1000

Price: .................................... Rs.

Typeset by: .......................... M. Hameed Zahid

Printing Incharge: ................ Dr. Sarmad Iqbal

Printer: ................................. AIOU-Printing Press, Sector H-8, Islamabad

Publisher: ............................. Allama Iqbal Open University, Islamabad

ii
 COURSE TEAM

Chairman: Prof. Dr. Syed Muhammad Amir Shah

Chairman, Department of Commerce

Course Development
Coordinator: Asia Batool

Writer: Irfan Karim

Reviewer: Professor Dr Syed Muhammad Amir Shah

Editor: Humera Ejaz

Layout Design: M. Hameed Zahid

iii
 CONTENTS

Page #
Preface ............................................................................................................. v

Course Introduction ....................................................................................... vi

Course Objectives ........................................................................................... viii

Unit 1: Basics of Banking .............................................................................. 1

Unit 2: Managing Bank Sources of Funds ..................................................... 19

Unit 3: Consumer Banking............................................................................. 49

Unit 4: Lending to Business Firms................................................................. 67

Unit 5: Introduction to Islamic Banking ........................................................ 87

Unit 6: Managing Bank’s Investments Portfolio and Liquidity Position ....... 109

Unit 7: Asset-Liability Management .............................................................. 131

Unit 8: Financial Statements of Banks ........................................................... 153

Unit 9: Special Categories of Lending Management in Pakistan .................. 167

iv
 PREFACE

Banking is closely linked to trade and commerce. New trends, evolving businesses
along technological advancement have led to innovative banking products and
practices. Time and again, banking laws are made and altered compatible with
modernized operations. Therefore, learning banking management is now one of the
specialized courses in bachelor and master levels programs.

Allama Iqbal Open University endeavours to enhance students’ learning through

contemporary and updated materials. It is a matter of immense pleasure that the
Department of Commerce of Allama Iqbal Open University has developed fresh
course material on ‘Bank Operations Management’ in the form of a new course
book (Course Code:5479). This course book provides extensive learning tools on
banking business and operations and includes theoretical materials and managerial
practices from a practitioner’s viewpoint.

Primarily, AIOU books are developed in the self-learning mode. The course
developers have put their best efforts into making the materials self-explanatory.
The author has extensively based concurrent business and regulatory environments
to help the readers understand conceptual and operative models of banking
operations. The book is written for non-formal and distance learners. It is also
helpful for the students and tutors of the formal education system. The book is
strongly recommended as a textbook for BS level and Master level students at
AIOU. It can also be used as a good reference book for further courses.

The newly developed book is a good addition to the learning treasure of AIOU.
However, we also believe that knowledge should not be restricted to one book or
specified learning materials. It is advised to all teachers and learners of commerce
studies to go beyond the boundaries of the course book and keep updating
yourselves with the latest developments in the field. I wish all the readers of this
book an enlightening journey of education ahead.

Prof. Dr. Nasir Mahmood

Vice-Chancellor

v
 COURSE INTRODUCTION

Banking in today’s world is an integral part of commerce and wealth management.

It’s a business in itself, as well as a support arm of the economy and financial
facilitation for the public at large.

Realizing the importance of this evolving field of education, the Department of

Commerce of Allama Iqbal Open University took the initiative by introducing a
separate course for its degree programs on ‘Bank Operations Management’.

This course book on ‘Bank Operations Management’ covers various modes of

banking business, processes and principles. The book can largely be divided into
two parts: The first part, which comprises Units No. 1 to Unit No. 4, and (partly
Unit 8) covers mostly the traditional and popular banking operations, in practice at
almost every bank. These have been deliberated with the latest market practices,
with current banking laws/regulations governing these operations. Units 1 to 4
comprise the following:
1. Basics of Banking (This unit also covers various topics, from popular banking
services, the latest technology-driven solutions and basic laws/ regulations to
detailed customer due diligence and banks’ responsibilities concerning
implementing anti-money Laundering laws)

2. Unit 2 is about Banks’ sources of funds and deposit schemes. Various types
of deposits and management of the bank’s funding sources and public-to-bank
relations are discussed in detail. The Unit also covers advanced topics of non-
deposit funding raised by banks through financial market operations.

3. Unit 3 discusses the business of Consumer Banking. The importance of

accounts for any bank and related operational processes and various modes of
consumer banking are described with practical examples. Both asset and
liability side banking services are covered here.

4. Unit 4 is about the banks’ role in supporting businesses and the economy at
large. Banks’ utilization of available funds by lending to business firms is
discussed in this unit. Various modes of bank loans, advances and
management aspects are covered in detail.

The next part, Units 5, Unit 6, Unit 7, Unit 8 and Unit 9 are more specialized in
nature and talk of rather emerging or advanced topics that include modes of
investments, liquidity and their significance to the successful management of a
bank. The function of Asset-liability Management is taught in this part and its

vi
impact on a bank’s profitability is worked out. Islamic modes of banking are also
introduced and explained along with Agricultural and SME lending under
specialized facilitation policy.

It is sincerely hoped that the book will fulfil the objectives for which it has been
designed. The book will meet the needs of BS-level students, advanced diplomas,
and references for higher degree programs.

I owe a great deal and oblige you to the efforts of Mr. Irfan for his valuable time
and efforts. He wrote the units of the book by enriching the book with lifelong
banking experience and made the book an asset for the students.

I am also thankful to Mr. Moazzam Ali Assistant Professor for his support in the
development of the course.

Finally, special gratitude is owed to Dr Syed Muhammad Amir Shah, Chairman

Department of Commerce, reviewed the Book. His supervision, support, and
guidance led to the successful completion of this book.

Comments from users are welcome.

Asia Batool
Course Coordinator

vii
 COURSE OBJECTIVES

“Bank Operations Management” is a major course in the BS program for students.

The basic purpose of the course is to introduce students to the major concepts of
banking in the field of business.

The content of the course is developed to serve the following objectives enumerated
below:
 To provide the students of degree programs with up-to-date insight into
banking and its role in the promotion of commerce and business.

 To provide learning on conventional and current modes of banking operations

and management tools to enable the students and learners to perform
effectively in their competitive work environment.

 At the end of each chapter, students are provided with practice questions so
that they can assess themselves.

viii
Unit–1

BASICS OF BANKING

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
1
 CONTENTS

Page #
Introduction ....................................................................................................... 3

Objectives ........................................................................................................ 3

1.1 Banking Services: A Brief Introduction ................................................. 4

1.2 Impacts of Government Policy and Regulation for Banking ................... 8

1.3 Anti-Money Laundering Law and Implementation ................................. 11

1.4 Measuring and Evaluating Bank Performance ........................................ 13

1.5 Self-Assessment Questions ..................................................................... 15

1.6 Summary .................................................................................................. 17

References ........................................................................................................ 18

2
 INTRODUCTION

This unit introduces basic concepts about banking services, operations, and
regulations. Both traditional and modern technological tools are elaborated to
familiarize the readers with contemporary banking practices. The legal structure
behind the banking business in Pakistan and the regulatory authority of the State
Bank of Pakistan have also been touched upon.

This basic learning will prepare the students for the next study units, where banking
operations and modalities are described in detail. This unit assumes that the
students already have background knowledge of the fundamentals of Money and
Banking, which was taught in initial study courses in business/commerce.

OBJECTIVES

After studying this unit, you will be able to:

 Learn about the basics of modern banking and the role of banks and financial
institutions in developing financial services, including both conventional and
modern technological solutions.

 Understand the application of government laws and regulations to strengthen

banking operations, with particular reference to emerging developments in
controlling money laundering.

 Have basic knowledge of the role of the central bank in regulating and
performance evaluation.

3
1.1 Banking Services: A Brief Introduction
Banking companies provide facilitation to the public, businesses and governments
with their financial services and money channels. Banks play a significant role in
the economic system by accepting and securing deposits and extending loans.
Services, like fund transfers, remittances, financing of local trade and imports/
exports, provision of foreign exchange etc. are important contributors to business
and the economy.

1.1.1 Popular Banking Services

a) Liability Products
Deposits of customers, held in various accounts and payable on demand or after a
certain time, are considered bank liability. Customer deposits provide the basic
funding source for any bank's business. Banks accept and attract deposits from the
public, business enterprises governments etc.
i. Demand deposits, which are payable when demanded by the customer by
drawing a cheque.
ii. Time deposits, or Term Deposit, which are fixed for a certain period
iii. Basic banking account to attract the under-banked section of society, i.e. for
those individuals who had not opened any bank account before.

b) Asset Side Services offered by Banks

The banking business under which funds are deployed/ disbursed or advanced as
loans to the customer is considered as the bank's assets in the bank's balance sheet.
Such earning assets for income generation comprise the following modes:
i. Personal Loans, Credit cards, Vehicle financing for retail or individual consumers
ii. Loans to business firms for inventory, imports and plant and equipment
iii. Investments in financial markets
iv. Credit for Small and Medium Enterprises, Real Estate projects and Agriculture
Finance

c) Cash Management Services

Business firms utilize banking services for the collection of their receivables/
revenues. Banks having the advantage of their large country-wide network, collect
funds online on behalf of such customers. The customers are offered incentives and
profitable deposit schemes on the funds retained with the bank. In this way, banks
and customers both benefit from Cash Management Services.

d) Payment Services Offered to the Bank's Depositors and Walk-in-Customers

Services related to the clearing of cheques, payments and fund transfers are among
the basic banking operations. Banks provide services to depositors for the collection

4
of cheques and funds. General public or business firms utilize bank services for
fund transfers to other persons within the same banks, or to other banks, both
nationwide and overseas.

Conventional modes of Payment services:

Traditionally, the following modes of services are provided to facilitate customers
in making payments to other persons:
i. Inter-branch funds transfer: Depositors can transfer funds online to other
accounts with the same bank.
ii. Pay Order/Demand draft: The Bank issues a payment order under a
customer's request for payments to other persons. Being a banker's cheque,
it's accepted as a confirmed payment mode by any other bank.
iii. Telegraphic Transfer or TT: Historically, through telex, and now an
electronic mode of funds transfers between two accounts. This mode is also
referred to as Wire Transfer.

Modern technological-based transfer systems:

i. RTGS: For customer payments to any account and bank in Pakistan, TT is
replaced by a more technologically capable network of RTGS (Real Time
Gross Settlement System). This system is controlled under the settlement
mechanism of the State Bank of Pakistan and can transfer funds to payees'
accounts on an interactive and real-time basis.
All banks in Pakistan are connected to the RTGS central server under the
control of SBP, Karachi.
ii. SWIFT for international transfers: Abbreviation of 'Society for Worldwide
Interbank Financial Telecommunications'. Transactions of fund transfer
between two institutions, worldwide are carried out through bank identification
codes of SWIFT.
iii. Digital banking, Internet banking: Banks encourage their customers to use
digital banking and transact through the Internet, while sitting at home. Under
digital banking, all operations, starting from account opening to fund deposits
or payments are managed through mobile banking, Internet banking or
ATMs, without the physical involvement of any branch.
iv. Banking for Non-Resident Pakistanis and Remittances: Latest information
technology systems have opened ways for banks to improve banking services
for Pakistanis living or working abroad. Funds sent in foreign exchange to their
families back at home are now channelized quickly and with more accuracy
with digital banking and after the implementation of the International Banking
Account Number (IBAN).

5
Use of IBAN in Payments/Transfer of Funds
Pakistani banks operate worldwide through their network of branches. So, money
can be transferred from any country to a consumer's account in Pakistan through
banking channels. To achieve transparency and accuracy, IBAN (International
Bank Account Number) has also been implemented in Pakistan.

Definition
IBAN is an internationally agreed system of identifying bank accounts to facilitate
the communication and processing of fund transfers with a reduced risk of
transcription errors.

How IBAN is formulated in Pakistan

For Pakistan, the 24-digit IBAN is implemented in all banks.
i. The first four characters identify the country code.
ii. The next four letters are used as Bank Identifier.
iii. The next 16 digits denote the account number of the particular account holder
with that bank.
iv. Example of IBAN being used in Pakistan:

PKnnUNIL1234567890000001

IBAN Benefits
 A standard bank account across Pakistan, brings more efficiency in payment
processing and electronically validates account numbers and the payment
route. RTGS also uses IBAN for domestic fund transfers.
 Elimination of delays in fund transfers originating from foreign countries to
Pakistan
 IBAN enhances security in remittance transactions and addresses the
beneficiary bank and the customer.

1.1.3 Banking Services Based on Various Customer Types

Each group of customers may have different banking needs. Banking services are
therefore categorized into various types and banks and financial institutions
distribute their operations into different specialized departments.

6
Broadly, the previously discussed banking services are compared in the following
three functional groups.
Parameters of Retail or Comparison of
Investment Banking
Comparison Consumer Banking Banking
A more specialized
Commercial Banking means
Consumer banking is a function of lending
deposit mobilization from
Meaning bank's provision to the investment, which may
all sources and extending
general public, rather than involve financial markets,
loans to businesses, trade
companies other banks or
and inventory financing.
governments.
Commercial customers
Retail Banking includes Large size corporates,
Customer Base include Traders, small and
Mass marketing to High net-worth individuals
medium enterprises (SMEs)
personal customers and Governments
and mid-size corporates.
Personal loans, credit Business current accounts, Investments in financial
Example Products and cards, Auto loans, Loans for inventory and markets and by acquisition
Services Personal current and business expansion, of shares, Project financing
savings accounts, and Financing for equipment like lending for electricity
remittances. and import business . transmission lines, etc.

1.1.4 Personal Selling of Banking Services

Sales and marketing operations play a vital role in the introduction and sale of the
bank's products/services. Banks can increase their business by offering the right
type of services to meet customer’s demands. In addition to advertising campaigns
through various media, personal selling is also practised at bank branches for the
marketing of asset or liability services.

Leaflets/brochures are placed in the branches for customers' information. Sometimes,

bankers may also approach the customers present in the branch premises for the
distribution of leaflets/brochures or request a discussion and introduction about new
schemes.

However, a salesperson needs training and knowledge of both the customer and the
product being marketed. Good ethical standards, transparency and honest practices
are expected from a banker.

Responsible marketing practices by understanding Consumer's rights

In the context of marketing and customer relations, the banker and consumer should
understand that fair treatment is a shared right and responsibility of both of these
parties.

A consumer has the right to:

 Be provided with accurate, elaborate and updated information on the required
product/ service.
 Be timely informed of important changes in terms and conditions of the
availed services

7
 Read and understand all terms and conditions before accepting them and ask
the bank questions if required.
 Be extended special assistance if the consumer is a senior or disabled citizen
 Safeguard of financial and personal data, and private information. NIC
number and photographs, family profile etc. be handled with complete trust
and confidence
 Be protected against fraud and unprotected sharing of digital information.
 Be informed of the complaint handling mechanism at the bank

1.2 Impacts of Government Policy and Regulation on Banking

1.2.1 Policy Goals and Banking Laws

Banks are the custodian of public money and their role in channeling this money
for business and investment is vital for the country's economy. Therefore,
governments provide a working environment for banking companies by making
laws and with policy formulation.

Laws are framed to implement Government Policies and are approved at the level
of Parliament.

Laws and Regulations are formulated for:

a. Development and strengthening of the banking sector
b. Protection of the depositors' rights and interests under the authority of the
State Bank of Pakistan.

Laws Relevant to the Opening and Operations of Banking Companies in Pakistan:

Banking Companies Ordinance 1962, amended from time to time.

Currently Functions of the State Bank of Pakistan are mainly governed by:
- SBP Act, 1956 (as amended from time to time)

Under this Act, SBP is authorized to regulate the banking sector in Pakistan, the
country's monetary and credit system and to nurture their growth.
- Banking Companies Ordinance, 1962
- Foreign Exchange Regulations Act, 1947
- Microfinance Institutions Ordinance, 2001 (for setting up microfinance
banks)
- Payment System and Electronic Fund Transfer Act, 2007

8
Definition
Microfinance Banks: These are specifically established to extend small loans to
low-income groups and rural businesses. These banks may collect deposits from
all, but provide credit facilities to financially weaker communities for supporting
micro businesses.

Definition
Cash Reserve Requirement: Banks are required to keep a certain percentage of their
deposits/liabilities with the State Bank of Pakistan, as a mandatory Reserve. This
percentage of deposit, to be kept as a Reserve, is known as the Cash Reserve Ratio
(CRR). SBP notifies CRR from time to time and may increase or decrease based
on its policy.

1.2.2 Monetary Policy by State Bank of Pakistan

Central banks are also responsible for managing the monetary system of the country
and thereby take action about money circulation, banking, inflation and policy
interest rates.

In Pakistan, this function is entrusted to the State Bank of Pakistan.

Central Banks of some other countries are named as follows:

Federal Reserve System (in the USA)
The Bank of England (UK)
Reserve Bank of India

The State Bank of Pakistan issues a Monetary Policy every two to three months
after reviewing the data on the country's inflation, trade and foreign exchange
inflows/outflows etc.

Central Banks may adopt the following measures to stabilize inflation or support
business growth:
1. Changes in Policy Interest rates to control money circulation and credit
expansion
2. Reduction in Cash Reserve requirement (CRR) to be kept by banks with SBP
3. Under high inflation, adopt monetary tightening by pulling liquidity from the
banking system
4. or conversely injection of liquidity for business growth (Monetary Easing)

9
Impacts of Monetary Policy Decisions on Banks and the Business Environment
Monetary Policy Action Impacts on Banks, Business
Banks’ deposit and lending rates will also
Increase or Decrease in Policy Rates
change
Banks business volume may increase due
Reduction in Cash Reserve Requirement
to more funds available for investment/
for Banks
customer’s lending
Business will suffer due to lesser credit
Monetary Tightening by increasing CRR
from banks and higher cost of funds
Banks will have more comfort in
Injection of funds to banks for monetary
developing new businesses. Inflation may
Easing, against government securities
increase later on.

1.2.3 Implementation of Prudential Regulations by State Bank of Pakistan

Under financial sector reforms in various phases, the role of the State Bank of
Pakistan has been strengthened further by implementing its autonomy.

State Bank of Pakistan issues Prudential Regulations for banking business under
the authority of the SBP Act.

Objective of Prudential Regulations:

- To safeguard the interests of both the depositor/customer and the banking
business
- To keep the banks/FIs lending business within the affordable risk limits
- To monitor the financial fitness of the banking institutions for the growth and
stability of the country's financial system as a whole

SBP exercises complete independence in the supervision and inspections of banks

and enforcement of its regulations.

Being a binding obligation, all banks and financing/lending transactions must

adhere to the limits and guidelines set in various Prudential Regulations and SBP
circulars. Prudential Regulations have been issued separately for various types of
banking operations, such as:
- Consumer Financing (i.e. loans and banking facilities to individuals and families)
- Corporate and Commercial Banking (i.e. regulations for loans and bank's
dealings with large-scale businesses or trade)
- Agriculture Financing
- Financing to Small and Medium Enterprises
- Housing Finance

10
1.3 Anti-Money Laundering Law and Implementation
In this section, a brief overview has been given on understanding the concept of
money laundering and efforts so far by the Government of Pakistan to counter such
illegal practices.

1.3.1 Money Laundering Explained

Money Laundering is a criminal activity, referred to as disguising funds and
proceeds of the un-lawful business, or un-taxed money for deposit in a bank or
transfer by using banking or non-banking channels.

In other words, the Transfer of funds from one account or country to another is
considered Money Laundering activity if it involves:
i) Hiding of the actual business or illegal source of funds
ii) Fake documents or accounts/ persons
iii) and violates banking and tax laws

Examples
For example, a person generates money through the illegal business of gambling,
and tries to use bank services to transfer it abroad. To hide his activity from law
enforcement agencies, he tries to use fake documents regarding income sources and
his identity. The bank under the laws and regulations is bound to verify all the
documents and accordingly, the bank should not accept these funds and report the
illegal act to the concerned authorities.

Similarly, a transaction of money transfer through someone else's account also falls
under Money Laundering if this action is carried out to hide the income from the
application of tax as required under the Tax laws of the country.

1.3.2 Anti-Money Laundering Act 2010: Bankers Duties to check Illegal

use of Banking Channels for Criminal Intent
Banking worldwide has been going through a phase of transformation. Earlier the
banks would happily accept deposits without going into details of customer's
background/data. But the events in the last few decades including cross-border
terrorism and hiding of un-taxed money (black money) have made banks more
vigilant.

Money Laundering Act 2010 is the primary law that prohibits the use of bank
accounts and channels for money Laundering, illegal funds or by persons belonging
to banned organizations.

11
Definition
Know-your-customer is a term used in banks and businesses alike, which implies
that the institution must know in detail about the person, with whom it enters into
a business relation. Banks must explore the true identity of the person who
approaches for a deposit or for obtaining a loan. Getting to know about a customer's
identity, address, business or income profile etc. is also termed as Customer's due
Diligence.

Banks therefore put in place the following systems and operations for checking
undesirable transactions:
1. For compliance with the Law, banks implement software systems and
operations to check customers' transactions that may involve illegal routing
of money, both domestically or across borders.
2. Bankers adopt the following actions to understand customer's business/
transactions:
- Verify the customer's identity by linking cash flows in the account to its
business. Refuse accounts, if found in fake names
- Also check the account holder (individuals, or directors in case of
companies) through a designated database of the banks, and
governments, and raise suspicion, if any person has links with
organizations banned by governments.
- For the avoidance of suspicion/doubt, monitor the pattern of funds
transfers, and check such transactions that are repeated in large volumes
(cash or TTs).

3. Checking and Reporting of Suspicious Transactions under the Money

Laundering Act:

Suspicion here means that the volume and pattern of cash deposits or fund
receipts/transfers in the account are not in line with the customer's declared income
sources and may raise doubt:
i. That customer may be using the bank account for the deposit of funds raised
through illegal sources
ii. or the account is being used to transfer funds for Money Laundering or
indirectly to banned organizations
iii. or the account is operated by fake persons and the true beneficiary is being
hidden.

In summary, large transactions that do not match the customer's general behaviour/
profile and income sources may raise suspicion for further verification. Such
transactions are classified as 'Suspicious transactions'.

12
4. Financial Monitoring Unit of the Government of Pakistan:
A Financial Monitoring Unit (FMU) is set up under the federal government to
implement money laundering laws and exercise control over financial crimes.

Currency Transactions, i.e. deposits and withdrawals exceeding certain daily limits
are reported under the Currency Transaction Report (CTR). Suspicious
Transactions are also required to be reported to FMU.

1.3.3 SBP Regulations for Anti-Money Laundering

Implementing the Money Laundering Act to complete banking operations, the
State Bank of Pakistan issued detailed regulations on Anti-Money Laundering
procedures to be adopted by banks, Microfinance Banks, and development financial
institutions.

The objectives of these regulations are:

a) To make banks responsible for understanding their customer's financial
background and behaviour
b) Be assured of his/her true identity and safeguard banking channels from
illegal use.
c) To report any suspicious transactions and accounts in line with the Money
Laundering Act 2010.

These regulations are available on SBP guidelines and provide guidelines for banks
to set up operational systems and training so that banking channels are not allowed
for illegal purposes.

The regulations and circulars are binding obligations and their compliance is
checked by periodic inspections by the State Bank of Pakistan.

In terms of the Banking Companies Ordinance, 1962, violation of the State Bank
of Pakistan regulations renders the bank/FI/officer(s) concerned liable for penalties.

Detailed operational procedures of account documentation and implementation of

rules related to know-your-customer are described in further detail in the next units.

1.4 Measuring and Evaluating Bank Performance

This section briefly discusses the performance indicators of banks and financial
institutions.

13
A bank's financial health and business performance can be measured from various
angles, including deposit growth to achievement of net profit.

Performance is broadly measured at two levels:

i. Internal performance evaluation and
ii. External Monitoring by Regulatory authorities

1.4.1 Internal Performance Evaluation of Banks

An internal performance evaluation may further be divided into two tiers
a) At Branch or Regional levels
b) For the bank as a whole

a) Targets Evaluation at Branch or Regional levels.

Each branch or region may get targets to achieve progress in the following areas.
- Deposits
- Number of new accounts
- Booking of new loans to consumers through personal selling

After the end of each quarter/year, performance evaluation is carried out on the
following lines.
Achievements Budget variance Growth in
Performance Target/Budget
during the (achievement – comparison to
Parameter for the Year
year Budget) previous year (%)
Deposits (Rs in Million)
Number of new accounts
Loans and Advances

b) Target Evaluation of the Bank/financial institution as a whole

Banks' overall performance evaluation involves a few further parameters, also
based on the results of its financial statements. These are also compared to industry
standards. These may include:
i. Net Operating Income and Net Profit before tax
ii. Advance to Deposit Ratio (ADR)
iii. Investment to Deposit Ratio (IDR)
iv. Bad debts to advances Ratio

 ADR and IDR are performance indicators of a bank's business. These ratios
indicate how well the bank's deposits are applied in loans or investment
business. IDR means investments in the numerator compared with deposits,
in the denominator

14
 During the performance evaluation of banks, ADR and IDR are also
compared with the competitor banks to gauge the efficiency of the bank's
operations and its team.
 Ratio of Band Debts to Advances indicates possibility of loss due to bad debts

1.4.2 Performance Evaluation by External Authorities

Regulator/State Bank of Pakistan carries out supervision and inspections of banks
and financial institutions. Performance evaluation is reported in such inspections
from a different angle, with a focus on the quality of business operations and
regulatory compliance.

External evaluation therefore highlights the following performance indicators:

1. Liquidity condition of a bank and its ability to raise funds at a competitive cost
2. Asset Quality: The Inspection analyses the loans, advances and bank
customers in detail
3. Earnings: Based on their analysis, SBP also assess the ability of income
generation from earning assets
4. KYC: Customer documents are inspected to issue a report on the 'know-your-
customer' (KYC) process of the bank.

Further, External Credit Rating is another external process, important for banks'
evaluation. The credit rating of any institution informs the lenders about its strength
and ability to repay the deposited amounts.

above-referred performance indicators are also applied by Credit Rating

Companies to assess the quality of Management and the bank's operations. Based
on their assessment, Credit ratings of banks and financial institutions are issued
every year.

1.5 Self-Assessment Questions

a) Short Questions
i) Name a few asset side products/services offered by banks to its customer
ii) What do you understand from the term 'CRR' and its relation to deposits
of a bank
iii) What is meant by IBAN, and write a few banking services in which
IBAN is required

15
b) Long Questions
i) Write at least three (3) conventional modes of Payment Services/ fund
transfers of banks and compare these with Modern technological
transfer systems
ii) Write a few characteristics of a responsible marketing officer of a bank,
who performs the function of personal selling of banking services to its
consumers.

c) Exercise
A bank publishes its Balance Sheet as of December 31, xxxx. The following
are amounts under some of the assets and liabilities:

Assets: (Rs in Millions)

Cash and Balances with treasury accounts 267,937
Investments 1,496,542
Advances 646,188

Liabilities:
Deposits 1,750,944

From the above data, calculate the following in light of definitions and illustrations
studied in this Unit.
1. Advances-to-Deposit ratio of the bank
2. Investment-to-deposit ratio of the bank
3. Cash Reserve Requirement (in million rupees) on December 31 of year xxxx
(say 14% of deposits are required to be held as CRR)

Also write about some basic documents (for Know-your-Customer or anti-money

laundering procedures), that should be required from a person who approaches a
bank to open his/her deposit account.

16
1.6 Summary
In this first unit, the student has developed a basic understanding of banking
services and operations. Introduction to modern technological solutions and the
transition of banking to more efficient systems have also been deliberated. The
banking business in the modern era is characterized and branded based on
customer-focused services. Accordingly, a comparison of banking operations based
on various customer types is discussed in this unit. This elaboration will help the
students to better understand the detailed description of such topics in the next units.

The second section of the Unit introduces the application of regulatory framework
on banks’ operations. The regulatory authority of the State Bank of Pakistan, its
jurisdiction over inspection of banks, implementation of Prudential Regulations and
monetary policy are emphasized. Emerging subjects of Know-your-customers and
Anti-Money Laundering are also introduced in this unit. Examples are used for
quick learning, along with a review of the basic requirements that bankers are
expected to follow for verifying customers' credentials and combating the illegal
use of banking channels.

Continuing the discussion on the importance of performance oversight and credit

rating, the Unit also discusses, in basic terms, how the performance of banks and
bankers is measured and evaluated within the institution and by the State Bank of
Pakistan during the periodic inspections.

This Unit provides insight into the present-day banking environment and
operational standards. The next units deliberate on each respective topic in detail.
These will include various deposit products, lending and investment modalities,
customer-wise banking services, specialized banking facilitation and operational
management, along with standards of compliance with relevant laws and
regulations.

17
 REFERENCES

Padmalatha Suresh (2011) Management of Banking and Financial Services. India

Pearson Education

[Link]

[Link]

[Link]

18
Unit-2

MANAGING BANKS’
SOURCES OF FUNDS

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah

19
 CONTENTS

Page #
Introduction ....................................................................................................... 21

Objectives ........................................................................................................ 21

2.1 Deposits and Pricing Deposit-Related Services ....................................... 22

2.3 Pricing of Deposits — Strategies Used in Pakistan ................................. 26

2.3 Basic (Lifeline) Banking and Liability Management .............................. 33

2.4 Alternative Non-Deposit Sources of Bank Funds .................................... 38

2.5 Self-Assessment Questions ...................................................................... 45

2.6 Summary .................................................................................................. 47

References ......................................................................................................... 48

20
 INTRODUCTION

Generally, the source of funds for any corporate entity is a combination of Equity and
Debt. Banking is a business of borrowing and lending, i.e. handling deposits, money,
currencies and extending loans and financial services. Deposit accounts are a core
source of funding for banks, while other diversified sources provide crucial support for
business operations. Banking companies mobilize deposits from their customers and
structure a range of services to attract short-term or long-term deposits and utilize these
funds for investment, loaning and other business products. A stable deposit base is
essential for achieving profitable operations and healthy creditworthiness.

Treasury operations and inter-bank trading also provide a pivotal platform for
sourcing instant currency, funding needs as well and earning profit on surplus
liquidity. In addition, banks also mobilize resources by raising/issuing redeemable
capital or liability notes (within the regulatory bounds), such as Term Finance
Certificates or preference shares. These mobilizations are for the long term and
primarily serve the purpose of regulatory compliance on capital adequacy and
liquidity of banks. This unit elaborates on these funding sources with examples and
references included for more practical comprehension.

OBJECTIVES
The basic objective of this unit is to provide an overview of various deposit
products, a mix of funding sources for the banks, their pricing, banking strategies
and competitiveness in their resource mobilization.

After studying this unit, you will be able to comprehend:

 Definition and various types of deposits and sources mobilized by banks

 Relative Pricing and rate of return on deposits

 Pricing strategies and marketing for resource mobilization and deposit wars

 Overview of Inter-Bank market and Treasury Operations

 Alternate funding sources, long-term redeemable capital, notes issued by banks

 Practical examples of funding sources of various banks, emerging versus

large banks

 Basic Banking and Liability management

21
2.1 Deposits and Pricing Deposit-Related Services

2.1.1 Definition and Purposes of Banking Deposit

Deposit at a bank is defined as the depositor's money in his/her name at a bank/
financial institution under the respective account title. The bank acts as custodian
of the depositor's money and is liable to return the same against customer demand
or at maturity of the underlying contract, under the agreed terms of the deposit
scheme/contract.

Profit /interest may accrue on certain deposits, while for certain others (explained
later hereunder) no interest is payable, depending upon the nature of the deposit.
Banking companies established under the Banking Companies Ordinance 1962
and/or other related laws are eligible to mobilize deposits from the public, business
persons, corporations and institutions. The eligible banking companies include
commercial banks, Islamic banks, specialized commercial banks, investment banks,
development finance institutions, microfinance banks and leasing companies.

The basic objectives of the business of fund mobilization by a bank are as follows:
 Sources of funds for managing business operations e.g. extending loans,
financing of trade business, consumer loans, investments, cash management etc.
 Meeting liquidity outflows including deposit withdrawals, payment
commitments, statutory/ regulatory reserve maintenance
 Earning income spread by investing/deploying surplus funds in permissible
profitable modes in financial markets, e.g. asset-liability management and
placements in Treasury accounts of other banks
 Meeting regulatory stipulations of the central bank (i.e. State Bank of
Pakistan) concerning the governance of banks and protection of depositors,
e.g. Statutory liquidity Reserve (referred to as SLR) and Cash Reserve
Requirement (referred to as CRR)

2.1.2 Categories and Types of Deposits and their Relative Pricing

Deposits mobilized by banks from their customers are broadly categorized into:

Demand Deposits
Time Deposits or Fixed Deposit
A demand Deposit or checking account is a deposit account that does not put any
limit on withdrawals and deposits of funds from/into the account. Current deposits,
Call Deposits and saving accounts where no limit of funds In/Out applies, fall under
the category of Demand Deposits. Also called checking accounts, these are liquid
and can be accessed using cheques, ATMs and Internet Banking. Given this
flexibility in banking services, either no rate or low rate of profit is applied to demand
deposits. Hence these are useful for banks in terms of relatively lower cost of funds.

22
Fixed deposits or Time Deposits on the other hand are structured by banks to
achieve a relatively more stable and predictable funding source. In return for fixing
customers' deposits for a certain certain period, more attractive rates of profit and
periodical income streams are offered.

Following is the detail of Demand Deposits:

Core Deposit
Core deposits are the deposits that form a stable source of funds for banks and
financial institutions. These provide sustainable and rewarding advantages to
financial institutions, including a profitable and predictable liquidity profile within
desirable limits of deposit costs and the development of a reliable customer base.
These are comprised of current and saving deposits generally known as CASA.

These low-cost deposits provide pivotal support to the bank in enhancing

profitability and managing a healthy liquidity profile. Banks depend heavily on
CASA to meet their funding needs and compete with each other by developing
respective strategies and competitive pricing to attract new accounts for
maintaining and enhancing the market share of CASA volume.

Current Account
The current account is one of the most common types of Demand Deposit accounts.
It is an attractive deposit category from a bank's point of view given its low cost.
The current account is offered to such customers where retention of the daily
balance in the bank account is not predictable and/or the business entails frequent
turnover of receipts/outward payments. Current accounts may suit sole
proprietorship accounts or businesses. In addition, government receipts of taxes,
challans etc. are also handled in current accounts. Banks may offer specific free
banking services to attract deposits under current accounts. Traditionally, the banks
prefer not to provide any interest/profit on current accounts. Exceptions are there,
like for example Remunerative Current Accounts: In this case large accounts are
marketed to attract more current deposits which promises a certain remuneration
on the account balances. Profit is paid on a monthly/weekly average basis for a
certain threshold of deposit balances. Higher profit slabs may be applicable for
higher amounts to encourage the customer to retain funds in the account.

Saving Deposits
Saving deposit schemes are developed for large numbers of depositors, both
individuals and businesses alike. This deposit type is suitable for customers who
need to maintain liquid funds and simultaneously pursue profit motives. Given
fluctuating amounts of deposit balance and no condition of tenure/term, a relatively
lower rate of interest is applied on saving deposits as compared to other schemes.

23
Having features of Demand Deposit, depositors can withdraw through ATMs, and
cheques while also being eligible to receive profit on the surplus balance (mostly
based on slabs of deposit balances).

Examples of saving deposits: PLS Saving deposits, Deposits under Salary accounts,
checking accounts of business enterprises, and Foreign currency accounts.

Tenure Based or Fixed Term Deposits

The deposit types discussed so far did not put any proviso of holding the funds in
the deposit account for a specific tenure. On the contrary Time Deposits are held
for a certain period and are subjected to withdrawal after maturity of the term.
Banks generally pay higher interest rates compared to demand deposits. Time
deposits generally refer to certificates of deposit (CDs) or Fixed Term Deposits,
also referred to as Fixed Deposits or TDR (Term Deposit Receipt). These are held
by the bank for a specified and agreed tenure in return for a higher rate of profit.
Under these arrangements, banks get the advantage of managing their cash flow
utilization for a known period, while depositor receives higher profit. Pre-mature
withdrawals may be agreed upon subject to prior notice and reduced profit rate,
related to the holding period of the deposit.

Other Remunerative Deposits

To enhance the liquidity base and attract large amounts from high net-worth
accounts, banks may offer higher profit rates and income schemes. A few examples
of such schemes and their category, and elaboration are as under:

Table 2.1
Deposit
Category Main Features
Schemes
Monthly/ Suitable for those customers who need income annuity on a
Time
Quarterly Profit monthly/periodic basis. High-value accounts and longer tenure
Deposit
Schemes attract higher income.
Saving deposits of large value, mostly of business corporates.
Daily Product Demand
Profit is calculated on daily balances. Bank may offer premier
Savings Account Deposit
services/free banking facilities to manage customer relationship
Development financial institutions and Investment Banks
depend largely on time deposits given their limited customer
Certificate of
base and the nature of investment-focused operations. COI is a
Investment (COIs Time
fixed-term deposit instrument, from short to medium term,
of Investment Deposit
suitable for high net-worth individuals, Trust Funds, Mutual
Banks, Other FIs)
Funds and corporates. Depositors generally desire a negotiated
rate of return for higher amounts.

24
Islamic Banking Deposits and PLS Deposits
Islamic banks in Pakistan operate under separation regulations aimed at the
development and promotion of Islamic finance. From a historical perspective,
efforts towards the initiation of Islamic baking and Profit and Loss Sharing
Accounts in Pakistan were first made from 1979 to 1985, followed by the
promulgation of related Laws. A more comprehensive amendment in the Banking
Companies Ordinance 1962 was notified in the Gazette of Pakistan on November
4, 2002, which provided that banks could form subsidiaries for "carrying on
banking business strictly in conformity with the Injunctions of Islam….”. In
January, 2003 the State Bank issued BPD Circular No. 01 outlining detailed
instructions on setting up of subsidiaries and Stand-alone branches for Islamic
Banking by existing commercial banks in Pakistan.

Islamic banks seek deposits based on the expected rate of profit, while the actual
rate is subsequently arrived at under a profit and loss sharing basis within the
Modaraba Pools developed for allocating profit/loss among the customers. There is
a strong customer base in the world as well as in Pakistan for this banking segment.
Backed by strong clientele and vibrant regulatory oversight, Islamic banking
institutions in Pakistan have recorded robust growth in deposits and lending
operations during the last two decades.

2.1.3 An Overview of Deposits of Banks in Pakistan

Currently Banking industry in Pakistan primarily comprises 53 banking institutions
under various categories. The deposit base of these institutions, as per SBP (Economic
Data as of December 2020) is Rs. 17.330 trillion. These institutions are regulated by
the central bank (State Bank of Pakistan). These institutions compete in various
segments of the deposit market to build up their respective market share. Banking
institutions currently in operation within Pakistan are of the following categories:
Table 2.2
Banking Institutions Regulated by State Bank of Pakistan
Type of Banking License Number of Institutions
Local Private Commercial Banks 15
Public Sector Commercial Banks 5
Specialized Banks 4
Islamic Banks 5
Foreign Banks 4
Development Finance Institutions 9
Microfinance Banks 11
Total 53
Reference: Website of State Bank of Pakistan

25
Note: There are a few other Investment Finance Service and Leasing Companies
(regulated separately by SECP), but their role in deposit handling is negligibly limited.

2.2 Pricing of Deposits — Strategies Used in Pakistan

2.2.1 Determinants of Deposit-Pricing

Interest on deposit is the cost of funds for the banks. This cost of funds is the most
significant variable for a bank's sustainable operations. Changes in the cost of funds
could render the bank less competitive in the market. Banks therefore will be keen
to understand how to measure the cost of their funding sources and correspondingly
price their assets to ensure a positive desired spread on deposits. The pricing policy
of a bank lays down guidelines for deposit sources and their pricing in line with the
business model and profitability targets of the bank. The following aspects are
considered in this regard:
 Bank's target Income spread, considering available business modes where
deposited funds are utilized/ invested
 Banks Target customers (in what proportion, bank approaches various
segments, Individual, corporate, SME etc.)
 Volume of CASA (growth in cheap demand deposit)
 Intermediation cost of deposit function
 Policy Rate changes in Monitory Policy
 Likely changes in the Bank's credit rating
 Deposit volumes and cost of each product about profits
 Banks' appetite for managing market share in deposit mobilization (an
aggressive approach would lead to higher deposit rates, or vice-versa)
 Rack Rates of deposits and special rates

Banks compete in the deposit market to attract deposits and make new customers.
For this purpose, each bank develops customer-focused strategies depending upon
their standing, branch network and operational domain. Several factors that define
the relative capacity of each bank to mobilize deposits are:
 Service standards and geographical size (branch network) of a bank
 Range of products of a bank for diversification of banking services and
historical standing
 Credit Rating assigned by external credit rating agencies
 Banks for specific defined operational Domain (like rates of microfinance
banks and development finance Institutions are higher than those of
commercial banks)
 Islamic Banking Modes, focused on an exclusive market segment (rates are
determined on riba free basis from Common Modaraba Pools and Special
Modaraba Pools)

26
2.2.2 Rack Rate Announcement
Banks are obliged to disclose and publish a list of profit/markup rates on deposits
of various categories, types and tenures a regularly. These rates are referred to as
Rack Rates, which are published and valid for a certain period. In addition to the
factors referred to above that determine the policy of each bank on rate setting, the
following market/regulatory variables also impact rate setting strategy where banks
may announce revision of the rack rates.

Table 2.3
Market action Impact on Rack Rates
Market Action Impact on Rack Rates
With any change in this benchmark, all market
variables are impacted. Accordingly, banks need to
reset their deposit prices to align with the trend. Like
Revision in Policy Rate by
for example in the case of monetary tightening in
State Bank of Pakistan
Monetary Policy, Rack Rates may go up to attract
more deposits and customers may benefit from pass-
on impact.
Most banks need higher deposits at quarter/ year-end
Market Competition to compete with others and therefore, revise rack rates
upward to beat deposit wars
Any negative development or rating downgrade may
Systemic Default or a
result in a deposit run, which may be mitigated by an
specific bank's default risk
upward revision of rack rates.
Issuance of rating watch or
This is an extraordinary scenario.
External Credit Rating
Weaker banks keep their rates high to retain deposits.
Report of a specific bank

2.2.3 Various Approaches to Deposit-Pricing

In today's competitive banking industry, deposit campaigns, their pricing and
product differentiation have gained vital significance for planners. While preparing
strategy documents and at the time of annual or periodic budget exercises or while
carrying out mid-cycle performance reviews, deposit pricing is reviewed and
deliberated from various angles.

Some of the commonly applied strategies are as under:

a) Basic approach: Cost plus Spread based Pricing
The price paid by a bank to the depositor constitutes one component of the costs
incurred on fund mobilization. Other costs like the operating costs of developing
the sales team and deposit raising function are also significant. Similarly, costs of
marketing, travel, advertisement, printing, entertainment and duties/taxes are also
part of overheads directly related to deposit mobilization. Regulatory reserves are
27
also required to be maintained at a certain proportion of demand and time liabilities.
Currently, 5% of such deposits are held in non-remunerative reserve as a Cash
Reserve Requirement with the State Bank of Pakistan. Accordingly, all such costs
are considered while working out the deposit price.

Under the basic approach Average deposit price is arrived at by summing up the
operating costs of the deposit unit, overheads, and regulatory duties/cost, which is
then added to a plausible spread or margin of profit that deposit funds can generate
in the given business environment.

The spread can also be defined as the difference of average yield on earning assets
over the average cost of interest-bearing liabilities (i.e. deposits).

This basic cost-based approach determines a benchmark for a bank concerning total
deposit price, from where the cost of each deposit constituent can be estimated by
applying the respective weight of each constituent in the budgeted pool.

b) Competitive Net Interest Margin (NIM) Approach

While formulating a strategy for deposits or review thereof, the NIM approach is
used to develop comparisons among peer groups earning competitively positive
income for the bank. Net Interest Margin (or Gross Income Spread) is derived from
P & L Account from the following two components:
i. Markup/Interest/Return Earned (on the fund deployed in earning assets)
ii. Markup/Interest/Return Expensed (i.e. cost of deposits paid to depositors)

The difference between the above two is recorded as Net Markup/Interest Earned
in the bank's P&L account.

The NIM of a bank is defined as follows:

(Markup/In terest/return Earned - Markup/Int erest/return Expensed)

NIM = x 100
Markup/Int erest/Return Earned

NIM describes the cost efficiency of the deposits raised by a bank. Higher NIM or
Gross Income Spread provides room to efficiently manage expenses related to
operations, better customer services and expansion of branch network and
technology leading to desirable bottom line profit and shareholders value. Banks
structure their deposit products and pricing in a way that ensures comparable NIMs
within the peer group.

28
A Comparison of NIM: Examples of a few Pakistani Banks

Table 2.4
Comparative Approach: Pakistani Banks
(Amounts in PKR Billion, for the year 2020)
Emerging Islamic Emerging
Large Banks
Banks Bank
Credit Credit Credit Credit Credit
Rating Rating, Rating Rating Rating
AA+ AA+ A+ A+ AA
255.4 75.2
Deposits (2020 Average) 1,553.5 832.1 223.7
Billion Billion
Return/Markup Earned 152.0 92.6 25.7 25.9 13.6
Return/Markup Expensed 77.1 47.9 13.3 14.1 9.9
Net Markup/Interest Income 74.9 44.7 12.5 11.895 3.7
NIM or Gross Income
49.3% 48.3% 48.6% 45.9% 27.2%
Spread
Average Deposit
5% 5.8% 5.2% 6.3% 13%
Cost p.a.

Source: Annual Audited Accounts (for the year 20200) of banks UBL, Bank Alfala,
Bank Islami, Bank Dubai Islamic, SAMBA

From the above comparative analysis, you can have an idea that:
 Large Banks in Pakistan have the advantage of their long-standing brand
name and a wide range of branch networks. As a result, these banks enjoy
customer loyalty and less elasticity of deposits price. These banks have
developed large-scale banking services and expertise over time both locally
and in overseas branches. Therefore, deposits in-flow from their diversified
group of customers is less elastic to price-driven function and more influenced
by their expanded network and service superiority. Their pricing strategies
are based on maintaining their NIMs.

 As a result of the above factors, large Banks have a very high deposit base of
demand liabilities, i.e. CASA deposits (Current and savings accounts), where
the deposit rate is minimal. Thus overall deposit cost of such banks is very
low. These banks in Pakistan, (known as big-four or big-five) compete with
each other while devising pricing strategies or increasing the market share of
deposits and NIM.

 Emerging banks on the other hand strive hard to compete and develop various
market segments to generate business. These banks have smaller branch
networks (40 in the case of the above example) and pursue growth strategies
in their deposit campaign. To develop and attract new customers, these banks

29
 offer high deposit rates and better service standards. Their target market both
for deposits as well as lending, may also be different, including a larger
proportion of high-value individual customers in consumer banking. Here the
deposit pricing competes with National Saving Schemes and Pension Plans,
which usually promise higher profit rates.

 Islamic Banks in the above comparison also have the advantage of lower
deposit costs, despite being in the emerging category. The reason for this
phenomenon is the exclusive clientele which is less price-elastic and more
committed to Riba-free banking that Islamic Banks promise. There is a
specific market domain in which these banks operate and compete and due to
service superiority and less price-elastic clientele, enjoy lower deposit costs.
To increase their market, share and attract new business, these banks promise
special rates to high-value customers while pooling their funds in the Special
Mudaraba Pool, where large customers may get higher returns due to high
yields on respective lending modes and cut in Madarib's fee in the pool.

c) Market Penetration Strategy and Pricing (Particularly for Emerging

Banks)
Banks that pursue product diversification and growth in their profits may come up
with new products to penetrate that particular market. Emerging banks striving to
increase their share of the market also need an aggressive strategy to attract a new
client base. At the onset and to beat the competition factor, banks may be ready to
incur higher costs for the current period to penetrate the market for times to come.
New products will therefore be priced to add attractive features such as:
 Higher Markup rate
 More flexible profit payment frequency
 Keeping minimum balance requirement at low
 Clubbing other financial services like insurance, Mutual funds

As an example, a bank desirous of increasing its deposit base identifies room for
expansion in its SME sector (Small and Medium-sized Enterprises). It will carry
out an in-house analysis by reviewing data of branches in in medium-sized cities or
industrial areas to work out the plausible size of this segment. Their pattern of
banking services may also give an idea of their business appetite. The bank would
accordingly announce a new deposit scheme suited to the banking needs of such
groups. The new product would consider the business cycle and funding flows of
SME businesses. Bank would advertise to such customers through personal phones
or social media. Broad-based campaigns will also be developed to attract these
business segments. Technology-based innovations on fund transfers and free
services may also be clubbed to add more flavour. Banks are willing to incur

30
promotional expenses for penetrating new markets and developing a new customer
base for long-term benefits.

These factors would lead to higher deposit costs for the banks in terms of
intermediation cost and on a present value basis. Banks would mitigate this impact
on the back of higher volumes and by following the relationship wallet strategy
(explained separately hereunder).

d) High-value Target Pricing

Most common types of demand and time deposits generally carry a range-bound
pricing. However, some banking products in their basket may carry very attractive
profit payment rates from depositors’ point of view. Banks like to have a strong
presence of rich people around them. They structure high-profit payment schemes
on large deposits having longer maturity periods as part of their wealth management
schemes. The size of this customer base is strengthened by attracting foreign
travellers, rich business families and among others, high-value professions such as
lawyers, doctors, accountants, free-lancer business persons, retired senior citizens,
etc. Since such customer has more high-income options available to park their
surplus funds, the pricing of such deposits has to consider competitive factors like
rates on long-term National Saving Schemes, Government bonds and Treasury Bill
Rates. The deposit retention period is generally high in this segment.

Banks mitigate the high-cost factor on the back of attracting higher volume
accounts and developing customer loyalty/ stability in funding sources with the help
of better and priority service standards such as having premier service lounges in
the branch premises and dedicated relationship officers for high-value customers.
Plus, conditional pricing may also be applied by putting in a minimum balance
requirement and retention of funds for a specific duration for earning the agreed
rate.

e) Relationship Wallet Pricing

Customers such as large corporates, SMEs and high-value individuals may have
multiple needs for banking services. For such customers, the concept of dedicated
Relationship Management in the banking industry is relatively a modern concept
whereby a Relationship Manager is assigned to a particular customer to look after
all of its banking needs, be its liability or asset side or daily services, queries and
issues under one platform. For example, while a corporate customer may approach
short-term or long-term financing from a bank, under relationship management, the
bank will go further and would offer all other services, like checking account, cash
management, salary account management, remittances and deposit schemes
tailored to its needs. In other words, the Relationship Manager would like to build

31
up a wallet of services for the mutual benefit of both the customer and the bank. to
make the wallet look healthy and fat, the bank would pitch the customer with a
range of competitively priced services to cater to the large volume of their business.
As a result, banks may get large deposits, but at a high rate due to high volume and
competition factors. Such pricing of deposits falls within the category of special
rates, negotiated with the customer and approved by higher authorities and the
Treasury of banks. Large customers sometimes have their own treasuries, where
they work with Relationship teams to borrow on a short to long-term basis and also
place deposits, both at fine pricing. Market benchmarks like Treasury Bills, Kibor
and expected changes in Policy rates define the mutual pricing strategy. Large
volumes mitigate the price risk.

f) Special Rates and Year ending Deposit wars

While rack rates are applicable on a broad basis, deposits from a few special
customer’s large accounts, or corporates cannot be mobilized at the market rates.
For this purpose, banks also develop a mechanism whereby branches can seek
special approval or guidelines for mobilizing high-value deposits at special rates of
deposits. Banks will not like to announce such rates publically as these are allowed
when banks eagerly need deposits due to retention of certain customers, or due to
pressure of meeting quarter/yearly ending deposit targets. High cost for a few such
accounts is justified if the bank has mobilized sufficient/ targeted demand and time
deposits and current account at lower costs.

Special rates particularly come into effect at year ends when banks are keenly
desirous of showing strong balance sheet footing and strong growth in deposits. At
the quarter-end or year-end, sales teams like to retain good customers and attract
new deposits. They would therefore seek to offer special rates, specifically
approved by the top management to strengthen their baseline deposits. Usually,
short-term tenures are allowed for such deposits to minimize the high-cost impact
on the bank's bottom line. Here a regulatory attention also needs to be considered,
whereby window dressing of the balance sheet should be avoided (may be possible
as a result of the deposit retained at the accounting period ending date and returned
immediately at the start of the next period).

g) Procedures applied by Islamic Banks: Profit and Loss Sharing on

Mudaraba Pools
Islamic Banks allocate profit/markup to the deposit accounts based on the theory of
Islamic finance of profit and loss sharing. These banks collectively sum the customer
deposits in Common Mudaraba Pools, where the depositor is considered as a capital
provider (rabbul mal) and the bank acts as Fund manager/mudarib. Any profit
generated from the capital is shared between the rabbul mal and mudarib according to

32
mutually agreed terms and the bank's declared policy on costs and expenses. At the
end of each calendar cycle, profit rates on various deposit types are declared and
accrued.

2.3 Basic (Lifeline) Banking and Liability Management

2.3.1 Introduction to Basic Banking and Roadmap towards Financial

Inclusion

Basis Bank accounts or lifeline banking refers to extending banking services to

under-banked or low-income groups of society broadening the horizon of banking
services through financial inclusion. A basic bank account goal is to bring all
members of such groups into the economy by encouraging saving and long-term
investing, regardless of the volumes. Low-income citizens are often ignored in the
economy. However, by fostering their long-term financial fitness, they can become
more significant contributors down the road and their aggregate contribution can
bring a sizeable impact.

Basic banking accounts are non-remunerative and ensure that fees and service
charges are kept at negligible or at the lowest level. These accounts carry no
minimum balances charges while ATM and fund transfer services are provided free
of cost.

In Pakistan, efforts have been made to enhance formal financial access to a larger
portion of the population with particular reference to under-banked and low-income
groups at the national level. To address the challenges of low levels of financial
inclusion, Basis Banking accounts were made mandatory for all banks under
regulatory directives in 2005. (SBP circular No 30, 2005). Later the country has
also developed a broader National Financial Inclusion Strategy to provide financial
access to a larger portion of the population. Progress in this direction is manifested
with the introduction and putting into action of the following:
 Basic banking account started in 2005 under the regulatory directives to
provide banking services to a larger population
 Microfinance banks, due to their presence in remote areas, were expanded
under a more viable and growth-oriented regulatory set-up in the previous
decades. Microfinance Investment Company has also been set up under the
government's initiative to provide funding support help expand these banks
and attract under-banked accounts from far-flung areas
 Islamic Banks also encouraged new customer segments, which had remained
under-banked

33
 Creating an enabling environment for Telecommunication Companies to
establish microfinance banks on the back of their large network and remote
clientele. Companies like Mobilink and Ufone and others developed Fintech
Payment Gateways, which has broadened financial access to a larger segment
of the population
 Payment App like 'Raast' link all existing gateways and have opened further
prospects to familiarize and motivate a large proportion of users to open
banking accounts

2.3.2 Advantages to the Economy and Banking Sector

Basic banking accounts with low fees can act as lifelines to those who need them.
These accounts are lifeline banking not only for the account holder, but banks that
can approach a large proportion of the population can also generate strong
commercial value. Further benefits in the long run can accrue on the following
fronts:
a) The growing population in Pakistan and the large size of under-banked
accounts provide an opportunity to enhance the customer base. Deposits in
these accounts are held under demand deposits, with no or negligible markup.
Combining small deposit amounts for a huge number of accounts country-
wide promises a healthy deposit volume and a window of profitable
opportunity at almost negligible cost.
b) Including a large proportion of the population/economic activity into the
banking network will benefit the economy as a whole in terms of ease of doing
business and documentation of the economy, leading to more transparency in
controlling illicit money channels and broadening the tax base.

2.3.3 Liability Management in Banks

Under this section, a broad-based liability management function of banks will be
viewed from the practical approach in line with the functions adopted at
headquarters or down the line at banks and financial institutions.

Liability Management is a function of banking whereby

a) Coordinated planning and operations are carried out to execute the core
function of mobilization of deposits at optimum economic cost
b) and maturities of banks’ liabilities are managed in line with those of the assets
to achieve a balance that minimizes mismatch risk while ensuring the
availability of liquidity to facilitate lending operations. In this context,
liabilities primarily include depositors' money as well as funds borrowed on
long-term

34
Accordingly, functions of Liability Management in a bank are comprised of:
a) Devising suitable deposit policy, Planning and implementation of deposit
mobilization strategies and campaigns
b) Publishing rack rates and approval of special or incremental rates for sales
teams/ branches (These can be obtained from respective websites or branches)
c) Maintain data on deposit pricing and cost analysis, Region, and by each
deposit unit
d) Setting up of transfer pricing mechanism between branches and Head Office
(Deposits are transferred to/from the central pool at transfer price after taking
consideration of intermediation cost)
e) Analysis of cost of fund sources, yield on earning assets and spread on each
deposit product
f) Working out maturity gaps between assets and liabilities and devising
strategies/products that may keep these gaps at a minimum
g) Proposing new issues of liability notes, if needed to meet regulatory
conditions or to replace short-term deposits with long-term liabilities to
bridge anticipated gaps

2.3.4 Policy on Liability Management

Deposits, being lifelines for a bank, are mobilized under well well-planned strategy
at the top management level. The planning phase therefore needs data on the
following significant factors while devising policies and strategies for Liability
Management
 What competitors are offering to their customers, historically and currently
 Prevailing and upcoming internal factors that determine deposit pricing
 Regional and local economic environment
 Earning profile of the bank's assets and near-term revenue capacity
 Existing Maturity profile of earning assets and mismatches, their future trend
 Need for product innovation and new products including issuance of long-
term papers to manage interest rate risks.
 Regulatory changes and Monetary Policy trends

The liability Management function devises and proposes a Deposit Policy. The
Policy defines broad guidelines on liability sources, geographical preferences of
branches and target market sectors (like SMEs, consumer financing or corporate)
as suited to the Bank's business approach, pricing guidelines, new products and gap
management measures. Policies are approved at the level of the Board of Directors,
while the LM function further implements the same and develops business
strategies and operational tools.

35
2.3.5 Gap Management
Deposit pricing and its strategies (described under Section 2.2) are determined
under the Liability Management function. Interest rate re-pricing and liquidity gap
management is the other most significant function of Liability Management that
needs periodic attention. These gaps, if not monitored or allowed to expand over
and above the desired limits, may expose the bank to risk to its profitability and
funds availability. Banks measure the gaps on the following lines in various time
buckets and work out suitable solutions to minimize these gaps.

Table 2.5
Gap Measurement Between Maturities of Liabilities and Earning Assets
(say the total assets of the bank are 5,500 million)
Maturity of Maturity of Gap as a
Time to Mis-Match / Gap
Deposits/Liabilities Advances/assets percentage of
Maturity (Rs. in Million)
(Rs. in Million) (Rs. in Million) total assets
Less Than
1,000 1,750 750 13.6%
1 Month
1-3 Months 500 0 (500) (9.1%)
3-6 Months 750 1,500 750 13.6%
6-9 Months 2000 1,250 (750) (13.6)
9-12 Months 1250 1000 (250) (4.5)
Total 5,500 5,500 -

This example pertains to short-term gap analysis (next year). Practically, this
analysis could be expanded for the inclusion of long-term time buckets.

Inferences from the gap measurement analysis.

a) In the time buckets of ' 1-3 months' and '6-9 months' gaps are relatively high
and are in the negative bracket. This implies that the maturities of deposits
will be higher in these slots as compared to the expected inflow of cash during
the same period. These are referred to as short positions. Under 9-12 Months,
a short position is also there, but it is relatively lesser. Banks in their policy
set limits for defining high or manageable gaps. Here we assume that a gap
of less than 5% is considered reasonable and manageable by the Policy.

b) Within the next one month and in '3-6 months', maturities of advances or cash
inflows are higher than expected withdrawals. Such gaps are positive, but the
level of 13.6% reflects a higher gap, needing attention from the Treasury and
business units to deploy this surplus/long position when it arrives.

c) In the other time brackets, gaps are less risky, but management would be keen to
consider the absolute values of the mismatch to arrive at an appropriate strategy.

36
Solutions to Manage High Mis-matches/Gaps
Under scenarios a) and b), gaps are higher and reflect a relatively higher degree of
risk. Liability Management Function needs to consider this risk. In case of negative
gaps, more withdrawals are expected to be handled by branches than cash inflows.
In scenario a), branches and sales teams would therefore be issued alerts to be
prepared to mobilize more deposits in the respective time bucket to improve their
inflows.

An alternate strategy would be to refer the shortfall to Treasury, which can manage
short position under '1-3 months' by booking short-term funds to bridge the gaps in
the upcoming near-term period. Treasury may raise funds in forward dates and/or
in the Call market/ through other modes (Referred to in Section 2.4).

From the liability side, the strategy will be adjusted to seek the higher level of time
deposit that matures beyond the risky period so that the gap does not increase
further.

Also in the current example, branches and sales teams will be given targets to make
more advances (assets) that mature in the next '6-9-month time period so that such
inflows mitigate the negative funding gap in this time horizon.

Under scenario b), within the next one month and '3-6 months' the funding gap is
positive and higher. The bank would like to utilize these higher cash inflows to
deploy in profitable business. On an Immediate basis, the Treasury can deploy
funds in Call or Money Market on the overnight basis at a certain spread. The
business function of the bank will be taken on board so that plans for generating
assets/advances are prepared to meet this scenario during the next one month or 3
to 6 months. Treasury will utilize the surplus funds in Money Market, if any surplus
is left un-deployed.

2.3.6 Organizational Structure of Liability Management

Depending on the size of the bank, the liability management function starts from the
top hierarchy and goes down to the level of branch and sales team or Relationship
Managers. Branch Manager and Sales/Relationship Teams are the field forces that
directly work with customers and potential depositors to meet their respective targets.
Daily feedback and data is being provided to Head Offices by Areas or Regions.

At the Head Office level, Strategy and operations teams work together on data and
feedback received from branches, Money Market and research units. The head of
Strategy/ Liability Management works closely with Business units and Treasury to

37
formulate suitable business approaches on new sources, deposits and gap
management strategies.

Here below is an example of an organogram of the hierarchy of Liability

Management within a large commercial bank with a branch network across the
country. (This hierarchy may be different for other banks depending upon their
operations, network and size).

2.4 Alternative Non-Deposit Sources of Bank Funds

Though bank deposits are a core source of funds for the continuity of its operations,
there are other avenues that are blended to boost fund management and profitably
manage the banking risks. These may comprise the following:
38
 Treasury sources and trading, Call market, Inter-bank borrowing
 Long Term Redeemable Capital (Tier II Capital, Term Finance Certificates)
 Preference Shares, Convertible bonds, Additional Tiers of capital

Treasury sources take care of the short-term funding needs of a bank, while
blending long-term liability modes/ issuance of new bonds to cover capital
adequacy and liquidity management in a broader perspective. These modes are
described in more practical detail hereunder.

Definitions
 Term Finance Certificate is an instrument of liability whereby a loan may
be raised by an institution by issuing these certificates (or bonds) in multiple
denominations with the objective of convenience in transfer and trading of
any portion of the loan to a third party.
 Treasury Bills are instruments of borrowing by the government with a
maximum term of 1 year. Financial institutions invest their funds in
government securities and develop a pool of liquid assets which also earn
income return. Treasury Bills are issued by the government through the State
Bank of Pakistan at a discount to face value with the promise to return full
face value at the maturity
 Credit Rating of a company or bank refers to the rating of its credit strength
and capacity of repayment of its financial commitments/liabilities. Credit
rating agencies independently undertake a review of the bank's portfolios,
sponsors' support and operations etc. and issue their objective opinion on
credit rating, entity ratings and rating reports. These credit ratings are used by
regulators, creditors, depositors and market counterparts to assess credit risks
and limits of business and deposit transactions.
 Kibor: Karachi Inter-bank offered rate (KIBOR) is a measure of interest rate
quoted by banks in the inter-bank market for lending funds to other
counterparts. During each trading day State Bank of Pakistan publishes Kibor
for various tenors based on average of lending rates for overnight to tenure-
based offers of funds by the banks. This rate is a benchmark rate for pricing
loans to customers and related business. Bank loans are priced on a floating
basis, pegged to Kibor to have more transparent and fair pricing that also
minimizes interest rate risks both for lenders and borrowers.
 Capital Adequacy Ratio is the amount of risk-based capital as a per cent of
risk-weighted assets. Regulations for banks set limits of Capital Adequacy
Ratio (CAR) from time to time as a measure of risk management for the
banks.
 Liquidity risk arises when a bank will be unable to accommodate a fall in
liabilities or to fund new assets. Liquidity represents the bank's ability to

39
 efficiently and economically accommodate decreases in deposits and to fund
increases in loan demand without negatively affecting its earnings.
 Market risk reflects the degree to which changes in interest rates as a result of
Monetary Policy changes or market factors, foreign exchange rates and equity
prices can adversely affect the earnings of a bank. The higher the re-pricing
mismatch between liabilities and loans, the higher the market risk, or vice-
versa.
 Redeemable capital is a form of long-term source where funds so mobilized
are paid back at maturity of the term or on a staggered basis with periodic
profit. The funds are used by banks to meet their long-term funding business
and to bridge gaps arising out of deposits of shorter maturity profiles.

2.4.1 Funding by Treasury Sources under Call market, Trading and

Inter-Bank Borrowing
The Treasury of a bank manages the central funding pool of a bank. Branches and
regions transfer their surplus balances, if any to the central Treasury, or requisition
funds in case of shortfall or to meet any immediate deposit withdrawal. Treasury
mobilizes instant funds from the Money Market through various modes, which
include:
 Repurchase/Repo: This refers to the sale of a security under a repurchase
agreement with a commitment to buy back the same from the purchaser at a
specified price and future date. A repurchase agreement is a collateralized
loan, where the collateral is a security (e.g. government bond, Treasury Bill,
Term Finance Certificates, good rating stocks). Banks that need funds on a
particular day (i.e. short position) use this mode as a source of money against
the collateral of securities. The tenure of such transactions ranges from
overnight to one month.

Example: Bank A holds Treasury bills of Rs 100 million, but needs cash to disburse
a loan to his customers. It will engage other banks to borrow cash against this
security for 1 month. Bank B is currently liquid in cash and it accepts the security
of the Treasury Bill for lending to Bank A at a 6% p.a. markup.
- Bank A and B will execute a Repurchase agreement
- A sells Treasury Bills to B today and receives cash of Rs 100 million
- A will return this amount and profit to B after 1 month and A will repurchase
the same security on that day to settle the transaction

Call Money: This refers to funds placed with a financial institution or vice-versa
borrowed, without any security or fixed maturity date. The money can be "called"
(withdrawn) at any time. It is a form of clean borrowing/lending for short-term
requirements without collateral. Banks operate in a two-way Call market for

40
sourcing instant money and placing surplus funds within the risk limits set by the
credit rating, size and market presence of counterparts. The loans in the call money
market are very short-term, usually up to one week.

Letter of Placement (LOP). This mode is used by financial institutions to borrow

money from other banks. Non-banking financial institutions with good standing/
ratings also raise funds under this mode. The tenure of such mobilization is 1 day
or more. Rates of borrowing hover around Kibor of the respective tenure. LOPs
are not preferred for tenures of a few months due to the risk of any unpredictable
change in future market rates.

Example: Bank A does not have enough security to borrow funds. However, it
enjoys a good credit rating. It needs cash of Rs 100 million to make a committed
payment. The option of Call is also not available today It will therefore engage
other banks to borrow cash under a Letter of Placement for 1 month. Bank A have
to offer a higher rate of 8% p.a. for this borrowing due to the unsecured nature of
the transaction. Bank B accepts the rate for lending to Bank A at 8% p.a. markup.
- Bank A and B will execute and exchange a brief contract of the transaction
'Letter of Placement'.
- B transfers Rs. 100 million to A on the day of the transaction
- A will return this amount and profit to B after 1 month to settle the transaction

 Certificate of Investment or Certificate of Deposit. This product for is used

for mobilizing unsecured money/deposits. Financial institutions with good
credit ratings borrow funds for a certain tenure (may be up to 6 months) and
issue receipts in the form Certificate of Deposit or Certificate of Investment
(CD or COI).
 Bai-Muaajal or Ijara: Islamic banks trade in the Money Market and
mobilize/ place funds through dedicated Islamic products that meet their
specified criterion.
 Sale of Treasury Bills and other liquid assets
Treasuries hold sufficient inventory of liquid assets that carry a profit rate and
are trade worthy. These can be offloaded in case banks need liquid funds to
meet financial commitments. Liquid assets include such securities that are
readily convertible into cash or can be sold in financial markets.

Example of Generating funds through Secondary Market Sale of Treasury Bills.

Treasury Bills are instruments of borrowing by the government within a maximum
term of 1 year. Financial institutions invest their funds in government securities and
develop a pool of assets. These are issued by the government through the State
Bank of Pakistan at a discount to face value with the promise to return full face

41
value at maturity. Government securities are also tradable in the secondary market
and the investors desirous of raising liquid funds before maturity may sell their
holding.
For example, a bank holds the following Treasury Bills in its inventory and its
Treasury has offered to sell it against cash. The following are details of the
transaction:
Holding:
GOP Treasury Bill Face value: Rs 100 million
Tenor: 1 year (364 days)
Issue Date March 4, 2021
Maturity date March 3, 2022
Yield to maturity 11% p.a.

Definitions:
Face Value in the case of a Treasury Bill is the promised value of the bond that the
investor will receive on holding till maturity, including both the invested amount
and return earned.

Yield to Maturity or YTM refers to the discount rate that equates the present value
of future payments of profit/ returns and redemption value, with the present price
of the bond.

Today's Transaction: Sale of above T-Bill in the Money Market

Sale Transaction Date July 31, 2021
Settlement date Transaction date Plus 1 (i.e. Aug 01, 2021)
No of days since issuance 150
Sold to: ABC Bank (counterpart)
Sold at 11% YTM p.a. (current market YTM)

The calculation of the Amount to be received on the settlement date of August 1,

2021, is as follows:
Formula for T-Bill Pricing in sale/ purchase transaction

Sale Price per currency unit of face value (Rs 1.00)

= 365/((days to maturity X YTM/100)+365)
= 365 / ((150 x 0.11) + 365))
= 365/ (381.5)
= 0.95675

The above number is multiplied by face value to arrive at the cheque amount
received on the settlement day.

42
Face value of Rs. 100 million X 0.95675 = Rs. 95.675 million
The above implies that after pre-mature selling of a Treasury Bill of face value Rs. 100
million, the holding bank will receive Rs. 95.675 million (assuming no tax is
applicable). This includes principal and prorated yield.

2.4.2 Management of Long-Term Sources, Risk Management and

Capital Adequacy
Banks having large deposits and lending portfolios are often faced with a dilemma
of mismatch between maturity profiles of liabilities versus assets. Business
expansion and non-performing portfolios may lead to regulatory calls on meeting
capital adequacy limits. Such scenarios call for mobilizing new sources which
sufficiently minimize gaps and create more room for managing capital risks. Banks
use long-term instruments to mobilize liabilities from a variety of customer bases,
including peer banks and financial institutions, mutual funds, high-value customers
etc. There are a number of ways such liabilities are structured and arranged. State
Bank of Pakistan has also developed various frameworks for allowing banks to
raise long-term resources for strengthening liquidity and developing supplementary
capital base in line with international best practices including Basel II and Basel III
accords on the capital of banks.

Banks in Pakistan have raised long-term funding by the following sources:

a) Preference shares, convertible or Redeemable
Preference shares are like long-term bonds where funds can be mobilized for the
long term at a declared rate and dividend/profit. For a banking institutions, the
regulator requires the protection of depositors and senior creditors and therefore
puts conditions of subordination to senior credit. Condition of redemption or
convertibility after a certain time period is also applied. Such preference shares are
non-voting and may also include the condition of convertibility under duly declared
terms and conditions that suit the bank's capital structure, depositors' interest and
regulatory criterion.

Banks use this mode to raise funds and bridge liquidity and interest rate gaps. The
source of this mobilization may include capital markets, high value customers and,
corporate investors.

b) Redeemable capital in the form of Term Finance Certificates

State Bank of Pakistan implemented the Basel Accords for capital adequacy and
risk management of banks in various phases during the last two decades The
banking industry has been advised of various schemes to raise funds as
supplementary capital to benefit from enhanced measures of liquidity risk

43
management and capital adequacy. Relevant circulars on the implementation of
these schemes include:
BSD circular no 8 of 2006 on Basel II Capital Accord
BSD Circular No. 02 of 2007
BPRD Circular # 06 dated August 15, 2013

Within the regulatory bounds prescribed in these circulars, Banks structure liability
schemes according to their needs for five years’ tenure or more and raise funds from
institutional clients and financial institutions by issuing Term Finance Certificates.
These certificates may provide additional features of transfer and trading in the
secondary market. The liability raised in this way is treated as supplementary (Tier
II) capital, provided it meets various regulatory conditions, including credit rating,
minimum tenure, staggered principal repayments and subordination to deposits and
other liabilities. This structure helps the bank to strengthen its liquidity profile and
capital adequacy along with the availability of further cushion in the expansion of
its lending business.

c) Foreign Sources and Additional Tier-I capital

Funds from foreign sources are also mobilized for business operations. However,
exchange risk hedging is necessary to avoid any exposure to exchange loss at the
time of repayment. Banks use derivatives and currency swaps through their
offshore network to hedge this risk.

State Bank of Pakistan has allowed to treat foreign mobilization (for banks, DFIs
and Microfinance Banks with majority foreign shareholding, greater than 50%) as
Additional Tier-I capital provided it meets the subordination and other conditions
as set out in its regulations and also under BPRD Circular No. 02 of 2020.

Additional Tier-I capital is also raised by local banks by issuing convertible and
perpetual Term Finance certificates. Being perpetual in nature, banks are obliged
to service periodic profit payments without a stipulated maturity date. Investors can
exercise exit options through trading or converting the bonds into listed shares of
the bank after the expiry of a certain period. Such convertibility features and other
Put/Call options differentiate this mode from common stock. Strong credit and
entity rating and Money Market standing are imperative for the successful financial
close of such issues.

d) Participative Term Finance Certificates (or PPTFC)

Islamic Banks and non-banking financial institutions may use this mode to mobilize
funds from markets and individual high-value customers under Modaraba or Profit

44
and Loss sharing systems, subject to regulatory clearance and approval of the
product. Repayments and profit distribution are carried out based on profits earned
on the funds so mobilized. Apart from the strong credit rating of the issuer and the
instrument, the appointment of a rated external auditor and Trustee are significant
the lender's confidence.

2.5 Self-Assessment Questions

a) Short Questions
i) How do you differentiate between demand deposits and time deposits?
ii) Define the following:
CASA
Rack Rates
Basic banking accounts

iii) Write a few non-deposit sources of funds for any bank.

b) Long Questions
i) What are the key determinants of deposit pricing for a bank? Explain at
least four (4) such factors.

45
 ii) Explain the Relationship-Wallet strategy applied in mobilizing large
value deposits.

c) Exercise

Study the balance sheet of a local bank in Pakistan, as snipped below:

Source: Website of United Bank Limited (Published annual report 2021)

After going through the above financial statement, answer the following questions:
1) Highlight non-deposit sources of funds under the heads of Liability in the
above balance sheet.
2) The total assets of the bank have recorded growth in the year 2021, as
compared to 2020. What could be the key sources of funds for this growth?

46
2.6 Summary
In this unit, students have learnt about various sources from where banks mobilize
funds for their business. Banking is a business of borrowing and lending. Efficient
arrangement of funds at an economically competitive cost is a lifeline to a banking
company. In addition to owners' equity, Banks need to raise funds from various
deposit schemes and also in the form of long-term liability. These funds are
deployed in profitable modes for earnings and managing expenses/costs. Starting
from the basic definition of Demand and Time Deposits, various deposit schemes
and their characteristics have been discussed in this Unit. The importance of CASA
(Current and saving accounts) for any bank is highlighted and its relation to the
pricing of the overall deposit of any bank has been deliberated.

Various approaches to deposit pricing and comparison of rack rates versus high-
value relationship pricing are also included in a separate section of Unit 2. The
concepts of average deposit cost, gross spread, and Net Interest Margin are
explained with the help of practical data, obtained from the financial statements of
a few commercial banks. At the macro level, the relationship between deposit costs
to monetary policy is also explained with the help of tables.

Development of funding sources and time management of deposit inflow/outflows

are fundamental banking operations. In the 3rd section (i.e. Section 2.3) of this unit,
the functions of liability management and liquidity gap management are first
explained from a textbook approach and then discussed thoroughly with a practical
perspective, by applying examples and solutions.

Under section 2.4, non-deposit sources of banks' liquidity are described under the
heads of Treasury, Call market and Redeemable capital etc. Definitions of modern
days’ financial market tools and terminology are explained in separate boxes to
attract students' attention. Relevant regulatory guidelines for banks on mobilizing
long-term funding sources are also referred to. Numerical calculations of the
pricing formula for leveraging Treasury Bills (used for mobilizing short-term
liquidity in the inter-bank market) are also made part of this section. Banks' usage
of financial market platforms for managing their liquidity is covered in this section.
This unit has described deposit sources and liquidity arrangements of banks and
financial institutions in a comprehensive way. From there onwards, the next units
will take care of banking functions related to profitable usage/deployment of such
resources for generating revenue and meeting deposit costs. In these units, students
will study consumer business, of lending to various sectors, investments and
specialized sector financing, among other topics.

47
 REFERENCES

Stephen A. Ross, Jeffrey F. Jaffe, Randol W. Westerfield, Corporate Finance,

(second edition)

Padmalatha Suresh (2011) Management of Banking and Financial Services. India

Pearson Education

Institute of Bankers, Pakistan, Managing Risk in Financial Sector (2006)

Website Sources:
[Link]

[Link]/research/fintech-in-pakistanPakistan

Websites of commercial banks (Bank Alfala, Bank Islami, Dubai Islamic Bank,
UBL, Samba Bank, for referring financial statements

48
Unit–3

CONSUMER BANKING

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
49
 CONTENTS

Page #
Introduction ....................................................................................................... 51

Objectives ........................................................................................................ 51

3.1 Factors Determining the Growth and Mix of Bank’s Consumer Business 52

3.2 Regulations for Know-Your-Customer and Account Documentation..... 56

3.3 Overview of Prudential Regulations for Lending .................................... 59

3.4 Handling Problem Loan Situation ........................................................... 61

3.5 Self-Assessment Questions ...................................................................... 64

3.6 Summary .................................................................................................. 65

References ......................................................................................................... 66

50
 INTRODUCTION

Consumer business in a bank refers to primary banking business related to

individual customers and their accounts. Consumer banking customers primarily
avail of popular banking products, such as small loans and credit cards for day-to-
day consumption and vehicle leasing etc. On the liability side, banks also benefit
by attracting deposits from such customers. Due to the large size of general public
accounts, banks avail greater access to consumer business and offer products and
services to achieve business growth.

In line with the size and turnover of consumer business, central banks have also
provided regulatory guidelines for the protection of both the banks and the
customers from over-exposure and unethical practices. Prudential Regulations for
Consumer Financing set limits and guidelines for banks and financial institutions.
Similarly, the regulators have also developed guidelines and Rules related to
‘Know-You-Customer’ and the obligations of financial institutions. This aspect
gained importance after the realization of the fact that banking channels must not
be used for the illegal flow of money and financing of terrorism or unlawful
purposes, detrimental to the country’s interest.

This unit provides basic knowledge of various products and modes of business (also
known as Retail Banking). The unit describes regulatory procedures that banks are
obliged to adopt and apply to customers at the time of account opening and/ or
obtaining a loan.

OBJECTIVES

 After study of this unit, you will be able to:

 Understand the modes of retail banking/consumer business and its importance

to banks in terms of its scope and growth

 Have an overview of operational procedures and Regulations related to

account opening, ‘know-your-customer’ and verification of the true identity
of consumer or their beneficiary

 Understand the importance of keeping retail banking secure from illegal use
by un-verified individuals

 Have an introduction to Prudential Regulations on consumer financing and

handling problem loans
51
3.1 Factors Affecting Growth and Mix of Consumer Banking

3.1.1 Introduction to Consumer or Retail Banking

Definition of consumer: A consumer is a customer or individual who purchases
products or services for their personal use, and not for further sale or trading.
Consumer markets consist primarily of products and services that people use as part
of their everyday lives.

Consumer banking, also known as Retail Banking, comprises of bank’s business

operations for the general public, rather than companies, corporations or other
banks.

In the banking industry, consumers are referred to as:

- retail individual customers who have bank accounts to avail of banking
services
- or with whom banks may engage in extending its services and products for
personal consumption, like personal loans, credit cards, car leasing etc.

3.1.2 Mix of Banking Services and Products for Consumers

The consumer Banking function in a bank gets business from the following
products and services:

Further elaboration:
Personal Deposit Schemes here refer to various deposit services offered by a bank
to its customers or family members of an account holder. For example, deposits
that offer monthly profits are suited to pensioners or non-working people, like a
housewife.

52
Payment transfer systems refer to
- bank’s operations of fast and efficient handling of payment requests of the
consumers and their families/related parties.
- The banks with large branch networks and strong bases, local and abroad, will
be able to provide better services and therefore, will attract more customers.

Consumer Loans: The loans availed by individuals/family persons from banks for
non-business/personal usage.

Similarly, loans, availed by an account holder of banks in the form of leasing a car,
or against shopping by using credit cards, are considered consumer banking
services.

How do banks market their retail business?

o To attract consumer business, the banks first pursue their existing depositors.
Dedicated customer service desks are set up in branches, where the sales
representatives/marketing team of the bank welcomes the visiting account
holders customers or walk-in customers for introduction to various consumer
services.

o Banks also develop their consumer base with the help of marketing the
following segments of the population through personal selling, media or
telemarketing:
i. High net worth individuals
ii. Salary accounts of their corporate clients
iii. Families receiving income from foreign sources (e.g. Expat Pakistani)
iv. Pensioners

o Electronic and social media platforms are also used for advertisement

3.1.3 Business Growth in Consumer Banking

Various sections of the population that rely banking services turn into a very large
market size. Banks, therefore, develop suitable services including deposit schemes
for local and foreign remittances, digital payment systems, loan products
installment-based purchases etc. for such customers.

Banks see a big potential for consumer business of banks in urban areas. Each
section of society needs specific types of services, based on their income level and
living standard.

53
The following mix of loans and services could be applicable or tailor-made for
specific groups of consumers:

Customer Group The Mix of Consumer loans and services

Employment backed personal loans, Housing
Salaried Individuals
Finance, Car Leasing, Credit Cards
Car financing, custodial and investment
services (e.g. purchase of government
High net worth Individuals
securities, mutual funds), deposits Income
schemes
Fast Payment Services, Credit cards,
Accounts receiving foreign workers’ Insurance, Mutual funds and high-profit
remittances deposit accounts like Roshan Digital
Account (SBP initiative)
Free online payment services, personal loans,
Freelancers and persons receiving High-Value debit or Credit cards, vehicle
fixed annuities leasing, and free banking services to attract
deposits

Individual Accounts, the main driving force behind the growth

The scope of consumer lending continues to increase, particularly in a society
where the urban working class grows at a fast pace. The following factors are
important contributors:
i. Growth in the number of salaried individuals and increase in the urban
population
ii. Growth in foreign remittance from workers abroad through banking channels

The banks also improve their service standards and develop technology-efficient
fast payment systems to attract new business. In this way, banks compete with each
other for local retail customers, as well as for serving accounts of foreign
remittances.

3.1.3 Remittances and their Benefits to Bank’s Operations

Funds transferred to Pakistan for their family or friends by persons working abroad
are generally referred to as workers’ remittances. There are large numbers of
Pakistani nationals who work in different countries worldwide to earn their
livelihood. Money sent in foreign currencies to their home country constitutes a
sizeable portion of Pakistan’s foreign exchange inflows. Banks in Pakistan are
encouraged by the government to facilitate the inflow of these foreign remittances
through banking channels.

54
How the banks benefit from these remittances?
- The money received from abroad is parked in consumer’s deposit accounts
and therefore banks’ deposit base gets stronger
- Banks offer their allied banking products to such customers as credit and debit
cards, auto or housing loans etc.
- Banks develop and provide fast and quality banking services to both the
remitter of the funds through foreign branches, as well as the local accounts
where this money is received.

How foreign remittances help governments:

In line with the rules on foreign exchange inflows, remittances received in foreign
exchange are routed through SBP foreign currency reserves and are exchanged for
Pak Rupee at the prevailing rate. The rupee equivalent is transferred to the
beneficiary account. The country thus benefits from such remittances in terms of
an increase in its foreign exchange reserves and re-payment of import bills and
loans foreign exchange

Government’s Initiatives to attract foreign remittances through banks/ consumer

accounts:
a. Exemption from income tax on the receipts of foreign remittances in bank
accounts
b. The facility of the online opening of digital bank accounts
c. Scheme of Roshan Digital Account in local or foreign currencies
d. Implementation of International Bank Account Number (IBAN) for secured
fund transfer (IBAN explained earlier under Unit-I.)

These initiatives over some time have successfully resulted in growth in remittance
inflow through banking channels. Deposits of banks are also growing along with
consumer accounts and related banking products.

55
Challenges with Opening and Operations of Accounts
The business of consumer banking and marketing of new accounts is rewarding for
banks, but faces certain challenges:
i. Risk of hidden/ unlawful use of bank accounts for the un-taxed wealth
ii. Risk of fund transfer/remittances for illegal activities using bank accounts
iii. Weaker recovery options in case of default of personal consumer loans

In the sections below, these challenges are elaborated along with the bank’s
responsibilities to counter such challenges.

3.2 Regulations for Know-Your-Customer and Account

Documentation
The challenges referred to (i) and (ii) above have far-reaching implications.

While dealing with new consumers or existing accounts, banks sometimes come
across situations where:
 accounts opened by certain persons in the guise of a consumer/customer, but
the true identity is not disclosed in the documents provided for account
opening
 High-value customers with good cash volume open accounts, but are not
ready to fully disclose their source of income

At the time of starting business relations/Account Opening, the following should

be remembered:
 Lack of complete knowledge about the customer and his/her source of income
may lead to a violation of rules and the bank could face penalties and legal
difficulties.
 Flaws in account documentation may lead to unlawful use of banking services
if the real persons behind the account want to hide un-taxed money or have
criminal intent. Banks could be used to receive remittances from abroad from
fake accounts in the guise of consumer deposits.

Hidden use of banking accounts by proscribed entities, or such organizations, which

have been declared defunct, or illegal has also remained a point of concern.

That is why banks adopt and follow specified procedures for ‘know-you-customer’
and implement these at the time of account opening.

56
3.2.1 Regulations on ‘Know-Your-Customer’
Keeping in view the importance of safeguarding the banking channels from illegal
activities, the central bank in Pakistan has formulated comprehensive regulations
for banks/financial institutions. The objectives of these regulations are:
 to make the banks responsible for understanding their customer’s financial
background and behaviour and be assured of his/her true identity by
identifying fake accounts.
 To stop the illegal use of banking channels by such persons which are linked
to terrorist financing or Money Laundering

These regulations are binding obligations and their compliance is checked by

periodic inspections and supervision by the State Bank of Pakistan.

The regulations require that:

 the bank will obtain certain identity documents at the time of opening an
account or starting relations with the customer.
 based on these, the regulation further asks to apply a few verification checks
and procedures for the banks to completely understand the consumer’s profile
and income status.
 This detailed know-your-customer process is also known as ‘Customer Due
Diligence’ (CDD).
SBP regulations and circulars on this subject have been revised and amended from
time to time. The title of such regulations initially was ‘know-your-customer
Regulations’. Later their scope was broadened by including new issues and more
stringent procedures. These comprehensive regulations now carry the following
title on the SBP website:
Anti-Money Laundering, Combating the Financing of Terrorism & Countering
Proliferation Financing (AML/CFT/CPF) Regulations
These regulations were briefly discussed under Unit-I concerning Anti-Money
Laundering rules. Here the requirement under these regulations is discussed in more
detail with particular reference to account opening for consumer business and
verification of customer’s identity.

3.2.2 Account Documentation Procedures

At the time of opening an account, the following minimum documents are required
under the Regulations:
i. Valid National Identity card, or Nicop/Passport for overseas nationals
ii. Certificates of Income and source, like salary certificate, rental agreement, or
proof of remittances
iii. Account opening form (or KYC form) asking customer’s social or political
background
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iv. In case the account holder authorizes a signatory, different from the account
title, all identity documents of the signatory will also be sought for the
verification procedure

For basic banking accounts (for facilitation of students or low-income groups etc.),
an income certificate at (ii) is not mandatory. However, such accounts only accept
deposits/credit of funds up to a certain maximum limit.

Verification Procedures and Identification of True Beneficiary:

a. The validity and verification of NIC/Nicop are checked from the NADRA
website by the bank/FI
b. The identity of the customer is verified by the bio-metric identification
procedure of NADRA. The pattern of banking transactions (particularly
amounts deposited in cash) is reviewed and compared with the declared
sources of income.
c. Tax filer status is checked from the websites of relevant authorities
d. The name of the customer and its close relatives/nominees or partners, in case
of a joint account, is scanned (for any possible links to banned organizations
or UN sanctioned/prohibited) by applying checks on the databases/websites,
referred by the Regulations

In case the beneficiary of the account is found different from the account holder,
details and identity documents of the true beneficiary are also sought. All
verification procedures are also applied to such persons.

Example I.
A person who wants to travel abroad has handed over some money to his/her
relative for deposit and convenience purposes and has asked to open/ operate a new
bank. In cases, the real owner or beneficiary is the person whose money is deposited
in the account. The title of the account is in the name of the relative and the bank
will ask for identification documents for both the title holder and the beneficiary.

Example II.
A wealthy person having good business turnover decides to shift a part of their
business segment and its cash receipts to his son. However, his son is not available
daily for the operation of the bank account and the businessman therefore asked
one of his employees to open and operate a bank account. The account holder in
this case is the employee, but he is not the real beneficiary and is acting only in
trust and as an agent of the son. Such an account needs complete disclosures and
verifications of the identity of all the parties and sources of income. However, such
accounts are discouraged by banks due to the risk of ‘benami’ accounts, which
could be used for hiding un-taxed money/illicit purposes.

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The procedures and checks are applied to all consumer banking customers. Given
the sensitivity of the verification process, account opening has mostly been made a
centralized function at senior levels of the management hierarchy. Documents and
verification carried out at the branch level are sent to the of the Quarter for approval
or directions on further requirements, if any.

The processes discussed so far are prerequisites for the opening of the account or
the start of business relations, both for deposit and for any other banking service.
For availing of specific facilities, further requirements may apply as per the nature
of the banking service.

Third-Party Agencies for Verification

Banks also rely on the services of Verification Firms/agencies to carry out identity
and physical verification of the residential/official address of their consumers and
to know about the profession or job status, before starting business relations with
them. The verification agencies carry out physical visits to the given addresses of
applicants/references and develop their opinions after informal interviews or cross-
referencing etc. This outsourcing arrangement helps banks to obtain specified
services from firms having experience in the specialized area.

3.2.3 Penalties
In terms of the Banking Companies Ordinance, 1962, violation of the State Bank
of Pakistan regulations shall render the bank/FI/officer(s) concerned liable for
penalties. SBP carries out regular inspections of banks to check the operational
systems of banks and compliance with regulations.

In the recent past, several banks have been penalized heavily by the State Bank of
Pakistan for violating or not fully adhering to the above regulations on customer
documentation and verification.

3.3 Overview of Prudential Regulations for Lending

3.3.1 Background and Objective
State Bank of Pakistan, in the capacity of regulator of the banking sector, has
developed rules and guidelines for regulating and safeguarding the banking
business and the consumers. These rules/guidelines/regulations are issued under the
title of Prudential Regulations separately for each segment of the lending business
of banks and financial institutions.
The objective of Prudential Regulation is to:
 Keep the banks/FIs lending business within the affordable risk limits

59
 and safeguarding their financial and business capability in the larger interest
of the depositors and the economy.

These are binding obligations for banks and all financing/lending transactions must
adhere to the limits and guidelines set in the regulations.

Currently, Prudential Regulation have been issued by the State Bank of Pakistan,
for various categories of lending/ and financing. These include consumer financing
as well as other areas such as lending for infrastructure, Agriculture or SME
financing Corporate banking etc. These other areas will be discussed separately
later under the respective sections, while Regulations for consumer financing are
touched upon here in more detail as follows:

3.3.2 Prudential Regulations for Consumer Financing

The following lending services/ banking products are covered under Consumer
Financing:

Credit cards
Auto financing (car leasing etc.)
Personal Loans
Loans for the purchase of personal durables (e.g. household items)

While the Regulations referred to under the ‘Account Documentation’ in the earlier
section deal with initial processes of account opening and customer verifications,
Prudential Regulations for Consumer Financing specifically deal with consumer
loans/financing and define and set:
i. Loan limit for individual transactions and margin requirement on loans
ii. Total loan limit of a bank on facilities of credit cards, auto
loans, Personal Loans
iii. Minimum operational requirement of a bank’s eligibility to
undertake consumer lending
iv. Ethical standards to be adopted by banks and disclosure of
information to consumers
v. Reporting and accounting requirement of defaulted loans

Prudential Regulations for Consumer Financing

Prudential Regulations for Consumer Financing are available on the SBP website
for detailed reference and use and implementation by the bankers. In addition,
regulatory updates and amendments are also issued from time to time and are posted
on the SBP website.

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3.4 Handling Problem Loan Situation
Most consumer loans and credit card advances generally involve no tangible
security. Rather the regulations allow certain unsecured loans (up to defined
maximum limits) to individual customers, who cannot provide collateral. Such
loans, if recovered as per the re-payment schedule agreed between the customer
and the bank, result in income for the bank and a good credit rating to the borrower.
However, challenges emerge when consumer loans have defaulted and the bad
debts hit the bank’s Profit Loss and Loss account.

Definition: Non-Performing Loan

The loan/advance where the due instalment remains unrecovered for a certain
period is known as a non-performing loan. According to the definition under
Prudential Regulations, non-performing loans are classified into different
categories (substandard or Loss) based on the respective period of default from the
due date of repayment.

3.4.1 Reasons for Loan Default and its Handling

If repayment of instalments of loans is delayed the customer, the bank’s information
system or software generates an immediate signal. The banks follow up on such
accounts through telephonic reminders, or emails/letters. Some customers may
respond to the reminders and banks’ dues are recovered, but a few others may not
be ready to settle the due amount.

A default situation could be the result of intentional default by the borrower, or

some material reasons, such as loss of income source or on health grounds etc.

From the Bank’s point of view, the following factors could cause recovery delay or
default of consumer loans:
i. Weak identification procedures, incorrect assessment of income and verification
of credentials, addresses etc.
ii. Due to excessive loans disbursed in violation of allowed limits
iii. Due to willful default by the borrower in meeting its commitments

In the case of factor i) above, there could be a possibility that the bank staff or the
verification agency could not correctly assess the data provided by the borrower.
In-eligible accounts (e.g. having less income or already under the default of some
other bank) may continue to bank advances under such situations.

In other cases, the borrower might have given fake references and employment
details with fraudulent intentions.

61
The solution in both these situations lies in obtaining and verifying the authenticity
of the provided documents and complete adherence to the ‘know-you-customer’
procedures of the bank.

In the case of a factor at serial ii) above, the verification process could be fine, but
the bank have done aggressive lending and extended higher loan amounts without
consideration of true repayment capacity.

Also in certain cases, the Credit Department of the bank may have crossed the
maximum overall limit allocated to one branch or region. To achieve the aggressive
target, banks might have given loans to borrowers with unstable income sources.
Such accounts are prone to delays or default in repayments going forward.

The banks may find difficulties in recovery as a result of such control violations.

3.4.2 Classified Loan Accounts

The Prudential regulations on Consumer financing require the banks to classify
their non-performing loans based on ageing or delay from the scheduled date of
repayments. If the loan is classified or remains unrecovered, its impact on the
financial statements must be recorded and disclosed.

Classification of non-performing Consumer Loans and Accounting Treatment

Period of Default of Loan Accounting Treatment
Consumer Loan Classification Income Account Provisions for Bad Debts
Where markup/profit Substandard Income accrual on such 25% of the overdue
or principal is overdue loans is kept in a principal amount, net of
by 90 days or more memorandum account liquid security in hand, if
from the due date and not credited to P&L any
Where markup/profit Loss Income accrual on such 100% of the overdue
or principal is overdue loans is kept in a principal amount, net of
by 180 days or more memorandum account liquid security in hand
from the due date. and not credited to P&L

Recovery Operations to Manage Classified Loans

Substandard Loan
A consumer loan or credit card advance etc. if remains overdue by 90 days or more
is classified as ‘substandard’ in the books of accounts. During the initial default
period, banks adopt various measures to recover the due amounts from irregular
customers, such as:
 Phone calls, reminder letters and in-person follow-ups for recovery
 In case of weak recovery results, a negotiated settlement can be worked out
mutually by conditional rescheduling/deferral of loan Installments

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Role of Credit Information Bureau Database
- If the above efforts fail to materialize recovery and the overdue period crosses
the 90-day limit, the account has to be reported to the Credit Information
Bureau (CIB) as a classified/substandard account. The CIB database is used
by banks and financial institutions to obtain and share information related to
the credit behaviour of borrowers.

- Banks obtain credit reports from CIB before the grant of any loan and also
share the overdue status of classified loans (past 90-day period) during the
recovery cycle.

- Data related to overdue or un-settled accounts in CIB, affects the rating of the
borrower and may render him/her ineligible to obtain further loans.

Loss Categories
If the overdue amount is not recovered even after 180 days of the due date, it is
classified under the ‘Loss’ category in the books of accounts. Loss on account of
bad debts is booked in books of accounts as per the requirement of prudential
regulations. Its reporting to CIB will also change from ‘substandard’ to Loss
category.

The bank now has two options to deal with such situations:
1. Restructuring of loan repayments under revised terms and conditions.
a) Based on mutual negotiations and reasonable and genuine grounds (loss
of income source or health ground etc.), banks may enter into a new
agreement with the borrower. Certain dues may be waived off or
deferred and the schedule of due instalments could be revised according
to the current repayment capacity.
b) Any recovery from the ‘Loss category’ account after re-structuring is
credited to the P&L Account. CIB data is updated as ‘re-structured or
scheduled in place of ‘default/loss’.

2. In case settlement is not possible due to the non-cooperation of the borrower,

or his/her whereabouts are not traceable, banks may pursue legal options
through the court of law. However, this option is time-consuming and may
prove expensive and is advised after all recovery options have failed to yield
results.

Later down the line, costly and time-consuming recovery procedures, with low
recovery chances may justify the write-off of defaulted amounts from the bank
books with full disclosure of bad debts.

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3.5 Self-Assessment Questions
a) Short Questions
i) Name a few banking services that are offered by the retail banking
department of a bank.
ii) How banks increase their sales of credit cards to existing account
holders.
iii) What is the role of the Credit Information Bureau

b) Long questions
i) Write a detailed procedure for opening a new bank account for an
individual customer. Describe both the identity documents required and
verification procedures.
ii) How non-performing consumer loans or defaults in credit cards impact
the profitability of a bank. Also, what are the requirements of Prudential
Regulations for consumer financing to classify a bank’s non-performing
loans based on the ageing of overdue repayments?

c) Exercise
In light of the material studied in this unit, mark which of the following items
of earning assets fall in the category of consumer banking/retail banking:

Asset side:
- Lease financing for the purchase of a 1000 cc car
- Loans for the purchase of personal durables (e.g. household items)
- Credit card schemes of the bank for its account holders
- Loans to a large medicine manufacturing company for the purchase of
machinery

Liability Side
- Current Deposit account of a government organization
- Deposit account (remunerative) of a large medicine company
- Deposits under individual accounts under the monthly profit scheme of the
bank

Also visit the main branch of a bank or browse its website to understand its products
and services under ‘Retail Banking’ and write answers to the following questions:
 Documents required to open an account with the bank
 Further documents needed to obtain a credit card or consumer loan
 Rates of markup are generally charged on the money advanced under consumer
loans

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3.6 Summary
This unit is about the business branch of banking that specifically focuses on
individual customers, with an appetite to consume bank loans for their personal
financial needs. Students have studied various banking services offered by banks
to meet consumer demand. Consumer Banking, also known as retail banking,
primarily comprises various modes of profitable deposit schemes and loans for
individuals/ families and banking services of credit cards and vehicle leasing. This
mix of services has been elaborated on in this unit in detail. Growth prospects of
consumer banking and its relation to home remittances and fast and efficient
technology-driven payment systems have also been highlighted with practical
examples.

The unit also touched upon the importance of this segment given the expanding
urban middle class with rising demand for consumer business. Side by side, current
subjects of legal significance for banking are also touched upon, whereby banks are
required to implement new standards of due diligence of individual accounts and
emerging legal requirements for combating any illegal use of banking channels in
the guise of the bank’s customer. In this respect, operations related to account
documentation and verification are included in this unit to keep the students abreast
with the latest developments.

The last section of the unit deals with problem loans or bad debts arising from
consumer loans of banks. Various approaches applied in managing such loans and
their fair treatment in the books of accounts have been described in light of separate
regulations of the State Bank of Pakistan on Consumer financing. The Unit also
discusses the role of the Credit Information Bureau in maintaining credit data and
the history of borrowers from where banks can benefit in obtaining credit reports
and reporting any defaults.

65
 REFERENCES

Padmalatha Suresh (2011) Management of Banking and Financial Services. India

Pearson Education

Website Sources for definitions, references and examples

[Link]
banking/

[Link]
[Link]

66
Unit–4

LENDING TO BUSINESS FIRMS

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
67
 CONTENTS

Page #
Introduction ....................................................................................................... 69

Objectives ........................................................................................................ 69

4.1 Bank Loans to Various Categories of Firms ............................................ 70

4.2 Credit Lines ............................................................................................. 75

4.3 Lease Finances ......................................................................................... 78

4.4 Loan’s Purpose Vs Tenure ....................................................................... 79

4.5 Pricing of Bank Credit ............................................................................ 79

4.6 Risk Analysis and Financial Appraisal of Loan Applications ................ 82

4.7 Loan’s Security and Documentation ....................................................... 83

4.8 Self-Assessment Questions ...................................................................... 85

4.9 Summary .................................................................................................. 86

References ......................................................................................................... 86

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 INTRODUCTION

The lending function in a bank refers to loans or advances provided to its customers.
These customers may comprise various groups, such as individual borrowers or
business firms etc. Banking operations related to lending to individual customers
have already been studied in the last unit under ‘Consumer Banking’ (Unit 3). This
unit covers banks’ lending to various types of business firms.

In the context of a bank, the phrase ‘lending’ is used interchangeably with

‘Advances’, ‘Loans’ or ‘Credit’. From the viewpoint of Balance Sheet disclosure,
the cumulative balance of loans or bank credits to various types of borrowers is
reflected under ‘Bank Advances’ in the financial statements. This unit starts with
the basics of this broad category and explores further sub-groups and modes of
lending functions currently in practice. The lending operations are explained by
differentiating the bank advances into various banking products of Cash Credits,
Credit Lines, Running Finances and Loans and Leases.

This unit will explore and describe the operational features of banks-to-firm lending
from basic theory to its practical implementation. Definitions have been highlighted
in separate blocks, where needed. Popular lending modes applied in banks and
financial institutions along with processes related to loan applications, appraisal
and evaluation functions are illustrated in detail with citations of financial ratio
analysis and examples. Prudential Regulations of the State Bank of Pakistan on
lending operations are also touched upon.

OBJECTIVES

 To understand various modes of bank’s Advances and their suitability to

respective categories of borrowers.

 To develop a comprehension of the bank’s products and credit operations

related to lending to business firms.

 To learn basic tools to process a loan application and carry out a financial
appraisal

 Have an overview of the applicability of Prudential Regulation concerning

documentation and security of bank advances for the ultimate goal of healthy
credit operations with minimum risk of bad debts.

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4.1 Bank Loans to Various Categories of Firms
This section will provide an understanding to the students which modes of lending
are suitable for a specific type of business firm, and what category of banks extends
these services.

4.1.1 Modes of Lending

Banks utilize their available funds (from deposits, equity Reserves etc.) to create
earning assets in several ways, which may include:
1. Giving loans to individuals (consumer banking, already studied in Unit 3)
2. Lending to business firms for day-to-day funding and operational needs
3. Tenure-based credit for supporting customer’s/firm’s businesses growth.

Definitions from a banking viewpoint

Lending:
It is a general term, which means. Giving money to someone with an agreement to
return, is typically known as Lending. Banks and financial institutions are the most
common lenders.

Credit:
Credit is a more specific term used in bank operations. In simplified form, the word
‘Credit’ is the ability to borrow money or obtain goods or services with the
commitment to pay later. In other words, borrower firms obtain Credit from the
Bank. Literal meanings of credit are identical to lending.

Bank Advances
Lending or Bank Credit is also referred to as ‘Advances’ in the financial statements
of Banks

A bank can give credit against some security or in some cases unsecured credit may
also be obtained by a firm. Acceptance of a customer for credit purposes is
dependent upon the borrower’s ability and rating to pay back the borrowed amount.
This rating is also referred to as Credit Rating.

Banks manage their lending functions by dividing their customer base into various
segments, based on their financial profile and needs for bank credit. Each group of
customers is assigned specialist human resources, with the necessary training to
deal with the customer and devise credit transactions for the mutual benefit of both
the bank and the customer.

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For extending bank advances and services, the banks generally categorize their
customers or firms in the following manner:
Suitable Modes of
Type of Business Firm Categorization at Banks
Lending
Sole Enterprises (individual Sole enterprises are dealt with Cash Credits, or small
businesses, retail stores) by the Retail Banking section Loans
of Banks
Small and Medium SMEs are looked after by SME Cash Credits, Leasing
Enterprises (SMEs), like banks and commercial banking facilities or tenure based
software Houses sections of large banks Credit/ loans
Listed Companies and firms/ Corporate Banking divisions of Running Finance Facilities,
Large business groups commercial banks Long Term Credit Lines,
Tenure Based Loans

The above-stated lending modes/ Various types of Advances are elaborated under
the following broad groups:

4.1.2 Cash Credits

Banks deal with a variety of customers that need bank credit for their day-to-day
business needs. Based on their requirements, the bank may devise various
transactions/products to match customers’ demands.

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Cash Credits are short-term bank advances for business firms meeting to meet their
running or immediate requirements. Such credit is suitable for almost all
businesses. Cash Credit may comprise the following transactions:
a) Working Capital Advance
b) Overdraft Facility
c) Unsecured advance under permissible limits

a) Working Capital Advance

The purpose of such bank credit is mostly to support the cash flow cycle of the firm
and to meet its working capital needs.

To meet its expenses while waiting for the finished goods inventory to convert into
cash, the firm may approach a bank to take a working capital advance.

Working capital advance/credit is disbursed to help the firm in payments of

i. Raw material purchases
ii. Staff’s salaries and sundry expenses
iii. or to build up finished goods inventory for onward sales.

The bank advance is paid back by the firm within the agreed time (generally within
a year) when it receives maximum cash on peak season sales or after it has
improved its cash flow through the recovery of credit sales etc.

Definition
b) Working capital means the funds needed by a business for procurement of its
raw material or inventory, payment to sundry creditors, or to finance its credit
sales.
c) From an Accounting perspective, working capital is calculated by subtracting
current liabilities from current assets. Banks extend loans to businesses for a
3–12-month period to meet short-term working capital requirements.

The following are the basic features of Working Capital credit.

- This credit facility is for a short-term period, with repayment of principal and
the accrued profit within a maximum period of one year.
- The bank can extend this facility for the next business/ year upon satisfactory
recovery/ track record of the firm.
- Banks charge a market-based rate of markup/profit on the disbursed amount.
Certain security is also required against the amount of money lent to the
business firm. (detail is discussed further in later sections)

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Working capital credit can be utilized by the firm for the purchase of materials,
inventory for trading, advances to suppliers, payment of salaries or rent and utility
bills etc.

Example:
A business firm needs funds at the start of the business season for the purchase of
raw materials. It approaches the bank with a request to provide cash credit for a
maximum of 12-month period. The firm operates a sugar mill (a seasonal business),
with sugar cans as its raw material.

Estimated Budget for raw material: say Rs.500 million

Procurement time: November-April
Production Cycle: Production starts from November and onwards

Inventory of sugar sales may start slowly from Nov-

December. During the cycle, the firm will raw
materials and meet expenses of utility bills, salaries,
repair and maintenance, etc.
Credit sales will take time to convert to cash.

Working Capital Needs: At the start of this cycle, the company has
approached the bank to provide working capital
credit of Rs. 300 million, the funds will be used for
the above payments and the firm will continue the
production cycle to build up finished goods stocks.
The remaining amount for raw material purchases
(Rs. 200 million) can be arranged by the firm from
its internal reserves. The approves a credit limit of
Rs. 300 million by November.

Repayment The firm sales will mostly be completed by June to

September next year. The firm will repay the
borrowed amount, along with bank profit by that
time.

b) Overdraft Facility:
Overdraft is another form of Cash Credit. It meets the immediate cash requirement
of a firm. When a firm is faced with a situation where it does not have sufficient
cash in its bank account to pay current bills, it may request the bank to provide an
overdraft facility so that the firm can timely meet its payment commitment.

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The following are essential features of Overdraft credit:
- Overdraft is a quick cash support facility to support the firms in making timely
payments so that business is not affected due to any temporary cash shortage.
- Overdraft means that the bank allows the customer to issue cheques (up to an
approved limit), even if there is no balance left in the customer’s bank
account. The excess amount drawn by the customer is considered an overdraft
(or bank advance) and is repayable by the customer within a short period (a
few months) when its cash flows are improved.
- Banks provide such credit to those customers, who actively operate a business
unit and are well known for their financial dealings. Banks also analyze past
activity in their bank accounts to assess their capacity for timely repayments
of bank credit.

Example of Overdraft Facility in Favour of a Firm

For example, a grocery store is facing a cash shortage due to unexpected lower
sales. The sales have dropped after the closure of its approach road due to
construction work on the Metro Bus route. The store has not been able to fully settle
the bills of its goods suppliers and an electricity bill is also payable. Its bank account
carries a balance of Rs. 2.0 million, while its immediate needs are Rs 3.0 million.
The store owner approaches the bank for an overdraft facility and has committed to
repay after 3 months when his road would be clear after the completion of the metro
bus route.

The bank, based on the good reputation of the customer, agreed to provide an
overdraft with a maximum limit of Rs 1.0 million. The bank will honour/ cheques
on this account up to a total amount of Rs 3.0 million (available balance of Rs 2.0
million plus overdraft of Rs 1.0 million).

The grocery store is liable to adjust/repay the overdrawn amount, plus the agreed
profit rate within the period of 3 months.

c) Unsecured Advance under Permissible Limits

The above two categories of cash credit required some form of security. However,
the State Bank of Pakistan in its Regulations has also allowed the banks to extend
unsecured credit, within certain maximum limits (to specific types of borrowers
only).

For small business units and sole enterprises, banks may extend cash credit up to a
certain limit, without any security, provided:
- the bank is satisfied with the business operations

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- and past credit behaviour persons concerned. (i.e. the person has not
committed default on any personal bank transaction).

This facilitation is allowed to promote such small-scale businesses, which

otherwise could not benefit from banking services due to a lack of suitable security/
collateral.

State Bank of Pakistan has issued guidelines and regulations for cash credit/
advances to Small and Medium Enterprises and Agriculture Finance. These areas
are deliberated separately at length in the last unit of this course.

4.2 Credit Lines

A credit line is a form of bank credit which involves bank-to-business (B-to-B)
lending for a longer time limit and in continuity.

A credit Line is defined as a flexible loan scheme of a defined maximum limit,

which can be availed by a firm:
o in parts (in various tranches) or in full as per its needs
o and at suitable time intervals to suit the firm’s business scheme.

Banks extend Credit lines for a defined purpose. That is, the borrower firm and
bank will agree on the purpose for which the borrower will utilize the bank advance.
For example, Banks may give credit lines for the following purposes:
i. Short-term working capital Requirement
ii. Renovation and central air conditioning of a Shopping Complex
iii. Purchase of new machinery for expansion of the firm’s production

Prudential Regulations of the State Bank of Pakistan require that the purpose of
seeking a bank loan by a business should be clearly understood and recorded on the
loan application. This practice ensures transparency and leads to proper utilization
of bank credit and its timely recovery, going forward.

The purpose mentioned in the example at serial no i) above is for a short-term

nature, while those at serial numbers ii) and iii) are related to credit facilitation for
a longer time horizon. Here below, credit lines are discussed separately from the
perspective of both short-term and long-term purposes of credit utilization.

(a) Running Finance Limits (Short term Credit)

Working capital credit for meeting the short-term requirements of a firm was
discussed in an earlier section.
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What if a business firm does not like to avail of working capital credit and considers
it a costly option? There are certain businesses where cash flows are not dependent
upon seasonal or pre-determined factors.

Running a Finance Limit is a solution to such a proposition. Running Finance of

large amounts is also regarded as a Credit Line due to its flexible nature. This type
of bank credit is for a short-term period and can also be extended upon satisfactory
recovery performance.

Definition
Running Finance Facility (generally known as RFF) is a form of Credit Line for
medium to large business units, which have frequent high-value cash inflows and
outflows in their bank accounts. The purpose of extending this credit line is to
support the working capital needs of the borrower.

Running Finance Facility (RFF) carries the following features:

- A maximum credit limit is worked out by the bank after evaluating the firm’s
financial statements, business cycle and the value of security in hand
- RFF is allocated on a short-term maturity basis (within one year)
- Firm can request to the bank for disbursement of any amount within the RFF
limit, whenever it needs funds for working capital or to make a payment.
- Mostly, RFF is suitable for those firms who already operate a business deposit
account with the bank. The amount drawn under RFF may be repaid or
adjusted (automatically), whenever the firm receives any cash-inflow into its
account.
- In case, cash inflows into the account remain lesser than the disbursed credit,
the firm is liable to repay the remaining debit balance, before the terminal day
of RFF to clear the account.

Examples
RFF is suitable for:
- A steal rerolling mills, could request the RFF in large amounts at the time
purchase billets and scarp. It may adjust/ repay the due amount, in parts, as
and when it receives cash inflow from sales of steel products.
- A soap and detergent manufacturing unit, which needs large amounts while
purchasing raw materials, but receives cash inflows from sale operations
gradually during the whole year.
- A supermarket brand store with large volume transactions.

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(b) Long Term Loans (or Tenure Based Bank Advances)
While short-term credits provide benefits or financial facilitation for a period of up
to one year, tenure-based loans could range for a period of over 1 year (to say 3
years). If the purpose of the loan is such that the firm will need more time for
repayments, then the bank would consider a longer-term loan (say of 5 years
duration).

In this section, we will discuss credit facilities by banks to finance the longer-term
asset growth of business firms.

Cash Credits (i.e. working capital or credit limits) and running finances meet the
short-term working capital needs of business firms. On the other hand, bank
advances extended to business firms for the development of new assets or
expansion purposes are categorized under Term Loans. Such credit is repaid by
firms over an agreed time horizon, which may range from 2 to 5 years.

If a firm needs funds for its project or construction etc. involving multiple
disbursements, it may prefer to avail of a Long Term Credit Lines. While a term
loan is disbursed once in full, a Credit Line may be drawn as per the funding need
during the construction/ renovation phase.

Long-term credit lines are needed by firms for a certain project or asset
development, where funds are needed at various intervals and the revenue
generation will also take more time to materialize. That is why the firm will need
some grace period before instalments of repayments become due.

Features of credit lines for the specific business purposes of longer terms can be
understood as follows:

Structure of Long-Term Credit Line:

When a firm needs a funding line for a business scheme involving a longer time
horizon, the bank may provide a Long Term Credit Line. It may include the
following parameters:
Total finance Limit: i.e. Maximum Limit of the Credit Line
Purpose of the Credit Line: This could be the construction of a commercial
building in phases or Renovation and central air
conditioning of a Shopping Complex

Disbursement mode: The firm is allowed to avail disbursement of the limit

amount, whether in full or in tranches, as and when
suited to the firm

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Availability Period: i.e. Time limit up to which the complete limit can be
drawn by the firm

Tenure/Term: Period of repayments, e.g. 3 years starting from the

first disbursement date

Pricing: Rate of markup on the disbursed amount

Repayments: Installments of repayments, within the above-stated

tenure

Security: This may comprise some asset of the firm or another

property

Examples of Long Term Credit Lines

Balancing, Modernization and Replacement (i.e. BMR). This term is used by
factories and production facilities, where plants and machinery need major repairs
or replacements due to technological changes or obsolescence (wear and tear).

The process of BMR may be long (say one year) and requires a loan in multiple
tranches. The bank may approve a maximum loan limit in the form of a credit line,
to be disbursed as and when a firm needs funds for procurement, installation etc. of
machinery during the estimated one-year period.

The bank has set a 6-year Term for this credit line. Therefore, after completion of
BMR in the first year, the loan amount is repayable in the next five years (divided
into 10 equal semi-annual instalments).

4.3 Lease Finances

The structure of Term Loans is defined in the above section. Lease Financing is
also a similar type of bank credit, which is useful for borrower firms in the
acquisition of certain equipment or machinery.

Under Lease finance, the funds disbursed by banks are applied towards the purchase
of machinery, vehicles or equipment, which are utilized by the borrower in business
for its business growth.

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These assets remain in the ownership of the bank (but under the possession of the
borrower) until the bank receives repayments of the due instalments. After full
repayments, the bank transfers ownership in favour of the firm. The borrower firm
repays in instalments, and repayment amounts are treated as lease rentals.
Accordingly, the borrower firm avails certain tax benefits under Lease Financing.
Apart from tax advantage, this mode of bank financing is more suited to Islamic
Banking. (Discussed further in a separate Unit).

4.4 Loan’s Purpose versus Tenure

For more clarity, the diagram below depicts the comparison of various credit types
(studied in this section) in terms of their term or period of the loan’s maturity.

Purpose: Running Cash requirements/ working capital

Cash Credits, Working Capital Credit, up to 12 months’ term

Renovation of a business site or office building: (Medium Term Loan)

Repayments of such loan is possible in Medium Term (1.5 to 2 years)

Loan for Purchase of Computers and Installation of Networking Systems

(Medium Term Credit of 3 years)

Loan for Balancing, Modernization and Replacement (i.e. BMR) of Plant and Equipment
Long Term Credit Line, say for 6 years. Repayments of loans are made from future profits

4.5 Pricing of Bank Credit

As we earlier studied, the following aspects are decided by banks while deciding
on extending bank credit:
- Amount of Loan suitable to meet the borrower’s requirement
- Purpose and type of credit facility
- Pricing factors i.e. fixed fee and charges and rate of markup

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Pricing of a bank credit here means the cost charged by a bank to the borrower on
the loan amount.

There are two types of such costs, which a borrower is obliged to pay:
i) Fee and Charges
ii) Markup payable periodically at a decided rate

Fee and Charges

Banks recover certain charges from borrowers in place of their service costs. These
are mostly published and announced by banks yearly as ‘Schedule of Charges’.

In the case of bank credit, the following fees are applied and are payable by the
borrower:

Processing Charges: These are fixed one-time charges payable to banks in

advance. These may also include service charges
paid by banks to third-party evaluation firms, which
assist banks in the verification of applicants

Legal/ Documentation Fee These are applicable at the time of approval of the
bank loan to cover expenses on legal documents,
lawyers’ fees about the loan agreement registration
of security etc.

Commitment Charges: These are levied on large credit transactions (like

credit lines). A small percentage (like 0.25% per
annum) may be charged on an un-disbursed portion
of the loan limit. For example, a bank has sanctioned
a credit limit of Rs. 1,000 million to a firm. During
the first six months, the firm has utilized half of the
limit, while Rs 500 million remains unutilized. Bank
would charge Commitment Charges @0.25% on Rs.
500 million until the same is fully utilized.

The markup on Bank Advances

Markup constitutes a major portion of the bank’s earnings from Advances/ Loans.
These are priced on the following models:

a) Fixed or floating rate of markup

In earlier times, a fixed rate of markup or interest was applied to all types of bank
advances. Bank used to accrue and recover interest income based on the fixed rate

80
for the whole term of the advance. However, this model has now been replaced by
a floating rate method to better manage certain market fluctuations, which caused
risks in the earlier model.

The floating Rate of markup is based on the benchmark rate prevailing in the inter-
bank Market. This model operates as follows:
i. Banks decide the markup rate on a particular transaction by adding a certain
load/spread on the benchmark rate.
ii. Mostly benchmark rate of Kibor is used, which is published on the State Bank
Website.
iii. Kibor is Karachi Inter Bank Offered Rates for various terms and floats daily.
iv. Banks may add some percentage points (say 3% p.a.) to Kibor to arrive at the
price charged to the borrower of bank credit.
v. The price will be re-fixed based on fresh Kibor after payment of each markup
instalment. That is why this model is called the ‘floating rate model’

b) Payment Frequency
The markup on loans/advances is payable in full, or in certain instalments, decided
based on the suitability of loan terms and conditions. In the case of instalments,
markup frequency could be set on a monthly, quarterly or semi-annual basis. In rare
cases, yearly payment of markup is also agreed upon.

c) Risk-based Pricing
While deciding on the rate of markup to be charged on a loan/advance, banks also
consider the risk of default or the probability of late recovery from the borrower. In
case of higher uncertainty about a certain sector of the economy or about any
borrower firm, banks may cover their risk by charging higher prices.

This risk-based pricing is achieved by following methods:

i. By charging a higher spread of load (say 5%), instead of the standard price of
Kibor plus 3% p.a. on certain types of customers.
ii. This higher risk premium is charged to the customer who carries a weak
repayment history or has offered security, which is not readily convertible to
cash and may take more time for recovery in case of default.

d) Upfront or in Arrears
These terms are applicable for payment of fees and markup. Fees are usually paid
in advance and therefore are known as upfront. i.e. before or instantly with the loan
disbursement

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Markup is not recovered in advance. It is payable by the borrower after the same is
accrued on the utilized amount of bank credit. This practice is termed as payment
markup in arrears.

4.6 Risk Analysis and Financial Appraisal of Loan Applications

Bank Lending is considered a business of risk management. While giving credit
facilities to business firms, the bank takes some risk of unpredictable delays/
defaults by a few of the borrowers. This risk is minimized if the Credit Department
of the bank has properly evaluated the loan proposals from all angles.

Here below the operations of the Credit Department of a bank related to such
evaluation are described in further detail:

(a) Management Appraisal and understanding of Borrower’s Profile

The processes of borrower’s appraisal/evaluation comprise of the following:
1. Understanding of the firm’s business and market standing
2. Management appraisal or Customer’s due Diligence: (as also defined in Unit-I)

These operations may include the following process:

- Retrieval of the Credit history of the firm from the eCIB portal

The credit history of the owner of the business is obtained in the case of sole
enterprises, while in the case of larger firms, credit dealings of all the
partners/owners and directors of the limited company are assessed.
- Know-your-customer details are verified to meet the requirement of
Prudential Regulation (also discussed in detail under Unit I).
- Third-party evaluators may also be hired for the evaluation of small loan
applications.

(b) Financial Appraisal/Evaluation of Loan Application

The next step is to evaluate the loan application from a financial angle. While
considering a loan request, banks require financial statements of the firm for the
past few years to carry out financial analysis. For small businesses, cash flow
estimates are accepted by banks.

For larger companies, audited financial statements of the last few years along with
future projections of the business and the scheme of loan utilization may also be
required.

Ratio analysis on the following lines provides useful information to understand the
business standing and future trends of the borrower firm:

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 Ratio Analysis from Financial Statements
Current Ratio Formula: Current Assets over Current Liabilities
The current ratio of over 1.0 times is a good indication of the
firm ability to service short-term liabilities
Quick Ratio This is similar to the Current ratio and is worked out by taking
current assets after excluding inventory/stocks. The quick ratio
of nearly 1 indicates a strong liquidity profile and ability to
service bank loans
Debt to Equity or This ratio is calculated by comparing the company’s debt to the
Leverage ratio total balance sheet as of the closing date of each year/quarter.
A company with a debt of over 60% of its total balance sheet
size is considered high in leveraging. Banks may not prefer to
give more loan to highly leveraged firms, unless strong security
cover is provided.
Operating Ratios of gross profit margin and profit Margin are analyzed
Performance, or horizontally, i.e. these ratios are compared over a period of the
analysis of P&L last 3 years.
account Gross Profit Margin: Gross Profit divided by total Sales Revenue
Profit Margin: Operating Profit divided by total Sales Revenue
Net Margin: Net Profit divided by total Sales Revenue

The above ratio analysis and year-wise comparison help the bank to:
i. Evaluate the current profitability and asset/ liabilities position of the firm
ii. And also whether it will generate sufficient cash flows to repay the bank loan
promptly.

Based on good management appraisal, borrowers’ financial standing and operating

performance, banks, may decide to sanction the credit facility. However certain
borrowers may not come out as the best performer under all of these appraisal criteria.
A higher risk of default implies that the bank will ask for a stronger security cover.

Details of various types of security/ assets acceptable to banks are given in the
following section.

4.7 Loan Security and Documentation

Bank Lending is considered a business of risk management. The security cover
obtained by the bank from the borrower minimizes the risk of default. The borrower
firm will make all efforts to repay the bank dues to preserve its reputation and to
take back the valuable security.

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4.7.1 Types of Assets Acceptable to Banks as Security
The borrower may offer the following assets or deposits as security to obtain bank
credit.
1. Lien on existing bank account with a sufficient running balance to cover the
advance amount
2. Lien on firm’s Stocks (acceptable by the bank to cover working capital
advances or running finance)
3. Lien or mortgage on fixed assets of the firm: i.e. the borrower mortgages
certain declared fixed assets of its business, as security of a long-term loan.
The security is registered with the Companies Registrar’s Office.
4. Collateral in the form of property, house, plot or building. The possession of
the property remains with the borrower, but its rights are put under the lien of
the bank by executing legal agreements and registration with the Companies
Registrar’s Office
From the practical perspective, banks may ask for the following type of assets as
security of the respective bank advance:
Type of Bank Credit Suitable Security
Cash Credits, Running Finances Lien on the existing bank account of the borrower
working capital advances to Lien on firm’s Stocks/inventory. Examples include
manufacturing business a pledge of cotton stock or finished goods
Medium to Long Term Credit Charge on firm’s fixed assets: i.e. the borrower
Lines to large business firms mortgages certain fixed assets of its business, like
plant and machinery, movable assets etc.
Medium to long-term loan with Collateral in the form of property, house, plot or
higher risk building

4.7.2 Loan Documentation and SBP Prudential Regulations

The term ‘documentation’ means certain types of applications/s letters/undertakings
and legal documents, required during the process of giving bank credit to borrower
firms.
These documents are mostly binding requirements, both from the bank’s operations
angle and in terms of compliance with the Prudential Regulations of the State Bank
of Pakistan.
State Bank of Pakistan has issued Prudential Regulations for various types of bank
lending. (also referred to in earlier units). Compliance with these regulations is
mandatory for all banks and borrowers. Banks, advise their borrowers to execute
and provide the following sets of documents at various stages.
a) Loan Application, signed by the borrower

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b) Borrower’s Basis Fact Sheet, as format provided in Prudential Regulation
The applicant discloses basic introductory data and details of existing or
previous loans availed from any bank
c) KYC documents including CNIC and details of the business as required under
regulations on Customer Due diligence (also covered in earlier units)
d) Undertaking for proper Utilization of Bank Loan
e) Demand promissory Note:
This legal document creates the bank’s right to receive back the due amount

f) Documents and legal Agreements related to the security of the loan

These documents serve the following purposes at various stages of banking

operations:
i. To streamline the credit appraisal and approval operations, written record
helps to achieve error-free communication with the borrower
ii. Useful for banks in understanding customer’s profiles and later during
internal audits and inspections
iii. Provides necessary assistance in the recovery of loans or legal proceedings at
court cases, if need be.
iv. Compliance with the bank’s policies and SBP Regulations

4.8 Self-Assessment Questions

a) Short Questions
1. Write down three major types of bank advances that a bank may offer
to a business firm.
2. What is meant by Cash Credit and how long is its maximum tenure/term
3. Define the following:
Working Capital
Current Ratio
Quick Ratio

b) Long Questions and Exercise

i) Write a note on two types of credit lines and their salient features. How a long-
term credit line is generally structured by banks with suitable types of security?
ii) Download a Balance Sheet of any listed company and work out the following,
as of the balance sheet date:
- Cash Credits/Short term loans from banks
- Long Term Loans payable to banks
- Debt-to-equity or Leverage ratio

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Also, write your views on
i. financial strengths/weaknesses of the Company and
ii. give an opinion on whether a bank should consider this company for a higher
amount of loan if it approaches the bank for running finance limit

4.9 Summary
This unit is about one of the core functions of a bank, i.e. credit and advances. Banks
create credit in the economy by lending their deposited funds to businesses. This unit
has focused only on banks’ lending to firms. Credit function has been elaborated by
categorization of bank advances into Cash Credits, tenure-based Credit Lines and base
Lease finances. The differentiation between loans for working capital and long-term
asset creation has been described in detail. Various features of these advances with
respective targeting of banks-customers are explained with examples. The Unit has
also discussed loan-pricing models prevalent at banks.

The banks provide loans to credit-worthy firms, or strong asset-backed security is

required to provide cover against any risk of bad debts. This aspect is also covered in
the unit and processes involved in the evaluation of loan applications and assessing
credit viability have been described. Ratio analysis for determining the financial
viability of a borrower company is also deliberated along with options and operations
concerning collateral/security acceptable to banks for securing their advances.

REFERENCES

Managing Risk in Financial Sector, The Institute of Bankers Pakistan (01/2006)

Rose S. Peter and Hudgins C. Sylvia (2007) Bank Management & Financial
Services the McGraw-Hill Companies
The Islamic Institute of Banking and Insurance, New Horizon, Issue no 162/2006

Website source:
[Link]
[Link]
[Link]

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Unit–5

INTRODUCTION TO ISLAMIC
BANKING OPERATIONS

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
87
 CONTENTS

Page #
Introduction ....................................................................................................... 89

Objectives ........................................................................................................ 89

5.1 Islamic Banking, Growing Popularly .................................................... 90

5.2 Instruments of Borrowing, Advances and Investments in Islamic Banking 94

5.3 Comparison of Islamic and Conventional Modes in Banking ................. 104

5.4 Self-Assessment Questions ...................................................................... 106

5.5 Summary .................................................................................................. 108

References ......................................................................................................... 108

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 INTRODUCTION

The banking business provides pivotal support to trade, business and economic
governance. Individuals, governments and business companies depend heavily on
banking networks for carrying out financial transactions. During the era of modern
banking, Islamic societies worldwide felt a need to manage financial business in a
more precisely defined environment, which is in line with their ideological
standards and also economically supportive of society as a whole. Over the years,
financial theories and tools that meet such standards have been adopted by banks
(generally known as Islamic banks or financial institutions) to meet the growing
demand from customers.

This unit introduces salient developments in the Islamic banking industry and
financial instruments in vogue.

OBJECTIVES

After studying the unit, will be able to have an insight into the following:

 Conceptual and development perspective of Islamic Banking and certain

prohibitions that differentiate their niche market

 Regulatory and supervisory framework to ensure compliance, and disclosure

standards and to promote the growth of this particular segment of banking

 Various instruments applied in Islamic banking to structure financial

transactions in line with the underlying principles of partnership, trade and
asset-based financing, along with their comparison with the conventional
modes.

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5.1 Islamic Banking, Growing Popularly

5.1.1 The Basic Concepts

The concept of Islamic banking is based on supporting financing activities, trade
and business in line with Islamic principles, derived from Quran and Hadith,
without engaging in a suppressive interest-based regime.

Islamic banking, therefore, follows profit/loss sharing between all the stakeholders
in the spirit of partnership.

In more specific terms, Islamic Banking finance refers to methods, sources, and
instruments whereby funds, money, investments or loans are put into business for
mutually agreed benefits & and risks in line with the principles of trade and
business permissible under Islamic ideology.

Worldwide, the Islamic banking system has gained popularity over the last few
decades. Key driving factors of this growth are:
a) A large customer base, having specialized needs on ethical grounds to refrain
from interest-based conventional banking products.
b) A good number of entrepreneurs or wealthy equity investors, who desire to
put money in banking businesses which do not involve any ideologically
prohibited modes, and thus promote and set up Islamic banking institutions.

Prohibited Elements in Islamic Finance

o Riba: usury or interest
o Gharar: excessive risk or excessive uncertainty
o Maysir: gambling
o Dealings in prohibited products or un-disclosed business: like unlicensed
drugs, alcohol, or sources of customer's funds are not known.

The financial products in the Islamic system of banking have been developed in
various countries after going through an evolutionary process of research and
development by scholars and economists. Standardized products have been
adopted in Pakistan also. For any new transaction or product/service, clearance
from the Sharai Board/ Advisor of the bank is needed before implementation.

Definitions:
Sharia Compliance
Principles adopted in trade, business and borrowing of money that do not involve
prohibited elements such as RiBA, gambling /speculation etc. are considered
compliant with Islamic Shariah. Islamic banks are assisted by a Board or advisors,

90
who have expertise in Islamic theories and teachings (fiqh etc.). These experts
advise the bank on each banking product transaction about any deviation from the
teachings of the Holy Quran, if any, the bank to remain compliant. Buying and
selling of goods for profit, agreements of Profit and loss sharing, purchase and re-
sale of assets, leasing of assets on rent etc. are amongst the Shari-compliant modes
in banking.

Definition of Riba
Riba is defined as any excess compensation or increase without due consideration,
which results from predetermined interest, that the lender receives over and above
the principal amount.

Islamic Sharai is the application of Riba or penal interest on funds lent to meet one's
requirements. In Islamic banks, the Banking business of borrowing, deposits, lending,
investments etc. should take place under Riba-free/Sharia-compliant methods.

Islam strictly believes in values and ethics in trade, business and financial
facilitation:
- It demands transparency in contracts, dealing and selling.
- It requires complete disclosure of business terms and the depositor's profile
(KYC) for the benefit of both the bank and the depositor/customer.
- It protects weaker sections of the economy by replacing fixed interest with
sharing formulas joint/ collective investment schemes.
- It encourages Qarz-e-Hasna and rebates for low-income populations and state
support through legislation.

5.1.2 Evolution of Islamic Banking in Pakistan

Internationally, Islamic finance gained practical significance in the 1970s.
Presently there are over 400 Islamic institutions in Malaysia, the Middle East, South
Asia, and Gulf countries, with branches worldwide.

Many countries encourage the Islamic finance model as a preferred mode of

banking - particularly the Middle East, such as Saudi Arabia and Qatar, as well as
Malaysia. Some of the largest Islamic banks today include Al Rahji Bank and Bank
Al Jazira in Saudi Arabia, Dubai Islamic Bank, Abu Dhabi Islamic Bank and Qatar
Islamic Bank.

According to a recent study, the assets of Islamic banks are USD 1.99 trillion,
constituting 6% of banking assets worldwide.

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In countries like Malaysia, about 50% of their total banks' assets are under Islamic
Banks.

The Islamic model is based on a participative approach. To attract new market

share, Islamic Banks also take up aggressive marketing campaigns and absorb more
of the strain of the initial transaction processes by a supportive environment to
smaller businesses enabling finance to be more accessible in this otherwise weakly
served group (like SMEs etc...)

In Pakistan, new Laws/ Ordinance regarding Banking and House

Financing under Profit and Loss Sharing (P&L account) were introduced
from 1979 to 1985.

During 1990s, new financial companies were allowed to expand financial outreach.
These included modaraba companies, investment banks and leasing companies.
Islamic finance largely gained momentum in Pakistan during these times.

However, full scale Islamic banks with a Sharia Board and supervisory
framework, in line with international practices, progressed in the last
two decades

5.1.3 Regulatory Framework of Islamic Banks

The central banks have played a key role in the development, licensing and
regulation of the new Islamic banks. In Pakistan, the State Bank of Pakistan has
encouraged the existing commercial banks and new entrepreneurs to set up Islamic
Baking institutions. During the last three decades, this process in Pakistan has gone
through the following phases:
1. Initially, new Modaraba and Leasing companies were allowed to set up,
which introduced Riba-free products
2. Later in early 2000, State Bank allowed the existing conventional banks to set
up independent Islamic Banking Divisions to meet the growing demand of
customers

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3. Based on the experiences of these operations, new licenses for full-fledged
Islamic banks were issued along with a separate regulatory framework. This
was necessitated also due to rising demand from a large customer segment
that needed Islamic banking products for their savings and business.

State Bank of Pakistan also set up a dedicated department 'Islamic Banking

Department' to monitor and oversee regulations and policy matters concerning
Islamic banking operations. This department performs monitoring and inspection
of Islamic banks in its supervisory capacity.

Islamic Banking Sharia Advisory

Department Board of SBP

As referred in Unit 2 also,

currently there are five (5)
Islamic Banks operating in
Pakistan. In addition, Out of
the other fifteen (15) local
Regulations private banks, mostly operate
and separate divisions, licensed to
Inspections carry out Islamic Banking
operations.

Islamic Banking
Institutions/Divisions

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5.1.4 Role of Sharia Advisor
Islamic Banks can deal only in those products and services that are free from Riba
and are structured within the bounds that are not against the Islamic provisions of
Sharia. ascertain this fitness, every transaction deposit funding scheme etc. is vetted
by an independent Sharia Advisor within each banking institution. This advisory
system also filters the profile of the borrower/lender to ensure that complete due
diligence of the customer is available to ensure regulatory compliance and to avoid
any illicit or terrorist financing.

Persons with prescribed qualifications and expertise are appointed as Sharia

Advisors. Bankers have to seek clearance of every transaction before approval or
implementation.

The appointment of a Sharai Advisor also has to follow a due process, whereby
banks are required to meet certain criteria (in terms of qualification, experience,
and integrity). In this respect, the State Bank of Pakistan has issued regulatory
guidelines for 'Fit and Proper Criteria for Sharia Advisors'.

Sharia Advisor has the authority to refuse such transactions that involve any income
not considered halal or legitimate from the viewpoint of Islamic injunctions.

Examples:
Generally, the following types of banking transactions are not endorsed/ cleared by
Sharia Advisors of Islamic Banks:
- Deposit schemes with pre-determined interest rates, without consideration of
actual profit/loss
- Loaning to individuals for consumption needs by pledging their household
items.
- Transactions where related information or terms of the deal are not fully
disclosed to the customers or where customer/depositor profile is not
available
- Banking Services that relate to or are based on gambling
- Investment by banks where expected income is drawn from speculation
- Investment by banks in shares of those companies which produce or deal in
prohibited products

5.2 Instruments of Borrowing, Advances and Investments in

Islamic Banking
Islamic banks perform all such banking functions (i.e. deposits, payments,
investments advances etc.), provided these do not involve the basic prohibitions, as
94
described under 5.1.1 (b). The difference in operations of Islamic banks and other
conventional banking stems from the following:
 Scope of banking business and avoidance from Riba, gambling etc.
 Procedure and structure of the transactions.

In this section, we will touch upon these areas and discuss methods and
standardized modes, which are applied to structure transactions of deposits or
advances/in Islamic banking.

Within the specified boundaries, these banks can compete with other conventional
banks in attracting business.

5.2.1 Scope of Banking under Islamic Society

As explained earlier, Islamic banks are required to seek clearance of each
transaction or a new product from their Sharia Advisor. The basic criterion of
Islamic Banks for their investments and dealing with other businesses are:
1. Islamic banks deal, with for-profit motive, with such counterparts that
do not manufacture or trade any product/ service which involves Riba,
Gharrar or Maysir mays, or liquor (Reference section 5.1.1)

Islamic banks follow the same principle while undertaking investments in financial
markets. These banks do not invest their surplus funds in fixed-income government
securities; (e.g. Pakistan Investment Bonds, to which conventional banks are more
attracted.) Islamic banks rather invest in specific modes only allowed under the
regulations. These modes may include:
i) Government of Pakistan Ijara SUKUK
ii) National Investment Trust (NIT) units,
iii) Or listed shares that meet the above-said criteria.

2. The concept of partnership and trade between the bank and its
customer/counterpart is the basic essence of Islamic banking. While
extending financial assistance (advances etc.) or deposit mobilization, the
Islamic banks work on principles of trade, business and partnership.

Bank Loans to private individuals: In conventional banking services, lending to

individuals for personal needs (i.e. personal loans) has remained a common
practice. However, charging interest on the amounts lent to meet the personal needs
of a financially weaker individual is against the spirit of the Islamic system of
finance. Such riba-based transactions are not within the scope of Islamic banking.
Rather, the Islamic principles advocate Qarz-e-Hasna (interest-free need-based

95
loans). However, practically such facilitation comes mostly from government-
sponsored schemes, rather than from banks.

5.2.2 Procedure and Structure of Transactions

Based on above stated principles, there are standardized instruments and
procedures derived from the research and development work of scholars and
economists. These are applied worldwide by Islamic Banks to structure advances,
deposits, investments, and other trade/ profit motives transactions.

These are largely comprised of the following:

[Link] Musharaka
o Musharaka is a partnership of two or more in a transaction or a joint business.
The partner partners put together their capital and labour based on mutual
trust, share in the profit and loss of the joint venture and have similar rights
and liabilities.
o Partners could contribute towards Musharaka Assets in cash or kind

96
Example
 Mr. A and Mr. B decided to establish a coffee shop so they entered into a
Musharaka agreement. A contributed Rs 20,000 and B contributed Rs. 40,000.
The total capital is 60,000.
 Partners can receive profit based on capital contribution. (Profit shared
based on pro-rata to the capital contribution)
 A gets= 20,000/60,000= 0.333 (33.33%) of profit
 B gets= 40,000/60,000= 0.666 (66.66%) of profit
 Partners can receive profit based on the agreement regardless of the
capital contribution. (Based on pre-agreed ratio)
 A may get 50% and B gets 50% (50:50) (if A has more experience in this business)
 Partners bear losses according to their capital contribution
A bears 33.33% and B bears 66.66% of losses.

Musharaka Application in Deposit Schemes

Deposits or borrowing of funds is a key function in any bank. Islamic banks follow
two types of deposit schemes:
 Current account pool, where no excess money/interest is paid
 Business Deposits Pool: This Pool operates under the Musharaka Agreement.

Regarding, the Business Deposits Pool, Islamic banks consider their depositors as
their partners. The money raised in the deposit pool along with the bank's funds is
deployed in business or investment. After a calendar cycle, any profit on these
funds is distributed to the depositors, after subtracting the cost of transactions and
the bank's share (as a partner and instead its skill).

That is the reason that Islamic banks do not quote a fixed rate of profit or interest,
in advance, on their deposit schemes. The profit is worked out on an actual basis,
which could be higher or lower than the depositor's expectation.

Loss Scenario
The Musharaka partner, i.e. the depositor may get no profit on the deposit, if the
bank or pooled funds have suffered a loss. However, banks would try to avoid such
a situation as this could lead to a run on its deposits. The regulatory authority (SBP)
also monitors any such situation that could lead to losses.

Musharaka in Bank Advances

Musharaka mode is also applied in extending bank loans/advances to businesses,
which desire to operate on profit and loss sharing. Musharaka is created by pooling
of bank's funding and owners' funds/equity on a pre-agreed ratio. (Just like the
Debt-to-Equity Ratio).

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Working Capital Credit or Long Term Credit for some specific business
purpose (as referred to in an earlier Unit) may be provided to business firms
by Islamic Banks under the Musharaka agreement

Example I
Working capital financing to a manufacturing concern can be structured under
Musharaka as follows:
The bank agrees to extend funds of Rs. 10 million to the borrower/ customer for the
purchase of Raw materials with a total cost of Rs 20 million.
The Customer requires raw material worth Rs 20 million to complete its production.
The customer also contributes Rs. 10 million and deposits the same with the bank on
profit.
The bank and the customer enter into a musharak agreement for 6-month tenure.
The bank issues financial facilities in the form of guarantees to the supplier of raw
materials for payment of Rs 20 million upon satisfactory deliveries of the goods.
The bank will disburse the funds and purchase the raw material in joint ownership
with the customer.
Upon receipt of goods, the bank authorizes the customer to receive the material
required for production (in tranches) upon re-payment of equivalent installments of
the bank funds, so that the bank recovers its portion of financing and profit amount
monthly, until the Musharka terms are completed in 6 months.

Example II. Musharaka in Long-Term Project Financing

Banks also extend long-term financing under the Musharak contract. For example,
a customer possesses land in a commercial area (worth Rs 1 billion) and approaches
the bank to participate in the construction of a -floor 20-floor tower. The bank can
enter into a Musharaka contract, where the bank partners in the project by extending
long-term financing of Rs 1.0 billion for construction purposes. The land and future
building will be under the joint ownership of the Mushraka holders, until complete
repayment of the due instalments of bank financing.

The bank will recover its funds against the re-sale of units of the constructed
building, at profit, to the land owner/customer during the currency of the finance
period. After full re-payments, the owner/customer will regain the complete title of
the property.

98
[Link] Mudaraba Contract
Mudarabah is a concept applied in Islamic Finance for structuring a business
contract. It is based on partnership and trust where:
- one party (or group of persons) provides the capital
- while the other provides the skill, labour, and expertise (known as Mudarib)
- and both share in the profits, No funds are shared by the Mudarib, who only
provides skilled labour.

It is a form of partnership contract wherein one

party invests its funds , with another party
which agrees to manage the Mudaraba Capital
for the benefit of both the parties.

The capital provider is called the (Rab al Maal

)while the entrepreneur who manages and runs
the business called the (Mudarib )

Rab al Maal does not interfere in the day-to-

day running of the business but may specify
some conditions related to management of the
business.

Application of Modaraba in Investment Transaction

In Islami Banks, the Mudaraba concept is applied to such schemes of investment
whereby banks offer their skills to manage depositors' funds in investments etc. for
the sharing of profits.

Such schemes are also referred to as Discretionary Investment Pool, whereby

banks/financial institutions are authorized to skillfully pool funds for investments
at the bank's discretion.

Deposit schemes:
Banks attract deposits from customers and utilize these funds in business and
investment. In the Mudaraba contract, banks do not quote the exact profit rate on
deposits, rather a distribution of profit is made on a profit and loss sharing basis at
the end of each calendar period after adjusting the Mudarib fee and expenses. All
such terms are duly agreed upon and signed between the parties (Rab- all and
Mudarib) as a part of the account opening documentation.

99
Mutual Funds, (under trust schemes),
Mutual Funds in Pakistan are operated by Asset Management Companies under
SECP Rules. These companies operate collective investment schemes, whereby
depositors/customers deposit funds as trust and the Company (as Mudarib)
manages the pooled funds to invest in the stock market or for property rental etc.
allowed under SECP rules.

Example of Trust funds in Pakistan

National Investment Trust Units (NIT manages unit-holder funds as Mudarib by
investing in Stocks and other modes and distributing profit/loss proportionately)
There are several other Asset Management Companies set up by private banks
under SECP regulations, that operate mutual funds under discretionary collective
investment schemes such as Mudarib.

[Link] Asset-backed financing

As the above discussion on deposits highlighted those Islamic banks operate on a
partnership model for fund mobilization. We now discuss the other side of the
banking business, i.e. advances and investments.

Islamic banks extend financial support to their customer’s/business firms by

procuring or applying certain assets needed by their clients or through purchase/re-
sale. That is why Islamic banking transactions are regarded as 'asset-based', i.e. the
bank will not give a loan directly to the borrower, rather it will facilitate the
customer by partnering in purchase/sale or pooling of funds (as also discussed in
case of Musharaka/Mudaraba).

The contracts for extending financial assistance (i.e. loan/advances) and financing
modes are described in more detail, as follows:

a) Murbaha Financing
1) Murabaha financing is a mode of working capital finance. In Murabaha, only
banks' funds are applied to procure goods for trading by the firm.
2) Musharaka's mode of bank advance is also used to finance the working capital
needs of their borrowers.
3) The difference is that Musharaka is suited to those firms, where firms' funds
are also used along with the bank's participation.

Working Capital Credit (as a reference in an earlier Unit) may be extended by

Islamic Banks under the Murabaha agreement

Definition
Working capital means the funds needed by any business to finance its raw material
procurement or inventory, or payment to sundry creditors.

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From an Accounting perspective, working capital is arrived at by subtracting current
liabilities from current assets. Banks extend loans to businesses for a 3–12-month
period to meet short-term working capital requirements.

A Case of Murabaha Finance

A business may need to purchase goods for its trading, and the customer has ordered
the material, but needs money to pay to supplier etc.
The bank may agree with the customer to extend money under Murabaha Finance
in the following manner:
1. Execute the Murabaha Agreement with details of terms and conditions.
2. The Islamic bank purchases the goods/raw materials/inventory from the supplier.
3. The Islamic bank pays on a spot basis and takes the good's possession.
4. The Islamic bank sells the goods to the customer at a mutually agreed price,
covering the bank's profit and costs.
5. The customer agrees on the transaction on a deferred payment basis for an
agreed period.
6. The Islamic bank delivers the goods to the customer. The customer makes the
payments in installments to the Islamic bank after he utilizes the goods in his
trading business.

The customer has benefitted from the goods by doing business with the help of
goods funds provided by the bank's funds, while the bank has benefitted from
earning markup or profit in instalments.

b) Bai' Muajjal
In Islamic jurisprudence (fiqh), Bai-muajjal, is a credit sale or deferred payment
sale, i.e. the sale of goods on a deferred payment basis. Thus the terms Murabaha
Finance or Bai' Muajjal are often used interchangeably. Bai' muajjal as a finance
product was introduced in 1983 by Bank Islam Malaysia Berhad.

c) Ijarah
Ijarah means “to give something on rent” and is a leasing or renting contract.

In traditional Islamic jurisprudence (fiqh), it means a contract for the hiring of

services, or property, generally for a fixed period and price.

In Islamic finance, Ijarah usually refers to a leasing contract and is applied to long-
term financing for industrial and commercial customers.

 Ijarah is applied by Islam, whereby the bank acquires an asset or property,

such as a plant, office automation, motor vehicle etc.
 Property is leased to a client for rental and purchase-price payments (in
instalments)

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 At the end of the leasing period and completion of installments, the transfer
of ownership of the asset to the lessee is completed.
 Banks have earned rental income and received their money in installments,
while the customer has benefitted by using the assets for productive use over
the same period.

Ijara is an alternate lending mode used by Islamic banks in place of Lease

Financing (as a reference in the earlier Unit)

Sukuk
Sukuk is an instrument of fund mobilization, which is repayable for a longer
duration. In conventional terms, it's close to a long-term bond or Term Finance
Certificates.

Sukuk is a liability product for the issuer while those who subscribed or invested
funds, are termed as purchasers or investors.

Here we will deliberate on this subject from the viewpoint of the purchase/investor
of SUKUK.

Structuring of SUKUK

Bank/Adviser

Trustee

Investors/Subscribers

o A corporate company, ABC or a government needs funds for its development

needs. (e.g. a project of Construction of a commercial building, or a Motorway.)

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o The customer (ABC) desires to approach a large number of financiers and the
Money market to raise Rs 5 billion, which will be repaid over a period of 7
years from the income of the project.

o A financial institution is engaged as a financial adviser to execute and to

manage procedures to issue SUKUK of Rs. 5 billion to financiers by
securitizing the underlying project.

o A financial institution may also act as a Trustee

o A Special Purpose Vehicle (i.e. SPV, a company with limited liability) may
be created for SUKUK issuance. The SKUKUK issuing party (usually a
government) transfers its asset to SPV for a specifically defined purpose. Now
the SPV in its legal capacity will share the risk of the project with the investor.

o In other cases, the project land and related assets are sold in favour of the
SUKUK investors, (with the buy-bank option upon timely re-payment by the
customer (ABC)). These may also be held in trust with a Trustee

o SUKUK units are subscribed by various investors, who deposit their

payments to the bank's branches. They are entitled to the value of the property
(held with the Trustee) in proportion to their investment.

o Sukuk could also be traded on stock exchanges for wider market access.

o Under this arrangement, the company or the government can raise a large
amount from a large number of customers at an affordable cost.

SUKUK may carry a profit rate on a variable basis, with payment quarterly or after
every 6 months, linked to Kibor or Libor.

At the maturity of SUKUK and upon repayment of the principal to subscribers, the
issuer (i.e. Company ABC) is entitled to buy back the property, which is reclaimed
from the Trustees.

Banks may also invest their funds for profit motive in SUKUK issued either by
their big customers, or the Government.

Examples of Fund Mobilization by Issuing SUKUK

1. US dollar-denominated bonds, in the form of SUKUK, launched by the
Government in the international market to boost foreign exchange reserves.

103
 Currently, such an issue was launched in January 2022.

Here the Issuer is the Government of Pakistan and subscribers/investors are non-
residents or investors from international markets

The purpose of SUKUK is to fetch US Dollars in Pakistan to strengthen our

reserves.

The government placed an asset-backed guarantee of Motorway (M-2) portions

for launching the $1 billion Sukuk Bond. It has established a Special Purpose
Vehicle (SPV) for the launching of the Sukuk Bond, which has securitized the
assets in favour of the investors.

2. Ijara Sukuk of the Government of Pakistan

The government raises funds from banks, (particularly from Islamic Banks) by
issuing Ijara Sukuk from time to time. The funds raised by governments are
utilized for budgetary support.

Here the issuer is the Government of Pakistan. State Bank Pakistan act as an
Issuing agent and functions in line with the advice of its Sharia Board.

Ministry of Finance provides undertaking of holding the underlying pool of

assets, which, in terms of SUKUK documents, are the ownership of the
purchaser/investors of SUKUK in proportionate terms, until these assets are
purchased back by the government upon repayment to the SUKUK holders at
maturity.

For SUKUK issuance, the Ministry of Finance creates and manages a Pool of
Assets consisting of state-owned projects and assets that are Shariah compliant.

5.3 Comparison of Islamic and Conventional Modes in Banking

Islamic Banking processes are currently in an evolutionary phase. Continuingly,
modifications are introduced after the research and review of the existing set of
products. Here in this section, a comparative overview of certain banking modes in
the Islamic finance system is given for more clarity.

104
 Banking Under Islamic Under Key Difference in the basic
Service Bank Conventional Bank structure
Deposit Profit rates are Banks commit fixed Islamic banks follow
Schemes not pre- rates for deposit Musharaka or Mudaraba
determined schemes beforehand principles for profit
sharing/distribution.
Depositor and bank share
profit or loss. Conventional
banks pay the pre-determined
interest fixed rate.
Short-Term Murabaha Running Finance Islamic Banks purchase
Working Finance Facility or Working assets/inventory as partners
Capital Capital Credit in business. While Running
Advance (Reference Unit 4) finance is cash Credit, the
client repays on time
otherwise the security of the
loan is forfeited
Long Term Ijarah Finance Long Term Loans or Islamic Bank extend funds
Financing or Musharaka Credit Lines under the Leasing Contract of
Contract an asset and earn rental
income. Conventional banks
create charges on borrowers’
assets and may also require
land or property as security.

Investments and Payment Systems

Product and Under Islamic Under Key Difference in the basic
Services Bank Conventional Bank structure
Collective Mudaraba Unit Trust or Under Mudaraba, investment
Investment Contract Discretionary is made only in sharia-
Schemes, Portfolio schemes compliant companies/modes,
Mutual Fund without riba or speculation.
No such conditions in
conventional schemes.
Investor shares profit or loss
in both cases.

Long-Term Ijara SUKUK Long-Term Bond: Ijara Sukuk is based on

Instruments of the Pakistan Investment ownership of certain assets,
of Investment Government of Bond while other government
Pakistan bonds are based on
government guarantees only.

Payment No difference in services related to Banker’s cheques, demand drafts

Systems transfer of funds and digital banking payment transactions. Disclosure
requirements related to customer profile/source of funds are applicable

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5.4 Self-Assessment Questions
a) Short Questions
i) What is the role of the State Bank of Pakistan in our Islamic Banking
system
ii) Which are the banking services where the Mudarba contract is applied
in Islamic Banking
iii) Define Musharka with examples

b) Long Questions
i) Define basic principles of Islamic Banking and prohibitions. Give at
least two examples of banking services, which are not acceptable under
the principle of Sharia compliance with Islamic
ii) Write a note on various modes of Asset-backed financing under Islamic
banking.

c) Exercise
The data below is taken from a published Financial Statement of a bank. This
relates to financial data and disclosures of Islamic banking operations of the
bank, under a separate annexure/notes to the account.

Please study the information below and answer questions at the end.

106
Source: Annual Report of United Bank Limited 2021

Questions:
Why separate ‘Modaraba Pools' are managed for the distribution of profit on
deposits under the Islamic Banking System?

The bank has also disclosed (under 11.1) the various sectors where funds obtained
from deposits are deployed, give your opinion about why such disclosure is needed.

107
5.5 Summary
This unit deliberated on the operations of Islamic banking from a practical viewpoint.
The historical background is also discussed in the earlier section to broadly introduce
various evolutionary developments of this particular segment of baking. Islamic
banking has grown worldwide on the back of a large population of depositors/investors
who prefer to generate income through a business-like model, rather than in the form
of a fixed-rate interest. Such banks are also growing in Pakistan. After the initial
legislation on the elimination of Riba, the development of specialized product
structures in the field of the Islamic banking system is still an ongoing process.

The unit further discusses various approaches applied in constructing banking

products/services of deposits, lending, business financing and investments. These
structures are based on a participative approach and banks and the customer share
profits and loss. These are based on Mudaraba, Musharak or Murabha, Ijarah. These
concepts have been explained with examples from the perspective of relevant
banking services (like deposits, lending and investments by Islamic banks).
SUKUK is a widely applied model, both for investors as well as for large project
financing or resource mobilization by governments. This has also been deliberated
in detail in the later part of the Unit.

A comparative overview of operations in conventional banks, as studied under

earlier units, viz-a-viz Islamic banking has also been referred to, where necessary,
with a summary in tabular form at the end of the unit.

Being in the beginning phase, the Islamic banking system continues to explore
development and refinement. With a view of making the banking services
completely free from prohibitions (from an Islamic viewpoint), supervisory
systems are in place at banks and at the State Bank of Pakistan, which undertake
evaluation and research continuously.

REFERENCES
Dr Muhammad Imran Ashraf Usmani, Meezan Bank's Guide to Islamic Banking,
Darul-Ishaat Karachi.
The Islamic Institute of Banking and Insurance, New Horizon, Issue no 162/2006.

THE INTERNATIONA Association of Islamic banks, Karachi. Journal of Islamic

Banking and Finance Volume no 23, (2006).
Website source:
[Link]

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Unit–6

MANAGING THE BANK’S

INVESTMENTS PORTFOLIO AND
LIQUIDITY POSITION

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
109
 CONTENTS

Page #
Introduction ....................................................................................................... 111

Objectives ........................................................................................................ 111

6.1 Investment Options Available to Banks .................................................. 112

6.2 Factors Affecting the Banker’s Choice of Investment ............................. 119

6.3 Demand and Supply of Bank Liquidity System ...................................... 123

6.4 Self-Assessment Questions ...................................................................... 128

6.5 Summary .................................................................................................. 129

References ......................................................................................................... 130

110
 INTRODUCTION

Banks’ profitable operations depend upon an efficient mix of business products and
modes of funds deployment. While banks may follow their specific business
models, in general terms they rely on business modes such as advances, lending,
investments and fee-based services for the deployment of available resources.

The unit will focus on banks’ investment portfolios and liquidity positions. The
investment portfolio is one of the key drivers of profitability and liquidity. A good
bank would build up a portfolio of investments that promises return/reward as well
as reasonable means of convertibility into liquid funds within a quantifiable time
horizon. Having a good and vibrant mix of assets is fundamentally significant for a
bank to meet its customer needs and sustainable growth.

Liquidity from a banking perspective is defined as the ability of a financial

institution to timely service its financial commitments and meet customer’s
demands for banking services. A fair liquidity position of a bank implies the
availability of such assets in its investment portfolio that are readily convertible
into cash for timely payments or to capture re-investment opportunities.

This unit will deliberate on various modes of investment avenues permissible for
banking businesses and their return-risk characteristics, marketability, portfolio
management and significance of liquid or marketable assets.

Banking practices, and regulatory limits applicable to banks concerning investments,

liquidity and portfolios are also touched upon.

OBJECTIVES

After studying this unit, you will be able to understand:

 Investment function in the banking industry and their relation to funding

sources and liquidity

 Choice among various instruments, in which banks undertake investments,

along with their characteristics.

 Planning process of building up a balanced portfolio that also efficiently

manages the bank’s liquidity system.

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6.1 Investment Options Available to Banks
While deciding on the profitable utilization of available funds, banks are faced with
several options in terms of available instruments of investment and their respective
feasibility. Selection must be made whether:
 Choice between short-term or long-term investment
 Choice between advances and investment
 Or what proportion of liquid funds are needed within the next few working
days to address anticipated deposit withdrawals, etc.

These parameters are dependent upon the bank’s purpose, positioning and
projections, (we refer to these as 3Ps of Investment Decisions). These are viewed
from the perspective of both short-term and long-term. The 3Ps are discussed in
detail later (section 6.2). Before that various permissible modes and instruments of
investment by banks and financial institutions are touched upon hereunder in the
following sections.

6.1.1 Permissible Modes of Long-term Instruments of Investments

Investment banking is a broader and specialized function of banking whereby
investments and capital formation schemes are advised and formulated to meet
customers’ needs; these usually involve rather complex and long-term structuring.
Following banking functions, where banks may take investments alongwith
advisory services, fall in the domain of investment banking:
 Financing of long-term infrastructure or business projects
 Asset-backed sukuk and funding of government projects
 Underwriting and advisory in the issuance of the share capital of
companies/customers
 Investment in subsidiaries for long-term holding
 Investment/participation in raising business debt through public floatation of
bonds/securities.
 Participation in loan settlement schemes like debt-equity swaps for default or
troubled companies etc.
 Merger /Acquisition and privatization transactions

Commercial banks have dedicated investment banking units or divisions to

undertake such business. In addition, dedicated investment banks also operate
worldwide with specialized investment banking expertise. Their scope and market
share in Pakistan are limited; however, these are licensed to carry out the above
functions along with financial market brokerage services to individual and
corporate clients directly or through their subsidiaries.

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6.1.2 Strategic Investments
Investments that have long-term risks and strategic objectives are categorized as
strategic investments. These may have longer gestation periods and banks have to wait
for the maturity of the business cycle to receive dividends. Investments are made after
a thorough analysis of inherent risks and the bank’s decisions are based on reaping
benefits both in terms of profits as well as the future growth in the value of their
holding. Prudential Regulations in Pakistan define that a bank’s intention of holding
the investment should be at least five years to qualify for Strategic Investment.
Examples of strategic investments may include:
o Subscription or acquisition of a shareholding in a related business company
having promising growth prospects, or
o Participation in Real Estate Investment Trust (REIT) of a business tower on a
high street for rental income and value growth.

However, these are subject to regulatory and risk limits set in the Prudential
Regulations. Also, strategic investments need to be duly approved at the highest
forum (BOD) and are subject to due disclosure under a separate head in the
financial statements.

6.1.3 Risk Limits on Investments

Investments are undertaken for profit and value maximization. However, returns
cannot be earned without risks. Only government securities are considered free
from credit risk, being backed by a sovereign authority. Every other mode of
financial and business investment may carry risks of one another or another.
Banking is therefore also termed as a risk management business. To effectively
control risk exposures and enable the bank to protect its depositor’s interest, limits
are applied to investments, advances, and other banking exposures.

Examples of a few such limits:

In case of acquisition, market purchase of shares, and strategic investments,
Prudential Regulations of the State Bank of Pakistan has set an aggregate
investment limit of up to 30% of the bank’s equity. This limit applies to such banks
which mobilize public deposits. For other institutions, s this limit is 35% of their
respective equity.

Single-party investment limit is set in regulations where banks cannot own shares of
any single company above 5% of their equity. The aggregate investment limit of
banks is also linked to the total equity of the bank to minimize the vulnerability of
the portfolio and control any adverse impact of unforeseen or untoward economic
shocks.

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Definition: Financial Instruments and Common Modes of Investment

Market Treasury Bills (MTBs)

MTBs, also commonly known as ‘T-bills’, are short-term, highly liquid
government securities issued in 3, 6 and 12 months’ tenors. The government
borrows money from banks through MTB auctions, conducted fortnightly (mostly
on Wednesdays).

Pakistan Investment Bonds (PIBs) and Government Ijara Sukuk

PIBs are medium-to-long-term government securities issued in 3, 5, 10 and 20-year
tenors. The auctions of PIBs are based on pre-announced auction calendars.

GIS: Government Ijara Sukuk are Shariah-compliant Islamic debt instruments

currently issued in 3-year tenors. GIS may be issued by the State Bank of Pakistan
based on Variable Rate Rentals or Fixed Rate Rentals.

Term Finance Certificate (TFC): A means of raising debt from a broader horizon
of lenders. TFCs are issued by corporates or banks as a liability product with a
trading feature, where these units are transferrable to other lenders. Listed TFCs are
tradeable in financial markets.

Marketable instruments are those modes of investment, where certain units of such
investment (e.g. shares or certificates etc.) can be transferred to other purchasers
and there is a marketplace where such units are traded.
Shares of listed companies traded on stock exchanges, government securities and
units of Term Finance certificates are a few examples of marketable instruments.
Short Term versus Long Term
Instruments that have a maturity period of one year or less are regarded as short-
term investments.

Long-term investments include bonds and certificates having maturity periods of

higher than 1 year. Investments intended for retention of the longer term, but with
no time-defined time horizon are also referred to under long-term exposures.

6.1.4 Marketable Instruments of Investments

Financial markets offer the most common path to choosing a suitable type of
investment. Banks’ liquidity position varies daily since it depends upon cash
inflows and outflows of branches and credit disbursement/recovery units. Even the
central treasury may see intra-day fluctuations as well. In such scenarios, trade-able
financial instruments provide a convenient mode for the bank to invest its surplus
funds or liquidate/leverage existing investments for generating instant cash.

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Common modes of investment in financial markets are as follows:
 Pakistan Investment Bonds (these are government securities for long-term
borrowing)
 Market Treasury Bills (Issued by the government for raising short-term
borrowing)
 Listed Companies Stock Portfolio
 Government Ijara sukuks
 Eligible Foreign currency government securities (for overseas operations)
 Listed Term Finance Certificates i.e. corporate securities
 Preference shares, Tier- 2 Term Finance Certificates of other banks
 Perpetual bonds
 Currency Trading and Swaps
 Mutual funds, REITs and Commercial Papers

Table 6.1
Instruments of Investments: Marketable Features
Instrument of Market Turnover
Tenure till
Investment by Issuer Marketability (High
Maturity
bank Medium/Low)
Pakistan Investment Government 3 Years to Traded in the
High
Bonds of Pakistan 30 Years Money Market
3 months to Traded in the
Treasury Bills GOP High
1 year Money Market
Listed Companies Listed No tenure on Traded on the Depending on the
Stock Portfolio corporates shares stock exchange selection of stocks
Islamic banking Listed Sukuks High for
GOP,
instruments, long term are traded on government Sukuks,
Corporates
including sukuks capital markets otherwise Low
Eligible Foreign Dependent
Dependent upon
currency government Foreign upon ratings
Variable ratings and foreign
securities (overseas governments and foreign
markets
operations) markets
Listed Term Finance Variable, Traded on
Certificates i.e. Corporate/ dependent upon The stock
Low
corporate securities Companies the issuer’s exchange with
appetite thin volume
Trade worthy
Corporate/
Commercial Papers Short term in the Money Medium
Companies
Market
Preference shares, The Long-
Trade worthy
Tier- 2 Term Term as per
Banks in the Money Medium
Finance Certificates regulatory
Market
of banks limits

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 Long-Term
Trade worthy
Banks or and meets
Perpetual bonds in the Money Medium
governments regulatory
Market
limits
Trading in the
Currency trading
- Short term Inter-bank High
and swaps
market
Trade worthy
Real Estate FIs, Long Term or
in capital Low
Investment Trust Corporates Perpetual
markets
Redeemable
Mutual funds NBFC Perpetual High
by NBFC

6.1.5 Banks Trade in Marketable Securities

In this section, we will discuss how banks trade in marketable securities. Banks are
among the major players in Financial markets. Each bank operates through its
dedicated desks of Treasury to interact with other participants and market brokers
via electronic platforms and telephonic conversations.

The participants may transact for trading purposes, i.e. buying, selling or leveraging
their holding to generate cash and currencies for immediate profitability or forward
needs.

Surplus cash with banks is placed with other profitable modes while demand for
any payments is met by raising money through trading or the sale of securities in
hand.

Inter-connectivity of Trading Desks of Banks:

o Treasury desks are connected with financial markets and other banks
electronically as well as telephonically.
o Large banks utilize services of popular trading platforms like Bloomberg,
Reuters, SWIFT etc. for live global connectivity.
o Smaller institutions may remain connected to other participants via
telephones and through financial brokerage firms.
o The Pakistan Stock Exchange is accessible electronically to investors and
online trading portals provide convenient trading services within the
regulatory oversight of the National Clearing Company of Pakistan Limited
(NCCPL) and Central Depository Company of Pakistan Limited.

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Auction/Issuance of Government securities
The State Bank of Pakistan has devised a mechanism for the trade of government
securities. SBP appoints primary dealers for this purpose. Banks invest in
government-backed securities whereby SBP periodically banks/investors’
participation and issues short-term or long-term securities under an auction
mechanism.

The funds so mobilized are termed as government borrowing and provide budgetary
support to the governments. The securities issued by the governments for this
purpose are called government securities or Treasury/ sovereign papers. These are
generally traded in the Money Market to attract secondary market investment.

State Bank of Pakistan has developed a system of primary dealers of government

securities for transparent debt mobilization by the government, where the rate is
decided by bidding under the auction schedule. This system encourages banks to
broaden their customer base so that their public and corporate customers may also
invest in new government securities.

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Price formulae for participation in the bidding of Market Treasury Bills:

Before participating in the auction of the Market Treasury Bill (MTB), the
following data is available:
Instrument of Investment (investor’s choice): 6 Month MTB (i.e. 180 days)
Desired return by the investor (say) 12% p.a.
Face Value of Investment PKR 1,000 million

The method of calculating the purchase price to be quoted by the primary dealer
and the amounts invested are as follows:

Example I:
Desired yield on auction date = 12.00% (Yield)
Maturity days = 180 Days (days to maturity)

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The price per 100 Rupee of face value is calculated as follows:
100
Price
1  (Yield x Days to Maturity)
365

100
Price  Rs.94.4128
1  (12/100 x 180)
365

The amount to be invested if a bid is accepted the Rs. 94.4128 = 1,000 million x
94.4128/100 = PKR 944.128 million

The investor/financial institution will earn a 12% p.a. return on PKR 944.128
million, if holds the bill till maturity. At maturity, the face value of the bill is
received.

Example II:
Now in another case, suppose the desired yield of another investor is 11.50% for
three months of investment
Desired return/Bid = 11.50% p.a.
Maturity period = 90 Days

100
Price   11 .50 % p.a.
1  (Yield x Days to Maturity)
365
100
Therefore,  Rs.97 .2426
1  (11.5/100 x 90)
365

The price of this instrument at the above bid/yield is 97.2426 per 100 of face value.

6.2 Factors Affecting the Banker’s Choice Among Investment

While undertaking investments, banks holistically evaluate the available options
concerning their positioning in terms of capital cost, liquidity projections, and risk-
taking capacity.

The choice among various investments also depends upon the purpose of a
particular transaction or portfolio.

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The Bank’s position concerning its cost of funds, competitiveness and liquidity
profile also drives the selection of a certain mode of investment.

Keeping all these factors, projections of near-term and long-term inflows, outflows,
business targets and regulatory compliance are developed.

This now leads to a discussion on the 3Ps of Investment Decisions (i.e. Purpose,
Projections and Positioning).

6.2.1 Purpose of Investment on a Particular Day

1. Profitability versus liquidity
Banker’s primary purpose is to make a profit on each transaction. However, the
specific purpose of investment on a particular day may include other factors, such
as:
 How much liquid funds are kept at hand to meet instant requirements.?
 Regulatory limits and bank’s internal risk limits

These factors may affect the choice of investment.

For example, Prudential Regulation requires that the maximum exposure of the
listed stocks portfolio should not exceed 30% of the bank’s equity. Similarly, the
Bank’s internal limits for minimum liquidity ratios are also there. Therefore, while
choosing profitable modes of investment, bankers may have to shift the choice to
more liquid modes, for meeting both profitability as well as liquidity standards.
1. Liquidity purpose

If the purpose is to primarily build up a portfolio of liquid assets to guard against

expected withdrawals, then highly marketable and short-term instruments will be
preferred, even though their returns are lower.

e.g. For creating a remunerative liquidity reserve, the banker’s immediate choice
would be Market Treasury Bills and parts may also include investment in high-
rated listed stocks/shares.

2. Trading or Portfolio Management for Longer Term Gains

Marketable investments are subject to price fluctuation in the financial markets.
This factor may create trading opportunities in the short run. Therefore, when
choosing an investment instrument, trading motives sometimes take precedence
over the stated rate of profit. Bankers build up a trading portfolio by purchasing
shares of listed companies or bonds and government securities etc. when their

120
prices are low and attractive enough to a provide potential gains in the form of price
appreciation within a few days/weeks.

Such portfolios are categorized as ‘held for Trading’ in the books of accounts and
regulations put a risk limit of a maximum 90-day retention period to materialize the
available profit.

Simultaneously other portfolios of trade-worthy shares/ bonds may also be

developed where the potential of dividend income and price escalation are both
there. Such portfolios are categorized as ‘Available for Sales’. These are useful for
a bank given their profit potential and liquidity.

3. Investment for Regulatory Reserves

Regulators impose a condition of parking certain funds in marketable securities and
placement of deposits in the Treasury account of the central bank. These are
respectively referred to as ‘Statutory Liquidity Reserve’ (SLR) and ‘Cash Reserve
Requirement’ (CRR). These are regulatory obligations of banks and aim at the
creation of reserves for depositors’ benefit and monetary management by the
central bank.

SBP issues directives (Circulars and Monetary Policy) to fix criteria for placing a
certain percentage of deposits as SLR and CRR. SLR and CRR requirements may
vary from time to time depending upon the SBP criterion of monetary management.

Further Reading
Students may visit SBP site and search the latest circulars (related to the DM
Department and BPRD) applicable and understand the currently applicable ratio for
maintenance of CRR and SLR (i.e. %age of deposits/liabilities to be kept under
reserves).

6.2.2 Selection from Short-Term or Long-Term Modes of Investment

for Portfolio Management
o Strategic investments and investment banking are for long-term profit
objectives. Banks’ choice/selection between short-term and long term
depends upon profitability and availability of matching funds.
o Decision of either short-term or long term is also derived from the existing
balance sheet position. Higher short-term investments may be good for one
bank, while for others, more long-term investments would be needed for value
enhancement.

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Examples: A bank’s quarterly statement reflects that 80% of its portfolio is parked
in short-term investments. Its liquidity coverage ratio is also very high in
comparison to market standards. This position would demand that the bank may
invest either in long-term bonds to increase its profit margins or may further look
for investment banking instruments (like participation in preference shares or
buying out more stocks of its profitable subsidiary, as earlier described under 6.1.1).

Examples of short-term and long term Investment instruments:

Short Term Instruments: Purchase of Market Treasury Bills from bi-weekly

auctions. Tenure range from 3-12 months
Purchase of listed shares from the stock exchange
Subscription of commercial paper or mutual fund

Long-Term Investments Purchase of long -term government securities for

variable tenures, i.e. Pakistan Investment Bonds (PIBs)

Participation in TFCs issue of banks/ corporate

Participation in long-term infrastructure financing

In summary, the factors and choices affecting investment decisions are further
elaborated in the following matrix.

Table 6.2
Examples of Investment Baskets under various Choices
Factors/ Portfolio Long term
Choices---> High Liquidity High Income Management growth
Instrument will
Bankers will Good dividend be selected to For short term
value growth,
Short Term prefer to invest yieding shares meet the investment is
in MTBs or top will be targetted mix
rated stocks purchased and allowed based upon
market research
limits
Investment
Banks needing Perpetual bonds, Mix of bankig and
like Additional investment is
Long Term high liquidity Teir- I capital or determined on strategic
will invest less investment may
in long term high coupon the basis of promise long
TFCs market trends
term value

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6.3 Demand and Supply of Bank Liquidity System
The liquidity of a bank is closely linked to the quality of investment instruments in
which the bank has deployed its funds. Banks maintain their liquidity profile
through a reserve of liquid assets, e.g. government bonds and marketable
instruments, while simultaneously maintaining their capacity to raise and manage
more liabilities.

Liquidity for a bank means its ability to meet financial obligations. In other words,
if a bank can pay its obligations, it is liquid. For this purpose, the bank doesn’t need
to be full in cash. Instead, it may utilize its liquid assets, draw on credit limits, or
raise more deposits to pay its obligations. It might also borrow from another bank
or entity without collateral. Whatever the source, if the bank is liquid, it has access
to a liquidity system at its will.

Definitions Related to Bank’s Liquidity

Liquidity Coverage Ratio is the requirement whereby banks must hold an amount
of high-quality liquid assets that’s enough to fund net cash outflows for 30 days.
Generally, the Regulator requires this ratio at 100% to ensure strong liquidity
coverage against the bank’s commitments and deposited funds.

High-Quality Liquid assets

The numerator of the ratio is the “Stock of High-Quality Liquid Assets (HQLA)”.
Assets are considered to be high-quality liquid assets if they can be readily sold or
used as collateral to obtain cash from the financial markets.

Examples of High-Quality Liquid assets

High-quality liquid assets of a bank (mostly of earning nature) would comprise:
i. Cash & treasury balances (including balances held with SBP)
ii. Investments in Pakistan Government securities (e.g. Treasury bills, Pakistan
investment bonds etc.) - excluding Held to Maturity instruments
iii. Government of Pakistan Ijara Sukuks
iv. Marketable securities representing claims on or guaranteed by sovereigns or
central banks
v. Further, corporate debt securities (e.g. TFCs, Sukuks & commercial papers)
are also included that satisfy certain conditions and maximum limit/ margin
based on the respective credit rating of the securities.
vi. Common equity shares, which are Exchange-traded and a constituent of the
Pakistan stock exchange’s KSE-100 index. that satisfy conditions set in the
regulations (subject to applicable margin) and are not issued by a financial
institution or any of its affiliated entities

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Definitions
The investment-to-deposit ratio (IDR) is the relationship between investments and
deposits of a bank. A higher IDR would reflect more projected earnings and a need
to manage a certain degree of risk as compared to a lower IDR.

Advances to Deposit Ratio (ADR) is the relationship between advances/loans

extended by a bank and its deposits. A balanced ADR should reflect good business
and liquidity prospects.

6.3.1 Demand for Liquidity

For a banking institution, the following may create a demand for liquid funds:
i) Deposit withdrawals
A bank branch does not need to be flush with cash all the time. Considering the
nature of its customer base, the branch can anticipate the pattern of cash
requirement daily and therefore keeps its central office in the loop for the
requisition of cash at the start of the day and during the business hours as the need
arises.

For example, a branch in a busy business area of wholesale business would be faced
with a much higher volume of cash in and out than the one in a residential area
serving mostly individual or family accounts. Therefore, the demand for liquidity
will be higher for the former, than in the case of the latter.

Cash requisitions from all the branches are ultimately clubbed at the Head Office
or central Treasury level, which meets the demand by using its interbank credit
lines or with the help of its liquid assets.

ii) Abrupt deposit calls under extraordinary scenarios

Demand deposits or special notice deposits are sometimes sensitive to external
scenarios or stress factors. Travelling or holiday seasons and days near any festival
may create extra demand for cash withdrawals. Similarly, any news about strikes,
riots, or negative developments on the part of a specific bank may trigger a deposit
run and unusual demand. Banks keep their systems intact to deal with any
extraordinary situation to preserve the reputation factor. It is significant to note here
that the bank continues to enjoy the trust of its depositors only by exhibiting the
strong ability to meet its obligations in all situations.

iii) Credit Disbursement, Trade or Investment Banking transactions

Internal demand for liquid fund arises from various business units. Smaller
transactions are handled at the branch level, while the central treasury is mobilized
to manage large outflows of local or foreign currency.

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iv) Regulatory Reserves, taxes, duties
At the day or week ending dates, certain investments are required to meet statutory
liquidity reserves. The regulation requires a proportion of liquid funds to be placed
in government or other eligible securities. Banks meet this requirement by setting
aside a portion of deposited funds as a reserve or through inter-bank borrowings.

6.3.2 Liquidity Supply in a Bank

i) Remittances and government receipts
Foreign remittances to domestic accounts constitute a significant portion of
deposits in our banks. The money sent by Pakistani citizens working abroad is
routed to local currency accounts in equivalent Pak Rupees through the central
bank. The liquidity pool is available to banks until cash is withdrawn by respective
account holders.

Similarly, banks collect utility bills, government taxes and levies from public and
business enterprises, which also constitute a supply of liquidity on a day-to-day basis.

ii) Equity injections and Recoveries of stuck-up Receivables

Fresh equity injection in the form of the right issues or various tiers of capital enhances
the liquidity cushion of a bank. Similarly, recovery of bad debts also compensates for
the liquidity loss incurred due to the default of certain borrowers/customers.

iii) Portfolio of Liquid Assets

The most important component of banking liquidity comprises a portfolio of liquid
assets. Banks park a portion of their deployable funds in government securities,
shares and listed or trade-worthy instruments. These assets are put to market
whenever there is a need to increase the supply of liquid funds to branches or for
business transactions.

iv) Liability Management and new products

Liquidity planning in a bank is a continuous function. When the demand for liquid
funds increases, the Liability Management unit gears up its operations to raise new
deposits. This may be done by offering better pricing, or expansion of sales and
marketing network etc. In case banks see new investment or business opportunities
in the forthcoming period, they may initiate product diversification and issue new
deposit schemes.

For example, the Business Strategy Department of a bank identifies that the
government has issued a policy of tax rebates and other incentives to local
businesses to encourage new industrial setups in the country. Banks envisage that
such incentives would lead to fresh procurement of plant and machinery and
construction of industrial units. The bank, therefore, sees this as an opportunity for
long-term loaning for machinery and building purposes. To meet this anticipated

125
demand for liquidity, the bank would plan to mobilize matching funds from deposit
schemes. The Liability Management unit would now develop a long-term deposit
scheme with quarterly or monthly income options and would set a deposit target to
be mobilized from high-value clients.

v) Inter Bank Credit Lines

These constitute a short-term, but high-volume supply of liquidity from counterpart
Bank. Whenever there is a large demand for funds from branches or business units,
the central Treasury arranges the necessary funds by using the available options.
Borrowing from counterpart banks through Call or against the security of a liquid
asset or through its sale are among such sources.

vi) Discounting from State Bank Window or Last Resort Borrowing

In case the supply of liquidity from the interbank market is not sufficient to meet
demand from banks, the central banks’ supply function provides exigency support.
State Bank of Pakistan has set up a discount window where banks can borrow funds
on an overnight basis against mortgage of government securities held by them. Such
action becomes necessary when a certain bank/ exhausts all the available options
to meet the demand for liquidity or due to certain systematic factors, liquid funds
on a particular day are not available in the inter-bank market. State Bank, as a lender
of last resort, lends funds at a specified rate, known as ‘Discount Rate’ duly notified
after issuance of each Monitory Policy. On the flip side, State Bank also accepts
the placement of funds from banks when there is surplus liquidity in the inter-bank
market and certain bank/banks are not able to deploy their funds profitably.

6.3.3 Liquidity Risk for Banks

Banks constantly calculate their liquidity position daily to demonstrate if the bank
can meet its cash flows without negatively impacting daily operations. Liquidity
sources are measured/monitored along with the anticipation of future withdrawals
under stress & shock scenarios to guard against any risk of shortage of funds.

Liquidity risk is the potential for loss to an institution arising from its inability to
meet its obligations. It surfaces when the cushion provided by the liquid assets is
not sufficient to meet the cash outflows.

Banks can experience liquidity risk from unexpected demands of deposit

withdrawals, high credit disbursements, and dependence on market assets that
suffer a loss due to a lack of trading turnover. In a vulnerable situation, the other
source of liquidity risk may arise from counterpart banks, which may be unlikely
to lend to the bank given its credit risk to them.

126
Impact of holding Illiquid Assets or larger Real Estate Exposure
If the pressure of withdrawal or outflows continues and the bank is unable to cover
them after exhausting its liquid sources, it may have to start selling other illiquid
assets. Because of the nature of such assets, the bank will be limited in its ability to
liquidate those assets and will find itself in a loss position at the end of the
liquidation.

If a bank carries more exposure to illiquid investments, which cannot be quickly

converted into cash, it will face liquidity risk. For example, banks having large
investments in shares and real estate projects may face a crunch situation when their
stocks cannot be sold at the stock exchange due to a market crash. Similarly, when
the real estate market is faced with oversupply or slow business, banks depending
on cash flows from this sector may face liquidity constraints.

The Real Estate sector often faces cycles of high and low tides. The investments
booked in boom cycles may suffer price drops or losses in a recession. When an
investor is not able to liquidate its holding when it needs funds to pay off liabilities,
it has to either opt for distress selling or default in servicing its liability. During the
last two decades, certain investment banks and financial institutions both in
Pakistan and abroad have witnessed collapsed situations due to overexposure to
less liquid assets like stocks and real estate.

References for Study:

Dubai World Property Collapse 2008
Dubai experienced one of the world’s massive real estate bubbles in 2003-2008.
After the collapse of property rates in 2008, Dubai World, one of the emirate’s
largest government-sponsored companies, defaulted in repayments of some of its
debts, and a shock wave triggered in the markets around the globe.
The reason was a risk and a very high volume of investments in real estate projects,
where most investors put money for future income/gains by taking bank loans.
The property prices, due to over-supply in the region did not rise to the expectation
of investors, which led to a market crash and panic amongst both the builders and
the banks, which had given huge loans.
In Pakistan, investment banks, leasing companies and financial institutions, which had
benefitted from the stock market and property boom before 2008 and had developed
large exposures, found themselves struggling for liquidity after property and stock
markets went through a prolonged downward trend in 2008-2009. As a result of this
financial meltdown, few financial institutions and funds became insolvent.

127
6.3.4 How to Maintain a Healthy Liquidity Position
There are many ways that banks can improve asset liquidity over a longer horizon:
 By investing more in Securities (trade-able instruments), as these are
normally more liquid than loans and real estate assets
 Shorter maturity assets and loans are usually more liquid than longer ones.
 Securities that are issued in large volume and by large companies generally
have greater marketability and liquidity
 Build up new deposit schemes that address gaps. Raising more liabilities with
long-term maturities to provide room for the bank, if currently it is in a cash
crunch.
 Issue more equity, Common equity does not commit interest payment
 Obtain more funding lines from counterpart banks against the strength of
credit rating

Internal strengths and vulnerabilities or gaps/risks faced by the banks are closely
watched by rating agencies and are reflected in respective credit ratings. Banks,
therefore, put strong risk management systems and limits in place to ensure the
continuity of their financial viability and ratings under all economic conditions.

6.4 Self-Assessment Questions

a) Short Questions:
i) What do the following stand for? Write down brief definitions of these
instruments of investment:
MTBs, PIB, TFC
ii) List at least three (3|) modes of long-term investments that are
permissible for the bank’s investment.
iii) What are sources of liquidity for a bank

b) Long Questions/Exercise
i) Write a note of purposes of investment that a bank may like to achieve
on any particular day. Give at least three (3) choices.
ii) Write a few reasons for the high demand or withdrawal of liquidity of
the banking system. How do banks manage such a high demand for
funds?

c) Exercise:
Down load following link of the SBP website (under the Financial Markets tab)

[Link]

128
In this link, the MTB Auction Bid Report provides data on the SBP auction of
Treasury Bills, where banks invest their funds and in return earn a profit on Market
Treasury Bills.

After reviewing this report and as per working in the example of this unit (under
section 6.1.5), answer the following questions:

Q. 1 Use the data in the above-referred link/ report for the 3-Month Government
of Pakistan Market Treasury Bill.

After reviewing row 1 of the data table of the report, work out the price of
MTB that SBP accepted given the following data:
Settlement day (i.e. October 20, 2022)
Term = 84 days
yield = 15.4899% p.a.

Q. 2 Similarly, take data from Row 2 and in the reverse calculation, work out the
yield of the GOP MTB quotation offer of Rs. 96.557 in column 3 of the same
table.

Q. 3 Write briefly the purpose of auctions of Government of Pakistan Treasury

Bills, carried out by the State Bank of Pakistan and what was the total amount
raised/realized under the auction results provided in the above-referred link.

6. 5 Summary
This unit talks about the investment function of banks for the profitable utilization
of funds along with liquidity management for carrying out smooth banking
operations. Banks primarily generate business by deploying funds in loans and
various modes of investments. The investment modes, permissible for banking
business are thread-bared in this unit. The characteristics of each type of investment
instrument and its earning potential along with convertibility into liquid funds (i.e.
marketability) are compared are analyzed in this unit. Market Treasury Bills,
Pakistan Investment Bonds, Ijara Sukuk, Term Finance Certificates, Commercial
Papers and others are defined in generic terms explained by using examples.
Possible risks and returns on banks’ investments are analyzed in a matrix format
for better comprehension.

The Unit has also touched upon procedures of investment in government securities
under the auction mechanism of the State Bank of Pakistan. In the next sections,
choices of investment modes available to bankers with varying purposes/ scenarios

129
are discussed at length. Banks prefer to build up a balanced portfolio of investments
where risk, reward and liquidity factors are taken into consideration. These factors
are studied under various approaches to portfolio management.

The last section of the Unit reviews the functions related to liquidity management
and maintaining a healthy pool of liquid assets. This function is of critical
importance to banks in preserving bank’s rating and reputation. Sources of the
instant liquid fund within the framework of inter-bank credit lines and SBP discount
widow are explained. The importance of having a pool of liquid assets, which are
readily convertible into cash by using trade opportunities at financial markets is
also highlighted. Linkages of illiquid investments with banks’ liquidity risk are
demonstrated with the help of a real-life case study.

REFERENCES

Timothy W. Koch, S. Scott McDonald, Bank Management (2014)

Institute of Bankers, Pakistan, Managing Risk in Financial Sector (2006)

Rose S. Peter and Hudgins C. Sylvia (2007) Bank Management & Financial
Services the McGraw-Hill Companies.

Website sources:
[Link]

Websites of bank [Link]

[Link]

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Unit–7

ASSET-LIABILITY
MANAGEMENT

Written by:
Irfan Karim
Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah
131
 CONTENTS

Page #
Introduction ....................................................................................................... 133

Objectives ........................................................................................................ 133

7.1 Asset-Liability Management (ALM) Strategies ...................................... 134

7.2 Duration Gap Management in the Banking System ................................ 142

7.3 Interest Rate Risk Management ............................................................... 148

7.4 Self-Assessment Questions ...................................................................... 151

7.5 Summary .................................................................................................. 151

References ......................................................................................................... 152

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 INTRODUCTION

The assets and liabilities of a bank go hand-in-hand with its business. Apart from
equity, banks raise liabilities under various modes and deploy these funds in assets for
earning income/ return. The range of liability sources available to a bank, its pattern of
funds deployment and asset quality collectively determine the business and financial
performance. Banks have to compete in the deposit market in terms of cost and
availability of funds; similarly, the efficiency of assets is also related to the nature of
this liability mix and prevailing economic trends, particularly the monetary policy
trends. Therefore, the banking business needs to apply a two-way strategy, that
simultaneously addresses both liabilities and assets in a synchronized manner.

Banks’ sources of funds are not necessarily matched with the pattern of their
receivables from earning assets. The future economic environment and interest rates
are also subject to change or cyclical movement, which may lead to financial risks
and losses.

ALM functions to refer to working out suitable strategies to manage and balance
the liability- asset schedules and gaps to achieve continuity of stable liquidity and
profitability. In other words, Asset and Liability Management (ALM) is a way for
financial institutions to address challenges and risks resulting from a mismatch of
assets and liabilities.

This unit deliberates on the significance of this function and elaborates on various
action plans adopted by banks to manage and balance the respective liability-asset
portfolios and gaps arising out of mismatches and economic factors.

OBJECTIVES
After studying this unit, you will be able to:

 Understand the significance of the Asset-Liability function in the bank along

with tools for building an efficient mix of liabilities/deposits and earning
assets to maximize future earnings

 Comprehend the concept of duration gaps, and be able to work out duration-
based analysis and gap management tools.

 Knowledge of interest rate risk and various approaches applied to manage

market rate fluctuations, causing risks to the bank’s liquidity and profitability.

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7.1 Asset-Liability Management (ALM) Strategies
The assets and liabilities of a bank in the context of ALM are primarily comprised
of as follows:
Assets: Bank’s investments, Loans and advances to its debtors, lending to
other Institutions
Liabilities: Deposits, Liabilities payable to other banks/ creditors

Although assets of a bank include fixed assets like land & buildings furniture etc.
But here in this unit asset implies earning/financial assets of a bank comprising the
Bank’s investments, Loans and advances to its debtors and lending to other
Institutions/Receivables.

Assets-liability Management (ALM) is defined as a function whereby banks plan,

and monitor their cash flows from investments and other earning assets, as against
cost and sources of their funds under a measured approach. ALM is a practice used
by financial institutions to mitigate financial risks resulting from a mismatch of
assets and liabilities. By strategically matching assets and liabilities, financial
institutions can achieve greater efficiency and profitability while also minimizing
risk and meeting compliance with risk tolerance limits.

7.1.1 How Assets and Liabilities Create Risk in a Banking Business

Before going to strategies for better management of asset-liabilities, an
understanding of various risks associated with banking assets and deposit business
is important. Future economic conditions and uncertain factors like variations in
Policy Interest Rates and the cost of raising fresh deposits, exchange rates volatility,
etc. may lead to opportunities and threats for the banking business.

Definition
Risk is defined as the quantifiable likelihood of loss or less-than-expected returns.

In the financial sector, the risk is the possibility or probability that the outcome of
an action or event could bring up adverse impacts. Such outcomes could either
result in a direct loss of earnings/capital or may adversely impact the ability to meet
the business targets.

Here are some examples of risks of which banks need to be aware concerning their
portfolios of assets and liabilities:
a) Credit Risk:
i.e. variability in earnings that could result from default by any debtor, or security
of the loan and consequent losses of income and principal funds.

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 Figure 7.1
Risks Associated with
Assets-Liabilities

Liquidity Market Risk Interest Rate Currency

Risk Risk Risk

b) Liquidity Risk:
It is defined as the potential of loss to an institution arising from its inability to meet
its financial obligations. This risk is of specific significance for banks, which
heavily rely on borrowed resources (i.e. liabilities), and are also obliged to service
their obligation under all future circumstances. This risk is also dependent upon
other risks, and liquidity problems may increase proportionately with the higher
credit risk, market risk and reputation risk of an institution.

c) Market Risk:
It is the risk of adverse effects on the valuation of the balance sheet, as a result of
movement in market prices (due to fluctuation in the markets). The markets include
the capital market. Money Market and currency market.

d) Interest Rate Risk

No financial institution can completely avoid the potentially damaging form of risk,
i.e. interest rate risk. When Policy rate changes, interest rates in the market also
follow suit and the whole financial sector is faced with rate variation e.g. profit on
marketable securities, interest costs and valuation of their existing assets and
liabilities, etc. Currency markets and stock markets also react. In more developed
markets, the sectors like housing, real estate, and commodities also respond in terms
of price changes.

For example, when the policy rate is increased by the central bank, say by 2.5%,
the new loans will be given by banks at higher rates in line with this hike. The
benchmark rate of Kibor is also quoted at a higher rate and similarly, investors will
demand higher profit rates on new issues of Market Treasury Bills and government

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bonds. The objective of the rise in Policy Rate is to bring an upward shift in the
overall cost of capital from all sources.
From the perspective of risks resulting from the above upward shift in rates, the
following example highlights the impact on the bank’s earnings.

Example 7.1.1
Bank A has a portfolio of earning assets of Rs. 1000 million in year 1, which yields
a 10% p.a. return. The bank estimates this position to continue for the next 2 years.

Simultaneously, the bank has mobilized deposits of the same amount to fund these
earning assets. The deposit comprises of demand deposit and there is no time bar
on its withdrawals. The bank pays an average rate of 8% p.a. to depositors. The
bank desires to continue to receive a net income spread of 2% p.a. (10% minus 8%)
for the full tenure of these assets (until the end of year 2).

However, near the end of year 1, the central bank given rising inflation and other
economic factors, increased the policy rate by 250 basis points (2.5%).

The Bank’s depositors now demand higher rates, or otherwise, they may withdraw
the deposits to switch over to other banks for higher rates. All other banks have
started increasing their deposit rates after the Policy rate change.

Consequently, Bank A is first faced with liquidity risk due to large withdrawals. To
retain liquid funds, it has now decided to increase its deposit rates. As a result, its
deposit cost from year 2 increased from 8% to 10.5%. Its earning assets, however,
will remain invested at the same rate of 10% due to a tenure of 2 years already
fixed.

Bank A is now facing interest rate risk due to the upward shift/re-pricing of
deposits, while it cannot demand a higher profit rate on investment. As a result, its
earnings for the year 2 have turned to negative 0.5% (10% minus 10.5%). Due to a
change in the Policy Interest Rate and fixed tenure of its investments, the bank in
the year 2 has incurred a loss on its earning assets instead of anticipated profit.

e) Exchange Risk or Currency Risk

When assets and liabilities are held in different currencies, a change in exchange
rates can result in a mismatch of value.

Rates of foreign currencies vis-à-vis local currency continue to fluctuate in the

financial market. Economic and trade factors and developments on the political
fronts of both host and foreign countries also impact the prices of foreign exchange.

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Since banks also participate in cross-region or international transactions, they
actively carry assets or liabilities in foreign currencies and therefore face the risk
of a rise or fall in exchange rates.

Example: For example, a new bank/financial institution has just started its business
in Pakistan. It receives deposits from its patrons abroad in US Dollars. i.e. its
liability is denominated in USD. The deposit amount received from its patron is
USD 1,000,000 and is also repayable in the same currency after one year.

The bank, working in Pakistan has to invest this money in Pak Rupee. Therefore, it
invested in Government of Pakistan Treasury Bills after converting the foreign
exchange at the following current rate, which is:
1 USD = 175 Pak Rupee (say)

The invested amount in rupees is therefore

USD 1,000,000x 175 = Rs. 175,000,000

After one year, Banks receives back its investment of Rs 175,000,000 plus profit.
It has to now pay off its liability in USD on the same day.

However, it found out that the exchange rate on that day in the currency market was:
1 USD = 185 Pak Rupee

The bank had to fulfil its commitment and therefore incurred a higher cost by
paying Rs. 185,000,000 to purchase the principal amount of the deposit.

By planning future changes in the exchange rate, the bank incurred an exchange
loss of Rs. 10,000,000 on the principal amount.

One of the solutions to manage this risk in advance was to enter into a forward or
currency swap contract with some other bank on the same day when investment in
local currency was made.

Banks need to be aware of prevailing economic and market factors, that may affect
their assets and liabilities and pose challenges in the way of achieving their business
target. These include:
i. Changes in Policy Interest rates (increase or decrease) announced by the
central bank.
ii. Extraordinary inflation, higher government borrowings or the emergence of
war, leading to liquidity shortage and cost escalation.
iii. Increase of deposit rate by competitor banks
iv. Stock Market crash, resulting in losses on the value of shares’ portfolio
v. Prolonged economic slump, leading to fewer business opportunities for banks

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7.1.2 Prudent Strategies of Asset-Liabilities Management
To avoid chances of losses due to predictable or unpredictable factors, and to
optimize benefits from upcoming opportunities, banks adopt watchful procedures
to evaluate anticipated variations and future risks to their assets and liabilities.
Banks generally develop their research teams which work on economic and market
data along with the bank’s internal position. Business teams collaborate with
research teams and the Asset Liability Management Committee (generally called
ALCO) to revise existing strategies or devise new action plans to address
opportunities, threats and risks. These may comprise the following:

a) Measuring and Monitoring

Definition
A floating rate of markup refers to a rate applied on assets/loans/advances that are
not fixed for the whole life of the asset and is floated/linked to some variable
benchmark (like Kibor) for a certain calendar month or period. The floating rate of
asset or liability is therefore re-priced after every instalment of repayment or cycle.

Various analytical techniques could be applied periodically for better risk

assessment, which may include:
Measuring Advances and Investments Relation to Deposits
If the economy is expected to face liquidity tightening or a hike in interest rates,
banks having higher Advances to Deposit Ratio may feel comfortable. The reason
is that advances/loans are priced on a floating rate of markup and therefore any
future increase in benchmark/ KIBOR will also lead to an upward revision of the
markup rate on the loan portfolio. On the other hand, investments or bonds mostly
carry fixed profit or coupon rates. If market rates and policy rates increase, the
existing investment of the bank will still be yielding profit at the old rate for the
remaining tenure. The bank will have to wait for the end of the term for re-
investment and to benefit from any rate increase. As a result, the market value of
long-term investments/ securities goes down.

Economic Scenarios/ Policy Rate Immediate Impact on the Value of Assets

Monetary tightening, Policy Rate Net income on Fixed-cost loans may deteriorate
increases, leading to hike in deposit
Existing Fixed Income Government Securities are now
cost less attractive, market value comes down
New issues of securities will become attractive due to a
high profit rate
Attraction in the Share market is lesser, Bank’s portfolio
may lose value
Monetary Easing, Policy Rate drops The existing portfolio of Fixed Income Government
Securities appreciates in terms of market value
The stock market may attract more investment because
investors will get lower profits from bank deposits
Prolonged Economic Slump, Floating Rate Loans/assets remain largely immune to
uncertain business environment uncertain changes or increases in the cost of funds

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On the deposit side, under the scenario of high-interest rates and liquidity
tightening, demand deposits will face withdrawals and depositors will demand a
higher return on their funds. Time deposits will however remain fixed for the
particular tenure and the bank will continue to benefit from lesser costs until the
maturity of the respective term.

Banks, therefore, tend to create a balance by developing efficient systems of

measuring their exposures and monitoring economic trends, so that they can timely
adjust their positions and existing from risky assets.

Continuing with the Example 7.1.1

The bank in the example under section 7.1.1, was carrying no time deposit and it
had to face loss due to an upward revision in market benchmark rates at the end of
year 1, Had it mobilized half the deposit amount under time liability, i.e. fixed for
2 years (matching with the investment period), it could have reduced half of its loss
due to matching of tenure.

b) Balancing the Basket

There is an old saying “Don’t put all eggs in one basket.” This signals a safety
measure in case of any breakage or risk to the basket. The same also holds good
for investing or borrowing money while choosing among available options.
Investing the whole of the funds in a single type of instrument of the investment
may face higher-ups or downs than a pool of different investments. A good
investment basket consists of variety and diversification. i.e. a bank can invest its
funds in a variety of instruments, depending upon available modes and income
prospects like:
o Fixed income securities, e.g. long-term bonds for stable income
o Short-term liquid investments (Shares of listed companies, Treasury Bills)
o Real Estate Investment Trust for high return (e.g. REIT of ISE Tower, Islamabad)
o Liquid Assets, Bank Balances, Call Money Placements with other banks
o Strategic investment for long-term value growth

The above basket may currently provide good income prospects; however, macro
level changes and fluctuation in market trends may bring down profits in certain
sectors or instruments, while other sectors may neutralize and retain the safety
cushion.

For example, the central bank, in response to high inflation and an unstable
exchange rate decided to increase Policy Rate. Banks would immediately try to
adjust their portfolios to bring changes that minimize the negative impacts or
capture any favorable market opportunities as a result of such action.

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Fig 7.2: Possible Changes in Investment Basket Due to Policy Rate Increase

Before Rate Hike Few Month After Rate Hike

Long Term Floating Rate

Securities Loans
Liquid Assets Liquid assets
10% Investment
7% 20% 20% Investment in
25% in shares
5% Shares
REIT 7%
REIT
18% 5%
35% Strategic 8% 40%
Strategic
Investments Investments
Treasury Bills Short Term
Treasury Blls

In another scenario, for example, a law and order situation in the country or war in
a neighbouring region created an uncertain economic environment. The stock
markets and currency markets under such conditions react quickly. Predicting the
unavoidable fall in marketable assets, bankers try to balance their basket. They may
start reducing their investment in more vulnerable modes by selling shares and
mutual funds, and switch over to safer modes by purchasing more secured
instruments, e.g. government securities.

On the liabilities side, the basket of deposits should also be diversified and exhibit
a balance between demand deposits and time deposits of varying maturity. If a
larger portion of the deposit consists of demand deposits, the bank will face higher
cash demand in a war-like scenario. Time deposits on the other hand are bound to
follow tenure schedules and the bank is less likely to face unpredictable pressure of
withdrawals.

c) Floating Rate Mechanism

Loans under a floating rate of profit along with liabilities, also based on a variable
cost, provide a strong mechanism for risk prevention to banks.

Ideally speaking, if all the loans/ assets of a bank carry a floating method of pricing,
which is fully matched with any variation in the cost of liability/deposits, the bank
is said to be in good control or well-managed in terms of future risks to its asset-
liabilities. fully hedged from future changes in policy rates.

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Continuing with example 7.1.1 of Bank A (from the earlier section), we now
assume as follows:

Scenario: The assets/investments of Bank A carry floating rates of profit, linked to

12 Months of Kibor (12 M Kibor is a market benchmark, published every day and
may float in line with changes in the Policy rate and market factors). The deposit
profile remains the same, i.e. mostly demand deposits, where rates are also sensitive
to market fluctuations.

Under the floating rate system, the profit rate will be revised after year 1, based on
the prevailing value of 12 M Kibor at the start of year 2. As a result of the hike in
Policy Rate, published 12 M Kibor is also impacted, and might have registered a
similar increase of around 2.5%.

We had seen in the example, that deposits were also re-priced at the start of year 2,
due to a hike in Policy Rate.

Therefore, both assets and liabilities now carry revised prices at the start of year 2.
The hike in market rates has been reflected both in the Profit rate and in the cost of
deposit. The bank has overcome interest rate risk by adopting a floating rate
strategy. The bank, therefore will continue to earn income in Year 2 also.

d) Future and Forward contracts

Under rapidly changing trends in currency or the stock market, the risk of future
uncertainty of cost or price can be minimized by purchasing certain assets or
liabilities in financial markets w.e.f a forward date. Under this strategy, for
example, a transaction of divestment/ sale shares can be booked today, in advance,
at the FUTURE counter on the stock exchange. (The future counter of PSX allows
shares to trade on future dates, where a transaction executed today is settled at a
future date)

Further Readings:
Students can study the web portal of the Pakistan Stock Exchange and the balance
sheet of a large bank to understand the FUTURE counter and the Bank’s receivables
or obligations under forward contracts.

e) Lengthening of Liabilities
While working out an asset-liability strategy, a good balance of short-term or long-
term asset-liability mix affects the future direction of a bank’s profit or risks. In
developing economies, Policy rates often fluctuate with higher magnitude. In such
situations, banks face challenges in managing their cost of deposit when policy rates

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increase drastically. Conversely, when the rates go down, the return on assets also
faces a downward trend.

Typically, banks’ assets/loans on average take longer to mature than the deposit.

So deposit costs may have to face revisions earlier than the return on assets.

Therefore, one of the useful strategies is based on increasing the average tenure of
deposits. When the rates are likely to undergo an increasing trend, banks prefer to
devise new liability schemes to mobilize deposits for a longer duration. When the
rates rise thereafter in the market, the cost of existing liability will yield useful
savings on a long-term basis.

A bank, which invests more in long-term assets should have more deposits for a
longer term to better manage its funding requirement. Mostly, banking deposits are
for short to medium-term time horizons. If a bank desires to invest in long-term
assets, like a 5-year lease for an electricity transmission project or strategic
investment in preference shares, it should have a matching funding plan. In the
absence of such a funding cushion, the bank may face liquidity risk if its routine
deposits face withdrawals or cost hikes earlier than repayments of the long-term
investment.

Though perfect matching of tenure of assets with that of liability is practically not
possible, respective tenures should not vary on a wider scale. This leads us to
discussion and understanding of duration gaps, which is an important tool for risk
managing risks.

7.2. Duration Gap Management in the Banking System

7.2.1 Definitions of Duration Gaps

Duration of asset or liability in its simple form, refers to the period during which
the asset or liability continues towards the maturity date, or materializes in cash
flow.

The duration may also be defined as the weighted average of the time until expected
maturity or cash flows from security will be received.

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Here are some examples:
Nature of Maturity Re-pricing/cash
Instrument asset/liability Period Flows Frequency Simple Duration

Market Short term Fixed investment,

Treasury 6 Months cash inflow at final 0.5 years
Bill asset maturity
Loan for 4 Markup received at 6 0.5 years (floating
years on a Long Term 4 years to final monthly period, along rate loan is
floating maturity/principal
rate of asset repayment with re-pricing of the repriced after
markup rate every ½ years
In simple terms,
the duration is 3
years, but taking
the impact of bi-
Profit payment at each annual markup,
Term Long Term 3 years to final 6 Monthly periods. the weighted
Deposit liability maturity Principal payable at average duration
maturity after 3 years will slightly
reduce to the
extent of 6
monthly cash
flows

The duration gap is the difference between the duration of a bank’s assets and the
duration of its liabilities. The duration gap measures how well matched the timings
of cash inflows (from assets) and cash outflows (from liabilities). When the
duration of assets is larger than the duration of liabilities, the duration gap is termed
positive. Conversely, the gap is said to be negative when the duration of liabilities
is higher.

Duration Gap of Balance Sheet

The balance sheet comprises assets and liabilities along with equity. In a banking
business, assets and liabilities mostly have a period attached to their maturity or re-
pricing profile, while equity is perpetual. The difference in the maturity period of
assets over liabilities may create a gap, referred to as a duration gap.

Changes in interest rates in the market may have an impact on the business of banks.
Increases or decreases in market rates are translated into the cost of new deposits,
and markup on fresh loans issued near or after this change, while the existing
portfolios of liabilities and assets/loans carry the same prices until their respective
contractual tenures are completed. Banks, therefore, are exposed to consequential
changes in the value of these assets/liabilities in comparison to the prevailing
parameters.

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7.2.2 Measuring Net Duration
Typically, business model of commercial banks is based on longer-term loans and
investments in comparison to the duration of their deposits. This implies that banks’
net duration will mostly be higher. To manage or quantify the extent of risks, which
ultimately translates into an upward or downward change in the value of their net
equity, duration analysis provides a useful direction for remedial measures and
business strategy. This analysis is carried out on the following lines:
 Duration of all the assets in the balance sheet items is calculated by working
out the average time to contractual maturity (or re-pricing) of each class of
asset in proportion to its respective weightage. (Cash held in Treasury or
current accounts has zero duration).
 Similarly, duration of deposits and liabilities is worked out along with the
weightage of each type of liability.
 The difference between the above two weighted durations is called the
Duration gap of the balance sheet or Net duration.

Example:
Assume the Balance Sheet of a Bank with total assets of Rs. 7,000 million and
Liabilities of Rs. 6,300 million.

Before reaching out to the detail working, the duration of each item under asset or
liability in the balance sheet is measured in terms of the period left to its maturity
or re-pricing.

For understanding and simplicity of calculations, duration is assumed to be based

on contractual maturity and re-pricing schedules. Months or days are reported in
‘years’ for calculation purposes.

Each asset or liability group is then tabulated in the respective rows of the table
below.

The average Duration of respective assets and liabilities of the Balance Sheet as of
December 31, X has been summed up on a proportionate weight basis in the last
column. For more clarity, the last column is worked out as per the following
equation:

Duration of Assets = D1*P1/100 + D2*P2/100 ………. D7*P7/100

Duration of Assets as of December 31, _____

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 Weighted
Amount (Rs. Weight in Duration
Duration
in Millions) percentage (Years)
Asset Type (years)
( A) (P) (D)
(D*P/100)
1 Cash and Treasury
700 (700/7000)*100 0 0.0
Accounts
2 Receivables 350 5% 0.3* 0.02
3 Investments in liquid
1,400 20 0.2* 0.04
Instruments
4 Short Term Lending 700 10 1.0 0.01
5 Loans, floating rates 700 10 0.5* 0.05
6 Medium Term Securities 2000 29 2.0 0.58
7 Long Term Securities,
1150 16 5.0 0.8
investments
Total /sum 7,000 100 1.5
Total weighted Duration of Assets is 1.5 Years
*Explainer: Receivables are assumed to have an average turnover of 4 months (0.33 years)

The bank assumes that it can hold liquid investments for 60-90 days (average
duration 75 days or 0.2 years)

Floating rate assets are re-priced every 6 months, hence duration is ½ year.

Duration of Liabilities = D1*P1/100 + D2*P2/100……….... D6*P6/100

Liabilities as of December 31, ______

Amount Weight in Duration Weighted

Liability Type (Rs. in percentage (Years) Duration
Millions) (years)
( L) (P) (D) (D*P/100)
1 Sundry Creditors/Payables 300 (300/6300)*100= 5% 0 0.0
2 Demand Deposit* 2400 38% 0.29* 0.11
3 Time Deposits 6 Months 1,200 19 0.5 0.095
4 Time Deposits 1 year 1,200 19 1.0 0.19
5 Time Deposits over 1
600 9.5 3.5* 0.33
year*
6 Long-Term Liabilities
600 9.5 0.5* 0.05
Floating Rate
Total /sum 6,300 100 0.775
The total weighted Duration of Liabilities is 0.8 Years (rounded off)
*Explainer

Given no fixed time for demand deposits, a turnover is assumed from 1 to 6 months
(i.e. avg. 3.5 months or 0.29 years).

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The average is worked out by clubbing an assumed duration range of 2 to 5 years
of various long-term deposits.

Floating rate liabilities are re-priced after 6 months.

Net Balance Sheet Duration = 1.5 – 0.8 = 0.7 Years

Net Duration = Asset Duration - Liabilities Duration

The duration of assets is longer than liabilities. Therefore, the net duration is
positive.

Inference from the above analysis:

The duration gap in the above example reflects that the assets of the bank take a
longer time to reach their maturity than the liabilities. Hence any change in market
interest rates will take more time to re-pricing or create an impact on assets, while
liabilities and deposits will carry this impact earlier on an overall basis.

In case of monetary tightening by the central bank, policy rates are increased. If the
net duration of the balance sheet is positive, the bank’s advances and investments
will largely continue on the previous markup rates, while deposit costs will rise in
response to the Policy rate. Hence, such assets may lose value in comparison to
market trends, leading to a fall in the market worth of the owner’s equity.

This is the reason that share prices of some financial institutions drop on the stock
exchange when the State Bank increases the Policy Rate in its monetary policy.

On the flip side, If the net duration is negative, (i.e. with lower asset duration), the
bank will be in a better position to mature its existing loans/advances (earlier than
its deposits) and benefit from revised markup-rates rates. Such banks are not likely
to register any duration-related fall in the market value of their shares.

7.2.3 Bank Immunization and Strategies to Minimize Duration Risks

Duration gap measures the per cent change in the economic value of a net asset-
liability position that will occur given a small change in the level of interest rates.

Asset-liability management allows an institution to recognize and quantify the risks

present on its balance sheet and reduce risks resulting from a mismatch of assets
and liabilities. By purposefully matching the re-pricing or maturity period of assets
and liabilities, financial institutions can achieve greater efficiency and profitability.
Bank immunization is a strategy that completely matches the duration of assets and
liabilities and minimizes the impact of interest rate changes on net worth.

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From the above definition of duration gap, a bank is said to be immune from
duration risk, if it can achieve the following balance:

Duration of assets - Duration of liabilities = 0

Or for a more exact calculation:

Duration of assets - p* Duration of liabilities = 0

*Where p is a liability to asset proportion in the balance sheet

More Realistic approach:

In this model, the bank’s net worth was secure from any risk of changes in interest
rates. However, this is an ideal position. In a typical business environment, banks’
assets and liabilities are prone to gaps and market factors continue to pose
opportunities or challenges. Banks develop suitable monitoring systems to
proactively measure the gaps and adopt action plans accordingly. The following
organizational system is generally put in place within or over the bank’s operations
management to review and control issues related to asset liability:

Asset-Liability Committee (ALCO)

Risk Management department
Risk Management Committees of the Board
External credit rating also reviews the duration and gap sensitivity of the banks

After ascertaining the duration gap and its likely impact or sensitivity to market
factors, banks adopt various remedies by altering their business strategies and
product diversification, best suited to the changing environment.

Strategies under variable economic scenarios

Once the duration of assets and liabilities and gaps/ mismatches are determined, the
following adjustments could be pursued to minimize the risk of losses.
 In a rising interest rate scenario, a reduction in asset duration may minimize
the net duration and slow down the negative effects. This could also be
done by shifting business focus more towards short-term loans/advances,
rather than term loans
 Adopt floating rates for long-term advances/loans so that this portfolio
remains balanced with the market trends.
 Duration gap may also be minimized by attracting long-duration deposits.
Such deposits may provide a cost cushion in case of further increases in
market rates.
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 When the policy rate is expected to go up and sell long-term securities which
carry lower profit rates. Investment in such securities could be enhanced once
rates have increased, or are near achieving the peak level of the economic cycle.

In case of the likelihood of a drop in Policy/market interest rates, minimizing the

duration of liabilities could provide useful cost-saving, going forward. This could
be done by accepting more demand deposits and lowering the price and tenure of
new time deposits.

For example, if a bank cannot correctly evaluate the upcoming rate cut in Monetary
Policy and continues to raise deposits for a fixed 3-year tenure, it may end up
locking the current high cost for the next 3 years, while Policy rates and the deposit
cost of other banks adjusted downward in this period. As a result, the long duration
of the 3-year term deposit proved to be costly and the bank could not make a profit
on these funds as there were hardly any opportunities to utilize these funds (for
loans or investment) at a profitable margin under a declining rate situation.

7.3 Interest Rate Risk Management

7.3.1 Definition and Sources

Interest rate risk is referred to as the risk of loss of income due to mismatches in
the maturity of assets and liabilities. It is the risk that changes in market interest
rates might adversely affect an institution’s financial condition. The immediate
impact of changes in Policy or market interest rates is on the Net Interest Income
(NII). A long-term impact of fluctuation in interest rates is on the institution’s net
worth. (This long-term perspective has been deliberated separately under Duration
Gap).

The Interest rate risk when viewed in the near term has its significance in terms of
‘earnings perspective’. This involves analyzing the impact of changes in interest
rates on accrual or reported earnings in the near term. (i.e. on Net Interest Margin)

Re-pricing risk
Financial institutions encounter interest rate risk in several ways. The primary and
most often discussed form of interest rate risk arises from timing differences in the
maturity (for fixed rate) and re-pricing (for floating rate) of assets and liabilities.
While such re-pricing mismatches are fundamental to the business of banking, these
can expose an institution’s income and underlying economic value to unanticipated
fluctuations as interest rates vary. For instance, a bank that funded a long-term
fixed-rate loan with a short-term deposit could face a decline in both the future net

148
income and its underlying value if interest rates increase. The declines resulted
because the cash flows on the loan are fixed over its lifetime, while the interest paid
on the funding is variable, and has increased after the short-term deposit matures.

Basis risk
Another important source of interest rate risk (commonly referred to as basis risk)
arises from applying different benchmarks on earning assets in comparison to
liabilities. The two benchmarks may not necessarily float or move in harmony.
Differences and imperfect correlation in the adjustment of the rates earned and paid
on different instruments can give rise to unexpected changes in the cash flows when
interest rates change. Therefore, assets liabilities must be assets and liabilities must
be pegged to identical benchmarks. For example, the pricing of foreign currency
lending and borrowings are linked/floated with Libor. Banks in Pakistan are
required to price their long-term loans and liabilities from financial institutions,
both linked to Kibor. The frequency of their re-pricing is also matched with the
relevant tenor of Kibor to avoid basis risk. E.g., banks are not allowed to keep the
re-pricing frequency of floating rate loans at 3 months and float the price of this
loan with 6-month Kibor. Both the tenors should be the same.

7.3.2 Interest Sensitivity Gap Analysis

Interest rate changes affect the most important source of revenue, viz. interest
income on loans /securities, and the most important source of expense, viz. cost of
deposits/borrowings. If the cost of borrowed funds rises faster than the income
received from assets, or the fall in interest income is more than the decrease in
interest cost, the institution is said to be exposed to interest-sensitive gaps.

The techniques available for measuring interest rate risk range from calculations
that rely on simple maturity and re-pricing tables, to more sophisticated
simulations, based on the nature and size of the institution. The simplest methods
however are intended primarily to capture the risks arising from maturity and re-
pricing mismatches.

Gap analysis is one of the first methods developed to measure an institution’s

interest rate risk exposure, which continues to be widely used by banks. For this
analysis, maturity/ re-payment schedules are used to arrive at gaps in different time
horizons. Maturities of interest rate sensitive liabilities (e.g. deposits, borrowings)
in each time band are subtracted from the corresponding interest rate sensitive
assets (e.g. loans, government securities etc.) to produce a re-pricing “gap” for that
time band.

149
This gap can be multiplied by an assumed change in future interest rates to yield an
approximation of the impact on net interest income that would result from such an
interest rate movement. The assumption of the interest rate movement used in the
analysis can be based on a variety of factors, including historical experience,
research-based projections or judgment of bank management.

Definitions
A negative, or liability-sensitive gap occurs when liabilities exceed assets in a given
time band. This means that an increase in market interest rates could cause an
escalation of future costs, or a net negative impact on Net Interest Income.
Conversely, a positive or asset-sensitive gap implies that the bank’s Net Interest
Income could decline as a result of a decrease in the level of Policy/ interest rates
(due to larger assets over liabilities).

7.3.3 Principles for Interest Rate Risk Management

Generally applied principles by Management of banks in implementing risk
management systems may include:
 Senior management must ensure that the structure of the bank’s business and the
level of interest rate risk it assumes are effectively managed, that appropriate
policies and procedures are established to control and limit these risks
 There should be top-level oversight of risk management policies, procedures
and reports at the level of the Board of Directors or Risk Management
Committee
 Banks should have risk measurement, monitoring and control functions with
clearly defined duties that are sufficiently independent and report risk
exposures directly to senior management. Asset Liabilities Committee is a
mandatory committee under the regulatory framework, to oversee and review
risk, remedies and tolerance limits.
 It is important that banks identify the risks inherent in new products and
activities and ensure these are subject to adequate procedures and controls
before being introduced or undertaken.
 Banks should measure their vulnerability to loss under stressful market
conditions - including the breakdown of key assumptions - and consider those
results when establishing and reviewing their policies and limits for interest
rate risk. Stress testing procedures are relied upon under assumed scenarios.
 Banks must have an adequate system of internal controls over their interest
rate risk management process. One such control is the separation of reporting
lines of risk management personnel from risk takers (i.e. business units) to
ensure independent reporting
 Banks should release to the public information on the level of interest rate risk
and their risk management policies.
150
7.4 Self-Assessment Questions
a) Short Questions
i) Define Risk from a banking perspective and list down a few risks that
banks mostly face.
ii) What is the difference between fixed and floating rates of markup
iii) How a long-term investment in property/real estate by a bank may create
a risk of mismatch

b) Long Question
i) Write a note on strategies, generally applied in Asset-Liabilities
Management
ii) What is meant by re-pricing risk and basis-risk

c) Exercise
Balance Sheets or Annual reports of listed banks are commonly available.
Study the balance sheet and related notes of any bank and work out answers
to the following:

Under the asset side, explain how the banks have structured pricing of
Advances (i.e. on fixed markup or a floating basis)

Also, compare the pricing structure of Deposits (i.e. liabilities) of the bank
and give your comment on any mismatch or asset-liability gap

Under the section ‘Notes to the Accounts’ in the Annual Report, study the Note on
‘Risk Management’ and write your views about the findings on Credit Risk and
Liquidity Risk of the bank.

7.5 Summary
Banks’ sources of funds are not necessarily matched, in terms of the timing of cash
flows, with the pattern of funds deployment. In other words, expected deposit
withdrawals may not be instantly managed with the inflows from earning assets of
the banks. In this Unit, students have studied possible risks arising out of such gaps
and strategies and tools for minimizing and managing these gaps so that the bank’s
profitability and liquidity are not adversely impacted.

151
Asset-Liability Management (ALM function) refers to working out suitable
strategies to manage and balance the liability-asset schedules and gaps in order to
achieve continuity of stable banking operations.

The unit has also explained the relationship between the future economic
environment and changes in policy interest rates with the quantum of gaps in the
cash flows of any bank. Possible changes in monetary policy and interest rates are
discussed in detail to develop a comprehension of these concepts and their relation
to smooth operations. Asset-Liabilities Management strategies are deliberated both
from a theoretical and practical perspective. The concepts of future/forward
contracts, floating rate lending, and re-pricing risks of fixed-income securities are
explained. Possible policy adjustments adopted by bankers in their asset/liability
business, as a result of monetary policy changes, are also mentioned.

The concepts of ‘duration’ and the duration gap of the balance sheet have been
thoroughly explained with a practical viewpoint. Net Duration is worked out with
the help of a financial model for better understanding. Interest rate risks associated
with the central bank’s policies of monetary tightening or easing (as the case may
be) are correlated to this model along with an analysis of possible impacts and
inferences.

The unit concludes with a review of some standard principles of interest rate risk
management.

REFERENCES

Managing Risk in Financial Sector, (By Irfan Karim, Published by Institute of

Bankers, Pakistan, 2006).
[Link]
[Link]
[Link]
liability-management-alm/

152
Unit–8

FINANCIAL
STATEMENTS OF BANKS

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah

153
 CONTENTS

Page #
Introduction ....................................................................................................... 155

Objectives ........................................................................................................ 155

8.1 Overview of Balance Sheet and Income Statement ................................. 156

8.2 Balance Sheet of a Bank and Assets and Liabilities Items ...................... 157

8.3 Components of Income Statements (Revenue and Expenses) ................. 160

8.4 Accounting Standards and Policies .......................................................... 162

8.5 Self-Assessment Questions ...................................................................... 164

8.6 Summary .................................................................................................. 165

References ......................................................................................................... 166

154
 INTRODUCTION

Banking services and operations have been taught and discussed earlier in various
Units of this course book. These services and business considerations are ultimately
reflected in the financial form in the book's accounts, with the ultimate objective of
full disclosure of true income, expenses, assets, and liabilities of the bank/financial
institutions along with shareholders' equity. Since banks deal with deposits and
money of the public at large, disclosure of their financial position by the publication
of periodic accounts is a mandatory function for shared benefits. The financial
statements are studied and analyzed by all the stakeholders, including depositors,
regulators, and shareholders.

The balance sheet and income statement of financial institutions are formulated and
presented in a specifically defined format, slightly different from that of other non-
financial companies. The Assets and liabilities reported under this format are
explained item by item, along with a description of various heads of Income
statements.

Banks are obliged to follow certain rules in financial reporting and comply with the
requirements of the central bank, SECP and International financial reporting
standards. These are also touched upon in this Unit for developing basic
comprehension.

OBJECTIVES

In this unit, you will learn about the:

 The importance of the regular publication of financial statements in the

banking business and their value to various stakeholders

 Format of presentation of financial statements and interpretation of significant

balance sheet and income statement heads

 Rules in financial reporting for compliance with the requirements of the

central bank, SECP and International financial reporting standards.

155
8.1 Overview of Balance Sheet and Income Statement
Deposits from the general public, companies/ corporates are amongst the largest
funding sources for any bank. Their trust in the bank is key to the success of any
banking business. This trust is asserted and re-assured by banks by pursuing certain
Core Values, which are also expressed in the financial statements:

Core Values in Financial Reporting

o Transparency in operations
o Complete Disclosure of financial affairs
o Compliance with Regulations and Laws

The affairs of the banking business and core values are reflected and transpired in
the Balance Sheet, Income Statement and Cash Flow Statement, supported by Notes
to the Accounts.

Financial Statements of a bank comprised of (at least) the following:

o Balance Sheet (also referred to as Statement of Financial Position)
o Income Statement (or Profit & Loss Account)
o Cash Flow Statement
o Statement of Changes in Equity
o Notes to the Accounts (covering further details and sub-accounts of the above)

Frequency of Preparing Balance Sheet and Income Statement

In terms of regulatory requirements, each banking company is obliged to prepare
and publish financial statements in the following form and time frame:
Financial Time Frame of Audit
Statements Period Publishing Requirement
1st Quarterly (for the Quarter Within 30 days of the
Un-Audited
Jan-March) Quarter ended
Half Yearly For the period Within 60 days of the half-
Audited
Jan-June year ended
3rd Quarterly (for the Quarter Within 30 days of the
Un-Audited
July-September) Quarter ended
Annual Financial Statement
Within 90 days of year-end Audited
(for the full year, Jan-Dec.)

156
What is the Annual Report of a Bank?
On this basis, Banks publish their Balance Sheets, Income Statements and related
accounts in their Annual Reports. These Annual Reports showcase their performance
and achievements.
According to requirements of the State Bank of Pakistan and guidelines of various
accounting standardization bodies, Banks are also obliged to include certain
compliance reports in their Annual Reports, along with Audited Financial
Statements, for transparent disclosure of their operations and policies. These reports
include the following:
o Directors Report to Members: (The Board of Directors present a report on the
Bank's affairs, profitability and business to its shareholders/members, also
useful for depositors/public)
o Independent Auditors Review Report (Issued and Signed by external auditors)
o Statement on Internal Controls
o Report on membership of the Board of Directors and meetings held during
the year
o Statement on Shareholding Structure and Compliance of Code of Corporate
Governance

Stake Holders to whom the Bank's financial statements are important:

1. Shareholders/owners of the Bank, for assessing the value of the bank,
shareholding/dividends
2. Depositors, who have placed their funds with the bank and need to be aware
of the bank's affairs
3. General Public
4. Regulator (State Bank of Pakistan, Securities and Exchange Commission of
Pakistan)
5. Credit Rating Companies, which analyze banks' performance and issue
reports on the credit worthiness of banks for the benefit of depositors or
customers
6. Stock Exchange (in the case of listed banking companies)

8.2 Balance Sheet of a Bank and Assets/Liabilities Items

Banks in Pakistan follow a model/format of Balance Sheet, advised by the State
Bank of Pakistan, in line with the standards of The International Financial
Reporting Standards (IFRS).

IFRS is a set of accounting rules for public companies with the goal of encouraging
to encourage banking companies to prepare financial statements, which are
consistent, transparent, and easily comparable around the world. Banks in Pakistan
also follow these standards.

157
The Balance sheet reflects the value of the Bank's assets, liabilities and equity on
the of closing day of the accounting period. This is also referred to as Statement of
Financial Position.

8.2.1 Format of Balance Sheet/Statement of Financial Position

Banks prepare their financial statements in a format advised by the State Bank of
Pakistan, where assets/liabilities are reported in the order of their liquidity, i.e. the
ability to convert to Cash. The assets are reported in the order of their availability
in cash, while liabilities are reported in terms of the probability of conversion to
cash outflows, thus making the bank liable to settle the liability.

The format along with item-wise wise item-wise descriptions of assets and liabilities
are in the order and manner in which banks present their Statement of Financial
Position. The second column in this format is meant for reference of ‘Notes’. This
column is used here for the description of Asset/Liability items (in italics).

ABC Bank Limited

STATEMENT OF FINANCIAL POSITION AS AT ____________
NOTES/Item-wise Description of Asset/ (Current (Prior
Liability Year) Year)
Rupees in '000

ASSETS

Cash and balances with Cash available in vaults and balances held at State
xxxxxxx xxxxxxxx
treasury banks Bank
Balances with other Deposits of Banks with other banks and Call
xxxxxxxx xxxxxxxx
banks Deposits
Amounts placed with other financial institutions
Lendings to financial
for profit motives (e.g. under Term Deposit, xxxxxxxx xxxxxxxx
institutions
Certificate of investment)
Value of Govt. Securities, SUKUK, Shares, trading
Investments xxxxxxx xxxxxxxx
portfolios etc. as at quarter/year-ended
Balance of loan receivables from customers,
Advances xxxxxxx xxxxxxxx
including cash credits, Leases etc., net of bad debts
The Bank’s non-liquid assets like buildings, vaults,
Fixed assets xxxxxxx xxxxxxxx
equipment
Value of licenses, software purchased, goodwill
Intangible assets xxxxxxxx xxxxxxxx
etc.

Other assets Includes accrued markup, receivables, prepayments xxxxxxxx xxxxxxxx

xxxxxxxx xxxxxxxx

158
 LIABILITIES

Bills payable Immediate due amounts, like sundry debtors xxxxxxx xxxxxxxx
Call money borrowings or credit lines from other
Borrowings xxxxxxxx
banks xxxxxxxx
Balance of all Time and demand liabilities of the bank.
Deposits and other
Includes current, savings, and term deposits held by xxxxxxxx xxxxxxxx
accounts
the bank
Payable amount on the closing day against
Liabilities against assets
borrowing for the purchase of vehicles, equipment, xxxxxxxx xxxxxxxx
subject to finance lease
fixtures etc., on lease.
Debt raised by the bank for its operations from
owners etc., which is repaid after settling all the
Subordinated debt xxxxxxxx xxxxxxxx
above liabilities i.e. This debt is subordinated to
deposits and liabilities
Installments or unpaid Tax, payable on the Bank’s
Deferred tax liabilities xxxxxxxx xxxxxxxx
income
This may include accrued expenses and other
Other liabilities xxxxxxx xxxxxxxx
commitments

xxxxxxx xxxxxxxx

NET ASSETS xxxxxxx xxxxxxxx

REPRESENTED BY

Paid-up capital by shareholders, including any

Share capital-net xxxxxxx xxxxxxxx
premium or discount etc.
Profit accumulated as equity reserve, net of losses,
Reserves xxxxxxx xxxxxxxx
if any
Differences in the Market value of government
Surplus/ (Deficit) on securities/ listed shares into their cost result in a
xxxxxxx xxxxxxxx
revaluation of assets surplus (or deficit) on the closing date of financial
statements.
Un-appropriated/ Accumulated profit after appropriations to
xxxxxxx xxxxxxxx
Unremitted profit dividends or reserves
xxxxxxx xxxxxxxx
CONTINGENCIES May include disclosures on Guarantees issued or
AND COMMITMENTS contingent liabilities of the Bank

The annexed notes and annexures form an integral part of these financial statements

________________________ ____________________ ___________ ___________

President/Chief Executive Chief Financial Officer Director Director

159
8.3 Components of Income Statements (Revenue and Expenses)
As also referred to above, all formats of financial statements of banks are prescribed
by the State Bank of Pakistan for consistency. Accordingly, Income Statement, or
Profit &Loss Account is required to be prepared on the following lines:

ABC Bank Limited

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED _________
(Current (Prior
Notes/Item wise Description of Year) Year)
Revenue, Expenses
Rupees in ‘000’
Mark-up/Return/ Markup Income from lending and investments
xxxxxxxx xxxxxxxx
Interest Earned by the Bank
This comprises of return paid to depositors on
Mark-up/Return/
time and demand deposits and markup on xxxxxxxx xxxxxxxx
Interest Expensed
borrowed funds
The difference between the above two items is
Net Mark-up/
the net Interest Income of the Bank (Also xxxxxxxx xxxxxxxx
Interest Income
referred to as NII)
NON-MARK UP/
INTEREST INCOME
Income from banking services, e.g. fee charged
Fee and Commission
on ATM transactions or the issuance of demand xxxxxxxx xxxxxxxx
Income
draft etc.

Dividend Income Dividend on Bank’s investments xxxxxxxx xxxxxxxx

Foreign Exchange Income from dealing in foreign currencies and

xxxxxxxx xxxxxxxx
Income trading

Gain / (Loss) on Gain or losses on trades of shares, government

xxxxxxxx xxxxxxxx
securities securities etc. in financial markets

Income is booked from the recovery of bad debts

Other Income or on the sale of assets. Details are disclosed in xxxxxxxx xxxxxxxx
respective Notes

Income from banking services, e.g. fee charged

Total non-markup/
on ATM transactions or the issuance of demand xxxxxxxx xxxxxxxx
Interest Income
draft etc.

Total Income xxxxxxxx xxxxxxxx

160
 NON-MARK-UP/
INTEREST EXPENSES
Operating expenses Includes all administrative expenses, salaries etc. xxxxxxxx xxxxxxxx
Contribution to funds and expenses on staff
Workers Welfare Fund xxxxxxxx xxxxxxxx
welfare
Other charges xxxxxxxx xxxxxxxx
Total non-markup/
xxxxxxxx xxxxxxxx
interest expenses
Profit /(Loss) Before
xxxxxxxx xxxxxxxx
Provisions
Provision of bad debts is charged for certain
Provisions and write- loans where recovery becomes doubtful. Those
xxxxxxxx xxxxxxxx
offs - net which are declared ‘unrecoverable’ are disclosed
as ‘write-offs’
These require full disclosure of any other Income
Extraordinary/unusual
or expense items, not covered in routine xxxxxxxx xxxxxxxx
items (to be specified)
operations

PROFIT/(LOSS)
xxxxxxxx xxxxxxxx
BEFORE TAXATION
Taxation As per tax laws xxxxxxxx xxxxxxxx

PROFIT/(LOSS)
xxxxxxxx xxxxxxxx
AFTER TAXATION

Profit/(Loss) after taxes, divided by the number

Basic Earnings/ (Loss)
of paid-up shares held by Shareholders of the xxxxxxxx xxxxxxxx
per share
Bank
The annexed notes and annexures form an integral part of these financial statements.

______________________ ____________________ ___________ ___________ _________

President/Chief Executive Chief Financial Officer Director Director Director

Source: Format of Balance Sheet and P&L Account is provided in SBP BPRD Circular No 2, 2018

Further Reading
Students are encouraged to study the Annual Accounts of a few banks. These
accounts are presented and published in their Annual Reports, which can be
downloaded or previewed from their respective websites. In addition to annual
accounts, quarterly accounts are also posted here. For Banks listed on stock
exchanges, copies of Annual Reports are also provided to stock exchanges.

While going through the Balance sheet and Profit & Loss account of any bank,
students may explore constituents of key earning assets, i.e. Advances and
Investments (studied in Units 3 to 6) along with revenue, and expenses by referring
to the respective Notes to the Accounts.

161
8.4 Accounting Standards and Policies
While preparing financial statements, banks have to follow a standard set of
accounting principles of measurement and reporting of the value of assets/
liabilities. These standards are also referred to in their financial statements for un-
hidden disclosure of their business affairs. For uniformity and transparency, most
of such principles and accounting policies are advised to banks under regulatory
directives of central banks. In our case, banks in Pakistan are obliged to comply
following accounting and reporting standards:
1. International Financial Reporting Standards (IFRS), adopted by the State
Bank of Pakistan
2. Directives/Circulars issued by the State Bank of Pakistan and the Securities
and Exchange Commission of Pakistan

International Financial Reporting Standards or IFRS, comprise of a set of

accounting rules for public companies’ financial statements consistent, transparent,
and easily comparable around the world. Banks in Pakistan also follow these
standards.

8.4.1 Standard IFRS Requirements

IFRS covers a wide range of accounting activities. As an example, the following
set of financial statements must be included to meet the requirement of IFRS, while
preparing financial statements for every bank.
 Statement of Financial Position: This is a balance sheet, reported in the
specified format, (as also highlighted earlier section).
 Statement of Comprehensive Income: This statement is included in
addition to the profit and loss statement. It covers details of other Income of
the bank, which may be subject to variation or fluctuations, for example, the
surplus on revaluation of property or portfolio of listed shares. This statement
portrays the Income of the bank in a more realistic outlook and covers the
fluctuations during the time gap between the end of the accounting period and
the presentation of accounts.
 Statement of Changes in Equity: Also known as a statement of retained
earnings, this statement reports the company's change in owner's equity about
earnings, and appropriations of profit for the given financial period.
 Statement of Cash Flows: This report summarizes the financial transactions
in the given period, separating cash flow into operations, investing, and
financing activities. Through this report, the bank's financial position is more
vividly analyzed from the viewpoint of cash inflows or its utilization in the
business.

162
In addition to these basic reports, a company must give a summary of its accounting
policies.

8.4.2 Accounting Policies Adopted under SBP Directives

For consistency and continuity, the State Bank of Pakistan issues instructions to
adopt policies for key accounting area areas. For example, the reported values of
banks' fixed assets, property and investment should follow a consistent method of
measurement over the years. A few of the significant accounting policies that banks
must follow are highlighted as follows:

Revenue recognition:
Revenues from advances and investments comprise of major income of any bank.
Therefore, SBP keeps a close eye on accounting procedures applied by banks to
check any over-statement or under-statement of a bank's revenue. The following
treatment is mandatory for booking of markup Income:
o Banks have to distribute their advances and investments into performing and
non-performing categories, based on their recovery performance.
o To correctly arrive at Income, markup receivable only on performing
Advances is recognized as revenue on an accrual basis. No markup is booked
as revenue on Non-performing advances, rather it's kept in a suspense account
until recovery is materialized.
o Any income accrued earlier on those accounts which have now become bad
debts is deducted from revenue in line with the relevant circulars of the State
Bank of Pakistan.
o In addition, a prior Provision for bad debts is also created (and treated as a
deductible expense from the P&L account) in line with the rates and criteria
advised by SBP circulars.

Fixed Assets valuation:

A bank's real estate property can be valued on a market basis within certain
conditions. However, there are approved valuation firms, which have to follow
certain rules and guidelines while assessing the true value of the property. Such
guidelines and methods of evaluation are reported in financial statements for
purposes.

Modes of depreciation:
The policy on depreciation should also be consistent and continue for the whole life
of the asset. For example, if a straight-line method of depreciation is applied, the
rate of depreciation, calculation and time duration of each category of assets is
declared in the financial statement.

163
Accounting policy for Securities Held for Trading
Trading portfolios (comprising of shares, government securities or currencies) are
of critical importance to a bank's profitability or otherwise. That is why, all banks
are obliged to follow a uniform policy of accounting, which is issued by regulatory
directives of the State Bank of Pakistan. According to these guidelines:
 Value of Securities held for trading purposes is reported based on the market
price on the closing day of the accounting period. Any surplus or deficit (in
comparison to purchase cost) is charged to the P&L Account.
 Trade-able securities can be held for trading in the markets for a period of a
maximum of 90 days, after which profit or loss has to be realized for booking
to the P&L Account
 Other securities, such as long-term bonds, if held on a long-term basis, need
to be fully disclosed as 'Held to Maturity', and are not liable to the above
criteria, provided these are not sold before maturity.

Audit Requirement
Each Bank has to appoint a renowned external auditor firm (from the approved
panel of auditors), who shall review and audit the financial statements and accounts
of the bank on a semi-annual and annual basis.

Quarterly accounts may be published without an external audit. The Internal

Auditor of the bank also follows pre-post-audit procedures. For better control over
financial reporting, the Internal Auditor of banking companies reports directly to
the Banks Audit Committee of the Board of Directors.

8.5 Self-Assessment Questions

a) Short Questions:
i. Write at least 3 core values that each bank should adopt while reporting
its financial statements.
ii. How many times in a year banks are obliged to prepare and publish
financial statements
iii. What does IFRS stand for?
iv. Write at least three modes/names of that are shown under 'Investments'
in a balance sheet of a bank.

b) Long Questions:
i) Write descriptions and constituents of at least four financial statements
that must be published by banks to meet the Requirements/ criteria of
IFRS.

164
 ii) Also explain salient features of the Accounting policy for 'Securities
Held for Trading' that banks should adopt to meet requirements set by
SBP.

c) Exercise:
Download the Balance Sheet and Profit and Loss account of a bank and work
out the following:
i. Separate the Earning assets of the bank from total assets and compare
growth or decline in earning assets (as the case may be), over the two-
year reported period reported
ii. Analyze the income and expenses of the bank to see which portion of
income is the main contributor to the bank's profitability. Also comment
on the item' Gain or loss on trading securities, reported in the P&L
account.
iii. Comparison of growth in Deposits and total assets of the banks over the
two years.
iv. Give your opinion on the overall performance of the bank

8.6 Summary
The earlier unit has taught various business operations of the bank that generate
assets, and liabilities along with Income and expenses. This unit has described the
way and manner in which these assets, liabilities, income and expenses are recorded
and reported. Financial statements, therefore, are of significant importance for the
bank itself as well as for its depositors, customers and business circles as a whole.
Publication of Periodic financial statements also has its value from the viewpoint
of Regulatory oversight of central banks.

Banks prepare financial statements within a framework advised by the State Bank
of Pakistan. The Unit has explained various components of Assets, Liabilities and
Profit and Loss Account, item-wise, in the form and manner as prescribed under
the rules and as per applicable format.

The Unit has further discussed the existing framework of accounting policies and
reporting standards that the banks in Pakistan are required to follow. The
contemporary financial statements follow International Financial Reporting
Standards along with regulatory directives of the State Bank of Pakistan. These are
elaborated for comprehension purposes.

165
Banks are required to follow and disclose various accounting policies in their
financial statements. Most significant policies are advised by the State Bank of
Pakistan to achieve transparency and uniformity among banks. International
Financial Reporting Standards have also made been applicable in Pakistan. These
standards are adopted worldwide by banks and aim for more disclosures on banks'
affairs and cash flows. Under these standards and accounting policies, banks in
Pakistan report their assets on market-related values, with complete details of any
bad debts, and variation in the value of trading portfolios fully taken into account
to reflect relative strengths or vulnerabilities. Thus the adoption of these policies
and standards has added value to the financial statements for all the stakeholders,
including the general public, shareholders and investors at stock exchanges.

REFERENCES

Annual Reports of public banking companies Public Banking Companies.

[Link]

[Link]

166
Unit–9

SPECIAL CATEGORIES OF LENDING

MANAGEMENT IN PAKISTAN

Written by:
Irfan Karim

Reviewed by:
Prof. Dr. Syed Muhammad Amir Shah

167
 CONTENTS

Page #
Introduction ....................................................................................................... 169

Objectives ........................................................................................................ 170

9.1 Advances to Small and Medium Enterprises ........................................... 171

9.2 Prudential Regulations for SME Financing ............................................ 174

9.3 Agriculture Finance ................................................................................. 176

9.4 Self-Assessment Questions ...................................................................... 181

9.5 Summary .................................................................................................. 181

References ......................................................................................................... 183

168
 INTRODUCTION

Banks' lending operations are mostly concentrated in such sectors and markets from
where they can generate maximum revenue. However, certain other sectors, which
are otherwise important for the economy and the people, may not benefit from a
similar level of banking outreach due to lower business feasibility. Under such a
situation, government, and regulators, with larger national and social objectives,
provide the necessary direction to fill the gap.

The sectors comprising small, and medium businesses and Agriculture farming are
those areas, which have required dedicated policy from the government and
specialized access to credit to harness their true growth potential. Accordingly,
under the guidelines of the regulatory authorities, Banks in Pakistan have set up
separate lending functions for extending banking facilities to the Agriculture and
Small and Medium Enterprises by regarding these two sectors under the specialized
category, with certain separate procedures to meet their peculiar needs.

This unit discusses modalities of financing for the Agriculture sector and Small and
Medium Enterprises (SMEs) sector-specific measures for credit facilitation by
banks. Guidelines and regulations of the State Bank of Pakistan for promoting these
sectors for achieving economic growth have also been deliberated in this unit.

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 OBJECTIVES

After study of this unit, you will be able to:

 Understand how Agriculture and SMEs are considered specialized sectors for
their contribution to the country's economy.

 Know about various modes of financing or credit operations, formulated by

the regulators and implemented/facilitated by banks to support special
category lending.

 Have an overview of specific Prudential Regulations of the State Bank of

Pakistan for SME financing and Agriculture financing.

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9.1 Advances to Small and Medium Enterprises

9.1.1 Definition of Small and Medium Enterprises

Small and Medium Enterprises are considered as separate groups for banking
policies, taxation etc. A business firm or organization, engaged in the production
and/or sale of goods or services, which also employs a certain number of
employees, but operates within limited scope and capital, may generally be
categorized as a Small or Medium Enterprise (SME).

Banks prefer to categorize their business clients and target market into various
segments so that each one of these could be focused separately for specific banking
services that suit best the particular category.

The banks generally divide their commercial banking function into the following
two sectors:
a) Corporate sector (large companies, multi-nationals, Government corporations)
b) Small and Medium Enterprises (SMEs)

Various yardsticks (number of employees, annual revenue etc.) are applied to

segregate SMEs from corporates. However, current definitions of SME, applicable
in the banking business are derived from various SBP Regulations. This definition
is based on the following criteria for categorizing small or medium enterprises:

a) Small Enterprise
A small Enterprise (SE) is a business entity with an annual sales turnover of a
maximum of Rs. 150 million. Banks apply limits and rules for small enterprises to
such entities while handling their loan requests.

b) Medium Enterprise
A Medium Enterprise is a business entity with an annual sales turnover of above
PKR 150 Million and up to PKR 800 Million.

Small and Medium enterprises, together are known as SMEs:

Examples of SMEs:
The following business setups may be categorized under SMEs:
- Manufacturing of handicrafts and decorative products
- Small mills of cloth weaving or textile printing units
- Baby Garment factories
- Fans and room cooler manufacturing
- Software development startups, employing a reasonable number of technical
staff

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9.1.2 SME Sector, a Key Driver of the Economy
Small medium-sized business firms are important for a country's economic system.
These can play a crucial role in achieving economic growth and generating
employment opportunities. In this section, we will discuss why such organizations
are vital for a country's business success, and how the government pays special
attention to promoting banking services to SMEs.

Significance of SMEs for business growth in a developing country

Small firms mostly apply local/indigenous skills, where young generations learn
and grow workmanship and new entrepreneurs are produced. For example, a
family-owned fan manufacturing firm employs about 20 skilled workers. |Its raw
materials and technical skills are mostly available in nearby localities. However,
such firms may face a shortage of capital and may not have enough security to
obtain loans. If these constraints are addressed, the business may grow further with
an injection of more funds and machinery, and it can offer employment to local un-
skilled residents and extended family members. This skilled youth in future may
also be able to set up new SMEs in future to meet the rising demand of fans.

SMEs mostly produce goods that are in demand in nearby communities or cities.
These big numbers can together produce goods and services in large volumes and
contribute to increasing GDP. If given good financial support, support, these can
produce export surplus and earn foreign exchange for the country. In the Asian
region alone, the examples of China and Taiwan are relevant, where small and
medium enterprises have remained a key driver of their GDP growth.

In China, there were over 140 million SMEs and self-employed businesses in 2020.
Overall, SMEs contribute over 60% of total GDP, 50% of tax income, 79% of job
creation and 68% of exports. In 2020, there were about 2.52 million new
companies, and the number of newly registered enterprises reached 22,000 per day.
According to an analysis of Small and Medium Enterprises in Taiwan, there were
1,491,420 SMEs in Taiwan, accounting for 97.65% of all enterprises. These SMEs
employed 9,054,000 persons, or 78.73% of the working population.

In Pakistan, SMEs are growing and various initiatives of governments provide

facilitation for the development of this sector. However, data based on the
registration of all small or medium enterprises lack formalization.

Further Reading
Students may visit the websites of the State Bank of Pakistan, the Economic Survey
of Pakistan and SMEDA (Small and Medium Enterprise Development Authority)
for further knowledge on the SME sector in Pakistan and efforts and initiatives of
government organizations to promote and facilitate the business of SMEs.

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9.1.3 Specialized Financing by Banks and Recommendations of SMEDA
(Small and Medium Enterprise Development Authority)

Considering the importance of SMEs in minimizing unemployment and positive

contribution to much-needed growth in our GDP, the government of Pakistan has
adopted various policies over time for the promotion of the SME sector. Some of
the steps taken in this regard are as follows:
i. Establishment of Small and Medium Enterprise Development Authority
(SMEDA)
ii. Given SMEDA's recommendations, commercial banks have been facilitated
to extend advances to SMEs. SBP has set a minimum bank-wise limit of such
loans, that each bank is required to meet.
iii. Establishment of specialized commercial banks in the government sector to
cater banking needs of SMEs. (However, currently, this SME Bank Limited
awaits privatization to achieve full-fledged operations)

The State Bank also reviews key regulations relating to SMEs periodically implements
necessary changes to smoothen the process and advises credit limits to banks.

Various Modes of Bank Advance to SMEs:

Within the guidelines of SME policies of SMEDA and SBP, commercial banks
allow advances/lending to SMEs in a convenient and specialized mode. SBP has
issued separate regulations for SME financing taking into consideration the
resource constraints of such small borrowers and the non-availability of suitable
collateral. (discussed under a separate section).

Small and Medium enterprises can obtain advances from banks under the following
modes:
i. Un-secured finance (up to limits allowed by SBP)
ii. Running finance: This type of loan is short-term in nature (one-year tenure).
The maximum advance limit approved by the bank is utilized by drawing the
required funds (in instalments or in full) to meet the working capital requirement
of the borrower. (i.e. the payment of raw materials, expenses, salaries etc.)
iii. Revolving Credit: Such Credit limit is sanctioned for a certain tenure
(say 1-2 years) against the security of assets held by the borrowing SME. The
borrower utilizes the funds for business purposes and to enhance its
production. At the expiry of the term, the credit facility may be renewed for
another term (subject to satisfactory evaluation by the bank).

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iv. Term Finance Facility: This credit facility meets the longer-period funds
requirement. SMEs may utilize such credit for the purchase of new machinery
or expansion and growth of their business.

Medium and Long Term Facilities mean facilities with maturities of more than one
year and Short Term Facilities mean facilities with maturities of up to one year.

SMEs can avail of bank financing within the following limits:

a. Small Enterprise (SE, as defined earlier above) can avail total loan exposure
up to Rs. 25 million each from a single bank, or all banks & and development
financial institutions.
b. Medium Enterprise can avail financing for working capital (raw material/
operating expenses) or assets purchase etc. up to Rs 200 million either from a
single bank or collectively from all banks & and development financial
institutions.
The banks carry out a need assessment of the borrower based on its cash flows and
management appraisal before deciding on the loan amount for any enterprise,
within the above maximum limit allowed under the SBP regulations.

For those SMEs, where financial statements are available, ratio analysis of financial
statements is included in the primary assessment criteria, such as:
Current ratio (current assets/current liability)
Solvency ratios (Year wise Debt to Equity ratios and total debt to total assets)
Profitability Ratios (like operating profit over sales revenue, quarter-wise and
year-wise)

9.2 Prudential Regulations for SME Financing

9.2.1 Reason for Separate Regulations for Credit Facilities to SMEs
As also touched upon in earlier units, regulations related to advances/loaning by
banks are issued separately for each specific sector. The reason for this segregation
is to provide a supportive environment to all the sectors of the economy and
facilitate borrowers to obtain loans on the terms and conditions that best suit the
specific sector. For example, there is a marked difference between large corporates
and agriculture or SME borrowers, when it comes to negotiating terms and
conditions of bank credit or arranging the desired security. Similarly, individuals
or SMEs, given their smaller size, may default earlier on repayments when their
business suffers even a small loss, as compared to corporations, which have more
reserves or options to manage cash flows.

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Therefore, SBP Prudential Regulations (PRs) and guidelines have been issued by SBP,
separately for each category of borrower, i.e. consumers, SMEs, corporate sector or
Agriculture, so that the specific needs of all these sectors may be addressed equitably.

PRs are issued for the following categories of loaning:

 Infrastructure Project Finance
 SME Financing
 Agriculture Financing
 Corporate/Commercial Banking
 Consumer Financing
 Housing Finance
Detailed Prudential Regulations for SME Financing are available on the SBP website.
The purpose of this regulation is to promote bank financing to the SME sector
within affordable limits, make the loan process simpler and help this sector grow
and contribute effectively to the country's economy.

9.2.2 Salient Features of Prudential Regulations for SME Financing

 These regulations have separately defined small enterprises and maximum loan
limits for such firms restrict the loan amount to the affordable limit. Criteria for
medium-size enterprises have also been defined along with higher limits.

 Prudential Regulations have also instructed the banks to set up special units
for SME financing under a formally documented policy and arrange training
of their staff to welcome credit proposals from this preferred sector.

 The regulations have considered the limitations of SME borrowers, who

usually run businesses, and may not be able to meet all the requirements of
banks, generally applicable to other customers of the bank. Accordingly, the
following facilitation has been allowed in the regulation for SME financing:
i. Small loan applicants are not required to submit audited accounts, as in
the case of all other routine customers. Rather, a cash flow statement
signed by the borrower is used as a basic document for evaluation and
further verification of the loan application.
ii. Loans up to certain limits (Rs 5 million) may also be allowed to such
SMEs which cannot provide security, but are otherwise eligible for
credit facilities. Loans to such borrowers (called clean facilities) are
allowed against the personal guarantee.
iii. The regulations make it binding for the banks to process loan
applications within a period (15 working days for small firms).

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 iv. In specialized credit, defaults and delays can happen more frequently
than in routine banking. The regulations, therefore, provide more
breathing space to banks while handling bad debts or booking losses
against SME advances. Relaxations are allowed in case of rescheduling
of loans (due to delay in repayments) and restructuring (in case of
default by the borrower). The purpose of such facilitation is to help
SMEs run their businesses by providing more time for repayments.

9.2.3 Security of Loan Required from SMEs under the Regulation

Prudential Regulations provide guidelines to banks for seeking securities against
SME loans and also set maximum limits for unsecured (or clean loans) in case the
borrower is unable to provide physical assets as security.
Regulation SME R-4 sets a limit on the clean facility of up to Rs 5 million by SME
(solely against personal guarantees) from a bank or all banks. Banks will first
ensure that the firm/applicant falls within the SME definition and meets the criteria
of loan eligibility as required by the bank's policy and SBP PRs. The bank will also
obtain information that the person is not in default of a loan from any other bank.

Other securities acceptable to banks may comprise of as follows:

i. Liquid assets, such as bonds, treasury Bills etc.
ii. Personal guarantee of any person not in default of any bank loan, supported
by a declaration of his/her assets
iii. Mortgage of land or building
iv. Pledge of Raw material or finished goods stock. (Pledge means creating and
documenting rights of the bank on the stocks of the borrower, while
physically the stock remains at the SME premises.)

9.3 Agricultural Finance

Like the SME sector, Agriculture finance is also considered specialized banking.
Agriculture is the backbone of Pakistan's economy. With the rural sector
comprising over 68% of the country's population, special attention has been given
to the agricultural sector and rural finance in the banking service network.

Following are some of the key initiatives of the government in this regard:
1. Specialized Commercial Bank for Agriculture Development (Zarai Taraqaiti
Bank)

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2. Specific policies of the State Bank of Pakistan, whereby commercial banks
are required to allocate special credit schemes for crops, procurement of
agricultural inputs, equipment, fertilizers, horticulture development etc.
3. Channelizing bank finance to farmers against the security of small holdings
of agricultural land under a convenient system of pass-book entry

9.3.1 Specific Credit Facilities for Agriculture

In the following section, various forms of credit facilities and services offered by
commercial banks to farmers and agriculturists, countrywide, are elaborated:
a) Unsecured Loan limit: For the convenience of farmers, who cannot provide
security against loans, banks are allowed to extend unsecured (clean limit)
loans of a maximum of Rs 1.0 million to such farmers, against the personal
guarantee. Over and above this limit, banks may extend credit to farmers as
secured loans.
b) Farm Credit, which includes: Loans for the purchase of inputs like seeds,
fertilizers, pesticides, etc. This is a short-term loan (usually less than one
year), which is due for repayment upon crop harvesting. This may be part of
the 'clean limit' or against security.
c) Farm Development Finance is a medium to long-term loan extended by the
banks/DFIs for different types of improvements/ developmental work at the
farm including:
i. construction of godowns,
ii. development of orchards, nurseries, etc.
Farmers can avail of such loans from banks against the security of a passbook,
or mortgage of a godown building. Terms and conditions of the loans are set
in terms of the policy of the banks based on the duration of the development/
construction phase and business cycle.
d) Term Finance for Machinery/ Equipment: This is a secured loan and is issued
by the banks/DFIs for the purchase of machinery and equipment to be used
for agriculture like tractors, threshers, reapers/ harvesters, tube wells, etc.
These could carry a term of 2-3 years.
e) The bank also issues Credit/Debit Card services, where cardholders are
facilitated to purchase agricultural inputs/ machinery under agri. financing
schemes and draw money through these cards.

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f) Letter of Guarantee & Letter of Credit etc. for procurement/import of
agricultural supplies. These letters are issued to respective suppliers as a
Bank's commitment to timely payment by the customers/farmers.
g) Non-farm credit and financing for livestock: Include financing for fisheries and
livestock goat/sheep farming, breeding of animals, dairy, and poultry business.
The loan term depends on the cash flow cycle of the respective business.
h) Finance for horticultural development: The horticulture business involves a
wide range of machinery and materials and banks are encouraged to extend
finances for new and existing ventures, which may extend to:
i. Purchase of horticulture equipment, pulp extraction, storage, transportation
etc.
ii. New land development for fruit production and development of flowering
farms, ornamental products
iii. Installation of structures involved in Tunnel & Green House Technology
and equipment for modern irrigation systems
iv. Scientific System of commodity-specific cold storage
v. Seeds, and rootstock etc.

The repayment cycle of such loans could be fixed for a 1-5-year period, depending
upon the business cycle.

9.3.2 Security of Agricultural Loans, Acceptable to Banks

Bank loans for agriculture or any other business are issued against certain securities
acceptable to banks. Prudential Regulations of the State Bank of Pakistan also spell
out criteria for obtaining security against the disbursement of loans (whether for
agriculture or any other bank credit). In the case of agricultural loaning, Banks are
advised to link such security to the specific assets that farmers utilize to carry out
farming or their agriculture business. Security of agriculture credit therefore may
include the following:
 Mortgage of rural agricultural land by an entry in the passbook record.

 Mortgage of building and equipment in case of Farm Development Finance

or Term Finances

 For financing tractors, trucks and movable assets, banks can retain title
documents and lines/charges on the assets and re-possess the same in case of
default.

 For fisheries or live-stock financing, banks can also add the value of live-
stock in the security in addition to security created in the passbook.

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Definitions:
Agriculture Pass Book
This means a document which confirms land ownership of the farmers and is
issued by the concerned official from Revenue Records of the Provincial
Governments/District/City Governments. It contains all revenue records and gives
ownership of land with address and value, the exact location of the land, (Khewat,
Khatooni & Khasra Number), Loan obtained/repaid etc. Passbook is accepted at
banks for marking security against agricultural loans.

Mortgage: This term refers to recording/registering a bank's right on an asset as

security of a loan extended by the bank to the holder of this asset. The bank's right
or lien is recorded by:
– Writing and signing a mortgage deed by the borrower or entry into Passbook,
and/or physical deposit of title deed/documents.

9.3.3 Prudential Regulations and Relaxation in Agriculture Loans

under Natural Calamities
Agriculture production is often subjected to natural factors like, swear weather
conditions, droughts, floods and other natural calamities. The farmers, particularly
those with weaker financial resources are the most affected and their livelihood
could be affected due to such factors. Banks, therefore, used to consider agri-credit
as a more risky business when natural factors render the farmers unable to repay
the loans.

However, after the formulation of special regulations on Agriculture Finance, these

factors have been addressed so that commercial banks may feel comfortable
initiating Agri-financing through their branch networks. To provide guidelines and
to provide facilitation to banks and financial institutions in this area, the State Bank
of Pakistan has issued specific Regulations for Agricultural Financing.

These regulations are available on the SBP website. There are specific provisions
which instruct banks to allow special relaxation in case of default by farmers due
to reasons, which are not in their control (e.g. overall crash of crop prices, or natural
calamities).

The regulations allow certain facilitation for agri-credit, both to banks and the
farmers.

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Some of the examples from these regulations are:
o For the convenience of farmers, who cannot provide security against bank
loans, banks are allowed to extend unsecured (clean limit) loans of a
maximum of Rs 1.0 million to such farmers, against the personal guarantee.
This would be subject to the satisfaction of banks that the borrower is not in
default of any loan from banks/financial institutions.
o Maximum loan amount to one party is linked to the valuation of security
provided by the borrower after adjustment by a margin, along with need
assessment and repayment capacity of the borrower, determined by the bank
o Relaxation in repayment: Banks/DFIs are allowed to grant relaxation up to
one year in the repayment schedule, to their (agriculture) borrowers who have
been adversely affected due to certain unforeseen and unexpected factors like
weather, availability of water, etc. which are not under the control of the
farmers. Such relaxation may be granted on a case-to-case basis or en-block
to the borrowers in the affected area.
o INSURANCE: The banks/DFIs would ensure that the tractors, or moving
machinery financed by them remain insured at all times during the tenure of
the loan. Banks/DFIs are also encouraged to arrange insurance for all other
machinery and equipment financed by them to protect their interest.

9.3.4 Specialized Bank for Agriculture

Zarai Taraqiati Bank Limited is a specialized financial institution for the
development of the agriculture sector and provides banking services and technical
support to the farming sector. This is a government-sector bank and is designated
as a specialized commercial bank. The bank is therefore dedicated to serving the
needs of agriculture in a focused way.

ZTBL is a key institution providing agriculture financial/technical services to rural

Pakistan, comprising 68 % of the total population.

The Bank through a country-wide network of 488 branches is serving around half
a million clients annually. The Bank accepts deposits as well as extends small or
large value loans passbook/other permissible modes of security, as per Prudential
Regulations for Agriculture Finance.

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9.4 Self-Assessment Questions
a) Short Questions
i) What are the maximum limits in Prudential Regulations for bank loans
to Small enterprises and Medium Enterprises.?
ii) Define Passbook and mortgage in the context of Agriculture finance
iii) Name a few relaxations provided to farmers under Prudential Regulations
for Agriculture finance

b) Long Questions
i) Describe various types of credit facilities that SMEs may avail from banks
ii) Write about at least two specific credit facilities that farmers may for
the development of their farms/ businesses. Also, provide details of
security acceptable to banks against such loans.

c) Exercise
Students are encouraged to go through the website of the Annual Report of
Zarai Taraqati Bank Limited and study its Mission Statements, Objectives and
Directors Report.

Write about the objectives of the specialized commercial bank (i.e. ZTBL)

Evaluate special banking facilities offered by ZTBL to the farming

community and give your views about the role of ZTBL in promoting
Agriculture Finance.

9.5 Summary
This Unit has discussed special categories of banks' lending operations, i.e. SME
lending and Agriculture Finance. Given their key role in the economic development
of the country, these sectors are receiving focused attention, both from the banks as
well as government policymakers. In this Unit, the students have learnt basic
definitions, followed by a review of key policy initiatives of the authorities aimed
at financial inclusion and growth of such specialized sectors.

Small and Medium enterprises, due to their limited size and financial scope, had to
face certain constraints in accessing the banking facilities, which otherwise are
available in routine to other business sectors. Considering these constraints, suitable
policies and banking operations have been formulated to facilitate SMEs to fully
benefit from banking credit and allied facilities. This Unit has elaborated on these

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initiatives and their significance in achieving business sustainability for small or
medium-sized business entities. The permissible modes of advances and security
of loans, (considering SME-specific needs) along with operational requirements
have been deliberated in detail. Various measures of credit facilitation advised by
the regulator and specific Prudential Regulations for SME financing have also been
referred to, where needed.

Agriculture is another priority area, where banking outreach is being expanded for
mainstreaming the rural economy. The rural population comprises two-thirds of the
total population of the country. Lack of physical infrastructure had kept the
Agriculture sector mostly under-banked in the past. However, in compliance with
the specialized policy guidelines of the regulator (State Bank of Pakistan) and given
good prospects of business growth, the banks have now set up separate Agri-credit
operations for extending credit and allied facilities to the agriculture sector.
Against the above backdrop, this unit has highlighted special category lending
operations and described various modes of farm credit, short-term and unsecured
credit long-term development financing etc. Specific regulatory guidelines,
facilitations, loan limits and modes of security against specialized lending have also
been explained, in light of Prudential Regulations for Agriculture Finance, for
better comprehension of the readers.

Zarai Taraqaiti Bank is a dedicated specialized bank for agriculture development.

A brief introduction to this institution has also been included in the Unit. Students
are also encouraged to explore more information under the 'Further Reading'
windows (two such windows sections 9.1 and 9.3). By going through the websites
of Zarai Taraqaiti Bank, State Bank of Pakistan and SMEDA, readers may advance
their knowledge on the latest developments or amendments to the rules and
emerging banking services for specialized lending.

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 REFERENCES

Natural Resources and Economic Development in Pakistan.

Dr Badshah Sardar, Department of Pakistan Studies Allama Iqbal Open University

Islamabad (2019 Islamabad).

[Link]

[Link]

[Link]

[Link]

[Link]

For generic definitions/circulars, references from the following websites are included:

[Link]

[Link]

[Link]

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