Commercial Banking

COMMERCIAL BANKING
“CAPITAL RISK MANAGEMENT”
ASKARI BANK AND BANK ALFALAH

BAHRIA UNIVERSITY ISLAMABAD CAMPUS
Submitted To:

Submitted By:

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

Bank Al-Falah   Mr. Zeeshan Tanveer
Mr. Zia Hanfi

i

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

ii

TABLE OF FIGURES

Figure 1 Risk Management Framework ........................................................................................................ i Figure 2: Components of Regulatory Capital of ABL ............................................................................... ii Figure 3 Capital Adequacy Ratio .................................................................................................................... iii Figure 4 Credit Risk Exposure ........................................................................................................................ iv Figure 5 Loan Classification And Provisioning ......................................................................................... iv

iii

INTRODUCTION
A commercial bank acts an intermediary between surplus units (entities having excess of fund) and deficit units (entities in need of funds). The essentiality of a commercial bank for a country cannot be described enough as it plays various roles, for instance it also plays an important role in enhancing economic conditions of the country by allowing people to engage in various economic activities using borrowed funds. Banks are a fundamental component of the financial system, and are also active players in financial markets. Therefore it is important to ensure safety and soundness of financial system of the country by putting up parameters for banks. Capital risk is closely tied to the asset quality and a bank's overall risk profile. Banks and financial institutions are faced with long-term future uncertainties, which they intend to account for. It is in this context that the Basel Accords were created, aiming to enhance the risk management functions of banks and financial institutions. Basel II provides directives on the regulatory minimum amount of capital that banks should hold against their risks, such as credit risk, market risk, operational risk and others. Basically, capital provides a cushion for banks to absorb losses and also provides ready access to financial markets, guards against liquidity problems. The more risk taken, the greater is the amount of capital required. To hold more capital means forcing banks to have more of their own funds at risk. Even a bank's dividend policy affects its capital risk by influencing retained earnings. So managing the capital risk through different techniques is the important concern of the bank. Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

Page | 1

Financial stability exists when the financial system is resilient to a wide range of economic and financial shocks, and able to absorb financial crisis losses with least disruption. It cannot be emphasized enough that the soundness and efficiency of banks to manage various risk including the capital risk which is important as it matters a lot for financial stability. Therefore, in Pakistan, Basel Accords recommendations are enforced by State Bank of Pakistan in their guidelines that are provided to the banking industry so that commercial banks can tailor their operations accordingly. We can see that this system is effective in many ways. The purpose of this project is to see implementation of Basel II in form of SBP regulations in commercial banks and see how it effectively manages its capital by mitigating the risks associated with all bank businesses with special emphasis on credit risk. We have chosen two banks that are successfully working with risk management framework as prescribed by SBP: Askari Bank Limited and Bank Al-Falah. We will look into their capital management techniques with thorough study of their credit risk mitigation.

Page | 2

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

Page | 3

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

1

http://www.sbp.org.pk/riskmgm.pdf Date Visited: May 25th, 2010

Page | 4

The risks to which a bank is particularly exposed in its operations are: liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and risk from change in market price of securities, financial derivatives and commodities), exposure risks, investment risks, risks relating to the country of origin of the entity to which a bank is exposed, operational risk, legal risk, reputational risk and strategic risk.2 NEED OF BASEL 1 From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States. Bank failures were particularly prominent during the '80s, a time which is usually referred to as the "savings and loan crisis". Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate. As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security. In order to prevent this risk, the Basel Committee on Banking Supervision, comprised of central banks and supervisory authorities of 10 countries, met in 1987 in Basel, Switzerland. The Basel Committee consists of representatives from central banks and regulatory authorities of the Group of Ten countries, plus others (specifically Luxembourg and Spain). The committee does not have the authority to enforce recommendations, although most member countries (and others) tend to implement the Committee's policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee's recommendations - thus some time may pass between recommendations and implementation as law at the national level.3 The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold. This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and should be implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the banking industry as it enters the Basel II phase. The Purpose of Basel I In 1988, the Basel I Capital Accord was created. The general purpose was to: 1. Strengthen the stability of international banking system.

2

http://www.nbs.rs/export/internet/english/55/55_6/index.html Date Visited: May 25th, 2010 3 http://en.wikipedia.org/wiki/Basel_Accords Date Visited: May 27th, 2010

Page | 5

2. Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. The basic achievement of Basel I have been to define bank capital and the so-called bank capital ratio. In order to set up a minimum risk-based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. Indeed, before this international agreement, there was no single definition of bank capital. The first step of the agreement was thus to define it. Two-Tiered Capital Basel I define capital based on two tiers: 1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holder’s equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. 2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). In 1996 the Basel I agreement was revised to incorporate market risk. As a result, the new definition of capital ratio is defined as: Market risk includes general market risk and specific risk. The general market risk refers to changes in the market values due to large market movements. Specific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. There are four types of economic variables that generate market risk. These are interest rates, foreign exchanges, equities and commodities. The market risk can be calculated in two different manners: either with the standardized Basel model or with internal value at risk (VAR) models of the banks. These internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for the total capital, which includes short-term unsecured debts. This is at the discretion of the central banks. Pitfalls of Basel I Basel I Capital Accord has been criticized on several grounds. The main criticisms include the following:  Limited differentiation of credit risk There are four broad risk weightings (0%, 20%, 50% and 100%), as shown in Figure1, based on an 8% minimum capital ratio. Static measure of default risk
Page | 6









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

BASEL II Basel Committee on Banking Supervision (BCBS) finalized the New Capital Adequacy framework commonly known as Basel II in June 2004. This new capital adequacy regime offers a comprehensive and more risk sensitive capital allocation methodology for major risk categories. Basel II framework comprises of three parts referred to as three pillars of the Accord; Pillar I, which is about minimum capital requirement, prescribes the capital allocation methodology against credit and operational risks. The capital requirement for Market risk remains the same as envisaged under Basel I in 1996. The risks, which are not captured under pillar I, are covered in pillar II. Pillar II of the New Accord outlines the supervisory review process of the capital adequacy of banks. It requires banks to establish a robust risk management framework to identify, assess and manage major risks inherent in the institution and allocate adequate capital against those risks. The supervisor has to review the adequacy of risk management function and capital allocation mechanism against major risks including those that are not covered under pillar I i.e. Liquidity Risk, Concentration risk, Interest rate Risk in Banking Book etc. and ensures it commensurate with the size and nature of business of the institution. The pillar 3 of the Accord sets out disclosure requirement depending upon which particular approach of Pillar I the
4

http://www.investopedia.com/articles/07/BaselCapitalAccord.asp Date Visited: May 25th, 2010

Page | 7

institutions adopt for calculating Minimum Capital Requirement. The New Capital Accord is not mandatory even for the member countries of the BCBS. However, there is consensus among member countries to adopt Basel II standardized approach by the end of 2006 and advance approaches by 2007. Among Non Member countries Basel II is expected to be adopted by most of the economies in 2008 or later on. Why Basel II? The Basel I had a number of flaws. For instance, it provided “one size fit all” approach and did not differentiate between assets having less risk and assets having higher risk. There was no capital allocation against operational risk as well as no consideration was given to other risks such as concentration risk, liquidity risk etc. The new accord has risk management embedded in it; so it will be a driving force for bringing improvement in risk management capabilities of banks. Basel II provides incentive to banks having good risk management and punishes those that are not managing their risk profile appropriately by requiring higher capital. On the basis of foregoing and keeping in view the global response towards Basel II, SBP has, in principle, decided to adopt Basel II in Pakistan. The ensuing pages outline a proposed Roadmap for the implementation of Basel II in Pakistan. While preparing this Roadmap, the State Bank has conducted a survey to assess the existing capacity of the banks and their financial position to meet additional capital requirement. The plans of other countries for adoption of Basel II have also been reviewed. Efforts have been made to draw a realistic timeline so as to give banks sufficient time to prepare themselves for meeting the requirement of Basel II.5 TRADITIONAL METHOD TO CREDIT RISK MANAGEMENT TRADITIONAL APPROACH: It is hard to differentiate between the traditional approach and the new approaches since many of the ideas of traditional models are used in the new models. The traditional approach is comprised of four classes of models  Expert Systems In the expert system, the credit decision is left in the hands of the branch lending officer. His expertise, judgment, and weighting of certain factors are the most important determinants in the decision to grant loans. the loan officer can examine as many points as
5

www.sbp.org.pk/bsd/2005/C3_ROADMAP-Basel.pdf Date Visited: May 17th, 2010

Page | 8

possible but must include the five “Cs” these are; character, credibility, capital, collateral and cycle (economic conditions) in addition to the 5 Cs, an expert may also take into consideration the interest rate.  Artificial Neural Networks Due to the time consuming nature and error- prone nature of the computerized expertise system, many systems use induction to infer the human expert’s decision process. The artificial neural networks have been proposed as solutions to the problems of the expert system. This system simulates the human learning process. It learns the nature of the relationship between inputs and outputs by repeatedly sampling input/output information.  Internal Rating at Banks Over the years, banks have subdivided the pass/performing rating category, for example at each time, there is always a probability that some pass or performing loans will go into default, and that reserves should be held against such loans.  Credit Scoring Systems A credit score is a number that is based on a statistical analysis of a borrower’s credit 1report, and is used to represent the creditworthiness of that person. A credit score is primarily based on credit report information. Lenders, such as banks use credit scores to evaluate the potential risk posed by giving loans to consumers and to mitigate losses due to bad debt. Using credit scores, financial institutions determine who are the most qualified for a loan, at what rate of interest, and to what credit limits (Wikipedia, 2008). 6 Contingency planning: Institutions should have a mechanism to identify stress situations ahead of time and plans to deal with such unusual situations in a timely and effective manner. Stress situations to which this principle applies include all risks of all types. For instance contingency planning activities include disaster recovery planning, public relations damage control, litigation strategy, responding to regulatory criticism etc.

6

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

Page | 9

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

SECONDARY RESEARCH   Internet News Articles

PRIMARY RESEARCH  Interview with Bank Managers.

ASKARI BANK INTERVIEW WITH KHALIL CHUADHRY

BANK ALFALAH INTERVIEW WITH ZEESHAN TANVEER

Page | 10

FINDINGS
ASKARI BANK
Askari Bank Limited takes pride in being one of the commercial banks in Pakistan that is effectively managing risk through an efficient risk management framework. The Bank strives to “to effectively manage and mitigate all kinds of risks inherent in the banking business.” (Risk management framework can be referred in Annexure; figure 1) According to the Annual Report of 2009, Askari Bank enjoys the entity rating: Long term: AA Short term: A1+ RISK MANAGEMENT The Bank has provided an overview of their risk management in their annual report. Risk Management is a core function at the Bank that performs critical activities of measuring, monitoring, controlling and reporting credit, market, liquidity, operational and other risks. The risk management framework of the Bank covers (i) risk policies and limits structure, (ii) risk infrastructure and (iii) risk measurement methodologies. In the Annual Report of 2009, the Bank outlines its Capital Risk management as follows: CAPITAL ADEQUACY Scope of Applications Standardized Approach is used for calculating the Capital Adequacy for Market and Credit risk while Basic Indicator Approach (BIA) is used for Operational Risk Capital Adequacy purpose. The Bank has two subsidiaries, Askari Investment Management Limited (AIML) and Askari Securities Limited (ASL). AIML is the wholly-owned subsidiary of Askari Bank Limited while ASL is 74% owned by the Bank. Both these entities are included while calculating Capital Adequacy for the Bank using full consolidation method. The fact that Askari Bank has neither any significant minority investments in banking, securities, or any other financial entities nor does it has any majority or significant minority equity holding in insurance excludes it from a need for further consolidation. Furthermore, the Bank does not indulge in any securitization activity that shields it from the risk inherent in securitization. The risk-weighted assets are determined according to specified requirements of the State Bank of Pakistan that seek to reflect the varying levels of risk attached to on-balance sheet
Page | 11

and off-balance sheet exposures. The total risk-weighted exposures comprise the credit risk, market risk and operational risk. Types of Exposures and ECAIs used For domestic claims, ECAIs recommended by the State Bank of Pakistan (SBP), namely Pakistan Credit Rating Agency Limited (PACRA) and JCR-VIS Credit Rating Company Limited (JCR-VIS) were used. For foreign currency claims on sovereigns, risk weights were assigned on the basis of the credit ratings assigned by Moody’s. For claims on foreign entities, rating of S&P, Moody’s, and Fitch Ratings were used. Foreign exposures not rated by any of the aforementioned rating agencies were categorized as unrated. Type of exposures for which each agency is used in the year ended 2009 is presented below

Capital adequacy ratio as at December 31, 2009 The capital to risk weighted assets ratio, calculated in accordance with the State Bank of Pakistan’s guidelines on capital adequacy, using Basel II standardized approaches for credit and market risks and basic indicator approach for operational risk is presented in Figure 2 & 3 in Annexure.7 HIERARCHY OF RMD AT ABL
Country Head

Market Risk Management Department (“MRMD”)

Operational Risk Management (ORM)

Post Facto Review

Basel Implementation

Policy

Credit Risk

7

http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf Accessed on: June 05, 2010

Page | 12

Market Risk Management Department: This department develops and implements the market risk policy and risk measuring / monitoring methodology, and reviews and reports market risk against regulatory and internal limits. Basically this department deals with risk related to bank’s investments for e.g. treasury bills, preference shares etc. Operational Risk Management (ORM) Department: it has been established to increase the efficiency and effectiveness of the Bank’s resources, minimize losses and utilize opportunities. This department deals with risk related to bank’s day to day operations such as Account Opening, Fraud cases etc. Credit Risk Department is further divided into two departments.  Post Facto Review  Basel Implementation. The role of the subdivisions will be discussed later in detail as they are main scope of project. Policy Department: it is responsible for formulation of policies in light of all the bank business risks prevailing. These policies are made in discussion and results are communicated to Country Head for approval. Once the policies have been approved, these are communicated across the respective Departments. ROLE OF POST FACTO REVIEW & BASEL IMPLEMENTATION DIVISIONS Basel Implementation Division During the Interviews, this is how the credit risk department views the significance and effectiveness of Basel Accord II: In earlier times, banks were lending on the basis of deposits: lending ratio, meaning the banks’ lending decision and calculations were based on its deposit base. Bank of International Settlements (BIS) took the initiative of making lending activities more sophisticated with more emphasis on risk mitigation in terms of credit risk; this led to the formulation of Basel Accords. Basel Accord II is a more conservative method to mitigate credit risk which requires banks to keep check on credit, operational and market risk to manage its capital. Basel Accord II restricts the risk to be born by depositors to minimum level arising from the banks’ lending activities. It requires banks to share risk by injecting its own capital when investing in riskier assets in form of loans and advances. The type of capital being maintained at Askari Bank Limited is regulatory capital, and as the name implies, it is regulated by the Central Bank (SBP). The Bank is required to quantify risk weighted assets and set aside capital according to the risk bank undertakes.
Page | 13

Basel Implementation Division is responsible for:  Implementation of Basel Accords, mainly Basel Accord II in lending activities, and  Calculations of Capital Adequacy Ratio based on guidelines of SBP. When the department receives the report for loan request, the first step is to categorize it in any one of the following:  Retail portfolio  Mortgage  Corporate  Public/ sector enterprise (PSE)  Government  Past due exposure The treatment of each category is uniquely designed by the Bank under the SBP guideline. The department then checks the collateral. A few examples of the collateral taken by the bank as specified by the SBP are:  Cash margins or deposit  Gold reserves  Government securities The bank then calculates the Risk Weighted Assets= Exposure – Eligible Collateral. By clubbing all these risk weighted assets, the department calculates the capital it needs to set aside. The Credit Risk exposure of 2009 is in figure 3: Capital Adequacy Ratio is calculated by Standardized method= Total Regulatory Capital/ RWAs Post Facto Review Division This division is responsible for monitory of the loans disbursed. They use different models to analyze the performance of loans. The models conduct quantitative analysis by checking profits, trend analysis of Cash Flows and so, as well as qualitative analysis by checking management practices and performance. The bank gives more weight age to qualitative measures as it provides an insight into the character of entity, for e.g., does the borrower intend to repay the loan. The Post Facto Reviews for borrowers are done after regular intervals to know about the current position. Based on the results of various analyses, the division raises alarm if it cites problems in the loan performance, and future course of action with the customer is planned. For example, Bank is now restricting its credit facilities to Textile sector to rare cases, since it has been moved from low risk to high risk due to greater no. of NPLs arising
Page | 14

from recent events like strikes, decline in textile performance, fluctuating government policies etc. PROBLEMS FOR CREDIT RISK MITIGATION EXTERNAL FACTORS According to Askari Bank, different environmental factors have a direct while some have indirect impact on credit risk for bank:  Fluctuating Government policies: fluctuations in government policies hit many sectors badly, rendering them incapable to repay loans, leading to increase in NPLs.  Energy Crisis: this has led to deterioration in performance of many one-time leading and favorable entities to provide credit like Textile Sector.  Inflation: burden of individuals/ corporations etc. increase, they are likely to default.  Unemployment: downsizing, limited job opportunities and so leads to inability to pay off loans. PROBLEMS FOR CREDIT RISK MITIGATION DUE TO INTERNAL FACTORS As Askari Bank has a decentralized system, problem often arises from Management Information System to gather data from all sources that leads to problems in calculating CAR. It may happen that information from some departments maybe delayed, or reports may have flaws; data collection and processing of bulk of data takes time, and bank often faces time constraint in submitting the Capital Adequacy return report required by SBP at required time due to these factors. ASKARI BANK’S PRACTICE CLASSIFICATION AND PROVISIONING This is done as per the type of facility and according to SBP’s regulation. For example, if bank has lent credit for auto loans, according to SBP guidelines the loan shall be classified and provisioning shall be made according to Figure 4 in Annexure. IMPROVEMENTS IN ASKARI BANK’S CAPITAL ADEQUACY RATIO MEASUREMENT Askari Bank has embarked upon a major initiative of overhauling its technology infrastructure with the aim of upgrading business and operational capabilities while improving quality of customer service. For this purpose, five new software application products have been acquired and are currently in different stages of implementation. One of these includes a Risk Management System. The bank is in process of implementing IFLEX “Reveleus”, risk management software of Oracle financial Services Solution, having the ability to generate live Capital Adequacy Ratio and at day end generate report.
Page | 15

The key features of this product include:  Pre-configured reports covering Pillar I and Pillar II reporting  Enables tabular as well as graphical reporting  Drill-through functionality allows for detailed analysis  Risk measures and capital numbers displayed as point in- time values, trends, heat maps, distributions etc.  Metrics displayed across multiple levels and risk categories8

8

http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf http://www.oracle.com/us/industries/financial-services/046223.pdf Date Visited: June 7th, 2010

Page | 16

BANK ALFALAH
Bank Alfalah manages the capital as to safeguard its ability to absorb large unexpected losses and to protect depositors and other claim holders. It is the policy of the bank to maintain a strong capital base so as to maintain investor, creditor, and market confidence and to sustain future development of the business. PACRA, a premier rating agency of the country, has rated the bank ‘AA’ (double A), Entity Rating for long term and A1+ (A one plus) for the short term. GOALS OF MANAGING CAPITAL The goals of managing capital of the Bank are as follows:  To be an appropriately capitalized institution, considering the requirements set by the regulators of the banking markets where the Bank operates  Maintain strong ratings and to protect the Bank against unexpected events  Availability of adequate capital at a reasonable cost so as to enable the Bank to operate adequately. RISK MANAGEMENT Bank Alfalah has in place an approved integrated risk management framework for managing credit risk, market risk, liquidity risk and operational risk under risk management policy and risk management and internal control manual according to SBP prescription. In it, the risk awareness culture is being encouraged by communicating the principles of proper risk management to all bank employees. Following is the governance structure and important policies on risk management of the bank  The board of directors through sub committee called board risk management committee (BRMC) oversees the overall risk of bank Risk Management Division (RMD) is the organizational arm performing the functions of identifying measuring monitoring and controlling the various risks and assists other various sub committees in conversion of polices into action. As part of its mandate the central management committee is entrusted with overseeing the operational risk of the bank.





Page | 17



After reviewing the Basel II, the bank has exclusively pursued the implementation of Basel II with the help of external consultants and has compiled with all pillars requirements of Basel II. In the light of SBP circulars and guidelines, significant progress has also been made in respect of advance approaches of Basel II. The bank has acquired temenos T24 banking system as its core banking solutions and its risk management system called T-Risk used for managing credit market and operational risk. A watch list procedure is also functioning which identifies loans showing early warning signals of becoming non-performing.







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

Page | 18

Standardized Approach VS Internal Rating Based Bank Alfalah uses both approaches. Standardized Approach The bank, as per State Bank of Pakistan’s guideline, has migrated to Basel II as on January 01, 2008, with Standardized Approach. So for the purpose of estimating credit risk weighted assets, the Bank Alfalah limited is using standard approach of SBP Basel II accord.  Under the standardized approach, they determined the risk weights by the category of borrower with risk weights based on the external credit ratings (with un-rated credits assigned to the 100% risk bucket). Those external credit assessment agencies (ECAI’s) should be authentic and should be those as prescribed by the State Bank of Pakistan. Namely PACRA, JCR-VIS, Moodys, Fitch and Standard & Poors. For exposures with maturity of less than or equal to one year, short term rating given by approved rating agencies id used where as for long term exposure with maturity of greater than one year, long term rating is used. Where there are two ratings available, the lower is considered and where there are three or more ratings, the second lowest rating is considered.







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

Internal Rating Based A sophisticated Internal Credit Rating System has been developed by the bank which is capable of measuring counter party risk in accordance with best practices. The system takes into consideration qualitative and quantitative factors of the counter party and generates an internal rating of that counter party. The system has been statistically tested, validated and checked for compliance with the State Bank of Pakistan’s guidelines for Internal Credit Rating. The system is backed by secured database with back up support and
Page | 19

is capable of generating MIS report providing snapshot of the entire portfolio for decision making. This system supports the Internal Rating Based Approach. Under the Internal Rating System, the bank is allowed to monitor risk of counterparties against different grade/scores ranging from 1-12 (1 being best and 10-12 for defaulters. Different variables have been identified according to which scores are marked. Like business operation, history, legal entity, market reputation etc. They have introduced the Internal Rating Based, because of two reasons  Bank Alfalah lends money to the individual, SME, commercial and corporate firms. It ranges from small to big firms therefore bank is of the view that not all of the firms or individuals can get rated from external credit rating agencies as they are very expensive. Moreover, they can’t rely only on the external credit rating agencies.



Collateral The bank defines the collateral as the assets or right provided to the bank by the borrower or a third party in order to secure a credit facility. Alfalah Bank reduces its exposure under the particular transaction by taking into account the risk mitigating effect of the collateral.    . Adjustment of Collateral Comprehensive Approach As stipulated in the SBP Basel II guidelines, the bank uses the comprehensive approach for collateral valuation. Under this approach, the bank reduces its credit exposure to counterparty when calculating its capital requirements to the extent of risk mitigation provided by the eligible collateral as specified in the Basel II guidelines. In line with Basel II guidelines, the bank makes adjustment in eligible collaterals received for possible future fluctuations in the value of the collateral. These adjustments are also referred to as haircuts. Value of collateral should be higher than the loan amount. Generally amount of loan that Bank Alfalah lends should not exceed the 60% of the value of the collateral. Collateral is revalued at least every three or six months.

Page | 20

For example Bank Alfalah lends Rs 40 million to a particular counterparty, which is secured by collateral worth Rs 30 million. Rating of the counter part is B+ where as the collateral consists of securities issued by an A-rated company. So, the risk weight for the counterparty is 150% and the risk weight for the collateral is 50%. Under the Comprehensive Approach: Assume that the adjustment to exposure to allow for possible future increases in the exposure is +10% and the adjustment to the collateral to allow for possible future decreases in its value is -15%. The new exposure is: 1.1 X 40 -0.85 X 30 = 18.5 million A risk weight of 150% is applied to this exposure: Risk-adjusted assets = 18.5 X 1.5 = Rs. 27.75 M Types of Collateral The decision on the type and quantum of collateral for each transaction is taken by the Credit Approving Authority as per the credit approving authorization approved by the Board of Directors. Collateral used include: government of Pakistan guarantees, gold, cash, shares, government securities, all that fall in eligible collateral. Bank Alfalah limited determines the appropriate collateral for each facility based on the type of product and counter party.   In case of corporate and SME financing, fixed assets are generally taken as security for longer tenor loans and current assets for working capital finance. For project finance, security of the assets of the borrower and assignment of the underlying project contracts is generally obtained. Additional securities such as pledge of shares, cash collateral etc may also be taken. Bank Alfalah markup for shares is 35- 50% and for cash and all A category securities is 10%. Moreover in order to cover the entire exposure Personal Guarantee of Directors is also obtained by the bank. For retail products the security to be taken is defined by the product policy for the respective products. Housing loans and automobile loans are secured by the security of the property being financed. The valuation of the properties is carried out by an approved valuation agency. Here the Bank Alfalah markup for property is 40%.

  

Page | 21

Bank alfalah usually avoid litigation, therefore if the client hasn’t payback the credit then leverage of 3-6months is given, and they check on it. Proactive credit risk management practices in the form of studies, research work, internal rating system, integrated bank-wide risk management and internal control framework, adherence to Basel II accord, portfolio monitoring are only some of the prudent measures the bank is engaged in for mitigating risk exposures.

Page | 22

RECOMMENDATIONS

ASKARI BANK
 Askari Bank at present requires the entities from smallest (individual) to largest (MNC) to get ratings from external rating agencies. However, it may be losing customers for loans as they may not afford the cost of valuation and documentation. Askari bank does offer services at charge, therefore burden remains on entities. Askari Bank should form policies to give relaxation to entities for loan process. The Bank should make an organization wide networking with a central database, where information from all the departments from bank is available and can be used for risk mitigation purposes whenever needed. It will save time. Askari Bank can initiate the process of implementing IRB, despite the time, cost and efforts involved. This would allow the Bank to keep aside capital as close to the risk it is taking with the exposures. The bank should implement VAR system for Credit Risk Mitigation as well, as it is being used for Market Risk management. Basel II is shifting its focus from regulatory capital to economic capital. Economic capital requires banks to set aside capital based on actual, expected and unexpected losses, based on historic data, the system is able to calculate the possible risk associated with sample set and it would help the bank also prepare for unexpected loss. The Bank can formulate policies to provide insurance to the entities that perform well on an average but may default for loan repayment due to unforeseen involuntary factors, such as natural disasters. This will increase bank’s customer base.









Page | 23

BANK ALFALAH
 Bank Alfalah should implement IFLEX “Reveleus”, risk management software of Oracle financial Services Solution, having the ability to generate live Capital Adequacy Ratio and its board should review at least annually its overall credit risk strategy to keep it current with the global financial trends. The credit strategy of Alfalah should also take into consideration the country’s economy as well as the shifting in composition and quality of overall credit portfolio, because of the long term nature of this credit strategy, periodical amendments should be done, if necessary. A sound risk management structure should be in place such that the structure should be in sync with the concerned bank Alfalah’s overall size, complexity and diversified activities. Alfalah Bank should not over rely on collaterals but should consider them only as a buffer that would provide protection incase of default. It should rather focus on the borrower’s debt servicing ability and reputation in the market Also Bank Alfalah should make sure that the size of its credit limit should depend on the strength of the borrower; genuine requirements of debt, economic conditions and Alfalah’s own risk tolerance, credit limits should be reviewed regularly.









Page | 24

CONCLUSION
Based on our project we can say that the banking system and in turn financial system is safe and sound due to the implementation of Basel Accord II in SBP regulation. The banks are able to prevent or limit risk to their capitals by setting aside part of their total capital risk for risk and also get deposits without depositors fearing loss due to risk from banks’ activities. We can see many of its advantages in form of:      Reduction in the level of risk bank creditors are exposed to (i.e. to protect depositors) Reduction in Systemic risk reduction, that is reduction in possibilities that may cause multiple or major bank failures Avoid misuse of banks for illegal and unethical purposes Credit allocation -- to direct credit to favored sectors Increase in the confidence of investors, local and foreigners due to effective risk mitigation framework in place.

But still bank has to keep themselves up-to-date to the new technologies and software which can make their procedures and way of managing credit risk more effective. Now Basel Committee has introduced Basel III, more concentrating on liquidity risk. Therefore banks have to focus on that too as credit risk can’t be analyzed in isolation.

Page | 25

BIBLIOGRAPHY
 Bank alfalfa Annual Report 2009 www.bankalfalah.com/about/download/AnnualReport2009.pdf Risk management guidelines by SBP www.sbp.org.pk/riskmgm.pdf Need for regulation of banking system http://en.wikipedia.org/wiki/Basel_Accords Basel II http://en.wikipedia.org/wiki/Basel_II







Page | 26

ANNEXURE

Page | 27

Figure 1 Risk Management Framework Source: http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf

Page | i

Figure 2: Components of Regulatory Capital of ABL Source: http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf

Page | ii

Figure 3 Capital Adequacy Ratio Source: http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf

Page | iii

Figure 4 Credit Risk Exposure Source: http://www.askaribank.com.pk/Reports/Askari%20Financials%202009.pdf

Figure 5 Loan Classification And Provisioning Source: http://www.sbp.org.pk/publications/prudential/PRs-Corporate.pdf

Page | iv

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

Page | v