The author declares that this research paper is original work. All the papers, reports and other material consulted during the preparation of this paper are duly acknowledged. The author understands the plagiarism policy at Lahore School of Economics and has followed good academic practices. Saba Javed Hayat
I would like to express my sincere gratitude to my supervisor; Professor Fareed. A. Fareedy who guided me at every step in writing this research paper. I truly appreciate his enduring patience, encouragement and intellectual insight during the formulation phases of this paper. His feedback for each query broadened my perspective about this research and made it a priced endeavor for me. I would also like to thank all the authors/researchers whose work has formed a foundation to this research. A sincere effort has been made to acknowledge their work wherever cited in this paper. Lastly I would like to thank my parents; Muhammad Javed Hayat and Zahida Javed, for their unequivocal support and great patience at all times. For any errors/inadequacies that may remain in this business research paper, the sole responsibility lies on me.
ABL Allied Bank Limited ALM Asset Liability Management CBG Corporate banking Group CLA Corporate Law Authorities DCMS Debt Capital Markets and Syndications Division DMU Decision Making Unit FI Financial Institution IBG Investment Banking Group MCB Muslim Commercial Bank NAV Net Asset Value OMO Open Market Operations PBC Pakistan Banking Council SBP State Bank of Pakistan T1capital Tier one capital UBL United Bank Limited YTD Year to Date
The banking industry in Pakistan has been through the inception, nationalization and post nationalization phases. During all the phases, it has been involved in managing the three core portfolios; deposit portfolio, loan portfolio and investment portfolio. The management of asset and liabilities as under ALM has become a key feature for the commercial as well as specialized banks in Pakistan. Due to global integration of financial markets and systems, the impact of mismanagement can lead to severe repercussions for the financial institution. Moreover, in this time the banks are also more prone to external financial distress than ever before. The financial system of Pakistan comprises of private commercial banks, specialized banks, public banks, foreign banks, NBFIs, leasing companies, insurance companies, securities firms and the like. The commercial banks; irrespective of their ownership structure, play a crucial role as the other channels are yet under developed and as per State Bank of Pakistan, almost 80% of money supply is held by these banks. The apex body for the banking sector is State Bank of Pakistan which sets the prudential regulations for their working. The financial system is too bank centered in Pakistan and hence the multitude of impact of activity in this sector has significant ramifications for the economy at large. In present economic condition of Pakistan, Banking industry is facing a multitude of macro factors that are causing a constriction in the core business of banks as the involuntary defaults are leading to impairment of the loan portfolio.
Electricity shortages, devaluing currency, heightened inflation and political unrest is severely impacting the business of the banks. Hence forth the banking industry is undergoing a shift in asset mix; away from loan portfolio towards investment portfolio. It can be safely stated that on the supply side, banks are taking a foot back from lending and are showing a preference to maintain higher liquidity. Moreover on the demand side, corporations are facing macro problem prevalent in economy and an uncertain business environment. According to Banking Surveillance Department at SBP, the profitability of banks has increased by 23% but it has been attributed by top five banks according to the asset structure. The increase in profitability is maintained by shift in asset mix towards quality investments primarily government t-bills and treasury bonds. It seems that banks are less eager to extend loans to the private sector and are more excited to invest in the risk free government papers in the presence of very high impairments on their existing loan portfolios. Although at present, the idea of the shift in asset portfolio mix is generating adequate income considering the macroeconomic situation prevailing in the country but it is also shifting the focus away from the development of parallel banking channels which can contribute to non funded income leading to more profitability.
The business research problem is “to evaluate the investment portfolio of United bank Limited to determine the nature of shifts in asset towards risk free government securities at the expense of lower development of alternate delivery channels and core banking functions as potential avenues of profit for the bank. ” Commercial banks in Pakistan are steering towards increasing their investment portfolio and squeezing their loan portfolios in the past few to evade the economic repercussions in local economy after the outset of financial crisis in global market in 2008 which had its contagion effect on the local financial market despite the weak linkages between the two markets. As per Moody’s Rating Agency (2012), large banks in Pakistan have around 430 percent of T1 capital as direct exposure in government bonds while the exposure in Public sector enterprises is another whopping 139 percent of T1 capital. This enlarged exposure influences their risk profile in foreign market as the banks will have to face more stringent conditions in the international markets. The core function of lending has also been neglected despite the fact that lending to private sector, as an activity, is usually able to generate higher spread due to involvement of higher risk. The foremost attention is geared towards investment in risk free securities which give a good return as the PLS account’s deposit is kept by the State Bank of Pakistan at 6%. Hence banks are earning good spread and are continuously increasing exposure to government securities as the government is increasingly financing its debt through the stated instruments. Moreover the continued focus on development of Investment portfolio is taking the focus away from the development of alternate delivery channels for the majority of unbanked population of Pakistan which account for around 85% of population. Although the a few banks are taking a foot ahead with the development but the volume wise expansion in alternate profit generating avenues is very small. According to Qayyum (2005), these channels are also low risk addendums but the development focus has been very small due to development of other areas particularly investment portfolio as a low risk prospectus. The gravity of situation is immense as it will determine the future profitability of banks as the rates on deposits are practically fixed by the central banks and the differential can be earned by higher interest and non interest income.
It is important to study the topic as the banks’ core function is intermediation of funds which is primarily exhibited by the deposit and loan portfolio. The normal operations of banks have been geared towards these two sets but by under the post reforms regulations of State Bank of Pakistan, the banks are allowed to manage their foreign currencies and can actively manage their investment portfolios. Though there is limit on overall investment portfolio as a percentage of total assets but the classification within the portfolio is not barred. Hence the composition is based on the sole discretion of banking authorities. Due to present high returns on risk free investment portfolios the profitability is on rise but the changes in discount rates can switch the odds and the lack of focus on other profit generating avenues will be studied. The study will draw attention to fact that is the shift towards risk free securities is causing a huge impact on the performance of financial markets and will give response to the myths pertaining to power of large banks in influencing capital markets. Moreover the study will draw attention to a newly evolving low risk phenomenon of alternate delivery channels in the banking sector and its prospective role in case of adverse situations for the investment and loan portfolio.
A PESTEL analysis of banking industry is conducted to know about the banking industry in Pakistan. This environmental analysis helps to understand the business problems more intricately and to recognize threats, avoid shocks, identify opportunities, and develop better long-term and short-term planning. The political impact on the banking industry is sizably reduced after the practical autonomy of central bank whereby the State bank of Pakistan has autonomy in making policies for the banking sector. But political forces do play in auction of t-bills and government securities in terms of acceptance amounts as the government is doing more than 60% deficit financing from commercial banks. Economic factors like interest rate discounting by 150 bps and depreciating rupee dollar exchange rate is shifting the dynamics of the industry. Social factors have a slightly growing part to play as the social class which now can access banking products has started to widen up. Financial inclusion through alternate delivery channels is a possible gateway ahead. Technologically the industry is at par with international standards where the top banks in industry are keeping themselves automated by using systems like Symbols, Unibank, LOS programming and other financial integration software environmental factors have no direct impact on the industry but they can indirectly impact the banks by causing damages to their clients. The legal status of banks at large is secured by SBP wher the banks are penalized as per the prudential regulations and special courts are also available in case of financial indiscipline on part of FIs or their clients.
Banking industry in Pakistan has played a significant role in the progression of economy. It has been impacting the growth of various sectors in economy and hence is not just a sector but a system. According to Wachtel (2001), banks perform core function of intermediation and hence investing is a secondary function. The division depends on the central bank regulations and risk return profile. Jaffe and Levonian (2011) say that banks determine asset allocation based on the risks and associated costs as well as their usage in generating value. Haque (1997) says that nationalized banks had lower efficiency due to non diversified group of assets. In view of Qayyum, A. (2005), the degenerated banking industry at inception was turned into publically owned enterprise in nationalization phase. Later it was privatized slowly to generate a mix of public and private owned banks. In nationalization phase the banking industry was primarily involved in servicing the needs of government with secondary focus on the corporate businesses. Moreover nationalization wiped out the private sector. According to Khan, A H. (1995), due to marked regressive effects in economy, nationalization policy was repealed. Qayyum, A. (2005), further says that initially banking industry was regulated by SBP, PBC and CLA. In pre reform era, PBC was regulating the commercial banks of public sector and CLA regulated the capital markets and SBP was the apex body. After that SBP assumed the complete role in regulating the commercial banks in Pakistan. In his view, the SBP was later required to perform quarterly performance review of all banks. Later the banks were regulated under the revised Banking Companies Ordinance (1962) and amended State Bank of Pakistan Act (1976). After this, SBP rose as apex body for commercial banks with SECP as regulatory body for capital markets.
The banking sector underwent nationalization giving complete control of operations and portfolio management to the government. According to Qayyum, A. (2005), this period was marked by concentrated ownership of assets, initiation of overly subsidized credit schemes with political motivations, restriction on private commercial banks, introduction of credit ceilings and controlled interest rate regime which lead to demise of banking system in Pakistan. The tax rate of 35% also contributed to increases in lending rate during the nationalization phase. Hayat, S. (2011), discusses that correction in the banking system practices was brought about by the financial sector reforms which were done in two sets of phases. The first phase of reforms were introduced in 1991 opening doors of banking business to private investor to reduce to negative sentiments created by nationalization. Accordingly, foreign first tier banks were allowed to make entry in the market. State Bank played a crucial role to regulatory as well as planning body to reduce the ramifications of nationalization and planned the recovery path for the banking system at large. The second phase was marked with suspension of Banking Council and State bank of Pakistan became the sole regulatory authority. International ratings like CAELS and CAMELS were introduced. The important reforms pertained to privatization, equity sufficiency model for the banks, better corporate governance and subsidized financing of non conventional sector. According to State Bank of Pakistan (2011), Banking Sector Strategy (BSS) has been strategized for the coming decade. BSS focuses on ten core areas that include implementation of a financial inclusion program, Strengthening consumer protection, Strengthening competition and efficiency, strengthening and consolidating the banking sector, Strengthening prudential regulation and supervision, introduction of a framework for consolidated supervision, development of a financial safety net, Strengthening of powers of SBP to maintain financial and monetary stability, deepening financial intermediation and developing the financial infrastructure, especially payment systems.
According to Financial Sustainability Review (2011), “The asset base of the banking system has soared by 8 percent (Rs. 577 billion), the most significant rise in a half year since 2007, on the back of a robust increase in investments, overwhelmingly in government papers”. This justifies the issue at hand and overall investment in the government papers. Overall banking deposits have increased by 9.4% aggregative. Moreover profits are rising and the overall contribution of top five banks in Pakistan is falling. Hence the smaller banks are also showing amore contribution in aggregate banking profits. A surprising element is that the earning from investment in government securities has become 30% of total interest income as compared to 24% in last year. The trend in government securities expansion beneficial to government as it is able to keep the deficit financing within SBP prescribed limits. But according to Financial Sustainability Review (2011), this trend is not sustainable as it subdues the core function of intermediation and its profitability is hinged upon the discount rate. Further Financial Sustainability Review (2011) says that “rise in investments (22.4 percent) outpacing the growth in advances (1.04 %) by a wide margin, advances to deposits ratio (ADR) of the banking sector has further come off, dropping from 61.4 to 56.7 percent during H1-CY11.” This shows that banks have adequate liquidity and also shows that banks are risk averse to the total advances to private sector. Private sector investment is crowding out and trend can be reversed only by better macro economic conditions. NPLs are rising progressively despite contraction in the loan portfolio. Credit risk pertains high and infection ratio though high is well curtailed. Capital adequacy as determined by CAR is showing favorable movements in the numerator and the denominator. This has improved the solvency profile of banks as CAR has increased from 11% to 14%.
Commercial banks are investing heavily in the financial markets of Pakistan, mostly in currency and money markets. According to Faruqi, S. (2011), banks have monopolized the short term money markets including t-bills market, funds market and repo market. They are also active in government bonds market investing heavily in T – bills. He further says that banks are not active in the stock market of Pakistan for the investor risk and SBP imposed regulations. This breaks the myth of banks controlling the stock markets. According to Watchel, P. (2001), large banks tend to avoid undue exposure to securities market and invest only in less risky securities: t-bills, government bonds and AAA rated bonds. In reality, even though individually the exposure to stock market is small but is considered aggregative, the exposure to securities market is substantial reaching to around one third by the end of last year. Faruqi, S. (2011) says that average annual growth rate has been around 20% over the decade. It was faster in second half of decade where it outpaced the asset growth rate of 14%. In 2010, the investment was at around 43% of the total investment hence implying that the banks are preferring to enhance their exposure to securities market than to enhance their exposure in the credit markets.
Investment portfolio is concentrated in government securities and within those mainly in t-bills. As per Financial Sustainability Review (2011), more than 50% of investment portfolio is held in t-bills. Though it is difficult to gauge the overall investment flow as it is short term but stock follows of t-bills rose from 106 billion rupees to 1120 billion rupees over the last decade. According to Faruqi, S. (2011), there is considerable reshuffle of securities as well as size of those securities with a primary focus on shorter term t-bills. Moreover banks are also investing in government bonds; t-bonds and Sukuks. Faruqi, S. (2001) says that the proportion of investment in investment portfolio is declining and has taken a nosedive from 41% in start of decade to 11% in the end of decade. The proportional share of investment in securities to total assets of banking inclusive of all types of assets has grown from 16 percent in 2000 to 28 percent in 2010. There has been a steady shift in composition of banks in favor of securities. Faruqi, S. (2001) says that rise share of investments has occurred with corresponding decline in share of banking credit and other asset, mainly cash balances held, inter-bank lending and loans to financial institutions and the like. Even though the overall exposure is rising in the end, but exposure is very volatile in case of both for long and short term securities. The exposure of securities of entire banking system is reported at 30 percent of securities market.
According to the Infosyst Limited Report (2011), “Channelize through channels” is the new mantra for present day banks, which older days relied exclusively on the branch network to fulfill transactions, sell products and acquire customers. Before ADCs, expanding the business meant adding more branches at high real estate and licensing costs. Channels like the Kiosk, ATM and Internet Banking have enabled banks to reach a broad consumer base across geographies with little time and effort. Valluri (2011) says that in international market, there is a growing demand for channel and supporting technology. Banks are integrating channels in order to guarantee accuracy and integrity of transaction data. Channels are means of customer service as well as the means for sales and customer acquisition. With wealth banking customers becoming more technology savvy, their usage of alternate channels of banking is increasing. Banks are also investing in mobile banking applications to enable wealth banking customers transact over smart-phones. As per the Infosyst Limited Report (2011), banks around the world are searching for solutions that can reduce costs without impacting customer service. It is important that banks efficiently manage vendors for different service delivery channels along with the versions of software. Although alternate channels are not the most effective at generating new sales, they improve customer satisfaction and retention. With the help of technology, the banking industry can develop or expand into new channels to survive in the current competitive environment. Any new channel involves cost and in alternate channels, technology plays a vital role in terms of providing a near to branch experience to the well-informed wealth management customer.
According to Aurora (2012), UBL has developed alternate delivery channels slowly by providing the opportunity to customers of using the internet banking, kiosks, ATMs and branchless banking. According to Branchless Banking Regulations announced by the State Bank of Pakistan (SBP) in June 2011, introduced a Level ‘0’ branchless banking account to bring the low income segment into the financial services loop.A As one of the two major providers of branchless banking services in Pakistan, UBL Omni was the first to introduce Level 0 accounts. (Telenor EasyPaisa is currently in the preparatory phase of launching these accounts.) According to the latest edition of the SBP’s Branchless Banking Newsletter (April-June 2012), UBL Omni’s Level 0 accounts have been so popular that the branchless banking segment experienced a record growth of 37% in the second quarter of 2012 in terms of the number of mobile banking accounts opened. The Newsletter says that “the growth is attributable to a notable increase of 370% in Level 0 accounts opened entirely by UBL Omni.” Apart from the Level 0 accounts and ATM card, UBL Omni has achieved a great deal more in the last two years giving the new campaign stronger legs to stand on. Chapter 3: Financial Analysis – United Bank Limited UBL has been able to achieve higher net income year on year basis and it has been able to generate Net Income of around 15.5 billion and has a large pretax profit amounting to 24.2 billion. Despite the turbulent situation in the economy due to fiscal indiscipline, inflationary pressures and power outages, UBL has managed to grow by 10% in its domestic network and has showed 37 percent increase in the pretax profit.
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