Management of Financial Institutions (original code MGT604 BNK604 book HANDOUTS in pdf

<b><span style="font-size: large;">Management of Financial Institutions (original code MGT604 BNK604 book HANDOUTS in pdf</span></b><br /><br />Handouts | Lectures | Contents | Books<div> <br /></div> <div> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5_UyiWFnTK9J3d12gMNinkNaxpqLiBDI-GQA8oz4e8n0yyC1adCEhCcl8uqr7Ua9PoaXoA3iSUGdU9Bm0VPIpeO3UiQYWTQdXrlv4Nk3JfbEyPexy7G-jgb_0b2aEh8EY_dWsE28iCBs/s1600/16146.jpg" imageanchor="1"><img border="0" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5_UyiWFnTK9J3d12gMNinkNaxpqLiBDI-GQA8oz4e8n0yyC1adCEhCcl8uqr7Ua9PoaXoA3iSUGdU9Bm0VPIpeO3UiQYWTQdXrlv4Nk3JfbEyPexy7G-jgb_0b2aEh8EY_dWsE28iCBs/s640/16146.jpg" width="492" /></a></div> <div> <br /></div> <div> <div> MANAGEMENT OF FINANCIAL INSTITUTIONS BNK-604</div> <div> Table of Content</div> <div> Lesson No. Title / Topic Page No.</div> <div> 1 Financial Environment & Role of Financial Institutions 1</div> <div> 2 Financial Institutions 7</div> <div> 3 Central Banks 10</div> <div> 4 Policy Instruments 13</div> <div> 5 Balance of Trade 17</div> <div> 6 State Bank of Pakistan 19</div> <div> 7 State Bank of Pakistan-Various Departments 22</div> <div> 8 State Bank of Pakistan-Various Departments 25</div> <div> 9 State Bank of Pakistan-Various Departments 28</div> <div> 10 State Bank of Pakistan-Various Departments 31</div> <div> 11 Major Drivers of Financial Industry 33</div> <div> 12 International Financial Institutions 36</div> <div> 13 Pakistan Economic Aid & Debt 40</div> <div> 14 Increasing Foreign Direct Investment 42</div> <div> 15 Role of Commercial Banks 45</div> <div> 16 Role of Commercial Banks 48</div> <div> 17 Role of Commercial Banks 51</div> <div> 18 Role of Commercial Banks 57</div> <div> 19 Role of Commercial Banks 62</div> <div> 20 Branch Banking in Pakistan 65</div> <div> 21 Role of Commercial Banks in Micro Finance Sector 69</div> <div> 22 Mutual funds 72</div> <div> 23 Mutual Funds 77</div> <div> 24 Mutual Funds 81</div> <div> 25 Mutual Funds 85</div> <div> 26 Mutual Funds 88</div> <div> 27 Mutual Funds 92</div> <div> 28 Role of Investment Banks 96</div> <div> 29 Letter of Credit 100</div> <div> 30 Letter of Credit and International Trade 106</div> <div> 31 Foreign Exchange & Financial Institutions 110</div> <div> 32 Foreign Exchange 115</div> <div> 33 Leasing Companies 119</div> <div> 34 The Leasing Sector in Pakistan and its Role in Capital Investment 122</div> <div> 35 Role of Insurance Companies 124</div> <div> 36 Role of Insurance Companies 131</div> <div> 37 Role of financial Institutions in Agriculture Sector 138</div> <div> 38 Agriculture Sector and Financial Institutions of Pakistan 142</div> <div> 39 Can Government of Pakistan Lay a Pivotal Role in this Sector? 146</div> <div> 40 Financial Crimes 150</div> <div> 41 DFIs & Risk Management 154</div> <div> 42 Banking Fraud & Misleading Activities 157</div> <div> 43 The Collapse of ENRON 160</div> <div> 44 Classic Financial Scandals 163</div> <div> 45 RECAP 166</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1</div> <div> Lecture # 1</div> <div> Financial Environment & Role of Financial Institutions</div> <div> The economic transformation under way in the former centrally planned economies</div> <div> (FCPEs) was motivated in part by the recognition that central planning has failed to allocate</div> <div> financial and real resources efficiently. This paper addresses the question of what kind of</div> <div> financial system should replace central planning in allocating capital and maintaining</div> <div> effective corporate governance during the transformation period. Financial sector reform</div> <div> has, at times, been portrayed as a question of adopting either a bank-based or a (securities)</div> <div> market-based model. In the bank-based model, commercial banks, often licensed as</div> <div> universal banks, take the lead in financing enterprise restructuring and investment.</div> <div> Proponents of the market-based model argue that the structural problems in the banking</div> <div> sector cannot be overcome easily; so firms will have to look to equity and bond markets for</div> <div> sources of new capital. Equity and bond markets in the FCPEs are not sufficiently well</div> <div> developed to support significant issues of new securities or to provide a mechanism for</div> <div> corporate control. They lack adequate liquidity, regulatory oversight, information</div> <div> disclosure, and clearing and payment systems. The important role of banks in maintaining</div> <div> the payment system and in providing credit to market participants to support trading and</div> <div> settlement means that until banks are restructured and recapitalized, securities market</div> <div> development will be constrained.</div> <div> Investment funds emerging from mass privatization schemes may create concentrations of</div> <div> equity ownership that would allow them to play an important role in corporate control and</div> <div> perhaps, too, in finding sources of investment capital. They are a relatively recent</div> <div> innovation, however, and it remains to be seen how active they will be in financing and</div> <div> managing privatized enterprises.</div> <div> The authorities should first establish a healthy banking sector, because it is the banks that</div> <div> are the most promising source of working capital and corporate control. This does not mean</div> <div> that securities market development should be ignored, only that it should not be a priority</div> <div> use of scarce government resources at the present time.</div> <div> Many observers recommend that banks be given the power to act as universal banks,</div> <div> combining lending with securities market operations and equity investment. The potential</div> <div> problems associated with such a model in the FCPEs during the transformation period</div> <div> outweigh any potential benefits. It is recommended, therefore, that commercial banking and</div> <div> investment banking activities be separated, at least until banks have demonstrated</div> <div> competence in their commercial lending operations.</div> <div> Long Run Performance of Financial Institutions for Economic Growth:</div> <div> The recent economic difficulties in Southeast Asian economies are often linked to the</div> <div> financial sector in these countries. The business and popular press around the world are</div> <div> replete with stories connecting the economic crisis with difficulties in the financial sectors</div> <div> in these economies. The connection between the troubled banking sector and the economic</div> <div> slowdown is especially stressed. Asian economies that have been less impacted by the</div> <div> economic crisis, for example Taiwan, are often characterized as having more stable</div> <div> financial institutions then their neighbors.</div> <div> Yet this is not the first time “financial difficulties” have been linked with poor</div> <div> macroeconomic performance. Many today believe the Great Depression of the 1930s was</div> <div> made much more sever by problems in the banking sector specifically and financial markets</div> <div> inefficiencies in general. More recently the dramatic economic slowdown in the 1980s in</div> <div> the state of Texas in the United States are often linked to the banking and savings and loan</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 2</div> <div> crisis that gripped the state at the same time. This raises the question, what is the link</div> <div> between financial institutions and the macroeconomic performance of an economy?</div> <div> Economists hold dramatically different views regarding this question. From a much earlier</div> <div> time, Bagehot (1873), and Schumpeter (1911) argued that an efficient financial system</div> <div> greatly helped a nation’s economy to grow. As Ross Levine has pointed out it was</div> <div> Schumpeter’s contention that well-functioning banks spurred technological innovation by</div> <div> offering funding to entrepreneurs that have the best chances of successfully implementing</div> <div> innovative products and production processes.</div> <div> More recent economists have more skeptical about the role of the financial sector in</div> <div> economic growth. Joan Robinson (1952) asserted that economic growth creates (emphasis</div> <div> added) demand for financial instruments and that where enterprise leads finance follows.</div> <div> Robert Lucas (1988) has also dismissed the finance-economic growth relationship stating</div> <div> that economists “badly over-stress” the role financial factors play in economic growth.</div> <div> However in recent years thanks to the work of Ross Levine (1997, 1998), Robert King</div> <div> (King and Levine 1993a, 1993b, 1993c) and others (Pagano 1993), economists are again</div> <div> reexamining the role financial markets play in economic growth. On the theoretical side</div> <div> complex models have been developed to illustrate the many channels through which the</div> <div> development of financial markets affect and are affected by economic growth. These</div> <div> channels include the facilitation of trading hedging, diversifying, and pooling of risk; the</div> <div> efficient allocation of resources; the monitoring of managers and exerting corporate control;</div> <div> the mobilization of savings; and the facilitation of the exchange of goods and services.</div> <div> On the empirical side a growing body of studies at the firm-level, industry-level, countrylevel</div> <div> and cross-country comparisons have demonstrated the strong link between the</div> <div> financial sector and economic growth. King and Levine’s (1993a, 1993b, and 1993c)</div> <div> research has shown that level of financial depth (defined as the ratio of liquid assets to</div> <div> GDP) does in fact help to predict economic growth. Other work by Levine (1997, 1998)</div> <div> has shown that financial intermediary development does positively influence economic</div> <div> growth, these results are shown to be robust, that is the relationships still hold when other</div> <div> factors that are know to influence economic growth are held constant. In many ways the</div> <div> current research has opened as many new questions as it has attempted to answer. On the</div> <div> theoretical side, questions still exist on how and why do financial markets and institutions</div> <div> evolve? Why are financial markets at different levels of development in different markets?</div> <div> This research has also raised a number of very interesting public policy questions. Such as:</div> <div> under what legal environment do financial institutions development more rapidly? Financial</div> <div> regulation -- how are countries’ financial systems regulated and supervised, how can these</div> <div> be quantified, and to what extent do the differences matter. What is role of regulation in</div> <div> encouraging financial market development? What impacts both positive and negative will</div> <div> the recent bailout of financial institutions and financial markets have on the long run</div> <div> development of financial markets?</div> <div> I would like to turn our attention to one of these issues that I find most intriguing: why do</div> <div> financial markets develop at different rates in different economies? That is, why do</div> <div> financial institutions tend to cluster in high-income areas or economies and low-income</div> <div> areas seem to suffer from a lack of financial institutions? A related question is; do financial</div> <div> markets drive economic growth or does economic growth drive the creation of financial</div> <div> market and institutions?</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 3</div> <div> FINANCIAL MARKETS &INSTITUTIONS:</div> <div> In economics a financial market is a mechanism that allows people to easily buy and sell</div> <div> (trade) financial securities (such as stocks and bonds), commodities (such as precious metals</div> <div> or agricultural goods), and other fungible items of value at low transaction costs and at</div> <div> prices that reflect the efficient market hypothesis.</div> <div> Financial markets have evolved significantly over several hundred years and are undergoing</div> <div> constant innovation to improve liquidity.</div> <div> Both general markets, where many commodities are traded and specialized markets (where</div> <div> only one commodity is traded) exist. Markets work by placing many interested sellers in</div> <div> one "place", thus making them easier to find for prospective buyers. An economy which</div> <div> relies primarily on interactions between buyers and sellers to allocate resources is known as</div> <div> a market economy in contrast either to a command economy or to a non-market economy</div> <div> that is based, such as a gift economy.</div> <div> In Finance, Financial markets facilitate:</div> <div> • The raising of capital (in the capital markets);</div> <div> • The transfer of risk (in the derivatives markets); and</div> <div> • International trade (in the currency markets).</div> <div> They are used to match those who want capital to those who have it.</div> <div> Typically a borrower issues a receipt to the lender promising to pay back the capital. These</div> <div> receipts are securities which may be freely bought or sold. In return for lending money to</div> <div> the borrower, the lender will expect some compensation in the form of interest or dividends.</div> <div> Definition</div> <div> The term financial markets can be a cause of much confusion.</div> <div> Financial markets could mean:</div> <div> 1. Organizations that facilitate the trade in financial products. I.e. Stock exchanges</div> <div> facilitate the trade in stocks, bonds and warrants.</div> <div> 2. The coming together of buyers and sellers to trade financial products. I.e. stocks and</div> <div> shares are traded between buyers and sellers in a number of ways including: the use of</div> <div> stock exchanges; directly between buyers and sellers etc.</div> <div> In academia, students of finance will use both meanings but students of economics will only</div> <div> use the second meaning.</div> <div> Financial markets can be domestic or they can be international.</div> <div> Types of financial markets:</div> <div> The financial markets can be divided into different subtypes:</div> <div> • Capital markets which consist of:</div> <div> o Stock markets, which provide financing through the issuance of shares or</div> <div> common stock, and enable the subsequent trading thereof.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 4</div> <div> o Bond markets, which provide financing through the issuance of Bonds, and</div> <div> enable the subsequent trading thereof.</div> <div> • Commodity markets, which facilitate the trading of commodities.</div> <div> • Money markets, which provide short term debt financing and investment.</div> <div> • Derivatives markets, which provide instruments for the management of financial</div> <div> risk.</div> <div> o Futures markets, which provide standardized forward contracts for trading</div> <div> products at some future date; see also forward market.</div> <div> • Insurance markets, which facilitate the redistribution of various risks.</div> <div> • Foreign exchange markets, which facilitate the trading of foreign exchange.</div> <div> The capital markets consist of primary markets and secondary markets. Newly formed</div> <div> (issued) securities are bought or sold in primary markets. Secondary markets allow investors</div> <div> to sell securities that they hold or buy existing securities.</div> <div> Raising Capital</div> <div> To understand financial markets, let us look at what they are used for, i.e. what is their</div> <div> purpose?</div> <div> Without financial markets, borrowers would have difficulty finding lenders themselves.</div> <div> Intermediaries such as banks help in this process. Banks take deposits from those who have</div> <div> money to save. They can then lend money from this pool of deposited money to those who</div> <div> seek to borrow. Banks popularly lend money in the form of loans and mortgages.</div> <div> More complex transactions than a simple bank deposit require markets where lenders and</div> <div> their agents can meet borrowers and their agents, and where existing borrowing or lending</div> <div> commitments can be sold on to other parties. A good example of a financial market is a</div> <div> stock exchange. A company can raise money by selling shares to investors and its existing</div> <div> shares can be bought or sold.</div> <div> The following table illustrates where financial markets fit in the relationship between</div> <div> lenders and borrowers:</div> <div> Lenders</div> <div> Many individuals are not aware that they are lenders, but almost everybody does lend</div> <div> money in many ways. A person lends money when he or she:</div> <div> • Puts money in a savings account at a bank;</div> <div> • Contributes to a pension plan;</div> <div> • Pays premiums to an insurance company;</div> <div> Financial Environment</div> <div> Lenders Financial Intermediaries Financial Markets Borrowers</div> <div> Individuals</div> <div> Companies</div> <div> Banks</div> <div> Insurance Companies</div> <div> Pension Funds</div> <div> Mutual Funds</div> <div> Inter bank</div> <div> Stock Exchange</div> <div> Money Market</div> <div> Bond Market</div> <div> Foreign Exchange</div> <div> Individuals</div> <div> Companies</div> <div> Central Government</div> <div> Municipalities</div> <div> Public Corporations</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 5</div> <div> • Invests in government bonds; or</div> <div> • Invests in company shares.</div> <div> Companies tend to be borrowers of capital. When companies have surplus cash that is not</div> <div> needed for a short period of time, they may seek to make money from their cash surplus by</div> <div> lending it via short term markets called money markets.</div> <div> There are a few companies that have very strong cash flows. These companies tend to be</div> <div> lenders rather than borrowers. Such companies may decide to return cash to lenders (e.g. via</div> <div> a share buyback.) Alternatively, they may seek to make more money on their cash by</div> <div> lending it (e.g. investing in bonds and stocks.)</div> <div> Borrowers</div> <div> • Individuals borrow money via bankers' loans for short term needs or longer term</div> <div> mortgages to help finance a house purchase.</div> <div> • Companies borrow money to aid short term or long term cash flows. They also</div> <div> borrow to fund modernization or future business expansion.</div> <div> • Governments often find their spending requirements exceed their tax revenues. To</div> <div> make up this difference, they need to borrow. Governments also borrow on behalf of</div> <div> nationalized industries, municipalities, local authorities and other public sector</div> <div> bodies. In the UK, the total borrowing requirement is often referred to as the public</div> <div> sector borrowing requirement (PSBR). Governments borrow by issuing bonds. In</div> <div> the UK, the government also borrows from individuals by offering bank accounts</div> <div> and Premium Bonds. Government debt seems to be permanent. Indeed the debt</div> <div> seemingly expands rather than being paid off. One strategy used by governments to</div> <div> reduce the value of the debt is to influence inflation.</div> <div> • Municipalities and local authorities may borrow in their own name as well as</div> <div> receiving funding from national governments. In the UK, this would cover an</div> <div> authority like Hampshire County Council.</div> <div> • Public Corporations typically include nationalized industries. These may include</div> <div> the postal services, railway companies and utility companies.</div> <div> • Many borrowers have difficulty raising money locally. They need to borrow</div> <div> internationally with the aid of Foreign exchange markets.</div> <div> Derivative Products</div> <div> During the 1980s and 1990s, a major growth sector in financial markets is the trade in so</div> <div> called derivative products, or derivatives for short.</div> <div> In the financial markets, stock prices, bond prices, currency rates, interest rates and</div> <div> dividends go up and down, creating risk. Derivative products are financial products which</div> <div> are used to control risk or paradoxically exploit risk.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 6</div> <div> Currency markets</div> <div> Seemingly, the most obvious buyers and sellers of foreign exchange are</div> <div> importers/exporters. While this may have been true in the distant past, whereby</div> <div> importers/exporters created the initial demand for currency markets, importers and exporters</div> <div> now represent only 1/32 of foreign exchange dealing, according to BIS.</div> <div> Analysis of financial markets</div> <div> Much effort has gone into the study of financial markets and how prices vary with time.</div> <div> Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal,</div> <div> enunciated a set of ideas on the subject which are now called Dow Theory. This is the basis</div> <div> of the so-called technical analysis method of attempting to predict future changes. One of</div> <div> the tenets of "technical analysis" is that market trends give an indication of the future, at</div> <div> least in the short term. The claims of the technical analysts are disputed by many academics,</div> <div> who claim that the evidence points rather to the random walk hypothesis, which states that</div> <div> the next change is not, correlated to the last change.</div> <div> The scale of changes in price over some unit of time is called the volatility. It was</div> <div> discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian</div> <div> distribution, but are rather modeled better by Levy stable distributions. The scale of change,</div> <div> or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large</div> <div> changes up or down are more likely that what one would calculate using a Gaussian</div> <div> distribution with an estimated standard deviation.</div> <div> Financial markets in popular culture</div> <div> Only negative stories about financial markets tend to make the news. The general</div> <div> perception, for those not involved in the world of financial markets is of a place full of</div> <div> crooks and con artists. Big stories like the Enron scandal serve to enhance this view.</div> <div> Stories that make the headlines involve the incompetent, the lucky and the downright</div> <div> skillful. The Barings scandal is a classic story of incompetence mixed with greed leading to</div> <div> dire consequences. Another story of note is that of Black Wednesday, when sterling came</div> <div> under attack from hedge fund speculators. This led to major problems for the United</div> <div> Kingdom and had a serious impact on its course in Europe. A commonly recurring event is</div> <div> the stock market bubble, whereby market prices rise to dizzying heights in a so called</div> <div> exaggerated bull market. This is not a new phenomenon; indeed the story of Tulip mania in</div> <div> the Netherlands in the 17th century illustrates an early recorded example.</div> <div> Financial markets are merely tools. Like all tools they have both beneficial and harmful</div> <div> uses. Overall, financial markets are used by honest people. Otherwise, people would turn</div> <div> away from them en masse. As in other walks of life, the financial markets have their fair</div> <div> share of rogue elements.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 7</div> <div> Lecture # 2</div> <div> FINANCIAL INSTITUTIONS</div> <div> In financial economics, a financial institution acts as an agent that provides financial</div> <div> services for its clients. Financial institutions generally fall under financial regulation from a</div> <div> government authority.</div> <div> Types of Financial Institutions</div> <div> Common types of financial institutions include banks, Insurance Co, Leasing Co,</div> <div> Investment Co, and Mutual Funds.</div> <div> Banks</div> <div> A bank is a commercial or state institution that provides financial services, including issuing</div> <div> money in various forms, receiving deposits of money, lending money, and processing</div> <div> transactions and the creating of credit.</div> <div> Central Bank</div> <div> A central bank, reserve bank or monetary authority, is an entity responsible for the</div> <div> monetary policy of its country or of a group of member states, such as the European Central</div> <div> Bank (ECB) in the European Union, the Federal Reserve System in the United States of</div> <div> America, State Bank in Pakistan.</div> <div> Its primary responsibility is to maintain the stability of the national currency and money</div> <div> supply, but more active duties include controlling subsidized-loan interest rates, and acting</div> <div> as a "bailout" lender of last resort to the banking sector during times of financial crisis</div> <div> (private banks often being integral to the national financial system).</div> <div> Commercial Bank</div> <div> A commercial bank accepts deposits from customers and in turn makes loans, even in</div> <div> excess of the deposits; a process known as fractional-reserve banking. Some banks (called</div> <div> Banks of issue) issue banknotes as legal tender.</div> <div> Investment Bank</div> <div> Investment banks help companies and governments and their agencies to raise money by</div> <div> issuing and selling securities in the primary market. They assist public and private</div> <div> corporations in raising funds in the capital markets (both equity and debt), as well as in</div> <div> providing strategic advisory services for mergers, acquisitions and other types of financial</div> <div> transactions.</div> <div> Saving Bank</div> <div> A savings bank is a financial institution whose primary purpose is accepting savings</div> <div> deposits. It may also perform some other functions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 8</div> <div> Micro Finance Bank</div> <div> For the purpose of poverty reduction program, such kind of banks is working in the</div> <div> different countries with the contribution of UNO or World Bank.</div> <div> In Pakistan 7 Micro Finance Banks are providing services under the SBP prudential</div> <div> regulation.</div> <div> Islamic Bank</div> <div> Islamic banking refers to a system of banking or banking activity that is consistent with</div> <div> Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law</div> <div> prohibits usury, the collection and payment of interest, also commonly called riba in Islamic</div> <div> discourse.</div> <div> Specialized Banks</div> <div> 1. ZTBL</div> <div> The Zarai Taraqiati Bank Limited It is also known as Agricultural Development</div> <div> Bank of Pakistan (ADBP).</div> <div> It is the premier financial institution geared towards the development of the agricultural</div> <div> sector through the provision of financial services and technical know-how.</div> <div> 2. IDBP</div> <div> Industrial Development Bank of Pakistan is one of Pakistan's oldest developments</div> <div> financing institution created with the primary objective of extending term finance for</div> <div> investment in the manufacturing sector and SME Sector of the economy.</div> <div> 3. SME Bank</div> <div> SME bank Ltd was established to exclusively cater to the needs of the SME</div> <div> sector. It was created to address the needs of this niche market with specialized financial</div> <div> products and services that will help stimulate SME development and pro poor growth in the</div> <div> country.</div> <div> Non Banking Financial Companies</div> <div> Non-bank financial companies (NBFCs) also known as a non-bank or a non-bank. Banks</div> <div> are financial institutions that provide banking services without meeting the legal definition</div> <div> of a bank, i.e. one that does not hold a banking license. Operations are, regardless of this,</div> <div> still exercised under bank regulation. However this depends on the jurisdiction, as in some</div> <div> jurisdictions, such as New Zealand, any company can do the business of banking, and there</div> <div> are not banking licenses issued. Non-bank institutions frequently acts as suppliers of loans</div> <div> and credit facilities, supporting investments in property, providing services relating to</div> <div> events within peoples lives such as funding private education, wealth management and</div> <div> retirement planning. However they are typically not allowed to take deposits from the</div> <div> general public and have to find other means of funding their operations such as issuing debt</div> <div> instruments. In India, most NBFCs raise capital through Chit Funds.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 9</div> <div> Investment Companies</div> <div> Generally, an "investment company" is a company (corporation, business trust, partnership,</div> <div> or Limited Liability Company) that issues securities and is primarily engaged in the</div> <div> business of investing in securities.</div> <div> An investment company invests the money it receives from investors on a collective basis,</div> <div> and each investor shares in the profits and losses in proportion to the investor’s interest in</div> <div> the investment company.</div> <div> The performance of the investment company will be based on (but it won’t be identical to)</div> <div> the performance of the securities and other assets that the investment company owns.</div> <div> Brokerage Houses</div> <div> Stock brokers assist people in investing, online only companies are called 'discount</div> <div> brokerages', companies with a branch presence are called 'full service brokerages' or 'private</div> <div> client services.</div> <div> Leasing Companies</div> <div> A lease or tenancy is the right to use or occupy personal property or real property given by a</div> <div> lessor to another person (usually called the lessee or tenant) for a fixed or indefinite period</div> <div> of time, whereby the lessee obtains exclusive possession of the property in return for paying</div> <div> the lessor a fixed or determinable consideration (payment).</div> <div> Insurance Companies</div> <div> Insurance companies may be classified as</div> <div> 1. Life insurance companies, which sell life insurance, annuities and pensions</div> <div> products.</div> <div> 2. Non-life or general insurance companies, which sell other types of insurance.</div> <div> Mutual Funds</div> <div> An investment, which is comprised, of a pool of funds collected from many investors for the</div> <div> purpose of investing in securities such as stocks, bonds, money market securities and similar</div> <div> assets. Mutual funds are operated by money mangers, which invest the fund's capital and</div> <div> attempt to produce capital gains and income for the fund's investors. A mutual fund's</div> <div> portfolio is structured and maintained to match the investment objectives stated in its</div> <div> prospectus.</div> <div> Financial Institution Functions</div> <div> Financial institutions provide a service as intermediaries of the capital and debt markets.</div> <div> They are responsible for transferring funds from investors to companies, in need of those</div> <div> funds. The presence of financial institutions facilitates the flow of monies through the</div> <div> economy. To do so, savings accounts are pooled to mitigate the risk brought by individual</div> <div> account holders in order to provide funds for loans. Such is the primary means for</div> <div> depository institutions to develop revenue. Should the yield curve become inverse, firms in</div> <div> this arena will offer additional fee-generating services including securities underwriting,</div> <div> sales & trading, and prime brokerage.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 10</div> <div> Lecture # 3</div> <div> CENTRAL BANK</div> <div> A central bank, reserve bank or monetary authority, is an entity responsible for the</div> <div> monetary policy of its country or of a group of member states, such as the European Central</div> <div> Bank (ECB) in the European Union or the Federal Reserve System in the United States of</div> <div> America. Its primary responsibility is to maintain the stability of the national currency and</div> <div> money supply, but more active duties include controlling subsidized-loan interest rates, and</div> <div> acting as a "bailout" lender of last resort to the banking sector during times of financial</div> <div> crisis (private banks often being integral to the national financial system).</div> <div> It may also have supervisory powers, to ensure that banks and other financial institutions do</div> <div> not behave recklessly or fraudulently. A central bank is usually headed by a governor, but</div> <div> the titles are president, chief executive, and managing director respectively for the European</div> <div> Central Bank the Hong Kong Monetary Authority and the Monetary Authority of</div> <div> Singapore.</div> <div> In most countries the central bank is state owned and has a minimal degree of autonomy,</div> <div> which allows for the possibility of government intervening in monetary policy. An</div> <div> "Independent central bank" is one which operates under rules designed to prevent</div> <div> political interference; examples include the US Federal Reserve, the Bank of England (since</div> <div> 1997), and the Bank of Canada, the Reserve Bank of Australia, the Banco de la República</div> <div> de Colombia, and the European Central Bank.</div> <div> Activities and responsibilities</div> <div> Functions of a central bank (not all functions are carried out by all banks):</div> <div> • Implementing the basis of monetary policy</div> <div> • Monopoly on the issue of banknotes</div> <div> • Controls the nation's entire money supply</div> <div> • The Government's banker and the bankers' bank ("Lender of Last Resort")</div> <div> • Manages the country's foreign exchange and gold reserves and the Government's</div> <div> stock register</div> <div> • Regulation and supervision of the banking industry</div> <div> • Setting the official interest rate - used to manage both inflation and the country's</div> <div> exchange rate - and ensuring that this rate takes effect via a variety of policy</div> <div> mechanisms.</div> <div> Monetary Policy</div> <div> Central banks implement a country's chosen monetary policy. At the most basic level, this</div> <div> involves establishing what form of currency the country may have, whether a fiat currency,</div> <div> gold-backed currency, currency board or a currency union. When a country has its own</div> <div> national currency, this involves the issue of some form of standardized currency, which is</div> <div> essentially a form of promissory note: a promise to exchange the note for "money" under</div> <div> certain circumstances. Historically, this was often a promise to exchange the money for</div> <div> precious metals in some fixed amount. Now, when many currencies are fiat money, the</div> <div> "promise to pay" consists of nothing more than a promise to pay the same sum in the same</div> <div> currency.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 11</div> <div> Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold,</div> <div> and other financial assets) and liabilities. A central bank's primary liabilities are the</div> <div> currency outstanding, and these liabilities are backed by the assets the bank owns.</div> <div> Unusually, however, central banks in jurisdictions with fiat currencies may "create" new</div> <div> money to back its own liabilities, to theoretically unlimited amounts.</div> <div> In many countries, the central bank may use another country's currency either directly (in a</div> <div> currency union), or indirectly, by using a currency board. In the latter case, local currency is</div> <div> directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this</div> <div> mechanism is used, notably, in Hong Kong and Estonia.</div> <div> In countries with fiat money, monetary policy may be used as a shorthand form for the</div> <div> interest rate targets and other active measures undertaken by the monetary authority.</div> <div> Central or National</div> <div> There is no standard terminology for the name of a central bank, but many countries use the</div> <div> "Bank of Country" form (e.g., Bank of England, Bank of Canada, and Bank of Russia).</div> <div> Some are styled national banks, such as the National Bank of Ukraine. In other cases they</div> <div> may incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland).</div> <div> In many countries, there may be private banks that incorporate the term national. Many</div> <div> countries have state-owned banks or other quasi-government entities that have entirely</div> <div> separate functions, such as financing imports and exports.</div> <div> In some countries, particularly in some Communist countries, the term national bank may</div> <div> be used to indicate both the monetary authority and the leading banking entity, such as the</div> <div> USSR's Gosbank (state bank). In other countries, the term national bank may be used to</div> <div> indicate that the central bank's goals are broader than monetary stability, such as full</div> <div> employment, industrial development, or other goals.</div> <div> Interest Rate Interventions</div> <div> Typically a central bank controls certain types of short-term interest rates. These influence</div> <div> the stock- and bond markets as well as mortgage and other interest rates. The European</div> <div> Central Bank for example announces its interest rate at the meeting of its Governing</div> <div> Council (in the case of the Federal Reserve, the Board of Governors).</div> <div> Both the Federal Reserve and the ECB are composed of one or more central bodies that are</div> <div> responsible for the main decisions about interest rates and the size and type of open market</div> <div> operations, and several branches to execute its policies. In the case of the Fed, they are the</div> <div> local Federal Reserve Banks, for the ECB they are the national central banks.</div> <div> Interest rate interventions are the most common and are dealt with in more detail below.</div> <div> Limits of Enforcement Power</div> <div> Contrary to popular perception, central banks are not all-powerful and have limited powers</div> <div> to put their policies into effect. Most importantly, although the perception by the public may</div> <div> be that the "Central bank" controls some or all interest rates and currency rates, economic</div> <div> theory, (and substantial empirical evidence) shows that it is impossible to do both at once in</div> <div> an open economy. Robert Mundell's "Impossible Trinity" is the most famous formulation of</div> <div> these limited powers, and postulates that it is impossible to target monetary policy (broadly,</div> <div> interest rates), the exchange rate (through a fixed rate) and maintain free capital movement.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 12</div> <div> Since most Western economies are now considered "Open" with free capital movement, this</div> <div> essentially means that central banks may target interest rates or exchange rates with</div> <div> credibility, but not both at once.</div> <div> Even when targeting interest rates, most central banks have limited ability to influence the</div> <div> rates actually paid by private individuals and companies.</div> <div> Even the US must engage in buying and selling to meet its targets. In the most famous case</div> <div> of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and</div> <div> (after making $2B himself and forcing the UK to spend over $8B defending the pound)</div> <div> forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies</div> <div> and argued that no one should be able to do what he in fact did.</div> <div> The most complex relationships are those between the yen and the US dollar, and between</div> <div> the Euro and its neighbors. The situation in Cuba is so exceptional as to require the Cuban</div> <div> peso to be dealt with simply as an exception, since the US forbids direct trade with Cuba.</div> <div> US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were</div> <div> officially removed from circulation in 2004 and replaced by the Convertible peso.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 13</div> <div> Lecture # 4</div> <div> POLICY INSTRUMENTS</div> <div> The main monetary policy instruments available to central banks are open market operation,</div> <div> bank reserve requirement, interest-rate policy, re-lending and re-discount (including using</div> <div> the term repurchase market), and credit policy (often coordinated with trade policy). While</div> <div> capital adequacy is important, it is defined and regulated by the Bank for International</div> <div> Settlements, and central banks in practice generally do not apply stricter rules.</div> <div> To enable open market operations, a central bank must hold foreign exchange reserves</div> <div> (usually in the form of government bonds) and official gold reserves. It will often have</div> <div> some influence over any official or mandated exchange rates: Some exchange rates are</div> <div> managed, some are market based (free float) and many are somewhere in between</div> <div> ("managed float" or "dirty float").</div> <div> Interest Rates</div> <div> By far the most visible and obvious power of many modern central banks is to influence</div> <div> market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number.</div> <div> Although the mechanism differs from country to country, most use a similar mechanism</div> <div> based on a central bank's ability to create as much fiat money as required.</div> <div> The mechanism to move the market towards a 'target rate' (whichever specific rate is used)</div> <div> is generally to lend money or borrow money in theoretically unlimited quantities, until the</div> <div> targeted market rate is sufficiently close to the target. Central banks may do so by lending</div> <div> money to and borrowing money from (taking deposits from) a limited number of qualified</div> <div> banks, or by purchasing and selling bonds. As an example of how this functions, the Bank</div> <div> of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks</div> <div> borrow from each other within this band, but never above or below, because the central</div> <div> bank will always lend to them at the top of the band, and take deposits at the bottom of the</div> <div> band; in principle, the capacity to borrow and lend at the extremes of the band are</div> <div> unlimited. Other central banks use similar mechanisms.</div> <div> It is also notable that the target rates are generally short-term rates. The actual rate that</div> <div> borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity</div> <div> and other factors. For example, a central bank might set a target rate for overnight lending</div> <div> of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of</div> <div> inverted yield curves, even below the short-term rate. Many central banks have one primary</div> <div> "headline" rate that is quoted as the "Central bank rate." In practice, they will have other</div> <div> tools and rates that are used, but only one that is rigorously targeted and enforced.</div> <div> "The rate at which the central bank lends money can indeed be chosen at will by the central</div> <div> bank; this is the rate that makes the financial headlines." - Henry C.K. Liu, in an Asia</div> <div> Times article explaining modern central bank function in detail He explains further that</div> <div> "the US central-bank lending rate is known as the Fed funds rate. The Fed sets a target for</div> <div> the Fed funds rate, which its Open Market Committee tries to match by lending or</div> <div> borrowing in the money market.... a fiat money system set by command of the central bank.</div> <div> The Fed is the head of the central-bank snake because the US dollar is the key reserve</div> <div> currency for international trade. The global money market is a US dollar market. All other</div> <div> currencies markets revolve around the US dollar market." Accordingly the US situation isn't</div> <div> typical of central banks in general.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 14</div> <div> A typical central bank has several interest rates or monetary policy tools it can set to</div> <div> influence markets.</div> <div> • Marginal Lending Rate (currently 5.00% in the Euro zone) a fixed rate for</div> <div> institutions to borrow money from the CB. (In the US this is called the Discount rate).</div> <div> • Main Refinancing Rate (4.00% in the Euro zone) this is the publicly visible interest</div> <div> rate the central bank announces. It is also known as Minimum Bid Rate and serves as a</div> <div> bidding floor for refinancing loans. (In the US this is called the Federal funds rate).</div> <div> • Deposit Rate (3.00% in the Euro zone) the rate parties receive for deposits at the</div> <div> CB.</div> <div> •</div> <div> These rates directly affect the rates in the money market, the market for short term loans.</div> <div> Open Market Operations</div> <div> Through open market operations, a central bank influences the money supply in an</div> <div> economy directly. Each time it buys securities, exchanging money for the security, it raises</div> <div> the money supply. Conversely, selling of securities lowers the money supply. Buying of</div> <div> securities thus amounts to printing new money while lowering supply of the specific</div> <div> security.</div> <div> The main open market operations are:</div> <div> • Temporary lending of money for collateral securities ("Reverse Operations" or</div> <div> "repurchase operations", otherwise known as the "repo" market). These</div> <div> operations are carried out on a regular basis, where fixed maturity loans (of 1 week</div> <div> and 1 month for the ECB) are auctioned off.</div> <div> • Buying or selling securities ("Direct Operations") on ad-hoc basis.</div> <div> • Foreign exchange operations such as forex swaps.</div> <div> All of these interventions can also influence the foreign exchange market and thus the</div> <div> exchange rate. For example the People's Bank of China and the Bank of Japan have on</div> <div> occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the</div> <div> decline of the U.S. dollar versus the Renminbi and the Yen.</div> <div> Capital Requirements</div> <div> All banks are required to hold a certain percentage of their assets as capital, a rate which</div> <div> may be established by the central bank or the banking supervisor. For international banks,</div> <div> including the 55 member central banks of the Bank for International Settlements, the</div> <div> threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain</div> <div> assets (such as government bonds) are considered to have lower risk and are either partially</div> <div> or fully excluded from total assets for the purposes of calculating capital adequacy. Partly</div> <div> due to concerns about asset inflation and term repurchase agreements, capital requirements</div> <div> may be considered more effective than deposit/reserve requirements in preventing indefinite</div> <div> lending: when at the threshold, a bank cannot extend another loan without acquiring further</div> <div> capital on its balance sheet.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 15</div> <div> Reserve requirements</div> <div> Another significant power that central banks hold is the ability to establish reserve</div> <div> requirements for other banks. By requiring that a percentage of liabilities be held as cash or</div> <div> deposited with the central bank (or other agency), limits are set on the money supply.</div> <div> In practice, many banks are required to hold a percentage of their deposits as reserves. Such</div> <div> legal reserve requirements were introduced in the nineteenth century to reduce the risk of</div> <div> banks overextending themselves and suffering from bank runs, as this could lead to knockon</div> <div> effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th</div> <div> century gold standard and late 20th century dollar hegemony evolved, and as banks</div> <div> proliferated and engaged in more complex transactions and were able to profit from</div> <div> dealings globally on a moment's notice, these practices became mandatory, if only to ensure</div> <div> that there was some limit on the ballooning of money supply. Such limits have become</div> <div> harder to enforce. The People's Bank of China retains (and uses) more powers over reserves</div> <div> because the Yuan that it manages is a non-convertible currency.</div> <div> Even if reserves were not a legal requirement, prudence would ensure that banks would hold</div> <div> a certain percentage of their assets in the form of cash reserves. It is common to think of</div> <div> commercial banks as passive receivers of deposits from their customers and, for many</div> <div> purposes, this is still an accurate view.</div> <div> This passive view of bank activity is misleading when it comes to considering what</div> <div> determines the nation's money supply and credit. Loan activity by banks plays a</div> <div> fundamental role in determining the money supply. The money deposited by commercial</div> <div> banks at the central bank is the real money in the banking system; other versions of what is</div> <div> commonly thought of as money are merely promises to pay real money. These promises to</div> <div> pay are circulatory multiples of real money. For general purposes, people perceive money as</div> <div> the amount shown in financial transactions or amount shown in their bank accounts. But</div> <div> bank accounts record both credit and debits that cancel each other. Only the remaining</div> <div> central-bank money after aggregate settlement.</div> <div> Final Money - can take only one of two forms:</div> <div> • physical cash, which is rarely used in wholesale financial markets,</div> <div> • Central-bank money.</div> <div> The currency component of the money supply is far smaller than the deposit component.</div> <div> Currency and bank reserves together make up the monetary base, called M1 and M2.</div> <div> Exchange Requirements</div> <div> To influence the money supply, some central banks may require that some or all foreign</div> <div> exchange receipts (generally from exports) be exchanged for the local currency. The rate</div> <div> that is used to purchase local currency may be market-based or arbitrarily set by the bank.</div> <div> This tool is generally used in countries with non-convertible currencies or partiallyconvertible</div> <div> currencies. The recipient of the local currency may be allowed to freely dispose</div> <div> of the funds, required to hold the funds with the central bank for some period of time, or</div> <div> allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or</div> <div> use the foreign exchange may be otherwise limited.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 16</div> <div> In this method, money supply is increased by the central bank when the central bank</div> <div> purchases the foreign currency by issuing (selling) the local currency. The central bank may</div> <div> subsequently reduce the money supply by various means, including selling bonds or foreign</div> <div> exchange interventions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 17</div> <div> Lecture # 5</div> <div> BALANCE OF TRADE</div> <div> • The balance of trade is the difference between the monetary value of exports and</div> <div> imports in an economy over a certain period of time.</div> <div> • A positive balance of trade is known as a trade surplus and consists of exporting</div> <div> more than is imported;</div> <div> • A negative balance of trade is known as a trade deficit or, informally, a trade gap.</div> <div> Physical balance of trade</div> <div> • Monetary balance of trade is different from physical balance of trade (which is</div> <div> expressed in amount of raw materials). Developed countries usually import a lot of</div> <div> primary raw materials from developing countries at low prices.</div> <div> • Often, these materials are then converted into finished products, and a significant</div> <div> amount of value is added</div> <div> Factors that can affect BOT</div> <div> 1. Exchange rates</div> <div> 2. Trade agreements or barriers</div> <div> 3. Other tax, tariff and trade measures</div> <div> 4. Business cycle at home or abroad.</div> <div> Balance of Payment</div> <div> • The Balance of Payments (or BOP) measures the payments that flow between any</div> <div> individual country and all other countries. It is used to summarize all international</div> <div> economic transactions for that country during a specific time period, usually a year.</div> <div> • The BOP is determined by the country's exports and imports of goods, services, and</div> <div> financial capital, as well as financial transfers. It reflects all payments and liabilities</div> <div> to foreigners (debits) and all payments and obligations received from foreigners</div> <div> (credits).</div> <div> Current Account</div> <div> • The current account is the sum of net sales from trade in goods and services, net</div> <div> factor income (such as interest payments from abroad), and net unilateral transfers</div> <div> from abroad.</div> <div> • Positive net sales to abroad correspond to a current account surplus; a negative net</div> <div> sale to abroad correspond to a current account deficit.</div> <div> Capital account (or financial account)</div> <div> • The financial account is the net change in foreign ownership of domestic assets. If</div> <div> foreign ownership of domestic assets has increased more quickly than domestic</div> <div> ownership of foreign assets in a given year, then the domestic country has a</div> <div> financial account surplus.</div> <div> • The financial account is the net change in foreign ownership of domestic assets. If</div> <div> foreign ownership of domestic assets has increased more quickly than domestic</div> <div> ownership of foreign assets in a given year, then the domestic country has a</div> <div> financial account surplus.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 18</div> <div> • Balance of Payments Equilibrium</div> <div> Is defined as a condition where the sum of debits and credits from the Current Account and</div> <div> the Financial Account equal zero;</div> <div> Current Account + Financial Account = 0</div> <div> Challenges of a Central Bank</div> <div> 1. Economic Growth: Economic growth is the increase in value of the goods and</div> <div> services produced by an economy. It is conventionally measured as the percent rate</div> <div> of increase in real gross domestic product, or GDP.</div> <div> 1. Poverty Reduction: In politics, the fight against poverty is usually regarded as a</div> <div> social goal and many governments have — secondarily at least — some dedicated</div> <div> institutions or departments.</div> <div> 2. Unemployment: Unemployment is the condition of willing workers lacking jobs or</div> <div> "gainful employment". In economics, unemployment statistics measure the</div> <div> condition and extent of joblessness within an economy.</div> <div> 5. Inflation: Inflation is the persistent rise in the general price level as measured</div> <div> against a standard level of purchasing power. There are many varying measures of</div> <div> inflation in use because different prices affect different people.</div> <div> 6. Stability in Forex Rate: Central banks play an important role in the foreign</div> <div> exchange markets. They try to control the money supply, inflation, interest rates and</div> <div> often have official or unofficial target rates for their currencies.</div> <div> Public Policy and Financial Stability</div> <div> • It seems useful at the outset to define financial stability and to do so by defining it’s</div> <div> opposite, financial instability. The most useful concept of financial instability for</div> <div> central banks and other authorities involves some notion of market failure or</div> <div> externalities that can potentially impinge on real economic activity.</div> <div> • With this definition of financial instability, a clear public policy interest arises for</div> <div> central banks and other authorities to act in two distinct roles in pursuing financial</div> <div> stability—prevention of instability and management of the consequences once</div> <div> markets become unstable.</div> <div> Independence of Central Banks</div> <div> • In this context, independence is usually defined as the central bank’s operational and</div> <div> management independence from the government.</div> <div> • World Bank, the BIS, and the IMF are strong supporters of central bank</div> <div> independence. Governments generally have some degree of influence over even</div> <div> "independent" central banks; the aim of independence is primarily to prevent shortterm</div> <div> interference.</div> <div> • For example, the chairman of the U.S. Federal Reserve Bank is appointed by the</div> <div> President of the U.S., and his choice must be confirmed by the Congress.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 19</div> <div> Lecture # 6</div> <div> STATE BANK OF PAKISTAN</div> <div> The State Bank of Pakistan (SBP) is the central bank of Pakistan. While its constitution,</div> <div> as originally lay down in the State Bank of Pakistan Order 1948, remained basically</div> <div> unchanged until January 1, 1974, when the bank was nationalized, the scope of its functions</div> <div> was considerably enlarged. The State Bank of Pakistan Act 1956, with subsequent</div> <div> amendments, forms the basis of its operations today. The headquarters are located in the</div> <div> financial capital of Pakistan, Karachi with its second headquarters in the capital, Islamabad.</div> <div> History</div> <div> Before independence on 14 August 1947, the Reserve Bank of India (central bank of India)</div> <div> was the central bank for what is now Pakistan. On 30 December 1948 the British</div> <div> Government's commission distributed the Bank of India's reserves between Pakistan and</div> <div> India - 30 percent (750 M gold) for Pakistan and 70 percent for India.</div> <div> The losses incurred in the transition to independence were taken from Pakistan's share (a</div> <div> total of 230 million). In May, 1948 Muhammad Ali Jinnah (Founder of Pakistan) took steps</div> <div> to establish the State Bank of Pakistan immediately. These were implemented in June 1948,</div> <div> and the State Bank of Pakistan commenced operation on July 1, 1948.</div> <div> Functions</div> <div> Under the State Bank of Pakistan Order 1948, the state bank of Pakistan was charged with</div> <div> the duty to "regulate the issue of bank notes and keeping of reserves with a view to securing</div> <div> monetary stability in Pakistan and generally to operate the currency and credit system of the</div> <div> country to its advantage".</div> <div> A large section of the state bank's duties were widened when the State Bank of Pakistan Act</div> <div> 1956 was introduced. It required the state bank to "regulate the monetary and credit system</div> <div> of Pakistan and to foster its growth in the best national interest with a view to securing</div> <div> monetary stability and fuller utilization of the country’s productive resources". In February</div> <div> 1994, the State Bank was given full autonomy, during the financial sector reforms.</div> <div> On January 21, 1997, this autonomy was further strengthened when the government issued</div> <div> three Amendment Ordinances (which were approved by the Parliament in May 1997).</div> <div> Those included were the State Bank of Pakistan Act, 1956, Banking Companies Ordinance,</div> <div> 1962 and Banks Nationalization Act, 1974. These changes gave full and exclusive authority</div> <div> to the State Bank to regulate the banking sector, to conduct an independent monetary policy</div> <div> and to set limit on government borrowings from the State Bank of Pakistan. The</div> <div> amendments to the Banks Nationalization Act brought the end of the Pakistan Banking</div> <div> Council (an institution established to look after the affairs of NCBs) and allowed the jobs of</div> <div> the council to be appointed to the Chief Executives, Boards of the Nationalized Commercial</div> <div> Banks (NCBs) and Development Finance Institutions (DFIs). The State Bank is having a</div> <div> role in their appointment and removal. The amendments also increased the autonomy and</div> <div> accountability of the chief executives, the Boards of Directors of banks and DFIs.</div> <div> The State Bank of Pakistan also performs both the traditional and developmental functions</div> <div> to achieve macroeconomic goals. The traditional functions may be classified into two</div> <div> groups:</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 20</div> <div> 1. The primary functions including issue of notes, regulation and supervision of the</div> <div> financial system, bankers’ bank, lender of the last resort, banker to Government, and</div> <div> conduct of monetary policy.</div> <div> 2. The secondary functions including the agency functions like management of public</div> <div> debt, management of foreign exchange, etc., and other functions like advising the</div> <div> government on policy matters and maintaining close relationships with international</div> <div> financial institutions.</div> <div> The non-traditional or promotional functions, performed by the State Bank include</div> <div> development of financial framework, institutionalization of savings and investment,</div> <div> provision of training facilities to bankers, and provision of credit to priority sectors. The</div> <div> State Bank also has been playing an active part in the process of islamisation of the banking</div> <div> system.</div> <div> Regulation of Liquidity</div> <div> The State Bank of Pakistan has also been entrusted with the responsibility to carry out</div> <div> monetary and credit policy in accordance with Government targets for growth and inflation</div> <div> with the recommendations of the Monetary and Fiscal Policies Co-ordination Board without</div> <div> trying to affect the macroeconomic policy objectives.</div> <div> The state bank also regulates the volume and the direction of flow of credit to different uses</div> <div> and sectors, the state bank makes use of both direct and indirect instruments of monetary</div> <div> management. During the 1980s, Pakistan embarked upon a program of financial sector</div> <div> reforms, which lead to a number of fundamental changes. Due to these changed the conduct</div> <div> of monetary management which brought about changes to the administrative controls and</div> <div> quantitative restrictions to market based monetary management. A reserve money</div> <div> management programme has been developed, for intermediate target of M2 that would be</div> <div> achieved by observing the desired path of reserve money - the operating target.</div> <div> Banking</div> <div> The State Bank of Pakistan looks into a lot of different ranges of banking to deal with the</div> <div> changes in economic climate and different purchasing and buying powers. Here are some of</div> <div> the banking areas that the state bank looks into;</div> <div> • State Bank’s Shariah Board Approves Essentials and Model Agreements for Islamic</div> <div> Modes of Financing</div> <div> • Procedure for Submitting Claims with Sbp In Respect of Unclaimed Deposits</div> <div> Surrendered By Banks/Dfis.</div> <div> • Banking Sector Supervision in Pakistan</div> <div> • Micro Finance</div> <div> • Small Medium Enterprises (SMEs)</div> <div> • Minimum Capital Requirements for Banks</div> <div> • Remittance Facilities in Pakistan</div> <div> • Opening of Foreign Currency Accounts with Banks in Pakistan under new scheme.</div> <div> • Handbook of Corporate Governance</div> <div> • Guidelines on Risk Management</div> <div> • Guidelines on Commercial Paper</div> <div> • Guidelines on Securitization</div> <div> • SBP.Scheme for Agricultural Financing</div> <div> • Bank Assets and Liabilities</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 21</div> <div> This is a chart of trend of major assets and liabilities reported by scheduled commercial</div> <div> banks to the State Bank of Pakistan with figures in millions of Pakistani Rupees.</div> <div> Year Deposits Advances Investments</div> <div> 2002 1,466,019 932,059 559,542</div> <div> 2006 2,806,645 2,189,368 799,285</div> <div> Departments</div> <div> • Agricultural Credit</div> <div> • Audit</div> <div> • Banking Inspection</div> <div> • Banking Policy</div> <div> • Banking Supervision</div> <div> • Corporate Services</div> <div> • Economic Policy</div> <div> • Exchange and Debt Management</div> <div> • Exchange Policy</div> <div> • Human Resource</div> <div> • Information System</div> <div> • Islamic Banking</div> <div> • Legal Services</div> <div> • Payment System</div> <div> • Research</div> <div> • Statistics</div> <div> • Real Time Gross Settlement System (RTGS System)</div> <div> • Small and Medium Enterprises</div> <div> Governor</div> <div> The principal officer of the SBP is the Governor. During December 2005, the President of</div> <div> Pakistan appointed Dr. Shamshad Akhtar as the new Governor of the State Bank for a three</div> <div> year term, to replace Dr. Ishrat Hussain, who retired on December 1, 2005.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 22</div> <div> Lecture # 7</div> <div> STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS</div> <div> Agricultural Credit Department</div> <div> Established under Section 8(3) of SBP Act 1956, is mainly responsible to meet credit needs</div> <div> of agriculture that being the mainstay of Pakistan’s economy generates nearly one fourth of</div> <div> the total out put and 44% of total employment and is the major source of foreign exchange</div> <div> earning.</div> <div> 􀂋 To operate as a focal point in SBP for all agriculture and rural finance policies,</div> <div> programs and projects.</div> <div> 􀂋 To assess/estimate the credit needs of farm & non farm sector in rural areas.</div> <div> To review the issues and challenges faced and developments taking place in agriculture and</div> <div> rural finance both in the country and elsewhere to develop an adequate knowledge and</div> <div> information base for policy formulation etc</div> <div> 􀂋 To formulate agri & rural finance policies in consultation with stakeholders to</div> <div> ensure adequate flow of institutional credit in rural areas.</div> <div> 􀂋 To monitor growth and trends in agri /rural finance portfolio of banks & financial</div> <div> institutions.</div> <div> 􀂋 To collect periodical agri/rural finance data for analysis, policy formulation and</div> <div> dissemination to general public.</div> <div> 􀂋 To advise Federal and Provincial Governments, Banks, Cooperative Banks &</div> <div> agriculture chambers on agri & rural finance issues.</div> <div> 􀂋 To initiate and undertake information dissemination and awareness building</div> <div> programs for farmers and special training programs for commercial banks.</div> <div> 􀂋 To build SBP rural and agriculture finance capacity</div> <div> 􀂋 To operate as a Secretariat for Agriculture Credit Advisory Committee (ACAC)</div> <div> The organization of the Department is spread over the following Divisions: -</div> <div> 1. Division – I Agriculture Credit Estimation & Target Monitoring Division</div> <div> 2. Division – II Agriculture Financing Policy Division</div> <div> 3. Division – III Services, Training & Development Division</div> <div> Banking Inspection Department</div> <div> (BID) is one of the core departments at SBP. Its mission is to strive for soundness &</div> <div> stability of the financial system and safeguard interest of stakeholders through proactive</div> <div> inspection, compatible with best international practices. BID plays a pivotal role in meeting</div> <div> SBP’s main responsibility of supervising the financial institutions to maintain soundness of</div> <div> the system and protection of the interest of depositors, thereby ensuring public confidence</div> <div> in the system. In order to assess a financial institution, BID conducts regular on-site</div> <div> inspection of all scheduled banks inclusive of the foreign banks & DFIs. The present</div> <div> supervisory structure at the department is institution focused whereby concerned Desk Incharges</div> <div> have been assigned specific institutions for effective monitoring through on-site</div> <div> examination, off-site reports from Banking Supervision Department and various market</div> <div> reports. The regular on-site inspection is conducted on the basis of CAMELS Framework.</div> <div> (Capital, Asset Quality, Management, Earnings, Liquidity, Sensitivity and System</div> <div> Controls). CAMELS are an effective rating system for evaluating the soundness of</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 23</div> <div> financial institutions on a uniform basis and for identifying these institutions requiring</div> <div> special attention or concern. Here the focus of inspection is generally on risk assessment</div> <div> policies & procedures of the banks and control environment to keep attached risks within</div> <div> acceptable limits and compliance with laws, regulations, and supervisory directives.</div> <div> Risk Assessment Polices</div> <div> In continuation of the inspection process, discussions are held with external auditors to</div> <div> review banks’ internal controls, compliance with legislation & prudential standards and</div> <div> adequacy of provisions. Here it would be important to mention that BID works in close</div> <div> coordination with Off-Site Surveillance Desk at Banking Supervision Department and other</div> <div> departments in SBP. BID conducts the regular full scope examination of banks pursuant to</div> <div> an inspection schedule; however, flexibility exists in policy for frequency of inspections</div> <div> depending upon the need to maintain safety & soundness. CAMELS rating are criteria to</div> <div> determine the frequency of inspection of banks as weak institutions are given greater</div> <div> attention. Special investigations (targeted inspections) are also conducted as and when</div> <div> circumstances so warrant on the basis of complaints or market reports about specific</div> <div> institution.</div> <div> Financial Markets Strategy & Conduct Department (FSCD)</div> <div> FSCD is one of the three new Departments constituted on restructuring of Exchange & Debt</div> <div> Management Department (EDMD) and Investment Services Cell (ISC) on September 14,</div> <div> 2006. The Department is responsible to formulate Policies & Regulate conduct of Domestic</div> <div> Money, Exchange, Securities, and Derivatives Markets as well as to disseminate market</div> <div> data/analysis & to set-up strategies/ products for market development.</div> <div> Functions:-</div> <div> To fulfill above, the Department has been divided into three Divisions, each Division is subdivided</div> <div> into different units.</div> <div> Markets Policy & Regulations</div> <div> • Review & formulate Market related Policies/Regulations vis-à-vis FEEL, CRR/SLR,</div> <div> Dealers Code of Conduct, Public Debt Act, Market Settlement Issues, PD System,</div> <div> Inter-bank Brokerage monitoring etc.</div> <div> • Secretariat for the Derivatives Approval & Review Team (DART).</div> <div> • Review & coordinating with Banking Inspection Department on enforcement of</div> <div> Treasury specific inspection comments viz existing regulations governing FX,</div> <div> Derivatives & Debt Markets.</div> <div> • Policy issues pertaining to other departments etc.</div> <div> • Coordination with relevant Market Associations, Committees & Players e.g., Sub-</div> <div> Committee on Treasury & Capital Markets, etc.</div> <div> Market Analysis & Forecasting</div> <div> a) Exchange Rate & FX Market Analysis</div> <div> b) Analysis of Money and Debt Markets</div> <div> c) Derivatives market analysis.</div> <div> d) Preparation of monthly market update/ Quarterly Financial Market Review.</div> <div> e) Liquidity Forecasting & Data base Management of Permanent & Floating Debts</div> <div> f) Assist in formulation of Sovereign Domestic Debt plan.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 24</div> <div> g) External Debt maturity Profile.</div> <div> h) External Debt maturity Profile.</div> <div> Market & Product Development Strategies</div> <div> • Product development initiatives for Sovereign Debt instruments. Derivatives</div> <div> products/strips, Islamic Instruments.</div> <div> • Market Development projects like…Listing of GOP Securities. Automated</div> <div> Auction/Payment System. IFSB Standards & Islamic market Development. Market</div> <div> Systemic Issues and Market Benchmarks.</div> <div> • Market Publications.</div> <div> • Foreign Exchange /Money Market, Derivatives Market Analysis.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 25</div> <div> Lecture # 8</div> <div> STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)</div> <div> Islamic Banking Department</div> <div> 􀂋 Islamic Banking Department was established on 15th September, 2003 and has been</div> <div> entrusted with the huge task of promoting & developing the Shariah Compliant</div> <div> Islamic Banking as a parallel and compatible banking system in the country.</div> <div> 􀂋 State Bank of Pakistan wants to develop a progressive and sound Islamic banking</div> <div> system that is in line and compatible with the global financial sector, providing</div> <div> innovative Shariah compliant products and services so as to achieve equitable</div> <div> economic growth.</div> <div> 􀂋 One of the biggest challenges being faced by this growing industry is the dearth of</div> <div> professional Islamic Bankers and capacity building in this regard is one of the top</div> <div> most priorities for the promotion of Islamic Banking.</div> <div> 􀂋 In order to play our regulatory and supervisory role more efficiently we are working</div> <div> on the areas like Risk Management, Corporate Governance, Prudential Regulations,</div> <div> Accounting & Shariah Standards etc. regarding Islamic Banking</div> <div> Islamic Banking Department consists of following four divisions:</div> <div> • Policy Division</div> <div> • Shariah Compliance Division</div> <div> • Business Support Division</div> <div> • Shariah Board Secretariat</div> <div> Islamic Banking is one of the emerging field in global financial market, having tremendous</div> <div> potential and growing at a very fast pace all around the world.</div> <div> Domestic Market & Monetary Management Department</div> <div> DMMMD is a newly constituted department of SBP. The idea of constitution of this</div> <div> department was to combine FX and money market activities under one roof, hence</div> <div> Securities department taking care of money market activities and Dealing room taking care</div> <div> of FX market activities were merged together on February 17, 2000.</div> <div> Main Objectives</div> <div> 1. Monetary Operations.</div> <div> 2. Raising short term and long-term domestic debts for the Government.</div> <div> 3. Management of Government Debts</div> <div> 4. Providing funds to the financial institutions as lender of last resort.</div> <div> 5. Monitoring of money and Foreign Exchange market activities.</div> <div> 6. Intervention in the Foreign Exchange market.</div> <div> 7. Reserve Management.</div> <div> The Primary functions of Domestic Market & Monetary Management Department fall</div> <div> into the following categories.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 26</div> <div> 1. Exchange Rate Policy Management</div> <div> 􀂙 Stable Exchange rates and Forward Premiums at appropriate/ sustainable levels</div> <div> 􀂙 Sale & Purchase of third currencies at optimum prices</div> <div> 􀂙 Smooth & sufficiently liquid Foreign Exchange Market</div> <div> 􀂙 Optimal accumulation of Foreign Exchange Reserves and Forward Portfolio.</div> <div> 2. Monetary Policy Implementation.</div> <div> 􀂙 Maintenance of stable interest rates in inter-bank money market through proactive</div> <div> management of Money Market liquidity.</div> <div> 􀂙 Raising short-term government debt and developing yield curve through auction of</div> <div> Market treasury bills.</div> <div> 􀂙 Proactive management of Money Market Liquidity through Open Market Operations.</div> <div> 􀂙 Providing liquidity to the market through SBP 3 day’s repo facility.</div> <div> 3. Reserve Management</div> <div> 􀂙 Optimal utilization of Reserve Portfolio and maximum returns on investment of</div> <div> surplus reserves. Hiring of investment consultant & Fund Managers for optimizing</div> <div> returns.</div> <div> 4. Debt Management.</div> <div> a) Domestic Debt</div> <div> 􀂙 Developing the markets for government securities.</div> <div> 􀂙 Coordination with monetary and Fiscal Policies.</div> <div> 􀂙 Raising short term and long term domestic debt for the government.</div> <div> 􀂙 Data base management of permanent and floating debts.</div> <div> b) External Debt</div> <div> 􀂙 Monitoring and ensuring prompt payment of external debt installments through State</div> <div> Bank of Pakistan and commercial banks.</div> <div> 􀂙 To generate reports on external debt, connectivity of Debt Management and Financial</div> <div> Analysis System have been established between Economic Affairs Division & SBP.</div> <div> Structure of the Department</div> <div> a) Local Foreign Exchange Division.</div> <div> b) Local Money Market Division.</div> <div> c) In house Reserve Management Division.</div> <div> d) Outsourcing Reserve Management Division.</div> <div> e) Government Securities Division.</div> <div> f) Debt Management Division.</div> <div> g) General Division.</div> <div> Research Department</div> <div> Research Department assumes an important role by providing key inputs for economic</div> <div> policy formulation through its analytical reviews and research work. Clearly, superior</div> <div> analysis of economic policies would be reflected in sounder macroeconomic management</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 27</div> <div> by the central bank and, in turn, the evolving structure of monetary and financial system</div> <div> would be more stable, and resilient against internal and external shocks. Thus the Research</div> <div> Department is expected to contribute significantly towards the main objectives of the State</div> <div> Bank of Pakistan.</div> <div> Finance Department SBP</div> <div> Functions of Finance Department</div> <div> 1. Maintenance of books of accounts and preparation of financial statements of the Bank</div> <div> in accordance with the International Accounting Standard, as adopted by the Bank.</div> <div> 2. Coordination and facilitation for Business planning and budgeting function in the Bank</div> <div> and periodic reporting to the management and to the Board.</div> <div> 3. Management of Federal, Provincial, and District Governments Accounts. Policy &</div> <div> operations related coordination Govt. agencies.</div> <div> 4. Maintenance of foreign currency accounts/ investments and execution of International</div> <div> payments and receipts.</div> <div> 5. Maintenance of accounts relating to International Organizations and Donor Agencies</div> <div> like International Monitoring Fund, Asian Development Bank, Asian Clearing Union etc</div> <div> 6. Currency issuance and its overall management.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 28</div> <div> Lecture # 9</div> <div> STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)</div> <div> Banking Surveillance Department</div> <div> Health of an economy depends on the degree of safety and stability of its banking and</div> <div> financial system. A sound, stable, and robust banking and financial system is a pre-requisite</div> <div> for economic well being of a country and its populace. In Pakistan, ensuring the stability</div> <div> and soundness of the banking system is a statutory responsibility of State Bank of Pakistan.</div> <div> The banking supervision departments viz. Banking Policy and Regulations Department</div> <div> (BP&RD), Banking Surveillance Department (BSD), Off-Site Supervision and Enforcement</div> <div> Department (OSSED) and Banking Inspection Department have been assigned this</div> <div> important function to work jointly and severally to ensure the soundness of individual banks</div> <div> and of overall banking industry. The Department is responsible to supervise financial</div> <div> institutions in the country. The department ensures effective adherence to regulatory &</div> <div> supervisory policies, monitors risk profiles, evaluate operating performance of individual</div> <div> banks/DFIs & the industry as a whole while issuing guidelines for managing various types</div> <div> of risks. It also ensures that banks are adequately capitalized & have policies & systems in</div> <div> place to assess various risks. The department is also responsible for the implementation of</div> <div> the Basel II Accord in Pakistan. The function & activities of Credit Information Bureau also</div> <div> falls within the domain of Banking Surveillance Department. The CIB collect credit data,</div> <div> under section 25A of the Banking Companies Ordinance 1962, maintain its database &</div> <div> disseminate credit information to financial institutions online to facilitate their credit</div> <div> appraisal process.</div> <div> Main Objectives</div> <div> 􀂾 To ensure effective regulatory and supervisory oversight of Banks and DFIs.</div> <div> 􀂾 To assess and review, periodically, performance and future outlook of banking</div> <div> system.</div> <div> 􀂾 To monitor risk profiles of banks, to prescribe guidelines etc requiring banks & DFIs</div> <div> to put in place adequate Risk Management Systems</div> <div> 􀂾 Developing detailed understanding of New Basle Capital Accord.</div> <div> 􀂾 To ensure compliance with Basel Core Principles of Banking Supervision.</div> <div> 􀂾 To provide online collection & dissemination of credit related information to financial</div> <div> institutions in order to facilitate their credit appraisal process.</div> <div> Structure of the Department</div> <div> 1. Risk Management & Analysis Division</div> <div> This Division is responsible for monitoring different risks faced/assumed by individual</div> <div> Banks/DFIs & prescribes policies/issues guidelines etc for managing/mitigating these risks.</div> <div> 2. Basel Accord & Core Principles Division</div> <div> The primary objective of this division is to implement the Basel II Accord in the banking</div> <div> sector. This involves participating in capacity building of the banking industry to</div> <div> understand, adapt, & implement the Basel Accord & then to also monitor compliance in this</div> <div> regard. The other objective is to ensure compliance with Basel Core principles of banking</div> <div> Supervision.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 29</div> <div> 3. Banking Sector Assessment Studies Division</div> <div> This division is primarily responsible for reviewing and assessing, on periodical basis, the</div> <div> banking system performance, and its future outlook. The division also conducts various</div> <div> stress testing exercises to assess the resilience of the banking sector to various shocks.</div> <div> 4. Credit Information Bureau (CIB)</div> <div> Collects & disseminates credit data from & to financial institutions to facilitate their credit</div> <div> appraisal process. It maintains database of all borrowers who avail credit facilities from</div> <div> financial institutions & provides online access to financial institutions to submit monthly</div> <div> credit data & to generate CIB reports.</div> <div> 5. Coordination & Administration Unit</div> <div> The primary objective of this division is to provide necessary support services to the</div> <div> Department’s staff and officers to facilitate them in effective & efficient discharge of</div> <div> assigned functions/ responsibilities. It coordinates with other departments & external</div> <div> organizations for timely provision of support services and technological assistance.</div> <div> It is also responsible for receipt/dispatch of correspondence & records of inward & outward</div> <div> mail, besides preparing a consolidated business plan for the department & its monitoring &</div> <div> follow up for effective implementation. The Division also coordinates on various training</div> <div> activities for imparting training to the staff/officers.</div> <div> Training Programs by SBP</div> <div> This much coordination among supervisory departments attempts to ensure stable &</div> <div> efficient banking system.</div> <div> Economic Policy Department</div> <div> Economic Policy Department is primarily engaged in eight fundamental activities. These</div> <div> include:</div> <div> • Preparation of Monetary Policy Statement</div> <div> • Preparation of Monetary Surveys</div> <div> • Preparation of Annual Credit Plan</div> <div> • Consultations with the IMF</div> <div> • Computation of REER index;</div> <div> • Computation of domestic public debt</div> <div> • Analysis of financial markets</div> <div> • Empirical research papers</div> <div> The Department also deals with external sector issues and references on money, credit, and</div> <div> exchange rates management. For operational purposes, the Department has been divided</div> <div> into the following four groups:</div> <div> 1. Monetary Survey & IMF Consultations Group</div> <div> • This group is responsible for preparation of Monetary Survey, details of</div> <div> Government budgetary borrowings, commodity operations, bank credit to private</div> <div> sector, public sector enterprises including (major autonomous bodies) and other</div> <div> items separately for SBP and Scheduled banks.</div> <div> • This group is responsible for preparation of Monetary Survey, details of</div> <div> Government budgetary borrowings, commodity operations, bank credit to private</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 30</div> <div> sector, public sector enterprises including (major autonomous bodies) and other</div> <div> items separately for SBP and Scheduled banks.</div> <div> In addition to this, the group is also assigned the task of preparation of material for IMF</div> <div> Consultations, World Bank and Ministry of Finance, monitoring of Performance Criteria</div> <div> and disposal of queries and references.</div> <div> 2. Money, Credit & Prices Group</div> <div> • The group is responsible for preparing credit plans, working papers & performs</div> <div> Secretariat work. Other assignments include credit targeting, credit monitoring,</div> <div> banking issues & reforms, Inflation watch, analysis of lending rates, large scale</div> <div> manufacturing developments & disposal of references on credit allocation.</div> <div> • The group also prepares periodic reports/reviews on Credit assessment of Private</div> <div> sector, credit assessment of govt. sector, analysis of tax revenue, domestic debt, &</div> <div> impact analysis of various policy initiatives. The group also intends to initiate work</div> <div> on micro credit and SMEs.</div> <div> 3. Financial Market & Exchange Rates Group</div> <div> • This group is responsible to keep constant watch & analyze developments in the</div> <div> financial markets</div> <div> • It prepares and supplies variety of background information for circulation in</div> <div> meetings.</div> <div> • Further, it is also assigned the task of dealing with the matters relating to exchange</div> <div> rate and foreign exchange reserves.</div> <div> 4. External Sector Group</div> <div> The group deals with the matters relating to Pakistan’s relationship with International</div> <div> Financial Institutions like</div> <div> • IMF: International monetary fund.</div> <div> • IBRD: International Bank for Reconstruction & Development.</div> <div> • ADB: Asian development Bank.</div> <div> • The issues of WTO and SAARC FINANCE.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 31</div> <div> Lecture # 10</div> <div> STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.)</div> <div> Exchange Policy Department</div> <div> (EPD) one of the core departments of the State Bank is responsible for overall stability of</div> <div> the foreign exchange market and is engaged in the process of policy formulation and</div> <div> implementation. It reviews on continuous basis, the existing rules and regulations, to</div> <div> facilitate foreign exchange activities in the country. Foreign exchange business in Pakistan</div> <div> is governed / regulated under Foreign Exchange Regulations Act, 1947 (FERA, 1947).</div> <div> Exchange Policy Department is structured into three divisions namely:</div> <div> 1. Policy Division:</div> <div> Policy Division is responsible primarily for dealing with policy matters in the areas of</div> <div> export/ import transactions, issuance of Authorized Dealer’s license, Foreign Exchange</div> <div> Exposure Limits, Foreign Currency Accounts Scheme, Exchange Risk Cover Fee on</div> <div> Medium & Long Term Loans, etc</div> <div> 2. Investment Division:</div> <div> This division primarily facilitates implementation and compliance of policy of the</div> <div> Government for investments in Pakistan and abroad. This is carried out by offering</div> <div> feedback on matters of varied natures, reviewing and updating of investment related policies</div> <div> and activities and operational management</div> <div> 3. Exchange Companies Division:</div> <div> Policy formulation for establishing Exchange Companies & ensuring adequate framework</div> <div> for licensing, operating, effective supervision & monitoring thereof are the prime</div> <div> responsibilities of Exchange Companies Division. These activities are carried out in close</div> <div> coordination with other the Field Offices of SBP-BSC and concerned government</div> <div> functionaries etc. It also organizes training and development activities for the respective</div> <div> financial institutions and concerned bodies.</div> <div> Banking Policy & Regulations Department</div> <div> Due to major fundamental changes in the scope and orientation of financial systems in</div> <div> 1990, and the subsequent need to put in place a more prudent regulatory framework to cope</div> <div> with the changing conditions, Prudential Regulations were put in place first in 1992.</div> <div> Since then, the Prudential Regulations have been reviewed many times and the latest</div> <div> version relates to three different sets covering the areas of Corporate, SMEs and Consumers</div> <div> financing.</div> <div> Basic Purpose of Prudential Regulations</div> <div> Prudential Regulations have been issued by State Bank of Pakistan to put in place a prudent</div> <div> regulatory framework for ensuring safety and soundness of the financial system besides</div> <div> protecting the interests of users of financial services.</div> <div> Human Resources Department</div> <div> Divisions of HRM Department</div> <div> • Compensation & Benefits Division</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 32</div> <div> • Employee Relations Division</div> <div> • Human Resource Information System Divisions</div> <div> • Performance Management Division</div> <div> • Planning & Development Division</div> <div> • Recruitment Division</div> <div> Information Systems & Technology Department</div> <div> ISTD with its capabilities, methodologies, and experience aims at technological</div> <div> advancement in SBP, focusing on solutions that intend to reduce operating costs, improve</div> <div> end-user performance, and meet overall business goals. Success competitiveness in today’s</div> <div> marketplace requires extra effort centered upon ISTD’s value to provide high-quality</div> <div> solutions and services, effective communication, and smooth 24/7 operations.</div> <div> Audit Department</div> <div> The prime objective of audit department is to examine and evaluate whether the SBP’s</div> <div> frame work of risk management, control, and governance processes, is adequate and</div> <div> functioning properly. In addition, the objectives of audit department include advising and</div> <div> recommending senior management for improvements in internal control and risk</div> <div> management systems. Audit Department is performing two types of functions i.e. Financial</div> <div> & Operational Audit and I.T Audit. Currently, Audit has three dedicated teams for Financial</div> <div> & Operational audit and one team for I.T audit. In addition to this, the Department has one</div> <div> Compliance Cell and one Services Unit</div> <div> Off-site Supervision & Enforcement Department</div> <div> (OSED) is one of the newly created departments emerging in the wake of re-organization of</div> <div> former Banking Supervision Department under recent SBP restructuring. OSED is</div> <div> responsible for off-site supervision of the financial institutions coming under regulatory</div> <div> purview of the State Bank of Pakistan (SBP). The department also ensures effective</div> <div> enforcement of regulatory and supervisory policies, monitors risk profiles, evaluates</div> <div> operating performance of individual banks/DFIs and takes necessary enforcement actions</div> <div> against institutions for their non-compliance (with laws of the land and regulations put in</div> <div> place by the SBP) as identified by, the inspection teams of BID during their onsite</div> <div> examination, and/or by the supervisors of this department based on submitted returns,</div> <div> interaction with financial institutions and market information. Currently, over 50 financial</div> <div> institutions are supervised by the State Bank of Pakistan. These include banks,</div> <div> Development Finance Institutions (DFIs), and Microfinance Banks & institutions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 33</div> <div> Lecture # 11</div> <div> MAJOR DRIVERS OF FINANCIAL INDUSTRY</div> <div> MACRO ECONOMIC PERFORMANCE OF A COUNTRY</div> <div> National Income</div> <div> People of any country produce a specific quantity of different goods and services from the</div> <div> natural resources by the help of capital goods with in a specific period, usually one year and</div> <div> this is called income of a country</div> <div> Concepts of National Income</div> <div> 1. Gross National Product “GDP” or Gross National Income “GNI” GDP or GNI</div> <div> is defined as “the total market value of all the final goods and services produced in a</div> <div> year.”</div> <div> 2. Net National Product “NNP” or Net National Income “NNP” “It means net value</div> <div> of all the goods and services produced in a country during a year is called Net</div> <div> National Income.”</div> <div> Difference b/w GDP & GNP</div> <div> 1. GDP is the value of goods and services in the country during a year minus the value</div> <div> of inputs.</div> <div> 2. GNP represents GDP plus net factor income payments from abroad.</div> <div> MAJOR DRIVERS OF FINANCIAL INDUSTRY</div> <div> Regulating risk and the importance of risk management</div> <div> Key challenge for regulators is to find ways to manage risks adequately. They have to</div> <div> ensure the prudential soundness of financial institutions and the stability of the system at</div> <div> large. But they also have to avoid stifling innovation and limiting the growth potential of the</div> <div> institutions concerned.</div> <div> Basel 2 Type Rules for Insurers</div> <div> Challenge in regulating institutions is to reflect market structures. There are now increasing</div> <div> calls to apply the principles of the Basel 2 bank capital accord to insurance regulation.</div> <div> There is an important angle to this call. Systemic risk in a financial stability sense is not any</div> <div> longer confined to banks. The process of securitization has changed all that. And more</div> <div> recently, growing inter linkages with the insurance sector emphasize the need for a further</div> <div> rethink.</div> <div> GLOBAL FINANCIAL SYSTEM</div> <div> The global financial system (GFS) is a financial system consisting of institutions and</div> <div> regulations that act on the international level, as opposed to those that act on a national or</div> <div> regional level. The main players are the global institutions, such as International Monetary</div> <div> Fund and Bank for International Settlements, national agencies and government</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 34</div> <div> departments, e.g., central banks and finance ministries, and private institutions acting on the</div> <div> global scale, banks and hedge funds.</div> <div> HISTORY OF INTERNATIONAL FINANCIAL INSTITUTIONS</div> <div> In Europe, it may have started with the first commodity exchange, the Bruges Bourse in</div> <div> 1309 and the first financiers and banks in the 1400–1600s in central and Western Europe</div> <div> The first global financiers the Fuggers (1487) in Germany; the first stock company in</div> <div> England (Russia Company 1553); the first foreign exchange market (The Royal Exchange</div> <div> 1566, England); the first stock exchange (the Amsterdam Stock Exchange 1602).</div> <div> Milestones in the history of financial institutions are the Gold Standard (1871–1932), the</div> <div> founding of IMF, World Bank at Bretton Woods, and the abolishment of fixed exchange</div> <div> rates in 1973.</div> <div> INTERNATIONAL FINANCIAL INSTITUTIONS</div> <div> International Monetary Fund</div> <div> The International Monetary Fund keeps account of international balance of payments</div> <div> accounts of member states. The IMF acts as a lender of last resort for members in financial</div> <div> distress, e.g. currency crisis, problems meeting balance of payment when in deficit and debt</div> <div> default. Membership is based on quotas, or the amount of money a country provides to the</div> <div> fund relative to the size of its role in the international trading system. The IMF describes</div> <div> itself as "an organization of 185 countries (Montenegro being the 185th, as of January 18,</div> <div> 2007), working to foster global monetary cooperation, secure financial stability, facilitate</div> <div> international trade, promote high employment and sustainable economic growth, and reduce</div> <div> poverty". With the exception of North Korea, Cuba, Andorra, Monaco, Tuvalu, and Nauru,</div> <div> all UN member states participate directly in the IMF. Some are represented by other</div> <div> member states on a 24-member Executive Board but all member countries are members of</div> <div> the IMF's Board of Governors.</div> <div> Membership Qualifications</div> <div> Any country may apply for membership to the IMF. The application will be considered first</div> <div> by the IMF's Executive Board. After its consideration, the Executive Board will submit a</div> <div> report to the Board of Governors of the IMF with recommendations in the form of a</div> <div> "Membership Resolution.</div> <div> The World Bank</div> <div> The World Bank (the Bank), a part of the World Bank Group (WBG), was formally</div> <div> established on December 27, 1945, following the ratification of the Bretton Woods</div> <div> agreement. The concept was originally conceived in July 1944 at the United Nations</div> <div> Monetary and Financial Conference. Two years later the Bank issued its first, & smallest,</div> <div> loan; $250 million to France for post-war reconstruction; an issue which has remained a</div> <div> primary focus, alongside reconstruction after natural disasters, humanitarian emergencies &</div> <div> post-conflict rehabilitation needs affecting developing & transition economies.</div> <div> The World Bank, as it is commonly referred to, consists of two agencies of the five that</div> <div> comprise the World Bank Group:</div> <div> 1. The International Bank for Reconstruction & Development (IBRD)</div> <div> 2. The International Development Association (IDA)</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 35</div> <div> Activities of World Bank</div> <div> The World Bank’s activities are focused on the reduction of global poverty, focusing on the</div> <div> achievement of the Millennium Development Goals (MDGs), goals calling for the</div> <div> elimination of poverty and the implementation of sustainable development. The constituent</div> <div> parts of the Bank, the IBRD and the IDA, achieve their aims through the provision of low or</div> <div> no interest loans and grants to countries with little or no access to international credit</div> <div> markets. The Bank is a market based non-profit organization, using its high credit rating to</div> <div> make up for the low interest rate of loans. The Bank not only provides financial support to</div> <div> its member states, but also analytical and advisory services to facilitate the implementation</div> <div> of the lasting economic and social improvements that are needed in many</div> <div> Under-developed countries, as well as educating members with the knowledge necessary to</div> <div> resolve their development problems while promoting economic growth.</div> <div> Country Assistance Strategies</div> <div> As a guideline to the World Bank's operations in any particular country, a Country</div> <div> Assistance Strategy is produced, in cooperation with the local government and any</div> <div> interested stakeholders and may rely on analytical work performed by the Bank or other</div> <div> parties. In the case of low income countries, the Country Assistance Strategy is derived</div> <div> from the country’s Poverty Reduction Strategy Paper.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 36</div> <div> Lecture # 12</div> <div> INTERNATIONAL FINANCIAL INSTITUTIONS</div> <div> World Trade Organization</div> <div> (WTO) is an international organization designed to supervise and liberalize international</div> <div> trade. The WTO came into being on January 1, 1995, and is the successor to the General</div> <div> Agreement on Tariffs and Trade (GATT), which was created in 1947, and continued to</div> <div> operate for almost five decades as a de facto international organization. The WTO is</div> <div> governed by a Ministerial Conference, which meets every two years; a General Council,</div> <div> which implements the conference's policy decisions and is responsible for day-to-day</div> <div> administration; and a director-general, who is appointed by the Ministerial Conference. The</div> <div> WTO's headquarters are in Geneva, Switzerland.</div> <div> Criticism on WTO</div> <div> Although the stated aim of the WTO is to promote free trade and stimulate economic</div> <div> growth, some believe that globally free trade results in the rich (both people and countries)</div> <div> becoming richer, while the poor are getting poorer. Martin Khor, Director of the Third</div> <div> World Network, argues that the WTO does not manage the global economy impartially, but</div> <div> in its operation has a systematic bias toward rich countries and multinational corporations,</div> <div> harming smaller countries which have less negotiation power. He argues that developing</div> <div> countries have not benefited from the WTO Agreements of the Uruguay Round, because</div> <div> (among other reasons): market access in industry has not improved; these countries have no</div> <div> gains yet from the phasing out of textiles quotas; non-tariff barriers such as anti-dumping</div> <div> measures have increased; domestic support and export subsidies for agricultural products in</div> <div> the rich countries remain high. Other critics have characterized the decision making in the</div> <div> WTO as complicated, ineffective, unrepresentative, and non-inclusive, and they have</div> <div> proposed the establishment of a small, informal steering committee (a "consultative board")</div> <div> that can be delegated responsibility for developing consensus on trade issues among the</div> <div> member countries.</div> <div> Role of WTO in Pakistan Trade Environment</div> <div> Pakistan is one of the founder Members of the WTO since 1995, and its predecessor</div> <div> organization the GATT set up in 1948. We are following an export led growth strategy and</div> <div> as such market access is of vital importance for our businesses. The increase in preferential</div> <div> arrangements and free trade areas between some members is also eroding our market</div> <div> access. Therefore in order to maintain current markets and gain new ones for our exportable</div> <div> goods and services we are dependent on the WTO to get tariff and non tariff barriers</div> <div> lowered on an MFN basis. Such MFN liberalization effectively levels the playing field for</div> <div> competitive suppliers.</div> <div> Pakistan has been actively engaged in the Doha round of trade talks that were launched in</div> <div> the Qatari capital in November 2001. Aptly named the "Doha Development Agenda", this</div> <div> round of trade talks has been focusing on removing distortions in the world agriculture</div> <div> markets and attaining enhanced market access for both products and service providers from</div> <div> Pakistan.</div> <div> Since 2001, there have two more ministerial conferences in Cancun in 2003 and Hong Kong</div> <div> in 2005 respectively. There have been many ups and downs in the road to a successful</div> <div> conclusion to the Doha round that takes into account the myriad interests of the developing</div> <div> membership. There was a breakdown of talks in the summer of 2006 which led many</div> <div> observers to be skeptical of the entire process. However, sustained efforts by the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 37</div> <div> membership led to a partial resumption of the talks in November 2006 & full resumption</div> <div> since January 2007 after the annual meeting of the World economic forum at Davos.</div> <div> Asian Development Bank</div> <div> (ADB) is a regional development bank established in 1966 to promote economic and social</div> <div> development in Asian and Pacific countries through loans and technical assistance. It is a</div> <div> multilateral development financial institution owned by 67 members, 48 from the region</div> <div> and 19 from other parts of the globe. ADB's vision is a region free of poverty. Its mission is</div> <div> to help its developing member countries reduce poverty and improve the quality of life of</div> <div> their citizens.</div> <div> The work of the Asian Development Bank (ADB) is aimed at improving the welfare of the</div> <div> people in Asia and the Pacific, particularly the 1.9 billion who live on less than $2 a day.</div> <div> Despite many success stories, Asia and the Pacific remains home to two thirds of the</div> <div> world's poor. All projects funded by the Asian Development Bank are evaluated to assess</div> <div> their development effectiveness. There are two levels of evaluation—self evaluation and</div> <div> independent evaluation.</div> <div> All projects are self-evaluated by the relevant ADB operations department in a project</div> <div> completion report. ADB’s project completion reports are publicly disclosed and are</div> <div> available on ADB’s Internet site. Client governments are also required to prepare their own</div> <div> project completion reports.</div> <div> ADB Projects in Pakistan</div> <div> ADB started its operations for Pakistan in 1968. As of 31 December 2001, ADB's</div> <div> cumulative assistance to Pakistan totaled some $11.5 billion, of which $8.0 billion had been</div> <div> disbursed. Cumulatively, 47 percent of this assistance has been from our soft window, the</div> <div> Asian Development Fund (ADF), while the balance 53 percent came from our Ordinary</div> <div> Capital Resources (OCR) window. In addition, we have provided cumulative grant technical</div> <div> assistance of $92 million.</div> <div> Investment projects have a common theme of poverty reduction and recent examples</div> <div> include:</div> <div> 1. Trade, Export Promotion and Industry Programme (TEPI - US$300 million)</div> <div> approved in March 1999 focuses on providing support to the Government for trade</div> <div> liberalization and modernization of trade policies. The Program was completed in</div> <div> July 2002;</div> <div> 2. Micro-finance Sector Development Programme (MFSDP-US$ 150 million)</div> <div> approved in December 2000 focuses on the development of sustainable rural</div> <div> microfinance services through commercial banking & credit unions to provide</div> <div> access to easy loans, assisted establishment of the Khushhali Bank. The Program is</div> <div> still ongoing;</div> <div> 3. Energy Sector Restructuring Programme (ESRP-US$ 355 million) approved in</div> <div> December 2000 focuses on a major reform of the energy sector by putting in place a</div> <div> self sustaining, efficient and competitive power sector. The Program is currently</div> <div> ongoing;</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 38</div> <div> 4. Decentralization Support Program (DSP- US$300 million) approved in</div> <div> November 2002 supports the ongoing decentralization process and related reforms</div> <div> of the Government;</div> <div> 5. Rural Finance Sector Development Programme (RFSDP- US$250 million)</div> <div> approved in December 2002 is providing easy access to loans by the rural</div> <div> population, provision of finance for the poor, expansion of rural finance, promotion</div> <div> of SMEs, and restructuring of the (ADBP);</div> <div> 6. Punjab Road Sector Development Project - US$150 million was approved in</div> <div> 2002 to build up the existing road structure, provincial highways, capacity building</div> <div> of executing agencies in Punjab. The Project has commenced recently.</div> <div> Paris Club</div> <div> The Paris Club is an informal group of financial officials from 19 of the world's richest</div> <div> countries, which provides financial services such as debt restructuring, debt relief, and debt</div> <div> cancellation to indebted countries and their creditors. Debtors are often recommended by</div> <div> the International Monetary Fund after alternative solutions have failed. Pakistan first went</div> <div> to the Paris Club in January 1999 for rescheduling of bilateral loans, which were contracted</div> <div> up to September 30, 1997.</div> <div> The country was granted debt service relief of $ 3 billion for the first consolidation period,</div> <div> which extended from January 1, 1999 to December 31, 2000.</div> <div> At the end of this period, Pakistan signed a second rescheduling agreement in January 2001,</div> <div> which covered debt service payments due in the period from January 1, 2001 to September</div> <div> 30, 2001.</div> <div> In 2004, the Club decided to write-off the debts of Iraq, as the rebuilding of Iraq is</div> <div> incomparable. After the 2004 Indian Ocean earthquake, the Paris Club decided to suspend</div> <div> temporarily some of the repayment obligations of the affected countries.</div> <div> In order to secure comparable treatment of its debt due to all its external public or private</div> <div> creditors, Pakistan commits itself to seek promptly from all its external creditors debt</div> <div> reorganization arrangements on terms comparable to those set forth in the present Agreed</div> <div> Minute, while trying to avoid discrimination among different categories of creditors.</div> <div> Consequently, Pakistan commits itself to accord all categories of creditors -and in particular</div> <div> creditor countries not participating in the present Agreed Minute, and private creditors- a</div> <div> treatment not more favorable than that accorded to the Participating Creditor Countries for</div> <div> credits of comparable maturity.</div> <div> For the purpose of the comparison between the arrangements concluded by the Islamic</div> <div> Republic of Pakistan with its creditors not listed in the present Agreed Minute on the one</div> <div> hand, and with the Participating Creditor Countries on the other hand, all relevant elements</div> <div> will be taken into account, including the real exposure of the creditors not participating in</div> <div> the present Agreed Minute, the level of cash payments received by those creditors from the</div> <div> Islamic Republic of Pakistan as compared to their share of the Islamic Republic of</div> <div> Pakistan's external debt, the nature and characteristics of all treatment applied, including</div> <div> debt buy backs, and all characteristics of the reorganized claims. And in particular their</div> <div> repayment terms whatever forms they take and in general the financial relations between the</div> <div> Islamic Republic of Pakistan and the creditors not listed in the present Agreed Minute.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 39</div> <div> The Islamic Republic of Pakistan will inform in writing the Chairman of the Paris Club not</div> <div> later than September 1, 2002 of the progress made in negotiations with other creditors, as</div> <div> well as of the contents of the negotiations. the Islamic Republic of Pakistan will further</div> <div> inform in writing regularly the Chairman of the Paris Club of the status of its negotiations</div> <div> with other creditors, as well as of the payments made to them. Pakistan receives economic</div> <div> aid from several sources as loans and grants. The International Monetary Fund (IMF),</div> <div> World Bank (WB), Asian Development Bank (ADB), etc provides long term loans to</div> <div> Pakistan. Pakistan also receives bilateral aid from developed and oil-rich countries.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 40</div> <div> Lecture # 13</div> <div> PAKISTAN ECONOMIC AID & DEBT</div> <div> The Asian Development Bank will provide close to $ 6 billion development assistance to</div> <div> Pakistan during 2006-9. The World Bank unveiled a lending program of up to $6.5 billion</div> <div> for Pakistan under a new four-year, 2006-2009, aid strategy showing a significant increase</div> <div> in funding aimed largely at beefing up the country's infrastructure. Japan will provide $500</div> <div> million annual economic aid to Pakistan.</div> <div> The major causes of poverty in Pakistan</div> <div> • Lack of employment opportunities, which in the rural setting is caused by the</div> <div> absence of rural-urban linkages.</div> <div> • A slowdown in the pace of economic growth in the 1990s</div> <div> • With the burgeoning debt obligations, a decline in the public sector development</div> <div> program.</div> <div> Key challenges facing the Government of Pakistan</div> <div> 1. Restoring economic growth-constrained further by a drought-affected agriculture</div> <div> sector</div> <div> 2. Managing the large debt burden with international financial institutions.</div> <div> 3. Promoting domestic and foreign investors' confidence</div> <div> 4. Increasing exports to generate foreign exchange,</div> <div> 5. Maintaining a level of social development spending to stem the deteriorating social</div> <div> indicators.</div> <div> 6. Law and Order, or Terrorism</div> <div> Future Prospects for Pakistan's Economy</div> <div> Pakistan's long term prospects will depend upon the interplay of evolution in political and</div> <div> social developments, economic policies to be pursued, the quality of governance and</div> <div> institutions, and most important investment in the human capital. It has become quite</div> <div> obvious from both Pakistan's own history and the experience of the developing countries</div> <div> that sustained economic growth and poverty reduction cannot take place merely on the</div> <div> strength of economic policies. Political stability, social cohesion, supporting institutions,</div> <div> and good governance are equally important ingredients coupled with both external</div> <div> environments for achieving economic success.</div> <div> Macroeconomic Stability</div> <div> Pakistan must strive to maintain its present level of macroeconomic stability. The most</div> <div> important thing needed is the will power of the ruling elite and the continuity of structural</div> <div> reforms undertaken by the military government. The country is now on the path to</div> <div> macroeconomic stability and is less vulnerable to external shocks than it was a decade ago.</div> <div> There has been improvement in all of the major macroeconomic indicators. The growth rate</div> <div> of the economy, which was under 4 percent during the 1990s, has shown considerable</div> <div> improvement.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 41</div> <div> Strengthening Institutions</div> <div> Recent empirical evidence suggests that sound economic policies cannot make any</div> <div> difference in the lives of the common citizens if the country does not have strong</div> <div> institutions to implement such policies. Pakistan inherited a strong civil service, judiciary,</div> <div> and police, which satisfied the demands of millions of people. But as its population</div> <div> expanded, the nature of governance became more complex and the capacity of these</div> <div> institutions did not keep pace with the emerging demands of the economy. These</div> <div> institutions were weakened by a succession of non-professional peoples. Finally, there is a</div> <div> need to improve the institutions of inter-provincial harmony to help in eradicating interprovincial</div> <div> competition and jealousy. The Council of Common Interest, National Economic</div> <div> Council, and National Finance Commission are three institutions that are concerned with the</div> <div> distribution of the resources among the provinces. If these institutions were strengthened,</div> <div> policies that favor one province over another would not be adopted, which has been quite</div> <div> common in the past.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 42</div> <div> Lecture # 14</div> <div> INCREASING FOREIGN DIRECT INVESTMENT</div> <div> Pakistan must increase Foreign Direct Investment, if it intends to enhance the growth of its</div> <div> economy. The experience of the developing countries is that FDI is directly related to</div> <div> economic growth. Two recent examples from the developing world are China and India.</div> <div> The following factors have proven to be critical for attracting foreign investment:</div> <div> 1. World-class physical infrastructure</div> <div> 2. A secure law and order situation</div> <div> 3. Skilled and productive labor</div> <div> 4. Innovative capacities</div> <div> 5. Agglomeration of efficient suppliers, competitors</div> <div> 6. A well-developed institutional infrastructure</div> <div> Foreign Interest in Local Financial Markets</div> <div> With the rapid growth in Pakistan's economy, foreign investors are taking a keen interest in</div> <div> the corporate sector of Pakistan. In the recent years, majority stakes in many corporations</div> <div> have been acquired by multinational groups.</div> <div> Enhancing and Sustaining a Growing GDP</div> <div> There have been two problems with the GDP growth rate in Pakistan. First, Pakistan has not</div> <div> been able to sustain growth over the long term. Sometimes Pakistan grows at a rate of</div> <div> around 7 percent and sometimes it retreats to a 3 percent growth rate.</div> <div> Second, the growth rate of the economy in Pakistan has not been linked to improvement in</div> <div> human development factors. Basic indicators like education, health, poverty, safe drinking</div> <div> water, etc., have been neglected in Pakistan. The "trickle down theories" and market forces</div> <div> of the 1970s and 1980s have failed to provide relief for the general public. A need exists to</div> <div> link the growth rate of the economy to improvement in human development. The basic</div> <div> argument is that a higher growth rate is of limited utility if it does not benefit the population</div> <div> as a whole, including the poor.</div> <div> How can Pakistan improve and sustain its growth rate?</div> <div> Production in agriculture must be enhanced because of its large share of the GDP.</div> <div> Agricultural production can be improved by taking two kinds of measures. First, the</div> <div> government must provide facilities to small and medium landowners to cultivate their lands.</div> <div> These facilities may include the provision of seeds, fertilizers, machinery, and water.</div> <div> Second, the government must play an important role in determining the prices of the goods</div> <div> produced in the agriculture sector. It is really discouraging to farmers when they are not</div> <div> getting adequate prices for their products, exacerbating rural flight to urban areas.</div> <div> Industrial Sector</div> <div> In the industrial sector, the government must place emphasis on the development of small</div> <div> and medium industries. The government can facilitate this by providing targeted loans to</div> <div> this sector. Pakistan can substantially increase export earnings from light industry in the</div> <div> areas of carpet and textiles, sports equipment, dairy products, etc. The sick heavy industrial</div> <div> units promoted in the past should be rationalized, because they have become a burden on</div> <div> the economy. India is a classic case study of effective transition in this regard.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 43</div> <div> Inter-provincial harmony in Pakistan</div> <div> There is a need to create inter-provincial harmony in Pakistan. In the past there has been a</div> <div> perception of deprivation and exploitation of the smaller provinces by the larger ones. Interprovincial</div> <div> tensions have revolved around issues of resource distribution, investment and</div> <div> employment, water issues, etc. These factors hinder the growth rate of the economy.</div> <div> Pakistan needs to create inter-provincial harmony to achieve better growth.</div> <div> Achieving a Favorable Balance of Trade</div> <div> Pakistan's trade balance has been in deficit most of the time since the country's</div> <div> independence. Despite much effort by successive governments to liberalize trade, Pakistan's</div> <div> trade regime still has many barriers that are preventing it from being successful. Pakistan</div> <div> has faced various problems in trying to integrate its economy with world markets. The</div> <div> opponents of economic integration with world markets argue that it will lead to deindustrialization</div> <div> of Pakistan. The basic problem for Pakistan is that its exports are mostly</div> <div> raw materials, which are subject to severe price fluctuations in international market prices.</div> <div> The main exports of Pakistan, cotton and rice, are less competitive in international markets.</div> <div> Managing the Debt</div> <div> The external debt can be managed by taking the following policy measures:</div> <div> 1) Controlling the non-development expenditures of the government, which are</div> <div> currently consuming around 70 percent of public revenue</div> <div> 2) Accelerating and sustaining the GDP growth rate</div> <div> 3) Introducing an effective judicial system that strengthens accountability. This will</div> <div> help in reducing economic corruption and mismanagement.</div> <div> 4) Continuing austerity measures and containing current expenditures on the part of the</div> <div> government.</div> <div> 5) Providing more incentive to Pakistani citizens abroad and foreign residents of</div> <div> Pakistan to transfer their currency into the country. Foreign remittances will help in building</div> <div> up the foreign exchange reserves, thereby reducing the demand on the public debt.</div> <div> Economic Resilience</div> <div> Despite this record of sustained growth, Pakistan's economy had, until a few years ago, been</div> <div> characterized as unstable and highly vulnerable to external and internal shocks. However,</div> <div> the economy proved to be unexpectedly resilient in the face of multiple adverse events</div> <div> concentrated into a four-year period.</div> <div> 􀂋 The Asian financial crisis;</div> <div> 􀂋 Economic sanctions — according to Colin Powell, Pakistan was "sanctioned to the</div> <div> eyeballs";</div> <div> 􀂋 Global recession;</div> <div> 􀂋 Severe rioting in the port city of Karachi;</div> <div> 􀂋 Heightened perceptions of risk as a result of military tensions with India — with as</div> <div> many as a million troops on the border, and predictions of impending (potentially</div> <div> nuclear) war;</div> <div> 􀂋 The post-9/11 military action in neighboring Afghanistan, with a massive influx of</div> <div> refugees from that country;</div> <div> 􀂋 The 2005 Pakistan earthquake</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 44</div> <div> Conclusion</div> <div> Despite these adverse events, Pakistan's economy kept growing, and economic growth</div> <div> accelerated towards the end of this period. This resilience has led to a change in perceptions</div> <div> of the economy, with leading international institutions such as the IMF, World Bank, and</div> <div> the ADB praising Pakistan's performance in the face of adversity.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 45</div> <div> Lecture # 15</div> <div> ROLE OF COMMERCIAL BANKS</div> <div> A bank is a commercial or state institution that provides financial services, including</div> <div> issuing money in various forms, receiving deposits of money, lending money and</div> <div> processing transactions and the creating of credit.</div> <div> A commercial bank accepts deposits from customers and in turn makes loans, even in</div> <div> excess of the deposits; a process known as fractional-reserve banking. Some banks (called</div> <div> Banks of issue) issue banknotes as legal tender. A commercial bank is usually defined as</div> <div> an institution that both accepts deposits and makes loans; there are also financial institutions</div> <div> that provide selected banking services without meeting the legal definition of a bank. Many</div> <div> banks offer ancillary financial services to make additional profit; for example, most banks</div> <div> also rent safe deposit boxes in their branches. Currently in most jurisdictions commercial</div> <div> banks are regulated & require permission to operate. Operational authority is granted by</div> <div> bank regulatory authorities who provide rights to conduct the most fundamental banking</div> <div> services such as accepting deposits and making loans.</div> <div> Purpose of a bank:</div> <div> Banks have influenced economies & politics for centuries. Historically, the primary</div> <div> purpose of a bank was to provide loans to trading companies. Banks provided funds to</div> <div> allow businesses to purchase inventory, and collected those funds back with interest when</div> <div> the goods were sold.</div> <div> Commercial Lending:</div> <div> For centuries, the banking industry only dealt with businesses, not consumers. Commercial</div> <div> lending today is a very intense activity, with banks carefully analyzing the financial</div> <div> condition of their business clients to determine the level of risk in each loan transaction.</div> <div> Banking Services:</div> <div> Banking services have expanded to include services directed at individuals, and risks in</div> <div> these much smaller transactions are pooled.</div> <div> A Bank’s Profit</div> <div> A bank generates a profit from the differential between the level of interest it pays for</div> <div> deposits and other sources of funds, and the level of interest it charges in its lending</div> <div> activities. This difference is referred to as the spread between the cost of funds and the loan</div> <div> interest rate. Historically, profitability from lending activities has been cyclic and dependent</div> <div> on the needs and strengths of loan customers. In recent history, investors have demanded a</div> <div> more stable</div> <div> revenue stream and banks have therefore placed more emphasis on transaction fees,</div> <div> primarily loan fees but also including service charges on array of deposit activities and</div> <div> ancillary services (international banking, foreign exchange, insurance, investments, wire</div> <div> transfers, etc.). However, lending activities still provide the bulk of a commercial bank's</div> <div> income.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 46</div> <div> The name bank derives from the Italian word banco "desk/bench", used during the</div> <div> Renaissance by Florentines bankers, who used to make their transactions above a desk</div> <div> covered by a green tablecloth.</div> <div> However, there are traces of banking activity even in the Babylonian times, and indeed a</div> <div> book about the history of banking is named: Banking, from Babylon to Wall Street.</div> <div> Services Typically Offered by Banks</div> <div> Although the basic type of services offered by a bank depends upon the type of bank and the</div> <div> country, services provided usually include:</div> <div> 1. Taking deposits from their customers and issuing current (Pak) or checking (US)</div> <div> accounts and savings accounts to individuals and businesses.</div> <div> 2. Extending loans to individuals and businesses.</div> <div> 3. Cashing cheque</div> <div> 4. Facilitating money transactions such as wire transfers and cashier's checks</div> <div> 5. Issuing credit cards, ATM cards, and debit cards</div> <div> 6. Storing valuables, particularly in a safe deposit box</div> <div> 7. Consumer & commercial financial advisory services</div> <div> 8. Pension & retirement planning</div> <div> Financial transactions can be performed through many different channels:</div> <div> 1. A branch, banking centre or financial centre is a retail location where a bank or</div> <div> financial institution offers a wide array of face to face service to its customers.</div> <div> 2. ATM is a computerized telecommunications device that provides a financial</div> <div> institution's customers a method of financial transactions in a public space without</div> <div> the need for a human clerk or bank teller</div> <div> 3. Mail is part of the postal system which itself is a system wherein written documents</div> <div> typically enclosed in envelopes, and also small packages containing other matter, are</div> <div> delivered to destinations around the world</div> <div> 4. Telephone banking is a service provided by a financial institution which allows its</div> <div> customers to perform transactions over the telephone.</div> <div> 5. Online banking is a term used for performing transactions, payments etc. over the</div> <div> Internet through a bank, credit union or building society's secure website.</div> <div> Types of banks</div> <div> Banks' activities can be divided into retail banking, dealing directly with individuals and</div> <div> small businesses; business banking, providing services to mid-market business; corporate</div> <div> banking, directed at large business entities; and investment banking, relating to activities on</div> <div> the financial markets.</div> <div> Most banks are profit-making, private enterprises. However, some are owned by</div> <div> government, or are non-profits.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 47</div> <div> Central banks are non-commercial bodies or government agencies often charged with</div> <div> controlling interest rates and money supply across the whole economy. They generally</div> <div> provide liquidity to the banking system and act as Lender of last resort in event of a crisis.</div> <div> • Commercial bank: the term used for a normal bank to distinguish it from an</div> <div> investment bank. After the Great Depression, the U.S. Congress required that banks</div> <div> only engage in banking activities, whereas investment banks were limited to capital</div> <div> market activities. Since the two no longer have to be under separate ownership,</div> <div> some use the term "commercial bank" to refer to a bank or a division of a bank that</div> <div> mostly deals with deposits and loans from corporations or large businesses.</div> <div> • Community Banks: locally operated financial institutions that empower employees</div> <div> to make local decisions to serve their customers and the partners</div> <div> • Community development banks: regulated banks that provide financial services</div> <div> and credit to underserved markets or populations.</div> <div> • Postal savings banks: savings banks associated with national postal systems.</div> <div> • Private Banks: manage the assets of high net worth individuals.</div> <div> • Offshore Banks: banks located in jurisdictions with low taxation and regulation.</div> <div> Many offshore banks are essentially private banks.</div> <div> • Savings bank: in Europe, savings banks take their roots in the 19th or sometimes</div> <div> even 18th century. Their original objective was to provide easily accessible savings</div> <div> products to all strata of the population. In some countries, savings banks were</div> <div> created on public initiative, while in others socially committed individuals created</div> <div> foundations to put in place the necessary infrastructure. Nowadays, European</div> <div> savings banks have kept their focus on retail banking: payments, savings products,</div> <div> credits and insurances for individuals or small and medium-sized enterprises.</div> <div> • Apart from this retail focus, they also differ from commercial banks by their broadly</div> <div> decentralized distribution network, providing local and regional outreach and by</div> <div> their socially responsible approach to business and society.</div> <div> • Building societies and Lands-banks: conduct retail banking.</div> <div> • Ethical banks: banks that prioritize the transparency of all operations and make</div> <div> only what they consider to be socially-responsible investments.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 48</div> <div> Lecture # 16</div> <div> ROLE OF COMMERCIAL BANKS</div> <div> Types of investment banks</div> <div> • Investment banks "underwrite" (guarantee the sale of) stock and bond issues,</div> <div> trade for their own accounts, make markets, and advise corporations on capital</div> <div> markets activities such as mergers and acquisitions.</div> <div> • Merchant banks were traditionally banks which engaged in trade financing. The</div> <div> modern definition, however, refers to banks which provide capital to firms in the</div> <div> form of shares rather than loans. Unlike Venture capital firms, they tend not to</div> <div> invest in new companies</div> <div> Banks in the Economy</div> <div> Role in the money supply</div> <div> A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or</div> <div> issuing financial instruments in the money market or a capital market. The bank then lends</div> <div> out most of these funds to borrowers. However, it would not be prudent for a bank to lend</div> <div> out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it</div> <div> can repay depositors who withdraw their deposits.</div> <div> Bank reserves are typically kept in the form of a deposit with a central bank. This is called</div> <div> fractional-reserve banking and it is a central issue of monetary policy.</div> <div> Note that under Basel I (and the new round of Basel II), banks no longer keep deposits with</div> <div> central banks, but must maintain defined capital ratios</div> <div> Size of Global Banking Industry</div> <div> Worldwide assets of the largest 1,000 banks grew 15.5% in 2005 to reach a record $60.5</div> <div> trillion. This follows a 19.3% increase in the previous year. EU banks held the largest share,</div> <div> 50% at the end of 2005, up from 38% a decade earlier.</div> <div> The growth in Europe’s share was mostly at the expense of Japanese banks whose share</div> <div> more than halved during this period from 33% to 13%. The share of US banks also rose,</div> <div> from 10% to 14%. Most of the remainder was from other Asian and European countries.</div> <div> The US had by far the most banks (7,540 at end-2005) and branches (75,000) in the world.</div> <div> The large number of banks in the US is an indicator of its geography and regulatory</div> <div> structure, resulting in a large number of small to medium sized institutions in its banking</div> <div> system.</div> <div> Japan had 129 banks and 12,000 branches. In 2004, Germany, France, and Italy had more</div> <div> than 30,000 branches each—more than double the 15,000 branches in the UK.</div> <div> Bank Crisis</div> <div> 􀂋 Banks are susceptible to many forms of risk which have triggered occasional</div> <div> systemic crises. Risks include liquidity risk (the risk that many depositors will</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 49</div> <div> request withdrawals beyond available funds), credit risk (the risk that those who owe</div> <div> money to the bank will not repay), Interest rate risk (the risk that the bank will</div> <div> become unprofitable if rising interest rates force it to pay relatively more on its</div> <div> deposits than it receives on its loans), among others. Banking crises have developed</div> <div> many times throughout history when one or more risks materialize for a banking</div> <div> sector as a whole. Prominent examples include the U.S. Savings and Loan crisis in</div> <div> 1980s and early 1990s, the Japanese banking crisis during the 1990s, the bank run</div> <div> that occurred during the Great Depression, and the recent liquidation by the central</div> <div> Bank of Nigeria, where about 25 banks were liquidated.</div> <div> Challenges within the Banking Industry</div> <div> Economic Environment</div> <div> The changing economic environment has a significant impact on banks and thrifts as they</div> <div> struggle to effectively manage their interest rate spread in the face of low rates on loans, rate</div> <div> competition for deposits and the general market changes, industry trends and economic</div> <div> fluctuations.</div> <div> Growth Strategies</div> <div> It has been a challenge for banks to effectively set their growth strategies with the recent</div> <div> economic market. A rising interest rate environment may seem to help financial institutions,</div> <div> but the effect of the changes on consumers and businesses is not predictable and the</div> <div> challenge remains for banks to grow and effectively manage the spread to generate a return</div> <div> to their shareholders.</div> <div> The Management of the Banks</div> <div> The management of the banks’ asset portfolios also remains a challenge in today’s</div> <div> economic environment. Loans are a bank’s primary asset category and when loan quality</div> <div> becomes suspect, the foundation of a bank is shaken to the core. While always an issue for</div> <div> banks, declining asset quality has become a big problem for financial institutions. There are</div> <div> several reasons for this, one of which is the lax attitude some banks have adopted because of</div> <div> the years of “good times.” The potential for this is exacerbated by the reduction in the</div> <div> regulatory oversight of banks and in some cases depth of management. Problems are more</div> <div> likely to go undetected, resulting in a significant impact on the bank when they are</div> <div> recognized. In addition, banks, like any business, struggle to cut costs and have</div> <div> consequently eliminated certain expenses, such as adequate employee training programs.</div> <div> Banks also face a host of other challenges such as aging ownership groups. Across the</div> <div> country, many banks’ management teams and board of directors are aging. Banks also face</div> <div> ongoing pressure by shareholders, both public and private, to achieve earnings and growth</div> <div> projections. Regulators place added pressure on banks to manage the various categories of</div> <div> risk. Banking is also an extremely competitive industry.</div> <div> Competing in the financial services industry has become tougher with the entrance of such</div> <div> players as insurance agencies, credit unions, check cashing services, credit card companies,</div> <div> etc. Bank regulations are a form of government regulation which subject banks to certain</div> <div> requirements, restrictions, and guidelines, aiming to uphold the soundness and integrity of</div> <div> the financial system. The combination of the instability of banks as well as their important</div> <div> facilitating role in the economy led to banking being thoroughly regulated.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 50</div> <div> The amount of capital a bank is required to hold is a function of the amount and quality of</div> <div> its assets. Major Banks are subject to the Basel Capital Accord promulgated by the Bank</div> <div> for International Settlements.</div> <div> In addition, banks are usually required to purchase deposit insurance to make sure smaller</div> <div> investors are not wiped out in the event of a bank failure. Another reason banks are</div> <div> thoroughly regulated is that ultimately, no government can allow the banking system to fail.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 51</div> <div> Lecture # 17</div> <div> ROLE OF COMMERCIAL BANKS</div> <div> Public perceptions of banks</div> <div> In United States history, the National Bank was a major political issue during the</div> <div> presidency of Andrew Jackson. Jackson fought against the bank as a symbol of greed</div> <div> and profit-mongering, antithetical to the democratic ideals of the United States.</div> <div> Currently, many people consider that various banking policies take advantage of customers.</div> <div> In Canada, for example, the New Democratic Party has called for the abolition of user fees</div> <div> for automated teller transactions. Other specific concerns are policies that permit banks to</div> <div> hold deposited funds for several days, to apply withdrawals before deposits or from greatest</div> <div> to least, which is most likely to cause the greatest overdraft, that allow backdating funds</div> <div> transfers and fee assessments, and that authorize electronic funds transfers despite an</div> <div> overdraft.</div> <div> In response to the perceived greed and socially-irresponsible all-for-the-profit attitude of</div> <div> banks, in the last few decades a new type of bank called ethical banks have emerged, which</div> <div> only make socially-responsible investments (for instance, no investment in the arms</div> <div> industry) and are transparent in all its operations.</div> <div> In the US, credit unions have also gained popularity as an alternative financial resource for</div> <div> many consumers. Also, in various European countries, cooperative banks are regularly</div> <div> gaining market share in retail banking.</div> <div> Profitability</div> <div> Large banks in the United States are some of the most profitable corporations, especially</div> <div> relative to the small market shares they have. This amount is even higher if one counts the</div> <div> credit divisions of companies like Ford, which are responsible for a large proportion of</div> <div> those companies' profits.</div> <div> In the past 10 years in the United States, banks have taken many measures to ensure that</div> <div> they remain profitable while responding to ever-changing market conditions. First, this</div> <div> includes the Gramm-Leach-Bliley Act, which allows banks again to merge with investment</div> <div> and insurance houses. Merging banking, investment, and insurance functions allows</div> <div> traditional banks to respond to increasing consumer demands for "one-stop shopping" by</div> <div> enabling cross-selling of products (which, the banks hope, will also increase profitability).</div> <div> Second, they have expanded the use of risk-based pricing from business lending to</div> <div> consumer lending, which means charging higher interest rates to those customers that are</div> <div> considered to be a higher credit risk and thus increased chance of default on loans. This</div> <div> helps to offset the losses from bad loans, lowers the price of loans to those who have better</div> <div> credit histories, and offers credit products to high risk customers who would otherwise been</div> <div> denied credit. Third, they have sought to increase the methods of payment processing</div> <div> available to the general public and business clients. These products include debit cards, prepaid</div> <div> cards, smart-cards, and credit cards. These products make it easier for consumers to</div> <div> conveniently make transactions and smooth their consumption over time (in some countries</div> <div> with under-developed financial systems, it is still common to deal strictly in cash, including</div> <div> carrying suitcases filled with cash to purchase a home). However, with convenience there is</div> <div> also increased risk that consumers will mismanage their financial resources and accumulate</div> <div> excessive debt. Banks make money from card products through interest payments and fees</div> <div> charged to consumers and transaction fees to companies that accept the cards.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 52</div> <div> The banking industry's main obstacles to increasing profits are existing regulatory burdens,</div> <div> new government regulation, and increasing competition from non-traditional financial</div> <div> institutions.</div> <div> Society for Worldwide Inter-bank Financial Transactions</div> <div> ("SWIFT") operates a worldwide financial messaging network. Messages are securely and</div> <div> reliably exchanged between banks and other financial institutions. SWIFT also markets</div> <div> software and services to financial institutions, much of it for use on the SWIFT Network,</div> <div> and ISO 9362 bank identifier codes are popularly known as "SWIFT codes". The majority</div> <div> of international inter-bank messages use the SWIFT network. As of April 2006 SWIFT</div> <div> linked almost 8,000 financial institutions in 205 countries. SWIFT does not facilitate funds</div> <div> transfer. Financial institutions would need a corresponding banking relationship for</div> <div> financial transactions.</div> <div> SWIFT is a cooperative society under Belgian law and it is owned by its member financial</div> <div> institutions. SWIFT has offices around the world. SWIFT headquarters are located in La-</div> <div> Hulpe, Belgium, near Brussels.</div> <div> It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to</div> <div> establish common standards for financial transactions and a shared data processing system</div> <div> and worldwide communications network. Fundamental operating procedures, rules for</div> <div> liability etc., were established in 1975 and the first message was sent in 1977.</div> <div> SWIFT Services</div> <div> There are four key areas that SWIFT services fall under within the financial marketplace,</div> <div> Securities, Treasury & Derivatives, Trade Services, and Payments & Cash Management.</div> <div> COMMERCIAL BANKING IN PAKISTAN</div> <div> The banking sector in Pakistan has been going through a comprehensive but complex and</div> <div> painful process of restructuring since 1997. It is aimed at making these institutions</div> <div> financially sound and forging their links firmly with the real sector for promotion of</div> <div> savings, investment and growth. Although a complete turnaround in banking sector</div> <div> performance is not expected till the completion of reforms, signs of improvement are</div> <div> visible. The almost simultaneous nature of various factors makes it difficult to disentangle</div> <div> signs of improvement and deterioration.</div> <div> Commercial banks have been exposed and withstood several types of pressure since 1997.</div> <div> Some of these are:</div> <div> 1. Multipronged reforms introduced by the central bank,</div> <div> 2. Freezing of foreign currency accounts,</div> <div> 3. Continued stagnation in economic activities and low growth and</div> <div> 4. Drive for accountability and loan recovery. All these have brought a behavioral</div> <div> change both among the borrowers as well as the lenders. The risk aversion has been</div> <div> more pronounced than warranted.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 53</div> <div> Commercial banks operating in Pakistan can be divided into four categories:</div> <div> 1. Nationalized Commercial Banks (NCBs),</div> <div> 2. Privatized Banks,</div> <div> 3. Private Banks and</div> <div> 4. Foreign Banks.</div> <div> While preparing this report efforts have been made to evaluate the performance of each</div> <div> group which enjoy certain strengths and weaknesses as per procedure followed by State</div> <div> Bank of Pakistan (SBP). The central bank has been following a supervisory framework,</div> <div> CAMEL, which involves the analysis of six indicators which reflect the financial health of</div> <div> financial institutions.</div> <div> These are:</div> <div> 1. Capital Adequacy,</div> <div> 2. Asset Quality,</div> <div> 3. Management Soundness,</div> <div> 4. Earnings and Profitability,</div> <div> 5. Liquidity and</div> <div> 6. Sensitivity to Market Risk.</div> <div> Capital adequacy</div> <div> To protect the interest of depositors as well as shareholders, SBP introduced the risk based</div> <div> system for capital adequacy in late 1998. Banks are required to maintain 8 per cent capital</div> <div> to Risk Weighted Assets (CRWA) ratio. Banks were required to achieve a minimum paidup</div> <div> capital to Rs 500 million by December 31, 1998. This requirement has been raised to one</div> <div> billion rupee and banks have been given a deadline up to January 1, 2003 to comply with</div> <div> this.</div> <div> The ratio has deteriorated after 1998. However, it was fallout of economic sanctions</div> <div> imposed on Pakistan after it conducted nuclear tests. The shift in SBP policy regarding</div> <div> investment in securities also led to a fall in ratio. However, most of the banks have been</div> <div> able to maintain above the desired ratio as well as direct their investment towards more</div> <div> productive private sector advances. Higher provisioning against non-performing loans</div> <div> (NPLs) has also contributed to this decline. However, this is considered a positive</div> <div> development.</div> <div> Asset quality</div> <div> Asset quality is generally measured in relation to the level and severity of non-performing</div> <div> assets, recoveries, adequacy of provisions and distribution of assets. Although, the banking</div> <div> system is infected with large volume of NPLs, its severity has stabilized to some extent. The</div> <div> rise over the years was due to increase in volume of NPLs following enforcement of more</div> <div> vigorous standards for classifying loans, improved reporting and disclosure requirements</div> <div> adopted by the SBP.</div> <div> In case of NCBs this improvement is much more pronounced given their share in total</div> <div> NPLs. In case of privatized and private banks, this ratio went up considerably and become a</div> <div> cause of concern. However, the level of infection in foreign banks is not only the lowest but</div> <div> also closes to constant.</div> <div> The ratio of net NPLs to net advances, another indicator of asset quality, for all banks has</div> <div> declined. Marked improvement is viable in recovery efforts of banks. This has been</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 54</div> <div> remarkable in the case of NCBs, in terms of reduction in the ratio of loan defaults to gross</div> <div> advances. Although, privatized banks do not show significant improvement, their ratio is</div> <div> much lower than that of NCBs. Only exception is the group of private banks for which the</div> <div> ratio has gone up due to bad performance of some of the banks in the group. However, it is</div> <div> still the lower, except when compared with that of foreign banks.</div> <div> Management soundness</div> <div> Given the qualitative nature of management, it is difficult to judge its soundness just by</div> <div> looking at financial accounts of the banks. Nevertheless, total expenditure to total income</div> <div> and operating expenses to total expenses help in gauging the management quality of any</div> <div> commercial bank.</div> <div> Pressure on earnings and profitability of foreign and private banks caused their expenditure</div> <div> to income ratio to rise in 1998. However, it started tapering down as they adjusted their</div> <div> portfolios. An across the board increase in administrative expenses to total expenditure is</div> <div> visible from the year 1999. The worst performers in this regard are the privatized banks,</div> <div> mostly because of high salaries and allowances.</div> <div> Earnings and profitability</div> <div> Strong earnings and profitability profile of banks reflects the ability to support present and</div> <div> future operations. More specifically, this determines the capacity to absorb losses, finance</div> <div> its expansion program, pay dividend to its shareholders, and build up adequate level of</div> <div> capital. Being front line of defense against erosion of capital base from losses, the need for</div> <div> high earnings and profitability can hardly be overemphasized. Although different indicators</div> <div> are used to serve the purpose, the best and most widely used indicator is return on assets</div> <div> (ROA). Net interest margin is also used. Since NCBs have significantly large share in the</div> <div> banking sector, their performance overshadows the other banks. However, profit earned by</div> <div> this group resulted in positive value of ROA of banking sector during 2000, despite losses</div> <div> suffered by ABL.</div> <div> Pressure on earnings was most visible in case of foreign banks in 1998. The stress on</div> <div> earnings and profitability was inevitable despite the steps taken by the SBP to improve</div> <div> liquidity. Not only did liquid assets to total assets ratio declined sharply, earning assets to</div> <div> total assets also fell. T-Bill portfolio of banks declined considerably, as they were less</div> <div> remunerative. Foreign currency deposits became less attractive due to the rise in forward</div> <div> cover charged by the SBP. Banks reduced return on deposits to maintain their spread.</div> <div> However, they were not able to contain the decline in ROA due to declining stock and</div> <div> remuneration of their earning assets.</div> <div> Liquidity</div> <div> Movement in liquidity indicators since 1997 indicates the painful process of adjustments.</div> <div> Ratio of liquid assets to total assets has been on a constant decline. This was consciously</div> <div> brought about by the monetary policy changes by the SBP to manage the crisis-like</div> <div> situation created after 1998. Both the cash reserve requirement ((CRR) and the statutory</div> <div> liquidity requirement (SLR) were reduced in 1999. These steps were reinforced by declines</div> <div> in SBP's discount rate and T-Bill yields to help banks manage rupee withdrawals and still</div> <div> meet the credit requirement of the private sector.</div> <div> Foreign banks have gone through this adjustment much more quickly than other banks.</div> <div> Their decline in liquid assets to total assets ratio, as well as the rise in loan to deposit ratio,</div> <div> are much steeper than other groups. Trend in growth of deposits shows that most painful</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 55</div> <div> part of the adjustment is over. This is reflected in the reversal of decelerating deposit growth</div> <div> into accelerating one in year 2000.</div> <div> Sensitivity to market risk</div> <div> Rate sensitive assets have diverged from rate sensitive liabilities in absolute terms since</div> <div> 1997. The negative gap has widened. Negative value indicates comparatively higher risk</div> <div> sensitivity towards liability side, while decline in interest rates may prove beneficial.</div> <div> Deposit Mobilization</div> <div> Deposit mobilization has dwindled considerably after 1997. Deposits as a proportion of</div> <div> GDP have been going down. Growth rate of overall deposits of banks has gone down.</div> <div> However, the slow down seems to have been arrested and reversed in year 2000.</div> <div> Group-wise performance of deposit mobilization is the reflection of the varying degree with</div> <div> which each group has been affected since 1998. Foreign banks were affected the most due</div> <div> to their heavy reliance of foreign currency deposits. They experience 14 per cent erosion in</div> <div> 1999. However, they were able to achieve over 2 per cent growth in year 2000. Similar</div> <div> recovery was shown by private banks.</div> <div> Deposit mobilization by NCBs seems to be waning after discontinuation of their rupee</div> <div> deposit schemes linked with lottery prizes. Growth in their deposits was on the decline.</div> <div> Despite the decline NCBs control a large share in total deposits. Aggressive posture of</div> <div> private banks in mobilizing more deposits in year 2000 is clearly reflected in their deposit</div> <div> growth, from 1.9 per cent in year 1999 to 21.7 per cent in year 2000. This has also helped</div> <div> them in increasing their share in total deposits to over 14 per cent in year 2000.</div> <div> Due to the shift in policy, now banks are neither required nor have the option to place their</div> <div> foreign currency deposits with the SBP. Although, the growth in foreign currency deposits</div> <div> increases the deposit base, it does not add to their rupee liquidity. The increasing share of</div> <div> foreign currency deposits in total base is a worrying development. In order to check this</div> <div> trend, SBP made it compulsory for the banks not to allow foreign currency deposits to</div> <div> exceed 20 per cent of their rupee deposits effective from January 1, 2002.</div> <div> Credit extension</div> <div> Bulk of the advances extended by banks is for working capital which is self-liquidating in</div> <div> nature. However, due to an easing in SBP's policy, credit extension has exceeded deposit</div> <div> mobilization. This is reflected in advances growing at 12.3 per cent in year 1999 and 14 per</div> <div> cent in year 2000.</div> <div> Group-wise performance of banks in credit extension reveals three distinct features.</div> <div> 1. Foreign banks curtailed their lending,</div> <div> 2. Continued dominance by NCBs and</div> <div> 3. Aggressive approach being followed by private banks. Private banks were the only</div> <div> group that not only maintained their growth in double-digit but also pushed it to over</div> <div> 31 per cent in year 2000. With this high growth, they have surpassed foreign banks,</div> <div> in terms of their share in total advances in year 2000.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 56</div> <div> Banking spreads</div> <div> Over the years there has been a declining trend both in lending and deposit rates. Downward</div> <div> trend in lending rates was due to SBP policy. The realized trend in lending rates was in line</div> <div> with monetary objectives of SBP, though achieved with lags following the sharp reduction</div> <div> in T-Bill yields in year 1999, needed to induce required change in investment portfolio of</div> <div> banks.</div> <div> Downward trend in deposit rates was almost inevitable. One can argue that banks should</div> <div> have maintained, if not increased, their deposit rates to arrest declining growth in total</div> <div> deposits. However, this was not possible at times of eroding balance sheet; steady earnings</div> <div> were of prime importance. Consequently banks tried to find creative ways of mobilizing</div> <div> deposits at low rates. However, due to inefficiencies of the large banks, the spread has</div> <div> remained high.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 57</div> <div> Lecture # 18</div> <div> ROLE OF COMMERCIAL BANKS</div> <div> Asset composition</div> <div> Assets of banking sector, as per cent of GDP, have been on the decline. Slowdown in asset</div> <div> growth was also accompanied by changing share of different groups. Negative growth in the</div> <div> assets of foreign banks during 1998 and 1999 was the prime reason behind declining growth</div> <div> in overall assets of the banking sector. Share of NCBs have been decreasing since private</div> <div> banks were allowed to operate in 1992. In terms of asset share, private banks are now as</div> <div> large as foreign banks.</div> <div> Problem bank management</div> <div> The central bank is the sole authority to supervise, monitor and regulate financial</div> <div> institutions. It is also responsible to safeguard the interest of depositors and shareholders of</div> <div> these institutions. Lately, SBP took actions against two private banks which became a threat</div> <div> to viability of the financial system in the country. These were Indus Bank and Prudential</div> <div> Commercial Bank. On the basis of detailed investigations, the license of Indus Bank was</div> <div> cancelled on September 11, 2000. After successful negotiations, management and control of</div> <div> Prudential Bank handed over to Saudi-Pak group.</div> <div> Outlook</div> <div> Commercial banks have been going through the process of restructuring. There are efforts</div> <div> to reduce lending rates. The SBP has been successful in implementing its policies. Most of</div> <div> the banks have been able to adjust to new working environment. The proposed increase in</div> <div> capital base will provide further impetus to financial system in the country.</div> <div> In the post September 11 era, the GoP borrowing from SBP and commercial banks is</div> <div> expected to come down substantially and private sector borrowing to increase. However, a</div> <div> temporary decline in repayment ability of borrowers may increase provisioning for the year</div> <div> 2001. The situation is expected to improve in year 2002. Unless efforts are made by banks</div> <div> to shrink spread, depositors will not be able to get return which corresponds with the rate of</div> <div> inflation in the country. Privatization of NCBs is expected to be delayed due to external</div> <div> factors. However, it is an opportunity for the banks to further clean their slate. Pakistan’s</div> <div> banking sector like many other developing countries had been faced with several problems</div> <div> and difficulties such as:</div> <div> Most of the financial assets and deposits were owned by nationalized commercial banks</div> <div> (NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable</div> <div> branches and poor customer service.</div> <div> 1. NCBs along with specialized banks such as ADBP, IDBP and Development</div> <div> financial institutions such as NDFC had a high ratio of non-performing loans.</div> <div> 2. Banking industry faced a high tax rate, which affected its profitability and</div> <div> attractiveness for new entrants.</div> <div> 3. There was a proliferation of banks and some of them were undercapitalized, poorly</div> <div> managed with a scanty distribution network.</div> <div> 4. Agriculture, small and medium enterprises, Housing sectors were underserved and</div> <div> the middle class and low income group had limited access to bank credit.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 58</div> <div> 5. Banks had typically focused on trade and corporate financing with a narrow range of</div> <div> products and had not diversified into consumer and mortgage financing for which</div> <div> there is an ample unsatisfied demand.</div> <div> 6. Poor quality of human resources, weak internal controls, non-merit based</div> <div> recruitments, high administrative costs and undue interference of unions in decisions</div> <div> making process affected the performance of public sector financial institutions</div> <div> adversely.</div> <div> BANKING SECTOR REFORMS</div> <div> Banking sector reforms were aimed at addressing these and other constraints. Although</div> <div> there is no room for complacency and a lot needs to be done it is fair to say that substantial</div> <div> progress has been made to improve the health and soundness of the banking sector in recent</div> <div> years. There are still few weak and vulnerable institutions but overall the banking sector in</div> <div> Pakistan is much stronger today compared to five years ago or in comparison to other</div> <div> countries in the region. What are the factors responsible for this improvement? A large</div> <div> number of reforms have either been undertaken or under way.</div> <div> 1. Privatization of NCBs</div> <div> The nationalized commercial banks are being privatized and their domination of the</div> <div> banking sector is likely to be reduced from almost 100 percent in 1991 to about 20 percent</div> <div> by December 2003. The shares of Muslim Commercial Bank are all in the private sector.</div> <div> United Bank has been sold to a consortium of private investors. Privatization of Habib Bank</div> <div> Ltd., is under way and is scheduled to be completed by end December, 2003. 23.5 percent</div> <div> of shares of National Bank have been floated through Stock Market mainly aimed at small</div> <div> retail investors. The NCBs have been restructured and professional management inducted</div> <div> which works under the supervision of independent Boards of Directors drawn from the</div> <div> private sector.</div> <div> 2. Corporate governance.</div> <div> Strong corporate governance is absolutely essential if the banks have to operate in a</div> <div> transparent manner and protect the depositors’ interests. The SBP has taken several</div> <div> measures in the last four years to put in place good governance practices to improve internal</div> <div> controls and bring about a change in the organizational culture. The salient features of this</div> <div> structure are:</div> <div> a. Banking license of one of the commercial banks which was found in</div> <div> violation of the prudential regulations and norms was cancelled for the first</div> <div> time in the history of Pakistan after following the due process. This decision</div> <div> was upheld by Peshawar High Court.</div> <div> b. Ownership and management were changed at two private commercial banks,</div> <div> one of which had committed breach through unauthorized transfer of funds</div> <div> from the bank to associated companies.</div> <div> c. A number of cases of willful bank defaulters were referred to National</div> <div> Accountability Bureau (NAB) for taking legal actions and recovering the</div> <div> amounts due.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 59</div> <div> d. The appointments of Board members, Chief Executive Officers and key</div> <div> Executives of all banks have to be screened so that they meet the fit and</div> <div> proper test prescribed by the SBP.</div> <div> e. Family representation on the Board of Directors of the banks where they</div> <div> hold majority ownership has been limited to 25 percent of the total</div> <div> membership of the Board.</div> <div> f. To avoid possible conflict of interest and use of insider information the</div> <div> Directors, executives and traders working in Brokerage companies will no</div> <div> longer serve on the Boards of Directors of the banks.</div> <div> g. External auditors are evaluated annually and classified in various categories</div> <div> based on their performance and other prescribed criteria. Two large audit</div> <div> firms were debarred from auditing the banks and only after showing</div> <div> improvement in their performance placed in a category lower than they</div> <div> originally belonged to.</div> <div> h. A detailed set of guidelines for the Board of Directors to effectively oversee</div> <div> the management of the banks and develop policies has been issued. A</div> <div> training course on Corporate Governance was organized for the members of</div> <div> the Boards of banks and their Chief Executives.</div> <div> i. The disclosure requirements for banks have been strengthened and now they</div> <div> are required to prepare their annual financial statements in accordance with</div> <div> the International Accounting Standards. They are also required to publish</div> <div> quarterly and half-yearly accounts to provide information to their</div> <div> stakeholders for taking well informed decisions.</div> <div> j. In order to institutionalize the decision making process and to provide</div> <div> guidance to staff, the banks are required to formulate and implement welldefined</div> <div> policies in credit, investment, recovery of write-offs, human</div> <div> resources, audit and compliance, risk management, etc. k. To provide</div> <div> guidance to banks in identifying, measuring, monitoring and controlling</div> <div> various risks and to make them proactive, a detailed set of guidelines on risk</div> <div> management has been issued.</div> <div> 3. Capital Strengthening.</div> <div> Capital requirements of the banking sector have to be adequate in relation to the risk</div> <div> weighted assets and conform to the Basle Accord. To further strengthen their competitive</div> <div> ability, both domestically and internationally and to encourage the economies of scale, the</div> <div> minimum paid-up capital requirements of the banks have been raised. The banks were</div> <div> required to increase their paid-up capital from Rs 500 million to Rs 1 billion by 1st January</div> <div> 2003 failing which they will no longer be allowed to carry out full banking activities as</div> <div> scheduled banks. This has resulted in mergers and consolidation of many financial</div> <div> institutions and weeding out of several weaker banks from the financial system.</div> <div> 4. Improving Asset quality.</div> <div> The stock of non-performing loans (NPLs) has been tackled in several ways. The gross</div> <div> NPLs amount to Rs 252 billion and account for 22 percent of the advances of the banking</div> <div> system and DFIs. However, there has been aggressive provisioning carried out during the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 60</div> <div> last three years. More than 60 percent of the NPLs are fully provided for and net NPLs to</div> <div> net advances ratio has thus declined to less than 10 percent. Efforts are being made to</div> <div> further reduce this ratio through the active involvement of Corporate & Industrial</div> <div> Restructuring Corporation (CIRC) and the Committee on Revival of Sick Units (CRSU).</div> <div> The settlement reached between loss category loan holders and banks under State Bank</div> <div> circular No.29 will further reduce the volume of NPLs and allow the sick industrial units to</div> <div> revive while at the same time enable the banks to clean up their balance sheets. The positive</div> <div> development is that the quality of new loans disbursed since 1997 has improved and</div> <div> recovery rate is 95 percent.</div> <div> 5. Liberalization of foreign exchange regime</div> <div> Pakistan has further liberalized its foreign exchange regime and ensured partial Capital</div> <div> account Convertibility by allowing foreign exchange companies to operate and Pakistani</div> <div> Corporate sector to acquire equity abroad.</div> <div> 6. Consumer Financing</div> <div> The State Bank has removed restrictions imposed on nationalized commercial banks for</div> <div> consumer financing. The positive experience of auto financing gives a lot of hope that the</div> <div> middle class of this country will be able to access consumer durables through banks. This</div> <div> will at the same time boost the manufacturing of TVs, air-conditioners, VCRs, washing and</div> <div> drying machines, deep freezers etc. in the country. Credit and Debit Cards are also gaining</div> <div> popularity and the numbers of card holders have doubled during the last two years.</div> <div> 7. Mortgage Financing</div> <div> A number of incentives have been provided to encourage mortgage financing by the banks.</div> <div> The upper limit has been raised from Rs 5 million to Rs 10 million. Tax deduction on</div> <div> interest payments on mortgage have been allowed up to a ceiling of Rs.500, 000. The new</div> <div> recovery law is also aimed at expediting repossession of property by the banks. The banks</div> <div> have been allowed to raise long term funds through rated and listed debt instruments like</div> <div> TFCs to match their long term mortgage assets with their liabilities.</div> <div> 8. Legal Reforms</div> <div> Legal difficulties and time delays in recovery of defaulted loans have been removed through</div> <div> a new ordinance i.e. The Financial Institutions (Recovery of Finances) Ordinance, 2001.</div> <div> The new recovery laws ensures expeditious recovery of stuck up loans by the right of</div> <div> foreclosure and sale of mortgaged property with or without intervention of court and</div> <div> automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission</div> <div> is reviewing, revising and consolidating the banking laws and drafting new laws such as</div> <div> bankruptcy law.</div> <div> 9. Prudential Regulations</div> <div> The prudential regulations in force were mainly aimed at corporate and business financing.</div> <div> The SBP in consultation with the Pakistan Banking Association and other stakeholders has</div> <div> developed a new set of regulations which cater to the specific separate needs of corporate,</div> <div> consumer and SME financing. The new prudential regulations will enable the banks to</div> <div> expand their scope of lending and customer outreach.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 61</div> <div> 10. Micro financing</div> <div> To provide widespread access to small borrowers particularly in the rural areas the licensing</div> <div> and regulatory environment for Micro Credit and Rural financial institutions have been</div> <div> relaxed and unlike the commercial banks these can be set up at district, provincial and</div> <div> national levels with varying capital requirements. There is less stringency and more</div> <div> facilitative thrust embedded in the prudential regulations designed for this type of</div> <div> institutions. Khushali Bank and the First Microfinance Bank in the private sector have</div> <div> already started working under this new regulatory environment. Khushali Bank has already</div> <div> reached a customer base of 125,000 mainly in poorer districts of the country and its</div> <div> recovery rate is above 95 percent.</div> <div> 11. SME Financing.</div> <div> The access of small and medium entrepreneurs to credit has been a major constraint to</div> <div> expansion of their business and up gradation of their technology. A Small and Medium</div> <div> Enterprise (SME) Bank has been established to provide leadership in developing new</div> <div> products such as program loans, new credit appraisal, and documentation techniques, and</div> <div> nurturing new skills in SME lending which can then be replicated and transferred to other</div> <div> banks in the country. Program lending, for example, can help up gradation of power looms</div> <div> to shuttle less looms in Faisalabad area and contribute to the achievement of goal set under</div> <div> Textile Vision 2005. The new</div> <div> Prudential regulations for SMEs do not require collateral but asset conversion cycle and</div> <div> cash flow generation as the basis for loan approval. The State Bank is also contemplating to</div> <div> develop capacity building among a select group of banks for SME lending. This will</div> <div> revitalize the lending to SMEs particularly export oriented ones.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 62</div> <div> Lecture # 19</div> <div> ROLE OF COMMERCIAL BANKING</div> <div> 12. Legal Reforms</div> <div> Legal difficulties and time delays in recovery of defaulted loans have been removed through</div> <div> a new ordinance i.e. The Financial Institutions (Recovery of Finances) Ordinance, 2001.</div> <div> The new recovery laws ensures expeditious recovery of stuck up loans by the right of</div> <div> foreclosure and sale of mortgaged property with or without intervention of court and</div> <div> automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission</div> <div> is reviewing, revising, and consolidating the banking laws and drafting new laws such as</div> <div> bankruptcy law.</div> <div> 13. Taxation</div> <div> The corporate tax rates on banks were exorbitantly high in Pakistan thus adversely affecting</div> <div> their profitability and attractiveness as an avenue for investment and new equity injection.</div> <div> The Government has already reduced the tax rate from 58 percent to 44 percent during the</div> <div> last three years and it is envisaged that the rate will be reduced gradually and brought at par</div> <div> with the corporate tax rate of 35 percent in the next three years. This will in turn help in</div> <div> reducing the spread between the deposit rate and lending rate and benefit financial savers.</div> <div> 14. Agriculture Credit</div> <div> A complete revamping of Agriculture Credit Scheme has been done recently with the help</div> <div> of commercial banks. The scope of the Scheme which was limited to production loans for</div> <div> inputs has been broadened to the whole value chain of agriculture sector.</div> <div> We have, with the grace of Allah, become a surplus country in food grains, livestock etc.</div> <div> and thus the needs of agriculture sector have also expanded. The SBP has included</div> <div> financing for silos, god-owns, refrigerated vans, agro processing and distribution under the</div> <div> cover of this scheme. This broadening of the scope as well the</div> <div> removal of other restrictions have enabled the commercial banks to increase their lending</div> <div> for agriculture by a multiple of four times compared to FY 1999-00 thus mainstreaming</div> <div> agriculture lending as part of their corporate business. Unlike the previous years when they</div> <div> were prepared to pay penalties for under performance they have set up higher targets for this</div> <div> year. The private commercial banks have also agreed to step in and increase their lending to</div> <div> agriculture.</div> <div> 15. E-Banking</div> <div> The banks are being encouraged to move towards Electronic banking. There is a big surge</div> <div> among the banks including NCBs to upgrade their technology and on-line banking services.</div> <div> During the last three years there is a large expansion in the ATMs has been witnessed and at</div> <div> present about 500 ATMs are now working throughout the country. The decision mandating</div> <div> the banks to join one of either two ATM switches available in the country will provide a</div> <div> further boost. Progress in creating automated or on-line branches of banks has been quite</div> <div> significant so far and it is expected that by 2004 a majority of the bank branches will be online</div> <div> or automated. Utility bills payment and remittances would be handled through ATMs,</div> <div> Kiosks or Personal Computers reducing both time and cost. Investment in information</div> <div> technology is being undertaken by the banks to enhance efficiency, reduce transaction costs</div> <div> and promote E-Commerce. It has been estimated that a banking transaction through ATM</div> <div> costs one fourth as much a transaction conducted over the counter in a traditional branch –</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 63</div> <div> and the similar transaction over the internet costs a mere fraction of the traditional teller</div> <div> costs.</div> <div> 16. Human Resources</div> <div> The banks have recently embarked on merit-based recruitment to build up their human</div> <div> resource base – an area which has been neglected so far. The private banks have taken lead</div> <div> in this respect by holding competitive examinations, interviews and selecting the most</div> <div> qualified candidates. The era of appointment on the basis of sifarish and nepotism has come</div> <div> to an end. This new generation of bankers will usher in a culture of professionalism and</div> <div> rigor in the banking industry and produce bankers of stature who will provide the leadership</div> <div> in the future.</div> <div> 17. Credit Rating</div> <div> To facilitate the depositors to make informed judgments about placing their savings with the</div> <div> banks, it has been made mandatory for all banks to get themselves evaluated by credit rating</div> <div> agencies. These ratings are then disclosed to the general public by the SBP and also</div> <div> disseminated to the Chambers of Commerce and Trade bodies. Such public disclosure will</div> <div> allow the depositors to choose between various banks. For example, those who wish to get</div> <div> higher return may opt for banks with B or C rating. But those who want to play safe may</div> <div> decide to stick with only AAA or AA rated banks.</div> <div> 18. Supervision and Regulatory Capacity</div> <div> The banking supervision and regulatory capacity of the Central Bank has been strengthened.</div> <div> Merit – based recruitment, competency – enhancing training, performance – linked</div> <div> promotion, technology – driven process, induction of skilled human resources and greater</div> <div> emphasis on values such as integrity, trust, team work have brought about a structural</div> <div> transformation in the character of the institution. The responsibility for supervision of nonbank</div> <div> finance companies has been separated and transferred to Securities Exchange</div> <div> Commission. The SBP itself has been divided into two parts – one looking after central</div> <div> banking and the other after retail banking for the government.</div> <div> 19. Payment Systems</div> <div> Finally, the country’s payment system infrastructure is being strengthened to provide</div> <div> convenience in transfer of payments to the customers. The Real-Time Gross Settlement</div> <div> (RTGS) system will process large value and critical transactions on real time while</div> <div> electronic clearing systems will be established in all cities.</div> <div> These reforms will go a long way in further strengthening the Banking sector but a vigilant</div> <div> supervisory regime by the State Bank will help steer the future direction.</div> <div> Commercial Banking in a Free Society</div> <div> Although we can say a great deal about the institutions of a free society, and why they are</div> <div> desirable, speculating about the specific ways in which people will choose to organize</div> <div> themselves within such institutions is always a tricky matter</div> <div> • After all, the whole justification for the institutions of a free society is that only</div> <div> through its institutions can human beings discover progressively better ways of</div> <div> dealing with scarcity (of both goods and knowledge)</div> <div> • And thus improve both our material and non-material welfare. Our ignorance of the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 64</div> <div> details of a free society is precisely why having a free society is so important.</div> <div> The banking industry is especially suited for just this kind of analysis. If we want to know</div> <div> what commercial banking might look like in a free society, we need only turn to</div> <div> contemporary regulation and the historical record to begin to piece together a coherent</div> <div> story.</div> <div> Private Deposit Insurance</div> <div> • Banks in a free society might choose to purchase privately supplied deposit</div> <div> insurance as a way to reassure customers. They might also enter into inter-bank</div> <div> mutual aid agreements, or be insured through clearinghouses.</div> <div> • Historically, banks have used these and other methods to convey trust to customers.</div> <div> Before deposit insurance banks would advertise their balance sheets and list the</div> <div> members of their boards of directors.</div> <div> • Providing this kind of information was a way to establish their trustworthiness to</div> <div> actual and potential depositors. With deposit insurance, banks need not do this.</div> <div> • It is reasonable to expect that banks in a free society will use these ways, and</div> <div> discover new and imaginative ones, of creating the trust on which all banking</div> <div> systems rest.</div> <div> • Banks in a free society will be literally nothing special. What makes banking so unfree</div> <div> today is that banks are treated differently from other business enterprises.</div> <div> • The rule of law that would characterize a free society would demand that banks be</div> <div> treated no differently than other firms. If they are fraudulent or use force, then they</div> <div> need to face the consequences. Otherwise, any sort of voluntary arrangement banks</div> <div> make with customers will be allowed.</div> <div> • The result will not only be a more free banking system, but a more efficient, safe,</div> <div> and productive one.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 65</div> <div> Lecture # 20</div> <div> BRANCH BANKING IN PAKISTAN</div> <div> A branch, banking centre or financial centre is a retail location where a bank or financial</div> <div> institution offers a wide array of face to face service to its customers.</div> <div> Remittances:</div> <div> Demand Draft</div> <div> It’s a written order, drawn by one branch of a bank upon another branch of the same bank,</div> <div> upon other bank under special arrangement to pay a certain sum of money to or to the order</div> <div> of a specified person.”</div> <div> Parties Involved</div> <div> 1. Purchaser</div> <div> 2. Issuing Branch</div> <div> 3. Drawee Branch</div> <div> 4. Payee/ Beneficiary</div> <div> Pay Order</div> <div> A Pay Order is a written authorization for Pmt, Made in a receipt from issued & Payable by</div> <div> the bank, to the person named & addressed therein on his giving a proper discharge thereon.</div> <div> Parties Involved</div> <div> 1. Purchaser</div> <div> 2. Issuing / Paying Branch</div> <div> 3. Payee</div> <div> Telegraphic Transfer</div> <div> “T.T instructions regarding PMT are sent to Drawee branch in a coded language and under</div> <div> confidential number known as TEST Number.”</div> <div> Parties Involved</div> <div> 1. Applicant</div> <div> 2. Remitting or Drawing Branch</div> <div> 3. Drawee Branch</div> <div> 4. Beneficiary /Payee</div> <div> Mail Transfer</div> <div> Like T.T funds can be remitted by MT for the Cr of the payee a/c or the Beneficiary can be</div> <div> advised to receive the PMT from Drawee branch either in cash on proper identification or</div> <div> through his banker.”</div> <div> Parties Mail Transfer</div> <div> 1. Applicant</div> <div> 2. Drawing Branch</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 66</div> <div> 3. Drawee Branch</div> <div> 4. Beneficiary</div> <div> Online Fund Transfer</div> <div> It’s also a fund transfer but only by Online within the Branches.</div> <div> Parties Involved</div> <div> 1. Applicant (a/c in Bank)</div> <div> 2. Beneficiary (a/c in Bank)</div> <div> 3. 2 Branches of Bank (online)</div> <div> Account Opening Department</div> <div> Types of Account</div> <div> 1. Individual</div> <div> 2. Joint Account</div> <div> 3. Sole Proprietorship</div> <div> 4. Club & Societies</div> <div> 5. Joint Stock Companies</div> <div> 6. Agents</div> <div> Operations & Status of Accounts</div> <div> Nature of Accounts</div> <div> 1. Current Account</div> <div> 2. Profit & Loss Sharing</div> <div> 3. Current foreign currency</div> <div> 4. Saving Foreign Currency</div> <div> 5. Term Deposits</div> <div> 6. BBA “Basic Banking Account”</div> <div> Deposit</div> <div> Commercial Bank deposit products offer you an array of privileges and services. Designed</div> <div> with your banking needs and comfort in mind, these convenient accounts prove that, at</div> <div> Commercial Banks, banking is about a shared long-term relationship between bank and you.</div> <div> 􀂋 Current Account</div> <div> The Current Account allows you the facility of unlimited withdrawals up to the extent of the</div> <div> balance in your account. Sometimes there will be no tax deducted on the funds that you</div> <div> choose to keep in these accounts.</div> <div> 􀂋 Savings or PLS Account</div> <div> The Savings Account allows you the facility of unlimited withdrawals (up to the extent of</div> <div> the balance in your account), while accruing profit on your deposit everyday. You can have</div> <div> the profit paid to you monthly, quarterly, annually or as per your requirement. The passbook</div> <div> is the traditional document to keep track of earnings in a savings account.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 67</div> <div> 􀂋 Term Deposit</div> <div> The Term Deposit offers you the dual benefit of attractive returns with high liquidity, with</div> <div> options to take your profit monthly, quarterly, annually or at maturity. A time deposit (also</div> <div> known as a term deposit, particularly in Canada, Australia and New Zealand) is a money</div> <div> deposit at a banking institution that cannot be withdrawn for a certain "term" or period of</div> <div> time. When the term is over it can be withdrawn or it can be held for another term.</div> <div> Generally speaking, the longer the term the better the yield on the money. A certificate of</div> <div> deposit is a time-deposit product. A deposit of funds in a savings institution under an</div> <div> agreement stipulating that</div> <div> a. The funds must be kept on deposit for a stated period of time,</div> <div> b. The institution may require a minimum period of notification before a</div> <div> withdrawal is made.</div> <div> 􀂋 Foreign Currency</div> <div> You have the option of opening Current, Savings and Term Deposit accounts in different</div> <div> foreign currencies – Like US Dollar, Pound Sterling, Japanese Yen, and Euros. This entitles</div> <div> you to avail all the convenience of local currency accounts including:</div> <div> 1. Unlimited cash withdrawals up to the balance in your account</div> <div> 2. Deposits facility</div> <div> 3. Profit accrued on a daily basis</div> <div> 4. Automatic rollover of deposits</div> <div> As per State Bank of Pakistan circulars/regulations</div> <div> 􀂋 Demand account</div> <div> 1. The cheque is the traditional mode of payment for a demand account.</div> <div> 2. A demand account or demand deposit (North America: checking account, UK</div> <div> and Commonwealth: current account) is a deposit account held at a bank or other</div> <div> financial institution,</div> <div> 3. For the purpose of securely and quickly providing frequent access to funds on</div> <div> demand, through a variety of different channels.</div> <div> Commercial Banks Loan Facilities:</div> <div> A loan is a type of debt. All material things can be lent but this article focuses exclusively</div> <div> on monetary loans. Like all debt instruments, a loan entails the redistribution of financial</div> <div> assets over time, between the lender and the borrower.</div> <div> The borrower initially receives an amount of money from the lender, which they pay back,</div> <div> usually but not always in regular installments, to the lender. This service is generally</div> <div> provided at a cost, referred to as interest on the debt.</div> <div> A borrower may be subject to certain restrictions known as loan covenants under the terms</div> <div> of the loan. Legally, a loan is a contractual promise of a debtor to repay a sum of money in</div> <div> exchange for the promise of a creditor to give another sum of money.</div> <div> 􀂋 Secured Loan</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 68</div> <div> A mortgage loan is a very common type of debt instrument, used by many individuals to</div> <div> purchase housing. In this arrangement, the money is used to purchase the property. The</div> <div> financial institution, however, is given security - a lien on the title to the house - until the</div> <div> mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the</div> <div> legal right to repossess the house and sell it, to recover sums owing to it. In some instances,</div> <div> a loan taken out to purchase a new or used car may be secured by the car; in much the same</div> <div> way as a mortgage is secured by housing. The duration of the loan period is considerably</div> <div> shorter often corresponding to the useful life of the car.</div> <div> There are two types of auto loans, direct and indirect.</div> <div> 1. A direct auto loan is where a bank gives the loan directly to a consumer.</div> <div> 2. An indirect auto loan is where a car dealership acts as an intermediary between the</div> <div> bank or financial institution and the consumer</div> <div> Other Types of Loans</div> <div> 1. Credit card debt</div> <div> 2. Personal loans</div> <div> 3. Bank overdrafts</div> <div> 4. Corporate bonds</div> <div> Personal finance</div> <div> Personal finance is the application of the principles of finance to the monetary decisions of</div> <div> an individual or family unit. It addresses the ways in which individuals or families obtain,</div> <div> budget, save and spend monetary resources over time, taking into account various financial</div> <div> risks and future life events. Components of personal finance might include checking and</div> <div> savings accounts, credit cards and consumer loans, investments in the stock market,</div> <div> retirement plans, social security benefits, insurance policies, and income tax management.</div> <div> Personal Finance is a parameter driven product for catering to the needs of the general</div> <div> public belonging to different segments. One can avail unlimited opportunities through</div> <div> Bank's Personal Finance. With unmatched finance features in terms of loan amount,</div> <div> payback period and most affordable monthly installments, Bank's Personal Finance makes</div> <div> sure that one gets the most out of his/her loan. Once a good credit history is established, the</div> <div> door to opportunity opens much wider.</div> <div> Mortgage Finance</div> <div> Offers the convenience of owning a house of choice, while living in it at its rental value.</div> <div> The installment plan has carefully designed to suit both the budget & accommodation</div> <div> requirements. It has been designed for enhancing financing facility initially for employees</div> <div> of corporate companies for purchase/ construction/ renovation of house.</div> <div> Business Finance</div> <div> In pursuance of the National objectives to revive the economy of the country, Bank is</div> <div> providing loans to small and medium size business enterprises under Bank's Business</div> <div> Finance Scheme. Goal is to offer a loan, which enables business community to receive the</div> <div> financing required by them based on their cash flows. Valued customers can enjoy the</div> <div> convenience of getting financing on attractive terms with the minimum processing</div> <div> turnaround time.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 69</div> <div> Lecture # 21</div> <div> ROLE OF COMMERCIAL BANKS IN MICRO FINANCE SECTOR</div> <div> Microfinance in its broadest terms can be defined as provision of a range of financial</div> <div> services such as deposits, loans, payment services, money transfers and insurance to poor</div> <div> and low income households, and their micro enterprises (Source: Asian Development bank</div> <div> report on microfinance development strategy). While a commercial bank is a financial</div> <div> institution that offers a broad range of deposit accounts, including checking, savings, and</div> <div> time deposits, and extends loans to individuals and businesses.</div> <div> The decision as to whether the commercial banks be involved in microfinance is a sensitive</div> <div> and debatable issue which requires a deep analysis of many factors.</div> <div> Primarily, the microfinance customers are large in number, scattered in far-flung areas with</div> <div> very minute transaction sizes. Only government or state bank alone cannot reach out to</div> <div> millions of potential Microfinance beneficiaries; a whole well knitted network with almost</div> <div> doorstep reach is required, which is only possible when the commercial banks will be</div> <div> involved in microfinance. In Pakistan it is estimated that as many as 5.6 million households</div> <div> need microfinance services but these services reach only to less than 1 percent, most</div> <div> probably because of the absence of commercial banks from the microfinance sector.</div> <div> (Source: Pakistan microfinance Network PMN) This way a poor person just need to visit</div> <div> his local commercial bank to get access to microfinance benefits, which will help reduce</div> <div> many economic problems.</div> <div> One criticism over involving the commercial banks in microfinance is that commercial</div> <div> banks will charge higher interest rates, further lower the standard of living and will exploit</div> <div> the public. The ground realities are totally different; empirical evidence has demonstrated</div> <div> that participants in microfinance programs have improved their living standards at both the</div> <div> individual and household level, and that this has provided increased educational</div> <div> opportunities for children. For example, the clients of the Bangladesh Rural Advancement</div> <div> Committee increased household expenditures by 28% and assets by 112%. It was also</div> <div> demonstrated that Bangladeshi children were sent to school in larger numbers and stayed for</div> <div> a longer time – almost all girls in Grameen Bank (A commercial bank!) client households</div> <div> had some schooling, compared with the rate of 60% in non-client households. (Source:</div> <div> World Bank group, 30 August 2005) No doubt on the other hand the loans provided by the</div> <div> commercial banks to the microfinance beneficiaries are a bit expensive, its not to discourage</div> <div> the poor but there is a sound reason behind it; Providing financial services to poor people is</div> <div> quite expensive, especially in relation to the size of the transactions involved. A $100 dollar</div> <div> loan, for example, requires the same personnel and resources as a $2,000 one thus</div> <div> increasing per unit transaction costs. Loan officers must visit the client's home or place of</div> <div> work, evaluate creditworthiness on the basis of interviews with the client's family and</div> <div> references, and in many cases, follow through with visits to reinforce the repayment culture.</div> <div> It can easily cost US$25 to make a micro loan. While that might not seem unreasonable in</div> <div> absolute terms, it might represent 25% of the value of the loan amount, and force the</div> <div> institution to charge a “high” rate of interest to cover its cost of loan administration.</div> <div> If commercial banks are to be involved in the micro finance by no means it would be a</div> <div> wrong decision for them as regard to their primary aim, profitability. Yes it can. Data from</div> <div> the Micro Banking Bulletin reports that 63 of the world's top MFIs had an average rate of</div> <div> return, after adjusting for inflation and after taking out subsidies programs might have</div> <div> received, of about 2.5% of total assets. This compares favorably with returns in the</div> <div> commercial banking sector and gives credence to the hope of many that microfinance can</div> <div> be sufficiently attractive to mainstream into the retail banking sector. Many feel that once</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 70</div> <div> microfinance becomes mainstreamed, massive growth in the numbers of clients can be</div> <div> achieved.</div> <div> According to a recent analysis conducted by the Consultative Group to Assist the Poor</div> <div> (CGAP), the compound annual growth rate of the world’s leading microfinance providers</div> <div> over the last five years has been a whopping 15%. Worldwide, these leading Microfinance</div> <div> institutions are nearly twice as profitable as the leading commercial banks. The trend is not</div> <div> new. In fact, in the last decade, microfinance has been a more stable business than</div> <div> commercial banking in emerging markets. During Indonesia’s 1997 financial crisis, for</div> <div> example, commercial bank portfolios imploded, but loan repayment among Bank Rakyat</div> <div> Indonesia’s three million-plus micro-borrowers barely declined at all. During the more</div> <div> recent Bolivian and Colombian banking crises, microfinance portfolios suffered slightly, but</div> <div> remained substantially healthier than commercial bank portfolios, and the microfinance</div> <div> institutions remained more profitable. (Source: The banker, 04 July 2005)</div> <div> There are 70million savings and loan accounts in the world in micro finance sector and</div> <div> about 80 percent of these accounts are savings rather than loans, suggesting that poor</div> <div> entrepreneurs often have to save to accumulate capital for investment rather than the faster</div> <div> if higher-route of borrowing it. Thus it’s absolutely favorable for the commercial banks to</div> <div> operate in the micro finance sector. For example in India ICICI bank, which has a large</div> <div> network of local branches, entered the micro finance market in 2001 and increased its</div> <div> portfolio from US $16m to US $63m in two years. (Source: Financial Times, 14</div> <div> September 2005)</div> <div> I see the commercial banks in micro finance in action, independently…without any</div> <div> government back, mandate or subsidy.</div> <div> On the whole microfinance is not an area commercial banks want to overtake. The majority</div> <div> of commercial banks that undertook microfinance lending were because it was required of</div> <div> them by their governments. Research findings came from in-depth interviews with over 40</div> <div> bankers in 22 banks in India, the Philippines and Australia, and from speaking with 17 other</div> <div> banks in the other seven countries covered in the study. A great deal of microfinance</div> <div> undertaken by commercial banks was found, but it was undertaken because of government</div> <div> mandates to lend to this sector rather than for business reasons.</div> <div> (Source: The Role of Commercial Banks in Microfinance: Asia-Pacific Region Ruth</div> <div> Goodwin-Groen, 1998)</div> <div> The involvement of commercial banks in micro finance is important because all those micro</div> <div> finance programs, which were directly run or backed by the government, faced a total</div> <div> failure. Sustainability and scale in microfinance by commercial banks were only found in</div> <div> the market-based programs when assessed on the basis of achieving both high portfolio</div> <div> quality and significant scale of outreach to the poor, most of the commercial bank</div> <div> microfinance programs that were mandated by governments can only be considered as</div> <div> failures. The exceptions were those programs that charged a commercial rate of interest.</div> <div> They had a higher portfolio quality than other programs but they were still not profitable.</div> <div> This almost universal failure is not explained by the different policy contexts across the</div> <div> Asia-pacific region. Further, because microfinance has not been a profitable business,</div> <div> government mandates have been unsuccessful in encouraging commercial banks to become</div> <div> involved in microfinance. The banks must have the incentive to design better products for</div> <div> micro entrepreneurs, which can be profitable.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 71</div> <div> A real world example of a successful micro finance commercial bank is of BRI’s Unit Desa</div> <div> system (its microfinance arm) has the best financial results of any microfinance institution</div> <div> in the world. In 1996-97 it earned a profit of $170 million on loans of $1.7 billion to 2.5</div> <div> million clients, with no subsidies. This is an approximate return on performing assets of 10</div> <div> per cent – a very competitive rate by commercial standards. The success of BRI’s Unit Desa</div> <div> systems can be attributed primarily to the fact that the system has adhered to the</div> <div> fundamentals of banking and finance for the rural micro entrepreneurs, including the</div> <div> provision of competitive savings services. The microfinance savings and loans of the Unit</div> <div> Desa system perform consistently for BRI and continue to grow quickly. BRI’s</div> <div> microfinance business may not compete with the most spectacular returns, but it does</div> <div> achieve these strategic goals. (Source: The Role of Commercial Banks in Microfinance:</div> <div> Asia-Pacific Region Ruth Goodwin-Groen, 1998)</div> <div> The types of commercial bank involvement in microfinance can be classified as;</div> <div> government-subsidized lending programs channeled through the banks, government</div> <div> mandated lending targets met by banks subsidizing interest rates, government-mandated</div> <div> lending targets with banks charging commercial interest rates and microfinance as a</div> <div> profitable business. Only the last one “micro finance as a profitable business” has seen</div> <div> success. Thus the involvement of commercial banks in micro finance sector should not be</div> <div> based on any government mandate, subsidy or target. The sole benefit of the society as well</div> <div> as commercial banks is the adoption of micro finance as a business. (Source: The Role of</div> <div> Commercial Banks in Microfinance: Asia-Pacific Region Ruth Goodwin-Groen, 1998)</div> <div> Involving commercial banks in micro finance would be a step to take these services at the</div> <div> doorstep of the potential customer, because if only some government agency or state bank is</div> <div> involved the extensiveness as regard to area covered cannot be brought.</div> <div> On the other hand commercial banks need not to make any special arrangements to cater for</div> <div> micro finance operations. Only a new “micro finance” counter might be needed in the</div> <div> existing branches. Thus there would be no high setup cost for the commercial banks to</div> <div> venture into this sector.</div> <div> In short I see micro finance as a very promising sector for commercial banks and on the</div> <div> other hand simultaneously it would help the standard of living to rise; and attached with it</div> <div> the literacy rate, employment level, socio-economic development would also take place.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 72</div> <div> Lecture # 22</div> <div> Mutual funds</div> <div> What are mutual funds?</div> <div> An investment vehicle which is comprised of a pool of funds collected from many investors</div> <div> for the purpose of investing in securities such as stocks, bonds, money market securities,</div> <div> and similar assets. Mutual funds are operated by money mangers, who invest the fund's</div> <div> capital and attempt to produce capital gains and income for the fund's investors. A mutual</div> <div> fund's portfolio is structured and maintained to match the investment objectives stated in its</div> <div> prospectus.</div> <div> In business encyclopedia</div> <div> Mutual funds belong to a group of financial intermediaries known as investment companies,</div> <div> which are in the business of collecting funds from investors and pooling them for the</div> <div> purpose of building a portfolio of securities according to stated objectives. They are also</div> <div> known as open-end investment companies. Other members of the group are closed-end</div> <div> investment companies (also known as closed-end funds) and unit investment trusts. In the</div> <div> United States, investment companies are regulated by the Securities and Exchange</div> <div> Commission under the Investment Company Act of 1940.</div> <div> Mutual funds are generally organized as corporations or trusts, and, as such, they have a</div> <div> board of directors or trustees elected by the shareholders. Almost all aspects of their</div> <div> operations are externally managed. They engage a management company to manage the</div> <div> investment for a fee, generally based on a percentage of the fund's average net assets during</div> <div> the year. The management company may be an affiliated organization or an independent</div> <div> contractor. They sell their shares to investors either directly or through other firms such as</div> <div> broker-dealers, financial planners, employees of insurance companies, and banks. Even the</div> <div> day-to-day administration of a fund is carried out by an outsider, which may be the</div> <div> management company or an unaffiliated third party.</div> <div> The management company is responsible for selecting an investment portfolio that is</div> <div> consistent with the objectives of the fund as stated in its prospectus and managing the</div> <div> portfolio in the best interest of the shareholders. The directors of the fund are responsible</div> <div> for overall governance of the fund; they are expected to establish procedures and review the</div> <div> performance of the management company and others who perform services for the fund.</div> <div> Mutual funds are known as open-end investment companies because they are required to</div> <div> issue shares and redeem (buy back) outstanding shares upon demand. Closed-end funds, on</div> <div> the other hand, issue a certain number of shares but do not stand ready to buy back their</div> <div> own shares from investors. Their shares are traded on an exchange or in the over-thecounter</div> <div> market. They cannot increase or decrease their outstanding shares easily. A feature</div> <div> common of both mutual funds and closed-end funds is that they are managed investment</div> <div> companies, because they can change the composition of their portfolios by adding and</div> <div> deleting securities and altering the amount invested in each security. Unit investment trusts</div> <div> are not managed investment companies like the mutual funds because their portfolio</div> <div> consists of a fixed set of securities for life. They stand ready, however, to buy back their</div> <div> shares.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 73</div> <div> History of Mutual Funds</div> <div> Massachusetts Investors Trust was founded on March 21, 1924, and, after one year, had</div> <div> 200 shareholders and $392,000 in assets. The entire industry, which included a few closedend</div> <div> funds, represented less than $10 million in 1924.</div> <div> The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock</div> <div> market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act</div> <div> of 1934. These laws require that a fund be registered with the Securities and Exchange</div> <div> Commission (SEC) and provide prospective investors with a prospectus that contains</div> <div> required disclosures about the fund, the securities themselves, and fund manager. The SEC</div> <div> helped draft the Investment Company Act of 1940, which sets forth the guidelines with</div> <div> which all SEC-registered funds today must comply.</div> <div> With renewed confidence in the stock market, mutual funds began to blossom. By the end</div> <div> of the 1960s, there were approximately 270 funds with $48 billion in assets. The first retail</div> <div> index fund, the First Index Investment Trust, was formed in 1976 and headed by John</div> <div> Bogle, who conceptualized many of the key tenets of the industry in his 1951 senior thesis</div> <div> at Princeton University. It is now called the Vanguard 500 Index Fund and is one of the</div> <div> largest mutual funds ever with in excess of $100 billion in assets.</div> <div> One of the largest contributors of mutual fund growth was individual retirement account</div> <div> (IRA) provisions added to the Internal Revenue Code in 1975, allowing individuals</div> <div> (including those already in corporate pension plans) to contribute $2,000 a year. Mutual</div> <div> funds are now popular in employer-sponsored defined contribution retirement plans</div> <div> (401(k)s), IRAs and Roth IRAs.</div> <div> As of April 2006, there are 8,606 mutual funds that belong to the Investment Company</div> <div> Institute (ICI), the national association of investment companies in the United States, with</div> <div> combined assets of $9.207 trillion.</div> <div> Types of international mutual funds</div> <div> 􀂋 Open-end fund</div> <div> The term mutual fund is the common name for an open-end investment company. Being</div> <div> open-ended means that, at the end of every day, the fund issues new shares to investors, and</div> <div> buys back shares from investors wishing to leave the fund.</div> <div> Mutual funds may be legally structured as corporations or business trusts but in either</div> <div> instance are classed as open-end investment companies by the SEC.</div> <div> Other funds have a limited number of shares; these are either closed-end funds or unit</div> <div> investment trusts, neither of which a mutual fund is.</div> <div> 􀂋 Exchange-traded funds</div> <div> A relatively new innovation, the exchange traded fund (ETF), is often formulated as an</div> <div> open-end investment company. ETFs combine characteristics of both mutual funds and</div> <div> closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares are issued</div> <div> or redeemed by institutional investors in large blocks (typically of 50,000). Investors</div> <div> typically purchase shares in small quantities through brokers at a small premium or discount</div> <div> to the net asset value; this is how the institutional investor makes its profit. Because the</div> <div> institutional investors handle the majority of trades, ETFs are more efficient than traditional</div> <div> mutual funds (which are continuously issuing new securities and redeeming old ones,</div> <div> keeping detailed records of such issuance and redemption transactions, and, to effect such</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 74</div> <div> transactions, continually buying and selling securities and maintaining liquidity position)</div> <div> and therefore tend to have lower expenses. ETFs are traded throughout the day on a stock</div> <div> exchange, just like closed-end funds.</div> <div> Exchange traded funds are also valuable for foreign investors who are often able to buy and</div> <div> sell securities traded on a stock market, but who, for regulatory reasons, are unable to</div> <div> participate in traditional US mutual funds.</div> <div> 􀂋 Equity funds</div> <div> Equity funds, which consist mainly of stock investments, are the most common type of</div> <div> mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds in the</div> <div> United States. Often equity funds focus investments on particular strategies and certain</div> <div> types of issuers.</div> <div> 􀂋 Bond funds</div> <div> Bond funds account for 18% of mutual fund assets. Types of bond funds include term</div> <div> funds, which have a fixed set of time (short-, medium-, or long-term) before they mature.</div> <div> Municipal bond funds generally have lower returns, but have tax advantages and lower risk.</div> <div> High-yield bond funds invest in corporate bonds, including high-yield or junk bonds. With</div> <div> the potential for high yield, these bonds also come with greater risk.</div> <div> 􀂋 Money market funds</div> <div> Money market funds hold 26% of mutual fund assets in the United States. Money market</div> <div> funds entail the least risk, as well as lower rates of return. Unlike certificates of deposit</div> <div> (CDs), money market shares are liquid and redeemable at any time. The interest rate quoted</div> <div> by money market funds is known as the 7 Day SEC Yield.</div> <div> 􀂋 Funds of funds</div> <div> Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds (i.e.,</div> <div> they are funds comprised of other funds). The funds at the underlying level are typically</div> <div> funds which an investor can invest in individually. A fund of funds will typically charge a</div> <div> management fee which is smaller than that of a normal fund because it is considered a fee</div> <div> charged for asset allocation services. The fees charged at the underlying fund level do not</div> <div> pass through the statement of operations, but are usually disclosed in the fund's annual</div> <div> report, prospectus, or statement of additional information. The fund should be evaluated on</div> <div> the combination of the fund-level expenses and underlying fund expenses, as these both</div> <div> reduce the return to the investor.</div> <div> Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same advisor),</div> <div> although some invest in funds managed by other (unaffiliated) advisors. The cost associated</div> <div> with investing in an unaffiliated underlying fund is most often higher than investing in an</div> <div> affiliated underlying because of the investment management research involved in investing</div> <div> in fund advised by a different advisor. Recently, FoFs have been classified into those that</div> <div> are actively managed (in which the investment advisor reallocates frequently among the</div> <div> underlying funds in order to adjust to changing market conditions) and those that are</div> <div> passively managed (the investment advisor allocates assets on the basis of on an allocation</div> <div> model which is rebalanced on a regular basis).</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 75</div> <div> The design of FoFs is structured in such a way as to provide a ready mix of mutual funds for</div> <div> investors who are unable to or unwilling to determine their own asset allocation model.</div> <div> Fund companies such as TIAA-CREF, Vanguard, and Fidelity have also entered this market</div> <div> to provide investors with these options and take the "guess work" out of selecting funds.</div> <div> The allocation mixes usually vary by the time the investor would like to retire: 2020, 2030,</div> <div> 2050, etc. The more distant the target retirement date, the more aggressive the asset mix.</div> <div> 􀂋 Hedge funds</div> <div> Hedge funds in the United States are pooled investment funds with loose SEC regulation</div> <div> and should not be confused with mutual funds. Certain hedge funds are required to register</div> <div> with SEC as investment advisers under the Investment Advisers Act. The Act does not</div> <div> require an adviser to follow or avoid any particular investment strategies, nor does it require</div> <div> or prohibit specific investments. Hedge funds typically charge a management fee of 1% or</div> <div> more, plus a “performance fee” of 20% of the hedge fund’s profit. There may be a "lockup"</div> <div> period, during which an investor cannot cash in shares.</div> <div> Usage of Mutual Funds</div> <div> Mutual funds can invest in many different kinds of securities. The most common are cash,</div> <div> stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can</div> <div> invest primarily in the shares of a particular industry, such as technology or utilities. These</div> <div> are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk</div> <div> bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies,</div> <div> corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock</div> <div> and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and</div> <div> foreign securities (global funds), or primarily foreign securities (international funds).</div> <div> Most mutual funds' investment portfolios are continually adjusted under the supervision of a</div> <div> professional manager, who forecasts the future performance of investments appropriate for</div> <div> the fund and chooses those which he or she believes will most closely match the fund's</div> <div> stated investment objective. A mutual fund is administered through a parent management</div> <div> company, which may hire or fire fund managers.</div> <div> Mutual funds are liable to a special set of regulatory, accounting, and tax rules. Unlike most</div> <div> other types of business entities, they are not taxed on their income as long as they distribute</div> <div> substantially all of it to their shareholders. Also, the type of income they earn is often</div> <div> unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free</div> <div> municipal bond income are also tax-free to the shareholder. Taxable distributions can be</div> <div> either ordinary income or capital gains, depending on how the fund earned those</div> <div> distributions.</div> <div> Mutual funds vs. other investments</div> <div> Mutual funds offer several advantages over investing in individual stocks. For example, the</div> <div> transaction costs are divided among all the mutual fund shareholders, who also benefit by</div> <div> having a third party (professional fund managers) apply their expertise, dedicate their time</div> <div> to manage and research investment options. However, despite the professional management,</div> <div> mutual funds are not immune to risks. They share the same risks associated with the</div> <div> investments made. If the fund invests primarily in stocks, it is usually subject to the same</div> <div> ups and downs and risks as the stock market.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 76</div> <div> Share classes</div> <div> Many mutual funds offer more than one class of shares. For example, you may have seen a</div> <div> fund that offers "Class A" and "Class B" shares. Each class will invest in the same pool (or</div> <div> investment portfolio) of securities and will have the same investment objectives and</div> <div> policies. But each class will have different shareholder services and/or distribution</div> <div> arrangements with different fees and expenses. These differences are supposed to reflect</div> <div> different costs involved in servicing investors in various classes; for example, one class may</div> <div> be sold through brokers with a front-end load, and another class may be sold direct to the</div> <div> public with no load but a "12b-1 fee" included in the class's expenses (sometimes referred to</div> <div> as "Class C" shares). Still a third class might have a minimum investment of $10,000,000</div> <div> and be available only to financial institutions (a so-called "institutional" share class). In</div> <div> some cases, by aggregating regular investments made by many individuals, a retirement</div> <div> plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the</div> <div> benefit of their typically lower expense ratios) even though no members of the plan would</div> <div> qualify individually. As a result, each class will likely have different performance results.</div> <div> A multi-class structure offers investors the ability to select a fee and expense structure that</div> <div> is most appropriate for their investment goals (including the length of time that they expect</div> <div> to remain invested in the fund).</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 77</div> <div> Lecture # 23</div> <div> Mutual Funds</div> <div> Criticism of managed mutual funds</div> <div> Historically, only a small percentage of actively managed mutual funds, over long periods</div> <div> of time, have returned as much, or more than comparable index mutual funds. This, of</div> <div> course, is a criticism of one type of mutual fund over another.</div> <div> • Another criticism concerns sales commissions on load funds, an upfront or deferred</div> <div> fee as high as 8.5 percent of the amount invested in a fund (although the average upfront</div> <div> load is no more than 5% normally). *(Mutual Funds have to qualify to charge</div> <div> the maximum allowed by law, which is 8.5% and most of them DO NOT qualify for</div> <div> this.)</div> <div> • In addition, no-load funds typically charge a 12b-1 fee in order to pay for shelf space</div> <div> on the exchange the investor uses for purchase of the fund, but they do not pay a</div> <div> load directly to a mutual fund broker, who sells it.</div> <div> • Critics point out those high sales commissions can sometimes represent a conflict of</div> <div> interest, as high commissions benefit the sales people but hurt the investors.</div> <div> Although in reality, "A shares", which appear to have the highest up front load,</div> <div> (around 5%) are the "cheapest" for the investor, if the investor is planning on 1)</div> <div> keeping the fund for more than 5 years, 2) investing more than 100,000 in one fund</div> <div> family, which likely will qualify them for "break points”, which is a form of</div> <div> discount, or 3) staying with that "fund family" for more than 5 years, but switching</div> <div> "funds" within the same fund company. In this case, the up front load is best for the</div> <div> client, and at times "outperforms" the "no load" or "B or C shares".</div> <div> • High commissions can sometimes cause sales people to recommend funds that</div> <div> maximize their income. This can be easily solved, buy working with a "registered</div> <div> investment advisor" instead of a "broker", where the investment advisor can charge</div> <div> strictly for advise, and not charge a "load, or commission" for their work, at all.</div> <div> This is a discussion of criticism, and solutions regarding one mutual fund over another.12b-</div> <div> 1 fees, which are found on most "no load funds”, can motivate the fund company to focus</div> <div> on advertising to attract more and more new investors, as new investors would also cause</div> <div> the fund assets to increase, thus increasing the amount of money that the mutual fund</div> <div> managers make.</div> <div> Mutual fund managers and companies need to disclose by law, if they have a conflict of</div> <div> interest due to the way they are paid. In particular fund managers may be encouraged to take</div> <div> more risks with investor’s money than they ought to: Fund flows (and therefore</div> <div> compensation) towards successful, market beating funds are much larger than outflows</div> <div> from funds that lose to the market. Fund managers may therefore have an incentive to</div> <div> purchase high risk investments in the hopes of increasing their odds of beating the market</div> <div> and receiving the high inflows, with relatively less fear of the consequences of losing to the</div> <div> market.</div> <div> Many analysts, however, believe that the larger the pool of money one works with, the</div> <div> harder it is to manage actively, and the harder it is to squeeze good performance out of it.</div> <div> This is true, due to the fact that there are only so many companies that one can identify to</div> <div> put the money into ( buy shares of) that fit with the "style" of the mutual fund, due to what</div> <div> is disclosed in the prospectus. Thus some fund companies can be focused on attracting new</div> <div> customers, and forget to "close" their mutual funds to new customers, when they get too</div> <div> big, to invest the assets properly, thereby hurting its existing investors' performance. A great</div> <div> deal of a fund’s costs is flat and fixed costs, such as the salary for the manager. Thus it can</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 78</div> <div> be more profitable for the fund to try to allow it to grow as large as possible, instead of</div> <div> limiting its assets. Most fund companies have closed some funds to new investors to</div> <div> maintain the integrity of the funds for existing investors. If the funds reach more than 1</div> <div> billion dollars, many times, these funds, have gotten too large, before they are closed, and</div> <div> when this happens, the funds tend to not have a place to put the money and can and tend to</div> <div> lose value.</div> <div> Other criticisms of mutual funds are that some funds illegally are guilty of market timing</div> <div> (although many fund companies tightly control this) and that some fund managers, also</div> <div> illegal, accept extravagant gifts in exchange for trading stocks through certain investment</div> <div> banks, which presumably charge the fund more for transactions than would non-gifting</div> <div> investment bank. This practice, although done, is completely illegal. As a result, all fund</div> <div> companies strictly limit -- or completely bar -- such gifts.</div> <div> Scandals of mutual funds</div> <div> In September 2003, the United States mutual fund industry was beset by a scandal in which</div> <div> several major fund companies permitted and facilitated "late trading" and "market timing".</div> <div> Mutual-fund families in the United States</div> <div> A family of mutual funds is a group of funds that are marketed under one or more brand</div> <div> names, usually having the same distributor (the company which handles selling and</div> <div> redeeming shares of the fund in transactions with investors), and investment advisor (which</div> <div> is usually a corporate cousin of the distributor).</div> <div> There are several hundred families of registered mutual funds in the United States, some</div> <div> with a single fund and others offering dozens. Many fund families are units of a larger</div> <div> financial services company such as an asset manager, bank, brokerages, or insurance</div> <div> company. Additionally, multiple funds in a family can be part of the same corporate</div> <div> structure; that is, one underlying corporation or business trust may divide itself into more</div> <div> than one fund, each of which issues shares separately.</div> <div> Mutual Funds in Pakistan</div> <div> Mutual Funds were introduced in Pakistan in 1962, with the public offering of National</div> <div> Investment (Unit) Trust (NIT) which is an open-end mutual fund in the public sector. This</div> <div> was followed by the establishment of the Investment Corporation of Pakistan (ICP) in 1966,</div> <div> which subsequently offered a series of closed-end mutual funds. Up to date, twenty six (26)</div> <div> closed-end ICP mutual funds have been floated. Initially there was both public and private</div> <div> sector participation in the management of these funds, but with the nationalization in the</div> <div> seventies, the government role become more dominant and today these mutual funds are</div> <div> totally in the public sector. Later, the government also allowed the private sector to establish</div> <div> mutual funds. Currently there exists one open-ended and eleven closed-ended mutual funds</div> <div> under private sector management.</div> <div> Rules Govern Mutual Funds in Pakistan</div> <div> There are two rules govern mutual funds in Pakistan, which are:</div> <div> • Investment Companies and Investment Advisors' Rules, 1971. (govern closed-end</div> <div> mutual funds)</div> <div> • Asset Management Companies Rules, 1995. (govern open-ended mutual funds)</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 79</div> <div> These rules however only apply to private sector operated mutual funds and are not</div> <div> applicable to NIT and ICP mutual funds.</div> <div> Money Market Fund</div> <div> We begin with a discussion of money market funds for several reasons:</div> <div> 1. They are the safest for the trainee investor;</div> <div> 2. They are the easiest, least complicated to follow and understand;</div> <div> 3. Almost without exception, every mutual fund investment company offers money</div> <div> market funds;</div> <div> 4. Money market funds represent an indispensable investment tool for the beginning</div> <div> investor.</div> <div> 5. They are the most basic and conservative of all the mutual funds available;</div> <div> Money market funds should be considered by investors seeking stability of principal, total</div> <div> liquidity, and earnings that are as high, or higher, than that Available through bank</div> <div> certificates of deposit. And unlike bank cash deposits, money market funds have no early</div> <div> withdrawal penalties.</div> <div> Specifically, a money market fund is a mutual fund that invests its assets only in the most</div> <div> liquid of money instruments. The portfolio seeks stability by investing in very short-term,</div> <div> interest-bearing instruments issued by the state and local governments, banks, and large</div> <div> corporations. The money invested is a loan to these agencies, and the length of the loan</div> <div> might range from overnight to one week or, in some cases, as long as 90 days. These debt</div> <div> certificates are called "money market instruments"; because they can be converted into cash</div> <div> so readily, they are considered the equivalent of cash.</div> <div> To understand why money market mutual funds is recommended as an ideal investment, let</div> <div> me reemphasize just seven of the advantages they offer:</div> <div> 1. Safety of principal, through diversification and stability of the short-term portfolio</div> <div> investments</div> <div> 2. Total and immediate liquidity, by telephone or letter</div> <div> 3. Better yields than offered by banks, 1% to 3% higher</div> <div> 4. Low minimum investment, some as low as $100</div> <div> 5. Professional management, proven expertise</div> <div> 6. Generally, no purchase or redemption fees, no-load funds</div> <div> Income Funds</div> <div> The objective of income mutual funds is to seek a high level of current income</div> <div> commensurate with each portfolio's risk potential. In other words, the greater the risk, the</div> <div> greater the potential for generous income yields; but the greater the risk of principal loss as</div> <div> well.</div> <div> The risk / reward potential are low to high, depending upon the type of securities that make</div> <div> up the fund's portfolio. The risk is very low when the fund is invested in government</div> <div> obligations, blue chip corporations, and short-term agency securities. The risk is high when</div> <div> a fund seeks higher yields by investing in long-term corporate bonds, offered by new,</div> <div> undercapitalized, risky companies.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 80</div> <div> Who should invest in income funds?</div> <div> • Investors seeking current income higher than money market rates, who are willing to</div> <div> accept moderate price fluctuations</div> <div> • Investors willing to "balance" their equity (stock) portfolios with a fixed income</div> <div> investment</div> <div> • Investors who want a portfolio of taxable bonds with differing maturity dates</div> <div> • Investors interested in receiving periodic income on a regular basis</div> <div> Income and Growth Funds</div> <div> The primary purposes of income and growth funds are to provide a steady source of income</div> <div> and moderate growth. Such funds are ideal for retirees needing a supplement source of</div> <div> income without forsaking growth entirely.</div> <div> Growth and Income Funds</div> <div> The primary objectives of growth and income funds are to seek long-term growth of</div> <div> principal and reasonable current income. By investing in a portfolio of stocks believed to</div> <div> offer growth potential plus market or above - market dividend income, the fund expects to</div> <div> investors seeking growth of capital and moderate income over the long term (at least five</div> <div> years) would consider growth and income funds. Such funds require that the investor be</div> <div> willing to accepts some share-price volatility, but less than found in pure growth funds</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 81</div> <div> Lecture # 24</div> <div> Mutual Funds</div> <div> Balanced Funds</div> <div> The basic objectives of balanced funds are to generate income as well as long-term growth</div> <div> of principal. These funds generally have portfolios consisting of bonds, preferred stocks,</div> <div> and common stocks. They have fairly limited price rise potential, but do have a high degree</div> <div> of safety, and moderate to high income potential.</div> <div> Investors who desire a fund with a combination of securities in a single portfolio, and who</div> <div> seek some current income and moderate growth with low-level risk, would do well to invest</div> <div> in balanced mutual funds. Balanced funds, by and large, do not differ greatly from the</div> <div> growth and income funds described above.</div> <div> Growth Funds</div> <div> Growth funds are offered by every investment company. The primary objective of such</div> <div> funds is to seek long-term appreciation (growth of capital). The secondary objective is to</div> <div> make one's capital investment grow faster than the rate of inflation. Dividend income is</div> <div> considered an incidental objective of growth funds.</div> <div> Growth funds are best suited for investors interested primarily in seeing their principal grow</div> <div> and are therefore to be considered as long-term investments - held for at least three to five</div> <div> years. Jumping in and out of growth funds tends to defeat their purpose. However, if the</div> <div> fund has not shown substantial growth over a three - to five-year period, sell it (redeem your</div> <div> shares) and seek a growth fund with another investment company. Candidates likely to</div> <div> participate in growth funds are those willing to accept moderate to high risk in order to</div> <div> attain growth of their capital and those investors who characterize their investment</div> <div> temperament as "fairly aggressive.</div> <div> Index Funds</div> <div> The intent of an index fund is basically to track the performance of the stock market. If the</div> <div> overall market advances, a good index fund follows the rise. When the market declines, so</div> <div> will be the index fund. Index funds' portfolios consist of securities listed on the popular</div> <div> stock market indices.</div> <div> It is also the intent of an index fund to materially reduce expenses by eliminating the fund</div> <div> portfolio manager. Instead, the fund merely purchases a group of stocks that make up the</div> <div> particular index it deems the best to follow. The stocks in an index fund portfolio rarely</div> <div> change and are weighted the same way as its particular market index. Thus, there is no need</div> <div> for a portfolio manager. The securities in an index mutual fund are identical to those listed</div> <div> by the index it tracks, thus, there is little or no need for any great turnover of the portfolio of</div> <div> securities. The funds are "passively managed" in a fairly static portfolio. An index fund is</div> <div> always fully invested in the securities of the index it tracks.</div> <div> An index mutual fund may never outperform the market but it should not lag far behind it</div> <div> either. The reduction of administrative cost in the management of an index fund also adds to</div> <div> its profitability</div> <div> Sector Funds</div> <div> As was discussed earlier, most mutual funds have fairly broad-based, diversified portfolios.</div> <div> In the case of sector funds, however, the portfolios consist of investment from only one</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 82</div> <div> sector of the economy. Sector funds concentrate in one specific market segment; for</div> <div> example, energy, transportation, precious metals, health sciences, utilities, leisure industries,</div> <div> etc. In other words, they are very narrowly based.</div> <div> Investors in sector funds must be prepared to accept the rather high level of risk inherent in</div> <div> funds that are not particularly diversified. Any measure of diversification that may exist in</div> <div> sector funds is attained through a variety of securities, albeit in the same market sector.</div> <div> Substantial profits are attainable by investors astute enough to identify which market sector</div> <div> is ripe for growth - not always an easy task.</div> <div> Specialized Funds</div> <div> Specialized funds resemble sector funds in most respects. The major difference is the type</div> <div> of securities that make up the fund's portfolio. For example, the portfolio may consist of</div> <div> common stocks only, foreign securities only, bonds only, new stock issues only, over - the -</div> <div> counter securities only, and so on.</div> <div> Those who are still novices in the investment arena should avoid both specialized and sector</div> <div> funds or the time being and concentrate on the more traditional, diversified mutual funds</div> <div> instead</div> <div> Islamic Funds</div> <div> In case of Islamic Funds, the investment made in different instruments is to be in line with</div> <div> the Islamic Shairah Rules. The Fund is generally to be governed by an Islamic Shariah</div> <div> Board. And then there is a purification process that needs to be followed, as some of the</div> <div> money lying in reserve may gain interest, which is not desirable in case of Islamic</div> <div> investments.</div> <div> Risks in Mutual Fund Investing</div> <div> There is some degree of risk in every investment. Although it is reduced considerably in</div> <div> mutual fund investing. Do not let the specter of risk stop you from becoming a mutual fund</div> <div> investor. However, it behaves all investors to determine for them the degree of risk they are</div> <div> willing to accept in order to meet their objectives before making a purchase. Knowing of</div> <div> potential risks in advance will help you avoid situations in which you would not be</div> <div> comfortable. Understanding the risk levels of the various types of mutual funds at the outset</div> <div> will help you avoid the stress that might result from a thoughtless or a hasty purchase.</div> <div> Let us now examine the risk levels of the various types of mutual funds.</div> <div> • Low Level Risks</div> <div> • Moderate level Risks</div> <div> • High Level Risks</div> <div> Measuring Risks</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 83</div> <div> LOW-LEVEL RISKS</div> <div> Mutual funds characterized as low-level risks fall into here categories</div> <div> 1. Money market funds</div> <div> 2. Treasury bill funds</div> <div> 3. Insured bond funds</div> <div> MODERATE-LEVEL RISKS</div> <div> Mutual funds considered moderate-risk investments may be found in at least the eight types</div> <div> categorized below.</div> <div> 1. Income funds</div> <div> 2. Balanced funds</div> <div> 3. Growth and income funds</div> <div> 4. Growth funds</div> <div> 5. Short-term bond funds (taxable and tax-free)</div> <div> 6. Intermediate bond funds (taxable and tax-free)</div> <div> 7. Insured government/municipal bond funds</div> <div> 8. Index funds.</div> <div> HIGH-LEVEL RISKS</div> <div> The types of funds listed below have the potential for high gain, but all have high risk levels</div> <div> as well.</div> <div> 1. Aggressive growth funds</div> <div> 2. International funds</div> <div> 3. Sector funds</div> <div> 4. Specialized funds</div> <div> 5. Precious metals funds</div> <div> 6. high-yield bond funds (taxable and tax-free)</div> <div> 7. Commodity funds</div> <div> 8. Option funds</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 84</div> <div> MEASURING RISK</div> <div> As you become a more experienced investor, you may want to examine other, more</div> <div> technical, measures to determine risk factors in your choice of funds.</div> <div> Beta coefficient is a measure of the fund’s risk relative to the overall market. For example,</div> <div> a fund with a beta coefficient of 2.0 means that it is likely to move twice as fast as the</div> <div> general market – both up and down. High beta coefficients and high risk go hand in hand.</div> <div> Alpha coefficient is a comparison of a fund’s risk (beta) to its performance. A positive</div> <div> alpha is good. For example, an alpha of 10.5 means that the fund manager earned an</div> <div> average of 10.5% more each year than might be expected, given the fund’s beta.</div> <div> Interest rates and inflation rates are other factors that can be used to measure investment</div> <div> risks. For instance, when interest rates are going up, bond funds will usually be declining,</div> <div> and vice versa. The rate of inflation has a decided effect on funds that are sensitive to</div> <div> inflation factors; for example, funds that have large holdings in automaker stocks, real estate</div> <div> securities, and the like will be adversely affected by inflationary cycles.</div> <div> R-Square factor is a measure of the fund’s risk as related to its degree of diversification.</div> <div> The information is supplied here merely to acquaint you with the terminology in the event</div> <div> you should wish to delve more deeply into complex risk factors. The more common risk</div> <div> factors previously described are all you really need to know for now, and perhaps for years</div> <div> to come.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 85</div> <div> Lecture # 25</div> <div> Mutual Funds</div> <div> Cost of Ownership</div> <div> 1. Management Fee</div> <div> All mutual funds, including no-load funds, have certain fixed expenses that are built into</div> <div> their per share net asset value. These expenses are the actual costs of doing business.</div> <div> They are deducted from the assets of the fund. It is advisable to check the prospectus to</div> <div> determine the percentage of the fund's total net assets that is paid out for expenses.</div> <div> Additionally, shareholder services provided by the fund, investment adviser's fees, bank</div> <div> custodian fees, and fund underwriter costs also come out of the fund's assets. These charges</div> <div> vary from fund to fund; however, they are clearly spelled out in the prospectus.</div> <div> On a per-share basis, however, management expenses are usually quite small, because they</div> <div> are spread over the tens of thousands, or the millions, of shareholders in the fund.</div> <div> The formula for determining the cost of a fund's management expenses is simple: From the</div> <div> current value of the fund's total assets subtract liabilities and expenses, and divide the result</div> <div> by the number of outstanding shares. The fund's prospectus and /or annual reports often</div> <div> provide this data. Management fees and expenses are usually expressed as a ratio of</div> <div> expenses paid out to total assets. Generally, the prospectus will show these expense ratios.</div> <div> 2. Redemption Fee</div> <div> All load funds levy a sales charge when purchasing shares. Some load and some no-load</div> <div> funds also charge a redemption fee when you take money out (redeem shares). The</div> <div> redemption fee is a percentage of the amount redeemed, usually 0.05% (1/2 of 1%).</div> <div> Avoid funds with redemption fees. There are excellent funds available that will meet your</div> <div> objectives and do not levy redemption fees.</div> <div> Generally redemption fees are levied only with the intent to cut down on the number of</div> <div> redemptions the fund experiences. The bottom line is that you are entitled to the full value</div> <div> of the shares you redeem.</div> <div> 3. Switching Fee</div> <div> Most, if not all, open-end mutual funds permit you to transfer all or any part of your</div> <div> investment from one fund to another fund within its family. This kind of transfer is</div> <div> commonly called "switching".</div> <div> For many years there was no charge required switching funds. In recent years, however,</div> <div> some funds have started to charge for switching. It is usually a flat fee. The few funds that</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 86</div> <div> are charging the investor for this service say it is to discourage too frequent moving in and</div> <div> out of funds. Constant switching of funds increases the administrative costs involved in</div> <div> keeping track of customer accounts made.</div> <div> 4. Maintenance Fee</div> <div> Be on the lookout for a fee that is being assessed against the shareholder's account(s)</div> <div> directly. It is called an "account maintenance" fee. According to prospectuses of the funds</div> <div> that levy this fee, it is to "offset the costs of maintaining shareholder accounts."</div> <div> The fee is deducted from the dividends to cover the maintenance fee, enough shares or</div> <div> fractions of shares will be automatically redeemed from the account to make up the</div> <div> difference.</div> <div> Avoid funds that charge the investor a separate maintenance fee. The list below shows a list</div> <div> of usual and justifiable fees charged by virtually all mutual funds. Expect to pay these fees;</div> <div> they are minimal and necessary. On the other hand, the other fees about which for which</div> <div> you need to take caution is not, in most cases, justifiable.</div> <div> Customary Fees Charged by Most Mutual Fund Companies</div> <div> 1. Investment Advisory Fees:</div> <div> The fund pays a set fee, stated in the prospectus, for investment management. This allows</div> <div> the fund the use of the advisor's investment research staff, equipment, and other resources.</div> <div> Administrative and accounting services, such as data processing, pricing of fund shares, and</div> <div> preparing financial statements, are included in this fee.</div> <div> 2. Transfer Agent Fees:</div> <div> The fund pays a set fee for each account for maintaining shareholder records and generating</div> <div> shareholder statements, plus answering your phone inquiries and correspondence.</div> <div> 3. Audit Fees and Expenses:</div> <div> Each fund is audited annually by an internationally recognized, independent accounting</div> <div> firm which is not affiliated with the fund.</div> <div> 4. Custodian Fees and Expenses:</div> <div> The Fund's assets, represented by stock certificates and other documents, are held by an</div> <div> outside source for safe keeping.</div> <div> 5. Directors' Fees and Expenses:</div> <div> The Fund's directors are compensated for their time and travel. The Board meets at least</div> <div> quarterly, as a whole and in subcommittees, to review the fund's business. (Directors or</div> <div> officers who are employed by the fund receive no compensation from the fund for serving</div> <div> as directors.)</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 87</div> <div> 6. Registration Fee:</div> <div> The SEC and various state securities agencies charge fees permitting a fun's shares to be</div> <div> sold.</div> <div> Reports to Shareholders:</div> <div> Annual, semiannual, and interim reports are printed and mailed to shareholders on a</div> <div> periodic basis.</div> <div> Investment Fraud</div> <div> Information is an investor's best tool when it comes to investing wisely and avoiding fraud.</div> <div> And the best way to gather information is to ask questions- about both the investment and</div> <div> the person or firm selling it. It doesn't matter if you are a beginner or have been investing</div> <div> for many years; it's never too early or too late to start asking questions.</div> <div> Too many investors who've suffered losses at the hands of swindlers could have avoided</div> <div> trouble if they had only asked basic questions from the start.</div> <div> This section will help you recognize and avoid different types of investment fraud. You'll</div> <div> also learn what questions to ask before investing, where to get information about</div> <div> companies, who to call for help, and what to do if you run into trouble.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 88</div> <div> Lecture # 26</div> <div> Mutual Funds</div> <div> Navigating the Investing Frontier: Where the Frauds Are</div> <div> Many fraudsters rely on the telephone to carry out their investment scams. Using a</div> <div> technique known as cold calling (so-called because a caller telephones a person with whom</div> <div> they have not had previous contact), these fraudsters will hound you to buy stocks in small,</div> <div> unknown companies that are highly risky or, sometimes, part of a scam. In recent years, the</div> <div> Internet has also become increasingly attractive to fraudsters because it allows an individual</div> <div> or company to communicate with a large audience without spending a lot of time, effort, or</div> <div> money.</div> <div> You should be skeptical of any offers you learn about from a cold caller or through the</div> <div> Internet. Here's what you need to know about cold calling and Internet fraud.</div> <div> Cold calling</div> <div> For many businesses, including securities firms, cold calling serve as a legitimate way to</div> <div> reach potential customers. Honest brokers use cold calling to find clients for the long term.</div> <div> They ask questions to understand your financial situation and investment goals before</div> <div> recommending that you buy anything.</div> <div> Dishonest brokers use cold calling to find "quick hits." Some set up "boiler rooms" where</div> <div> high-pressure salespeople use banks of telephones to call as many potential investors as</div> <div> possible. Aggressive cold callers speak from persuasive scripts that include retorts for your</div> <div> every objection. As long as you stay on the phone, they'll keep trying to sell. And they won't</div> <div> let you get a word in edgewise. Our advice is to avoid making any direct investments over</div> <div> the phone.</div> <div> Internet Fraud</div> <div> The Internet serves as an excellent tool for investors, allowing them to easily and</div> <div> inexpensively research investment opportunities. But the Internet is also an excellent tool</div> <div> for fraudsters. That's why you should always think twice before you invest your money in</div> <div> any opportunity</div> <div> you learn about through the Internet Anyone can reach tens of thousands of people by</div> <div> building an Internet Web site, posting a message on an online message board, entering a</div> <div> discussion in a live "chat" room, or sending mass e-mails. It's easy for fraudsters to make</div> <div> their messages look real and credible. But it's nearly impossible for investors to tell the</div> <div> difference between fact and fiction.</div> <div> Types of Investment Fraud</div> <div> The types of investment fraud seen online mirror the frauds perpetrated over the phone or</div> <div> through the mail. Here are the most common investment schemes and the "red flags" you</div> <div> should watch for:</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 89</div> <div> • The "PUMP and DUMP" rip-off</div> <div> It's common to see messages posted on the Internet that urge readers to buy a stock quickly</div> <div> or to sell before the price goes down. Cold callers often call using the same sort of pitch.</div> <div> Often the promoters will claim to have "inside" information about an impending</div> <div> development or an "infallible" combination of economic and stock market data to pick</div> <div> stocks. In reality, they may be insiders or paid promoters who stand to gain by selling their</div> <div> shares after the stock price is pumped up by gullible investors. Once these fraudsters sell</div> <div> their shares and stop hyping the stock, the price typically falls and investors lose their</div> <div> money. Fraudsters frequently use this ploy with small, thinly traded companies because it's</div> <div> easier to manipulate a stock when there's little or no information available about the</div> <div> company.</div> <div> • The Pyramid Scheme</div> <div> In the classic "pyramid" scheme, participants attempt to make money solely by recruiting</div> <div> new participants into the program. The hallmark of these schemes is the promise of skyhigh</div> <div> returns in a short period of time for doing nothing other than handing over your money</div> <div> and getting others to do the same. Money coming in from new recruits is used to pay off</div> <div> early stage investors. But eventually the pyramid will collapse. At some point, the schemes</div> <div> get too big, the promoter cannot raise enough money from new investors to pay earlier</div> <div> investors, and many people lose their money. Table 1 shows how pyramid schemes can</div> <div> become impossible to sustain.</div> <div> How to Avoid Investment Fraud</div> <div> To invest wisely and avoid investment scams, research each investment opportunity</div> <div> thoroughly and ask questions. Get the facts before you invest, and only invest money you</div> <div> can afford to lose. You can avoid investment scams by asking-and getting answers to-these</div> <div> three simple questions:</div> <div> 1. Is the investment registered?</div> <div> Many investment scams involve unregistered securities. So you should always find out</div> <div> whether the company has registered its securities with the SEC or your state securities</div> <div> regulators. You can do this by checking the SECP's website database or by calling SECP.</div> <div> Some smaller companies don't have to register their securities offerings with the SEC, so</div> <div> always make background check and ask for referrals etc.</div> <div> 2. Is the person licensed and law-abiding?</div> <div> Try and find out whether the person or firm selling the investment is properly licensed and</div> <div> whether they've had run-ins with regulators or received serious complaints from investors.</div> <div> This information may be difficult to get in Pakistan.</div> <div> 3. does the investment sound too good to be true?</div> <div> If it does, it probably is. High-yield investments tend to involve extremely high risk. Never</div> <div> invest in an opportunity that promises "guaranteed" or "risk-free" returns. Watch out for</div> <div> claims of astronomical yields in a short period of time. Be skeptical of "offshore" or foreign</div> <div> investments. And beware of exotic or unusual sounding investments. Make sure you fully</div> <div> understand the investment before you part with your hard-earned money. Always ask forManagement</div> <div> of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 90</div> <div> and carefully read-the company's prospectus. You should also read the most recent reports</div> <div> the company has filed with its regulators and pay attention to the company's financial</div> <div> statements, particularly if they do not say they have been audited or certified by an</div> <div> accountant.</div> <div> Mutual Funds - The Logic behind Investing in Them</div> <div> Mutual funds are investment companies that pool money from investors at large and offer to</div> <div> sell and buy back its shares on a continuous basis and use the capital thus raised to invest in</div> <div> securities of different companies. This article helps you to know in depth on:</div> <div> • Is it possible to diversify investment if invested in mutual funds?</div> <div> • Find more on the working of mutual fund</div> <div> • Know more about the legal aspects in relation to the mutual funds</div> <div> At the beginning of this millennium, mutual funds out numbered all the listed securities in</div> <div> New York Stock Exchange. Mutual funds have an upper hand in terms of diversity and</div> <div> liquidity at lower cost in comparison to bonds and stocks. The popularity of mutual funds</div> <div> may be relatively new but not their origin which dates back to 18th century. Holland saw</div> <div> the origination of mutual funds in 1774 as investment trusts before spreading to Anglo-</div> <div> Saxon countries in its current form by 1868. We will discuss now as to what are mutual</div> <div> funds before going on to seeing the advantages of mutual funds. Mutual funds are</div> <div> investment companies that pool money from investors at large and offer to sell and buy</div> <div> back its shares on a continuous basis and use the capital thus raised to invest in securities of</div> <div> different companies. The stocks these mutual funds have are very fluid and are used for</div> <div> buying or redeeming and/or selling shares at a net asset value. Mutual funds posses shares</div> <div> of several companies and receive dividends in lieu of them and the earnings are distributed</div> <div> among the share holders.</div> <div> Are Mutual Funds Risk Free and what are the Advantages?</div> <div> One must not forget the fundamentals of investment that no investment is insulated from</div> <div> risk. Then it becomes interesting to answer why mutual funds are so popular. To begin with,</div> <div> we can say mutual funds are relatively risk free in the way they invest and manage the</div> <div> funds. The investment from the pool is well diversified across securities and shares from</div> <div> various sectors. The fundamental understanding behind this is not all corporations and</div> <div> sectors fail to perform at a time. And in the event of a security of a corporation or a whole</div> <div> sector doing badly then the possible losses from that would be balanced by the returns from</div> <div> other shares. This logic has seen the mutual funds to be perceived as risk free investments</div> <div> in the market. Yes, this is not entirely untrue if one takes a look at performances of various</div> <div> mutual funds. This relative freedom from risk is in addition to a couple of advantages</div> <div> mutual funds carry with them. So, if you are a retail investor and planning an investment in</div> <div> securities, you will certainly want to consider the advantages of investing in mutual funds.</div> <div> • Lowest per unit investment in almost all the cases</div> <div> • Your investment will be diversified</div> <div> • Your investment will be managed by professional money managers.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 91</div> <div> There is no one method of classifying mutual funds risk free or advantageous. However we</div> <div> can do the same by way of classifying mutual funds as per their functioning and the type of</div> <div> funds they offer to investors. This Course makes you aware on:</div> <div> • What are the reasons that make the close ended mutual finds more attractive?</div> <div> • What are the factors that determine the prices of exchange traded funds?</div> <div> • Find out the features of open ended mutual funds</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 92</div> <div> Lecture # 27</div> <div> Mutual Funds</div> <div> Investing In International Mutual Funds</div> <div> Investing in international mutual funds has two faces:</div> <div> • First is buying funds from US based companies that buy and manage portfolio in</div> <div> internationally listed stocks/securities. These companies are governed by regulations</div> <div> of SEC (Securities and Exchange Commission)</div> <div> • Second is buying mutual funds from international non US companies.</div> <div> A word of caution before investing even in best international mutual funds - Unlike</div> <div> domestic mutual funds investment, international investments entail additional risk factors</div> <div> such as economic and political in addition to risk of FOREX value (simply put: foreign</div> <div> currency exchange value) fluctuations.</div> <div> Why Should You Invest In International Opportunities?</div> <div> The number of funds in international investing is on the rise. We can cite a few reasons for</div> <div> this.</div> <div> • Removal of trade barriers and expanding of economies have sparked off growth in</div> <div> many non-US companies.</div> <div> • Some of the major industries of the world are dominated by non US companies.</div> <div> • Over 72% of the world stocks are listed out side US.</div> <div> • Greater and true diversification and opportunity to capitalize on best overseas</div> <div> companies.</div> <div> Investing in international mutual funds is gaining popularity for various reasons. Rising</div> <div> political stability merging or opening of borders and currencies are some of the reasons.</div> <div> Vibrant and upcoming economies and non US corporations becoming financially stronger</div> <div> by the day are some of the reasons. In addition you get true diversification, balance and</div> <div> opportunities.</div> <div> Best guide for selecting the right mutual funds</div> <div> Selecting best mutual funds mean a lot more than deciding by indices and their past</div> <div> performances. However, you need to remember one thing that there is no quick gratification</div> <div> in investments of any kind. This article tells you regarding:</div> <div> • How can you select a mutual fund for investment?</div> <div> • Is it important to pick up companies that are performing above average?</div> <div> • Is it advisable to compare mutual funds across category?</div> <div> When your investment purpose is for saving for retirement, then risk minimization should</div> <div> be your mantra. And one of the best avenues for you to invest now is mutual funds as they</div> <div> have an average of 50 stocks in each portfolio for diversification and cushioning the risks.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 93</div> <div> Selecting best mutual funds mean a lot more than deciding by indices and their past</div> <div> performances. However, you need to remember one thing that there is no quick gratification</div> <div> in investments of any kind.</div> <div> Let us discuss the dos and don'ts of selecting the best mutual funds. These points should</div> <div> serve as guidelines for making decision on whether your pick is among the best in the</div> <div> industry or not.</div> <div> Dos in Selecting the Best Mutual Fund</div> <div> 1. Draw down your investment objective. There are various schemes suitable for</div> <div> different needs. For example retirement plan, capital growth etc. Also get clear about</div> <div> your time frame for investment and returns. Equity funds are not advisable for short</div> <div> term because of their long term nature. You can consider money market and floating</div> <div> rate funds for short term gains. This equals asking - What kind of mutual fund is</div> <div> right for me?</div> <div> 2. Once you have decided on a plan or a couple of them, collect as much information</div> <div> as possible on them from different sources offering them. Funds' prospectus and</div> <div> advisors may help you in this.</div> <div> 3. Pick out companies consistently performing above average. Mutual funds industry</div> <div> indices are helpful in comparing different funds as well as different plans offered by</div> <div> them. Some of the industry standard fund indices are Nasdaq 100, Russel 2000, S&P</div> <div> fund index and DSI index with the latter rating the Socially Responsible Funds only.</div> <div> Also best mutual funds draw good results despite market volatility.</div> <div> 4. Get a clear picture of fees & associated cost, taxes (for non-tax free funds) for all</div> <div> your short listed funds and how they affect your returns. Best mutual funds have</div> <div> lower cost out go.</div> <div> 5. Best mutual funds maximize returns and minimize risks. A number called as Sharpe</div> <div> Ratio explains whether a fund is risk free based on its expected returns compared</div> <div> against a risk free money market fund.</div> <div> 6. Some funds have the advantage of low minimum initial investments. You can start</div> <div> investing even with $250 a month. This is advisable for building asset bases over a</div> <div> long period with small regular investments.</div> <div> Best Tips to do an Analysis of Mutual Funds</div> <div> Before investing in mutual funds a proper analysis is required. While all analyses' efforts</div> <div> are aimed at maximizing returns and minimizing risks, it is the latter that gains importance</div> <div> as the single most fundamental criterion to compare mutual funds. This article makes you</div> <div> aware of:</div> <div> • How can you do a mutual fund analysis?</div> <div> • Important is the risk factor analysis?</div> <div> • Why is it important to track the record of mutual fund companies?</div> <div> Investing in mutual funds is not a child's play unless one does a mutual funds' analysis. At</div> <div> least it is not as easy as picking top performers going by indices and investing in them.</div> <div> While all analyses' efforts are aimed at maximizing returns and minimizing risks, it is the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 94</div> <div> latter that gains importance as the single most fundamental criterion to compare mutual</div> <div> funds.</div> <div> Look At the Portfolio of Your Pick of Funds</div> <div> Most of the plans will have invested in multiple stocks or securities for diversification.</div> <div> Critical point here is in what proportion they have invested in different stocks. Giving a</div> <div> higher weight-age to a high returning stock leaves less opportunity for broader allocation</div> <div> and may back fire when market is bearish (plummeting steadily). Also higher returning</div> <div> stocks carry high element of risk.</div> <div> The Optimum Portfolio Size</div> <div> What should be the optimum portfolio size (assortment investments under one plan) for</div> <div> your pick of fund? Well, opinions are divided about this, but it is crucial to look into the</div> <div> specifics of stock bets and sectors you will be exposed to. Higher exposure to specific</div> <div> sectors may see you loosing out on broad based rallies in the bourses (stock markets).</div> <div> Optimally 65 % to 85% may be allocated in stocks from different sectors for diversification</div> <div> plus growth and the balance being in typical bond and money market instruments.</div> <div> Is Your Pick of Funds Really Diversified</div> <div> Notice that the competing plans, though from different fund companies, perform almost on</div> <div> par as if they have a correlation. They indeed have. So, does it mean you have diversified by</div> <div> spreading your money amongst them? Well, think again. Similar plans have similar pattern</div> <div> of their holdings of stocks and with a similar portfolio. This means, in actual effect you are</div> <div> not diversifying. They all go up and down almost as if they do it in tandem. For clear</div> <div> diversification, pick those with different portfolios though they are similar plans (ex:</div> <div> growth, index, or dividend paying etc).</div> <div> Check Out the Facts before Jumping into Mutual Funds</div> <div> If you thought for a moment, you will see an enormous growth in mutual fund industry in</div> <div> the United States in recent years. A fact sheet gives you a bounty of information about the</div> <div> fund. It helps you decide on a particular fund and how to tell an ethical mutual fund from a</div> <div> non ethical one. This article covers:</div> <div> • What are the points that help you in pre-selecting the mutual funds?</div> <div> • Are the parameters that help you in comparing the performance of the mutual funds?</div> <div> • What are the points to be analyzed while comparing the risk factors of various</div> <div> mutual funds?</div> <div> If you thought for a moment, you will see an enormous growth in mutual fund industry in</div> <div> the United States in recent years. This is enticing more individuals to invest either directly</div> <div> or through retirement funds like 401(k) plans (a savings plan for retirement to be funded by</div> <div> the employees and employers in equal proportions. These funds are tax free till they are</div> <div> with drawn and also the contributions are deducted before tax). But come to think of it, for a</div> <div> number of innocent investors, the brochures are just the reminders of their investments. And</div> <div> the case is no different with fact sheets too. They elicit a quick check of their investment</div> <div> necessities, status or the like. In fact it needs to be regarded as a communication of better</div> <div> and more information that concerns the nature of investments the funds make.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 95</div> <div> The U.S. Securities and Exchange Commission (SEC) has some clause about the need for</div> <div> communicating facts by a fund to all its share holders.</div> <div> What is a Fact Sheet for Buying Mutual Funds</div> <div> A fact sheet gives you a bounty of information about the fund. It helps you decide on a</div> <div> particular fund and how to tell an ethical mutual fund from a non ethical one. Given below</div> <div> are some important facts that you should know as an investor in Mutual Funds.</div> <div> How to Pre-Select a Mutual Fund</div> <div> Before you zero in for investment, make a short list of funds that are broadly doing well.</div> <div> For doing this assessing following points may help:</div> <div> • Try to match your financial profile to a fund's characteristics and risk or reward</div> <div> history. Your profile may not permit you to invest in high paying funds if they have</div> <div> a high risk element. Reading the funds' prospectus in detail will give an insight into</div> <div> their portfolio and investment pattern. It is obvious that high returns are almost</div> <div> always associated with risky investments. Any down turn of fortune can see you</div> <div> loosing your principle haplessly.</div> <div> • Find out whether the fund's investment philosophy satisfies yours. If you have an</div> <div> inclination for social causes or looking for a steady build up of principle without</div> <div> much risk, look for funds that are socially responsible and/or investing in</div> <div> government bonds and T-Bills. Assess whether the fund's costs, fees and loads are</div> <div> too much or in line with your estimation.</div> <div> You may not need a portfolio of more than 8-10 funds from different companies to</div> <div> sufficiently diversify your fund allocation objectives. This helps you average out and to a</div> <div> certain extent stabilize returns (especially when your objective is regular income). Select</div> <div> specific funds in your chosen categories to meet your needs.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 96</div> <div> Lecture # 28</div> <div> Role of Investment Banks</div> <div> Investment banks</div> <div> It helps companies and governments (or their agencies) raise money by issuing and selling</div> <div> securities in the capital markets (both equity and debt).</div> <div> Almost all investment banks also offer strategic advisory services for mergers, acquisitions,</div> <div> divestiture, or other financial services for clients, such as the trading of derivatives, fixed</div> <div> income, and foreign exchange, commodity, and equity securities.</div> <div> Trading securities for cash or securities (i.e., facilitating transactions, market-making), or</div> <div> the promotion of securities (i.e., underwriting, research, etc.) is referred to as "sell side."</div> <div> The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing</div> <div> public who consume the products and services of the sell-side in order to maximize their</div> <div> return on investment. Many firms have both buy and sell side components.</div> <div> Organizational structure of an investment bank</div> <div> The main activities and units</div> <div> The primary function of an investment bank is buying and selling products both on behalf of</div> <div> the bank's clients and also for the bank itself. Banks undertake risk through proprietary</div> <div> trading, done by a special set of traders who do not interface with clients and through</div> <div> Principal Risk, risk undertaken by a trader after he or she buys or sells a product to a client</div> <div> and does not hedge his or her total exposure. Banks seek to maximize profitability for a</div> <div> given amount of risk on their balance sheet.</div> <div> An investment bank is split into the so-called Front Office, Middle Office and Back</div> <div> Office.</div> <div> Front Office</div> <div> • Investment Banking is the traditional aspect of investment banks which involves</div> <div> helping customers raise funds in the Capital Markets and advising on mergers and</div> <div> acquisitions. Investment banking may involve subscribing investors to a security</div> <div> issuance, coordinating with bidders, or negotiating with a merger target. Other terms</div> <div> for the Investment Banking Division include Mergers & Acquisitions (M&A) and</div> <div> Corporate Finance (often pronounced "corpfin").</div> <div> • Investment management is the professional management of various securities</div> <div> (shares, bonds, etc.) and other assets (e.g. real estate), to meet specified investment</div> <div> goals for the benefit of the investors. Investors may be institutions (insurance</div> <div> companies, pension funds, corporations etc.) or private investors (both directly via</div> <div> investment contracts and more commonly via collective investment schemes eg.</div> <div> mutual funds) .</div> <div> • Sales and Trading is often the most profitable area of an investment bank,</div> <div> responsible for the majority of revenue of most investment banks In the process of</div> <div> market making, traders will buy and sell financial products with the goal of making</div> <div> an incremental amount of money on each trade. Sales is the term for the investment</div> <div> banks sales force, whose primary job is to call on institutional and high-net-worth</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 97</div> <div> investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales</div> <div> desks then communicate their clients' orders to the appropriate trading desks, who</div> <div> can price and execute trades, or structure new products that fit a specific need.</div> <div> • Research is the division which reviews companies and writes reports about their</div> <div> prospects, often with "buy" or "sell" ratings. While the research division generates</div> <div> no revenue, its resources are used to assist traders in trading, the sales force in</div> <div> suggesting ideas to customers, and investment bankers by covering their clients. In</div> <div> recent years the relationship between investment banking and research has become</div> <div> highly regulated, reducing its importance to the investment bank.</div> <div> • Structuring has been a relatively recent division as derivatives have come into play,</div> <div> with highly technical and numerate employees working on creating complex</div> <div> structured products which typically offer much greater margins and returns than</div> <div> underlying cash securities.</div> <div> Middle Office</div> <div> • Risk Management involves analyzing the market and credit risk that traders are</div> <div> taking onto the balance sheet in conducting their daily trades, and setting limits on</div> <div> the amount of capital that they are able to trade in order to prevent 'bad' trades</div> <div> having a detrimental effect to a desk overall. Another key Middle Office role is to</div> <div> ensure that the above mentioned economic risks are captured accurately (as per</div> <div> agreement of commercial terms with the counterparty), correctly (as per</div> <div> standardized booking models in the most appropriate systems) and on time (typically</div> <div> within 30 minutes of trade execution). In recent years the risk of errors has become</div> <div> known as "operational risk" and the assurance Middle Offices provide now includes</div> <div> measures to address this risk. When this assurance is not in place, market and credit</div> <div> risk analysis can be unreliable and open to deliberate manipulation.</div> <div> Back Office</div> <div> • Operations involve data-checking trades that have been conducted, ensuring that</div> <div> they are not erroneous, and transacting the required transfers. While some believe it</div> <div> provides the greatest job security with the bleakest career prospects of the divisions</div> <div> within an investment bank, many have outsourced operations. It is however a critical</div> <div> part of the bank that involves managing the financial information of the bank and</div> <div> ensures efficient capital markets through the financial reporting functions. In recent</div> <div> years due to increased competition in finance related careers, college degrees are</div> <div> now mandatory at most Tier 1 investment banks. A finance degree has proved</div> <div> significant in understanding the depth of the deals and transactions that occur across</div> <div> all the divisions of the bank.</div> <div> • Technology: every major investment bank has considerable amounts of in-house</div> <div> software, created by the Technology team, who are also responsible for Computer</div> <div> and Telecommunications-based support. Technology has changed considerably in</div> <div> the last few years as more sales and trading desks are using electronic trading</div> <div> platforms. These platforms can serve as auto-executed hedging to complex model</div> <div> driven algorithms.</div> <div> Size of industry</div> <div> Global investment banking revenue increased for the third year running in 2005, to $52.8bn.</div> <div> This was up 14% on the previous year, but 7% below the 2000 peak. The recovery in the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 98</div> <div> global economy and capital markets resulted in an increase in M&A activity, which has</div> <div> been the primary source of investment banking revenue in recent years. Credit spreads are</div> <div> tightening and intense competition within the field has ensured that the banking industry is</div> <div> on its toes.</div> <div> The US was the primary source of investment banking income in 2005, with 51% of the</div> <div> total, a proportion which has fallen somewhat during the past decade. Europe (with Middle</div> <div> East and Africa) generated 31% of the total, slightly up on its 30% share a decade ago.</div> <div> Asian countries generated the remaining 18%. Between 2002 and 2005, fee income from</div> <div> Asia increased by 98%. This compares with a 55% increase in Europe, and a 46% increase</div> <div> in the US, during this time period.</div> <div> Recent evolution of the business</div> <div> New products</div> <div> Investment banking is one of the most global industries and is hence continuously</div> <div> challenged to respond to new developments and innovation in the global financial markets.</div> <div> Throughout the history of investment banking, many have theorized that all investment</div> <div> banking products and services would be commoditized. New products with higher margins</div> <div> are constantly invented and manufactured by bankers in hopes of winning over clients and</div> <div> developing trading know-how in new markets. However, since these can usually not be</div> <div> patented or copyrighted, they are very often copied quickly by competing banks, pushing</div> <div> down trading margins.</div> <div> For example, trading bonds and equities for customers is now a commodity business but</div> <div> structuring and trading derivatives is highly profitable. Each OTC contract has to be</div> <div> uniquely structured and could involve complex pay-off and risk profiles. Listed option</div> <div> contracts are traded through major exchanges, such as the CBOE, and are almost as</div> <div> commoditized as general equity securities.</div> <div> In addition, while many products have been commoditized, an increasing amount of profit</div> <div> within investment banks has come from proprietary trading, where size creates a positive</div> <div> network benefit (since the more trades an investment bank does, the more it knows about</div> <div> the market flow, allowing it to theoretically make better trades and pass on better guidance</div> <div> to clients).</div> <div> Vertical Integration</div> <div> In the US, the Glass-Steagall Act, initially created in the wake of the Stock Market Crash of</div> <div> 1929, prohibited banks from both accepting deposits and underwriting securities which led</div> <div> to segregation of Investment Banks from Commercial Banks. Glass-Steagall was repealed</div> <div> by the Gramm-Leach-Bliley Act in 1999.</div> <div> Another development in recent years has been the vertical integration of debt securitization.</div> <div> Previously, investment banks had assisted lenders in raising more lending funds and having</div> <div> the ability to offer longer term fixed interest rates by converting the lenders' outstanding</div> <div> loans into bonds. For example, a mortgage lender would make a house loan, and then use</div> <div> the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can</div> <div> be used to make new loans, while the lender accepts loan payments and passes the payments</div> <div> on to the bondholders. This process is called securitization. However, lenders have begun to</div> <div> securitize loans themselves especially in the areas of mortgage loans. Because of this, and</div> <div> because of the fear that this will continue, many Investment Banks have focused on</div> <div> becoming lenders themselves making loans with the goal of securitizing them. In fact, in the</div> <div> areas of commercial mortgages, many Investment Banks lend at loss leader interest rates in</div> <div> order to make money securitizing the loans, causing them to be a very popular financing</div> <div> option for commercial property investors and developers.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 99</div> <div> Possible conflicts of interest</div> <div> Potential conflicts of interest may arise between different parts of a bank, creating the</div> <div> potential for financial movements that could be market manipulation. Authorities that</div> <div> regulate investment banking (the FSA in the United Kingdom and the SEC in the United</div> <div> States) require that banks impose a Chinese wall which prohibits communication between</div> <div> investment banking on one side and research and equities on the other.</div> <div> Some of the conflicts of interest that can be found in investment banking are listed here:</div> <div> • Historically, equity research firms were founded and owned by investment banks.</div> <div> One common practice is for equity analysts to initiate coverage on a company in</div> <div> order to develop relationships that lead to highly profitable investment banking</div> <div> business. In the 1990s, many equity researchers allegedly traded positive stock</div> <div> ratings directly for investment banking business. On the flip side of the coin:</div> <div> companies would threaten to divert investment banking business to competitors</div> <div> unless their stock was rated favorably. Politicians acted to pass laws to criminalize</div> <div> such acts. Increased pressure from regulators and a series of lawsuits, settlements,</div> <div> and prosecutions curbed this business to a large extent following the 2001 stock</div> <div> market tumble.</div> <div> • Many investment banks also own retail brokerages. Also during the 1990s, some</div> <div> retail brokerages sold consumers securities which did not meet their stated risk</div> <div> profile. This behavior may have led to investment banking business or even sales of</div> <div> surplus shares during a public offering to keep public perception of the stock</div> <div> favorable.</div> <div> • Since investment banks engage heavily in trading for their own account, there is</div> <div> always the temptation or possibility that they might engage in some form of front</div> <div> running. Front running is the illegal practice of a stock broker executing orders on a</div> <div> security for their own account (and thus affecting prices) before filling orders</div> <div> previously submitted by their customers.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 00</div> <div> Lecture # 29</div> <div> Letter of Credit</div> <div> Commercial Letter of Credit</div> <div> Commercial letters of credit have been used for centuries to facilitate payment in</div> <div> international trade. Their use will continue to increase as the global economy evolves.</div> <div> Letters of credit used in international transactions are governed by the International</div> <div> Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The</div> <div> general provisions and definitions of the International Chamber of Commerce are binding</div> <div> on all parties. Domestic collections in the United States are governed by the Uniform</div> <div> Commercial Code.</div> <div> A commercial letter of credit is a contractual agreement between banks, known as the</div> <div> issuing bank, on behalf of one of its customers, authorizing another bank, known as the</div> <div> advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the</div> <div> request of its customer, opens the letter of credit. The issuing bank makes a commitment to</div> <div> honor drawings made under the credit. The beneficiary is normally the provider of goods</div> <div> and/or services. Essentially, the issuing bank replaces the bank's customer as the payee.</div> <div> Elements of a Letter of Credit</div> <div> • A payment undertaking given by a bank (issuing bank)</div> <div> • On behalf of a buyer (applicant)</div> <div> • To pay a seller (beneficiary) for a given amount of money</div> <div> • On presentation of specified documents representing the supply of goods</div> <div> • Within specified time limits</div> <div> • Documents must conform to terms and conditions set out in the letter of credit</div> <div> • Documents to be presented at a specified place</div> <div> Beneficiary</div> <div> The beneficiary is entitled to payment as long as he can provide the documentary evidence</div> <div> required by the letter of credit. The letter of credit is a distinct and separate transaction from</div> <div> the contract on which it is based. All parties deal in documents and not in goods. The</div> <div> issuing bank is not liable for performance of the underlying contract between the customer</div> <div> and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to</div> <div> insure that they meet all the terms and conditions of the credit. Upon requesting demand for</div> <div> payment the beneficiary warrants that all conditions of the agreement have been complied</div> <div> with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the</div> <div> bank.</div> <div> Issuing Bank</div> <div> The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute</div> <div> upon the completion of the terms and conditions of the letter of credit. Under the provisions</div> <div> of the Uniform Customs and Practice for Documentary Credits, the bank is given a</div> <div> reasonable amount of time after receipt of the documents to honor the draft.</div> <div> The issuing banks' role is to provide a guarantee to the seller that if compliant documents</div> <div> are presented, the bank will pay the seller the amount due and to examine the documents,</div> <div> and only pay if these documents comply with the terms and conditions set out in the letter of</div> <div> credit.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 01</div> <div> Typically the documents requested will include a commercial invoice, a transport document</div> <div> such as a bill of lading or airway bill and an insurance document; but there are many others.</div> <div> Letters of credit deal in documents, not goods.</div> <div> Advising Bank</div> <div> An advising bank, usually a foreign correspondent bank of the issuing bank will advise the</div> <div> beneficiary. Generally, the beneficiary would want to use a local bank to insure that the</div> <div> letter of credit is valid. In addition, the advising bank would be responsible for sending the</div> <div> documents to the issuing bank. The advising bank has no other obligation under the letter of</div> <div> credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to</div> <div> pay.</div> <div> Confirming Bank</div> <div> The correspondent bank may confirm the letter of credit for the beneficiary. At the request</div> <div> of the issuing bank, the correspondent obligates itself to insure payment under the letter of</div> <div> credit. The confirming bank would not confirm the credit until it evaluated the country and</div> <div> bank where the letter of credit originates. The confirming bank is usually the advising bank.</div> <div> Letter of Credit Characteristics</div> <div> • Negotiability</div> <div> Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the</div> <div> beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are</div> <div> passed freely from one party to another almost in the same way as money. To be negotiable,</div> <div> the letter of credit must include an unconditional promise to pay, on demand or at a definite</div> <div> time. The nominated bank becomes a holder in due course. As a holder in due course, the</div> <div> holder takes the letter of credit for value, in good faith, without notice of any claims against</div> <div> it. A holder in due course is treated favorably under the UCC.</div> <div> The transaction is considered a straight negotiation if the issuing bank's payment obligation</div> <div> extends only to the beneficiary of the credit. If a letter of credit is a straight negotiation it is</div> <div> referenced on its face by "we engage with you" or "available with ourselves". Under these</div> <div> conditions the promise does not pass to a purchaser of the draft as a holder in due course.</div> <div> • Revocability</div> <div> Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be</div> <div> revoked or modified for any reason, at any time by the issuing bank without notification. A</div> <div> revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a</div> <div> transaction that involves a revocable letter of credit, it serves as the advising bank.</div> <div> Once the documents have been presented and meet the terms and conditions in the letter of</div> <div> credit, and the draft is honored, the letter of credit cannot be revoked. The revocable letter</div> <div> of credit is not a commonly used instrument. It is generally used to provide guidelines for</div> <div> shipment. If a letter of credit is revocable it would be referenced on its face.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 02</div> <div> The irrevocable letter of credit may not be revoked or amended without the agreement of</div> <div> the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit</div> <div> from the issuing bank insures the beneficiary that if the required documents are presented</div> <div> and the terms and conditions are complied with, payment will be made. If a letter of credit is</div> <div> irrevocable it is referenced on its face.</div> <div> • Transfer and Assignment</div> <div> The beneficiary has the right to transfer or assign the right to draw, under a credit only when</div> <div> the credit states that it is transferable or assignable. Credits governed by the Uniform</div> <div> Commercial Code (Domestic) maybe transferred an unlimited number of times. Under the</div> <div> Uniform Customs Practice for Documentary Credits (International) the credit may be</div> <div> transferred only once. However, even if the credit specifies that it is nontransferable or no</div> <div> assignable, the beneficiary may transfer their rights prior to performance of conditions of</div> <div> the credit.</div> <div> • Sight and Time Drafts</div> <div> All letters of credit require the beneficiary to present a draft and specified documents in</div> <div> order to receive payment. A draft is a written order by which the party creating it, orders</div> <div> another party to pay money to a third party. A draft is also called a bill of exchange.</div> <div> There are two types of drafts: sight and time. A sight draft is payable as soon as it is</div> <div> presented for payment. The bank is allowed a reasonable time to review the documents</div> <div> before making payment.</div> <div> A time draft is not payable until the lapse of a particular time period stated on the draft. The</div> <div> bank is required to accept the draft as soon as the documents comply with credit terms. The</div> <div> issuing bank has a reasonable time to examine those documents. The issuing bank is</div> <div> obligated to accept drafts and pay them at maturity.</div> <div> • Standby Letter of Credit</div> <div> The standby letter of credit serves a different function than the commercial letter of credit.</div> <div> The commercial letter of credit is the primary payment mechanism for a transaction. The</div> <div> standby letter of credit serves as a secondary payment mechanism. A bank will issue a</div> <div> standby letter of credit on behalf of a customer to provide assurances of his ability to</div> <div> perform under the terms of a contract between the beneficiaries. The parties involved with</div> <div> the transaction do not expect that the letter of credit will ever be drawn upon.</div> <div> The standby letter of credit assures the beneficiary of the performance of the customer's</div> <div> obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of</div> <div> invoices, with evidence that the customer has not performed its obligation. The bank is</div> <div> obligated to make payment if the documents presented comply with the terms of the letter of</div> <div> credit.</div> <div> Standby letters of credit are issued by banks to stand behind monetary obligations, to insure</div> <div> the refund of advance payment, to support performance and bid obligations, and to insure</div> <div> the completion of a sales contract. The credit has an expiration date.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 03</div> <div> The standby letter of credit is often used to guarantee performance or to strengthen the</div> <div> credit worthiness of a customer. In the above example, the letter of credit is issued by the</div> <div> bank and held by the supplier. The customer is provided open account terms. If payments</div> <div> are made in accordance with the suppliers' terms, the letter of credit would not be drawn on.</div> <div> The seller pursues the customer for payment directly. If the customer is unable to pay, the</div> <div> seller presents a draft and copies of invoices to the bank for payment.</div> <div> The domestic standby letter of credit is governed by the Uniform Commercial Code. Under</div> <div> these provisions, the bank is given until the close of the third banking day after receipt of</div> <div> the documents to honor the draft.</div> <div> Procedures for Using the Tool</div> <div> The following procedures include a flow of events that follow the decision to use a</div> <div> Commercial Letter of Credit. Procedures required to execute a Standby Letter of Credit are</div> <div> less rigorous. The standby credit is a domestic transaction. It does not require a</div> <div> correspondent bank (advising or confirming). The documentation requirements are also less</div> <div> tedious.</div> <div> Step-by-step process:</div> <div> Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee</div> <div> payment.</div> <div> Buyer applies to his bank for a letter of credit in favor of the seller.</div> <div> Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its</div> <div> correspondent bank (advising or confirming). The correspondent bank is usually located in</div> <div> the same geographical location as the seller (beneficiary).</div> <div> • Advising bank will authenticate the credit and forward the original credit to the</div> <div> seller (beneficiary).</div> <div> • Seller (beneficiary) ships the goods, then verifies and develops the documentary</div> <div> requirements to support the letter of credit. Documentary requirements may vary</div> <div> greatly depending on the perceived risk involved in dealing with a particular</div> <div> company.</div> <div> • Seller presents the required documents to the advising or confirming bank to be</div> <div> processed for payment.</div> <div> • Advising or confirming bank examines the documents for compliance with the terms</div> <div> and conditions of the letter of credit.</div> <div> • If the documents are correct, the advising or confirming bank will claim the funds</div> <div> by:</div> <div> o Debiting the account of the issuing bank.</div> <div> o Waiting until the issuing bank remits, after receiving the documents.</div> <div> o Reimburse on another bank as required in the credit.</div> <div> • Advising or confirming bank will forward the documents to the issuing bank.</div> <div> • Issuing bank will examine the documents for compliance. If they are in order, the</div> <div> issuing bank will debit the buyer's account.</div> <div> • Issuing bank then forwards the documents to the buyer.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 04</div> <div> Standard Forms of Documentation</div> <div> When making payment for product on behalf of its customer, the issuing bank must verify</div> <div> that all documents and drafts conform precisely to the terms and conditions of the letter of</div> <div> credit. Although the credit can require an array of documents, the most common documents</div> <div> that must accompany the draft include:</div> <div> Commercial Invoice</div> <div> The bill for the goods and services is called. It includes a description of merchandise, price,</div> <div> FOB origin, and name and address of buyer and seller. The buyer and seller information</div> <div> must correspond exactly to the description in the letter of credit. Unless the letter of credit</div> <div> specifically states otherwise, a generic description of the merchandise is usually acceptable</div> <div> in the other accompanying documents.</div> <div> Bill of Lading</div> <div> A document evidencing the receipt of goods for shipment and issued by a freight carrier</div> <div> engaged in the business of forwarding or transporting goods. The documents evidence</div> <div> control of goods. They also serve as a receipt for the merchandise shipped and as evidence</div> <div> of the carrier's obligation to transport the goods to their proper destination.</div> <div> Warranty of Title</div> <div> A warranty given by a seller to a buyer of goods that states that the title being conveyed is</div> <div> good and that the transfer is rightful. This is a method of certifying clear title to product</div> <div> transfer. It is generally issued to the purchaser and issuing bank expressing an agreement to</div> <div> indemnify and hold both parties harmless.</div> <div> Letter of Indemnity</div> <div> Specifically indemnifies the purchaser against a certain stated circumstance.</div> <div> Indemnification is generally used to guaranty that shipping documents will be provided in</div> <div> good order when available.</div> <div> Common Defects in Documentation</div> <div> About half of all drawings presented contain discrepancies. A discrepancy is an irregularity</div> <div> in the documents that causes them to be in non-compliance to the letter of credit.</div> <div> Requirements set forth in the letter of credit cannot be waived or altered by the issuing bank</div> <div> without the express consent of the customer. The beneficiary should prepare and examine</div> <div> all documents carefully before presentation to the paying bank to avoid any delay in receipt</div> <div> of payment. Commonly found discrepancies between the letter of credit and supporting</div> <div> documents include:</div> <div> • Letter of Credit has expired prior to presentation of draft.</div> <div> • Bill of Lading evidences delivery prior to or after the date range stated in the credit.</div> <div> • Stale dated documents.</div> <div> • Changes included in the invoice not authorized in the credit.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 05</div> <div> • Inconsistent description of goods.</div> <div> • Insurance document errors.</div> <div> • Invoice amount not equal to draft amount.</div> <div> • Ports of loading and destination not as specified in the credit.</div> <div> • Description of merchandise is not as stated in credit.</div> <div> • A document required by the credit is not presented.</div> <div> • Documents are inconsistent as to general information such as volume, quality, etc.</div> <div> • Names of documents not exact as described in the credit. Beneficiary information</div> <div> must be exact.</div> <div> • Invoice or statement is not signed as stipulated in the letter of credit.</div> <div> When a discrepancy is detected by the negotiating bank, a correction to the document may</div> <div> be allowed if it can be done quickly while remaining in the control of the bank. If time is</div> <div> not a factor, the exporter should request that the negotiating bank return the documents for</div> <div> corrections.</div> <div> If there is not enough time to make corrections, the exporter should request that the</div> <div> negotiating bank send the documents to the issuing bank on an approval basis or notify the</div> <div> issuing bank by wire, outline the discrepancies, and request authority to pay. Payment</div> <div> cannot be made until all parties have agreed to jointly waive the discrepancy.</div> <div> Tips for Exporters</div> <div> • Communicate with your customers in detail before they apply for letters of credit.</div> <div> • Consider whether a confirmed letter of credit is needed.</div> <div> • Ask for a copy of the application to be fax to you, so you can check for terms or</div> <div> conditions that may cause you problems in compliance.</div> <div> • Upon first advice of the letter of credit, check that all its terms and conditions can be</div> <div> complied with within the prescribed time limits.</div> <div> • Many presentations of documents run into problems with time-limits. You must be</div> <div> aware of at least three time constraints - the expiration date of the credit, the latest</div> <div> shipping date and the maximum time allowed between dispatch and presentation.</div> <div> • If the letter of credit calls for documents supplied by third parties, make reasonable</div> <div> allowance for the time this may take to complete.</div> <div> • After dispatch of the goods, check all the documents both against the terms of the</div> <div> credit and against each other for internal consistency.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 06</div> <div> Lecture # 30</div> <div> Letter of Credit and International Trade</div> <div> A letter of credit is a document issued mostly by a financial institution which usually</div> <div> provides an irrevocable payment undertaking (it can also be revocable, confirmed,</div> <div> unconfirmed, transferable or others e.g. back to back: revolving but is most commonly</div> <div> irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter</div> <div> of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a</div> <div> documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply</div> <div> as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank</div> <div> acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any,</div> <div> within the expiry date of the LC, comprising documents complying with the terms and</div> <div> conditions of the LC, the applicable UCP and international standard banking practice, the</div> <div> issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions</div> <div> from the applicant to the contrary. In other words, the obligation to honor (usually payment)</div> <div> is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can</div> <div> also issue letters of credit however parties must balance potential risks.</div> <div> The LC can also be the source of payment for a transaction, meaning that an exporter will</div> <div> get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in</div> <div> international trade transactions of significant value, for deals between a supplier in one</div> <div> country and a wholesale customer in another. They are also used in the land development</div> <div> process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.)</div> <div> will be built. The parties to a letter of credit are usually a beneficiary who is to receive the</div> <div> money, the issuing bank of whom the applicant is a client, and the advising bank of whom</div> <div> the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.</div> <div> cannot be amended or cancelled without prior agreement of the beneficiary, the issuing</div> <div> bank, and the confirming bank, if any). However, the applicant is not a party to the letter of</div> <div> credit. In executing a transaction, letters of credit incorporate functions common to giros</div> <div> and Traveler's cheque. Typically, the documents a beneficiary has to present in order to</div> <div> avail him of the credit are commercial invoice, bill of lading, insurance documents.</div> <div> However, the list and form of documents is open to imagination and negotiation and might</div> <div> contain requirements to present documents issued by a neutral third party evidencing the</div> <div> quality of the goods shipped.</div> <div> Terminology</div> <div> The English name “letter of credit” derives from the French word “accreditif”, a power to</div> <div> do something, which in turn is derivative of the Latin word “accreditivus”, meaning trust.</div> <div> This in effect reflects the modern understanding of the instrument. When a seller agrees to</div> <div> be paid by means of a letter of credit s/he is looking at a reliable bank that has an obligation</div> <div> to pay them the amount stipulated in the credit notwithstanding any defense relating to the</div> <div> underlying contract of sale. This is as long as the seller performs their duties to an extent</div> <div> that meets the credit terms.</div> <div> How it works</div> <div> Imagine that a business called the Acme Electronics from time to time imports computers</div> <div> from a business called Bangalore Computers, which banks with the India Business Bank.</div> <div> Acme holds an account at the Commonwealth Financials. Acme wants to buy $500,000</div> <div> worth of merchandise from Bangalore Computers, who agree to sell the goods and give</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 07</div> <div> Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for</div> <div> the full amount. The steps to get the letter of credit would be as follows:</div> <div> • Acme goes to The Commonwealth Financials and requests a $500,000 letter of</div> <div> credit, with Bangalore Computers as the beneficiary.</div> <div> • The Commonwealth Financials can issue an LC either on approval of a standard</div> <div> loan underwriting process or by Acme funding it directly with a deposit of $500,000</div> <div> plus fees between 1% and 8%.</div> <div> • The Commonwealth Financials sends a copy of the LC to the India Business Bank,</div> <div> which notifies the Bangalore Computers that payment is ready and they can ship the</div> <div> merchandise Acme has ordered with the full assurance of payment to them.</div> <div> • On presentation of the stipulated documents in the letter of credit and compliance</div> <div> with the terms and conditions of the letter of credit, the Commonwealth Financials</div> <div> transfers the $500,000 to the India Business Bank, which then credits the account to</div> <div> the Bangalore Computers by that amount.</div> <div> • Note that banks deal only with documents under the letter of credit and not the</div> <div> underlying transaction.</div> <div> • Many exporters have misunderstood that the payment is guaranteed after receiving</div> <div> the LC. The issuing bank is obligated to pay under the letter of credit only when the</div> <div> stipulated documents are presented and the terms and conditions of the letter of</div> <div> credit have been met accordingly.</div> <div> Legal principles governing documentary credits</div> <div> One of the primary peculiarities of the documentary credit is that the payment obligation is</div> <div> abstract and independent from the underlying contract of sale or any other contract in the</div> <div> transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the</div> <div> sale contract is irrelevant. The defenses of the buyer arising out of the sale contract do not</div> <div> concern the bank and in no way affect its liability. Article 3(a) UCP states this principle</div> <div> clearly. Article 4 the UCP further states that banks deal with documents only, they are not</div> <div> concerned with the goods (facts). Accordingly, if the documents tendered by the</div> <div> beneficiary, or his agent, appear to be in order, then in general the bank is both entitled and</div> <div> obliged to pay without further qualifications.</div> <div> The policies behind adopting the abstraction principle are purely commercial and reflect a</div> <div> party’s expectations: firstly, if the responsibility for the validity of documents was thrown</div> <div> onto banks, they would be burdened with investigating the underlying facts of each</div> <div> transaction and would thus be less inclined to issue documentary credits as the transaction</div> <div> would involve great risk and inconvenience. Secondly, documents required under the credit</div> <div> could in certain circumstances be different from those required under the sale transaction;</div> <div> banks would then be placed in a dilemma in deciding which terms to follow if required to</div> <div> look behind the credit agreement. Thirdly, the fact that the basic function of the credit is to</div> <div> provide the seller with the certainty of receiving payment, as long as he performs his</div> <div> documentary duties, suggests that banks should honor their obligation notwithstanding</div> <div> allegations of misfeasance by the buyer. Finally, courts have emphasized that buyers always</div> <div> have a remedy for an action upon the contract of sale, and that it would be a calamity for the</div> <div> business world if, for every breach of contract between the seller and buyer, a bank were</div> <div> required to investigate said breach.</div> <div> The “principle of strict compliance” also aims to make the bank’s duty of effecting payment</div> <div> against documents easy, efficient and quick. Hence, if the documents tendered under the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 08</div> <div> credit deviate from the language of the credit the bank is entitled to withhold payment even</div> <div> if the deviation is purely terminological. The general legal maxim de minimis non curat lex</div> <div> has no place in the field of documentary credits.</div> <div> The price of LCs</div> <div> The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary.</div> <div> From the bank's point of view, the LC they have issued can be called upon at any time</div> <div> (subject to the relevant terms and conditions), and the bank then looks to reclaim this from</div> <div> the applicant.</div> <div> Legal Basis for Letters of Credit</div> <div> Although documentary credits are enforceable once communicated to the beneficiary, it is</div> <div> difficult to show any consideration given by the beneficiary to the banker prior to the tender</div> <div> of documents. In such transactions the undertaking by the beneficiary to deliver the goods to</div> <div> the applicant is not sufficient consideration for the bank’s promise because the contract of</div> <div> sale is made before the issuance of the credit, thus consideration in these circumstances is</div> <div> past. In addition, the performance of an existing duty under a contract cannot be a valid</div> <div> consideration for a new promise made by the bank: the delivery of the goods is</div> <div> consideration for enforcing the underlying contract of sale and cannot be used, as it were, a</div> <div> second time to establish the enforceability of the bank-beneficiary relation.</div> <div> Legal writers have analyzed every possible theory from every legal angle and failed to</div> <div> satisfactorily reconcile the bank’s undertaking with any contractual analysis. The theories</div> <div> include: the implied promise, assignment theory, the novation theory, reliance theory,</div> <div> agency theories, estoppels and trust theories, anticipatory theory, and the guarantee theory.</div> <div> Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary</div> <div> credits should be analyzed outside the legal framework of contractual principles, which</div> <div> require the presence of consideration. Accordingly, whether the documentary credit is</div> <div> referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is</div> <div> acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it</div> <div> possesses distinctive features, which make it sui generis.</div> <div> Even though a couple of countries and US states (see e.g. Article 5 of the Uniform</div> <div> Commercial Code) have tried to create statutes to establish the rights of the parties involved</div> <div> in letter of credit transactions, most parties subject themselves to the Uniform Customs and</div> <div> Practices (UCP) issued by the International Chamber of Commerce (ICC) in Paris. The ICC</div> <div> has no legislative authority, rather, representatives of various industry and trade groups</div> <div> from various countries get together to discuss how to revise the UCP and adapt them to new</div> <div> technologies. The UCP are quoted according to the publication number the ICC gives them.</div> <div> The UCP 600 are ICC publication No. 600 and will take effect July 1, 2007. The previous</div> <div> revision was called UCP 500 and became effective 1993. Since the UCP are not laws,</div> <div> parties have to include them into their arrangements as normal contractual provisions. It is</div> <div> interesting to see that in the area of international trade the parties do not rely on</div> <div> governmental regulations, but rather prefer the speed and ease of auto-regulation.</div> <div> Risks in International Trade</div> <div> • A Credit risk is a risk from a change in the credit of an opposing business.</div> <div> • An Exchange risk is a risk from a change in the foreign exchange rate.</div> <div> • A Force majeure risk is</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 09</div> <div> o A risk in trade incapability caused by a change in a country's policy, and</div> <div> o A risk caused by a natural disaster.</div> <div> • Other risks are mainly risks caused by a difference in law, language or culture. In</div> <div> these cases, the cargo might be found late because of a dispute in import and export</div> <div> dealings.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 10</div> <div> Lecture # 31</div> <div> Foreign Exchange & Financial Institutions</div> <div> The foreign exchange (currency or forex or FX) market exists wherever one currency is</div> <div> traded for another. It is by far the largest financial market in the world, and includes trading</div> <div> between large banks, central banks, currency speculators, multinational corporations,</div> <div> governments, and other financial markets and institutions. The average daily trade in the</div> <div> global forex and related markets currently is over US$ 3 trillion. Retail traders (individuals)</div> <div> are a small fraction of this market and may only participate indirectly through brokers or</div> <div> banks, and are subject to forex scams.</div> <div> Market size and liquidity</div> <div> The foreign exchange market is unique because of</div> <div> • its trading volume,</div> <div> • the extreme liquidity of the market,</div> <div> • the large number of, and variety of, traders in the market,</div> <div> • its geographical dispersion,</div> <div> • its long trading hours: 24 hours a day (except on weekends),</div> <div> • The variety of factors that affect exchange rates.</div> <div> • the low margins of profit compared with other markets of fixed income (but profits</div> <div> can be high due to very large trading volumes)</div> <div> According to the BIS, average daily turnover in traditional foreign exchange markets is</div> <div> estimated at $3,210 billion. Daily averages in April for different years, in billions of US</div> <div> dollars, are presented on the chart below:</div> <div> This $1.88 trillion in global foreign exchange market "traditional" turnover was broken</div> <div> down as follows:</div> <div> • $1,005 billion in spot transactions</div> <div> • $362 billion in outright forwards</div> <div> • $1,714 billion in forex swaps</div> <div> • $129 billion estimated gaps in reporting</div> <div> In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.</div> <div> Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile</div> <div> Exchange and are actively traded relative to most other futures contracts. Forex futures</div> <div> volume has grown rapidly in recent years, and accounts for about 7% of the total foreign</div> <div> exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).</div> <div> Average daily global turnover in traditional foreign exchange market transactions totaled</div> <div> $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New</div> <div> York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including</div> <div> non-traditional foreign exchange derivatives and products traded on exchanges, averaged</div> <div> around $2.9 trillion a day. This was more than ten times the size of the combined daily</div> <div> turnover on all the world’s equity markets. Foreign exchange trading increased by 38%</div> <div> between April 2005 and April 2006 and has more than doubled since 2001. This is largely</div> <div> due to the growing importance of foreign exchange as an asset class and an increase in fund</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 11</div> <div> management assets, particularly of hedge funds and pension funds. The diverse selection of</div> <div> execution venues such as internet trading platforms has also made it easier for retail traders</div> <div> to trade in the foreign exchange market.</div> <div> Because foreign exchange is an OTC market where brokers/dealers negotiate directly with</div> <div> one another, there is no central exchange or clearing house. The biggest geographic trading</div> <div> center is the UK, primarily London, which according to IFSL estimates has increased its</div> <div> share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in</div> <div> April 2006. RPP</div> <div> The ten most active traders account for almost 73% of trading volume, according to The</div> <div> Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually</div> <div> provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the</div> <div> difference between the price at which a bank or market maker will sell ("ask", or "offer")</div> <div> and the price at which a market-maker will buy ("bid") from a wholesale customer. This</div> <div> spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the</div> <div> bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is</div> <div> usually $100,000.</div> <div> These spreads might not apply to retail customers at banks, which will routinely mark up</div> <div> the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or</div> <div> travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more</div> <div> than 3 pips wide (i.e. 0.0003). Competition has greatly increased with pip spreads shrinking</div> <div> on the major pairs to as little as 1 to 2 pips.</div> <div> Market participants</div> <div> Unlike a stock market, where all participants have access to the same prices, the forex</div> <div> market is divided into levels of access. At the top is the inter-bank market, which is made up</div> <div> of the largest investment banking firms. Within the inter-bank market, spreads, which are</div> <div> the difference between the bids and ask prices, are razor sharp and usually unavailable, and</div> <div> not known to players outside the inner circle. As you descend the levels of access, the</div> <div> difference between the bids and ask prices widens (from 0-1 pip to 1-2 pips only for major</div> <div> currencies like the Euro). This is due to volume. If a trader can guarantee large numbers of</div> <div> transactions for large amounts, they can demand a smaller difference between the bid and</div> <div> ask price, which is referred to as a better spread. The levels of access that make up the forex</div> <div> market are determined by the size of the “line” (the amount of money with which they are</div> <div> trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there</div> <div> are usually smaller investment banks, followed by large multi-national corporations (which</div> <div> need to hedge risk and pay employees in different countries), large hedge funds, and even</div> <div> some of the retail forex market makers. According to Galati and Melvin, “Pension funds,</div> <div> insurance companies, mutual funds, and other institutional investors have played an</div> <div> increasingly important role in financial markets in general, and in FX markets in particular,</div> <div> since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly</div> <div> over the 2001–2004 period in terms of both number and overall size” Central banks also</div> <div> participate in the forex market to align currencies to their economic needs.</div> <div> Banks</div> <div> The inter-bank market caters for both the majority of commercial turnover and large</div> <div> amounts of speculative trading every day. A large bank may trade billions of dollars daily.</div> <div> Some of this trading is undertaken on behalf of customers, but much is conducted by</div> <div> proprietary desks, trading for the bank's own account.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 12</div> <div> Until recently, foreign exchange brokers did large amounts of business, facilitating interbank</div> <div> trading and matching anonymous counterparts for small fees. Today, however, much</div> <div> of this business has moved on to more efficient electronic systems, such as EBS (now</div> <div> owned by ICAP), Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange,</div> <div> Dukascopy - Swiss FX Marketplace, FXMarketSpace, Bloomberg, and TradeBook(R). The</div> <div> broker squawk box lets traders listen in on ongoing inter-bank trading and is heard in most</div> <div> trading rooms, but turnover is noticeably smaller than just a few years ago.</div> <div> Central banks</div> <div> National central banks play an important role in the foreign exchange markets. They try to</div> <div> control the money supply, inflation, and/or interest rates and often have official or unofficial</div> <div> target rates for their currencies. They can use their often substantial foreign exchange</div> <div> reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy</div> <div> would be for central banks to buy when the exchange rate is too low, and to sell when the</div> <div> rate is too high — that is, to trade for a profit based on their more precise information.</div> <div> Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because</div> <div> central banks do not go bankrupt if they make large losses, like other traders would, and</div> <div> there is no convincing evidence that they do make a profit trading.</div> <div> The mere expectation or rumor of central bank intervention might be enough to stabilize a</div> <div> currency, but aggressive intervention might be used several times each year in countries</div> <div> with a dirty float currency regime. Central banks do not always achieve their objectives.</div> <div> The combined resources of the market can easily overwhelm any central bank. Several</div> <div> scenarios of this nature were seen in the 1992–93 Enron collapse, and in more recent times</div> <div> in Southeast Asia.</div> <div> Investment management firms</div> <div> Investment management firms (who typically manage large accounts on behalf of customers</div> <div> such as pension funds and endowments) use the foreign exchange market to facilitate</div> <div> transactions in foreign securities. For example, an investment manager with an international</div> <div> equity portfolio will need to buy and sell foreign currencies in the spot market in order to</div> <div> pay for purchases of foreign equities. Since the forex transactions are secondary to the</div> <div> actual investment decision, they are not seen as speculative or aimed at profit-maximization.</div> <div> Some investment management firms also have more speculative specialist currency overlay</div> <div> operations, which manage clients' currency exposures with the aim of generating profits as</div> <div> well as limiting risk. Whilst the number of this type of specialist firms is quite small, many</div> <div> have a large value of assets under management (AUM), and hence can generate large trades.</div> <div> Hedge funds</div> <div> Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive</div> <div> currency speculation since 1990. They control billions of dollars of equity and may borrow</div> <div> billions more, and thus may overwhelm intervention by central banks to support almost any</div> <div> currency, if the economic fundamentals are in the hedge funds' favor.</div> <div> Retail forex brokers</div> <div> Retail forex brokers or market makers handle a minute fraction of the total volume of the</div> <div> foreign exchange market. According to CNN, one retail broker estimates retail volume at</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 13</div> <div> $25–50 billion daily, which is about 2% of the whole market and it has been reported by the</div> <div> CFTC website that un-experienced investors may become targets of forex scams.</div> <div> Trading characteristics</div> <div> There is no unified or centrally cleared market for the majority of FX trades, and there is</div> <div> very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency</div> <div> markets, there are rather a number of interconnected marketplaces, where different currency</div> <div> instruments are traded. This implies that there is not a single dollar rate but rather a number</div> <div> of different rates (prices), depending on what bank or market maker is trading. In practice</div> <div> the rates are often very close, otherwise they could be exploited by arbitrageurs</div> <div> instantaneously. A joint venture of the Chicago Mercantile Exchange and Reuters called</div> <div> FXMarketSpace opened in 2007 and aspires to the role of a central market clearing</div> <div> mechanism.</div> <div> The main trading centers are in London, New York, Tokyo, and Singapore, but banks</div> <div> throughout the world participate. Currency trading happens continuously throughout the</div> <div> day; as the Asian trading session ends, the European session begins, followed by the North</div> <div> American session and then back to the Asian session, excluding weekends.</div> <div> There is little or no 'inside information' in the foreign exchange markets. Exchange rate</div> <div> fluctuations are usually caused by actual monetary flows as well as by expectations of</div> <div> changes in monetary flows caused by changes in GDP growth, inflation, interest rates,</div> <div> budget and trade deficits or surpluses, large cross-border M&A deals and other</div> <div> macroeconomic conditions. Major news is released publicly, often on scheduled dates; so</div> <div> many people have access to the same news at the same time. However, the large banks have</div> <div> an important advantage; they can see their customers' order flow.</div> <div> Currencies are traded against one another. Each pair of currencies thus constitutes an</div> <div> individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217</div> <div> international three-letter code of the currency into which the price of one unit of XXX is</div> <div> expressed. For instance, EUR/USD is the price of the Euro expressed in US dollars, as in 1</div> <div> Euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency,</div> <div> was the stronger currency at the creation of the pair. The second currency, counter currency,</div> <div> was the weaker currency at the creation of the pair.</div> <div> The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive</div> <div> currency correlation between XXX/YYY and XXX/ZZZ.</div> <div> On the spot market, according to the BIS study, the most heavily traded products were:</div> <div> • EUR/USD: 28 %</div> <div> • USD/JPY: 18 %</div> <div> • GBP/USD (also called sterling or cable): 14 %</div> <div> And the US currency was involved in 88.7% of transactions, followed by the Euro (37.2%),</div> <div> the yen (20.3%), and the sterling (16.9%). Note that volume percentages should add up to</div> <div> 200%: 100% for all the sellers and 100% for all the buyers.</div> <div> Although trading in the Euro has grown considerably since the currency's creation in</div> <div> January 1999, the foreign exchange market is thus far still largely dollar-centered. For</div> <div> instance, trading the Euro versus a non-European currency ZZZ will usually involve two</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 14</div> <div> trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an</div> <div> established traded currency pair in the inter-bank spot market.</div> <div> Exchange Traded Fund</div> <div> Exchange-traded funds (or ETFs) are Open Ended investment companies that can be traded</div> <div> at any time throughout the course of the day. Typically, ETFs try to replicate a stock market</div> <div> index such as the S&P 500 (e.g. SPY), but recently they are now replicating investments in</div> <div> the currency markets with the ETF increasing in value when the US Dollar weakness versus</div> <div> a specific Currency, such as the Euro. Certain of these funds track the price movements of</div> <div> world currencies versus the US Dollar, and increase in value directly counter to the US</div> <div> Dollar, allowing for speculation in the US Dollar for US and US Dollar denominated</div> <div> investors and speculators.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 15</div> <div> Lecture # 32</div> <div> Foreign Exchange</div> <div> Factors affecting currency trading</div> <div> Although exchange rates are affected by many factors, in the end, currency prices are a</div> <div> result of supply and demand forces. The world's currency markets can be viewed as a huge</div> <div> melting pot: in a large and ever-changing mix of current events, supply and demand factors</div> <div> are constantly shifting, and the price of one currency in relation to another shifts</div> <div> accordingly. No other market encompasses (and distills) as much of what is going on in the</div> <div> world at any given time as foreign exchange.</div> <div> Supply and demand for any given currency, and thus its value, are not influenced by any</div> <div> single element, but rather by several. These elements generally fall into three categories:</div> <div> economic factors, political conditions, and market psychology.</div> <div> Economic factors</div> <div> These include economic policy, disseminated by government agencies and central banks,</div> <div> economic conditions, generally revealed through economic reports, and other economic</div> <div> indicators.</div> <div> Economic policy comprises government fiscal policy (budget/spending practices) and</div> <div> monetary policy (the means by which a government's central bank influences the supply and</div> <div> "cost" of money, which is reflected by the level of interest rates).</div> <div> Economic conditions include:</div> <div> • Government budget deficits or surpluses: The market usually reacts negatively to</div> <div> widening government budget deficits, and positively to narrowing budget deficits.</div> <div> The impact is reflected in the value of a country's currency.</div> <div> • Balance of trade levels and trends: The trade flow between countries illustrates the</div> <div> demand for goods and services, which in turn indicates demand for a country's</div> <div> currency to conduct trade. Surpluses and deficits in trade of goods and services</div> <div> reflect the competitiveness of a nation's economy. For example, trade deficits may</div> <div> have a negative impact on a nation's currency.</div> <div> • Inflation levels and trends: Typically, a currency will lose value if there is a high</div> <div> level of inflation in the country or if inflation levels are perceived to be rising. This</div> <div> is because inflation erodes purchasing power, thus demand, for that particular</div> <div> currency.</div> <div> • Economic growth and health: Reports such as gross domestic product (GDP),</div> <div> employment levels, retail sales, capacity utilization and others, detail the levels of a</div> <div> country's economic growth and health. Generally, the more healthy and robust a</div> <div> country's economy, the better its currency will perform, and the more demand for it</div> <div> there will be.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 16</div> <div> Political conditions</div> <div> Internal, regional, and international political conditions and events can have a profound</div> <div> effect on currency markets.</div> <div> For instance, political upheaval and instability can have a negative impact on a nation's</div> <div> economy. The rise of a political faction that is perceived to be fiscally responsible can have</div> <div> the opposite effect. Also, events in one country in a region may spur positive or negative</div> <div> interest in a neighboring country and, in the process, affect its currency.</div> <div> Market psychology</div> <div> Market psychology and trader perceptions influence the foreign exchange market in a</div> <div> variety of ways:</div> <div> • Flights to quality: Unsettling international events can lead to a "flight to quality,"</div> <div> with investors seeking a "safe haven". There will be a greater demand, thus a higher</div> <div> price, for currencies perceived as stronger over their relatively weaker counterparts.</div> <div> • Long-term trends: Currency markets often move in visible long-term trends.</div> <div> Although currencies do not have an annual growing season like physical</div> <div> commodities, business cycles do make themselves felt. Cycle analysis looks at</div> <div> longer-term price trends that may rise from economic or political trends.</div> <div> • "Buy the rumor, sell the fact:" This market truism can apply to many currency</div> <div> situations. It is the tendency for the price of a currency to reflect the impact of a</div> <div> particular action before it occurs and, when the anticipated event comes to pass,</div> <div> react in exactly the opposite direction. This may also be referred to as a market</div> <div> being "oversold" or "overbought". To buy the rumor or sell the fact can also be an</div> <div> example of the cognitive bias known as anchoring, when investors focus too much</div> <div> on the relevance of outside events to currency prices.</div> <div> • Economic numbers: While economic numbers can certainly reflect economic</div> <div> policy, some reports and numbers take on a talisman-like effect: the number it</div> <div> becomes important to market psychology and may have an immediate impact on</div> <div> short-term market moves. "What to watch" can change over time. In recent years,</div> <div> for example, money supply, employment, trade balance figures and inflation</div> <div> numbers have all taken turns in the spotlight.</div> <div> • Technical trading considerations: As in other markets, the accumulated price</div> <div> movements in a currency pair such as EUR/USD can form apparent patterns that</div> <div> traders may attempt to use. Many traders study price charts in order to identify such</div> <div> patterns</div> <div> Financial instruments</div> <div> There are several types of financial instruments commonly used.</div> <div> 􀂙 Spot</div> <div> A spot transaction is a two-day delivery transaction, as opposed to the futures contracts,</div> <div> which are usually three months. This trade represents a “direct exchange” between two</div> <div> currencies, has the shortest time frame, involves cash rather than a contract; and interest is</div> <div> not included in the agreed-upon transaction. The data for this study come from the spot</div> <div> market. Spot has the largest share by volume in FX transactions among all instruments.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 17</div> <div> 􀂙 Forward</div> <div> One way to deal with the Forex risk is to engage in a forward transaction. In this</div> <div> transaction, money does not actually change hands until some agreed upon future date. A</div> <div> buyer and seller agree on an exchange rate for any date in the future, and the transaction</div> <div> occurs on that date, regardless of what the market rates are then. The duration of the trade</div> <div> can be a few days, months, or years.</div> <div> 􀂙 Future</div> <div> Foreign currency futures are forward transactions with standard contract sizes and maturity</div> <div> dates — for example, 500,000 British pounds for next November at an agreed rate. Futures</div> <div> are standardized and are usually traded on an exchange created for this purpose. The</div> <div> average contract length is roughly 3 months. Futures contracts are usually inclusive of any</div> <div> interest amounts.</div> <div> 􀂙 Swap</div> <div> The most common type of forward transaction is the currency swap. In a swap, two parties</div> <div> exchange currencies for a certain length of time and agree to reverse the transaction at a</div> <div> later date. These are not standardized contracts and are not traded through an exchange.</div> <div> 􀂙 Option</div> <div> A foreign exchange option (commonly shortened to just FX option) is a derivative where</div> <div> the owner has the right but not the obligation to exchange money denominated in one</div> <div> currency into another currency at a pre-agreed exchange rate on a specified date. The FX</div> <div> options market is the deepest, largest and most liquid market for options of any kind in the</div> <div> world.</div> <div> Speculation</div> <div> Controversy about currency speculators and their effect on currency devaluations and</div> <div> national economies recurs regularly. Nevertheless, many economists (e.g. Milton Friedman)</div> <div> have argued that speculators perform the important function of providing a market for</div> <div> hedgers and transferring risk from those people who don't wish to bear it, to those who do.</div> <div> Other economists (e.g. Joseph Stieglitz) however, may consider this argument to be based</div> <div> more on politics and a free market philosophy than on economics.</div> <div> Large hedge funds and other well capitalized "position traders" are the main professional</div> <div> speculators.</div> <div> Currency speculation is considered a highly suspect activity in many countries. While</div> <div> investment in traditional financial instruments like bonds or stocks often is considered to</div> <div> contribute positively to economic growth by providing capital, currency speculation does</div> <div> not, according to this view; it is simply gambling, that often interferes with economic</div> <div> policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to</div> <div> raise interest rates for a few days to 150% per annum, and later to devalue the krona.</div> <div> Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this</div> <div> view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and</div> <div> other speculators.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 18</div> <div> Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who</div> <div> simply help "enforce" international agreements and anticipate the effects of basic economic</div> <div> "laws" in order to profit.</div> <div> In this view, countries may develop unsustainable financial bubbles or otherwise mishandle</div> <div> their national economies, and forex speculators made the inevitable collapse happen sooner.</div> <div> A relatively quick collapse might even be preferable to continued economic mishandling.</div> <div> Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the</div> <div> blame from them for having caused the unsustainable economic conditions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 19</div> <div> Lecture # 33</div> <div> Leasing Companies</div> <div> 1. A lease or tenancy is a contract that transfers the right to possess specific property.</div> <div> In law, there are two types of property: historically, land is the more important</div> <div> because, under normal circumstances, it holds the highest value in economically</div> <div> developed societies. Ownership of land is an aspect of the system of real property or</div> <div> realty in common law systems.</div> <div> 2. When structured as an operating lease, this is a form of financing that avoids the</div> <div> down payment usually required for the purchase of equipment. Because leased</div> <div> equipment is not owned by the company, it does not appear on the balance sheet. A</div> <div> financing lease does appear on the balance sheet.</div> <div> 3. Don't be intimidated! For most people, leasing is an unfamiliar concept and</div> <div> therefore a little scary, but leasing isn't any more difficult than purchasing a car.</div> <div> Fully understanding how the leasing process works is the first step toward a positive</div> <div> leasing experience.</div> <div> Leasing a vehicle is similar to renting a car, just for a longer time period. Like renting a car,</div> <div> a person who leases pays a pre-determined rate to drive a vehicle for a pre-determined</div> <div> amount of time. You never own the vehicle and return it when your lease is up. A person</div> <div> who leases enjoys the benefits of driving a car without assuming the up-front costs, and</div> <div> many of the risks of ownership.</div> <div> Basic Purpose of Leasing</div> <div> Bargain Purchase Option</div> <div> A lease provision allowing the lessee, at its option, to purchase the equipment for a price</div> <div> predetermined at lease inception that is substantially lower than the expected fair market</div> <div> value at the date the option can be exercised.</div> <div> Broker</div> <div> A company or person who arranges, for a fee, transactions between lessees and lesser of an</div> <div> asset.</div> <div> Certificate of Acceptance</div> <div> A document whereby the lessee acknowledges that the equipment to be leased has been</div> <div> delivered, is acceptable, and has been manufactured or constructed according to</div> <div> specifications.</div> <div> Economic Life</div> <div> The period of time during which an asset will have economic value and be usable.</div> <div> Effective Lease Rate</div> <div> The effective rate (to the lessee) of cash flows resulting from a lease</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 20</div> <div> Technological Benefits</div> <div> Technology provides a needed and powerful edge in business; the following points examine</div> <div> those benefits and let you decide how these benefits provide you with the needed edge in</div> <div> business. An equipment leasing arrangement provides you the edge you need without</div> <div> running the expensive costs associated with purchasing state-of-the-art equipment.</div> <div> Wider Options, Lesser Costs</div> <div> With equipment leasing arrangement you are free to select your choice of equipment</div> <div> without paying the full price. This advantage also comes with the fact that most business</div> <div> equipment leasing companies will often handle everything from the maintenance to the</div> <div> deployment of their equipment. Your company can save the costs associated with the</div> <div> equipment as the leasing company usually gets price cuts on equipment and related services</div> <div> since they buy in bulk.</div> <div> Leasing Companies</div> <div> Leasing has become increasingly important over the last few years. Uncertainty about future</div> <div> tax legislation and strong pressure on costs in bulk business are the controlling factors in the</div> <div> industry. A high level of product and market homogeneity for classical products, at the</div> <div> same time as low customer loyalty, is forcing companies to adopt positive distinguishing</div> <div> signs in the market.</div> <div> Leasing Act</div> <div> Leasing acts as a "hedge against inflation." Lease payments are fixed for the full term of the</div> <div> lease and, therefore, not subject to inflationary increases. New equipment obtained today is</div> <div> paid for with tomorrow's Rupees. A fixed lease payment enables you to effectively budget</div> <div> and manage the acquisition of capital equipment. At the end of the lease, you may choose to</div> <div> exercise the agreed upon purchase option or simply return the equipment. Leasing offers</div> <div> you the most manageable and economical way of keeping up with evolving technologies. A</div> <div> lease payment may include installation charges or other related out-of-pocket expenses.</div> <div> Down payments are seldom required. Leasing helps establish additional credit resources for</div> <div> your business. Current working capital is not used, which allows your business to use the</div> <div> cash for other investments or possible expansion. A lease is a simple and economical way to</div> <div> obtain the benefits of the latest technology without assuming the up-front costs, and risks, of</div> <div> ownership.</div> <div> Simply defined, a lease is a usage agreement between an equipment owner and a user of that</div> <div> equipment. The lessee pays a periodic fee, usually monthly, to the lesser for the use of the</div> <div> equipment. Leases most often take the form of written contracts with specific terms and</div> <div> conditions spelled out: length of term, amount and timing of payments, and any end-of-lease</div> <div> conditions or restrictions. The lesser is usually viewed as the owner of the equipment during</div> <div> the lease term, but depending on the type of lease you select either you or the lesser may be</div> <div> able to claim the benefits of ownership for tax purposes. Regardless of which type of lease</div> <div> you choose, the future expected value of the equipment (the residual value) is considered</div> <div> when pricing most types of leases. The residual value is the lesson’s estimate today of the</div> <div> equipment's value when the lease term ends. Or in other words we can say that it is like</div> <div> purchasing a car, a car lease typically lasts for 24, 36, or 48 months; the longer the lease the</div> <div> lower the monthly payment. However, it's usually smarter to get a shorter lease. Your best</div> <div> bet is to get a lease for the same amount of time the car is under warranty. Doing so insures</div> <div> you are covered for most car problems for the entire time you are leasing the vehicle.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 21</div> <div> Statistics show most cars begin experiencing problems after being driven for 4 years;</div> <div> therefore a lease term longer than 48 months should be carefully considered. Cars begin to</div> <div> lose value immediately after purchase and continue to lose value until they are scrapped.</div> <div> They become less desirable as they accumulate wear and tear or are replaced by newer</div> <div> models. This process is called depreciation. The cost of your lease depends on the expected</div> <div> depreciation of the vehicle you are leasing. All cars have an expected depreciation. In other</div> <div> words, before a car is leased for the first time, a dealer knows the vehicle's value, given</div> <div> normal wear and tear, for each year after it leaves the lot. When leasing, the difference</div> <div> between a car's original value and its value when the lease term is over, determines how</div> <div> much will be paid during the lease. When leasing a car, you should have a clear</div> <div> understanding of the vehicle's depreciation schedule. Some cars lose value faster than</div> <div> others. For example, some local brands are usually bringing better lease rates than many</div> <div> foreign brands because they are known to have low depreciation. Before leasing make sure</div> <div> you understand both the car's original value and its projected value at lease end, called the</div> <div> residual value.</div> <div> Leasing in Europe and United States of America</div> <div> The global technology equipment leasing market is worth an estimated US$25 billion a year</div> <div> and continues to grow rapidly. Currently, the Europe claims the lion’s share of the market.</div> <div> The concept is more deeply ingrained in the American culture where renting cars, houses</div> <div> and even furniture is the norm. And, because it is so much part of the mainstream, US</div> <div> businesses have historically been more receptive to the leasing message than their European</div> <div> counterparts. The US is also more homogenous than Europe, in terms of both business</div> <div> culture and financial and regulatory frameworks. However, largely because the business</div> <div> arguments in favor of equipment leasing are so compelling, the market is now beginning to</div> <div> take off in Europe. This article looks at the benefits of leasing and the reasons why IT</div> <div> directors and facilities managers across Europe are increasingly adopting this method of</div> <div> financing the acquisition of new equipment. With US-based equipment leasing companies</div> <div> establishing a stronger presence in the region, more European businesses are being educated</div> <div> on the advantages of this approach to asset finance. One of the most important benefits is</div> <div> that leasing helps companies conserve cash.</div> <div> Paying cash for equipment, or even making large down payments, can deplete reserves and</div> <div> ultimately even lead to the business failing, if insufficient reserves are available to pay off</div> <div> creditors on demand.</div> <div> In contrast, leasing enables customers to retain their cash, by eliminating the need for down</div> <div> payments. Many leasing packages provide 100 per cent financing and even cover "soft"</div> <div> costs like shipping, installation and training. In addition, there are no application fees.</div> <div> Instead, businesses are able to make affordable, flexible monthly payments. Today, leasing</div> <div> options exist that let users design a financing plan around the needs of their business,</div> <div> whether their priority is guaranteed ownership; the flexibility to return equipment; specified</div> <div> purchase options or varying monthly payments to match seasonal cash flow. Customers can</div> <div> even convert a recent purchase to a lease. To make certain their move into technology</div> <div> equipment leasing is a success, businesses must also work with providers capable of</div> <div> developing financial products tailored to their precise needs no matter the region in which</div> <div> they are operating. Drawing on expertise gleaned from its long-term presence in 15</div> <div> European countries, Key Equipment Finance is well positioned to do just this.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 22</div> <div> Lecture # 34</div> <div> The Leasing Sector in Pakistan and its Role in Capital Investment</div> <div> From the Third World perspective where a major source of economic capital is a form of</div> <div> foreign or local debt, Leasing acts as a hybrid form of debt cum investment. In the 80’s,</div> <div> when Pakistan floated its first leasing company, the characteristic of ‘asset-based’ financing</div> <div> made it a more ‘Islamic’ form of lending. (Asset based lending is a permitted form of debtfinancing</div> <div> in Islam). From the perspective of developmental finance, Leasing provided an</div> <div> alternative to interest based debt.</div> <div> Leasing as investment indicator</div> <div> Hypothetically, since leasing is directly related to the acquisition of an asset, indicating the</div> <div> Aggregate Investment in Leasing (AIL) of the leasing sector, in a country and at a point in</div> <div> time, would indicate the amount of incremental and fresh capital investment in a year.</div> <div> Hypothetically, we may ignore ‘leakages’ such as rescheduling and duplicate leasing.</div> <div> The aggregate figure for ‘Investment in Leasing’ for the leasing sector in Pakistan has been</div> <div> ranging between PKR18bn to PKR25bn over the past three years. We do not have statistics</div> <div> regarding the exact percentage of new investment in plant and machinery or other income</div> <div> generating assets. I think I can safely estimate about 90% of the AIL is plant and machinery.</div> <div> Of-course, the AIL is only indicative of new capital investment if compared with the same</div> <div> over the previous year. A fairly rough estimate of incremental capital investment would</div> <div> therefore be an average of Rs3billion per year. This does not mean all new investment in a</div> <div> year. That would be much higher since part of the AIL would be paid back, depending on</div> <div> the life of the lease contract.</div> <div> The cost of leasing for a Pakistani lessee averages around 20-25% per annum. The effective</div> <div> cost for a tax-paying lessee may be 16-20%. Assuming an 18% cost of capital (weighted</div> <div> average) for the lessee, the asset can only generate a net income for the lessee, if the lessee</div> <div> in turn earns at least 19-21% per annum from the asset. This would only be possible in high</div> <div> growth sectors of the economy. In my experience, it is rare to see a gross profit margin of</div> <div> 20%, especially in the manufacturing sectors who are the prime clients for leasing Plant and</div> <div> Machinery. The obvious and glaring fact seems to be that the biggest market of leasing</div> <div> cannot afford the product. The question then remains, “who is able to buy?”</div> <div> The other target markets of leasing are commercial-trade/service enterprises and small</div> <div> pockets of manufacturers. Commercial-trade/service enterprises for obvious reasons do not</div> <div> invest in capital machinery. Small pockets of manufacturers boil down to the ubiquitous</div> <div> multinational or the established Pakistani Group who invests in a new project or modernizes</div> <div> existing operations. The reason why this market may find leasing cost effective is because</div> <div> their overall cost of capital is effectively low enough to absorb the cost of leasing; in effect</div> <div> they use an already cash rich company/division to finance a new venture. The other</div> <div> possibility is that the new project has foreign equity interest, which acts as a source of</div> <div> comfort for the Pakistani lessor and provides support for import costs. A third reason for</div> <div> choosing leasing is as hedge against investing equity. In a macro-economic scenario where</div> <div> debt is the lynchpin of most investment, an investor would like to reduce the risk of</div> <div> investing equity.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 23</div> <div> Leasing as working capital</div> <div> Due to the reasons stated above, the product is being used as a source of working capital</div> <div> and quite often as a competing product with short term loans from commercial banks. A</div> <div> sale and lease back transaction is an instant source of funds, payable over the long-term.</div> <div> However, these days an SLB transaction is being used as a vehicle for a direct lease quite</div> <div> often. Because of the enhanced rate of tax at source on direct leases levied from July 98 as</div> <div> against a nil rate for sale and lease-back transactions, lessees prefer to show the lease as a</div> <div> Sale and Leaseback transaction. At the time of processing and obtaining approval, the asset</div> <div> may not have been purchased; but once the lessee is assured of the financing, the asset is</div> <div> purchased and necessary documents processed.</div> <div> Lessors as financial intermediaries</div> <div> With the demise of the development financial institution of Pakistan, a source of cheaper</div> <div> funds for long-term capital investment has dried-up. The private financial sector has grown</div> <div> tremendously in the last decade after the IMF’s directives of liberalization and de-regulation</div> <div> were affected. Greater economic efficiency, in terms of resource mobilization and</div> <div> allocation, was expected after the deregulation of the economy.</div> <div> However, the expected economic efficiency is still a long-way away. The private sector has</div> <div> not been able to satisfy the long-term capital needs of the economy. Lessor is suffering from</div> <div> chronic mismatch of funds and lack of availability of long-term funds. Foreign investors are</div> <div> a moody resource at the best of times and relying on foreign funds is a risky strategy.</div> <div> Contrary to the idea that the South Asian nuclear tests were responsible for driving away</div> <div> investors and the low popularity of Pakistan’s investment market, the absence of investors,</div> <div> be they foreign or local, is a symptom of deteriorating economic conditions over the past 3-</div> <div> 4 years.</div> <div> The true cost of leasing or the ‘economic’ cost of leasing</div> <div> Based on the principles of a ‘free market’, the true cost of leasing (from an economic</div> <div> perspective) is its return to the economy as a whole. If there is a marked and substantial</div> <div> difference between the rate of return of the lessor and the cost of the lessee (like in</div> <div> Pakistan), there may be inefficiency in the sector—a big gap in demand and supply or some</div> <div> other dis-equilibrium. Of-course, this is not true for manufacturing sectors and other</div> <div> services and products where the value added to a product is perceived to be high. In the</div> <div> financial services, value added cannot be high due to the nature of the product. In Pakistan,</div> <div> the net profit margin of the lessor ranges between 3% and 5%. The cost of lease to the</div> <div> lessee is 18-20%. Where is the bulk in between the two going? Who/what is earning this</div> <div> difference and who is being burdened with the cost of the difference? Poor credit policy,</div> <div> corruption, high uncertainty, and poor quality of information available are a few of the</div> <div> symptoms and reasons for the disparity in returns. The ‘real’ reason may well be the</div> <div> outflow of capital from developing countries to the developed countries like the USA,</div> <div> because of the ‘dollarization’ of their economies ... and consequent rapid devaluation of</div> <div> their own currency.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 24</div> <div> Lecture # 35</div> <div> Role of Insurance Companies</div> <div> Insurance, in law and economics, is a form of risk management primarily used to hedge</div> <div> against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk</div> <div> of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is</div> <div> the company that sells the insurance. Insurance rate is a factor used to determine the</div> <div> amount, called the premium, to be charged for a certain amount of insurance coverage.</div> <div> Risk management, the practice of appraising and controlling risk, has evolved as a discrete</div> <div> field of study and practice.</div> <div> Principles of insurance</div> <div> Commercially insurable risks typically share seven common characteristics.</div> <div> 1. A large number of homogeneous exposure units. The vast majority of insurance</div> <div> policies are provided for individual members of very large classes. Automobile</div> <div> insurance, for example, covered about 175 million automobiles in the United States</div> <div> in 2004.[2] The existence of a large number of homogeneous exposure units allows</div> <div> insurers to benefit from the so-called “law of large numbers,” which in effect states that</div> <div> as the number of exposure units increases, the actual results are increasingly likely</div> <div> to become close to expected results. There are exceptions to this criterion. Lloyd's of</div> <div> London is famous for insuring the life or health of actors, actresses and sports figures.</div> <div> Satellite Launch insurance covers events that are infrequent. Large commercial</div> <div> property policies may insure exceptional properties for which there are no</div> <div> ‘homogeneous’ exposure units. Despite failing on this criterion, many exposures like</div> <div> these are generally considered to be insurable.</div> <div> 2. Definite Loss. The event that gives rise to the loss that is subject to insurance</div> <div> should, at least in principle, take place at a known time, in a known place, and from</div> <div> a known cause. The classic example is death of an insured on a life insurance policy.</div> <div> Fire, automobile accidents, and worker injuries may all easily meet this criterion.</div> <div> Other types of losses may only be definite in theory. Occupational disease, for</div> <div> instance, may involve prolonged exposure to injurious conditions where no specific</div> <div> time, place or cause is identifiable. Ideally, the time, place and cause of a loss should</div> <div> be clear enough that a reasonable person, with sufficient information, could</div> <div> objectively verify all three elements.</div> <div> 3. Accidental Loss. The event that constitutes the trigger of a claim should be</div> <div> fortuitous, or at least outside the control of the beneficiary of the insurance. The loss</div> <div> should be ‘pure,’ in the sense that it results from an event for which there is only the</div> <div> opportunity for cost. Events that contain speculative elements, such as ordinary</div> <div> business risks, are generally not considered insurable.</div> <div> 4. Large Loss. The size of the loss must be meaningful from the perspective of the</div> <div> insured. Insurance premiums need to cover both the expected cost of losses, plus the</div> <div> cost of issuing and administering the policy, adjusting losses, and supplying the</div> <div> capital needed to reasonably assure that the insurer will be able to pay claims. For</div> <div> small losses these latter costs may be several times the size of the expected cost of</div> <div> losses. There is little point in paying such costs unless the protection offered has real</div> <div> value to a buyer.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 25</div> <div> 5. Affordable Premium. If the likelihood of an insured event is so high, or the cost of</div> <div> the event so large, that the resulting premium is large relative to the amount of</div> <div> protection offered, it is not likely that anyone will buy insurance, even if on offer.</div> <div> Further, as the accounting profession formally recognizes in financial accounting</div> <div> standards (See FAS 113 for example), the premium cannot be so large that there is</div> <div> not a reasonable chance of a significant loss to the insurer. If there is no such chance</div> <div> of loss, the transaction may have the form of insurance, but not the substance.</div> <div> 6. Calculable Loss. There are two elements that must be at least estimable, if not</div> <div> formally calculable: the probability of loss, and the attendant cost. Probability of</div> <div> loss is generally an empirical exercise, while cost has more to do with the ability of a</div> <div> reasonable person in possession of a copy of the insurance policy and a proof of loss</div> <div> associated with a claim presented under that policy to make a reasonably definite</div> <div> and objective evaluation of the amount of the loss recoverable as a result of the</div> <div> claim.</div> <div> 7. Limited risk of catastrophically large losses. The essential risk is often</div> <div> aggregation. If the same event can cause losses to numerous policyholders of the</div> <div> same insurer, the ability of that insurer to issue policies becomes constrained, not by</div> <div> factors surrounding the individual characteristics of a given policyholder, but by the</div> <div> factors surrounding the sum of all policyholders so exposed. Typically, insurers</div> <div> prefer to limit their exposure to a loss from a single event to some small portion of</div> <div> their capital base, on the order of 5 percent. Where the loss can be aggregated, or an</div> <div> individual policy could produce exceptionally large claims, the capital constraint</div> <div> will restrict an insurer’s appetite for additional policyholders. The classic example is</div> <div> earthquake insurance, where the ability of an underwriter to issue a new policy</div> <div> depends on the number and size of the policies that it has already underwritten.</div> <div> Wind insurance in hurricane zones, particularly along coast lines, is another example</div> <div> of this phenomenon. In extreme cases, the aggregation can affect the entire industry,</div> <div> since the combined capital of insurers and reinsures can be small compared to the</div> <div> needs of potential policyholders in areas exposed to aggregation risk. In commercial</div> <div> fire insurance it is possible to find single properties whose total exposed value is</div> <div> well in excess of any individual insurer’s capital constraint. Such properties are</div> <div> generally shared among several insurers, or are insured by a single insurer who</div> <div> syndicates the risk into the reinsurance market.</div> <div> Indemnification</div> <div> The technical definition of "indemnity" means to make whole again. There are two types of</div> <div> insurance contracts; 1) an "indemnity" policy and 2) a "pay on behalf" or "on behalf of"[3]</div> <div> policy. The difference is significant on paper, but rarely material in practice.</div> <div> An "indemnity" policy will not pay claims until the insured has paid out of pocket to some</div> <div> third party; i.e. a visitor to your home slips on a floor that you left wet and sues you for</div> <div> $10,000 and wins. Under an "indemnity" policy the homeowner would have to come up</div> <div> with the $10,000 to pay for the visitors fall and then would be "indemnified" by the</div> <div> insurance carrier for the out of pocket costs (the $10,000).</div> <div> Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the</div> <div> claim and the insured (the homeowner) would not be out of pocket anything. Most modern</div> <div> liability insurance is written on the basis of "pay on behalf" language.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 26</div> <div> An entity seeking to transfer risk (an individual, corporation, or association of any type,</div> <div> etc.) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by</div> <div> means of a contract, called an insurance 'policy'. Generally, an insurance contract includes,</div> <div> at a minimum, the following elements: the parties (the insurer, the insured, the</div> <div> beneficiaries), the premium, the period of coverage, the particular loss event covered, the</div> <div> amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of</div> <div> a loss), and exclusions (events not covered). An insured is thus said to be "indemnified"</div> <div> against the loss events covered in the policy.</div> <div> When insured parties experience a loss for a specified peril, the coverage entitles the</div> <div> policyholder to make a 'claim' against the insurer for the covered amount of loss as specified</div> <div> by the policy. The fee paid by the insured to the insurer for assuming the risk is called the</div> <div> 'premium'. Insurance premiums from many insured are used to fund accounts reserved for</div> <div> later payment of claims—in theory for a relatively few claimants—and for overhead costs.</div> <div> So long as an insurer maintains adequate funds set aside for anticipated losses (i.e.,</div> <div> reserves), the remaining margin is an insurer's profit.</div> <div> When is a policy really insurance?</div> <div> An operational definition of insurance is that it is</div> <div> • the benefit provided by a particular kind of indemnity contract, called an insurance</div> <div> policy;</div> <div> • that is issued by one of several kinds of legal entities (stock insurance company,</div> <div> mutual insurance company, reciprocal, or Lloyd's syndicate, for example), any of</div> <div> which may be called an insurer;</div> <div> • in which the insurer promises to pay on behalf of or to indemnify another party,</div> <div> called a policyholder or insured;</div> <div> • That protects the insured against loss caused by those perils subject to the indemnity</div> <div> in exchange for consideration known as an insurance premium.</div> <div> In recent years this kind of operational definition proved inadequate as a result of contracts</div> <div> that had the form but not the substance of insurance. The essence of insurance is the transfer</div> <div> of risk from the insured to one or more insurers. How much risk a contract actually transfers</div> <div> proved to be at the heart of the controversy.</div> <div> This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to</div> <div> reengineer insurer balance sheets under US GAAP became fashionable during the 1980s.</div> <div> The accounting profession raised serious concerns about the use of reinsurance in which</div> <div> little if any actual risk was transferred, and went on to address the issue in FAS 113, cited</div> <div> above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the</div> <div> guidance it contains is generally conceded to be equally applicable to US GAAP accounting</div> <div> for insurance transactions executed by commercial enterprises.</div> <div> Does the contract contain adequate risk transfer?</div> <div> FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a</div> <div> contract create a reasonable chance of a significant loss to the underwriter for it to be</div> <div> considered insurance.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 27</div> <div> 9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk</div> <div> in reinsurance of short-duration contracts requires both of the following, unless the</div> <div> condition in paragraph 11 is met:</div> <div> a. The reinsurer assumes significant insurance risk under the reinsured portions</div> <div> of the underlying insurance contracts.</div> <div> b. It is reasonably possible that the reinsurer may realize a significant loss from</div> <div> the transaction.</div> <div> Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the</div> <div> present value of all costs to the PV of all income streams. FAS give no guidance on the</div> <div> choice of a discount rate on which to base such a calculation, other than to say that all</div> <div> outcomes tested should use the same rate.</div> <div> Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National</div> <div> Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the</div> <div> accounting for insurance enterprises to conform to regulation. Paragraph 12 of SSAP 62 is</div> <div> nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to</div> <div> paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed</div> <div> rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is</div> <div> left as a matter of judgment.</div> <div> Is there a bright line test?</div> <div> Neither FAS 113 nor SAP 62 defines the terms reasonable or significant. Ideally, one would</div> <div> like to be able to substitute values for both terms. It would be much simpler if one could</div> <div> apply a test of an X percent chance of a loss of Y percent or greater. Such tests have been</div> <div> proposed, including one famously attributed to an SEC official who is said to have opined</div> <div> in an after lunch talk that a 10 percent chance of a 10 percent loss was sufficient to establish</div> <div> both reasonableness and significance. Indeed, many insurers and reinsurers still apply this</div> <div> 10/10" test as a benchmark for risk transfer testing.</div> <div> It should be obvious that an attempt to use any numerical rule such as the 10/10 test will</div> <div> quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper</div> <div> bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn't</div> <div> apply. Suppose a contract has a 1 percent chance of a 10,000 percent loss? It should be</div> <div> reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10</div> <div> test.</div> <div> It does not appear that any bright line test of reasonableness nor significance can be</div> <div> constructed.</div> <div> Excess of loss contracts, like those commonly used for umbrella and general liability</div> <div> insurance, or to insure against property losses, will typically have a low ratio of premium</div> <div> paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called</div> <div> the rate on line for historical reasons related to underwriting practices at Lloyd's of London,</div> <div> will typically be low for contracts that contain reasonably self-evident risk transfer. As the</div> <div> ratio increases to approximate the present value of the limit of coverage, self-evidence</div> <div> decreases and disappears.</div> <div> Contracts with low rates on line may survive modest features that limit the amount of risk</div> <div> transferred. As rates on line increase, such risk limiting features become increasingly</div> <div> important.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 28</div> <div> "Safe harbor" exemptions</div> <div> The analysis of reasonableness and significance is an estimate of the probability of different</div> <div> gain or loss outcomes under different loss scenarios. It takes time and resources to perform</div> <div> the analysis, which constitutes a burden without value where risk transfer is reasonably selfevident.</div> <div> Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to</div> <div> the reinsurance agreements their firms undertake. The American Academy of Actuaries, for</div> <div> instance, identifies three categories of contract as outside the requirement of attestation:</div> <div> • Inactive contracts. If there are neither premiums due nor losses payable, and the</div> <div> insurer is not taking any credit for the reinsurance, determining risk transfer is</div> <div> irrelevant.</div> <div> • Pre-1994 contracts. The attestation requirement only applies to contracts that were</div> <div> entered into, renewed or amended on or after 1 January 1994. Prior contracts need</div> <div> not be analyzed.</div> <div> • Where risk transfer is "reasonably self-evident."</div> <div> "Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence</div> <div> excess of loss reinsurance contracts. For these contracts, a predetermined amount of</div> <div> premium is paid and the reinsurer assumes nearly all or all of the potential variability in the</div> <div> underlying losses, and it is evident from reading the basic terms of the contract that the</div> <div> reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the</div> <div> reinsurer's loss. The existence of certain experience-based contract terms, such as</div> <div> experience accounts, profit commissions, and additional premiums, generally reduce the</div> <div> amount of risk transfer and make it less likely that risk transfer is reasonably self-evident."</div> <div> - "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note,"</div> <div> American Academy of Actuaries, November 2005. ...</div> <div> Risk limiting features</div> <div> An insurance policy should not contain provisions that allow one side or the other to</div> <div> unilaterally void the contract in exchange for benefit. Provisions that void the contract for</div> <div> failure to perform or for fraud or material misrepresentation are ordinary and acceptable.</div> <div> The policy should have a term of not more than about three years. This is not a hard and fast</div> <div> rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact</div> <div> the accounting treatment, and can obviously introduce the possibility that over the entire</div> <div> term of the contract, no actual risk will transfer. The coverage provided by the contract need</div> <div> not cease at the end of the term (e.g., the contract can cover occurrences as opposed to</div> <div> claims made or claims paid).</div> <div> The contract should be considered to include any other agreements, written or oral, that</div> <div> confer rights, create obligations, or create benefits on the part of either or both parties.</div> <div> Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no</div> <div> undisclosed written or oral side agreements that confer rights, create obligations, or create</div> <div> benefits on the part of either or both parties. If such rights, obligations or benefits exist, they</div> <div> must be factored into the tests of reasonableness and significance.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 29</div> <div> The contract should not contain arbitrary limitations on timing of payments. Provisions that</div> <div> assure both parties of time to properly present and consider claims are acceptable provided</div> <div> they are commercially reasonable and customary.</div> <div> Provisions that expressly create actual or notional accounts that accrue actual or notional</div> <div> interest suggest that the contract contains, in fact, a deposit.</div> <div> Provisions for additional or return premium do not, in and of themselves, render a contract</div> <div> something other than insurance. However, it should be unlikely that either a return or</div> <div> additional premium provision be triggered, and neither party should have discretion</div> <div> regarding the timing of such triggering.</div> <div> All of the events that would give rise to claims under the contract cannot have materialized</div> <div> prior to the inception of the contract. If this "all events" test is not met, then the contract is</div> <div> considered to be a retroactive contract, for which the accounting treatment becomes</div> <div> complex.</div> <div> Insurer’s business model</div> <div> Profit = earned premium + investment income - incurred loss - underwriting expenses.</div> <div> Insurers make money in two ways: (1) through underwriting, the process by which insurers</div> <div> selects the risks to insure and decide how much in premiums to charge for accepting those</div> <div> risks and (2) by investing the premiums they collect from insureds.</div> <div> The most difficult aspect of the insurance business is the underwriting of policies. Using a</div> <div> wide assortment of data, insurers predict the likelihood that a claim will be made against</div> <div> their policies and price products accordingly. To this end, insurers use actuarial science to</div> <div> quantify the risks they are willing to assume and the premium they will charge to assume</div> <div> them. Data is analyzed to fairly accurately project the rate of future claims based on a given</div> <div> risk. Actuarial science uses statistics and probability to analyze the risks associated with the</div> <div> range of perils covered, and these scientific principles are used to determine an insurer's</div> <div> overall exposure. Upon termination of a given policy, the amount of premium collected and</div> <div> the investment gains thereon minus the amount paid out in claims is the insurer's</div> <div> underwriting profit on that policy. Of course, from the insurer's perspective, some policies</div> <div> are winners (i.e., the insurer pays out less in claims and expenses than it receives in</div> <div> premiums and investment income) and some are losers (i.e., the insurer pays out more in</div> <div> claims and expenses than it receives in premiums and investment income).</div> <div> An insurer's underwriting performance is measured in its combined ratio. The loss ratio</div> <div> (incurred losses and loss-adjustment expenses divided by net earned premium) is added to</div> <div> the expense ratio (underwriting expenses divided by net premium written) to determine the</div> <div> company's combined ratio. The combined ratio is a reflection of the company's overall</div> <div> underwriting profitability. A combined ratio of less than 100 percent indicates profitability,</div> <div> while anything over 100 indicates a loss.</div> <div> Insurance companies also earn investment profits on “float”. “Float” or available reserve is</div> <div> the amount of money, at hand at any given moment that an insurer has collected in</div> <div> insurance premiums but has not been paid out in claims. Insurers start investing insurance</div> <div> premiums as soon as they are collected and continue to earn interest on them until claims</div> <div> are paid out.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 30</div> <div> In the United States, the underwriting loss of property and casualty insurance companies</div> <div> was $142.3 billion in the five years ending 2003. But overall profit for the same period was</div> <div> $68.4 billion, as the result of float. Some insurance industry insiders, most notably Hank</div> <div> Greenberg, do not believe that it is forever possible to sustain a profit from float without an</div> <div> underwriting profit as well, but this opinion is not universally held. Naturally, the “float”</div> <div> method is difficult to carry out in an economically depressed period. Bear markets do cause</div> <div> insurers to shift away from investments and to toughen up their underwriting standards. So</div> <div> a poor economy generally means high insurance premiums. This tendency to swing between</div> <div> profitable and unprofitable periods over time is commonly known as the "underwriting" or</div> <div> insurance cycle.</div> <div> Property and casualty insurers currently make the most money from their auto insurance</div> <div> line of business. Generally better statistics are available on auto losses and underwriting on</div> <div> this line of business has benefited greatly from advances in computing. Additionally,</div> <div> property losses in the US, due to natural catastrophes, have exacerbated this trend.</div> <div> Finally, claims and loss handling is the materialized utility of insurance. In managing the</div> <div> claims-handling function, insurers seek to balance the elements of customer satisfaction,</div> <div> administrative handling expenses, and claims overpayment leakages. As part of this</div> <div> balancing act, fraudulent insurance practices are a major business risk that must be managed</div> <div> and overcome.</div> <div> Gambling analogy</div> <div> Both gambling and insurance transfer risk and reward.</div> <div> Gambling transactions offer the possibility of either a loss or a gain. Gambling creates</div> <div> losers and winners. Insurance transactions do not present the possibility of gain. Insurance</div> <div> offers financial support sufficient to replace loss, not to create pure gain.</div> <div> Gamblers can continue spending, buying more risk than they can afford to pay for.</div> <div> Insurance buyers can only spend up to the limit of what carriers would accept to insure;</div> <div> their loss is limited to the amount of the premium.</div> <div> Gamblers, by creating new risk transfer, are risk seekers. Insurance buyers are risk avoiders,</div> <div> creating risk transfer in terms of their need to reduce exposure to large losses.</div> <div> Gambling or gaming is designed at the start so that the odds are not affected by the players'</div> <div> conduct or behavior and not required to conduct risk mitigation practices. But players can</div> <div> prepare and increase their odds of winning in certain games such as poker or blackjack. In</div> <div> contrast to gambling or gaming, to obtain certain types of insurance, such as fire insurance,</div> <div> policyholders can be required to conduct risk mitigation practices, such as installing</div> <div> sprinklers and using fireproof building materials to reduce the odds of loss to fire. In</div> <div> addition, after a proven loss, insurers specialize in providing rehabilitation to minimize the</div> <div> total loss.</div> <div> Insurance, the avoiding, mitigating and transferring of risk, creates greater predictability for</div> <div> individuals and organizations.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 31</div> <div> Lecture # 36</div> <div> Role of Insurance Companies</div> <div> Types of insurance</div> <div> Any risk that can be quantified can potentially be insured. Specific kinds of risk that may</div> <div> give rise to claims are known as "perils". An insurance policy will set out in detail which</div> <div> perils are covered by the policy and which is not.</div> <div> • Below is a (non-exhaustive) list of the many different types of insurance that exist.</div> <div> A single policy may cover risks in one or more of the categories set forth below. For</div> <div> example, auto insurance would typically cover both property risk (covering the risk</div> <div> of theft or damage to the car) and liability risk (covering legal claims from causing</div> <div> an accident). A homeowner's insurance policy in the U.S. typically includes property</div> <div> insurance covering damage to the home and the owner's belongings, liability</div> <div> insurance covering certain legal claims against the owner, and even a small amount</div> <div> of health insurance for medical expenses of guests who are injured on the owner's</div> <div> property.</div> <div> • Automobile insurance, known in the UK as motor insurance, is probably the most</div> <div> common form of insurance and may cover both legal liability claims against the</div> <div> driver and loss of or damage to the insured's vehicle itself. Throughout most of the</div> <div> United States an auto insurance policy is required to legally operate a motor vehicle</div> <div> on public roads. In some jurisdictions, bodily injury compensation for automobile</div> <div> accident victims has been changed to a no-fault system, which reduces or eliminates</div> <div> the ability to sue for compensation but provides automatic eligibility for benefits.</div> <div> Credit card companies insure against damage on rented cars.</div> <div> • Aviation insurance insures against hull, spares, deductible, hull war and liability</div> <div> risks.</div> <div> • Boiler insurance (also known as boiler and machinery insurance or equipment</div> <div> breakdown insurance) insures against accidental physical damage to equipment or</div> <div> machinery.</div> <div> • Builder's risk insurance insures against the risk of physical loss or damage to</div> <div> property during construction. Builder's risk insurance is typically written on an "all</div> <div> risk" basis covering damage due to any cause (including the negligence of the</div> <div> insured) not otherwise expressly excluded.</div> <div> • Business insurance can be any kind of insurance that protects businesses against</div> <div> risks. Some principal subtypes of business insurance are (a) the various kinds of</div> <div> professional liability insurance, also called professional indemnity insurance,</div> <div> which are discussed below under that name; and (b) the business owners policy</div> <div> (BOP), which bundles into one policy many of the kinds of coverage that a business</div> <div> owner needs, in a way analogous to how homeowners insurance bundles the</div> <div> coverage that a homeowner needs.</div> <div> • Casualty insurance insures against accidents, not necessarily tied to any specific</div> <div> property.</div> <div> • Credit insurance repays some or all of a loan back when certain things happen to the</div> <div> borrower such as unemployment, disability, or death. Mortgage insurance (which</div> <div> see below) is a form of credit insurance, although the name credit insurance more</div> <div> often is used to refer to policies that cover other kinds of debt.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 32</div> <div> • Crime insurance insures the policyholder against losses arising from the criminal</div> <div> acts of third parties. For example, a company can obtain crime insurance to cover</div> <div> losses arising from theft or embezzlement.</div> <div> • Crop insurance "Farmers use crop insurance to reduce or manage various risks</div> <div> associated with growing crops. Such risks include crop loss or damage caused by</div> <div> weather, hail, drought, frost damage, insects, or disease, for instance."[8]</div> <div> • Defense Base Act Workers' compensation or DBA Insurance insurance provides</div> <div> coverage for civilian workers hired by the government to perform contracts outside</div> <div> the US and Canada. DBA is required for all US citizens, US residents, US Green</div> <div> Card holders, and all employees or subcontractors hired on overseas government</div> <div> contracts. Depending on the country, Foreign Nationals must also be covered under</div> <div> DBA. This coverage typically includes expenses related to medical treatment and</div> <div> loss of wages, as well as disability and death benefits.</div> <div> • Directors and officers liability insurance protects an organization (usually a</div> <div> corporation) from costs associated with litigation resulting from mistakes incurred</div> <div> by directors and officers for which they are liable. In the industry, it is usually called</div> <div> "D&O" for short.</div> <div> • Disability insurance policies provide financial support in the event the policyholder</div> <div> is unable to work because of disabling illness or injury. It provides monthly support</div> <div> to help pay such obligations as mortgages and credit cards.</div> <div> o Total permanent disability insurance provides benefits when a person is</div> <div> permanently disabled and can no longer work in their profession, often taken</div> <div> as an adjunct to life insurance.</div> <div> • Errors and omissions insurance: See "Professional liability insurance" under</div> <div> "Liability insurance".</div> <div> • Expatriate insurance provides individuals and organizations operating outside of</div> <div> their home country with protection for automobiles, property, health, liability and</div> <div> business pursuits.</div> <div> • Financial loss insurance protects individuals and companies against various financial</div> <div> risks. For example, a business might purchase cover to protect it from loss of sales if</div> <div> a fire in a factory prevented it from carrying out its business for a time. Insurance</div> <div> might also cover the failure of a creditor to pay money it owes to the insured. This</div> <div> type of insurance is frequently referred to as "business interruption insurance."</div> <div> Fidelity bonds and surety bonds are included in this category, although these</div> <div> products provide a benefit to a third party (the "obligee") in the event the insured</div> <div> party (usually referred to as the "obligor") fails to perform its obligations under a</div> <div> contract with the obligee.</div> <div> • Health insurance policies will often cover the cost of private medical treatments if</div> <div> the National Health Service in the UK (NHS) or other publicly-funded health</div> <div> programs do not pay for them. It will often result in quicker health care where better</div> <div> facilities are available.</div> <div> • Kidnap and ransom insurance</div> <div> • Home insurance or homeowners insurance:</div> <div> • Liability insurance is a very broad superset that covers legal claims against the</div> <div> insured. Many types of insurance include an aspect of liability coverage. For</div> <div> example, a homeowner's insurance policy will normally include liability coverage</div> <div> which protects the insured in the event of a claim brought by someone who slips and</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 33</div> <div> falls on the property; automobile insurance also includes an aspect of liability</div> <div> insurance that indemnifies against the harm that a crashing car can cause to others'</div> <div> lives, health, or property. The protection offered by a liability insurance policy is</div> <div> twofold: a legal defense in the event of a lawsuit commenced against the</div> <div> policyholder and indemnification (payment on behalf of the insured) with respect to</div> <div> a settlement or court verdict. Liability policies typically cover only the negligence of</div> <div> the insured, and will not apply to results of willful or intentional acts by the insured.</div> <div> o Environmental liability insurance protects the insured from bodily injury,</div> <div> property damage and cleanup costs as a result of the dispersal, release or</div> <div> escape of pollutants.</div> <div> o Professional liability insurance, also called professional indemnity insurance,</div> <div> protects professional practitioners such as architects, lawyers, doctors, and</div> <div> accountants against potential negligence claims made by their</div> <div> patients/clients. Professional liability insurance may take on different names</div> <div> depending on the profession. For example, professional liability insurance in</div> <div> reference to the medical profession may be called malpractice insurance.</div> <div> Notaries public may take out errors and omissions insurance (E&O). Other</div> <div> potential E&O policyholders include, for example, real estate brokers, home</div> <div> inspectors, appraisers, and website developers.</div> <div> • Life insurance provides a monetary benefit to a decedent's family or other</div> <div> designated beneficiary, and may specifically provide for income to an insured</div> <div> person's family, burial, funeral and other final expenses. Life insurance policies</div> <div> often allow the option of having the proceeds paid to the beneficiary either in a lump</div> <div> sum cash payment or an annuity.</div> <div> o Annuities provide a stream of payments and are generally classified as</div> <div> insurance because they are issued by insurance companies and regulated as</div> <div> insurance and require the same kinds of actuarial and investment</div> <div> management expertise that life insurance requires. Annuities and pensions</div> <div> that pay a benefit for life are sometimes regarded as insurance against the</div> <div> possibility that a retiree will outlive his or her financial resources. In that</div> <div> sense, they are the complement of life insurance and, from an underwriting</div> <div> perspective, are the mirror image of life insurance.</div> <div> • Locked funds insurance is a little-known hybrid insurance policy jointly issued by</div> <div> governments and banks. It is used to protect public funds from tamper by</div> <div> unauthorized parties. In special cases, a government may authorize its use in</div> <div> protecting semi-private funds which are liable to tamper. The terms of this type of</div> <div> insurance are usually very strict. Therefore it is used only in extreme cases where</div> <div> maximum security of funds is required.</div> <div> • Marine insurance and marine cargo insurance cover the loss or damage of ships at</div> <div> sea or on inland waterways, and of the cargo that may be on them. When the owner</div> <div> of the cargo and the carrier are separate corporations, marine cargo insurance</div> <div> typically compensates the owner of cargo for losses sustained from fire, shipwreck,</div> <div> etc., but excludes losses that can be recovered from the carrier or the carrier's</div> <div> insurance. Many marine insurance underwriters will include "time element"</div> <div> coverage in such policies, which extends the indemnity to cover loss of profit and</div> <div> other business expenses attributable to the delay caused by a covered loss.</div> <div> • Mortgage insurance insures the lender against default by the borrower.</div> <div> • National Insurance is the UK's version of social insurance (which see below).</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 34</div> <div> • No-fault insurance is a type of insurance policy (typically automobile insurance)</div> <div> where insureds are indemnified by their own insurer regardless of fault in the</div> <div> incident.</div> <div> • Nuclear incident insurance covers damages resulting from an incident involving</div> <div> radioactive materials and is generally arranged at the national level. (For the United</div> <div> States, see the Price-Anderson Nuclear Industries Indemnity Act.)</div> <div> • Pet insurance insures pets against accidents and illnesses - some companies cover</div> <div> routine/wellness care and burial, as well.</div> <div> • Political risk insurance can be taken out by businesses with operations in countries</div> <div> in which there is a risk that revolution or other political conditions will result in a</div> <div> loss.</div> <div> • Pollution Insurance. First-party coverage for contamination of insured property</div> <div> either by external or on-site sources. Coverage for liability to third parties arising</div> <div> from contamination of air, water, or land due to the sudden and accidental release of</div> <div> hazardous materials from the insured site. The policy usually covers the costs of</div> <div> cleanup and may include coverage for releases from underground storage tanks.</div> <div> Intentional acts are specifically excluded</div> <div> • Property insurance provides protection against risks to property, such as fire, theft or</div> <div> weather damage. This includes specialized forms of insurance such as fire insurance,</div> <div> flood insurance, earthquake insurance, home insurance, inland marine insurance or</div> <div> boiler insurance.</div> <div> • Protected Self-Insurance is an alternative risk financing mechanism in which an</div> <div> organization retains the mathematically calculated cost of risk within the</div> <div> organization and transfers the catastrophic risk with specific and aggregate limits to</div> <div> an Insurer so the maximum total cost of the program is known. A properly designed</div> <div> and underwritten Protected Self-Insurance Program reduces and stabilizes the cost of</div> <div> insurance and provides valuable risk management information.</div> <div> • Purchase insurance is aimed at providing protection on the products people</div> <div> purchase. Purchase insurance can cover individual purchase protection, warranties,</div> <div> guarantees, care plans and even mobile phone insurance. Such insurance is normally</div> <div> very limited in the scope of problems that are covered by the policy.</div> <div> • Retrospectively Rated Insurance is a method of establishing a premium on large</div> <div> commercial accounts. The final premium is based on the insured's actual loss</div> <div> experience during the policy term, sometimes subject to a minimum and maximum</div> <div> premium, with the final premium determined by a formula. Under this plan, the</div> <div> current year's premium is based partially (or wholly) on the current year's losses,</div> <div> although the premium adjustments may take months or years beyond the current</div> <div> year's expiration date. The rating formula is guaranteed in the insurance contract.</div> <div> Formula: retrospective premium = converted loss + basic premium × tax multiplier.</div> <div> Numerous variations of this formula have been developed and are in use.</div> <div> • Self Insurance is protection against loss by setting aside one's own money. This can</div> <div> be done on a mathematical basis by establishing a separate fund into which funds are</div> <div> deposited on a periodic basis. Through self insurance it is possible to protect against</div> <div> high-frequency low-severity losses. To do this through an insurance company would</div> <div> mean having to pay a premium that includes loadings for the company's general</div> <div> expenses, cost of putting the policy on the books, acquisition expenses, premium</div> <div> taxes, and contingencies.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 35</div> <div> • Social insurance can be many things to many people in many countries. But a</div> <div> summary of its essence is that it is a collection of insurance coverages (including</div> <div> components of life insurance, disability income insurance, unemployment insurance,</div> <div> health insurance, and others), plus retirement savings, that mandates participation by</div> <div> all citizens. By forcing everyone in society to be a policyholder and pay premiums,</div> <div> it ensures that everyone can become a claimant when or if he/she needs to. Along</div> <div> the way this inevitably becomes related to other concepts such as the justice system</div> <div> and the welfare state. This is a large, complicated topic that engenders tremendous</div> <div> debate, which can be further studied in the following articles (and others):</div> <div> o Social welfare provision</div> <div> o Social security</div> <div> o Social safety net</div> <div> o National Insurance</div> <div> o Social Security (United States)</div> <div> o Social Security debate (United States)</div> <div> • Stop-loss insurance provides protection against catastrophic or unpredictable losses.</div> <div> It is purchased by organizations who do not want to assume 100% of the liability for</div> <div> losses arising from the plans. Under a stop-loss policy, the insurance company</div> <div> becomes liable for losses that exceed certain limits called deductibles.</div> <div> • Surety Bond insurance is a three party insurance guaranteeing the performance of</div> <div> the principal.</div> <div> • Terrorism insurance provides protection against any loss or damage caused by</div> <div> terrorist activities.</div> <div> • Title insurance provides a guarantee that title to real property is vested in the</div> <div> purchaser and/or mortgagee, free and clear of liens or encumbrances. It is usually</div> <div> issued in conjunction with a search of the public records performed at the time of a</div> <div> real estate transaction.</div> <div> • Travel insurance is an insurance cover taken by those who travel abroad, which</div> <div> covers certain losses such as medical expenses, lost of personal belongings, travel</div> <div> delay, personal liabilities, etc.</div> <div> • Volcano insurance is an insurance that covers volcano damage in Hawaii.</div> <div> • Workers' compensation insurance replaces all or part of a worker's wages lost and</div> <div> accompanying medical expense incurred because of a job-related injury.</div> <div> Types of insurance companies</div> <div> Insurance companies may be classified as</div> <div> • Life insurance companies, which sell life insurance, annuities and pensions products.</div> <div> • Non-life or general insurance companies, which sell other types of insurance.</div> <div> General insurance companies can be further divided into these sub categories.</div> <div> • Standard Lines</div> <div> • Excess Lines</div> <div> In most countries, life and non-life insurers are subject to different regulatory regimes and</div> <div> different tax and accounting rules. The main reason for the distinction between the two</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 36</div> <div> types of company is that life, annuity, and pension business is very long-term in nature —</div> <div> coverage for</div> <div> Life assurance or a pension can cover risks over many decades. By contrast, non-life</div> <div> insurance cover usually covers a shorter period, such as one year.</div> <div> In the United States, standard line insurance companies are your "main stream" insurers.</div> <div> These are the companies that typically insure your auto, home or business. They use pattern</div> <div> or "cookie-cutter" policies without variation from one person to the next. They usually have</div> <div> lower premiums than excess lines and can sell directly to individuals. They are regulated by</div> <div> state laws that can restrict the amount they can charge for insurance policies.</div> <div> Excess line insurance companies (aka Excess and Surplus) typically insure risks not covered</div> <div> by the standard lines market. They are broadly referred as being all insurance placed with</div> <div> non-admitted insurers. Non-admitted insurers are not licensed in the states where the risks</div> <div> are located. These companies have more flexibility and can react faster than standard</div> <div> insurance companies because they don't have the same regulations as standard insurance</div> <div> companies. State laws generally require insurance placed with surplus line agents and</div> <div> brokers to not be available through standard licensed insurers.</div> <div> Insurance companies are generally classified as either mutual or stock companies. This is</div> <div> more of a traditional distinction as true mutual companies are becoming rare. Mutual</div> <div> companies are owned by the policyholders, while stockholders (who may or may not own</div> <div> policies) own stock insurance companies. Other possible forms for an insurance company</div> <div> include reciprocals, in which policyholders 'reciprocate' in sharing risks, and Lloyds</div> <div> organizations.</div> <div> Insurance companies are rated by various agencies such as A. M. Best. The ratings include</div> <div> the company's financial strength, which measures its ability to pay claims. It also rates</div> <div> financial instruments issued by the insurance company, such as bonds, notes, and</div> <div> securitization products.</div> <div> Reinsurance companies are insurance companies that sell policies to other insurance</div> <div> companies, allowing them to reduce their risks and protect themselves from very large</div> <div> losses. The reinsurance market is dominated by a few very large companies, with huge</div> <div> reserves. A reinsurer may also be a direct writer of insurance risks as well.</div> <div> Captive insurance companies may be defined as limited-purpose insurance companies</div> <div> established with the specific objective of financing risks emanating from their parent group</div> <div> or groups. This definition can sometimes be extended to include some of the risks of the</div> <div> parent company's customers. In short, it is an in-house self-insurance vehicle. Captives may</div> <div> take the form of a "pure" entity (which is a 100 percent subsidiary of the self-insured parent</div> <div> company); of a "mutual" captive (which insures the collective risks of members of an</div> <div> industry); and of an "association" captive (which self-insures individual risks of the</div> <div> members of a professional, commercial or industrial association). Captives represent</div> <div> commercial, economic and tax advantages to their sponsors because of the reductions in</div> <div> costs they help create and for the ease of insurance risk management and the flexibility for</div> <div> cash flows they generate. Additionally, they may provide coverage of risks which is neither</div> <div> available nor offered in the traditional insurance market at reasonable prices.</div> <div> The types of risk that a captive can underwrite for their parents include property damage,</div> <div> public and products liability, professional indemnity, employee benefits, employers liability,</div> <div> motor and medical aid expenses. The captive's exposure to such risks may be limited by the</div> <div> use of reinsurance.</div> <div> Captives are becoming an increasingly important component of the risk management and</div> <div> risk financing strategy of their parent. This can be understood against the following</div> <div> background:</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 37</div> <div> • heavy and increasing premium costs in almost every line of coverage;</div> <div> • difficulties in insuring certain types of fortuitous risk;</div> <div> • differential coverage standards in various parts of the world;</div> <div> • rating structures which reflect market trends rather than individual loss experience;</div> <div> • Insufficient credit for deductibles and/or loss control efforts.</div> <div> There are also companies known as 'insurance consultants'. Like a mortgage broker, these</div> <div> companies are paid a fee by the customer to shop around for the best insurance policy</div> <div> amongst many companies.</div> <div> Similar to an insurance consultant, an 'insurance broker' also shops around for the best</div> <div> insurance policy amongst many companies. However, with insurance brokers, the fee is</div> <div> usually paid in the form of commission from the insurer that is selected rather than directly</div> <div> from the client.</div> <div> Neither insurance consultants nor insurance brokers are insurance companies and no risks</div> <div> are transferred to them in insurance transactions.</div> <div> Third party administrators are companies that perform underwriting and sometimes claim</div> <div> handling services for insurance companies. These companies often have special expertise</div> <div> that the insurance companies do not have.</div> <div> Life insurance and saving</div> <div> Certain life insurance contracts accumulate cash values, which may be taken by the insured</div> <div> if the policy is surrendered or which may be borrowed against. Some policies, such as</div> <div> annuities and endowment policies, are financial instruments to accumulate or liquidate</div> <div> wealth when it is needed. See life insurance.</div> <div> In many countries, such as the U.S. and the UK, the tax law provides that the interest on this</div> <div> cash value is not taxable under certain circumstances. This leads to widespread use of life</div> <div> insurance as a tax-efficient method of saving as well as protection in the event of early</div> <div> death.</div> <div> In U.S., the tax on interest income on life insurance policies and annuities is generally</div> <div> deferred. However, in some cases the benefit derived from tax deferral may be offset by a</div> <div> low return. This depends upon the insuring company, the type of policy and other variables</div> <div> (mortality, market return, etc.). Moreover, other income tax saving vehicles (e.g., IRAs,</div> <div> 401(k) plans, Roth IRAs) may be better alternatives for value accumulation. A combination</div> <div> of low-cost term life insurance and a higher-return tax-efficient retirement account may</div> <div> achieve better investment return.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 38</div> <div> Lecture # 37</div> <div> Role of financial Institutions in Agriculture Sector</div> <div> Which banks are authorized for providing agricultural credit to farmers/growers?</div> <div> All banks can provide agricultural credit to Farmers / growers. SBP does not restrain any</div> <div> bank from providing agricultural credit. However, under the Agricultural Credit Scheme</div> <div> indicative targets are given to 21 banks on annual basis. These include; two specialized</div> <div> banks (ZTBL & PPCBL), five major commercial banks (ABL, HBL, MCB, NBP & UBL)</div> <div> and 14 domestic private commercial banks; 1) Askari Com. Bank, 2) Bank Al-Habib, 3)</div> <div> Bank Al-Falah , 4) My Bank, 5) Faysal Bank, 6) Habib Metropolitan Bank, 7) PICIC Com.</div> <div> Bank, 8) KASB Bank, 9) Prime Com. Bank , 10) Saudi Pak Com. Bank, 11) Soneri Bank,</div> <div> 12) Bank of Khyber, 13) Bank of Punjab and 14)Standard Chartered Bank (Pakistan).</div> <div> Who is eligible for agricultural credit from the banks?</div> <div> Any individual (farmers/livestock farmers, fishermen, fish farmers), corporate firms,</div> <div> cooperative societies/self help groups under-taking livestock related activities, fish catching/</div> <div> processing /packing companies and fish exporters having sufficient knowledge and relevant</div> <div> experience are eligible to draw agricultural credit from banks.</div> <div> Are the traders and intermediaries engaged in trading/processing of agricultural</div> <div> commodities eligible for agricultural credit?</div> <div> Loans to entities exclusively engaged in processing, packaging and marketing of</div> <div> agricultural produce shall not fall under agricultural financing and would be covered under</div> <div> commercial or SME financing. However, agricultural financing can be extended to entities</div> <div> (including corporate farms, partnerships and individuals) engaged in farming activity as</div> <div> well as processing, packaging and marketing of mainly their own agricultural produce,</div> <div> provided 75% of the agriculture produce being processed, packaged and marketed is being</div> <div> produced by the abovementioned entities themselves.</div> <div> How can a person get agricultural loan from banks?</div> <div> Applicant must be a genuine farmer/tenant. For this purpose a farmer’s name must appear in</div> <div> revenue record and a tenant should establish this fact through a government</div> <div> acknowledgement or the applicant must be handling Non-Farm activities like livestock,</div> <div> poultry, dairy farming, fishery, forestry or firms/ cooperative societies/self help groups</div> <div> undertaking agriculture related activities.</div> <div> The borrower should be holder of computerized N.I.C in cases of individuals.</div> <div> The borrower should not be a defaulter of any Bank/Financial Institution. This condition</div> <div> may be relaxed in cases where the bank is satisfied with the creditworthiness of the</div> <div> borrower and that the earlier default was circumstantial and not willful.</div> <div> Applicant must produce proper securities / sureties / passbook or other collaterals</div> <div> acceptable to the banks.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 39</div> <div> If one brother was declared defaulter, do the banks provide loan to other brothers?</div> <div> Every individual could be separately considered for grant of loans if he had credit</div> <div> worthiness and separate landed property.</div> <div> For what purposes the banks provide Agricultural Credit?</div> <div> Agricultural credit is provided by banks for complete value chain of activities such as</div> <div> production/crop loans i.e. in-puts (seed, fertilizer, & pesticides etc.), development loans</div> <div> (tractors &tube wells, agricultural machinery / equipments / implements etc.), corporate</div> <div> farming, marketing, cold storage (godowns) on farm & off farm, silos, processing of crops</div> <div> (other than major crops), fruits & vegetables, grading, polishing, packing, transportation and</div> <div> exports of agricultural goods etc.</div> <div> Agricultural credit is also available for non-farm sector such as poultry, livestock, dairy</div> <div> farming, forestry and fisheries, apiculture, sericulture, floriculture, horticulture, etc.</div> <div> There is no provision of financing for procurement of fruits/crops under the list of eligible</div> <div> items for agricultural credit such lending would be covered under commercial or SME</div> <div> financing.</div> <div> What types of loans are provided to farmers/growers by banks?</div> <div> Banks are providing three types of loans; short-term (upto 18 months), medium-term (1.5</div> <div> years to 5 years) and long-term (5 – 7 years). While short-term loans are provided for</div> <div> working capital, medium and long-term loans are given for developmental requirements</div> <div> such as improvement and development of land, purchase of tractors and other agricultural</div> <div> machinery / equipments / implements related to farm and non-farm sector, etc.</div> <div> Why the mark-up rate of Agricultural Credit is higher than the mark-up rate of</div> <div> Commercial/Industrial Credit?</div> <div> In the post financial sector reforms era, banks’ markup rates are not fixed for different</div> <div> sectors but are based on their cost structure and risk profile of the borrowers and the sector.</div> <div> Banks are required to use KIBOR as a bench mark for determining pricing of their loans.</div> <div> Our farming community is generally unaware of different agricultural loan</div> <div> schemes/products. What efforts have been made by SBP for awareness of the farming</div> <div> community?</div> <div> For awareness building of the farmers, SBP has published pamphlets, brochures/book-lets</div> <div> containing information about different agricultural credit schemes/products in Urdu and</div> <div> English as well as in all regional languages and these publications have been distributed to</div> <div> the stakeholders including farming community.</div> <div> Besides, SBP has been arranging special outreach training programs since 2003 in different</div> <div> cities of Pakistan for the banks, Agriculturists, Nazims, Chambers of Agriculture and</div> <div> representatives of Farmers’ Associations. SBP officials along with banks’ representatives</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 40</div> <div> also undertake field visits across the country especially to make the farmers aware of</div> <div> loaning facilities available and various schemes & new products of banks.</div> <div> Banks are vigorously going for car leasing business. Can’t such facility be extended to</div> <div> farming / rural community by providing agricultural machines/equipments /</div> <div> implements including tractor on leasing, hiring, rental basis?</div> <div> SBP has already allowed banks to extend leasing facilities to the farmers under the scheme</div> <div> for tube wells, tractors, harvesters etc. These machines/equipments / implements are also</div> <div> available to the farmers on hiring, leasing and rental basis through Leasing Companies.</div> <div> Whether lease holders of orchards are eligible for agriculture loans from banks?</div> <div> Yes, lease holders of Orchards are also eligible to avail loan under Agricultural Credit</div> <div> Scheme</div> <div> Is there any limit for agriculture financing?</div> <div> No, there is no limit on agricultural loans; however, the loan limit amount is assessed by the</div> <div> ACO/branch manager on the basis of financing appraisal or feasibility report, etc.</div> <div> Do the bank branches functioning in remote areas have sufficient information about</div> <div> the schemes for agricultural financing?</div> <div> Guidelines on different financing schemes and other instructions issued to banks are</div> <div> communicated to banks with the instructions to send the same to all concerned branches. In</div> <div> addition to this, SBP has published brochures about different loan schemes which were</div> <div> translated into Urdu and regional languages and distributed among stakeholders including</div> <div> ACOs/MCOs of rural branches of banks. Moreover, special outreach and training programs</div> <div> organized in collaboration with commercial banks create awareness among the</div> <div> farming/rural community of agri-financing facilities they can access and also to enhance the</div> <div> capacity of commercial banks in agricultural & rural finance by providing training to local</div> <div> agricultural credit officers of the banks.</div> <div> What areas are covered under the Agricultural Loans scheme?</div> <div> The Agricultural Loans Scheme has been designed to cover the entire Pakistan including</div> <div> AJK with no restriction of territorial jurisdiction. Any farmer / grower can avail bank credit</div> <div> from any designated branch of banks throughout Pakistan as per his choice. Likewise banks</div> <div> are also free to provide credit to any farmer through out Pakistan subject to completion of</div> <div> required formalities.</div> <div> What types of sureties / securities/collaterals are acceptable to the banks for providing</div> <div> agricultural credit to farmers/growers?</div> <div> Agricultural land under the pass book system, urban/rural property, commercial property,</div> <div> Defense Saving Certificates, Special Saving Certificates, Gold & Silver Ornaments,</div> <div> personal surety, hypothecation of livestock and other assets e.g. motor boats / fishing</div> <div> trawlers, etc. are generally accepted by banks as collateral.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 41</div> <div> Is mark-up rate fixed by SBP on agricultural loans?</div> <div> SBP does not fix any maximum/minimum mark-up rate to be charged on agricultural loans.</div> <div> Banks’ mark-up is based on their cost structure and risk profile of the borrowers and the</div> <div> sector. However, for benchmarking, Karachi inter-bank Offered Rate (KIBOR) is used by</div> <div> banks for the purpose.</div> <div> What is “Revolving Credit Scheme”?</div> <div> Revolving Credit Scheme was introduced in 2003 in consultation with banks. Under the</div> <div> scheme, banks can provide finance for agricultural purposes on the basis of revolving limits</div> <div> for a period of three years with one-time documentation. The borrowers are required to clear</div> <div> the entire loan amount (including mark-up) once in a year at the date of their own choice.</div> <div> Multiple withdrawals are allowed and the borrowers are also allowed to make partial</div> <div> repayments. Only the amount utilized by the borrower will attract mark-up. This facility can</div> <div> be availed by the farmers just like “running finance”. The limits under this scheme are</div> <div> automatically renewed on annual basis without any request or fresh application.</div> <div> Is the credit facility under “Revolving Credit Scheme” available only on seasonal basis</div> <div> i.e. one crop only?</div> <div> The credit limits under Revolving Credit Scheme are available to the farmers for full one</div> <div> year i.e. covering both the crops in a year. To save the farmers from stress sale of their</div> <div> crops, they are required to clear their account only once in a year at a date indicated by the</div> <div> borrower and mutually agreed with lending bank.</div> <div> Is there any system/procedure under which farmers can get agricultural loans at their</div> <div> doorsteps?</div> <div> Mobile Credit Officers (MCOs) and Agricultural Credit Officers of banks are visiting the</div> <div> farmers regularly to ascertain the credit needs of the farmers and ensure its availability at</div> <div> their doorsteps and also provide technical help for different crops.</div> <div> Whether landless farmers/tenants can avail agricultural credit under Revolving Credit</div> <div> Scheme?</div> <div> Yes, agricultural credit under Revolving Credit Scheme can be availed against personal</div> <div> surety, guarantee or any other collateral acceptable to banks.</div> <div> Are farmers who had availed any concession or remission under Government relief</div> <div> package announced from time to time, eligible for fresh loans?</div> <div> Yes, borrowers who have availed concession under any scheme notified by the government</div> <div> or concerned bank/DFI in the light of guidelines issued by SBP may be eligible for fresh</div> <div> financing.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 42</div> <div> Lecture # 38</div> <div> Agriculture Sector and Financial Institutions of Pakistan</div> <div> What types of securities/collaterals are acceptable to the banks for providing</div> <div> agricultural credit to farmers/growers?</div> <div> Agricultural land under the pass book system, urban/rural property, commercial property,</div> <div> Defense Saving Certificates, Special Saving Certificates, Gold & Silver Ornaments,</div> <div> personal surety, hypothecation of livestock and other assets e.g. motor boats / fishing</div> <div> trawlers, etc. are generally accepted by banks as collateral.</div> <div> Is mark-up rate fixed by SBP on agricultural loans?</div> <div> SBP does not fix any maximum/minimum mark-up rate to be charged on agricultural loans.</div> <div> Banks’ mark-up is based on their cost structure and risk profile of the borrowers and the</div> <div> sector. However, for benchmarking, Karachi inter-bank Offered Rate (KIBOR) is used by</div> <div> banks for the purpose.</div> <div> Revolving Credit Scheme was introduced in 2003 in consultation with banks. Under the</div> <div> scheme, banks can provide finance for agricultural purposes on the basis of revolving limits</div> <div> for a period of three years with one-time documentation. The borrowers are required to clear</div> <div> the entire loan amount (including mark-up) once in a year at the date of their own choice.</div> <div> Multiple withdrawals are allowed and the borrowers are also allowed to make partial</div> <div> repayments. Only the amount utilized by the borrower will attract mark-up. This facility can</div> <div> be availed by the farmers just like “running finance”. The limits under this scheme are</div> <div> automatically renewed on annual basis without any request or fresh application.</div> <div> Is the credit facility under “Revolving Credit Scheme” available only on seasonal basis</div> <div> i.e. one crop only?</div> <div> The credit limits under Revolving Credit Scheme are available to the farmers for full one</div> <div> year i.e. covering both the crops in a year. To save the farmers from stress sale of their</div> <div> crops, they are required to clear their account only once in a year at a date indicated by the</div> <div> borrower and mutually agreed with lending bank.</div> <div> Is there any system/procedure under which farmers can get agricultural loans at their</div> <div> doorsteps?</div> <div> Mobile Credit Officers (MCOs) and Agricultural Credit Officers of banks are visiting the</div> <div> farmers regularly to ascertain the credit needs of the farmers and ensure its availability at</div> <div> their doorsteps and also provide technical help for different crops.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 43</div> <div> Whether landless farmers/tenants can avail agricultural credit under Revolving Credit</div> <div> Scheme?</div> <div> Yes, agricultural credit under Revolving Credit Scheme can be availed against personal</div> <div> surety, guarantee or any other collateral acceptable to banks.</div> <div> Are farmers who had availed any concession or remission under Government relief</div> <div> package announced from time to time, eligible for fresh loans?</div> <div> Yes, borrowers who have availed concession under any scheme notified by the government</div> <div> or concerned bank/DFI in the light of guidelines issued by SBP may be eligible for fresh</div> <div> financing.</div> <div> What are SMEs?</div> <div> As defined by State Bank of Pakistan - SME (Small and Medium Enterprise) means an</div> <div> entity, ideally not a public limited company, which does not employee more than 250</div> <div> persons (if it is manufacturing concern) and 50 persons (if it is trading / service concern)</div> <div> and also fulfills the following criteria of either ‘a’ and ‘c’ or ‘b’ and ‘c’ as relevant:</div> <div> a. A trading / service concern with total assets at cost excluding land and buildings up</div> <div> to Rs 50 million.</div> <div> b. A manufacturing concern with total assets at cost excluding land and building up to</div> <div> Rs 100 million</div> <div> c. Any concern (trading, service or manufacturing) with net sales not exceeding Rs 300</div> <div> million as per latest financial statements.</div> <div> SME Financing and Hand-Holding</div> <div> Research reveals that despite the lack of collateral, SMEs are a better credit risk, as the</div> <div> default rate of this sector is much below that of large enterprises (LEs). Throughout the</div> <div> world, SMEs have provided tremendous opportunities to financial institutions to design</div> <div> various tools for the sector's development (e.g. Program Lending Schemes, Credit Scoring,</div> <div> Venture Capital Financing, etc.). Then there are clusters, technology parks and industrial</div> <div> estates, all being fuelled by the dynamism and vibrancy of small and medium enterprises.</div> <div> Banking institutions, running on Islamic principles, are also experimenting with interest free</div> <div> financial instruments (e.g. Mudarabah, Murabaha, Ijarah etc.) for this sector.</div> <div> Small and medium enterprises or SMEs, also called small and medium-sized</div> <div> enterprises and small and medium-sized businesses or small and medium businesses or</div> <div> SMBs are companies whose headcount or turnover falls below certain limits.</div> <div> The abbreviation SME occurs commonly in the European Union and in international</div> <div> organizations, such as the World Bank, the United Nations and the WTO . The term small</div> <div> and medium-sized businesses or SMBs has become more standard in a few other countries.</div> <div> EU Member States traditionally had their own definition of what constitutes an SME, for</div> <div> example the traditional definition in Germany had a limit of 500 employees , while, for</div> <div> example, in Belgium it could have been 100. But now the EU has started to standardize the</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 44</div> <div> concept. Its current definition categorizes companies with fewer than 50 employees as</div> <div> "small", and those with fewer than 250 as "medium". By contrast, in the United States ,</div> <div> when small business is defined by the number of employees, it often refers to those with</div> <div> less than 100 employees, while medium-sized business often refers to those with less than</div> <div> 500 employees. However, the most widely used American definition of micro-business by</div> <div> the number of employees is the same of that of European Union less than 10 employees.As</div> <div> of 2005, Germany will use the definition of the European Commission .Business enterprises</div> <div> of fewer than 10 employees often class as SOHO</div> <div> In most economies, smaller enterprises are much greater in number. In the EU, SMEs</div> <div> comprise approximately 99% of all firms and employ between them about 65 million</div> <div> people. In many sectors, SMEs are also responsible for driving innovation and</div> <div> competition.Providing SME finance and support is thus an important area of economic</div> <div> policy.</div> <div> Significance of SMEs</div> <div> SMEs are considered the engine of economic growth in both developed and developing</div> <div> countries, as they: Provide low cost employment since the unit cost of persons employed is</div> <div> lower for SMEs than for large-size units.</div> <div> • Assist in regional and local development since SMEs accelerate rural</div> <div> industrialization by linking it with the more organized urban sector.</div> <div> • Help achieve fair and equitable distribution of wealth by regional dispersion of</div> <div> economic activities.</div> <div> • Contribute significantly to export revenues because of the low-cost labour intensive</div> <div> nature of its products.</div> <div> • Have a positive effect on the trade balance since SMEs generally use indigenous raw</div> <div> materials.</div> <div> • Assist in fostering a self-help and entrepreneurial culture by bringing together skills</div> <div> and capital through various lending and skill enhancement schemes.</div> <div> • Impart the resilience to withstand economic upheavals and maintain a reasonable</div> <div> growth rate since being indigenous is the key to sustainability and self-sufficiency.</div> <div> Problems Faced by Pakistan’s SME Sector?</div> <div> Pakistan’s economy has amazing potential for development but sadly, we haven't been able</div> <div> to derive optimal benefits despite a series of efforts launched by various policy makers at</div> <div> different times. The impetus of all these endeavors was on the large scale industries and</div> <div> manufacturing concerns. High rate of failures, owing to economic slumps, institutional</div> <div> malpractices, political motives and damaging activities of labour unions in that sector, left</div> <div> the formal lending institutions with huge infected portfolios, in addition to adverse effects</div> <div> on the entire economy e.g. insufficient and low quality production to meet the demands of</div> <div> local and international markets, deficit in balance of payments and ever rising</div> <div> unemployment, etc.</div> <div> Pakistan’s SMEs are still unable to achieve their maximum potential and are in dire need of</div> <div> ‘hand-holding' and business support services.</div> <div> A major challenge to economic policy in Pakistan at this time is to energize the private</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 45</div> <div> SME sector of the economy. This follows in part from the fact that other sectors are</div> <div> unlikely, under present circumstances, to provide the needed growth either of output or of</div> <div> reasonably remunerative employment; in fact, there will be a major employment challenge</div> <div> over the coming years as labour supply continues to expand rapidly and as neither the largescale</div> <div> private sector nor the public sector are poised to create significant numbers of jobs,</div> <div> and though agriculture and the non-agricultural micro enterprise sector can and probably</div> <div> will do so the levels of productivity and hence of remuneration are likely to be</div> <div> unattractively low. By contrast, the SME sector does have substantial untapped potential to</div> <div> contribute to those objectives; both economic logic and the experiences of other developing</div> <div> countries point to that potential, as well as providing evidence on how it may be achieved.</div> <div> A dynamic SME sector is an important complement to a more open economy; in most of the</div> <div> countries which appear to have reaped major benefits from export orientation the SME</div> <div> sector has been importantly involved in that process. Achieving the maximum contribution</div> <div> from SME, however, will require significant improvements in the support system. If</div> <div> achieved it will not only constitute an important source of dynamism in and of itself, but</div> <div> will also complement efficient large enterprise, strengthen the demand for agricultural</div> <div> products, and make it easier for micro enterprise to graduate into the SME size range.</div> <div> Promotion of Small and Medium Enterprises (SMEs) entails enhancement of the</div> <div> competitiveness of the economy and generation of additional employment. A thriving Small</div> <div> and Medium Enterprise (SME) sector has long been recognized as one of the key</div> <div> characteristics of any prosperous and growing economy.</div> <div> Pakistan is an economy comprising mainly of SMEs. The significance of their role is clearly</div> <div> indicated by various statistics. According to more recent estimates there are approximately</div> <div> 3.2 million business enterprises in Pakistan. Enterprises employing up to 99 persons</div> <div> constitute over 95% of all private enterprises in the industrial sector and employ nearly 78%</div> <div> of the non-agriculture labour force. They contribute over 30% to the GDP, Rs.140 billion to</div> <div> exports, and account 25% of exports of manufactured goods besides sharing 35% in</div> <div> manufacturing value added.</div> <div> However, there has been concern that in Pakistan the SME sector has not been able to</div> <div> realize its full potential. The SMEs continue to suffer from a number of weaknesses, which</div> <div> hamper their ability to take full advantage of the opening of economy and the increasingly</div> <div> accessible world markets. The areas of constraints are normally identified as labour,</div> <div> taxation, trade capacity, and finance and credit availability.</div> <div> It is understood that despite previous efforts the SME sector has not received due priority on</div> <div> account of segregated efforts and non-consolidation of programs to achieve well targeted</div> <div> results. In order to move forward, we need to develop a common vision for SMEs to be the</div> <div> real engine of growth. Our vision also needs to be achievable so we may find motivation in</div> <div> implementing phase.</div> <div> Implementing change requires the formulation of a Policy for SME development and</div> <div> assigning specific responsibilities for its implementation and continuous improvement. The</div> <div> Government of Pakistan has thus constituted the SME Task Force, by Notification No.1</div> <div> (68)/2003-Inv-III of 29 January 2004 of the Ministry of Industries and Production, which is</div> <div> to define the basic elements of our SME policy.</div> <div> As there are many cross-cutting issues to be addressed, the SME Task Force is composed of</div> <div> diverse sectors and levels of Government and includes major stakeholders of the private</div> <div> sector, and SME in particular. Where the SME Task Force deems it necessary or useful, it</div> <div> may invite specific organizations or individuals to assist its work. It may also co-opt further</div> <div> members.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 46</div> <div> Lecture # 39</div> <div> Can Government of Pakistan Lay a Pivotal Role in this Sector?</div> <div> In the recent past SMEDA stands out as a significant step towards Govt of Pakistan</div> <div> commitment to SME development. Created as an autonomous institution with private</div> <div> sector led governance structure, SMEDA promises to become an important institution</div> <div> spearheading Government’s SME development efforts. However, in absence of a</div> <div> coherent SME development policy framework it is unrealistic to expect a single</div> <div> organization such as SMEDA, to be able to implement aggressive SME development</div> <div> initiatives because:</div> <div> 1. Issues to be addressed for SME development fall within the purview of a</div> <div> large number of Ministries and Departments at the Federal, Provincial and</div> <div> Local government levels. SMEDA has no institutional jurisdiction or linkage</div> <div> with such institutions; and</div> <div> 2. SMEDA has limited budget and manpower, posing restrictions on its</div> <div> capacity to launch capital intensive initiatives and extend its outreach Thus to</div> <div> provide a coherent policy mechanism, there is a need to develop a</div> <div> comprehensive SME Policy for Pakistan that defines the role of concerned</div> <div> public sector institutions. Such a Policy framework will provide the required</div> <div> direction and focus for achieving SME led economic growth resulting in job</div> <div> creation and reduction in poverty. Private sector growth in SME sector (as</div> <div> opposed to the large scale manufacturing) will result in lesser investments</div> <div> per job created, wider geographic and social spread of investments and better</div> <div> income distribution.</div> <div> SME Policy & Their Objectives</div> <div> The objective of SME Policy is to provide a short and a medium to long- term policy</div> <div> framework with an implementation mechanism for achieving higher economic</div> <div> growth based on SME led private sector development.</div> <div> The SME Policy suggests concurrent and specific policy measures in all possible</div> <div> areas of SME development:</div> <div> 1. Business environment</div> <div> 2. Access to finance</div> <div> 3. Human resource development</div> <div> 4. Support for technology up gradation and marketing</div> <div> A single SME definition is recommended to be applicable to all institutions</div> <div> countrywide to allow uniformity in designing support systems and incentives and</div> <div> also to monitor progress.</div> <div> The SME Policy also contains an implementation and adjustment mechanism that</div> <div> identifies the following:</div> <div> 􀂋 Implementation and monitoring mechanism</div> <div> 􀂋 Capacity building requirements of the public institutions</div> <div> 􀂋 Resource allocation and potential sources of funding</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 47</div> <div> 􀂋 Linkages with other initiatives and public sector reform processes (Social</div> <div> Sector Reforms)</div> <div> 􀂋 Self contained framework for ongoing feedback and adjustment</div> <div> 􀂋 Role of various public and private sector players at Federal, Provincial and</div> <div> Local levels</div> <div> 􀂋 The Policy finds it appropriate to highlight the key principles on which i t is</div> <div> being based. They are:</div> <div> 􀂋 The recommendations proposed in the SME Policy may be implemented /</div> <div> supported through an SME Act 2006</div> <div> 􀂋 The SME Policy covers measures for promotion of ‘Entrepreneurship</div> <div> Culture’ and support for growth of existing enterprises</div> <div> 􀂋 The SME Policy realizes the different approaches required for supporting</div> <div> 􀂋 Small Enterprises as opposed to Medium Enterprises. Thus, wherever</div> <div> required, separate policy measures are proposed for small and for medium</div> <div> enterprise growth</div> <div> 􀂋 Women and other marginalized groups are proposed to receive special focus</div> <div> within the SME Policy.</div> <div> 􀂋 Rural based and agro processing enterprises are proposed to receive special</div> <div> attention while devising specific support mechanisms</div> <div> 􀂋 SME development offers most viable option for private sector led growth</div> <div> that reduces poverty and creates a large number of jobs all across Pakistan.</div> <div> 􀂋 SME development must be at the center stage of all economic growth</div> <div> policies of Pakistan</div> <div> 􀂋 SME development in Pakistan will require decisive and concurrent measures</div> <div> in a number of policy areas such as business regulations, fiscal, trade rules,</div> <div> labor, incentives and support (Human Resource Development, Technology,</div> <div> Marketing, etc.) leading to an ‘SME Space’ in these domains.</div> <div> 􀂋 Sues face inherent disadvantages (because of their size) vis-à-vis large firms,</div> <div> which need to be offset by government support mechanisms and incentives</div> <div> 􀂋 Effective implementation of the Policy framework will require ownership,</div> <div> commitment and monitoring at highest level of the Government</div> <div> 􀂋 SME development requires provision of level playing field for smaller firms’</div> <div> vis-à-vis large enterprises.</div> <div> 􀂋 Private sector will be encouraged to play a key role in implementation of the</div> <div> SME Policy including mobilization of capital and operational responsibility</div> <div> for implementing policy measures suggested in this document.</div> <div> 􀂋 Financial support to enterprises will be, wherever possible, at a collective</div> <div> level, and will essentially require resource commitment on behalf of the</div> <div> beneficiaries.</div> <div> 􀂋 Pakistan does not have a single definition of Small and Medium Enterprises.</div> <div> Various Government agencies, e.g., State Bank of Pakistan (SBP), Federal</div> <div> Bureau of Statistics (FBS), Provincial Labor Depts., etc. use their own</div> <div> definition. Absence of a single SME definition makes it difficult to identify</div> <div> target firms, align development programs, collect data and monitor progress.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 48</div> <div> Business Environment</div> <div> The fiscal, labor and enterprise regulations of the Federal and Provincial</div> <div> Governments in Pakistan do not provide for a focus on SMEs that is in line with</div> <div> their specific needs. Generally the fiscal regulations divide enterprises by income</div> <div> levels and labor related regulations realize only two forms of enterprises, small and</div> <div> large, thus, not providing laws and implementation mechanisms that are sensitive to</div> <div> SME needs. Largely, the support and grievance redressal regime of the Government</div> <div> does not differentiate between enterprises on the basis of their size thus making i t</div> <div> difficult for SMEs to access public support programs and attention of public</div> <div> authorities when competing for i t with the large firms. This dilutes the ability of</div> <div> SMEs to effectively compete with large firms.</div> <div> Access to Finance & Related Services</div> <div> Now banks provide for only 7-8% of the total funding requirement of SMEs. Also,</div> <div> as per a study by researches on ‘Barriers to SME Growth in Pakistan: an Analysis</div> <div> of Constraints ’, access to finance, was identified by SMEs, as the single most</div> <div> important impediment to growth. This problem increases in magnitude with</div> <div> reduction in size and experience of the firm. With the promulgation of the Prudential</div> <div> Regulations for SME Financing by SBP, the basic regulatory framework for</div> <div> promoting SMEs’ access to formal financing has been provided. However, increased</div> <div> SME access to financing will require interventions in all three areas of SME</div> <div> financing, i.e., demand side (SMEs), supply side (Banks) and intermediaries and</div> <div> regulators (SBP, SMEDA, etc)</div> <div> Supporting Human Resource Development Technology Up- gradation &</div> <div> Marketing</div> <div> 􀂋 Need Assessment Survey to identify major SME needs in HRD, technology</div> <div> up gradation and marketing.</div> <div> 􀂋 Establishment of Institutes of Small and Medium Enterprise &</div> <div> 􀂋 Entrepreneurship Development in select business schools.</div> <div> 􀂋 Capacity building and up-gradation (curriculum redesign, provision of</div> <div> equipment, teachers training, SME liaison, etc.) of selected sector specific</div> <div> technical training institutes serving in major SME clusters and establishment</div> <div> of such institutes where none exist.</div> <div> 􀂋 Encouraging use of the technical t raining infrastructure by the private sector</div> <div> BDSPs serving SME sector and incentives for investment in setting up SME</div> <div> training facilities Induction of genuine SME representatives in private sector</div> <div> boards of the technical training institutes.</div> <div> Entrepreneurship Development</div> <div> Pakistan is a society of ‘employees’. The education and social system does not</div> <div> encourage entrepreneurship as a preferred career option amongst the youth.</div> <div> Entrepreneurship is usually undertaken by those belonging to the existing business</div> <div> families. As a result the economy witnesses a small number of new enterprises being</div> <div> created and that too in traditional areas of business overcrowding the supply/product</div> <div> base and their markets. On the other hand, there are no limitations in the</div> <div> entrepreneurial capabilities in the populace. If, this entrepreneurial potential can be</div> <div> unleashed, by providing level playing field, information, awareness and support in</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 49</div> <div> establishing enterprises, Pakistan can witness fast paced growth in establishment of</div> <div> new enterprises creating new employment opportunities, improving distribution of</div> <div> wealth and exploiting the opportunities offered by international markets in the</div> <div> liberalized WTO regime. The past Government programs to encourage</div> <div> entrepreneurship were limited and not too comprehensively designed and thus</div> <div> achieved little in promoting entrepreneurship amongst the educated Pakistani youth.</div> <div> There is a need for Govt. to actively promote entrepreneurship through changes in</div> <div> education curricula, by creating awareness amongst youth and by providing effective</div> <div> support to those who wish to establish new enterprises.</div> <div> SME Policy Ownership and Implementation</div> <div> A large number of Government Ministries and organizations (in addition to the</div> <div> private sector) will have to play their role in removing impediments and providing</div> <div> support for SME growth. Therefore, it is imperative that the SME Policy is approved</div> <div> by the Prime Minister and endorsed by all Provincial Governments. Such support</div> <div> coupled with clear definition of responsibilities of various Government institutions</div> <div> will provide the required policy vehicle for promoting SME led economic growth in</div> <div> Pakistan.</div> <div> SME Policy Investment & Expected Impact</div> <div> The SME Policy also presents the estimates of public and private sector investments</div> <div> for implementation of the policy recommendations and envisages benefits in terms</div> <div> of enterprise growth, job creation and poverty reduction.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 50</div> <div> Lecture # 40</div> <div> Financial Crimes</div> <div> What is Money Laundering?</div> <div> Defined in non-technical terms, money laundering is the conversion of 'dirty' money into -</div> <div> seemingly - 'clean' money. Dirty money is money that meets the following conditions: (1) it</div> <div> has been derived by illegal means and (2) for an outside observer it is possible to identify</div> <div> that condition (1) applies. Money laundering is the practice of engaging in financial</div> <div> transactions in order to conceal the identity, source, and/or destination of money, and is a</div> <div> main operation of the underground economy. In the past, the term "money laundering" was</div> <div> applied only to financial transactions related to organized crime. Today its definition is</div> <div> often expanded by government regulators to encompass any financial transaction which</div> <div> generates an asset or a value as the result of an illegal act, which may involve actions such</div> <div> as tax evasion or false accounting. As a result, the illegal activity of money laundering is</div> <div> now recognized as potentially practiced by individuals, small and large businesses, corrupt</div> <div> officials, members of organized crime (such as drug dealers or the Mafia) or of cults, and</div> <div> even corrupt states, through a complex network of shell companies and trusts based in</div> <div> offshore tax havens. The increasing complexity of financial crime, the increasing</div> <div> recognized value of so-called "financial intelligence" in combating transnational crime and</div> <div> terrorism, and the speculated impact of capital extracted from the legitimate economy has</div> <div> led to an increased prominence of money laundering in political, economic, and legal</div> <div> debate.</div> <div> Process of Money Laundering</div> <div> Money laundering is often described as occurring in three stages: placement, layering, and</div> <div> integration.</div> <div> 􀂋 Placement: refers to the initial point of entry for funds derived from criminal</div> <div> activities.</div> <div> 􀂋 Layering: refers to the creation of complex networks of transactions which attempt</div> <div> to obscure the link between the initial entry point, and the end of the laundering</div> <div> cycle.</div> <div> 􀂋 Integration: refers to the return of funds to the legitimate economy for later</div> <div> extraction.</div> <div> The Anti Money Laundering Network Recommends the Terms</div> <div> 1. Hide: to reflect the fact that cash is often introduced to the economy via commercial</div> <div> concerns which may knowingly or not knowingly be part of the laundering scheme,</div> <div> and it is these which ultimately prove to be the interface between the criminal and</div> <div> the financial sector.</div> <div> 2. Move: clearly explains that the money launderer uses transfers, sales and purchase</div> <div> of assets, and changes the shape and size of the lump of money so as to obfuscate</div> <div> the trail between money and crime or money and criminal.</div> <div> 3. Invest: the criminal spends the money: he/she may invest it in assets, or in his/her</div> <div> lifestyle.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 51</div> <div> Can Legal Considerations Stop Money Laundering?</div> <div> Many jurisdictions adopt a list of specific predicate crimes for money laundering</div> <div> prosecutions as a "self launderer”. In addition, laws typically have other offences such as</div> <div> "tipping off," "willful blindness," not reporting suspicious activity, and conscious</div> <div> facilitation of a money launderer/terrorist financier to move his/her monies.</div> <div> Financial Institutions & Fight against Money Laundering</div> <div> The prime method of anti-money laundering is the requirement on financial intermediaries</div> <div> to know their customers - usually termed KYC (know your customer) requirements. With</div> <div> good knowledge of their customers, financial intermediaries will often be able to identify</div> <div> unusual or suspicious behavior, including false identities, unusual transactions, changing</div> <div> behavior, or other indicators that laundering may be occurring. But for institutions with</div> <div> millions of customers and thousands of customer-contact employees, traditional ways of</div> <div> knowing their customers must be supplemented by technology.</div> <div> Why Launder Dirty Money at All?</div> <div> Basically there are two motives for laundering money: avoiding suspicion and avoiding</div> <div> detection. Avoiding suspicion refers to the need to remove all traces that may indicate a</div> <div> crime has been committed - such as dirty money. Avoiding detection refers to the need to</div> <div> shield the money from attempts to confiscate it. If you are not entitled to own or dispose of</div> <div> money or assets someone may take it away!</div> <div> What do to against money laundering?</div> <div> Usually one distinguishes between preventive and repressive measures which are</div> <div> complementary rather than mutually exclusive. Preventive measures aim at denying</div> <div> criminals the access to the financial system and tend to rely heavily on the private sector's</div> <div> cooperation. The international standard model envisages that financial institutions identify</div> <div> their customers and keep records, maintain internal compliance programs and actively</div> <div> cooperate with the designated authorities by reporting suspicions of money laundering. The</div> <div> idea of course is that vital information is thereby transmitted from the private sector players</div> <div> that are being 'misused' for money-laundering purposes to the law enforcement agencies.</div> <div> Repressive measures on the other hand are instituted to facilitate prosecution or to have</div> <div> more effective sanctions at hand. Thus, among the repressive measures we find attempts to</div> <div> facilitate international legal cooperation and asset forfeiture or money laundering provisions</div> <div> in the penal code.</div> <div> Terrorist Financing</div> <div> Terrorist financing is a topic that shot into the limelight after the events of September 11,</div> <div> 2001. The US passed the USA PATRIOT Act, among other reasons, to ensure that both</div> <div> combating the financing of terrorism and anti-money laundering was given adequate focus</div> <div> by US financial institutions.</div> <div> The act also had extra-territorial impact and non-US banks having correspondent banking</div> <div> accounts or doing business with US banks had to upgrade their Anti-Money Laundering</div> <div> processes. Although efforts have brought about a huge change to global regulations and</div> <div> have ushered in a new era of information sharing. According to US Government, Islamic</div> <div> charities, which were prime sponsors of terrorist groups around the world, are now under</div> <div> much tighter controls albeit there is still a lot to do in the Middle East and specially</div> <div> Pakistan. Terrorist groups are on the run albeit they are also innovating – in making/moving</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 52</div> <div> monies and in hiring of their key operatives - the new terrorist is a western educated middle</div> <div> class technology savvy person and the source for getting information on a do-it-yourself</div> <div> bomb is the internet.</div> <div> The future of terrorist financing in Pakistan</div> <div> Looking into the near future, if terrorist groups are replaced by smaller, decentralized</div> <div> groups, the premise that terrorists need a financial support network may become outdated.</div> <div> Moreover, some terrorist operations do not rely on outside sources of money and may now</div> <div> be self-funding, either through legitimate employment or low-level criminal activity, for</div> <div> example, the 7/7 London 9/11 US terrorists .</div> <div> How we can trapped Terrorist Finances</div> <div> 1. Bilateral and multilateral diplomacy;</div> <div> 2. Law enforcement and intelligence cooperation;</div> <div> 3. Public designations of terrorists and their supporters for asset-freeze actions;</div> <div> 4. Technical assistance; and</div> <div> 5. Concerted international action through multilateral organizations and groups,</div> <div> notably the anti-money Laundering departments and the United Nations.</div> <div> US assistance to control Money Laundering in Pakistan</div> <div> South Asia, and especially Pakistan, is a priority region for counterterrorist financing, due to</div> <div> the presence of terrorist groups, porous borders, and cash-based economies that often</div> <div> operate through informal mechanisms. All countries in the region need to improve their</div> <div> terrorist financing regimes to meet international standards, including the establishment of</div> <div> functioning Financial Intelligence Units. And both political will and technical assistance are</div> <div> needed to make this region a more effective partner of established countries. Pakistan,</div> <div> specifically, US welcome the concrete actions it has taken to implement its obligations</div> <div> under UN Security Council Resolutions, including the freezing of over $10 assets. Pakistan</div> <div> has also apprehended terrorists, including big names of operational leaders. US, European</div> <div> Union are encouraged by Pakistan's concern about the money laundering & infiltration of</div> <div> terrorist groups into charitable organizations, and would welcome the opportunity to</div> <div> provide technical assistance to help Pakistan meet international standards on preventing</div> <div> abuse of its non-profit sector. US has provided Pakistan assistance on drafting an antimoney</div> <div> laundering/ counterterrorist financing (AML) law that meets international standards,</div> <div> but this legislation is still awaiting parliamentary consideration. In the absence of an antimoney</div> <div> laundering and counterterrorism financing law, the State Bank of Pakistan has</div> <div> introduced FATF-compliant regulations in know-your- customer policy, record retention,</div> <div> due diligence of correspondent banks, and reporting suspicious transactions. Also in</div> <div> compliance with FATF recommendations, the Securities and Exchange Commission of</div> <div> Pakistan has applied know-your-customer regulations to stock exchanges, trusts, and other</div> <div> non-bank financial institutions. All settlements exceeding Rs 50,000 ($840) must be</div> <div> performed by check or bank draft, as opposed to cash. Speaking generally, South Asian</div> <div> countries lack sophisticated tools to combat the money laundering. Anti-money laundering</div> <div> programs also tend to be absent or not up to international standards. Nonetheless, there is a</div> <div> degree of interest in all countries of the region, and we have seen some progress.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 53</div> <div> Know Your Customer (KYC) Guidelines – Anti Money Laundering Standards</div> <div> The objective of KYC guidelines is to prevent banks from being used, intentionally or</div> <div> unintentionally, by criminal elements for money laundering activities. KYC procedures also</div> <div> enable banks to know/understand their customers and their financial dealings better which</div> <div> in turn help them manage their risks prudently.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 54</div> <div> Lecture # 41</div> <div> DFIs & Risk Management</div> <div> Risks are usually defined by the adverse impact on profitability of several distinct sources</div> <div> of uncertainty. While the types and degree of risks an organization may be exposed to</div> <div> depend upon a number of factors such as its size, complexity business activities, volume etc,</div> <div> it is believed that generally the banks face Credit, Market, Liquidity, Operational,</div> <div> Compliance / legal / regulatory and reputation risks. Before overarching these risk</div> <div> categories, given below are some basics about risk Management and some guiding</div> <div> principles to manage risks in banking organization.</div> <div> Risk Management</div> <div> Risk management is the human activity which integrates recognition of risk, risk</div> <div> assessment, developing strategies to manage it, and mitigation of risk using managerial</div> <div> resources. The strategies include transferring the risk to another party, avoiding the risk,</div> <div> reducing the negative effect of the risk, and accepting some or all of the consequences of a</div> <div> particular risk. Some traditional risk managements are focused on risks stemming from</div> <div> physical or legal causes (e.g. natural disasters or fires, accidents, death and lawsuits).</div> <div> Financial risk management, on the other hand, focuses on risks that can be managed using</div> <div> traded financial instruments. Objective of risk management is to reduce different risks</div> <div> related to a pre-selected domain to the level accepted by society. It may refer to numerous</div> <div> types of threats caused by environment, technology, humans, organizations and politics. On</div> <div> the other hand it involves all means available for humans, or in particular, for a risk</div> <div> management entity (person, staff, and organization). In every financial institution of</div> <div> Pakistan, risk management activities broadly take place simultaneously at following</div> <div> different hierarchy levels.</div> <div> 􀂋 Strategic level: It encompasses risk management functions performed by senior</div> <div> management. For instance definition of risks, ascertaining institutions risk appetite,</div> <div> formulating strategy and policies for managing risks and establish adequate systems</div> <div> and controls to ensure that overall risk remain within acceptable level and the reward</div> <div> compensate for the risk taken.</div> <div> 􀂋 Macro Level: It encompasses risk management within a business area or across</div> <div> business lines. Generally the risk management activities performed by middle</div> <div> management or units devoted to risk reviews fall into this category.</div> <div> 􀂋 Micro Level: It involves ‘On-the-line’ risk management where risks are actually</div> <div> created. This is the risk management activities performed by individuals who take</div> <div> risk on organization’s behalf such as front office and loan origination functions. The</div> <div> risk management in those areas is confined to following operational procedures and</div> <div> guidelines set by management.</div> <div> Managing Credit Risk</div> <div> Credit Risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit</div> <div> (either the principal or interest (coupon) or both). Credit risk arises from the potential that</div> <div> an obligor is either unwilling to perform on an obligation or its ability to perform such</div> <div> obligation is impaired resulting in economic loss to the bank. In a bank’s portfolio, losses</div> <div> stem from outright default due to inability or unwillingness of a customer or counter party</div> <div> to meet commitments in relation to lending, trading, settlement and other financial</div> <div> transactions. Alternatively losses may result from reduction in portfolio value due to actual</div> <div> or perceived deterioration in credit quality. Credit risk emanates from a bank’s dealing with</div> <div> individuals, corporate, financial institutions or a sovereign. For most banks, loans are the</div> <div> largest and most obvious source of credit risk; however, credit risk could stem from</div> <div> activities both on and off balance sheet. In addition to direct accounting loss, credit risk</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 55</div> <div> should be viewed in the context of economic exposures. This encompasses opportunity</div> <div> costs, transaction costs and expenses associated with a non-performing asset over and above</div> <div> the accounting loss.</div> <div> Managing Market Risk</div> <div> It is the risk that the value of on and off-balance sheet positions of a financial institution will</div> <div> be adversely affected by movements in market rates or prices such as interest rates, foreign</div> <div> exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to</div> <div> earnings and capital. Financial institutions may be exposed to Market Risk in variety of</div> <div> ways. Market risk exposure may be explicit in portfolios of securities / equities and</div> <div> instruments that are actively traded. Conversely it may be implicit such as interest rate risk</div> <div> due to mismatch of loans and deposits. Besides, market risk may also arise from activities</div> <div> categorized as off-balance sheet item. Therefore market risk is potential for loss resulting</div> <div> from adverse movement in market risk factors such as interest rates, forex rates, equity and</div> <div> commodity prices.</div> <div> Managing Liquidity Risk</div> <div> Liquidity risk is the potential for loss to an institution arising from either its inability to</div> <div> meet its obligations or to fund increases in assets as they fall due without incurring</div> <div> unacceptable cost or losses. Liquidity risk is considered a major risk for banks. It arises</div> <div> when the cushion provided by the liquid assets are not sufficient enough to meet its</div> <div> obligation. In such a situation banks often meet their liquidity requirements from market.</div> <div> However conditions of funding through market depend upon liquidity in the market and</div> <div> borrowing institution’s liquidity. Accordingly an institution short of liquidity may have to</div> <div> undertake transaction at heavy cost resulting in a loss of earning or in worst case scenario</div> <div> the liquidity risk could result in bankruptcy of the institution if it is unable to undertake</div> <div> transaction even at current market-prices. Banks with large off-balance sheet exposures or</div> <div> the banks, which rely heavily on large corporate deposit, have relatively high level of</div> <div> liquidity risk. Further the banks experiencing a rapid growth in assets should have major</div> <div> concern for liquidity.</div> <div> Managing Operational Risk</div> <div> Operational risk is the risk of loss resulting from inadequate or failed internal processes,</div> <div> people and system or from external events. Operational risk is associated with human error,</div> <div> system failures and inadequate procedures and controls. It is the risk of loss arising from the</div> <div> potential that inadequate information system; technology failures, breaches in internal</div> <div> controls, fraud, unforeseen catastrophes, or other operational problems may result in</div> <div> unexpected losses or reputation problems. Operational risk exists in all products and</div> <div> business activities. Operational risk event types that have the potential to result in</div> <div> substantial losses includes Internal fraud, External fraud, employment practices and</div> <div> workplace safety, clients, products and business practices, business disruption and system</div> <div> failures, damage to physical assets, and finally execution, delivery and process</div> <div> management. The objective of operational risk management is the same as for credit, market</div> <div> and liquidity risks that is to find out the extent of the financial institution’s operational risk</div> <div> exposure; to understand what drives it, to allocate capital against it and identify trends</div> <div> internally and externally that would help predicting it. The management of specific</div> <div> operational risks is not a new practice; it has always been important for banks to try to</div> <div> prevent fraud, maintain the integrity of internal controls, and reduce errors in transactions</div> <div> processing, and so on. However, what is relatively new is the view of operational risk</div> <div> management as a comprehensive practice comparable to the management of credit and</div> <div> market risks in principles. Failure to understand and manage operational risk, which is</div> <div> present in virtually all banking transactions and activities, may greatly increase the</div> <div> likelihood that some risks will go unrecognized and uncontrolled.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 56</div> <div> Currency Risk</div> <div> • Currency Risk is a form of risk that arises from the change in price of one currency</div> <div> against another. Whenever investors or companies have assets or business operations</div> <div> across national borders, they face currency risk if their positions are not hedged.</div> <div> • Transaction Risk is the risk that exchange rates will change un-favorably over time.</div> <div> It can be hedged against using forward currency contracts;</div> <div> • Translation Risk is an accounting risk, proportional to the amount of assets held in</div> <div> foreign currencies. Changes in the exchange rate over time will render a report</div> <div> inaccurate, and so assets are usually balanced by borrowings in that currency. The</div> <div> exchange risk associated with a foreign denominated instrument is a key element in</div> <div> foreign investment. This risk flows from differential monetary policy and growth in</div> <div> real productivity, which results in differential inflation rates.</div> <div> • Interest Rate Risk is the risk that the relative value of an interest-bearing asset,</div> <div> such as a loan or a bond, will worsen due to an interest rate increase. In general, as</div> <div> rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is</div> <div> commonly measured by the bond's duration, the oldest of the many techniques now</div> <div> used to manage interest rate risk. Asset liability management is a common name for</div> <div> the complete set of techniques used to manage risk within a general enterprise risk</div> <div> management framework.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 57</div> <div> Lecture # 42</div> <div> Banking Fraud & Misleading Activities</div> <div> Bank fraud is a federal crime in many countries, defined as planning to obtain property or</div> <div> money from any federally insured financial institution. It is sometimes considered a whitecollar</div> <div> crime.</div> <div> • Rogue Traders</div> <div> A rogue trader is a highly placed insider nominally authorized to invest sizeable funds on</div> <div> behalf of the bank; this trader secretly makes progressively more aggressive and risky</div> <div> investments using the bank's money, when one investment goes bad, the rogue trader</div> <div> engages in further market speculation in the hope of a quick profit which would hide or</div> <div> cover the loss. Unfortunately, when one investment loss is piled onto another, the costs to</div> <div> the bank can reach into the hundreds of millions of dollars; there have even been cases in</div> <div> which a bank goes out of business due to market investment losses.</div> <div> • Fraudulent Loans</div> <div> One way to remove money from a bank is to take out a loan, a practice bankers would be</div> <div> more than willing to encourage if they know that the money will be repaid in full with</div> <div> interest. A fraudulent loan, however, is one in which the borrower is a business entity</div> <div> controlled by a dishonest bank officer or an accomplice; the "borrower" then declares</div> <div> bankruptcy or vanishes and the money is gone. The borrower may even be a non-existent</div> <div> entity and the loan merely an artifice to conceal a theft of a large sum of money from the</div> <div> bank.</div> <div> • Wire Fraud</div> <div> Wire transfer networks such as the international SWIFT inter-bank fund transfer system are</div> <div> tempting as targets as a transfer, once made, is difficult or impossible to reverse. As these</div> <div> networks are used by banks to settle accounts with each other, rapid or overnight wire</div> <div> transfer of large amounts of money is commonplace; while banks have put checks and</div> <div> balances in place, there is the risk that insiders may attempt to use fraudulent or forged</div> <div> documents which claim to request a bank depositor's money be wired to another bank, often</div> <div> an offshore account in some distant foreign country.</div> <div> • Forged or Fraudulent Documents</div> <div> Forged documents are often used to conceal other thefts; banks tend to count their money</div> <div> meticulously so every penny must be accounted for. A document claiming that a sum of</div> <div> money has been borrowed as a loan, withdrawn by an individual depositor or transferred or</div> <div> invested can therefore be valuable to a thief who wishes to conceal the minor detail that the</div> <div> bank's money has in fact been stolen and is now gone.</div> <div> • Uninsured Deposits</div> <div> There are a number of cases each year where the bank itself turns out to be uninsured or not</div> <div> licensed to operate at all. The objective is usually to solicit for deposits to this uninsured</div> <div> "bank", although some may also sell stock representing ownership of the "bank".</div> <div> Sometimes the names appear very official or very similar to those of legitimate banks. For</div> <div> instance, the "Chase Trust Bank" of Washington DC appeared in 2002 with no license and</div> <div> no affiliation to its seemingly apparent namesake; the real Chase Manhattan Bank is based</div> <div> in New York. There is a very high risk of fraud when dealing with unknown or uninsured</div> <div> institutions.</div> <div> The risk is greatest when dealing with offshore or Internet banks (as this allows selection of</div> <div> countries with lax banking regulations), but not by any means limited to these institutions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 58</div> <div> • Theft of Identity</div> <div> Dishonest bank personnel have been known to disclose depositors' personal information for</div> <div> use in theft of identity frauds. The perpetrators then use the information to obtain identity</div> <div> cards and credit cards using the victim's name and personal information.</div> <div> • Demand Draft Fraud</div> <div> Demand draft fraud is usually done by one or more dishonest bank employees. They remove</div> <div> few DD leaves or DD books from stock and write them like a regular DD. Since they are</div> <div> insiders, they know the coding, punching of a demand draft. These Demand drafts will be</div> <div> issued payable at distant town/city without debiting an account.</div> <div> Then it will be cashed at the payable branch. For the paying branch it is just another DD.</div> <div> This kind of fraud will be discovered only when the head office does the branch-wise</div> <div> reconciliation, which normally will take 6 months. By that time the money is unrecoverable.</div> <div> • Stolen Cheques</div> <div> Some fraudsters obtain access to facilities handling large amounts of cheques, such as a</div> <div> mailroom or post office or the offices of a tax authority (receiving many cheques) or a</div> <div> corporate payroll or a social or veterans' benefit office (issuing many cheques).</div> <div> A few cheques go missing; accounts are then opened under assumed names and the cheques</div> <div> (often tampered or altered in some way) deposited so that the money can then be withdrawn</div> <div> by thieves. Stolen blank cheque-books are also of value to forgers who then sign as if they</div> <div> were the depositor.</div> <div> • Accounting Fraud</div> <div> In order to hide serious financial problems, some businesses have been known to use</div> <div> fraudulent bookkeeping to overstate sales and income, inflate the worth of the company's</div> <div> assets, or state a profit when the company is operating at a loss. These tampered records are</div> <div> then used to seek investment in the company's bond or security issues or to make fraudulent</div> <div> loan applications in a final attempt to obtain more money to delay the inevitable collapse of</div> <div> an unprofitable or mismanaged firm.</div> <div> • Stolen Credit or Debit Cards</div> <div> Often, the first indication that a victim's wallet has been stolen is a 'phone call from a credit</div> <div> card issuer asking if the person has gone on a spending spree; the simplest form of this theft</div> <div> involves stealing the card itself and charging a number of high-ticket items to it in the first</div> <div> few minutes or hours before it is reported as stolen. A variant of this is to copy just the</div> <div> credit card numbers (instead of drawing attention by stealing the card itself) in order to use</div> <div> the numbers in online frauds.</div> <div> • Fraudulent Loan Applications</div> <div> These take a number of forms varying from individuals using false information to hide a</div> <div> credit history filled with financial problems and unpaid loans to corporations using</div> <div> accounting fraud to overstate profits in order to make a risky loan appear to be a sound</div> <div> investment for the bank.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 59</div> <div> Can We Avoid Cheque Fraud?</div> <div> 1. Reconcile your account; Reconcile your cheque account promptly and regularly. If</div> <div> you hold business accounts, consider opening a separate account specifically for</div> <div> higher value cheques, so they can be easily monitored.</div> <div> 2. Signing of Cheques; Never sign blank cheques, only sign cheques after all details</div> <div> have been completed.</div> <div> 3. Preparation; Cheques must be completed in a way that deters fraudulent</div> <div> alternation. Ensure that a strong bold and consistent font is used and that no gaps are</div> <div> left in completion of the payee name, amount in words and in figures. Use</div> <div> permanent ballpoint or ink (preferably black) when filling out a cheque.</div> <div> 4. Ordering and maintaining cheques; If cheques are lost or stolen contact your bank</div> <div> immediately and ask them to load a ‘Stop Payment’. Notify bank, if you have not</div> <div> received an ordered cheque book.</div> <div> Protect your credit / debit card</div> <div> Save your personal identification number (PIN). Don't use the same PIN for different cards</div> <div> or equipment, and don't choose your birth date or any other easily identifiable number that</div> <div> might be on something else in your wallet. Check statements and call your credit card issuer</div> <div> immediately if you see anything suspicious on your bill. You could help the company</div> <div> uncover fraud—and save yourself from paying un-authorized charges. Keep track of when</div> <div> new and reissued cards should arrive, and call the credit card issuer if they don't come on</div> <div> time. Make sure your mailbox is secure, and that only you and the postal carrier have access</div> <div> to it. When you use your credit card online, make sure you are using a secure website. Look</div> <div> for a small key or lock symbol at the bottom right of your browser's window. Never give</div> <div> your card number to strangers or telemarketers who call you on the phone. Don't give your</div> <div> card number unless you initiated the call.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 60</div> <div> Lecture # 43</div> <div> The Collapse of ENRON</div> <div> Only months before Enron Corporations bankruptcy filing in December 2001, the firm was</div> <div> widely regarded as one of the most innovative, fastest growing, and best managed</div> <div> businesses in the United States. With the swift collapse, shareholders, including thousands</div> <div> of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of</div> <div> billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron’s</div> <div> failure already raises financial oversight issues with wider applications. This lecture briefly</div> <div> examines the accounting system that failed to provide a clear picture of the firm’s true</div> <div> condition, the independent auditors and board members who were unwilling to challenge</div> <div> Enron’s management, the Wall Street stock analysts and bond raters who missed the trouble</div> <div> ahead, the rules governing employer stock in company pension plans, and the unregulated</div> <div> energy derivatives trading that was the core of Enron’s business. Formed in 1985 from a</div> <div> merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide</div> <div> natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated</div> <div> transportation of natural gas to unregulated energy trading markets. The guiding principle</div> <div> seems to have been that there was more money to be made in buying and selling financial</div> <div> contracts linked to the value of energy assets (and to other economic variables) than in</div> <div> actual ownership of physical assets. Until late 2001, nearly all observers – including</div> <div> professional Wall Street analysts – regarded this transformation as an outstanding success.</div> <div> Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $101</div> <div> billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and</div> <div> Senate have held or plan to hold hearings related to Enron’s fall. The Justice Department is</div> <div> conducting a criminal investigation. The challenge for financial oversight, however, does</div> <div> not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the</div> <div> swift and unanticipated collapse of such a large corporation suggests basic problems with</div> <div> the U.S. system of securities regulation, which is based on the full and accurate disclosure</div> <div> of all financial information that market participants need to make informed investment</div> <div> decisions.</div> <div> • Auditing Issues</div> <div> Federal securities law requires that the accounting statements of publicly traded</div> <div> corporations be certified by an independent auditor. Enron’s outside audits have received</div> <div> much attention. While external audits do not prevent corporations from making financial</div> <div> mistakes, let alone bankruptcy, problems with recent Enron audits may have contributed to</div> <div> both the rapid rise and the sharp fall in its stock price. Outside investors, including financial</div> <div> institutions may have been misled about the corporation’s net income (which was</div> <div> subsequently restated) and contingent liabilities (which were far larger than generally</div> <div> known). The auditor, Arthur Andersen, has admitted some mistakes. Andersen fired the</div> <div> partner in charge of Enron audits on January 15, 2002, and Enron dismissed Andersen on</div> <div> January 17. One issue is whether Andersen’s extensive consulting work for Enron may have</div> <div> compromised its judgment in determining the nature, timing, and extent of audit procedures</div> <div> and in asking that revisions be made to financial statements, which are the responsibility of</div> <div> Enron’s management. Questions have also been asked about Andersen destroying</div> <div> documents and e-mails related to its audits. Oversight of auditors has primarily rested with</div> <div> the American Institute of Certified Public Accountants (a nongovernmental trade group) and</div> <div> state boards of accountancy. On January 17, 2002, the Chairman of the Securities and</div> <div> Exchange Commission (SEC) proposed a new oversight board that would be responsible for</div> <div> disciplinary actions.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 61</div> <div> • Accounting Issues</div> <div> The Enron controversy involves several accounting issues. One concerns the rules</div> <div> governing whether the financial statements of special purpose entities (SPEs) established by</div> <div> a corporation should be consolidated with the corporation’s financial statements; for certain</div> <div> SPE partnerships at issue, consolidation is not required if among other things an</div> <div> independent third party invests as little as 3% of the capital, a threshold some consider too</div> <div> low. A second issue concerns the latitude allowed in valuing derivatives, particularly nonexchange</div> <div> traded energy contracts. Third, there are calls for improved disclosure, either in</div> <div> notes to financial statements or a management discussion and analysis, especially for</div> <div> financial arrangements involving contingent liabilities. Accounting standards for</div> <div> corporations are set by the Financial Accounting Standards Board, a nongovernmental</div> <div> entity, though there are also SEC requirements. (The SEC has statutory authority to set</div> <div> accounting standards for firms that sell securities to the public.)</div> <div> • Pension Issues</div> <div> Like many companies, Enron sponsors a retirement plan – a “401(k)” – for its employees to</div> <div> which they can contribute a portion of their pay on a tax-deferred basis. As of December 31,</div> <div> 2000, 62% of the assets held in the corporation’s 401(k) retirement plan consisted of Enron</div> <div> stock. Many individual Enron employees held even larger percentages of Enron stock in</div> <div> their 401(k) accounts. Shares of Enron, which in January 2001 traded for more than</div> <div> $80/share, were worth less than 70 cents in January 2002. Consequently, the company’s</div> <div> bankruptcy has substantially reduced the value of its employees’ retirement accounts. The</div> <div> losses suffered by participants in the Enron Corporation’s 401(k) plan have prompted</div> <div> questions about the laws and regulations that govern these plans.</div> <div> • Corporate Governance Issues</div> <div> The role of a company’s board of directors is to oversee corporate management to protect</div> <div> the interests of shareholders. However, in 1999 Enron’s board waived conflict of interest</div> <div> rules to allow chief financial officer Andrew Fastow to create private partnerships to do</div> <div> business with the firm. These partnerships appear to have concealed debts and liabilities that</div> <div> would have had a significant impact on Enron’s reported profits. Enron’s collapse raises the</div> <div> issue of how to reinforce directors’ capability and will to challenge questionable dealings by</div> <div> corporate managers. Specific questions involve independent or “outside” directors. (Stock</div> <div> exchange rules require that a certain percentage of board members be unaffiliated with the</div> <div> firm and its management.)</div> <div> • Securities Analyst Issues</div> <div> Securities analysts employed by investment banks provide research and make “buy,” “sell,”</div> <div> or “hold” recommendations for the use of their sales staffs and their investor clients. These</div> <div> recommendations are widely circulated and are relied upon by many investors throughout</div> <div> the markets. Analyst support was crucial to Enron because it required constant infusions of</div> <div> funding from the financial markets. On November 29, 2001, after Enron’s stock had fallen</div> <div> 99% from its high, and after rating agencies had downgraded its debt to “junk bond” status,</div> <div> only two of 11 major firm analysts rated its stock a “sell.” This performance added to</div> <div> concerns that were raised in 2000 in the wake of the “dot com” stock crash.</div> <div> Derivatives Issues</div> <div> The core of Enron’s business appears to have been dealing in derivative contracts based on</div> <div> the prices of oil, gas, electricity and other variables. For example, Enron sold long-term</div> <div> contracts to sell energy at fixed prices. These contracts allow the buyers to avoid, or hedge,</div> <div> the risks that increases (or drops) in energy prices posed to their businesses. Since the</div> <div> markets in which Enron traded are largely unregulated, with no reporting requirements,</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 62</div> <div> little information is available about the extent or profitability of Enron’s derivatives</div> <div> activities. Did Enron earn money from dealer commissions and spreads, or was it actively</div> <div> speculating on future price trends? Speculative losses in derivatives, perhaps masked by</div> <div> “creative” accounting, could have contributed to the firm’s downfall. On the other hand, the</div> <div> trading operations may have been profitable and trouble free, and Enron’s financial</div> <div> difficulties the result of other unrelated operations. Enron’s collapse raises the issue of</div> <div> supervision of unregulated derivatives markets.</div> <div> Corrective Actions</div> <div> The collapse of Enron proved to be a valuable wake-up call to a number of affected groups.</div> <div> The following actions have already been taken by private organizations: The Business</div> <div> Roundtable, composed of the chief executives of about 150 large firms, urged corporations</div> <div> to adopt a number of voluntary changes in corporate governance rules, including that a</div> <div> ‘‘substantial majority’’ of corporate boards be independent ‘‘both in fact and appearance.’’</div> <div> The New York Stock Exchange and the National Association of Securities Dealers</div> <div> approved major additions and changes in the rules for accounting, auditing, and corporate</div> <div> governance as necessary conditions for listing of a corporation’s stock for trade on the</div> <div> exchange. The major continuing uncertainty is how the exchanges will monitor and enforce</div> <div> these rules. The International Corporate Governance Network, institutional investors that</div> <div> control about $10 trillion in assets, has approved a set of international standards for</div> <div> corporate governance that its members would use their voting power to promote. Standard</div> <div> and Poor’s, one of the three major credit-rating agencies, has developed a new concept of</div> <div> ‘‘core earnings’’ as a measure of earnings from a company’s primary lines of business.</div> <div> Compared with earnings as defined by the generally accepted accounting principles</div> <div> (GAAP), for example, the S&P measure will exclude gains and losses from a variety of</div> <div> financial transactions. S&P plans to report this measure of earnings for all publicly held</div> <div> U.S. companies.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 63</div> <div> Lecture # 44</div> <div> Classic Financial Scandals</div> <div> "Bankers who hire money hungry geniuses should not always express surprise and</div> <div> amazement when some of them turn around with brilliant, creative, and illegal means</div> <div> of making money." “The quotation is from a speech by the financial thriller writer on the</div> <div> Psychology of Risk, Speculation and Fraud, at a conference on EMU in Amsterdam.</div> <div> Barings Bank collapsed when one of the Singapore based employees of London's Barings</div> <div> Bank, Nick Leeson, lost £827 million (US$1.4 billion) - primarily on futures contract</div> <div> speculation. Leeson's actions led the oldest merchant bank to default on its debts. The bank's</div> <div> collapse is considered a pivotal turning point in the history of banking and has become a</div> <div> textbook example of accounting fraud.</div> <div> • Internal auditing</div> <div> The way that Barings Bank's activities in Singapore were organized between 1992 and 1995</div> <div> enabled Leeson to operate effectively without supervision from Barings Bank's head office</div> <div> in London. Leeson acted both as head of settlement operations (charged with ensuring</div> <div> accurate accounting) and as floor manager for Barings' trading on Singapore International</div> <div> Monetary Exchange (SIMEX). Normally the positions would have been held by two</div> <div> employees. This concentration of functions placed Leeson in the position of reporting to an</div> <div> office inside the bank which he himself held. Several observers, including Leeson, placed</div> <div> much of the blame on the bank's own deficient internal auditing and risk management</div> <div> practices.</div> <div> • Corruption</div> <div> Because of the absence of oversight, Leeson was able to make seemingly small gambles in</div> <div> the futures market at Barings Futures Singapores (BFS) and cover for his shortfalls by</div> <div> reporting losses as gains to Barings in London. Specifically, Leeson altered the branch's</div> <div> error account, subsequently known by its account number 88888 as the "five-eight account,"</div> <div> to prevent the London office from receiving the standard daily reports on trading, price, and</div> <div> status. Leeson claims the losses started when one of his colleagues bought contracts when</div> <div> she should have sold them. By December 1994 Leeson had cost Barings £200 million but he</div> <div> reported to British tax authorities a £102 million profit. If the company had uncovered his</div> <div> true financial dealings then, collapse might have been avoided as Barings had capital of</div> <div> £350 million</div> <div> • Kobe earthquake</div> <div> Using the hidden "five-eight account," Leeson began to aggressively trade in futures and</div> <div> options on SIMEX. His decisions routinely lost substantial sums, but he used money</div> <div> entrusted to the bank by subsidiaries for use in their own accounts. He falsified trading</div> <div> records in the bank's computer systems, and used money intended for margin payments on</div> <div> other trading. Barings Bank management in London at first congratulated and rewarded</div> <div> Leeson for what seemed to be his outstanding trading profits. However, his luck ran out</div> <div> when the Kobe earthquake sent the Asian financial markets into a tailspin. Leeson bet on a</div> <div> rapid recovery by the Nikkei Stock Average which failed to materialize.</div> <div> • Discovery</div> <div> Appointed administrators began managing the finances of Barings Group and its</div> <div> subsidiaries on 26 February 1995. On 26 February, the Board of Banking Supervision</div> <div> launched an investigation led by Britain's Chancellor of the Exchequer. The Chancellor</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 64</div> <div> released his report on 18 July. By 27 February, Leeson had cost the bank £827 million. The</div> <div> collapse itself cost the bank another £100 million.</div> <div> Barings Bank auditors finally discovered the fraud, around the same time that Chairman</div> <div> Peter Barings received a confession note from Leeson, but it was too late. Leeson's activities</div> <div> had generated losses totaling £827 million (US$1.4 billion), twice the bank's available</div> <div> trading capital. The Bank of England attempted a weekend bailout but it was unsuccessful.</div> <div> Barings was declared insolvent 26 February 1995. The collapse was dramatic and</div> <div> employees around the world were denied their bonuses</div> <div> • Aftermath</div> <div> ING, a Dutch bank, purchased Barings Bank for the nominal sum of £1 and assumed all of</div> <div> Barings liabilities. Barings Bank therefore no longer has a separate corporate existence,</div> <div> although the Barings name still lived on as Baring Asset Management. BAM was split and</div> <div> sold by ING to Mass Mutual and Northern Trust in March 2005. Nick Leeson fled</div> <div> Singapore but was arrested in Germany and extradited back to Singapore, where he was</div> <div> convicted of fraud and imprisoned for six years. Upon release, he wrote an autobiography,</div> <div> Rogue Trader, covering the events leading up to the collapse. A film maker later dramatized</div> <div> the book in the film Rogue Trader.</div> <div> Black Wednesday</div> <div> In British politics and economics, Black Wednesday refers to 16 September 1992 when the</div> <div> Conservative government was forced to withdraw the Pound from the European Exchange</div> <div> Rate Mechanism (ERM) due to pressure by currency speculators—most notably George</div> <div> Soros who made over US$1 billion from this speculation. In 1997 the UK Treasury</div> <div> estimated the cost of Black Wednesday at £3.4 billion.</div> <div> The trading losses in August and September were estimated at £800m, but the main loss to</div> <div> taxpayers arose because the devaluation could have made them a profit. The papers show</div> <div> that if the government had maintained $24bn foreign currency reserves and the pound had</div> <div> fallen by the same amount, the UK would have made a £2.4bn profit on sterling's</div> <div> devaluation (Financial Times 10 February 2005). The papers also show that the Treasury</div> <div> spent £27bn of reserves in propping up the pound; the Treasury calculates the ultimate loss</div> <div> was only £3.4bn.</div> <div> The currency speculators' attack</div> <div> The fundamental sterling problem in September 1992 was that the dollar was rapidly</div> <div> depreciating against the deutschmark. Tied as it was to the ERM, the pound was hence</div> <div> appreciating to unsustainable levels against the US currency. With a large proportion of</div> <div> British exports priced in dollars, a pound/dollar correction was well overdue. ERM</div> <div> membership was preventing this from happening. In anticipation of the inevitable dambursting,</div> <div> speculators hastened the process by borrowing pounds (and also lire) and selling</div> <div> them for DM, in the expectation of being able to repay the loan in devalued currency and to</div> <div> pocket the difference.</div> <div> On September 16 the British government announced a rise in the base interest rate from an</div> <div> already high 10% to 12% in order to tempt speculators to buy pounds. Despite this and a</div> <div> promise later the same day to raise base rates again to 15%, dealers kept selling pounds,</div> <div> convinced that the government would not stick with its promise. By 19:00 that evening,</div> <div> Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would</div> <div> remain at the new level of 12%.</div> <div> EU economists' analysis of this event concluded that stable exchange rates are the result, not</div> <div> the cause, of a common approach to economic management, resulting in the Stability and</div> <div> Growth Pact that underpins ERM II and subsequently the Euro single currency.</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 65</div> <div> Treasury bond Scandal</div> <div> “Saloman Brothers”</div> <div> Salomon Brothers was a Wall Street investment bank. Founded in 1910, it remained a</div> <div> partnership until the early 1980s, when it was acquired by the commodity trading firm then</div> <div> known as Phibro Corporation. This proved a "wag the dog" type merger as the parent</div> <div> company became first Phibro-Salomon and then Salomon Inc. and the commodity</div> <div> operations were sold. Eventually Salomon was acquired by Travelers Group (now</div> <div> Citigroup) in 1998.</div> <div> It eventually became the largest issuer and trader of bonds in the United States, its PR man</div> <div> defining a liquid bond as any bond traded by Salomon Brothers.</div> <div> During its time of greatest prominence in the 1980s, Salomon became noted for its</div> <div> innovation in the bond market, creating the first mortgage-backed security. Later, it moved</div> <div> away from traditional investment banking (helping companies raise funds in the capital</div> <div> market and negotiating mergers and acquisitions) to almost exclusively proprietary trading</div> <div> (the buying and selling of stocks, bonds, options, etc. for the profit of the company).</div> <div> Salomon had an expertise in fixed income trading, betting large amounts of money on</div> <div> certain swings in the bond market on a daily basis. The top bond traders called themselves</div> <div> "Big Swinging Dicks", and were the inspiration for the books The Bonfire of the Vanities</div> <div> and Liar's Poker.</div> <div> During this period however the performance of the firm was not to the satisfaction of its</div> <div> upper management. The amount of money being made relative to the amount being invested</div> <div> in all the markets Salomon was in was small, and the company's traders were paid in a</div> <div> flawed way which was disconnected from their true profitability (fully accounting for both</div> <div> the amount of money they used and the risk they took). There were debates as to which</div> <div> direction the firm should head in, whether it should prune down its activities to focus on</div> <div> certain areas. For example, the commercial paper business (providing short term day to day</div> <div> financing for large companies), was apparently unprofitable, although some in the firm</div> <div> argued that it was a good activity because it kept the company in constant contact with other</div> <div> businesses' key financial personnel. It was decided that the firm should try to imitate Drexel</div> <div> Burnham Lambert, using its Investment Bankers and its own money to urge companies to</div> <div> restructure or engage in leveraged buyouts which would result in financing business for</div> <div> Salomon Brothers. The first moves in this direction were for the firm to compete on the</div> <div> leveraged buyout of RJR Nabisco, followed by the leveraged buyout of Revco stores (which</div> <div> ended in failure).</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 66</div> <div> LECTURE # 45</div> <div> RECAP</div> <div> 1) FINANCIAL ENVIRONMENT &FINANCIAL INSTITUTIONS</div> <div> • Role Of Financial Institutions</div> <div> • Long Run Performance Of Financial Institutions For Economic Growth</div> <div> • Capital market</div> <div> • Commodity markets</div> <div> • Money markets</div> <div> • Derivatives markets</div> <div> • Futures markets</div> <div> • Borrowers of financial markets</div> <div> • Lenders of financial market</div> <div> • Stock markets</div> <div> • Bond markets</div> <div> 2) FINANCIAL INSTITUTIONS</div> <div> • Types of Financial Institutions</div> <div> • Central Bank</div> <div> • Commercial Banks</div> <div> • Investment Bank</div> <div> • Saving Bank</div> <div> • Micro Finance Bank</div> <div> • Islamic Bank</div> <div> • Agriculture Bank</div> <div> • SME Banks</div> <div> • Non-Banking Financial Institutions</div> <div> • Investment Companies</div> <div> • Brokerage Houses</div> <div> • Leasing Companies</div> <div> • Insurance Companies</div> <div> • Mutual Fund</div> <div> • Financial Institution & Their Functions</div> <div> 3) CENTRAL BANK</div> <div> • Activities & Responsibilities</div> <div> • Monetary Policy</div> <div> • Central or National “Bankers Bank”</div> <div> • Interest Rate Intervention</div> <div> • Limits of Enforcement Power</div> <div> 4) Central Bank</div> <div> • Policy Instruments</div> <div> • Interest rate Intervention</div> <div> • Limits of Enforcement Power</div> <div> • Interest Rates</div> <div> • Open Market Operations</div> <div> • Repo Market known as repurchase operations</div> <div> • Direct Operations</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 67</div> <div> • Buying or selling securities ("Direct Operations")</div> <div> • Foreign exchange operations such as forex swaps.</div> <div> • Capital Requirements</div> <div> • Reserve requirements</div> <div> • Exchange Requirements</div> <div> 5) Balance of Trade</div> <div> • Balance of Trade</div> <div> • Balance of Payments</div> <div> • Factors that can affect BOT</div> <div> o Exchange rates</div> <div> o Trade agreements or barriers</div> <div> o Other tax, tariff and trade measures</div> <div> o Business cycle at home or abroad.</div> <div> • Current Account Surplus & Deficit</div> <div> • Capital or Financial Account Surplus & Deficit</div> <div> • Balance of Payments Equilibrium</div> <div> • Challenges of a Central Bank</div> <div> o Economic Growth</div> <div> o Poverty Reduction</div> <div> o Inflation</div> <div> o Stability in Forex Rate</div> <div> • Independence of Central Banks</div> <div> 6 to 11) State Bank of Pakistan</div> <div> • History</div> <div> • Functions</div> <div> • Primary Function</div> <div> • Secondary Function</div> <div> • Non-Promotional Function</div> <div> • Regulation of Liquidity</div> <div> • Banking Assets & Liabilities</div> <div> Various Departments of SBP</div> <div> • Agricultural Credit</div> <div> • Audit</div> <div> • Banking Inspection</div> <div> • Banking Policy</div> <div> • Banking Supervision</div> <div> • Corporate Services</div> <div> • Economic Policy</div> <div> • Exchange and Debt Management</div> <div> • Exchange Policy</div> <div> • Human Resource</div> <div> • Information System</div> <div> • Islamic Banking</div> <div> • Legal Services</div> <div> • Payment System</div> <div> • Research</div> <div> • Statistics</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 68</div> <div> • Real Time Gross Settlement System (RTGS System)</div> <div> • Small and Medium Enterprises</div> <div> 11 & 12) Macro Economic Performance of a Country</div> <div> • National Income</div> <div> • Concepts of National Income</div> <div> • Difference b/w GDP & GNP</div> <div> • Regulating risk and the importance of risk management</div> <div> • Basel 2 Type Rules for Insurers</div> <div> • Global Financial System</div> <div> • International Financial Institutions</div> <div> • International Monetary Fund</div> <div> • The World Bank</div> <div> • World Trade Organization</div> <div> • Role of WTO in Pakistan Trade Environment</div> <div> • Asian Development Bank</div> <div> • ADB Projects in Pakistan</div> <div> • Paris Club</div> <div> 13) Pakistan Economic Aid & Debt</div> <div> • The major causes of poverty in Pakistan</div> <div> • Key challenges facing the Government of Pakistan</div> <div> • Future Prospects for Pakistan's Economy</div> <div> • Macroeconomic Stability</div> <div> • Strengthening Institutions</div> <div> 14) Increasing Foreign Direct Investment</div> <div> • Foreign Interest in Local Financial Markets</div> <div> • Enhancing and Sustaining a Growing GDP</div> <div> • How can Pakistan improve and sustain its growth rate?</div> <div> 1. Industrial Sector</div> <div> 2. Inter-provincial harmony in Pakistan</div> <div> 3. Achieving a Favorable Balance of Trade</div> <div> 4. Managing the Debt</div> <div> 5. Economic Resilience</div> <div> 15 to 19) Role of Commercial Banks</div> <div> • Purpose of a bank</div> <div> • Commercial Lending</div> <div> • Banking Services</div> <div> • A Bank’s Profit</div> <div> • Services Typically Offered by Banks</div> <div> • Types of banks</div> <div> • Banks in the Economy</div> <div> • Role in the money supply</div> <div> • Size of Global Banking Industry</div> <div> • Bank Crisis</div> <div> • Challenges within the Banking Industry</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 69</div> <div> 1. Economic Environment</div> <div> 2. Growth Strategies</div> <div> 3. The Management of the Banks</div> <div> • Public perceptions of banks</div> <div> • Profitability</div> <div> • SWIFT Society for Worldwide Interbank Financial Transactions</div> <div> • Commercial Banking In Pakistan</div> <div> • CAMEL</div> <div> These are:</div> <div> 1) Capital Adequacy,</div> <div> 2) Asset Quality,</div> <div> 3) Management Soundness,</div> <div> 4) Earnings and Profitability,</div> <div> 5) Liquidity and Sensitivity to Market Risk.</div> <div> • Deposit Mobilization</div> <div> • Credit extension</div> <div> • Banking spreads</div> <div> • Asset composition</div> <div> • Problem bank management</div> <div> BANKING SECTOR REFORMS in Pakistan</div> <div> 1. Privatization of Nationalized Commercial Banks</div> <div> 2. Corporate governance.</div> <div> 3. Capital Strengthening.</div> <div> 4. Improving Asset quality.</div> <div> 5. Liberalization of foreign exchange regime</div> <div> 6. Consumer Financing</div> <div> 7. Mortgage Financing</div> <div> 8. Legal Reforms</div> <div> 9. Prudential Regulations</div> <div> 10. Micro financing</div> <div> 11. SME Financing</div> <div> 12. Taxation</div> <div> 13. Agriculture Credit</div> <div> 14. E-Banking</div> <div> 15. Human Resources</div> <div> 16. Credit Rating</div> <div> 17. Supervision and Regulatory Capacity</div> <div> 18. Payment Systems</div> <div> • Commercial Banking in a Free Society</div> <div> • Private Deposit Insurance</div> <div> 20) Branch Banking in Pakistan</div> <div> • Remittances</div> <div> • Demand Draft</div> <div> • Telegraphic Transfer</div> <div> • Mail Transfer</div> <div> • Online Fund Transfer</div> <div> • Types of Account</div> <div> 1. Individual</div> <div> 2. Joint Account</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 70</div> <div> 3. Sole Proprietorship</div> <div> 4. Club & Societies</div> <div> 5. Joint Stock Companies</div> <div> 6. Agents</div> <div> • Operations & Status of Accounts Nature of Accounts</div> <div> 1. Current Account</div> <div> 2. Profit & Loss Sharing</div> <div> 3. Current foreign currency</div> <div> 4. Saving Foreign Currency</div> <div> 5. Term Deposits</div> <div> 6. BBA “Basic Banking Account”</div> <div> • Commercial Banks Loan Facilities:</div> <div> 1. Types of Loan</div> <div> 2. Personal finance</div> <div> 3. Mortgage Finance</div> <div> 4. Business Finance</div> <div> 21) Role of Commercial Banks in Micro Finance Sector</div> <div> 22 to 26 ) Mutual Funds</div> <div> • History</div> <div> • Usage</div> <div> • Net asset value</div> <div> • Turnovers</div> <div> • Expenses and TER'S</div> <div> 1. Management Fees</div> <div> 2. Non-management Expenses</div> <div> 3. Service Fees</div> <div> 4. Fees and Expenses Borne by the Investor (not the Fund)</div> <div> 5. Brokerage Commissions</div> <div> • Types of mutual funds</div> <div> 1. Open-end fund</div> <div> 2. Exchange-traded funds</div> <div> 3. Equity funds</div> <div> i. Capitalization</div> <div> ii. Growth vs. value</div> <div> iii. Index funds versus active management</div> <div> 4. Bond funds</div> <div> 5. Money market funds</div> <div> 6. Funds of funds</div> <div> 7. Hedge funds</div> <div> • Mutual funds vs. other investments</div> <div> 1. Share classes</div> <div> 2. Load and expenses</div> <div> • Criticism of managed mutual funds</div> <div> 28) Investment Banking</div> <div> • Organizational structure of an investment bank</div> <div> • The main activities and units of Investment Banks</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 71</div> <div> • Size of industry</div> <div> • Recent evolution of the business</div> <div> • New products</div> <div> • Possible conflicts of interest</div> <div> • Types of Investment banks</div> <div> 29 & 30) Letter of Credit & International Trade</div> <div> • Terminology</div> <div> • How it works</div> <div> • Legal principles governing documentary credits</div> <div> • The price of LCs</div> <div> • Legal Basis for Letters of Credit</div> <div> • Risks in International Trade</div> <div> 31 & 32) Foreign Exchange & Role of Financial Institutions</div> <div> • Market size and liquidity</div> <div> • Market participants</div> <div> 1. Banks</div> <div> 2. Commercial companies</div> <div> 3. Central banks</div> <div> 4. Investment management firms</div> <div> 5. Hedge funds</div> <div> 6. Retail forex brokers</div> <div> • Trading characteristics</div> <div> • Factors affecting currency trading</div> <div> 7. Economic factors</div> <div> 8. Political conditions</div> <div> 9. Market psychology</div> <div> • Algorithmic trading in forex</div> <div> • Financial instruments</div> <div> 10. Spot</div> <div> 11. Forward</div> <div> 12. Future</div> <div> 13. Swap</div> <div> 14. Option</div> <div> 15. Exchange Traded Fund</div> <div> • Speculation</div> <div> 33 & 34) Leasing Companies</div> <div> • Conceptual background</div> <div> • Leasing of real property</div> <div> • Leasing of tangible personal property</div> <div> • Real leases</div> <div> • Private property rental</div> <div> • Commercial leasehold</div> <div> 1. Advantages of commercial leasing</div> <div> 2. Disadvantages of commercial leasing</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 72</div> <div> • The Leasing Sector in Pakistan and its Role in Capital Investment</div> <div> 35 & 36) Insurance Companies</div> <div> • Principles of insurance</div> <div> • Indemnification</div> <div> • When is a policy really insurance?</div> <div> 1. Does the contract contain adequate risk transfer?</div> <div> 2. Is there a bright line test?</div> <div> 3. "Safe harbor" exemptions</div> <div> 4. Risk limiting features</div> <div> • Insurer’s business model</div> <div> • Gambling analogy</div> <div> • History of insurance</div> <div> • Types of insurance</div> <div> • Types of insurance companies</div> <div> • Life insurance and saving</div> <div> • Size of global insurance industry</div> <div> • Financial viability of insurance companies</div> <div> • Controversies</div> <div> 1. Insurance insulates too much</div> <div> 2. Closed community self-insurance</div> <div> 3. Complexity of insurance policy contracts</div> <div> 4. Redlining</div> <div> 5. Health insurance</div> <div> 6. Dental insurance</div> <div> 7. Insurance patents</div> <div> 8. The insurance industry and rent seeking</div> <div> 9. Criticism of insurance companies</div> <div> 37) Role of Financial Institutions in Agriculture Sector</div> <div> 39) SME sector & Financial Institutions</div> <div> • SME Policy in Pakistan</div> <div> • Government of Pakistan & its Role</div> <div> 40) Financial Crimes</div> <div> • Money Laundering</div> <div> • Modern development</div> <div> • Process</div> <div> • Irregular funding</div> <div> • Captive business</div> <div> • Legal considerations</div> <div> • Fighting money laundering</div> <div> • Using information technology</div> <div> • September 11, 2001 and the international response to the underground economy</div> <div> 41) Financial Institutions & Risk Management</div> <div> Management of Financial Institutions - BNK 604 VU</div> <div> © Copyright Virtual University of Pakistan 1 73</div> <div> 42) Banking Crimes</div> <div> 43) Collapse of Enron</div> <div> 44) Misleading in Baring Bank, Black Wednesday, Soloman Brothers and Treasury</div> <div> Fraud.</div> <div> 45) Recap</div> </div> <div> <br /></div> <div> <b><span style="font-size: large;"><a href="http://www.genrica.com/vustuff/BNK604/BNK604_handouts_1_45.pdf" target="_blank">Management of Financial Institutions (original code MGT604 BNK604 book HANDOUTS in pdf</a></span></b></div> <div> <br /></div>

Management of Financial Institutions (original code MGT604 BNK604 book HANDOUTS in pdf

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