A Thesis Presented

ByABC

Reg. No.

To

The Committee on Academic DegreesIn partial fulfillment of the requirements

For a degree with honors of M.Com

Business School,The University of Lahore

June 2010

1

The Thesis committee for Adeel Javed certifies that this is the approved version of the following thesis:

(The effects of Basel I and Basel II on the risk taking behavior of banks)

APPROVED BYSUPERVISING COMMITTEE

Supervisor: __________________________(Usman Saeed)

Supervisor: __________________________( )

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This task is dedicated to my beloved parents and family members

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ACKNOWLEDGEMENT

Every praise is due to Allah alone the merciful and Peace Be upon Him his

Prophet who is, for ever, a torch of guidance and knowledge of humanity as whole.

I am also thankful to my respectful supervisor Mr. Usman Saeed as without his support

and valuable guidance this dissertation could not have been completed.

I have also deep feelings for whole of my family, in general, and for my mother and

father. They have always soothed me, elevated me and their words and du’a has floated

me in the deep seas of troubles. All of my successes are due to my family.

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ABSTRACT

An agreement on international banking regulations dealing with how banks handle risk,

the Basel Accord focuses mainly on credit risk; it divides banks' assets into five

categories according to how risky they are. The five categories are assets with no risk,

10% risk, 20%, 50% and 100%. All banks conducting international transactions are

required under the Basel Accord to hold assets with no more than 8% aggregated risk.

The Accord was promulgated in 1988. Banks in most G-10 countries have implemented it

since the early 1990s. It is now considered largely outdated and is in the process of being

replaced by Basel II. It is also called Basel I. The Basel I Capital Accord aimed to assess

capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill

its obligations. It launched the trend toward increasing risk modeling research; however,

its over-simplified calculations, and classifications have simultaneously called for its

disappearance, paving the way for the Basel II Capital Accord and further agreements as

the symbol of the continuous refinement of risk and capital. Nevertheless, Basel I, as the

first international instrument assessing the importance of risk in relation to capital, will

remain a milestone in the finance and banking history.

This study is mainly related to the risk management practices being followed by the

commercial Banks in Pakistan. The questionnaire is used as a main tool to collect

primary data and check the extent to which the risk management practices are being

carried upon by the commercial banks in Pakistan. The six important aspects of risk

management process are categorized as one dependent and five explanatory variables.

This study aims to investigate the awareness about risk management practices within the

banking sector of Pakistan. This study is comprised of data collected through both,

primary as well as secondary sources. The purpose of using primary source data is to

check the extent to which different risk management practices have been followed by the

commercial banks in Pakistan. Primary data is collected through the use of a

questionnaire. The questionnaire comprises a number of statements under one macro

statement. It includes Risk Management Practices (RMP) as the dependent variable, and

different aspects of risk management as the independent or explanatory variables.

Whereas, the objective to use secondary data is to link the risk weighted Capital

Adequacy Ratio to the different financial indicators of the commercial banks that are

used to measure their soundness.

5

TABLE OF CONTENTS

CHAPTER 1

INTRODUCTION

BACKGROUND OF THE STUDY

Basel Accord

BASEL 1

Definition

BASEL 2

Basel Agreement

About the Basel Committee

The Basel Consultative Group (BCG)

Coordination with other standard setters

IMF publishes study debunking Basel principles

Basel Committee told to address gaps in reform

Does The Basel Accord Strengthen Banks?

The Purpose of Basel I

Two-Tiered Capital

Pitfalls of Basel I

PROBLEM STATEMENT

AIMS AND OBJECTIVE OF THE STUDY

RESEARCH QUESTION / HYPOTHESIS

ASSUMPTIONS AND LIMITATIONS

CHAPTER 2

LITERATURE REVIEW

CHAPTER 3

RESEARCH METHODOLOGY

RESEARCH DESIGN

SAMPLE SELECTION METHOD

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Sample of the study

Variables

Dependent Variable:

Independent or Explanatory Variables:

Financial Soundness Indicators

ETHICAL CONSIDERATIONS

TIME SCHEDULE

ANALYSIS, RESULTS AND PRESENTATION

SUMMARY, CONCLUSION AND RECOMMENDATIONS

CHAPTER 4

ANALYSIS AND RESULTS

Risk Management practices followed by the Commercial Banks in Pakistan

Method of Data Analysis used for analysis

Data Analysis

Multiple-Regression Model:

Linear Regression Model:

Analysis of Variance:

CHAPTER 5

SUMMARY, CONCLUSION AND RECOMMENDATIONS

SUMMARY

CONCLUSION

RECOMMENDATIONS

REFERENCES

7

THE EFFECTS OF BASEL 1 AND BASEL 2 ON THE RISK TAKING BEHAVIOR OF BANKS

CHAPTER 1INTRODUCTION

BACKGROUND OF THE STUDY

Basel Accord

An agreement on international banking regulations dealing with how banks handle risk,

the Basel Accord focuses mainly on credit risk; it divides banks' assets into five

categories according to how risky they are. The five categories are assets with no risk,

10% risk, 20%, 50% and 100%. All banks conducting international transactions are

required under the Basel Accord to hold assets with no more than 8% aggregated risk.

The Accord was promulgated in 1988. Banks in most G-10 countries have implemented it

since the early 1990s. It is now considered largely outdated and is in the process of being

replaced by Basel II. It is also called Basel I (http://financial-

dictionary.thefreedictionary.com).

BASEL 1

Definition

A document written in 1988 by the Basel Committee on Banking Supervision, which

recommends certain standards and regulations for banks. The main recommendation of

this document is that in order to lower credit risk, banks should hold enough capital to

equal at least 8% of its risk-weighted assets. Most countries have implemented some

version of this regulation (www.investorwords.com).

BASEL 2

A document written in 2004 by the Basel Committee on Banking Supervision, which

makes more detailed recommendations for banks, building on its previous document,

Basel I. Basel II includes recommendations on three main areas: risks, supervisory

review, and market discipline. Many countries and banks are planning on implementing

8

the guidelines set out in Basel II, although it may take as long as the year 2015 for full

implementation (www.investorwords.com).

Basel II is an international business standard that requires financial institutions to

maintain enough cash reserves to cover risks incurred by operations. The Basel accords

are a series of recommendations on banking laws and regulations issued by the Basel

Committee on Banking Supervision (BSBS). The name for the accords is derived from

Basel, Switzerland, where the committee that maintains the accords meets. Basel II

improved on Basel I, first enacted in the 1980s, by offering more complex models for

calculating regulatory capital. Essentially, the accord mandates that banks holding riskier

assets should be required to have more capital on hand than those maintaining safer

portfolios. Basel II also requires companies to publish both the details of risky

investments and risk management practices. The full title of the accord is Basel II: The

International Convergence of Capital Measurement and Capital Standards - A Revised

Framework (http://searchsecurity.techtarget.co.uk).

The three essential requirements of Basel II are:

1. Mandating that capital allocations by institutional managers are more risk

sensitive.

2. Separating credit risks from operational risks and quantifying both.

3. Reducing the scope or possibility of regulatory arbitrage by attempting to align

the real or economic risk precisely with regulatory assessment.

Basel II has resulted in the evolution of a number of strategies to allow banks to make

risky investments, such as the sub prime mortgage market. Higher risks assets are moved

to unregulated parts of holding companies. Alternatively, the risk can be transferred

directly to investors by securitization, the process of taking a non-liquid asset or groups

of assets and transforming them into a security that can be traded on open markets

(http://searchsecurity.techtarget.co.uk).

Basel Agreement

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An accord developed during a 1975 meeting in Basel, Switzerland of central bankers of

the industrialized nations setting forth guidelines for the supervision of banks. Included

are guidelines for minimum capital requirements. The agreement was reached by the

Committee on Banking Regulations and Supervisory Practices (also known as the Cooke

Committee after its chairman, Peter Cooke), meeting under the auspices of The Bank for

International Settlements (www.teachmefinance.com).

About the Basel Committee

The Basel Committee on Banking Supervision provides a forum for regular cooperation

on banking supervisory matters. Its objective is to enhance understanding of key

supervisory issues and improve the quality of banking supervision worldwide. It seeks to

do so by exchanging information on national supervisory issues, approaches and

techniques, with a view to promoting common understanding. At times, the Committee

uses this common understanding to develop guidelines and supervisory standards in areas

where they are considered desirable. In this regard, the Committee is best known for its

international standards on capital adequacy; the Core Principles for Effective Banking

Supervision; and the Concordat on cross-border banking supervision. The Committee's

members come from Argentina, Australia, Belgium, Brazil, Canada, China, France,

Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico,

the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden,

Switzerland, Turkey, the United Kingdom and the United States. The present Chairman

of the Committee is Mr Nout Wellink, President of the Netherlands Bank (www.bis.org).

The Committee encourages contacts and cooperation among its members and other

banking supervisory authorities. It circulates to supervisors throughout the world both

published and unpublished papers providing guidance on banking supervisory matters.

Contacts have been further strengthened by an International Conference of Banking

Supervisors (ICBS) which takes place every two years. The Committee's Secretariat is

located at the Bank for International Settlements in Basel, Switzerland, and is staffed

mainly by professional supervisors on temporary secondment from member institutions.

In addition to undertaking the secretarial work for the Committee and its many expert

10

sub-committees, it stands ready to give advice to supervisory authorities in all countries.

Mr Stefan Walter is the Secretary General of the Basel Committee. The Standards

Implementation Group (SIG) was originally established to share information and

promote consistency in implementation of the Basel II Framework. In January 2009, its

mandate was broadened to concentrate on implementation of Basel Committee guidance

and standards more generally. It is chaired by Mr José María Roldán, Director General of

Banking Regulation at the Bank of Spain (www.bis.org).

Currently the SIG has two subgroups that share information and discuss specific issues

related to Basel II implementation. The Validation Subgroup explores issues related to

the validation of systems used to generate the ratings and parameters that serve as inputs

into the internal ratings-based approaches to credit risk. The group is chaired by Mr Alvir

Alberto Hoffmann, Deputy Governor at the Central Bank of Brazil.

The Operational Risk Subgroup addresses issues related primarily to banks'

implementation of advanced measurement approaches for operational risk. Mr Kevin

Bailey, Deputy Comptroller, Office of the Comptroller of the Currency, United States,

chairs the group.

The primary objective of the Policy Development Group (PDG) is to support the

Committee by identifying and reviewing emerging supervisory issues and, where

appropriate, proposing and developing policies that promote a sound banking system and

high supervisory standards. The group is chaired by Mr Stefan Walter, Secretary General

of the Basel Committee.

Seven working groups report to the PDG: the Risk Management and Modelling Group

(RMMG), the Research Task Force (RTF), the Working Group on Liquidity, the

Definition of Capital Subgroup, a Basel II Capital Monitoring Group, the Trading Book

Group (TBG) and the Cross-border Bank Resolution Group.

The Risk Management and Modelling Group serves as the Committee's point of contact

with the industry on the latest advances in risk measurement and management, and is

chaired by Mr Mark White, Assistant Superintendent at the Office of the Superintendent

of Financial Institutions. It focuses on assessing the range of industry risk management

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practices and the development of supervisory guidance to promote enhanced risk

management practices.

The Research Task Force serves as a forum for research economists from member

institutions to exchange information and engage in research projects on supervisory and

financial stability issues. It also acts as a mechanism for facilitating communication

between economists at member institutions and in the academic sector. It is chaired by

Mr Peter Praet, Executive Director at the National Bank of Belgium and member of the

Management Committee of the Banking, Finance and Insurance Commission, Belgium.

The Trading Book Group addresses issues relating to the application of Basel II to certain

exposures arising from trading activities. A current focus of this group is the appropriate

capital treatment of event risk in the trading book. It is co-chaired by Ms Norah Barger,

Associate Director, Board of Governors of the Federal Reserve System, United States,

and Mr Alan Adkins, Manager, Financial Services Authority, United Kingdom.

The Working Group on Liquidity serves as a forum for information exchange on national

approaches to liquidity risk regulation and supervision. In September 2008, the Working

Group issued Principles for Sound Liquidity Risk Management and Supervision, the

global standards for liquidity risk management and supervision. The Working Group is

also examining the scope for additional steps to promote more robust and internationally

consistent liquidity approaches for cross-border banks. The group is co-chaired by Mr

Thomas Wiedmer, Deputy Head at the Swiss national Bank, and Mr Marc Saidenberg,

Senior Vice President in the Banking Supervision Group of the Federal Reserve Bank of

New York, United States (www.bis.org).

The Financial Instruments Practices Subgroup assesses implementation of international

accounting standards related to financial instruments, and the links between accounting

practices in this area and prudential supervision. The Subgroup is chaired by Mr Ian

Michael, Technical Specialist, Accounting and Auditing Policy, Financial Services

Authority, United Kingdom.

The Audit Subgroup promotes reliable financial information by exploring key audit

issues from a banking supervision perspective. It focuses on responding to international

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audit standards-setting proposals, other issuances of the International Auditing and

Assurance Standards Board and the International Ethics Standards Board for

Accountants, and audit quality issues. The Subgroup is chaired by Mr Marc Pickeur,

Advisor for Supervisory Policy at the Banking, Finance and Insurance Commission,

Belgium.

The Basel Consultative Group (BCG) provides a forum for deepening the Committee's

engagement with supervisors around the world on banking supervisory issues. It

facilitates broad supervisory dialogue with non-member countries on new Committee

initiatives early in the process by gathering senior representatives from various countries,

international institutions and regional groups of banking supervisors that are not members

of the Committee. The BCG is chaired by Mr Karl Cordewener, Deputy Secretary

General of the Basel Committee.

Coordination with other standard setters

Formal channels for coordinating with supervisors of non-bank financial institutions

include the Joint Forum, for which the Basel Committee Secretariat provides the

secretariat function, and the Coordination Group. The Joint Forum was established in

1996 to address issues common to the banking, securities and insurance sectors, including

the regulation of financial conglomerates. The Coordination Group is a senior group of

supervisory standard setters comprising the Chairmen and Secretaries General of the

Committee, the International Organization of Securities Commissions (IOSCO) and the

International Association of Insurance Supervisors (IAIS), as well as the Joint Forum

Chairman and Secretariat. The Coordination Group meets twice annually to exchange

views on the priorities and key issues of interest to supervisory standard setters. The

position of chairman and the secretariat function for the Coordination Group rotate

among the member representatives of the three standard setters every two years

(www.bis.org).

IMF publishes study debunking Basel principles

The recent financial crisis has sparked widespread calls for reforms of regulation and

13

supervision. The initial reaction to the crisis was one of disbelief: how could such

extensive financial distress emerge in countries where the supervision of financial risk

had been thought to be the best in the world? Indeed, the regulatory standards and

protocols of the advanced countries at the center of the financial storm were being

emulated worldwide through the progressive adoption of the international Basel capital

standards and the Basel Core Principles for Effective Bank Supervision (BCPs). The

crisis exposed significant weaknesses in the financial system regulatory and supervisory

framework worldwide, and has spawned a growing debate about the role these

weaknesses may have played in causing and propagating the crisis. As a result, reform of

regulation and supervision is a top priority for policymakers, and many countries are

working to upgrade their frameworks. But what should the reforms focus on? What

constitutes good regulation and supervision? Which elements are most important for

ensuring bank soundness? What should be the scope of regulation?

To date, the best practices in supervision and regulation have been embodied by the

BCPs. These principles were issued in 1997 by the Basel Committee on Bank

Supervision, comprising representatives from bank supervisory agencies from advanced

countries. Since then, most countries in the world have stated their intent to adopt and

comply with the BCPs, making them a global standard for bank regulators. Importantly,

since 1999, the IMF and the World Bank have conducted evaluations of countries’

compliance with these principles, mainly within their joint Financial Sector Assessment

program (FSAP). The assessments are conducted according to a standardized

methodology developed by the Basel Committee and therefore provide a unique source of

information about the quality of supervision and regulation around the world. Hence the

international community has made significant investments in developing these principles,

encouraging their wide-spread adoption, and assessing progress with their compliance

(Asli Demirgüç-Kunt and Enrica Detragiache, 2010).

In light of the recent crisis and the resulting skepticism about the effectiveness of existing

approaches to regulation and supervision, it is natural to ask if compliance with the global

standard of good regulation is associated with bank soundness. This is the subject of this

paper. Specifically, we test whether better compliance with BCPs is associated with safer

banks. We also look at whether compliance with different elements of the BCP

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framework is more closely associated with bank soundness to identify if there are specific

areas which would help prioritize reform efforts to improve supervision...

...All in all, we do not find support for the hypothesis that better compliance with BCPs

results in sounder banks as measured by Z-scores. This result holds after controlling for

the macroeconomic environment, institutional quality, and bank characteristics. We also

fail to find a significant relationship when we consider different samples, such a sample

of rated banks only, a sample including only commercial banks, and samples including

only the largest financial institutions. In an additional test, we calculate aggregate Z-

scores at the country level to try to capture the stability of the system as a while rather

than that of individual banks, but also this measure of soundness is not significantly

related to overall BCP compliance (Asli Demirgüç-Kunt and Enrica Detragiache, 2010).

Basel Committee told to address gaps in reform

"The Basel Committee on Banking Supervision must make further progress on several

areas not fully tackled in its two major consultative documents published on December

17, the Committee's oversight board of central bank governors and heads of supervision

said this weekend. Meeting in Basel on January 10 to review the proposals, the board

highlighted several areas requiring further work. First, it asked that the Committee

produce a practical proposal for a provisioning approach based on expected credit losses

rather than incurred losses by March 2010. Although guiding principles have already

been issued to help accounting standard setters and regulators reach a common approach

in the replacement of International Accounting Standard (IAS) 39, the oversight board is

pushing for something more concrete. This could put regulators on a collision course with

the International Accounting Standards Board (IASB), which published proposals for

consultation on November 5 to replace the incurred loss model with an expected loss

model as part of the overhaul of IAS 39. But the IASB proposals require future losses to

be estimated using volatile point-in-time measures rather than the more counter-cyclical

through-the-cycle estimates the Basel Committee's oversight board is pushing (Riski.net,

2010).

Regulators hope the introduction of a through-the-cycle approach to provisioning would

15

address some of the widespread concerns over pro-cyclicality in the Basel II framework,

but the oversight board also renews calls for a framework of counter-cyclical capital

buffers – something the December package addressed from a high level but failed to

explain in detail. Committee members have attributed the lack of progress to a split

between central banks and supervisors over how the buffers would be structured.

Second, the board calls on the Basel Committee to tackle the risk posed by systemically

important banks – something that was on its agenda last year but was not addressed in

any detail in the consultation documents. The Committee has now created a new Macro-

prudential Group with a mandate to evaluate a range of options including capital and

liquidity surcharges, resolution mechanisms and structural adjustments.

Third, the board stresses the need for the Committee to review the role of contingent

capital and convertible capital instruments in the regulatory capital framework and to use

the quantitative impact study to review the details of its proposed minimum liquidity

standards.

The board also repeated its call for the Committee to deliver a final, fully calibrated

reform package by the end of 2010 with the aim of implementation by the end of 2012.

To make that possible, it stressed the importance of the current period of industry

consultation and quantitative testing that aims to capture the impact of the proposals on

the banking sector and the broader economy.

"The group of central bank governors and heads of supervision will provide strong

oversight of the work of the Basel Committee during this phase, including both the

completion and calibration of the reforms," said Jean-Claude Trichet, president of the

European Central Bank and chair of the oversight board.

It was a busy weekend in Basel, with two other high-profile meetings taking place at the

same time: a plenary meeting of the Financial Stability Board (FSB) and a Bank for

International Settlements (BIS) board meeting.

The FSB said it is reviewing the implementation of its September 2009 principles for

sound compensation practices in FSB member countries and will report back to the

Group of 20 (G-20) leaders in March. It also said it is pushing forward with proposals to

address the problems associated with systemically important financial institutions and

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will present preliminary policy options at the G-20 summit in June. In contrast to the FSB

and Basel oversight board meetings, the BIS board meeting took place behind firmly

closed doors, with press reports last week claiming it was a crisis meeting to which top

banking chiefs had been summoned to discuss a worrying rise in risk-taking (Riski.net,

2010). The BIS played down the reports. "The board meeting weekend always entails a

lot of different closed meetings of central bankers and different financial organisations.

This is a regular January board meeting at which commercial bankers come together with

central bankers and it's nothing new. We never issue an agenda or list of participants for

security reasons".

Does The Basel Accord Strengthen Banks?

From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United

States. Bank failures were particularly prominent during the '80s, a time which is usually

referred to as the "savings and loan crisis". Banks throughout the world were lending

extensively, while countries' external indebtedness was growing at an unsustainable rate.

As a result, the potential for the bankruptcy of the major international banks because

grew as a result of low security. In order to prevent this risk, the Basel Committee on

Banking Supervision, comprised of central banks and supervisory authorities of 10

countries, met in 1987 in Basel, Switzerland. The committee drafted a first document to

set up an international 'minimum' amount of capital that banks should hold. This

minimum is a percentage of the total capital of a bank, which is also called the minimum

risk-based capital adequacy. In 1988, the Basel I Capital Accord (agreement) was

created. The Basel II Capital Accord follows as an extension of the former, and should be

implemented in 2007. In this article, we'll take a look at Basel I and how it impacted the

banking industry as it enters the Basel II phase (www.investopedia.com).

The Purpose of Basel I

In 1988, the Basel I Capital Accord was created. The general purpose was to:

1. Strengthen the stability of international banking system.

2. Set up a fair and a consistent international banking system in order to decrease

17

competitive inequality among international banks.

The basic achievement of Basel I have been to define bank capital and the so-called bank

capital ratio. In order to set up a minimum risk-based capital adequacy applying to all

banks and governments in the world, a general definition of capital was required. Indeed,

before this international agreement, there was no single definition of bank capital. The

first step of the agreement was thus to define it.

Two-Tiered Capital

Basil I define capital based on two tiers:

1. Tier 1 (Core Capital): Tier 1 capital includes stock issues (or share holder’s

equity) and declared reserves, such as loan loss reserves set aside to cushion

future losses or for smoothing out income variations.

2. Tier 2 (Supplementary Capital): Tier 2 capital includes all other capital such as

gains on investment assets, long-term debt with maturity greater than five years

and hidden reserves (i.e. excess allowance for losses on loans and leases).

However, short-term unsecured debts (or debts without guarantees), are not

included in the definition of capital. Total capital is defined in the formula below:

The second step in Basel I was to define capital ratio as shown in the formula below:

Credit Risk is defined as the risk weighted asset (RWA) of the bank, which are banks

assets weighted in relation to their relative credit risk levels. According to Basel I, the

total capital should represent at least 8% of the bank's credit risk (RWA). In addition, the

Basel agreement identifies three types of credit risks:

The on-balance sheet risk.

The trading off-balance sheet risk. These are derivatives, namely interest rates,

foreign exchange, equity derivatives and commodities.

The non-trading off-balance sheet risk. These include general guarantees, such as

forward purchase of assets or transaction-related debt assets.

Let's take a look at some calculations related to RWA and capital requirement. Figure 1

displays predefined category of on-balance sheet exposures, such as vulnerability to loss

18

from an unexpected event, weighted according to four relative risk categories

(www.investopedia.com).

Figure 1: Basel's Classification of risk weights of on-balance sheet assets

As shown in Figure 2, there is an unsecured loan of $1,000 to a non-bank, which requires

a risk weight of 100%. The RWA is therefore calculated as RWA=$1,000 ×

100%=$1,000. By using Formula 2, a minimum 8% capital requirement gives 8% ×

RWA=8% ×$1,000=$80. In other words, the total capital holding of the firm must be $80

related to the unsecured loan of $1,000. Calculation under different risk weights for

different types of assets are also presented in Table 2.

Figure 2: Calculation of RWA and capital requirement on-balance sheet assets

In 1996 the Basel I agreement was revised to incorporate market risk. As a result, the new

definition of capital ratio is defined as:

Market risk includes general market risk and specific risk. The general market risk refers

to changes in the market values due to large market movements. Specific risk refers to

changes in the value of an individual asset due to factors related to the issuer of the

19

security. There are four types of economic variables that generate market risk. These are

interest rates, foreign exchanges, equities and commodities. The market risk can be

calculated in two different manners: either with the standardized Basel model or with

internal value at risk (VaR) models of the banks. These internal models can only be used

by the largest banks that satisfy qualitative and quantitative standards imposed by the

Basel agreement. Moreover, the 1996 revision also adds the possibility of a third tier for

the total capital, which includes short-term unsecured debts. This is at the discretion of

the central banks.

Pitfalls of Basel I

Basel I Capital Accord has been criticized on several grounds. The main criticisms

include the following:

Limited differentiation of credit risk: There are four broad risk weightings (0%,

20%, 50% and 100%), as shown in Figure1, based on an 8% minimum capital

ratio.

Static measure of default risk: The assumption that a minimum 8% capital ratio is

sufficient to protect banks from failure does not take into account the changing

nature of default risk.

No recognition of term-structure of credit risk: The capital charges are set at the

same level regardless of the maturity of a credit exposure.

Simplified calculation of potential future counterparty risk: The current capital

requirements ignore the different level of risks associated with different

currencies and macro economic risk. In other words, it assumes a common market

to all actors, which is not true in reality.

Lack of recognition of portfolio diversification effects: In reality, the sum of

individual risk exposures is not the same as the risk reduction through portfolio

diversification. Therefore, summing all risks might provide incorrect judgment of

risk. A remedy would be to create an internal credit risk model - for example, one

similar to the model as developed by the bank to calculate market risk. This

remark is also valid for all other weaknesses.

20

These listed criticisms have led to the creation of a new Basel Capital Accord, known as

Basel II, which adds operational risk and also defines new calculations of credit risk.

Operational risk is the risk of loss arising from human error or management failure. Basel

II Capital Accord will be implemented from 2007 on (www.investopedia.com).

The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk

that a loss will occur if a party does not fulfill its obligations. It launched the trend toward

increasing risk modeling research; however, its over-simplified calculations, and

classifications have simultaneously called for its disappearance, paving the way for the

Basel II Capital Accord and further agreements as the symbol of the continuous

refinement of risk and capital. Nevertheless, Basel I, as the first international instrument

assessing the importance of risk in relation to capital, will remain a milestone in the

finance and banking history.

PROBLEM STATEMENT

This study is mainly related to the risk management practices being followed by the

commercial Banks in Pakistan. The questionnaire is used as a main tool to collect

primary data and check the extent to which the risk management practices are being

carried upon by the commercial banks in Pakistan. The six important aspects of risk

management process are categorized as one dependent and five explanatory variables.

AIMS AND OBJECTIVE OF THE STUDY

The main objectives of the study are as follows:

Understanding risk and risk management.

To study the risk identification

To study the risk assessment and analysis

To study the risk monitoring

To study the credit risk analysis

RESEARCH QUESTION / HYPOTHESIS

21

Based on the research questions and problem of the study, a set of hypotheses are

developed and tested to show the degree of relationships between risk management

practices and each of the five aspects of risk management process. Each of the alternative

hypotheses formulated is stated below:

H1 There is a positive relationship between risk management practices and

understanding risk and risk management, risk identification, risk assessment and

analysis, risk monitoring and credit risk analysis.

H2 There are significant differences between Pakistan’s public sector and private

local banks in the use of understanding risk and risk management, risk

identification, risk assessment and analysis, risk monitoring and controlling, risk

management practices and credit risk analysis.

Based on the secondary data, the following alternative hypothesis is formulated to

check the difference between the values of all the financial soundness indicators

among the three separate groups of commercial banks in Pakistan.

H3 There is significant difference between the financial soundness indicator’s values

between Pakistan’s public sector, local private and foreign banks for all of the

nine years ranging from 2000-2008.

ASSUMPTIONS AND LIMITATIONS

Islamic Banks were not included in the sample since their structure and type of operations

are quite different from those of Conventional Banks; so they were not included in the

study. Since Islamic Banks form a growing segment in Pak Banking and are here to stay,

the conventional banks need to cooperate with them and study their specific types of risk

and risk management to improve theirs. Other studies are needed for specific type of risk

and method of management at the Islamic Banks in Pakistan according to Islamic

Shari’ah.

22

CHAPTER 2

LITERATURE REVIEW

Risk management practices by the Commercial Banks

Within the last few years, a number of studies have provided the discipline into the

practice of risk management within the corporate and banking sector. An insight of

related studies is as follows:

Amran, et al. (2009), explored the availability of risk disclosures in the annual reports of

Malaysian companies. The study was aimed to empirically test the characteristics of the

sampled companies. The level of risk faced by these companies with the disclosure made

was also assessed and compared. The findings of the research revealed that the strategic

risk came on the top, followed by the operations and empowerment risks being disclosed

by the selected companies. The regression analysis proved significantly that size of the

companies did matter. The stakeholder theory explains well this finding by stating that

“As company grows bigger, it will have a large pool of stakeholders, who would be

interested in knowing the affairs of the company.” The extent of risk disclosure was also

found to be influenced by the nature of industry. As explored within this study,

infrastructure and technology industries influenced the companies to have more risk

information disclosed.

Hassan, A. (2009), made a study “Risk Management Practices of Islamic Banks of Brunei

Darussalam” to assess the degree to which the Islamic banks in Brunei Darussalam

implemented risk management practices and carried them out thoroughly by using

different techniques to deal with various kinds of risks. The results of the study showed

that, like the conventional banking system, Islamic banking was also subjected to a

variety of risks due to the unique range of offered products in addition to conventional

products. The results showed that there was a remarkable understanding of risk and risk

management by the staff working in the Islamic Banks of Brunei Darussalam, which

showed their ability to pave their way towards successful risk management. The major

23

risks that were faced by these banks were Foreign exchange risk, credit risk and operating

risk. A regression model was used to elaborate the results which showed that Risk

Identification, and Risk Assessment and Analysis were the most influencing variables

and the Islamic banks in Brunei needed to give more attention to those variables to make

their Risk Management Practices more effective by understanding the true application of

Basel-II Accord to improve the efficiency of Islamic Bank’s risk management systems.

Al-Tamimi (2008) studied the relationship among the readiness of implementing Basel II

Accord and resources needed for its implementation in UAE banks. Results of the

research revealed that the banks in UAE were aware of the benefits, impact and

challenges associated in the implementation of Basel II Accord. However, the research

did not confirm any positive relationship between UAE banks readiness for the

implementation of Basel II and impact of the implementation. The relationship between

readiness and anticipated cost of implementation was also not confirmed. No significant

difference was found in the level of Basel II Accord’s preparation between the UAE

national and foreign banks. It was concluded that there was a significant difference in the

level of the UAE banks Basel II based on employees education level. The results

supported the importance of education level needed for the implementation of Basel II

Accord.

Al-Tamimi and Al- Mazrooei (2007) provided a comparative study of Bank’s Risk

Management of UAE National and Foreign Banks. This research helped them to find that

the three most important types of risks facing the UAE commercial banks were foreign

exchange risk, followed by credit risk and then operating risk. They found that the UAE

banks were somewhat efficient in managing risk; however the variables such as risk

identification, assessment and analysis proved to be more influencing in risk management

process. Finally, the results indicated that there was a significant difference between the

UAE National and Foreign banks in practicing risk assessment and analysis, and in risk

monitoring and controlling.

24

Koziol and Lawrenz (2008) provided a study in which they assessed the risk of bank

failures. They said that assessing the risk related to bank failures is the paramount

concern of bank regulations. They argued that in order to assess the default risk of a bank,

it is important considering its financing decisions as an endogenous dynamic process.

The research study provided a continuous-time model, where banks chose the deposit

volume in order to trade off the benefits of earning deposit premiums against the costs

that would occur at future capital structure adjustments. Major findings suggested that the

dynamic endogenous financing decision introduced an important self-regulation

mechanism.

Basel Core Principles and Bank Risk: Does Compliance Matter?

The recent financial crisis has sparked widespread calls for reforms of regulation and

supervision. The initial reaction to the crisis was one of disbelief: how could such

extensive financial distress emerge in countries where the supervision of financial risk

had been thought to be the best in the world? Indeed, the regulatory standards and

protocols of the advanced countries at the center of the financial storm were being

emulated worldwide through the progressive adoption of the international Basel capital

standards and the Basel Core Principles for Effective Bank Supervision (BCPs).

The crisis exposed significant weaknesses in the financial system regulatory and

supervisory framework worldwide, and has spawned a growing debate about the role

these weaknesses may have played in causing and propagating the crisis. As a result,

reform of regulation and supervision is a top priority for policymakers, and many

countries are working to upgrade their frameworks. But what should the reforms focus

on? What constitutes good regulation and supervision? Which elements are most

important for ensuring bank soundness? What should be the scope of regulation?

To date, the best practices in supervision and regulation have been embodied by the

BCPs. These principles were issued in 1997 by the Basel Committee on Bank

Supervision, comprising representatives from bank supervisory agencies from advanced

countries. Since then, most countries in the world have stated their intent to adopt and

comply with the BCPs, making them a global standard for bank regulators. Importantly,

since 1999, the IMF and the World Bank have conducted evaluations of countries’

25

compliance with these principles, mainly within their joint Financial Sector Assessment

program (FSAP). The assessments are conducted according to a standardized

methodology developed by the Basel Committee and therefore provide a unique source of

information about the quality of supervision and regulation around the world. Hence the

international community has made significant investments in developing these principles,

encouraging their wide-spread adoption, and assessing progress with their compliance.

In light of the recent crisis and the resulting skepticism about the effectiveness of existing

approaches to regulation and supervision, it is natural to ask if compliance with the global

standard of good regulation is associated with bank soundness.

Specifically, they test whether better compliance with BCPs is associated with safer

banks. They also look at whether compliance with different elements of the BCP

framework is more closely associated with bank soundness to identify if there are specific

areas which would help prioritize reform efforts to improve supervision.

The paper extends their previous work (Demirgüç-Kunt, Detragiache and Tressel, 2008:

henceforth DDT), in which they showed that banks receive more favorable financial

strength ratings from Moody’s in countries with better compliance with BCPs related to

information provision, while compliance with other principles does not affect ratings

significantly. The policy message from this study was that countries should give priority

to strengthening regulation and regulation in the area of information provision (both to

the market and to supervisors) relative to other areas covered by the core principles.

Using rating information to proxy bank risk significantly limited the sample size in that

study, making it necessary to exclude many smaller banks and many banks from lower

income countries. Furthermore, after the recent crisis, the credibility of credit ratings as

indicators of bank risk has also diminished, questioning the merit of using these ratings in

the analysis.

In this paper, they explore whether BCP compliance affects bank soundness, but instead

of using ratings they capture bank soundness using the Z-score, which is the number of

standard deviations by which bank returns have to fall to wipe out bank equity (Boyd and

Runkle, 1993). Because they can construct Z-scores using just accounting information,

and because assessment data for additional countries have also become available, they

26

can extend the sample size considerably relative to our earlier study, to over 3,000 banks

from 86 countries (compared to 200 banks from 37 countries analyzed in DDT). This is

not just a simple increase in sample size: the sample of rated banks was not a

representative sample, because rated banks tend to be larger, more internationally active,

and more likely to adhere to international accounting standards. From a policy point of

view, they would like to investigate the effect of BCP compliance on all types of banks

operating in different country circumstances, rather than a select subgroup. In this study,

the richer sample allows us to explore whether the relationship between BCPs and bank

soundness varies across different types of banks.

All in all, they do not find support for the hypothesis that better compliance with BCPs

results in sounder banks as measured by Z-scores. This result holds after controlling for

the macroeconomic environment, institutional quality, and bank characteristics. They also

fail to find a significant relationship when they consider different samples, such a sample

of rated banks only, a sample including only commercial banks, and samples including

only the largest financial institutions. In an additional test, they calculate aggregate Z-

scores at the country level to try to capture the stability of the system as a while rather

than that of individual banks, but also this measure of soundness is not significantly

related to overall BCP compliance. When they explore the relationship between

soundness and compliance with specific groups of principles, which refer to separate

areas of prudential supervision and regulation, they continue to find no evidence that

good compliance is related to improved soundness. If anything, they find that stronger

compliance with principles related to the power of supervisors to license banks and

regulate market structure are associated with riskier banks.

While these results cast doubts on whether international efforts to improve financial

regulation and supervision should continue to place a strong emphasis on BCPs, a

number of caveats are in order. First, insignificant results may simply indicate that

accounting-based measures, such as Zscores, do not adequately capture bank soundness,

especially for small banks and in low income countries, where accounting standards tend

to be poor. They may also reflect low quality in the assessment of BCP compliance,

especially in countries where laws and regulations on the books may carry little weight. It

might be also argued that assessments are not comparable across countries, despite the

27

best efforts of expert supervisors and internal reviewing teams at the IMF and the World

Bank to ensure a uniform methodology and uniform standards. If their negative results

arise because compliance assessments do not reflect reality or are not comparable across

countries, then at a minimum they should lead us to question the value of these

assessments in ensuring that supervision measures up to global standards.

Review of related literature of this paper is as follows: Defining good regulatory and

supervisory practices is a difficult and complicated task.

Barth, Caprio, and Levine (2001, 2004, and 2006) were the first to compile and analyze

an extensive database on banking sector laws and regulations using various surveys of

regulators around the world, and to study the relationship between alternative regulatory

strategies and outcomes. This research finds that regulatory approaches that facilitate

private sector monitoring of banks (such as disclosure of reliable, comprehensive and

timely information) and strengthen incentives for greater market monitoring (for example

by limiting deposit insurance) improve bank performance and stability. In contrast,

boosting official supervisory oversight and disciplinary powers and tightening capital

standards does not lead to banking sector development, nor does it improve bank

efficiency, reduce corruption in lending, or lower banking system fragility. They interpret

their findings as a challenge to the Basel Committee’s influential approach to bank

regulation which heavily emphasizes capital and official supervision. An important

limitation of this type of survey is that it mainly captures rules and regulations that are on

the books rather than actual implementation. IMF and the World Bank financial sector

assessments have often found implementation to be lacking, particularly in low income

countries, so that cross-country comparisons of what is on the books may hide substantial

variation in the quality of supervision and regulation. BCP assessments have the

advantage of taking into account implementation. Of course, assessing how rules and

regulations are implemented and enforced in practice is not an exact science, and

individual assessments may be influenced by factors such as the assessors’ experience

and the regulatory culture they are most familiar with. Nevertheless, although it is

difficult to eliminate subjectivity completely, assessments are based on a standardized

methodology and are carried out by experienced international assessors with broad

28

country experience.

Cihak and Tieman (2008) analyze the quality of financial sector regulation and

supervision using both Barth, Caprio and Levine’s survey data and BCP assessments.

They find that regulation and supervision in high-income countries is generally of higher

quality than in lower income countries. They also note that the correlation between

survey data and BCP data tend to be low, always less than 50 percent and in many cases

in the 20-30 percent range, suggesting that taking into account implementation may

indeed make an important difference. A number of papers also use BCP assessments to

study bank regulation and performance.

Sundararajan, Marston, and Basu (2001) use a sample of 25 countries to examine the

relationship between an overall index of BCP compliance and two indicators of bank

soundness: nonperforming loans (NPLs) and loan spreads. They find BCP compliance

not to be a significant determinant of these measures of soundness. Podpiera (2004)

extends the set of countries and finds that better BCP compliance lowers NPLs. Das et al.

(2005) relates bank soundness to a broader concept of regulatory governance, which

encompasses compliance with the BCPs as well as compliance with standards and codes

for monetary and financial policies. Better regulatory governance is found to be

associated with sounder banks, particularly in countries with better institutions. In this

paper, as already discussed they rely on the Z-score to measure bank soundness. While

the Z-score has its limitations, they believe it is an improvement over measures used in

previous studies, namely NPLs, loan spreads, interest margins, and capital adequacy.

Because different countries have different reporting rules, NPLs are notoriously difficult

to compare across countries. On the other hand, loan spreads or interest margins and

capitalization are affected by a variety of forces other than fragility, such as market

structure, differences in risk-free interest rates and operating costs, and varying capital

regulation. Thus, cross-country comparability is a serious issue. In contrast with ratings,

Z-scores do not rely on the subjective judgment of rating agencies’ analysts.

Results from the baseline regression, relating bank soundness measured by the Z-score to

29

the degree of compliance with the BCPs. In the sample including all countries, the Zscore

is higher, indicating a sounder bank, for banks with lower operating costs in countries

with higher GDP per capita. Also, non-commercial banks tend to have higher Z-scores,

while the other control variables are not significant. The coefficient of the BCP

compliance index is positive but not significant.

If they exclude Japanese banks, which account for over 20 percent of the sample, the fit

of the model improves markedly (the R-squared increases from 10 percent to 19 percent)

and the coefficients of many regressors change substantially.12 This suggests that the

variables explaining the Z-score of Japanese banks may be somewhat different than for

the rest of the sample, perhaps because of the lingering effects of Japan’s prolonged

banking crisis on bank balance sheets. For example, in the sample excluding Japan

inflation and the rule of law index are significant (with the expected coefficients), while

GDP per capita is not (though the coefficient remains positive).

Also, banks with a higher ratio of net loans to assets have higher Z-scores, perhaps

because Basel regulation mandating minimum levels of risk-adjustment capital forces

these banks to hold more equity. Also, in the sample excluding Japan larger banks have

lower Z-scores, likely because they tend to hold less capital than smaller banks. Despite

these differences, the coefficient of the BCP compliance index remains insignificantly

different from zero also in the sample without Japanese banks. The same is true when

they add to the regression additional macro controls, such as exchange rate appreciation,

private credit, or the sovereign rating. In the regressions, they explore how the

relationship between BCP compliance and bank soundness changes if they alter the

sample composition to include various categories of financial institutions to explore

whether BCP compliance may affect soundness for alternative types of banks. All these

results refer to the sample excluding Japan, so that the overrepresentation of Japanese

banks does not distort the results. The first exercise is to examine the widest sample

possible, i.e. one that includes investment banks/securities houses, medium and long-term

credit banks, nonbank credit institutions, and specialized government credit institutions.

These are institutions that in most countries are unlikely to fall under the perimeter of

bank regulation and supervision, so they have excluded them from the baseline sample.

When they include them, the sample size grows by 25 percent, but the main regression

30

results are unchanged. In particular, bank soundness is not significantly affected by

compliance with the BCPs.

If they restrict the sample to commercial banks only, thereby losing about 300 banks

compared to the baseline sample, once again they find that regression results remain very

close to the baseline. When they focus only on banks rated by Moody’s, as in our earlier

work, the sample shrinks considerably (to just over 300 banks), and the coefficient of the

BCP compliance index becomes positive and significant, albeit only at the 10 percent

confidence level. Thus, BCP compliance seems to have some positive effect on the

soundness of this specific group of banks. To explore this issue further, they ask whether

this result is driven by the fact that rated banks are larger banks. To do so, they consider

two alternative samples: the first includes the largest 10 percent of banks within each

country and the second includes the largest 20 percent of banks in the entire sample. In

both cases, the BCP compliance index has an insignificant coefficient, as in the baseline

sample.

The BCP compliance index is the weighted sum of compliance scores for several

individual chapters of the Core Principles. Could it be that, even though overall

compliance does not seem to matter for bank soundness, some aspects of the Core

Principles might be relevant? In fact, it may be possible that the overall index is not

significant because of offsetting effects of its different components. In fact, in our

previous study of Moody’s ratings, they found that, although overall compliance did not

seem to matter, higher financial strength ratings were associated with better compliance

with principles related to information provision to supervisors.

They address this question by re-running the baseline regressions breaking down the

compliance index into seven components, based on the standard grouping of principles

used by the Basel Committee. An important caveat is that compliance scores are fairly

strongly correlated, which may make it difficult to disentangle the effect of one set of

principles from the others. They replicate the regression for different samples of banks to

investigate the robustness of the results. There is only one component of the compliance

index that has a fairly robust relationship with bank Z-scores, and that is compliance with

Chapter 2 of the BCP, i.e. principles having to do with supervisors’ powers to regulate

bank licensing and structure. Interestingly, this component of the index is negatively

31

correlated with bank soundness, so that banks in countries were regulators have better

defined powers to give out licenses and regulate bank activities tend to be riskier. This

result holds in all the samples except those including only the largest banks. This finding

supports the contention that supervisory systems that tend to empower supervisors do not

work well (Barth, Caprio, and Levine, 2001, 2004, 2006).

So far, they have considered individual bank risk. In principle, bank supervision and

regulation should be primarily concerned with systemic risk, rather than individual bank

risk, although in practice it is not always easy to make this distinction. Could it be that

BCP compliance, while not relevant to individual bank soundness, is important to ensure

the stability of system as a whole? To address this question, it would be ideal to test

whether BCP compliance reduces the probability of a financial crisis. However, since

crises are rare events, this type of test requires a panel of data; since they have BCP

compliance assessments only at a point in time, they are restricted to cross-sectional data.

Nonetheless, to explore this question they compute a rough measure of systemic

soundness as the aggregate equivalent of the individual bank Z-score. More specifically,

they aggregate profits and equity of all the banks in the country (for which they have

data), they compute the standard deviation of aggregate profits, and then they compute an

aggregate Z-score. This measure tells us by how many standard deviations banking

system profits must fall to exhaust all the capital in the banking system. They then regress

this measure on the BCP compliance score and a number of macroeconomic control

variables.

Their measure of systemic soundness is correlated with the macro variables as one might

expect: higher growth, low inflation, low inflation volatility, appreciation of the currency,

favorable sovereign ratings are all significantly associated with higher values of the

aggregate Z-score. Once again, though, the BCP compliance index does not seem to be a

significant determinant of banking system soundness. Though it is positive, the

coefficient of the BCP index is small and not statistically significant in any specification.

Remarks

While the causes and consequences of the recent financial crisis will continue to be

debated for years to come, there is emerging consensus that the crisis has revealed

significant weaknesses in the regulatory and supervisory system. Resulting calls for

32

reform have led to numerous proposals and policymakers in many countries are hard at

work to upgrade their regulatory frameworks. This paper seeks to inform the on-going

reform process by providing an analysis of how existing regulations and their application

are associated with bank soundness. Specifically, they study whether compliance with

Basel Core Principles for effective banking supervision (BCPs) is associated with lower

bank risk, as measured Z-scores. They find no evidence of a robust statistical relationship

linking better compliance with BCPs and improved bank soundness. The analysis of

aggregate Z-scores to capture systemic stability issues yields similarly insignificant

results. If anything, they find that compliance with a specific group of principles, those

giving supervisors powers to regulate bank licensing and structure is associated with

riskier banks, potentially suggesting that such powers may be misused in practice. While

our results may reflect the difficulty of capturing bank risk using accounting measures, or

the inability of assessors to carry out evaluations that are comparable across countries,

nevertheless they raise questions about the relevance of the Basel Core Principles, the

current emphasis on these principles as key to effective supervision, and the wisdom of

carrying out costly periodic compliance reviews of BCP implementation in the

IMF/World Bank Financial Sector Assessment Programs.

33

CHAPTER 3

RESEARCH METHODOLOGY

RESEARCH DESIGN

This study aims to investigate the awareness about risk management practices within the

banking sector of Pakistan and all over the world. This study is comprised of data

collected through both, primary as well as secondary sources. The purpose of using

secondary source data is to check the extent to which different risk management practices

have been followed by the commercial banks in Pakistan.

This study aims to investigate the awareness about risk management practices within the

banking sector of Pakistan. This study is comprised of data collected through both,

primary as well as secondary sources. The purpose of using primary source data is to

check the extent to which different risk management practices have been followed by the

commercial banks in Pakistan. Primary data is collected through the use of a

questionnaire. The questionnaire comprises a number of statements under one macro

statement (variable). The questionnaire is comparable to one provided in a study by Al-

Tamimi and Al-Mazrooei (2007). It includes Risk Management Practices (RMP) as the

dependent variable, and different aspects of risk management as the independent or

explanatory variables. Whereas, the objective to use secondary data is to link the risk

weighted Capital Adequacy Ratio to the different financial indicators of the commercial

banks that are used to measure their soundness.

SAMPLE SELECTION METHOD

Sample of the study

Out of the total 36 of commercial banks in Pakistan 15 commercial banks were

approached; however, the commercial banks that responded timely and positively were

12 in total. A total of 7 questionnaires were distributed in each of the bank approached to

be filled by the staff working specifically in the Risk Management department. After the

elimination of the erroneous responses the effective response rate obtained was around

58% of the total sample. An attempt is made to collect data from each of the sampled

34

commercial bank’s risk management department in the major cities of Pakistan including

Islamabad, Rawalpindi, Lahore and Karachi. The secondary data is collected and

assembled from the different quarterly reports on “performance review of the banking

system. The available data covers a period of total 9 years from 2000-2008. The data is

mainly related to the Risk Weighted Capital Adequacy Ratio (RWCAR) and its impact

on different financial indicators of the commercial banks that are used to measure their

soundness. The data mainly related to the commercial banks in Pakistan is decomposed

into three main categories: Public sector commercial banks, local private banks and

foreign banks.

Variables

Dependent Variable:

The dependent variable of this study is risk management. It is measured with the help of

risk management practices and specifically their degree of usage within the commercial

banks of Pakistan.

Independent or Explanatory Variables:

The explanatory variables include the five main aspects of risk management. These

variables are as follows:

i. Understanding Risk and Risk Management.

ii. Risk Identification

iii. Risk Assessment and Analysis

iv. Risk Monitoring

v. Credit Risk Analysis

Financial Soundness Indicators: The secondary data is comprised of four main

financial soundness indicators, each of which is evaluated through a number of sub-

indicators are to aimed to evaluate the performance of the banks within a span of a year.

Their division is shown as follows:

i. Capital Adequacy Ratio

ii. Asset Quality

35

iii. Earning

iv. Liquidity

ETHICAL CONSIDERATIONS

Surely during my research I have did respect of ethical issues.

Who response to my research normally and remain confidential because privacy is one of

the ethical issue in undertaking research use of this data should protect and individual

right to anonymity .I should respect the individual rights. I have concentrated all these

points during my research.

Not to be subject to question that creates stress or discomfort.

Not to answer any question.

Not to be harasses to participants.

Not to be contact to the people unreasonable time.

Try to target right person.

Not to be subject to any attempts to prolong the duration of the interview or

observation.

TIME SCHEDULE

Time has been spent for this dissertation as follows:

Introductory chapter 2 weeks

Review of Literature 1 week

Data collection and analyzing & organizing 2 weeks

Rough draft 1 week

Final draft 1 week

Total Time 7 weeks

ANALYSIS, RESULTS AND PRESENTATION

After discussion and analysis, explanation and interpretations have been made as results.

SUMMARY, CONCLUSION AND RECOMMENDATIONS

36

After completion of first four chapters, summary, conclusion and recommendations have

been constructed for further improvements.

37

CHAPTER 4

ANALYSIS AND RESULTS

Risk Management practices followed by the Commercial Banks in Pakistan

Risk is defined as anything that can create hindrances in the way of achievement of

certain objectives. It can be because of either internal factors or external factors,

depending upon the type of risk that exists within a particular situation. Exposure to that

risk can make a situation more critical. A better way to deal with such a situation; is to

take certain proactive measures to identify any kind of risk that can result in undesirable

outcomes. In simple terms, it can be said that managing a risk in advance is far better

than waiting for its occurrence.

The idea of risk differs from that of probability and uncertainty. Risk is said to be absent

within a situation where a person is 100% certain about the outcome. This idea also

brought the rise of insurance with its origin. Insurance is the basis upon which people

show a good deal of willingness to take risk; it creates the foundation of the security

where fortune has been ousted by an active engagement with the future. On the other

hand, the practice of Risk Management is a measure that is used for identifying, analyzing

and then responding to a particular risk. It is a process that is continuous in nature and a

helpful tool in decision making process. According to the Higher Education Funding

Council for England, Risk Management is not just used for ensuring the reduction of the

probability of bad happenings but it also covers the increase in likeliness of occurring

good things. A model called “Prospect Theory” states that a person is more likely to take

on the risk than to suffer a sure loss. Risk exists as a part of an environment in which

various organizations operate. Banking is a business mostly associated with risk because

of its large exposure to uncertainty and huge considerations. Risk management is one of

the most important practices to be used especially in banks, for getting assurance about

the reliability of the operations and procedures being followed. In today’s dynamic

environment, all banks are exposed to a large number of risks such as credit risk, liquidity

risk, foreign exchange risk, market risk and interest rate risk, among others the risks

which may create some source of threat far a bank's survival and success. Due to such

exposure to various risks, efficient risk management is required. Managing risk is one of

38

the basic tasks to be done, once it has been identified and known. The risk and return are

directly related to each other, which means that increasing one will subsequently increase

the other and vice versa. And, effective risk management leads to more balanced trade-

off between risk and reward, to realize a better position in the future.

It is also realized recently that Risk Management is essentially more important to be

carried upon in the financial sector than any other part of the economy. It makes more

sense when it is known that the main purpose of the financial institutions is to maximize

revenues and offer the maximum value to the shareholders by facilitating them with a

variety of financial services especially by administering risks. The prime reason to adopt

risk management practices is to avoid the probable failure in future. But, in realistic

terms, risk management is clearly not free of cost. In fact, it is expensive in both

resources and in institutional disruption. But the cost of delaying or avoiding proper risk

management can lead to some adverse results, like failure of a bank and possibly failure

of a banking system.

The banking industry recognizes that an institution needs not do business in a manner that

unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently

transferred to other participants. Rather, it should only manage risks at the firm level that

are more efficiently managed there than by the market itself or by their owners in their

own portfolios. In short, it should accept only those risks that are uniquely a part of the

bank's array of services. Banking is one of the most sensitive businesses in any economy

since it acts as a life-blood of modern trade and commerce to provide them with the

major sources of finance. Pakistan is one of the key emerging markets of South Asia and

its banking sector consists of Commercial Banks and Specialized Banking Institutions,

regulated by the State Bank of Pakistan. Pakistan is one of few developing countries,

where the public sector banks were privatized within a limited time span. The Federal

Government is now left with only the National Bank and First Women Bank, while the

State Province owned banks are the Bank of Khyber and Bank of Punjab. The Banking

Sector has significantly improved its performance during the last few years as more

foreign banks have also started their operations in this region.

The time period between “2002-2007” proved to be of significant growth for the banking

sector of Pakistan. Classified as Pakistan’s and region’s best performing sector, the

39

banking industry’s assets increased over $60 billion, its profitability remains high,

nonperforming loans (NPLs) are low, credit is fairly diversified and bank-wide system

risks are well-contained. Almost 81% of banking assets are in private hands. It shows that

privatization of the major portion of the banks has increased competition among them

and resulted in the continuous increase in performance to retain their customers through

efficient means. Currently, it is more obvious that increased competition in consumer

banking has increased the need for effective and efficient risk management for the banks

to gain a competitive edge.

The risk arises from uncertainty of a particular situation and certainty of being exposed to

that situation. Risk Management as commonly perceived does not mean to minimize risk;

in fact, its goal is to optimize the risk-reward trade off. And, the role of risk management

is to assure that an institution does not have any need to engage in a business that

unnecessarily imposes risk upon it. Also, it should not absorb any such risks that have the

tendency to be transferred to other participants. Rather it should only accept those risks

that are uniquely a part of the array of bank’s services. In this regard, risk management

aspects such as Understanding risk and risk management, risk identification, risk

assessment and analysis, risk monitoring, risk management practices and credit risk

analysis of the banks have to be considered for assessing their risk management approach

(www.wbiconpro.com).

Method of Data Analysis used for analysis

A regression model is applied to estimate the relationship between one dependent

variable and the five explanatory variables. The model is as follows:

RMP = ƒ (URM, RI, RAA, RM, CRA)

Where:

RMP = Risk Management Practices;

URM = Understanding Risk and Risk Management;

RI = Risk Identification;

RAA = Risk Assessment and Analysis;

RM = Risk Monitoring; and

CRA = Credit Risk Analysis

40

This model is adopted to test the second hypothesis of the study. For the purpose of

testing rest of the hypotheses developed specifically for analyzing the primary data,

ANOVA test is run. Its purpose is to check the differences among various Pakistan’s

public sector and local private banks in use of all the six major aspects of the Risk

Management Process. Another tool used to determine whether a linear relationship exists

between the variables is Product Moment Correlation, r. For the purpose of testing the

secondary data analytically, Analysis of Variance test is used for each of the major

financial soundness indicator separately.

Data Analysis

The reliability of the scales used within the questionnaire is evaluated using Cronbach’s

alpha. It allows measuring the reliability of different variables. The questionnaire adopted

for this study contains 43 statements representing each of the six aspects of risk

management. It is used to estimate how much variation in scores of different variables is

attributable to chance or random errors (Selltiz et al., 1976). There is a general rule that a

coefficient greater than or equal to 0.7 is considered acceptable and a good indication of

construct reliability (Nunnally, 1978). The overall Cronbach’s alpha (α ), for the six

aspects of risk management process is 0.771 as shown below in table 4.1. It means that

there is an acceptable degree of consistency among the responses against each item.

Table 4.1: Overall Reliability Statistics for six Aspects of Questionnaire

Cronbach's Alpha N of Items

.771 6

Multiple-Regression Model:

The regression model is applied to estimate the relationship between Risk Management

Practices and the five explanatory variables as follows:

RMP = ƒ (URM, RI, RAA, RM, CRA)

Product moment correlation is used to analyze correlations among the explanatory

variables, namely understanding risk and risk management (URM), risk identification

(RI), risk assessment and analysis (RAA), risk monitoring (RM), and credit risk analysis

(CRA). Table 4.2 reveals the correlation coefficients between all the variables. This table

41

of bi-correlations is useful to detect any potential case of multicollinearity. An

examination of the results of correlations presented in Table 4.2 shown below suggests

that there is no problem of multicollinearity among all explanatory variables.

Table 4.2

RMP URM RI RAA RM CRA

RMP Pearson

correlation

1

Sig. (2-

tailed)

URM Pearson

Correlation

.299 1

Sig. (2-

tailed)

.062

RI Pearson

Correlation

.361(*) .439(**) 1

Sig. (2-

tailed)

0.11 .002

RAA Pearson

Correlation

.322(*) .403(**) .184 1

Sig. (2-

tailed)

.024 .004 .207

RM Pearson

Correlation

.305(*) .575(**) .413(**) .470(**) 1

Sig. (2-

tailed)

.033 .000 .003 .001

CRA Pearson

Correlation

.249 -.015 .255 .253 .089 1

Sig. (2-

tailed)

.084 .919 .077 .079 .541

42

Table 4.3 below shows the regression results. It can be seen from the results provided in

Table 4.3 that R2 is 0.351. This indicates that the five explanatory variables explain 35.1

percent of the variations in risk management practices.

Table 4.3: Model Summary for all explanatory variables

Model R R2 Adjusted R2 F Sig

1 .592(a) .351 .275 4.645* 0.002*

Model R R2 Adjusted

R2 F Sig

1 .592(a) .351 .275 4.645* 0.002*

Predictors: (Constant), CRA, URM, RI, RAA, RM * significant at α = 1%

The estimated coefficients of all the explanatory variables are insignificant but still show

a positive impact on risk management practices except URM that is slightly negatively

correlated with RMP. These results obtained using the study multiple-regression model is

displayed in Table 4.4.:

Table 4.4: OLS Regression Result for all Explanatory Variables

Coefficients (a)

Beta t Sig.

(Constant) 1.293 1.164 .251

URM -.004 -.023 .982

R1 .158 1.219 .230

RAA .213 1.259 .215

RM .265 1.794* .080*

CRA .151 1.000 .323

Linear Regression Model:

Since the results shown on table 4.2 reflect mild multicollinearity, each of the

explanatory variable is regressed alone to check its impact on RMP. All the results are

summarized in two tables, one of which shows the Model summary for checking the

43

impact of each of the explanatory variables upon RMP. The first explanatory variable is

URM and it shows that the value for R2 is .097, which means that URM explains only

9.7 percent of the variation in risk management practices.

Table 4.5: Model Summary of Linear Regression for all Independent or Explanatory

Variables

Model R R2 Adjusted

R2

F Sig

URM .312(a) .097 .078 5.071* 0.029**

R1 .395(a) .156 .138 8.699* 0.005*

RAA .451(a) .204 .187 12.016* 0.001*

RM .511(a) .261 .245 16.567* 0.000*

CRA .297(a) .088 .069 4.533* 0.039**

a. Predictors: (Constant), URM, RI, RAA, RM, CRA * Significant at α = 1% **

Significant at α = 5%

The second explanatory variable whose impact is checked in relation to RMP is RI.

Table 4.5 shows that the value for R2 is .156, which means that RI explains 15.6 percent

variations in the risk management practices. Similarly the model summary for RAA

shows that the value for R2 is .204, which means that RAA explains 20.4 percent

variations in the risk management practices. Likewise, the values depicted in the table 4.5

for R2, for RM and CRA are .261 and .088 respectively and thus explain 26.1 percent and

8.8 percent of the risk management practices respectively.

The table 4.6 below depicts the individual estimated coefficient of linear regression of the

independent or explanatory variables on RMP. URM is showing positive and significant

impact on risk management practices. It shows a positive relation between both the

variables. It means that results are significant and with one degree change in URM, RMP

will also change by 0.327 degrees in the same direction.

Table 4.6: Regression Coefficient Results for all Independent or Explanatory Variables

Independent or Beta T Sig.

44

Explanatory

Variables

(Constant) URM 3.627

.327

4.373*

2.252**

.000*

.029**

(Constant) R1 3.759

.350

6.359*

2.949*

.000*

.005*

(Constant) RAA 3.943

.478

3.988*

3.466*

.000*

.001*

(Constant) RM 2.965

.463

4.752*

4.070*

.000*

.000*

(Constant) CRA 3.650

.324

4.213*

2.129**

.000*

.039**

a. Dependent Variable: RMP * Significant at α = 1% ** Significant at α = 5%

The estimated coefficient of linear regression for RI is showing positive and significant

impact on risk management practices. It shows a positive relation between both the

variables. It means that results are significant and one degree change in RI will change

the value of RMP by 0.35 degrees. Likewise, the estimated coefficients of linear

regression for RAA, RM and CRA show positive and significant impact on risk

management practices. A positive relationship is shown between each of these variables

with RMP. It means that results are significant and one degree change in RAA, RM and

CRA will bring a significant change in the value of RMP by 0.478, 0.463 and 0.324

degrees respectively.

The results from all the linear regression lines between five explanatory variables and the

study dependent variable RMP show that there are significant relationships between

them. This result is obtained when each of the explanatory variables is regressed alone on

RMP. All the results are highly significant and show the positive relation between each of

the five explanatory variables and risk management practices.

Analysis of Variance:

To test rest of the other hypotheses ANOVA is used. The main purpose is to show the

difference in the risk management and all the six aspects of risk management process

45

among the public sector commercial banks and local private banks of Pakistan. Table 4.7

shows the ANOVA results and the difference among the risk management aspects

followed by public sector commercial banks and local private banks of Pakistan.

Table 4.7: Analysis of Variance

Sum of d.f. Mean F Sig.

Squares Square

URM Between Groups 1.987 1 1.987 6.302** .016**

Within Groups 14.822 47 .315

Total 16.809 48

RI Between Groups .508 1 .508 1.037 .314

Within Groups 23.056 47 .491

Total 23.564 48

RAA Between Groups .597 1 .597 1.764 .191

Within Groups 15.911 47 .339

Total 16.508 48

RM Between Groups 5.239 1 5.239 14.234* .000*

Within Groups 17.298 47 .368

Total 22.537 48

RMP Between Groups .850 1 .850 2.264 .139

Within Groups 17.650 47 .376

Total 18.500 48

CRA Between Groups .292 1 .292 .904 .347

Within Groups 15.209 47 .324

Total 15.501 48

• Significant at α = 1% Significant at α = 2%

The above ANOVA table clearly shows that only two of the explanatory variables

namely URM and RM are practiced differently in public sector commercial banks and

private local banks in Pakistan. There is a significant difference between the groups in

case of these two variables as shown in the above table 2.25. The secondary data analysis

46

consists of both descriptive and analytical analysis. This data type is used for the purpose

of showing various facts and figures related to the risk management of the commercial

banks in Pakistan. The secondary data is composed of three separate groups of

commercial banks. The three types of commercial banks are as follows: Public Sector

Commercial Banks, Local Private Banks and Foreign Banks.

The data is related to all the three bank types within the SBP’s quarterly performance

review reports for banking system. The secondary data is comprised of four major

financial soundness indicators.

a. Capital Adequacy Ratio: Capital Adequacy Ratio is the amount of risk-

based capital as a percent of risk-weighted assets. It further contains the

risk weighted items and sub-indicators such as Risk Weighted CAR, Tier I

Capital to Risk Weighted Assets and capital to total assets.

b. Asset Quality: This financial soundness indicator contains the items

related to Non-Performing Loans, which are loans and advances whose

mark-up/interest or principal is overdue by 90 days or more from the due

date. It contains four sub indicators all related to NPLs.

c. Earning: It contains return on assets before and after tax and return on

equity before and after taxes as well. Return on assets measures the

operating performance of an institution. It is a widely used indicator of

earning and is calculated as net profit as percentage of average assets. Net

Interest Income is included under the same earnings indicator that it is the

total interest income less total interest expense. This residual amount

represents most of the income available to cover expenses other than the

interest expense.

d. Liquidity: The final financial soundness indicator is liquidity. It comprises

all the liquidity ratios and it is used to represent the bank’s ability to

efficiently and economically accommodate decreases in deposits and to

fund increases in loan demand without negatively affecting its earnings. In

the same way, liquid assets are those assets that are easily and cheaply

convertible to cash. The commercial banks are divided into three main

types of public sector commercial banks, local private banks and foreign

47

banks. The ANOVA results are shown in tables 4.8, 4.9, 4.10, and 4.11

below. The table 4.8 below shows a significant difference between all sub-

indicators of financial soundness related to CAR among the three groups

of commercial banks in Pakistan.

Table 4.8: Analysis of Variance Results for CAR

Capital

adequacy

ratio

Sum of

squares

d.f. Mean

square

F Sig.

Risk

weighted

capital

adequacy

ratio

Between

groups

16839.870 2 8419.935 182.472* .000*

Within

groups

1107.451 24 46.144

Total 17947.321 26

Tier I

capital to

risk

weighted

assets

Between

groups

22245.443 2 11122.721 1179.087* .000*

Within

groups

226.400 24 9.433

Total 22471.843 26

Capital to

total

assets

Between

groups

558.314 2 279.157 29.702* .000*

Within

groups

225.564 24.6.399

Total 783.879 26

48

* Significant at α = 1%

Table 4.9: Analysis of Variance results for assets quality

Asset

quality

Sum of

squares

d.f. Mean

square

F Sig.

NPLs to

total

loans

Between

groups

687.380 2 343.690 13.282* 000*

Within

groups

621.047 24 25.877

Total 1308.427 26

Provision

to NPLs

Between

groups

23454.279 2 11727.139 179.214* .000*

Within

groups

1570.473 24 65.436

Total 25024.752 26

Net NPLs

/ Net

Loans

Between

groups

22548.732 2 11274.366 98.230* .000*

Within

groups

2754.609 24 114.775

Total 25303.341 26

Net NPLs

/ Capital

Between

groups

49467.205 2 24733.603 13.639* .000*

Within

groups

43522.538 24 1813.439

Total 92989.743 26

* Significant at α = 1%

Table 4.9 above shows a significant difference between all sub-indicators of Asset

Quality among each of the three groups of commercial banks in Pakistan. Table 4.10

49

below is a good indication that at there is a significant difference between all sub-

indicators of financial soundness related to Earnings among each of the three groups of

commercial banks in Pakistan except ROA after tax. Table 4.11 below shows that there is

a significant difference between all sub-indicators of financial soundness related to

Liquidity among each of the three groups of commercial banks in Pakistan except for the

ratio of ROA after taxes which clearly shows the drastic impact of taxes on Pak banks.

Table 4.10: Analysis of Variance results for Earning

Earning Sum of

squares

d.f. Mean

square

F Sig.

ROA before

tax

Between

groups

13401.327 3 6700.664 6.733* .005*

Within

groups

23884.247 24 995.177

Total 37285.574 26

ROA after

tax

Between

groups

1.676 2 .838 .099 .906

Within

groups

202.622 24 8.443

Total 204.299 26

ROE before

tax

Between

groups

2561.659 2 1280.829 28.316* .000*

Within

groups

1085.689 24 45.233

Total 3647.247 26

ROE after

tax

Between

groups

2922.183 2 1461.091 14.202* .000*

Within

groups

2469.124 24 102.880

Total 5391.307 26

NII/Gross Between 14342.054 2 7171.027 69.162* .000*

50

income groups

Within

groups

2488.442 24 103.685

Total 16803.496 26

Cost/Income

ratio

Between

groups

13648.092 2 6824.046 60.438* .000*

Within

groups

2709.831 24 112.910

Total 16357.923 26

* Significant at α = 1%

Table 4.11: Analysis of Variance results for Liquidity

Liquidity Sum of

squares

d.f. Mean

square

F Sig.

Liquid

assets/Total assets

Between

groups

2034.367 2 1017.184 13.460* .000*

Within

groups

1813.711 24 75.571

Total 3848.079 26

Liquid

assets/Total

Deposits

Between

groups

1372.005 2 686.003 12.390* .000*

Within

groups

1328.778 24 55.366

Total 2700.783 26

Advances/Deposits Between

groups

1180.476 2 590.238 5.449* .011*

Within

groups

2599.584 24 108.316

Total 3780.061 26

* Significant at α = 1%

51

From all the results, it can be interpreted that there is a significant difference among all

the each of the three groups of commercial banks in Pakistan as shown by the values

from the financial soundness indicators; the ratio of Advances : Deposits is almost at the

same level of significance.

From the descriptive and analytical results, it is concluded that there is a general

understanding of risk and risk management among the staff working in the risk

management department of the commercial banks of Pakistan. The study reveals that

most of the daily operations that they perform are risky by nature. The most critical types

of risk are: Credit risk, liquidity risk, interest rate risk foreign exchange risk, and

operating risk. The foreign exchange risk is important since Pakistan is part of the Global

Village and spills of international financial crises such as fluctuations in foreign exchange

rates and inflation affect the Pak banks drastically. Each of the independent variable is

regressed separately on the dependent RMP; and show encouraging results. Results of

ANOVA regarding the financial rations are encouraging except for ROA after taxes

which means that either the government of Pakistan has to reduce its corporate taxes to

improve performance of the Pak Banks or another study is needed with extended period

of time and including the Pak Islamic Banks who are less risk taking that the

conventional Pak Banks in order to corroborate or refute this finding.

52

CHAPTER 5

SUMMARY, CONCLUSION AND RECOMMENDATIONS

SUMMARY

The Basel 2 Accord comes into effect in the world's more advanced countries. South

Africa is the only African country to which the Accord will apply. I outline the provisions

of Basel 2 and what they will mean in the day to day world of banking.

The Basel Accords (1 and 2) are global regulatory frameworks designed to make banking

as safe as possible. The need for the prudent regulation of banks, allied with the

development, implementation and management of sound policy is critical to ensure the

robustness and resilience of a healthy global banking system.

Recent years have seen a veritable revolution within the financial services industry - with

a growing number of banks and non-banking financial institutions needing supervision

along with rapid advances in technology and financial product innovation. That, in turn,

has increased the complexity and magnitude of banking risks creating a strong and more

formal emphasis on regulation and supervisory practices around the world.

In June 2004, the Basel Committee on Banking Supervision (BCBS) endorsed a Revised

Framework on International Convergence of Capital Measurement and Capital Standards

(otherwise known as 'Basel 2 Accord') for implementation by the G-10 supervisors of

Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Switzerland, UK and the

US, from January 2008.

A few non G-10 countries (South Africa, India, Saudi Arabia, Bahrain and the United

Arab Emirates) have also confirmed their intention to follow the new capital norms.

The Basel 2 Accord is more sophisticated and risk sensitive than its predecessor, the 1988

Basel 1 Accord. It seeks to improve existing rules by aligning regulatory capital

requirements much closer to the underlying risks that internationally active banks face in

today's volatile marketplace.

The Accord replaces an institutional approach to credit risk with a risk-based model -

which encourages bankers to identify present and future uncertainties and to develop or

53

improve their capabilities to manage exogenous shocks. Therefore, it is designed to be

more flexible and better able to evolve with continuous advances in financial market

infrastructure and risk management practices.

In essence, Basel 2 is about upgrading internal risk control systems and reducing the

divergence between regulatory and economic capital. The Bank for International

Settlements (BIS) put it succinctly: "Risk is now too complex for simple measurement

methods."

The Accord in practice

The Basel 2's Framework is based on 'three' mutually underpinning concepts, or pillars of

capital adequacy - first, minimum capital requirements; second, supervisory review; and

third, market discipline. The three pillars are aimed at promoting greater stability in the

global financial system.

Pillar one places greater emphasis on internal capital models. It deals with the

maintenance of regulatory capital calculated to mitigate each bank's actual risk of

economic loss arising from credit risk, operational risk and market risk.

Bankers are required to develop systems and procedures to ensure sound risk

management within their institutions. Capital (equal to at least 8% of risk-weighted

assets) is needed to cover both expected and unexpected losses.

Basel 2 improves the capital sensitivity to risk-taking by requiring increased capital levels

(including provisions) for those borrowers judged to pose higher levels of credit risk, and

vice versa. This may lead to lower regulatory capital on low default probability exposures

and to improved risk/pricing standards.

Pillar Two requires an even more effective supervisory review process. The central banks

are expected to take a forward-looking approach to supervision by imposing higher

capital levels on them than the minimum required in Pillar One for some banking groups

in order to match their risk profiles.

The Framework provides regulators with enhanced powers (compared to Basel 1) to

scrutinise various other risks facing bankers, such as concentration risk, reputation risk,

legal risk, collateral management risk, interest rate risk, liquidity risk and strategic risk,

54

which Basel 2 combines under the heading of residual risk.

Pillar Three is the enforcement of market discipline by increased transparency. Basel 2

seeks to improve banks' public reporting to supplement reviews by the national

regulatory authorities.

Banks are required to disclose additional information, especially relating to counter-party

credit risk (i.e. exposures for derivatives and securitised lending). This, in turn, should

provide a better insight into the risk profile of a bank and allow the counter-parties of the

bank to price and deal appropriately.

Under Pillar One, bankers can better manage various risks by three different methods -

depending on their activities and internal controls - namely: Standardised Approach,

Foundation and Advanced Internal Rating Based (IRB) Approach.

The first method allows banks that engage in guaranteed lending and credit underwriting

activities and have simpler control systems to use external measures to assess the credit

quality of their borrowers for risk-weighting purposes.

Globally active banks, with sophisticated risk measurement systems, may - with the

approval of their regulators - select either Foundation or the Advanced IRB approach. In

the former, the supervisor provides some of the parameters for the model, whereas in the

Advanced Approach, the bank performs its own calculations for risk weighting. More

than 100 banks globally (including in South Africa) will initially follow the internalbased

approach, which requires increased capital charges for higher risk assets.

Risk management systems focus on three factors: (1) the probability of default - the

average percentage of obligors that default in the course of one year; (2) exposure at

default - an estimated amount outstanding in case the borrower defaults and (3) loss-

given default - the percentage of exposure the bank could lose if the borrower defaults.

The Basel 2 IRD approach is built on the three scenarios. Therefore, it forces bankers to

take into account future deteriorations in credit quality. The BIS notes: "The financial

system is pro-cyclical with or without regulatory capital standards."

The new Accord requires banks to undertake economic cycle stress tests to determine the

impact of a downturn on market and credit risks as well as on liquidity. Stress testing

55

involves identifying possible events or future changes in business conditions that could

undermine credit exposures and assesses the bank's capacity to withstand such changes.

As a result of the stress test, or scenario analysis, the bank must ensure that it holds a

sufficient capital buffer to cope with unforeseen external shocks.

Benefits and unresolved issues

Market participants generally welcome the new Framework, which boasts the potential

for creating a vibrant, more stable international banking sector.

Basel 2 confers significant benefits, both to individual institutions and supervisors as it

heralds:

More effective allocation of capital and human resources relative to risk-taking.

Greater shareholder value through the use of sophisticated risk models and

reporting systems, as well as increased operational efficiencies.

Sound risk management leads to more consistent profits and reduced volatility of

credit losses. It creates a competitive opportunity for competent bankers.

Providing incentives for good corporate governance and greater transparency.

Strong capitalised/well managed banks are better able to absorb losses and to

provide credit to consumers and businesses throughout the business cycle.

Jaime Caruana, the former governor of the Bank of Spain and chairman of the BCBS,

said: "It [the New Framework] builds on and consolidates the progress achieved by

leading banking organisations and provides incentives for all banks to continue to

strengthen their internal processes. By motivating banks to upgrade and improve their

risk management systems, business models, capital strategies and disclosure standards,

the Basel 2 Framework should improve their overall efficiency and resilience."

Despite substantial investment into IT systems and transition costs for banks and

supervisors, it seems major implementation challenges still remain.

Emmanuelle Sebton of the International Swaps and Derivatives Association believes:

"Certain parts of the Accord have not yet been fleshed out by the regulators. The

treatment of default risk in the trading book is a case in point. The Basel Accord

56

Implementation Group has wanted to publish principles on the modelling of default risk

in the trading book, but has not found agreement with the industry on the contents of the

principles. As a result, firms negotiate their models bilaterally with the regulators.

The use of downturn loss-given default (LGD) projections is another issue and regulators

feel that banks should not underestimate the levels of capital needed to cope with growth

slowdown or, worse, an economic recession. The UK's Financial Services Authority

(FSA) has asked banks to factor in effects of a 40% slump in property prices on their

respective portfolios.

Matthew Elderfield, head of the FSA's Basel 2 decision-making committee, explains:

"There are similar issues on the corporate LGD side that are perhaps even more

technically challenging. We're asking the banks to look at the downside risk of LGD in

terms of collateral and commercial property held, and people are struggling to come up

with a sensible, conservative approach to that." In fact, some banks are finding it more

challenging to achieve IRB status than had been expected. According to

PricewaterhouseCoopers, "Basel 2 projects have proved complex and many banks have

found that the final hurdle, obtaining waivers for the internal ratings-based approach or

advanced measurement approach (AMA) [for operational risk] models, has not been as

simple as they had hoped, particularly given the tough requirements for stress testing and

management oversight, as well as independent verifications."

Credit Suisse, the investment bank, argues that the industry wide benefits of a more

uniform, risk-based approach to capital adequacy could be undermined by the ever-

growing influence of non-bank players, notably private equity funds and hedge funds,

which are not subject to the Basel 2 Framework. Ultimately, the success of the Accord

rests with the national bank regulatory authorities (www.allbusiness.com).

The impact on developing-country risk weighting

Supervisory authorities in emerging-market regions are evaluating the implications for

their banking systems of the new Accord. On balance, internationally active banks will

have to allocate more regulatory capital than under the Basel? Code due to higher risk

loan books.

57

CONCLUSION

IMPACT OF BASEL II ON BANKING SECTOR OF PAKISTAN

The Pakistani banking industry, like its counterparts elsewhere in the world, has a

deadline to meet: it has to implement, and comply with, the capital adequacy framework

of new Basel II Accord by December 2006. The negotiations for Basel II, which started

in 1999 because the Basel Committee decided that the 1998 Basel I Accord needed to be

replaced by an updated version, are still not quite finished – of the two final papers, one

has already been published in May this year while the other is due this month.

The history of the new Basel II dates back to 1974 with the establishment of the Basel

Committee on Banking Supervision by the Governors of the central banks of the G-10

(Group of Ten) countries. Fourteen years later in 1988, the Basel Committee decided to

introduce a capital measurement system better known as Basel Capital Accord which

made the banks in the G-10 countries to implement a credit risk measurement framework,

virtually followed by all other countries. In June 1999, the Committee decided that the

1988 Accord needed to be replaced by an updated version.

The primary difference between the Basel I and Basel II Accords is that while the former

dealt mainly with “international convergence of capital measurement and capital

standards” to reduce risk in the banking industry, the latter provides a new capital

adequacy framework for it. Basel I set standards to reduce the risk of the banks by

finding a common definition of capital, and its division into various categories according

to its risk profiles, and by making it mandatory of the banks to maintain a minimum

capital ratio against the risks.

While Basel I worked and continue to work after being updated in 1996 to include

Market Risk, it is widely accepted as the standard for measuring capital adequacy in over

100 countries across the world but over the years a number of shortcomings have become

apparent over the years. For instance, one of the major shortcomings of Basel I that

became more apparent over the years was that it was not sufficiently risk sensitive for

major banks. It also became apparent that there was a lack of incentives for credit risk

mitigation due to little recognition of collateral. Another shortcoming of Basel-I was that

it offered limited scope for arbitrage for the treatment of securitization because it just did

not cover a number of new instruments. In addition it also resulted in the bundling of

58

operational and credit risk capital.

So December 2006 was just not another month for the Pakistani banking industry, like its

counterparts elsewhere in the world. The question is: whether the Pakistani banking

industry is prepared or is preparing to meet the Basel-II deadline.

Is the implementation o Basel II a must for the Pakistani banking industry? If so

why?

Implementation of Basel-II is essential for Pakistani Banks as it has been initiated by

State Bank of Pakistan and will be in conformity with the international banking

standards. Pakistani banks do not operate in isolation. They have considerable interaction

with international financial markets and being compliant with Basel II would facilitate

their relationships.

What the implementation of Basel II means for Pakistani banking industry from the

perspective of PBA?

The implementation of Basel II in the local banking system has been initiated by Bank of

Pakistan and hence it becomes mandatory for all banks to follow it. Bank of Pakistan’s

approach to implementing Basel II has been very appropriate, as it has provided the local

banks with sufficient time to understand and implement it. The impact of Basel II on the

banking system would be in the following areas.

Internal Impact: Basel II will enhance focus on economic capital management versus

regulatory capital management because the new accord drives banks to measure their

performance against risk factors other than market share or expected return. Under Basel

I most banks were volume driven; Basel II drives them to become risk-return driven.

Once banks can attribute risk to a potential transaction, product or process, they can

ascribe a portion of economic capital to it (based on the risk it poses), define an expected

return on it, consider how best to price it, consider risk mitigating techniques and thereby

decide, e.g. whether to enter a transaction, engage in a business or pursue an activity or

process.

Customer Impact: Improved risk management and data flows should enable banks to

identify clients, evaluate their customers in more thorough way than they might have

done in the past, and determine whether to retain certain customers. Banks will need to

request new and timely information from borrowers to perform the internal rating

59

assessments and the collateral evaluation that are essential to Basel II’s risk calculation

process.

Business Impact: The Basel Accord discriminated only marginally among credit risks

providing banks with no incentive to price high-risk loans adequately. By seeking to

enable banks to achieve a better relationship between risk and required capital, New

Accord is designed to reduce such regulatory arbitrage opportunities. Thus the New

Accord encourages banks to assume a new role as information intermediaries, a role in

which they collect and analyze customer related data using systematic risk appraisal and

classification process and tools. Customers who can supply such information may choose

to bypass a bank and go straight to the capital markets to obtain capital.

Global Impact: The banking industry’s improved risk management, enhanced

information flows and related disclosures could drive parallel improvement in the

stability of the financial markets. New disclosures will provide regulators with “early

warnings” that banks or rating agencies could pass on to the public and investors

potentially enhancing trust in the financial markets. For the individual institution, the

challenge will be to determine how to translate internal risk management to external

disclosures.

Are the Pakistani banks ready to face the challenges, both individually and

collectively?

During the past few years, Pakistan’s banking industry has experienced expanding

business arenas, deregulation and globalization of financial activities, emergence of new

financial products and increased level of competition. The financial state of the banking

industry is good. Banks are flushed with liquidity, capital adequacy is sound and non-

performing loans are in a manageable limit. At present most of the banks are in a position

/ state of readiness to adopt and implement the covenants of Basel II, however there may

be a few smaller banks which may not be entirely in the state of readiness. But taking into

consideration the time frame provided by Bank of Pakistan and the full hands-on

approach adopted by Bank of Pakistan, the entire banking sector should be ready for

implementation by 2006.

What kind of benefits does Basel II offer?

The question has already been answered by me. In a nutshell, implementation of Basel II

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would benefit the banking sector in three areas: increase focus on risk management, i.e.,

credit, price and operational risk; banks would assess their capital adequacy in relation to

their risk profile; greater disclosure from banks to make discipline more efficient.

What would be the financial costs of implementation of Basel II and can Pakistani

banks afford to manage it, in full as well as in part?

The additional financial cost that may arise as a result of implementing Basel accord and

Basel II would be in the areas of:

i. System / Software for capturing the areas exposed to price and operational risk,

and developing tools to monitor and control.

ii. Cost of training for development of skill base in the area of Price / Operational

risk measurement and monitoring.

iii. Creation of reserves for any shortfall in collateralized assets, which will be taken

at forced sale value. The cost of creating the reserve would depend upon the size

and quality of assets portfolio of each bank.

iv. The additional cost will be more than justified by the benefits which will accrue

with the implementation of Basel II.

In what specific ways Basel II improves on Basel I?

Basel II is a continuation of Basel accord. The specific areas in which it adds on to Basel

accord are:

i. Basel accord addresses market and credit risk for RCR, Basel II substantially

enhances the regulatory capital measurement of credit risk exposure and also

requires banks to have sufficient capital to cover operational risk.

ii. Basel II reinforces the principles of internal control and other corporate

governance practices by defining supervision requirements and assigning the

specific responsibilities to the Board and senior management.

iii. Basel II requires far greater disclosures from banks to make market disciplines

more effective. One of the challenges for the Banks management will be to

balance the greater transparency with the requirements of IFRS to avoid

duplication of efforts and for consistency in reporting of financial information.

What would be the role of the State Bank of Pakistan in its implementation?

The Bank of Pakistan has a vital role in the implementation of Basel II initially as a

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regulator in terms of dissemination of information and providing guidelines to all the

banks and once it is adopted it will act as a monitor.

How smooth do you think will be the transition from Basel I to Basel II?

As explained earlier, Basel II is a continuation of Basel accord. The implementation

would require time and effort. Banks would have to focus, but it could be achieved

smoothly with proper planning and resources.

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RECOMMENDATIONS

The following points should be noted:

For all - except the most highly-rated OECD debtors - the risk weight of lending

to banks and sovereigns will increase. For weaker banks, or banks located in low-

rated 'sub investment grade' countries, Basel 2 will have negative implications.

Their inter-bank risk weightings will increase from 20% to 150%.

For corporate exposures, the risk weighting for highly-rated borrowers will be

lower while that for lower-rated borrowers steeply higher. However, under the

Standardised Approach, lending to OECD-based banks below the top rating

categories would also attract higher risk weights than at present.

Lending to prime non-OECD banks will typically attract a lower risk weighting -

with no weight changes for short-term lending to such banks. But it rises, by

substantial margins, for medium and lower-rated banks.

For project finance loans, banks using the Advanced Internal Ratings Based

Approach and having sufficient data to validate could now simply use weightings

that apply to corporate borrowing.

Under the new proposals, capital flows to countries with low sovereign ratings (BB+ to

below B-) and unrated countries are likely to fall as capital requirements for lending to

such countries and their domestic corporate will increase. Accordingly, banking systems

will find it more expensive and difficult to open credit lines and tap global capital

markets for project financing.

Basel 2 regulators demand higher bad debt provisions on exposures to most developing

nations. However, many larger sophisticated banks have already incorporated such

country and credit risks into their lending operations, irrespective of the new capital

Accord. Nonetheless, Basel 2 will disadvantage the economically 'marginalised' by

restricting their access to credit. Most simply, future bank lending will be directed at

mainly low default probability portfolios.

Major international banks may have to compute capital requirements according to both

home and host country criteria. That, in turn, will increase regulatory burden. But not all

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national regulators in developing regions are equipped to supervise the Internal Ratings

Based Approach and/or execute properly their supervisory functions regarding the capital

adequacy of foreign banks within their jurisdiction, due to a lack of resources and

expertise.

Basel 2 from Africa's perspective

The Basel Committee does not regard the implementation of Basel 2 as a prerequisite for

compliance with the Basel Core Principles for Effective Banking Supervision. Indeed, the

BIS and the International Monetary Fund (IMF) have reiterated that non-BCBS countries

considering adopting the new Accord should "do so at their own speed and according to

their own priorities". Hence, Basel 2 is not 'binding' like the Basel 1 Capital Accord -

which was adopted by over 100 countries, including many in Africa.

The large South African financial institutions (notably Standard Bank, Absa Group,

Nedbank, Investec and FirstRand Banking Group) will aim at using the Advanced

Internal Ratings Based Approach.

Meanwhile, the Nigerian mega banks - Intercontinental Bank, Union Bank of Nigeria,

First Bank of Nigeria, Zenith International Bank and Guaranty Trust Bank - are expected

to strengthen their expertise, internal capital models and historical data on every asset's

probability of default required to qualify for using the internal rating systems aligned to

Basel 2 code.

However, achieving such demanding tasks may take a longer period. Last year, the

Central Bank of Nigeria acknowledged: "Very few [Nigerian] banks have robust risk

management systems in place."

The main objectives for the majority of sub-Saharan banks should be 'full compliance'

with the Basel Core Principles of which the key criteria are a minimum capital ratio of

8%; risk weighting; tighter rules on asset classification; bad debt provisions; the

suspension of interest arrears on NPLs; stringent reporting of balance sheets conforming

with international accounting standards; exposure limits to any one borrower in relation

to a bank's core capital; and checks on investments in subsidiaries and non-bank

businesses as well as restrictions on inside lending, including to shareholders and bank

directors.

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In sum, the new Framework is a longer-term process that, if embraced properly by

bankers and supervisors, will lay the foundation for the further evolution of the global

financial system. The Basel 1 Accord experienced about five upgrades during its lifetime.

In essence, stronger banks under dynamic capital management are agents of economic

growth in both developed and developing economies. The coming year will mark a new

chapter for banking institutions and regulators as they try to make the Basel 2 Accord

work smoothly.

Sub-Saharan countries should, for now, keenly monitor and incorporate into their systems

innovations in banking technology and market infrastructure, as well as improve risk

management practices and governance standards.

Many governments worldwide take seriously bank management practices. This is

because banks are central to many functioning economy. Nowadays, many banks have

gone beyond their traditional comfort zones of simply "banking" and have assumed many

other roles that have traditionally not belonged to them. Some of the activities that many

bank management have been undertaking recently other than the traditional deposit

taking and giving out loans include, underwriting and dealing with securities, managing

and selling shares in mutual funds, and the provision of insurance products known in

banking parlance as "bank assurance." Sometimes bank management has had to grapple

with some competition by non-banking firms that provide their products often from an

advantageous position in terms of supervision. One should however, note that assuming

other non-traditional roles by the banks does not necessarily mean new risks that the bank

management has to deal with. The challenge for the bank management strategies is to

manage and minimize the new risks. It should be conceded at this point that the role of a

bank in different countries may differ and this piece does not purport to be one-size-fits-

all as far as bank management is concerned. The new roles that many banks have

assumed in the wake of deregulation have meant that the risks management becomes

important part of a bank management strategy.

Bank management nowadays operates under an increasing pressure to make their branch

network more effective. The efficiency is measured against several things including the

level of financial intermediation, the quality of financial services, management of costs

65

and the ability to attract and retain customers. These four attributes provides the

benchmark against which the efficacy of the bank management system can be measured.

The primary objective of measuring efficacy at the branch level is to gain insights into

their operations so that the banks management may come up with the means to improve

the branch performance, and this will inevitably have effect on the overall banks

performance.

Another closely related factor to banks management’s concerns is the continued

improvements in technology. This has increased the volume and the speed with which

information can be exchanged, but it by no means completely does away with the ever-

present risks that bank management constantly worry about. For instance, that technology

may facilitate commission of fraud, or a costly mistake which can take a while before the

bank management can detect the problem and deals with it. Admittedly, mistakes and

fraud are nothing new, the improved delivery systems increases the risks that the banks

management have to deal with, and the complexity of some of the new techniques means

that only the specialists, who are expensive to hire and hard to find, who can detect them,

hopefully at an early stage. Further, the competition for the new technologies may delay

the implementation of new technology solutions to improve risk management.

Finally, the government in its supervisory role should provide well defined criteria for

sound bank management practices to ensure optimal efficiency. The major areas that are

good candidates to be covered in such discourse include accounting and auditing, the

structure and functions of market based banking bank risk management and organization,

bank funding, banks and privatization, role of the central bank, bank management best

practices, banking regulation and supervision and banks and enterprises.

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