Question

Muhammad Ali, the manager of the Bank Alfalah, has to make decisions about the appropriate amount of bank capital. Looking at the balance sheet of the bank, which look like Bank Alfalah has a ratio of bank capital to assets of 10% ($10 million of capital and $100 million of assets), Muhammad Ali is concerned that the large amount of bank capital is causing the return on equity to be too low. He concludes that the bank has a capital surplus and should increase the equity multiplier to increase the return on equity. To lower the amount of capital relative to assets and raise the equity multiplier, he can do any of three things: (1) He can reduce the amount of bank capital by buying back some of the bank’s stock. (2) He can reduce the bank’s capital by paying out higher dividends to its stockholders, thereby reducing the bank’s retained earnings. (3) He can keep bank capital constant but increase the bank’s assets by acquiring new funds—say, by issuing CDs—and then seeking out loan business or purchasing more securities with these new funds. Because the manager thinks that it would enhance his position with the stockholders, he decides to pursue the second alternative and raise the dividend on the Bank Alfalah stock. Now suppose that the Bank Alfalah is in a situation similar to that of low capital bank and has a ratio of bank capital to assets of 4%. The bank manager now might worry that the bank is short on capital relative to assets because it does not have a sufficient cushion to prevent bank failure. To raise the amount of capital relative to assets, he now has the following three choices: (1) He can raise capital for the bank by having it issue equity (common stock). (2) He can raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account. (3) He can keep capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities. Suppose that raising bank capital is not easy to do at the current time because Pakistani capital markets are tight or because shareholders will protest if their dividends are cut. Then Muhammad Ali might have to choose the third alternative and decide to shrink the size of the bank. In past years, many banks experienced capital shortfalls and had to restrict asset growth, as Ali might have to do if the Bank Alfalah were short of capital.

Discuss the details of bank capital requirements and their important role in bank regulation in the context of dynamics of Pakistani banking industry.
b). “Banking has become a more dynamic industry because of more active liability management”, List down the general principles of banking management.

Answer 1

a-Ans)

Banking Companies/Foreign Banks: To be able to commence business of banking,
locally incorporated banks as well as subsidiary of a foreign bank should have a
minimum paid up capital (free of losses) of Rs10 billion or any other amount as
prescribed by the SBP from time to time. Foreign banks intending to conduct banking
business in branch mode should have a minimum paid up capital (free of losses) of Rs 3
billion or any other amount as prescribed by SBP from time to time, subject to following
conditions: i) The foreign bank holds paid up capital (free of losses) of at least equivalent
to US$ 300 million and have a Capital Adequacy Ratio (CAR) of at least 8% or minimum
prescribed by their home regulator, whichever is higher; ii) The bank will operate with a
branch network of 5 branches; for more than 5 branches the Minimum Capital
Requirement (MCR) shall be as prescribed by SBP from time to time. Minimum CAR
requirement: Banks shall at times maintain a minimum capital adequacy ratio of 10% or
any other percentage as specified by the SBP from time to time. Other requirements: i)
Maintain a Reserve Fund as provided for in Section 21 of the 1962 Ordinance; ii)
Maintain a Cash Reserve as provided for in Section 22 of the 1962 Ordinance; iii)
Maintain a prescribed amount of liquid assets and a prescribed amount of assets as
specified in Sections 29 and 30 of the 1962 Ordinance.
Islamic Commercial Banks: To be able to commence business, the bank shall have a
minimum paid up capital of Rs 1 billion or any other amount as prescribed by SBP from
time to time and also shall at all times maintain minimum CAR of 8% based on risk
weighted assets. Other requirements: i) Cash reserve requirements; ii) Statutory liquidity
requirements.
MFBs: MFBs shall maintain a minimum Paid-up Capital (free of losses) of not less
than: i) Rs 300 million if licensed to operate in a specified district; ii) Rs 400 million if
licensed to operate in a specified region; iii) Rs 500 million if licensed to operate in a
specified province; iv) Rs 1 billion if licensed to operate at national level or any other
amount as may be prescribed from time to time. Minimum CAR requirement: MFBs shall
maintain CAR equivalent to at least 15% of their risk weighted assets. Other
requirements under Section 18 of the 2001 Ordinance: i) Maintenance of Statutory
Reserve Fund; ii) Statutory Liquidity requirements; iii) Case Reserve.

NBFC: A NBFC has to maintain separate tiers of minimum equity in respect of the
following forms of business as mentioned against each activity (or any other amount as
may be prescribed from time to time), namely: i) investment finance services: Rs 300
million; ii) leasing: Rs 200 million; iii) venture capital investment: Rs 5 million (for a
venture capital company); iv) discounting services: Rs 200 million; v) investment
advisory and asset management services: Rs 30 million; vi) housing finances services: Rs
100 million. Other requirements: Maintenance of a reserve fund wherein at least 20% of
the after tax profits of the NBFC shall be credited till the time that the reserve fund equals
the amount of the paid up capital of the NBFC and thereafter a sum not less than 5% of
its after tax profits shall be credited to the reserve fund.
Modaraba Companies: A Modaraba Company if solely engaged in the flotation and
management of Modaraba has to have a paid-up capital not less than Rs.2.5 million but if
it is engaged in other business as well then its paid up capital should be minimum Rs.7.5
million, or any other amount as may be prescribed from to time.

the capital reqirement ensures the liquidity of the banks

safeguarding the depositers amount.

provides assurance for public that insolvancy of the banks won't occur

safeguarding the liquidity position of the central bank of SBP

b-Ans)

Some principles are discussed below;

1. Principle of Liquidity
The principle of liquidity is very important for the bank. Liquidity refers to the ability of an asset to convert into cash without loss within a short time.

Paying the deposited money on demand of customers is called liquidity in the sense of banking.
2. Principle of Solvency
Solvency means financial capability or sufficiency in the capital. To stay in these competitive market banks must have sufficient capital. If the funds are not sufficient the bank cannot run his business.

The main source of funds of the bank is the deposited money by the depositors through the different types of accounts.

Depositors keep cash in the bank, especially for safety. So commercial banks must ensure the safety of deposited funds.

3. Principle of Profitability
The main objective of the bank is to earn a profit.

For earning profit bank have to invest by providing short-term loans, before providing loan commercial banks have to compensate a certain amount of money as liquidity.

4. Principle of Loan and Investment
The main source of profit of bank is granting loans to any individual or organization. Investment is a profitable and sound source of income. banks invest in the business and investment sectors.

5. Principle of Savings
banks collect funds by creating savings facilities. Commercial banks try to collect savings from society surplus.

The bank invests these savings to generate profit. So, more savings, more investment, and more profit.

6. Principle of Services
The bank ensures the best services to their customers. The success of a bank depends on the services provided by the bank. The customer chooses those banks that provide improved services.

7. Principle of Secrecy
Customers want to keep secrets about their valuable assets and money.

So banks must have to keep secrets about their customer’s accounts. If a bank does not maintain secrecy the customer will be dissatisfied.

8. Principle of Efficiency
The bank should operate their business efficiently. So that they can succeed at the objective.

In this competitive market, there is no alternative way without efficiency in management. So bank must train their employees to increase the efficiency in management.

9. Principle of Location
banks must have to locate their branches in the area where many customers are available. The location must be safe for the customers and an easy communication system must exist.

Other principles;

The principle of goodwill.
The principle of the economy.
The principle of technology.
The principle of publicity.
These are the basic principles of the bank