Basel II and Banks Software

Impact of Basel II on Credit Risk in
Pakistani Banks
By
Sadaf Fayyaz
ABSTRACT
Banking sector today is under immense pressure to sustain

the economy and improve regulatory measures. BASEL I was
introduced
but
it
had
its
own
shortcomings
and
limitations. Now State Bank of Pakistan has asked certain

Pakistani banks and DFI to implement BASEL II.
It is a regulatory frame work and State Bank has hired
certain consultants to work on it. The basic motivation
comes from an interest in banking sector and regulatory
reforms.
The scope of the research work is to see aims to see
whether
BASEL
II
would
benefit
the
credit
risk
in
Pakistani banks or not. The costs of implementation would

be high and certain banks have been asked to increase
their capital ratio. Some banks were taken as sample out
of the whole population and studied. It was found that
some banks may find it difficult to meet the requirements
and
may
go
for
restructuring.
The
banks
with
higher
capital base did not have any problems.

The research focuses on how Pakistani banks will benefit
from this approach. Certain banks find it difficult to
implement such regulatory measures, as it will drive them
out of competition. In the end the recommendation is that
however
costly
it
is,
for
banking
sector
improved
performance, Pakistani banks and DFI will have to go for

this supervisory measure.
ACKNOWLEDGEMENTS
First of all, all my heartiest thanks to the Almighty

ALLAH, whose mercy and blessings helped me to complete
this research work.
Yaseen
Anwar
(Deputy
Governor,
State
Bank
of
Pakistan)
Christian
Marlier
(Head
of
CRO
Executive
Office,
Counsellor to Chief Risk Officer)
David Keefe (Consultant Global Risk Regulator)
Christopher Chu (The Global Consulting Group)
Muhammad Akber
My account of acknowledgement would remain incomplete if

I do not express my gratefulness to my parents. They have
always been a source of inspiration for me.
TABLE OF CONTENTS
CHAPTER I INTRODUCTION
I.1 Background on Research
I.2 Research motivation and rational
I.3 Problem statement
I.4 Population
I.5 Element
I.6 Sample
I.7 Research objectives
I.8 Purpose of study
I.9 Unit of analysis
I.10 Data collection methods
I.11 Definition of terms
I.11.1 Basel I
I.11.2 Basel II
I.11.3 Capital Adequacy Ratio
I.11.4 Tier 1 Capital
I.11.6 Privatized Banks
I.11.7 Credit Portfolio (stochastic)
I.11.8 Confidence Interval
I.11.9 Value at Risk
10
I.11.10 Expected Loss
10
I.11.11 Unexpected Loss
10
I.11.12 Probability of Default
10
I.11.13 Exposure at Default
10
I.11.14 Off-Balance Sheet
11
I.11.15 Internal Based Rating
11
CHAPTER II THE LITERATURE REVIEW
12
CHAPTER III THE RESEARCH METHODOLOGY

III.1 Ten banks sample
23
III.2 The ratings based approach
23
III.3 Determination of risk variables
24
CHAPTER IV RESEARCH RESULTS AND DISCUSSIONS

IV.1 Basel II Process
25
IV.2 Basel II costs
25
IV.3 Impact on Local Banking System
26
IV.4 Challenges for Pakistani Banks
26
IV.5 Banks Qualification for Basel II
27
IV.6 Ratings Approach
27
IV.7 Mitigation of Credit Risk
28
IV.8 Rivalry among Banks
28
IV.9 Tools and Techniques
29
IV.10 Difference in Ratings Approach
29
IV.11 Findings
30
IV.12 Research Results
31
IV.12.1 Difference between Basel I and II
31
IV.12.2 Deadline for Pakistani Banks
31
IV.12.3 Standardized versus IRB Approach
31
IV.12.4 Anticipated Benefits
32
IV.12.4.1 Impact on Competition
32
IV.12.4.2 Better Information Systems
33
IV.12.4.3 Cost Analysis
34
IV.13 Feedback Results
35
IV.13.1 Deadline
36
IV.13.2 The Approach
36
IV.13.3 Slow Process
37
IV.13.3.2 Employee training
38
IV.13.3.1 Expensive Software
38
IV.13.3.3 Experts
38
IV.13.3.4 Need for a Big Investment
38
IV.14 Banks Paid-up Capital
39
IV.14.1 An overview
39
IV.14.2 Allied Bank Limited
39
IV.14.3 United Bank Limited
40
IV.14.4 Muslim Commercial Bank
40
IV.14.5 Abn Amro Bank
43
IV.14.6 NIB Bank
43
IV.14.8 Meezan Bank Limited
44
IV.14.7 Citi Bank N.A
44
IV.14.9 Bank Al Falah Limited
45
IV.14.10 Standard Chartered Bank
45
IV.14.11 KASB Bank
46
CHAPTER V CONCLUSION AND RECOMMENDATIONS

Bibliography
Appendix A Interview with Yaseen Anwar
Appendix B Interview with David Keefe
51
LIST OF ABBREVIATIONS
ABL
Allied Bank Limited
ADBP
Agricultural Development Bank of Pakistan
AIRB
Advanced Internal Ratings Based
BCBS
Basel Committee on Banking Supervision
BIS
Bank for International Settlements
BSRA
Banking Supervision Risk Assessment
CAR
Capital Adequacy Ratio
ED
Exposure at Default
EL
Expected Losses
ESOP
Employee Stock Option Plan
FSA
Financial services Authority
FSF
Financial Stability Forum
GDR
Global Depository Receipts
GRR
Global Risk Regulator
IBP
Institute of Bankers Pakistan
ICAP
Institute of Chartered Accountants of Pakistan
IRAF
Institution Risk Assessment Framework
IRB
Internal Ratings Based
JCR
Japan Credit Rating
LGD
Loss Given Default
MCB
Muslim Commercial Bank
PACRA
Pakistan Credit Rating Agency
PICIC
Pakistan Industrial Credit & Investment

Corporation Ltd
PCBL
PICIC Commercial Bank Ltd.
PD
Probability of Default
VAR
Value at Risk
SCB
Standard Chartered Bank Ltd.
SBP
State Bank of Pakistan
UBL
United Bank Limited
LIST OF FIGURES
Figure IV.1 Risk Class

Figure IV.2 The Anticipated benefits of Basel II
Figure IV.3 Impact on competition
Figure IV.4 Timely Information
Figure IV.5 Costs of Basel II
Figure IV.6 Feed back
Figure IV.7 Rating Approach
Figure IV.8 Excerpt from Balance Sheet

Figure IV.23 Banks Earnings after Taxes 2006 & 2007
Figure IV.24 Banks return on Equity 2006 & 2007
Figure IV.25 Banks assets 2006 & 2007
Figure IV.26 Banks loan growth rate
LIST OF TABLES
Table I.1 Pakistani Banks

Table II.1 Credit Rating
Table IV.1 Capital Summary
Table IV.2 Banks credit ratings 2007
CHAPTER I INTRODUCTION
I.1 Background on Research
Basel
II
is
the
term
which
refers
to
round
of
deliberations by central bankers from round the world. In

1988,
the
published
Basel
a
set
Committee
of
in
minimal
Basel,
capital
Switzerland,
requirements
for
banks. This is also known as the 1988 Basel Accord, and

was enforced by law in the Group of Ten countries in
1992,
with
Japanese
banks
permitted
an
extended
transition period. Purpose of the original 1988 accord

was
two-fold:
originally
from
12
The
adopted
guidelines
by
developed
the
of
central
countries
Basle
accord
banking
in
July
were
authorities
1988.
Their
implementation started in 1989 and was completed four

years
later
in
1993.
Basel
served
banking
industry
quite well since its introduction in 1988 but it delayed

behind the financial market developments and innovation.
It
became
outdated
and
flawed
as
it
relied
on
relatively rudimentary method of assigning risk weights

to assets, accentuating mostly on balance sheet risks
relative to multiple risks being faced by financial firms
today.
Furthermore,
it
offered
rigid
approach
to
capital determination and standard setting which did not

incarcerate fully the range of large and complex banking
operations and the accompanying series of assorted set of
economic risks. Addressing the perceived deficiency and
structural flaws of Basel I, the Basel II Accord offers a
newer
and
comprehensive
approach
and
methodology
for
financial
sector
recognizes
well
banks
dictatorial
the
advancements
businesses,
accompanying
capital
policies
financial
and
calculation
and
innovations
structures
engineering
and
which
and
in
the
innovation.
The
relevance and significance of Basel II comes from its

ability to recognize effectively the different types of
risks facing industry and the new products as well as
off-balance sheet transactions. Basel I is now widely
viewed as pass, and a more inclusive set of procedure,
known as Basel II is in the process of execution by
several countries.
I.2 Research motivation and rational
The
basic
motivation
is
an
interest
in
the
field
of
banking. The area of interest is credit risk. The other

motivation factor is basic research. The original Basel I
model
had
its
own
limitations.
The
implementation
of
Basel II may face some problems for Pakistani Banks. The

capital
requirements
and
other
constraints
are
still
there. There is a need to explore whether Basel II will

bring any improvements in the credit risk of Privatized
Pakistani banks. The total sample space comprises some of
Pakistani banks namely: Muslim Commercial Bank
www.mcb.com.pk
Allied Bank Limited
www.abl.com.pk
United Bank Limited
www.ubl.com.pk
ABN Amro Bank
www.abnamro.com.pk
Citi Bank Pakistan
www.sbp.com.pk
Standard Chartered Bank
www.standardchartered.com/pk/
Meezan Bank Limited
www.meezanbank.com
Bank Al Falah
www.bal.com
NIB Bank
www.nibpk.com
KASB Bank
www.kasbbank.com
The research study has helped us to know how Pakistani

banks undergo such the process of BASEL II in order to
improve
regulatory
framework.
This
would
help
to
see
whether Basel II costs exceed benefits or not. It may be

feasible for large banks whose capital requirements are
enough, as compared to small banks.
I.3 Problem statement

To what extent has Basel II overcome the potential
difficulties in the field of credit risk in Pakistani
Banks and will the impact be positive?
For this purpose, ten banks were considered and certain
study was done.
Certain research questions will be answered like:
Will Basel II lead to a jagged playing field between
banks and unregulated competitors?
Will the capital requirements lead to decreased bank
profits?
Will Basel II cost of compliance outweigh its benefits?
Will Basel II lead to threatening behavior in times of
crisis, increasing rather than decreasing systematic
risk?
Does Basel II favor large banks?
How does it relate to CAMELS? The rating system is
efficient
developed?
or
new
credit
rating
systems
need
to
be
The risk profile of all the banks is same or different?

If so, how does BASEL II fit into that?
I.4 Population
It was overall banking industry of Pakistan.
I.5 Element
Each
bank,
whether
local
or
foreign,
investment
or
commercial, was an element of the population.

I.6 Sample
The Pakistani banks were a sample, the mentioned above
ten
as well.
Table I.1 Pakistani Banks
Nationalized Commercial banks

National bank of www.nbp.org.pk
Pakistan
Habib Bank Ltd.
www.hbl.com.pk
First Women Bank www.fwbl.com.pk

Ltd.
Privatized banks
Allied Bank Ltd.
www.abl.com.pk
United bank Ltd.
www.ubl.com.pk
Muslim Commercial www.mcb.com.pk

bank Ltd.
Specialized banks
Agricultural
Development Bank
(ADBP)
Industrial
Development
of Pakistan
www.adbp.org.pk
www.idbp.com.pk
bank
Private Scheduled Banks

Punjab Provincial
Co-operative Bank
Ltd. (PPCB)
SME Bank Ltd.
www.smebank.org
Private Scheduled banks

Askari Commercial www.askaribank.com.pk
bank
Bank
Ltd.
Al-Falah www.bankalfalah.com
Bank
Ltd.
Al-Habib www.bankalhabib.com
Bolan bank Ltd.
www.mybankltd.com
Faysal Bank Ltd.
www.faysalbank.com.pk
Meezan bank Ltd.
www.meezanbank.com
Metropolitan Bank www.metrobank.com.pk

Ltd.
Platinum
Commercial
Ltd.
bank
Soneri bank Ltd.

Pak
Commercial
Ltd.
www.soneribank.com
Saudi www.saudipakbank.com
bank
The
Bank
Khyber
Of www.bok.com.pk
Provincial
before
www.bop.com.pk
Provincial
before
Bank of Punjab
Investment Banks
Atlas Investment www.atlasgrouppk.com
Bank Limited
Cresent
Investment
Limited
Bank
First
www.interbank.com.pk
International
Investment
Bank
Limited
Jehangir
Investment
Limited
Bank
Orix
Investment www.orixbank.com
Bank
(Pak)
Limited
Trust Investment www.trustbank.com.pk
Bank Limited
I.7 Research objectives

The research is focused towards finding certain answers
to
certain
questions.
Though
banks
find
it
helpful,
Pakistani Banks may face some potential implementation

difficulties.
Certain
issues
may
prove
difficult
to
resolve in Pakistani market. These include:

Banks, especially those facing profit challenges, may
find the cost of Basel II execution high-priced.
Many Pakistani banks will have noteworthy system and
process gaps to close.
Delaying
the
Basel
II
implementation
may
blow
the
competitiveness of the Pakistani Banking Industry.

Large number of Pakistani banks likely to mean that
reporting
is
variable
in
terms
of
consistency
and
quality.
Data availability and relevance identified as key issue
with
mergers
will
complicate
system
and
data
integration.
Potential shortage of core skills to implement Basel
II, especially given large number of banks.
Senior management may not succeed to appreciate the
importance / benefits of the Accord.
The research would further include whether Pakistan has

overcome some of the key challenges, as compared to
other developed countries. SBP has issued BSD circular
2 & 8, 2007 for capital adequacy standards at banks and
DFIs.
I.8 Purpose of study
The purpose of study is descriptive. Since some research
has already been conducted on Basel II, this lies under
descriptive studies. The investigation would be causeeffect.
I.9 Unit of analysis
(Banking) Banks of Pakistan
I.10 Data collection methods
Interviews and questionnaires are used. Qualitative data
is collected through some focus groups. The Secondary
data
sources
would
include
term
papers,
articles,
addresses, recent publications and case studies. Most of

the data was gathered via State bank of Pakistan. The
consultants
on
could
banks
help
Basel
II
interviewed
maintain
proper
and
risk
how
BASEL
measures.
II
This
included a discussion with the Deputy Governor, State

Bank of Pakistan.
I.11 Definition of terms
I.11.1 Basel I
Basel I chiefly focused on credit risk. Assets of banks
in this framework were classified and grouped in five
categories
weights
of
according
zero
(for
to
credit
example
risk,
home
carrying
country
risk
sovereign
debt), ten, twenty, fifty, and up to one hundred percent

(this category has, as an example, most corporate debt).
Banks
with
international
presence
are
needed
to
hold
capital equal up to 8 % of the risk-weighted assets.

I.11.2 Basel II
Basel
II
is
the
term
which
refers
to
round
of
deliberations by central bankers from round the world.

The new Basel Capital Accord puts down new guidelines for
determining the minimum solvency requirements for banks.
The key change in these guidelines is a new structure for
weighting the risks run by banks in their loans to retail
and corporate customers. The objective of Basel II is to
perk up the dependability of the financial system.
I.11.3 Capital Adequacy Ratio
CAR is defined as the ratio that determines the banks
ability and capacity in terms of liquidity needs, credit
risk
and
operational
risk
factors.
It
serves
as
cushion against the potential losses of the bank, which

save the lenders and depositors both.
CAR is same as leverage, but unlike traditional leverage,
CAR
recognizes
that
different
asset
classes
have
different risk levels. The regulations assign a 0% risk

factor to government bonds, 50% to residential mortgage
loans and 100% to consumer loans and credit cards.
Bank "A" has assets totaling 100 units, consisting of:
Cash: 10 units.
Government bonds: 15 units
Mortgage loans: 20 units
Other loans: 50 units
Other assets: 5 units
A term used for the capital adequacy of bank. Its the

core or base capital of the bank. It includes the equity
capital,
reserves
examples
are
and
common
shareholder
stock,
equity
preferred
too.
stock
The
(non-
redeemable and non-cumulative) and retained earnings. It

is the most reliable form of capital.
The
term
stands
for
the
second
most
important
and
reliable form of banks capital. These were standardized

with Basel I and come after Tier 1 capital.
I.11.6 Privatized Banks
Its the repurchase of all of a bank's outstanding stock
by employees or a private investor. As a result of such
an initiative, the company stops being publicly traded.
Sometimes, the company might have to take on significant
debt
to
Companies
finance
the
might
want
change
to
go
in
ownership
private
in
structure.
order
to
restructure their businesses. They might also want to go

private to avoid the expense and regulations associated
with remaining listed on a stock exchange.
I.11.7 Credit Portfolio (stochastic)
Its a combination of loans i.e. credit.
I.11.8 Confidence Interval
It is a statistical range with a specified probability
that
given
parameter
lies
within
the
range.
confidence interval is a range of values computed in such

a way that it contains the estimated parameter a high
proportion of the time. The 95% confidence interval is
constructed so that 95% of such intervals will contain
the parameter.
I.11.9 Value At Risk
technique
which
uses
the
statistical
analysis
of
historical market trends and its a technique volatility

to
estimate
the
likelihood
that
given
portfolio's
losses will surpass a certain amount.

I.11.10 Expected Loss
Its the average financial loss or impact that can be
expected
for
particular
loss
even
or
risk.
It
is
sphere
of
calculated based on experience and past.

It
is
the
expected
value
over
specified
portfolio losses due to default.

I.11.11 Unexpected Loss
The worst case financial loss or blow that a business
could incur due to a particular loss E / I / C or risk
I.11.12 Probability of Default

The Probability of Default is the likelihood that a loan
will not be re-payed and fall into default. This PD will
be calculated for each company who has a loan. The credit
history of the counterparty and nature of the investment
will
all
be
taken
into
account
to
calculate
the
PD
figures. Many banks will use external ratings agencies

such
as
Standard
and
Poors.
However,
banks
are
also
encouraged to use their own Internal Rating Methods as

well.
I.11.13 Exposure at Default
Exposure at Default or EAD is a parameter used in the
calculation
of
Economic
Capital
or
Regulatory
under Basel II for banking.
I.11.14 Off-Balance Sheet
Capital
This means that assets or liabilities not recorded on the

bank balance sheet. It could have a lease, independent
subsidiary or a liability like letter of credit. It also
has loan commitments, loans sold, futures and forwards.
I.11.15 Internal Based Rating

It
is
an
framework
approach
of
distinguished
advanced
the
by
its
method
may
to
internal
ratings
Basel
accords,
new
basic
be
and
used
advanced
only
by
within
the
which
is
methods.
The
institutions
satisfying more stringent requirements compared to the

basic approach. In this case, all the estimated input
(PD,
LGD,
EAD
and
Maturity)
used
for
credit
risk
assessment is done in-house. Instead, in the basic method

the Bank assesses only the PD.
CHAPTER II THE LITERATURE REVIEW
The
new
Basel
consists
of
II
comprises
minimal
three
capital
pillars.
requirements.
Pillar
Pillar
consists of supervisory review processes and Pillar 3

comprises market discipline (Council of Mortgage Lenders,
2008, p.2). Basel I served banking industry well since its
introduction
in
1988
developments
in
markets
market
but
developments
Chartered
it
could
and
put
and
Accountants
of
not
match
behind
the
the
financial
innovation.(Institute
Pakistan,
new
2006,
of
p.1-11).
According to (State Bank of Pakistan, 2007, p.1-32), its

known
by
its
importance
and
why
Basel
increasingly
became outdated and flawed as it relied relatively on a

simple
method
highlighted
multiple
mostly
risks
Furthermore,
could
of
not
risk
weights
balance
sheet
risks
being
the
fit
assigning
faced
Basel
in
the
by
large
set
firms
rigid
of
assets,
relative
financial
offered
to
today.
agenda
complex
to
that
banking
operations and following range of economic risks. Basel

II in some senses serves as more intelligent solvency
capital redeployment. Globally there is a deep interest
in Basel II. There is a strong global need for Basel II
standards but it would vary from economy to economy and
bank to bank (Cognos, 2007, [p.1]). Presently, on one
hand there are differences in economys and institutions
risk management procedures, state of technical know-how,
customers portfolio, and on the other hand, the state of
development of rating agencies, external auditors, and
above all, the variation of regulators across different
economies
(www.globalriskregulator.com).
The standard purpose of Basel Accord has

To
promote
world
financial
stability
by
coordinating supervisory definitions of capital,

risk
assessments
and
standards
for
capital
adequacy across countries (Ernst & Young, 2006,

p.8).
To
link
banks
systematically
activities,
to
capital
the
including
risk
requirements
level
various
of
its
off-balance-sheet
forms of risk exposure.

The relevance and significance of Basel II comes
from
its
ability
to
recognize
efficiently
the
different types of risks facing industry and the

new
products
as
transactions.
Some
well
as
distinct
off-balance
sheet
characteristics
of
Basel II are noteworthy:

@ It aligns capital of banks with their basic
risk profiles,
@ It is elaborate and far superior in terms of
its coverage and details,
@ It has the ability to develop effectively new
frontiers of risk management and gives thrust
to the development of sound risk management
systems,
which
promote
in
turn
efficiency
allocation
of
are
predictable
and
more
resources.(Financial
to
prudent
Services
Authority,2007,p.14)
First,
while
the
new
Accord
maintains
the
level
of
capital adequacy requirements at 8% (Tier 2 capital is

restricted to 100% of Tier 1 capital) consistent with
Basel
I,
it
has
shifted
emphasis
from
regulatory
to
economic capital framework, while giving appreciation to

new risk alleviation techniques (default protection etc.)
and expounding new trading book capital questions (Bank
For International Settlements, 2006, p.19).
Careful evaluation of these elements proposes that Basel

II is not ideologically about raising as per se capital
requirement
capital
but
focuses
allocation.
on
efficient
Appropriate
and
and
effective
sharpened
risk
expression and assessment and preserves would result in

reduced
capital
requirements
(Bank
for
International
Settlements, 2006, p.12). Conversely, the ill-conceived

financial
structures
with
risky
counterparties
will
attract disciplinary capital requirements. Basel II in

some senses serves as more intelligent solvency capital
redeployment.(Basel
Committee
On
Banking
Supervision,
2007, p.1-40).
Second, the new Accord has more intensity in its draft
than the older one (Federal Reserve Bank of Boston, 2005,
p.69). Basel II at the very basic level consists of the
Standardized
Approach
which
recognizes
and
defines
various asset classes and assigns them risk weights in

accordance with the type and nature of corporate issue
and other transactions and passing on its
assessment
to
external
raters
qualitative
(Pakistan
Banks
Association, 2006, p.3). The matrix of risk pails and

weights
is
considered
to
have
added
unnecessary
complexity for less sophisticated banks. The connection

and delegation of quality assessment to external ratings
lends
extreme
reliability
developing
confidence
of
rating
countries
proportion
of
International
has
on
the
agencies
only
corporate
Settlements,
which,
thus
and
objectivity
in
far
rated
issues.
2007,
at
a
and
least
small
(Bank
p.13).The
For
third
implication of Basel 2 and the Accord cheers banks to

recognize all types of risk and take suitable steps to
alleviate
these
capital.
Besides
risks,
the
while
credit
providing
risk,
the
for
Accord
adequate
for
the
first time identifies the operational risk, however, the
degree of guidance and complexity in measurement provided

within the framework for these risks varies. The credit
risk is dealt with most lengthily in the Basel II in line
with legacy of the first Accord as well as the banks
customary edge and capability in credit risk assessments
(www.bis.org).
Fourth, the IRB approach is being favored by large global
banks, which already competitively price credit risk. The
key strictures under IRB approach are PD (probability of
Default), LGD (loss given default), M (Maturity) and EAD
(Exposure
At
default)
(Bank
For
International
Settlements, 2007, p.26).

The banks and financial institutions have greeted Basel
II,
but
the
challenges
and
fore
comings
is
still
problem for banking industry. The credit risk is well

determined by mathematical formula:
Equation 1.1 Total Capitals
For
example,
if
bank
holds
$875
of
risk
weighted
assets, and market charge is $10, operational charge is $

20, the bank has to hold at least $100 in capital as
minimum. 875 + (10+20 *12.5) = $1250, 8% * 1250 =$100.
The
resolving
regulatory
the
outstanding
procedures
is
the
issues
most
of
Basel
challenging
II
task
(Kashyap, 2004, pp.1-13).

According to (Akhtar, 2007, p.13), the Basel II embodies
a
major
regulation
innovation
that
in
would
advances
result
in
to
financial
stronger
and
sector
much
reliable banking and financial system. The need is to
implement
it
to
its
full
potential.
Certain
key
outstanding issues need to get resolved. (Gestel, 2006,

p.2).
(Global
Risk
importance
Regulator,
of
2008,
regulatory
p.2)
framework
has
that
laid
the
the
Basel
Committee has put forward. The main issue of concern is

the starting dates of implementation for different world
zones.
EU
has
implementation
it
as
2008,
deadline
of
and
Pakistan
2009.
The
has
an
competitive
inefficiencies would develop among countries of different

world
zones
unhealthy
and
these
competition
would
among
cause
the
inefficient
banks
(Habib
and
Bank
Limited, 2007, [p.12]).

Basel II forces participant countries to reopen safetynet bargaining across affected sectors (Kane, 2007).
The accords success would primarily lies on the homehost supervisory link and the right balance between the
two. As far as up-and-coming countries are concerned,
they
need
to
get
associated
with
the
international
regulators to adopt a truly global accord. (Global Risk

Regulator, 2008, p.3).
According to Chernih, Vanduffel & Henrad, the Basel II
generates
framework
for
determining
the
capital
requirements for credit portfolios. Different businesses

operate in different socio-economic environments and a
capital requirement determination is necessary. The asset
co-relation
between
the
obligors
lie
between
8-24%.
( Institute of International Finance, 2006, p.12).

Jacobs has spoken of different risk models and Basel II
implementation. Smithson reviews both a top-down and a
bottom-up
first
one
approach
measures
to
measuring
cash
flow
economic
doubt
by
capital.
The
analyzing
the
historical cash flows of the firm. A measure of cash flow
analysis and assumed CI can be used. For example, use a

99%
CI,
and
the
change
in
annual
income
is
Rs.
300
million, how much capital must be set apart in offsetting

against
creates
this?
a
perpetuity,
Dividing
by
risk
capital
will
produce
(Hussain, 2008, p.10).
the
annual
amount
the
risk
which,
$300
free
rate
invested
million
each
in
year
The benefit to this approach is
that it is a comprehensive, total risk measure for a

business unit or firm. This approach suffers from a draw
back
of
historical
data
availability
(State
bank
of
Pakistan, 2007, p.12).

Market users need to understand better the structure and
risks of the credit risk transfer (CRT) products in which
they invest, according to the Joint Forum of banking,
insurance and securities market regulators.
A stoppage to understand and handle some of these risks
contributed to the financial market chaos stemming from
the
collapse
lending,
of
the
the
Joint
US
market
Forum
for
subprime
acknowledges
in
credit
report
prepared for a meeting in Rome of the Financial Stability

Forum (FSF).
credit
Users need also to understand better how
rating
agencies
assign
ratings
instruments and what circumstances
to
specific
would lead them to
downgrade ratings (Keefe, 2008, p.12).

The bottom up approach is used for measuring economic and
regulatory capital. Risks are measured definitely. The
risk break down of large banks is 70% of credit risk, 10%
market
risk
and
20%
operational
risk.
According
to
author, the credit risk is defined as the probability of

default (Bank for International Settlements, 2006, p.1).
Akhtar (2007) speaks of credit risk and two layers of
capital namely tier 1 and tier 2. The tier 1 constitutes
common
equity,
retained
earnings,
non-cumulative
preferred
stock
less
good
will.
The
tier
capital
comprises allowance for loan and lease losses, perpetual

preferred
debt.
stocks,
The
hybrid
off-balance
instruments
sheet
items
and
are
subordinated
converted
into
balance sheet items and multiplied by the appropriate

risk weight category. For example, a letter of credit
with maturity greater than 1 year lies in 50% range. The
new credit risk models according to Basel II consists of
internal ratings based (IRB), which is further divided
into
foundation
IRB
or
A-IRB.
The
other
one
is
standardized approach. The corporate credit risk can be

measured under Basel II like:Table II.1 Credit Ratings
S&P rating
Corporate risk weight
AAA to AA-
20%
A+ to A-
50%
BBB+ to BB-
100%
Below BB-
150%
Unrated
100%
The basic IRB differs from an advanced one in the context

of degree of control. The banks can exercise how much
control
over
determination
of
credit
risk
components.
There are 5 categories of exposure: Corporate (debt obligation to a corporation)

Sovereign
Bank
Retail
Equity
Smithson
like:-
also
speaks
of
the
credit
risk
components
Probability of Default (PD)

Loss given Default (LGD)
Exposure at default (EAD)
Effective maturity (M)
The main problem with the agency rating systems is that
agency ratings are based on stress scenarios and bank
ratings are based on borrower current conditions. The two
sets of rating criteria are not compatible (Monetary and
Economic Department, 2007, p.128).
The quantifications
are unbalanced and unreliable in the time in which data

planning is done. If the mapping is done in good economic
conditions, the banks ratings get slanted to good quality
credit ratings and prejudice the study (Department of
Finance, 2008, p.2).
US
banking
supervisors
information
in
expectations
the
for
hope
to
provide
next
month
or
so
banks
plans
for
some
about
more
their
executing
the
controversial Basel II safety rules, according to a top

federal supervisor. US Federal Reserve Board of Governors
member Randall Kroszner said plans by the Basel Committee
of global banking supervisors to enhance the resiliency
of the Basel II framework in the light of the credit
munch
should
in
no
way
interfere
with
institutions
efforts to meet the process and system requirements in

the US final (Basel II) rule.(Global Risk Regulator,
2008, p.12).
Wang
has
spoken
on
the
importance
of
how
capital
requirements influence monetary policy effectiveness. A

strict and conservative capital requirement affects the
lending supply and the balance sheet liquidity of banks
(Institute of Bankers Pakistan, 2007, p.4).
The Achilles' heel remarkably revealed in the Basel II

models by the chaos are a very bright, flashing yellow
light warning us to drive very carefully, Bair told the
Basel summit day of this weeks Risk Minds conference in
Geneva. She noted the turbulence took another twist today
with the announcement by Swiss banking giant UBS that it
is writing off a further $10 billion in losses in the US
subprime
lending
market.
Her
views
on
the
Basel
II
advanced approaches have often contrasted with those of

officials at the other three federal banking supervisory
agencies jointly involved in developing US policy on the
Basel II rules the Federal Reserve Board of Governors,
the Office of the Comptroller of the Currency and the
Office of Thrift Supervision. Officials at these agencies
have argued the current problems highlight the need for
large, complex banks to be regulated by the risk-focused
Basel II capital rules, which upgrade the simpler Basel I
rules
that
date
from
1988
(Federal
Deposit
Insurance
Corporation, 2008, p.14).

The more sensitive capital requirement would reduce the
bank lending in era of decline. He has also argued that
the credit ratings of the borrowers are exaggerated in
recession,
leading
to
greater
capital
requirements.
(Institute of Bankers Pakistan, 2008, p.2. Power (2004)

has a similar opinion. According to her, a rise in credit
risk may lead to a greater loan supply decrease and Basel
II may have a negative impact on the monetary policy. The
monetary policy would not be used as a inspiring tool
during
collapse.
Akhtar
(2007)
has
similar
view.
According to her, the weakness in the Basel II model is

that US banking industry is losing the lending market by
$ 10 billion. The large complex banks are facing this
problem. The Basel II credit rating models would fail
because
these
are
not
reliable
predictor
of
credit
responses (Hussain, 2008, p.12). They should never be

used where there is a change in the lending product. The
simpler
and
standardized
approaches
work
better
than
Basel II advanced risk rating systems. The regulators

require a cross risk approach under Basel II. (Institute
of Bankers Pakistan, 2007, p.3).
Basel
II
described
as
revolution
in
risk
management,
(Dawn, 2006, p.12), its mentioned that the new accord

would
definitely
prove
challenge
and
shape
up
the
banking industry. The main element for success is the

correct recognition and organization of risk. A higher
capital
allocation
against
the
credit
risk
would
be
needed for banks. The small businesses may suffer under

the
new
regime.
The
banking
industry
needs
better
credit rating and monitoring risk assessment system.

The deadline has been extended to July 2008. (Business
Recorder, 2006, p.10).
(Institute of Chartered Accountants of Pakistan, 2006,
p.3) holds a similar opinion. The eccentricity with Basel
II would a bad choice as it would demote the rating of
the
banking
industry.
This
would
in
turn
affect
the
payment of high risk premium to global financial markets.

Zubyr Soomro, (Gauhar, 2007, p.12) has spoken of how the
Basel II accord aims to lock up the different types of
risks
and
appropriate
accordingly
for
facing today.
each
requires
of
those
the
level
risks,
which
of
capital
banks
are
So the fact that banking system is going
from Rs. 3 billion to Rs. 6 billion by the end of 2009,

in
line
p.4).
with
global
trends
(Business
Recorder,
2008,
According to local papers (Business Recorder, 2008, p.6),

the Basel II replaces and overcomes some of the flaws
inbuilt in the Basel I credit risk model.
The
BCBS
papers
sharing
and
capital
standards
shed
cross
light
border
on
home-host
standards
application
as
and
information
international
mere
reason
for
successful Basel II (Qamar, 2006 p.2).

SAS
Pakistan
compliance,
works
(Daily
with
News,
banks
to
2006,
meet
p.12);
2008
it
Basel
seems
II
that
Pakistani banks have welcomed Basel II. The future of the

banking industry is further associated with the contract
of
software
preparation
that
Net
Sol
has
won
(Market
Wire, 2008, p.11).

Pakistan is likely to go for Basel II in 2008(The News,
2006, p.19) and some banks have been qualified as well.
According to (Dawn, 2006, p.20), it would be a great
revolution in Pakistani banking industry.
CHAPTER III THE RESEARCH METHODOLOGY
III.1 Ten banks sample

The
research
methodology
used
was
the
ten
banks
were
taken from the banking sector of Pakistan. The banks were

taken and how they could adopt to Basel II requirements.
Data from the balance sheets of these banks was taken and
analyzed. Some of these had problems in adopting Basel II
procedures for credit risk measures. Out of these banks,
MCB, ABL and UBL belonged to the privatized banks of
Pakistan, HBL and FWBL belonged to nationalized banks,
Meezan and Al Falah came under private scheduled banks,
and STC, Citi Bank and Abn Amro came under foreign banks
operating in Pakistan with head offices abroad.
III.2 The ratings based approach
The Internal Ratings Based approach used by some banks
was analyzed too. The balance sheets and other statements
showed well how the banks could tackle the problem of
tier
and
tier2
capital.
The
minimum
capital
requirements needed by the bank were feasible or not.

The banks were taken and samples of the latest financial
data were taken. The annual reports of 2006 and 2007 were
taken for Basel II implication, since the BSD circular no
08 was issued in the year 2007. Its not mandatory for
all Pakistani banks and DFIs to adopt Basel II, but it
would improve the performance of overall banking sector.
The credit risk is important and the credit portfolio of
the
customer/corporate
needs
to
be
checked
under
the
system. What was found from the three banks, UBL is the
first one to opt for Basel II standards?
The risk analysts jobs at the UBL require excel modeling
with Basel II standards.
III.3 Determination of risk variables
The most difficult task was the determination of risk

related variables. The proper risk assessment tools could
not be used since the process is in its infancy stage.
Also the financial data didnt disclose the quantitative
bank information. The determination of off-balance sheet
items made it further difficult. The data from the annual
reports of the banks was analyzed. The main source of the
analysis came from the banks balance sheets and profit
and
loss
statements.
The
capital
determination
was
conducted from the yearly financial data of the three

banks.
CHAPTER IV RESEARCH RESULTS AND DISCUSSIONS
As
things
were
discussed
with
the
deputy
governor
of
State Bank Pakistan, certain questions were put to him.

The discussions were held on telephone and mail as well.
The certain discussion research questions were asked and
certain answers provided.
The following answers were discussed and reproduced.
IV.1 Basel II Process
The State Bank of Pakistan has issued BSD circular 08,
and asked Pakistani banks and financial institutions to
have the minimum capital requirements. The issue has been
revised 3 times. The banks will be required to operate
and have a standardized internal ratings based approach
in order for the process to succeed. The BSD circular no.
08 of 2006, BSD circular no. 03 0f 2005 and BSD circular
no.
02
0f
2007
pertains
to
the
same
Basel
II
implementation. Though Pakistani banks are a bit slow in

acquiring Basel II, the system would improve the credit
rating and the market based risk rating systems under
this provision.
IV.2 BASEL II costs
Netsol, a NASDAQ listed company with CMM model 5 has won
the
bid
of
developing
the
internal
credit
rating
IRB
software for the banks. The software cost may be a little

high like, SAP cost but banks would benefit under this
program and likelihood of probability of default would
reduce too under this system. The costs are still unknown
but Netsol has been doing an excellent job in developing
Basel 2 software in other countries too. The State bank
has strictly asked the Pakistani banks to adopt Basel II.
The famous NASDAQ listed company has been successfully
providing the Basel II services in Asia pacific, Africa,

and UAE region too.
IV.3 Impact on Local Banking System
Certain
foreign
consultants,
who
are
making
careful
analysis of certain things and issues, have been hired by

SBP.
The foreign consultants have been working on these
specific
issues
and
how
Basel
II
standards
in
the
developing economies. Basel II regulations need certain

adaptations
usually
in
the
dont
have
developing
enough
economies.
capital
Large
banks
requirements.
The
capital needs, like tier 1 and tier 2 requirements are

same. The both should equal 8 % of total capital. The
total capital includes off balance sheet items as well.
Tier 1 needs to be 4 % of the capital, and tier 2 needs
to be 4 % of tier 2 too. Both contribute equally. Certain
small banks do not have maximum capital requirements. The
banks will need to increase the capital base.
IV.4 Challenges for Pakistani Banks
The Pakistani banks are under intense pressure, since the
corporate portfolios of loans are being changed too. The
emerging
economies
are
under
more
pressure
than
the
developed ones. The emerging economies are prone to more

shock
and
risk
macroeconomic
than
the
stability,
developed
the
credit
ones.
risk
Due
to
profile
of
corporate is significantly changing and banks are engaged

in diverse sectors and industries. The credit and market
risk is increasing due to this long exposure. The wide
array of risks that Pakistani banks are prone to now
include,
liquidity
credit
and
risk,
market
macroeconomic
risk,
risks.
operational
The
well
and
risk,
much
improved management and mitigation of all these risks is

important for the betterment of banking sector.
IV.5 Banks Qualification for Basel II

The new regulatory framework established by SBP, under
BIS
aims
towards
better
regulatory
procedure.
ask
to
banks
managed
The
increase
minimum
their
and
well
capital
capital
mitigated
requirements
base.
The
risk
management procedures would improve under this. We have

hired special consultants to work on Basel II. Pakistani
banks may/may not adopt these regulatory procedures, but
the fast coming trends would require banks to do so.
Banks
need
to
increase
their
capital
base
to
100
million by year 2009. some banks have already qualified

for these standards. The ones, who have found the capital
expansion
requirement
difficult,
are
working
hard
on
capital base expansion. Not only this, the state bank has
asked the banks to change the accounting mechanisms and
reporting
formats.
Some
new
financial
products
have
introduced too. Some special regulatory requirements are

needed in order to foster areas like consumer financing,
treasury, Islamic financing, information technology and
investment banking too.
IV.6 Ratings Approach
State Bank has recently introduced IRAF (Institution Risk
Assessment
Framework).
The
ratings
are
conducted
according to standards of SBP and come in compliance with

these. The composite rating system gives an onsite and
offsite
feedback
from
the
banks
management.
The
360
degree rating procedure is a supervisory rating process

that enables information about the health of different
banks
from
multiple
resources
like
SBP,
Board
of
Directors, management and market vigilance too. SBP has

also
been
in
the
process
of
developing
banking
supervision Risk Assessment Model. It would improve and

quantify the credit risk in the banks. The method used
would be VAR Value at risk by all the banks. The banks

position would be forecasted under the stress scenarios.
The system would extract the data from eCIB, Electronic
Credit
risk
Information
would
use
Bureau.
other
date
The
market
and
operational
statistics.
The
BSRA
model
would help banks to have better credit and market risk

appetite.
The
system
would
allow
for
corrective
and
timely measures, if needed.

IV.7 Mitigation of Credit Risk
The credit risk in an important element of bank lending
and needs to be dealt with care and supervision.
Credit operations are a main source of bank income and
boost economic activity too. Credit does impose a lot of
risk
on
the
banking
sector
too.
The
probability
of
default is one important thing. The number of consumer

financers has increased in the last 3 years from 2.4% in
2002 to 14.3% in 2006. It depends on the credit portfolio
also. The house financing is merely 2.3% of total loan
financing.
Besides
capital
requirements,
the
Basel
system encompasses a good risk management system. The

basic criterion is that according to the risk profile,
capital should be allocated accordingly. The pillar 1
comes under efficient capital utilization.
IV.8 Rivalry among Banks
Banks are asked to adopt the standardized risk approach
from 2009. In absence of regular rating agencies, the
banks would end allocating more capital than before and
this would generally affect the rate of competition among
the local banks. There is a need for better IT networks
and systems for the new framework to succeed. Secondly
historical data of banks need to be available in order to
make judgmental qualitative analysis.
IV.9 Tools and Techniques

The
rating
tools
used
systems
would
are
be
discussed
either
before
as
mathematical,
well.
The
statistical
(VAR), benchmarking, and other validation procedures as

well. A combination of both qualitative and quantitative
methods would be used. The most famous models to be used
are probability of default, (PD), exposure at Default
(EAD), Loss Given Default (LPD). The scorecards models
would be used for credit applications. The simulation
models would be used for project financing.
Special
Uncertain
Doubt
Figure IV.1 Risk Class
IV.10 Difference in Ratings Approach

The standardized rating approach is used by banks with
less complex operations. The IRB approach would be used
by banks with complex books and operations. The PD, LGD
and EAD are under IRB models. An IRB approach is there
for all the asset classes. The standardized approach is
for retail exposure. The Advanced IRB approach is for

whole
sale
banks
to
exposure.
change
It
the
compels
capital
some
small
Pakistani
requirements.
Only
Pakistani banks have been qualified up till now for Basel

II. The ones which do not qualify would increase the
capital base by the year 2009.
IV.11 Findings
The
Necessity
order
has
been
issued
by
the
State
Bank.
It
is
successful in the developing and the emerging economies.

So Pakistani banking sector must not lag far behind than
other nations. It must adopt Basel II Standards too.
Challenges for Pakistani banks
The Pakistani banking industry has seen much regulation

and deregulation in the last few years. It has to face
the
new
challenge.
The
business
cycles
and
corporate
behavior has changed a lot. Banks are washed out with

liquidity problems, non-performing loans. The credit risk
profile of different businesses has changed too. Small
banks may face some problem in adopting Basel II.
Expected benefits
The risk areas would concentrate more and the regulatory

requirements would help reduce risk from these 3 areas,
i.e. market risk, credit risk and operational risk also.
Cost benefits analysis
The costs would be in software development, (Netsol) has

already
won
software
incur,
as
creation
cost.
for
of
the
consultancy
Basel
the
II.
bank
reserves
The
contract
training
employees
may
also
need
for
cost
to
impose
developing
would
know
some
it.
also
The
additional
IV.12 Research Results

IV.12.1 Difference between Basel I and II
Basel needs lenders to compute a certain level of minimum
capital requirements. Basel II has 3 pillars. Basel II
goes beyond Basel I in allowing lenders to compute their
own risk measurement models. An IRB risk rating is used
with Basel II. Under pillar 1 of Basel II, the lenders
are required to cater for additional risk, which was not
done
by
pillar
dissimilarity
between
1.
For
the
example,
interest
there
rate
of
may
be
asset
and
liability classes.
IV.12.2 Deadline for Pakistani Banks
Up till now, only 8 banks have qualified for Basel II.
The
other
is
requirements
striving
to
100
hard
Million
to
change
dollars
the
till
capital
2009.
BSD
circulars issued by the State bank ask local banks to

adopt Basel II till year 2008.
IV.12.3 Standardized versus IRB Approach
The standardized approach is for banks with more capital
and less complex operations and books. The standardized
approach is just like Basel I. under IRB approach, the
lenders determine their own credit rating and minimum
capital requirements. They determine on their own how
much capital to allocate to what risk class.
The term capital under Basel II means that it includes
shareholders
shares
too.
funds,
Capital
debentures,
needs
to
bonds
be
held
and
by
preference
banks
and
financial institutions, so that it absorbs the loss and

acts as a cushion against the risk. Some borrowers may
not pay the loan or amount lent.
The capital requirement, both of risk adjusted assets, is

8% of total capital. The tier 1 plus tier 2 capital would
count for 8% in all.
IV.12.4 Anticipated Benefits
The new regulatory procedures would bring a substantial
change in the banking world though efficient port folio
management,
risk
based
measures
and
efficient
risk
models.
Basel II has an impact on spread; the risk pricing would
become more proactive. The banks would plan to work and
contribute
the
capital
to
risk
attribution
and
performance management both.
Figure IV.2 Anticipated Benefits of Basel II
IV.12.4.1 Impact on Competition

The positive impact of Basel II would be on competition.
The banks and financial institutions with better risk and
regulatory procedures would definitely get a competitive
advantage. The Basel II changes will allow the business
models that get more timely and accurate risk data. Thus
the competitive and comparative landscape would change a

lot.
Figure IV.3 Impact on Competition
IV.12.4.2 Better Information Systems

The Basel II would result in better information systems
and better risk management systems. The impact would be
positive on timely and quality risk information. Also,
there would be better understanding of risks profiles in
the
organizations.
Lastly,
assessment of risk-return.
it
would
lead
to
better
Figure IV.4 Timely Information
IV.12.4.3 Cost Analysis

The on-going cost analysis for Basel II is as under. The
diagram shows well the costs to be incurred. These are
development as well as operational costs.
A
better
terminology
would
be
to
use
the
word
investment instead of cost. The development as well as

the operational costs would be higher. The training and
software
development
costs
pertain
to
these. The cost of reserve is another one.
the
highest
of
Figure IV.5 Costs of Basel II
IV.13 Feedback Results

The capital allocation procedures under Basel II are more
risk sensitive and deep. This would cause improved risk
management procedures at banks. The implementation is not
a piece of cake in emerging market economies. The risk
assessment and management procedures need to be updated
and transformed into advanced ones. The Pakistani local
banks are in their infancy stage of Basel II standards.
It is more questionable in the developing economies.
The results obtained from some banks showed a positive
response.
None
of
the
bank
said
no
to
Basel
II
standards. The DFIs had the same answer. The figure below
shows the obtained results from banks.
IV.13.1 Deadline
Figure IV.6 Feedback
The above statistics clearly show the feedback obtained

from different banks. Most of the banks were of the view
that Basel II standards should be implemented from year
2008. though the SBP has extended the time line to year
2008. the other finding was that many banks were ready to
adopt the standardized rating approach. The other finding
was
the
response
from
the
local
banks.
Almost
banks
facing capital problems said yes to Basel standards to

start from 2008.
IV.13.2 The Approach
The local banks were of the view that standardized risk
rating approach would be the best for them. They were
hesitant in adopting the AIRB approach.
Figure IV.7 Rating Approach
Some of the banks may need to increase their paid-up

capital as well. Also the banks would need to increase
their capital requirements to charge off against credit
risk. The banks may get the Basel II software also. The
paid-up capital increase would be Rs. 2 billion. There
would be 3 credit rating approaches that the banks would
be using. The standardized approach would be used by the
banks with less complicated operations. The banks with
more
complicated
operations
would
be
using
the
IRB
approach. The IRB approach is further divided into the

foundation
IRB
and
the
Advanced
IRB.
Under
the
AIRB
approach, the banks would be able determine LGD and EAD

and estimates and build better flexibility in collateral
guarantees
and
credit
risk
formulas.
The
capital
allocation is determined by the quantitative and formulas

given by the committee.
IV.13.3 Slow Process
It was certainly found that most of the Pakistani banks,
even
those
with
no
capital
shortage,
are
slow
in
acquiring Basel II standards. As compared to other Asia
Pacific
countries,
Pakistani
banks.
the
The
process
is
much
reasons
for
the
slower
slow
in
the
process
include:IV.13.3.1 Expensive Software

The expensive cost of Basel II software has made the
process a bit slower.
IV.13.3.2 Employee training
The high cost on employee train on software usage has
also caused the process to slow down.
IV.13.3.3 Experts
The
job
descriptions
or
hiring
of
professional
may
include Basel II experts. It may take more time than

estimated. Since, its not that easy to find people from
a pool of banking and finance, who are well aware of the
Basel II standards.
IV.13.3.4 Need for a Big Investment
Adopting
human
Basel
II
resource
specifications.
standards
and
In
IT
most
of
needs
big
investments
software,
Pakistani
systems
banks,
in
and
the
risk
management function is still regarded as a requirement

laid by IBP. In order to implement Basel II and risk
management should not be looked at separately; rather,
instilling
environment
prudent
will
and
proactive
inevitably
lead
risk
management
towards
smooth
transition to Basel II compliance.

In a span of the next 3 years, the Pakistani banks have
to increase the capital from Rs. 2 billion to 6 billion.
This may get some small banks disappear. Up till now,
only
eight
banks
have
qualified
for
the
capital
requirements. The rest are meeting or trying to reach the

capital requirement threshold. This may cause 2 small
banks
to
merge
with
other
small
bank
to
have
more
capital. The problem only lies with the local banks. The
foreign banks like Abn Amro and Standard Chartered would
definitely be expected from this restriction if their
head offices have $100 million capital.
IV.14 Banks Paid-up Capital
IV.14.1 An overview
The State Bank of Pakistan has extended the Basel II
implementation deadline to year 2009 now. The central
bank has asked to increase the capital requirement from
Rs. 2 billion in 2007, and to increase by Rs. 1 billion
each year, to reach Rs. 6 billion in 2009. The commercial
banks were required to increase their capital up to Rs. 4
billion till 2007.
The
paid-up
capital
target
has
to
reach
minimum
threshold level of Rs. 6 billion by the end of 2009. The

paid up capital for First Women bank Limited is not is
meager. Such banks may go for restructuring or merging.
IV.14.2 Allied Bank Limited
The Allied Bank has currently a paid-up capital of above
Rs.
4.4
capital
billion.
increased
So
it
from
need
4.4
not
worry.
billion
in
The
2006
billion in 2007.
Figure IV.8 Excerpts from Balance Sheet
paid-up
to
5.38
Also, the long term credit rating is AA and the short

term is A1-. The credit ratings show the low expectation
of credit risk. A1- ratings support the highest capacity
for timely payments.
IV.14.3 United Bank Limited
The UBL has a paid-up capital of Rs. 6.47 billions. It
has increased its capital in 2005 from 5.1 billion to
6.47 billion in 2006. There is a better future associated
with Basel II. The Bank assets (loans in all) have also
increased from 21.6 billion to 29.863 billion. The bank
also has a credit rating of AA in the long term. The
short
term
rating
is
A-1+,
which
shows
good
credit
quality. The Pakistani government plans to sell GDR of

UBL
in
June.
This
would
further
increase
the
capital
base.
The data for 2005 and 2006 is as follows:
The paid-up capital did not increase but the net assets
increased.
IV.14.4 Muslim Commercial Bank
It has a paid-up capital of Rs. 5.4 billions.
Also, the long term credit rating is AA+ and short term
is
A1+.
endure
The
ratings
the
reflect
banking
MCB's
environment,
strong
capacity
arising
from
to
its
extensive franchise supported by an efficient technology

platform.
quality
The
ratings
having
absorption
recognize
positive
capacity.
The
impact
MCB
the
on
improving
the
experienced
asset
bank's
high
risk
deposit
ratio in 2006 and planned to increase it till 75%. The

GDR issue in 2005 led to a high CAR. The deposit ratio
was 46% in 2003, 62% in 2004, and 79% in 2005. It came to
a
level
of
75%
in
2006
and
then
75%
in
2007.
The
subsidiary of MCB asset management led Rs. 300 million

capitals injected. The estimated target of MCB in the
next 3-5 years is to have 30-35 % consumer lending.
The bank of Khyber would not be able to meet the capital
requirements till next year. It may require a deadline
extension. The First Women Bank Limited has it as:-
PACRA gives a similar view of the bank in maintaining the

capital needs. With its paid-up capital well short of the
statutory
requirement
and
uncertainty
regarding
its
future, the bank is finding it difficult to maintain the

momentum. Its rating is BBB+.
My
Bank
has
prepared
itself
for
the
new
capital
requirements. The latest data from 2007 annual report

shows:
From
the
above
financial
data,
its
obvious
that
the
increased capital does not cause bank assets (loans) to

decrease. In case of ABL, the capital did not increase
from 4.4 billion in 2005 to 2006, but assets increased
from 14.54 to 17.64 billion. The % increase is of 21.59%.
The capital has increased from 4.4 to 5.3 billion. The
assets
increased
from
17.64
to
19.87
billion.
The
increase in capital during 2006-07 was 20%. The growth in

assets in 2006-07 was 12.64%. The loans increased, but at
a decreased rate.
In case of UBL, the paid-up capital did not increase from
5.18 billion in 2004-05. The assets grew by 24.67%. The
capital increased from 5.18 to 6.47 billion. The assets
grew by 37.85%.
In
case
of
available.
MCB,
The
the
paid
up
five
year
capital
historical
kept
growing
data
was
till
5.4
billion till the end of 2006. The assets grew similarly.
IV.14.5 Abn Amro Bank
From the above financial data for the years 2005 and
2006, it is obvious that the foreign bank is already
exempted from Basel II compliance. The head office has a
capital base touching the 6 billion targets and there is
an increase in the capital base of the bank from 2005 to
year 2006. Also, the assets grew from 4.1 billion Rs. to
4.8 billion Rs. The bank has no problem with its capital
base, and can endure in the banking industry. Currently
Abn Amro is using the Delta, VAR and OCP model to manage
its market risk, and MDDR and OBSI to manage its credit
risk. The CAR of the bank declines from 12.37% in 2005 to
11.69% in 2006. Abn Amro is currently managing through
ALCO
and
risk
directorates.
The
bank
has
recently
acquired Prime Commercial Bank.

IV.14.6 NIB bank
The above financial data for the years 2006 and 2007
shows that NIB qualifies for Basel II with a high capital
base, though the reserve creation process is slow. There
is an increase in the capital base of the bank, but
reserves
show
no
change.
The
bank
plans
to
sell
its
shares to shareholders of PICIC and PCBL, which would

increase the capital base further. Also, the long term
credit rating of the bank is A+ and the short term is A-.
There is a remarkable increase in the bank assets from 46
billion Rs. to 176 billion Rs. So Basel II is not a
problem. (NIB acquired PICIC and PCBL recently). It is
the second most capitalized bank of Pakistan now. The
shareholders of PICIC bank will get 2.27 shares of NIB as
one
of
old
ones.
The
646
million
shares
will
be
introduced and the paid up capital would further increase

from 22 billion to 28 billion, with 6.5 billion swap
capital.
IV.14.7 Citi Bank N.A
Citi Bank may have to struggle a bit hard to sustain

itself. The capital base is 3.79 billion and increased a
little
over
the
past
one
year.
There
is
very
slight
increase in the capital base and reserves. Citi bank is

planning to buy Soneri bank.
IV.14.8 Meezan Bank Limited
The above financial data for the years 2006 and 2007
shows that there is no increase in the capital base,
though some reserves have been created and increased.
According to the requirements by SBP, the bank intends to
increase its capital base by issuing 9.9 million ordinary
shares at Rs. 10 under an Employee Stock Option Plan to
reach the target set by SBP.
IV.14.9 Bank Al Falah Limited
The
bank
already
qualifies
for
Basel
II
targets
and
standards. Though, the reserves have declined in year

2007. It is forecasted that the year 2008 and 2009 would
be very profitable for the bank. The bank has announced
to increase its capital base to 15 billion Rs. Also the
long term credit rating is AA and short term is A1+. Also
the bank has maintained a CAR of 8.34 % in 2007.
IV.14.10 Standard Chartered Bank
The paid up capital is quite high for the bank. This is

the highest capital base for a Pakistani bank. The NIB
bank
comes
Pakistan.
as
Also
second
the
most
highly
reserve
capitalized
creation
process
bank
is
of
quite
high. All the 3 credit rating agencies (JCR-VIS, PACRA

and S&P) have assigned high ratings to the bank.
IV.14.11 KASB Bank
The above financial data for the 5 years show the great
increase in the capital base. The bank has reached a
target of 4 billion Rs. The reserves have also increased.
Over
the
past
years,
the
bank
has
been
actively
increasing its capital base and reserves. The bank has

issued right shares and has an Employee Stock Option Plan
for increasing its capital base. There is also an upgrade
in the credit rating of the bank. The long term rating
has been upgraded to A- whereas the short term is A2. The

improved ratings show a low expectation of credit risk.
Table IV.1 Capital Summary
Bank
Year
2006 Year
capital
capital
(in billions (in
PKR)
PKR)
2007 Reserv
es
Reserves
2007
billions 2006
ABL
4.4
5.38
6.133
6.05
UBL
5.18
6.47
8.2
------
MCB
4.2
5.3
24.6
------
FWBL
0.2
0.2
0.175
------
Abn Amro
4.11
4.8
NIB
3.2
22.3
0.719
0.719
Citi bank
3.74
3.79
-----
------
Meezan
Bank
3.779
3.779
0.528
0.728
6.5
2.749
2.414
Bank
Falah
Al 5
------
Standard
Chartered
38.715
38.715
1.11
1.92
KASB bank
2.2
3.1
0.11
0.11
Figure IV.23 Banks Earnings after Taxes 2006 & 2007
UBL showed improvement in its after tax profits due to

overall improvement in retail banking, commercial banking
and corporate finance group. MCB showed an improvement in
profits because of its retail and consumer banking. The
increase
in
SCB
profits
acquisition of Union Bank.
is
associated
with
the
Figure IV.24 Banks return on Equity 2006 & 2007
Figure IV.25 Banks assets 2006 & 2007
Figure IV.26 Banks loan growth rate
Table IV.2 Banks Credits ratings 2007
Banks
Rating Agency
Ratings assigned
Short Term
ABL
JCR-VIS
Long Term
A+
PACRA
A1+
AA
UBL
JCR-VIS
A-1+
AA+
MCB
PACRA
A1+
AA+
Abn Amro
PACRA
A1+
AA
Pakistan
Citi Bank
Standard
& ----------
-----------
Poor
Meezan Bank
JCR-VIS
A-1
A+
Bank Al Falah
PACRA
A1+
AA
STC
PACRA
A1+
AAA
JCR-VIS
A-1+
AA+
PACRA
A1
A+
NIB
KASB
PACRA
A1
CHAPTER V CONCLUSION AND RECOMMENDATIONS
In the light of things and issues discussed above, its

obvious
that
the
changing
banking
environment
and
paradigm has increased the complexity of operations and

business. The businesses have increased their portfolio
risk and operational risk too. Also the Pakistani banking
industry
is
under
governmental
and
the
other
intense
pressure
operations.
The
of
changing
central
bank
operations may be affected and the banking industry has

to
handle
the
enhanced
exposures
to
not
only
the
corporate risk, but also the household sector.

The following is recommended for some banks:
Banks like ABL, UBL, MCB, NIB, STC, KASB, and Meezan
have no problem with their capital base. They can
simply go for Basel II standards. (It is estimated
that these banks will have increased capital for
year 2008).MCB announced its GDR which can increase
capital. NIB after acquiring PICIC has increased its
capital base. Bank Al Falah would have no problems
since
it
has
already
announced
to
increase
its
capital base to Rs. 15 billion in 2008.
Citi Bank has achieved little growth in its capital

base and reserves for the last one year. It may
acquire some local bank or can either merge with
some stronger bank to increase its capital base.
Citi Bank may find it difficult to meet Basel II
requirements.
Abn Amro has sufficient capital base but has to make

it to 6 billion. Also, the bank needs to change its
credit rating procedures from MDDR and OBI to Basel
II. Basel II covers all the three kinds of risks
(i.e. market, credit and operational. The STC is
using three different models i.e.
Delta, VAR and
OCB for market risk, and MDDR, OBI for credit risk).
FWBL will have to merge with a stronger bank or get

acquired by some other bank to maintain the Basel II
standards. Also My bank may fall prey to mergers if
it
doesnt
increase
its
capital
base.
Provincial
banks like Bank of Khyber would see a difficult time

in 2008-2009.
The SME and microfinance exposures also require better
risk management procedures. The SBP has taken a proactive
initiative
in
the
regulation
of
the
local
banks.
The
sound increased growth and diversity of businesses need

better
regulatory
and
supervisory
procedures
now.
The
macroeconomic pressures also make the adoption of Basel

II important. The results from differ banks show that
they would be prone to more credit and operational risk
during the next decade. The credit risk weight has been
quite high in the last decade and some regular capital
needs to be assigned against it.
In the short run, local banks would have to continue the
risk management procedures through better understanding
of market and credit risk both. It may be a bit costly
for
some
banks
procedures,
but
investment.
to
this
more
adopt
the
should
Basel
be
fundamental
II
regulatory
considered
credit
risk
as
an
ratings
approach needs to be adopted. Also a change is required

in the risk methodology and procedures too. The new and
advanced credit risk rating procedures need to be adopted
to
ensure
better
banking
supervision.
The
SBP
would
continue to take the initiative and recommend banks to

adopt the standards. It would continue its alignment with
the local banks and make sure that the banking industry
prospers more under the surveillance of SBP, under the

compliance of international supervision procedures.
So
its
recommended
operations
to
approach.
The
for
adopt
banks
the
local
with
standardized
banks
with
more
complex
credit
more
rating
complicated
operations would go for IRB credit rating approach.

The data showed from different banks that some of the
local banks usually have strived well increasing their
capital base. Some banks have already qualified for the
Basel II standards. The capital requirements are aligned
with
the
Basel
II
minimum
capital
requirements.
Some
banks are in the process of reaching the desired level of

capital requirements and would be able to attain it by
the end of 2009. The capital requirements may drive some
players out of the competition or may result in their
disappearance. A better standard for such small banks
would be consolidation or merger. A merger would help in
small
banks
achieve
the
capital
standards
and
hence
continue their existence too.

The Basel II capital increase requirement would certainly
drive out some small banking industry players out of the
competition. This may result in complete ebb. The small
banks with weak credit rating and meager capital base
seriously need to do something. Its visible that in order
to meet the capital needs, some small players would need
to merge and lot of consolidations would take place in
the banking sector in the next few years. The number of
banks
may
increase,
since
consolidations
would
take
place. The local banking industry has already seen about

twenty
five
mergers
in
the
last
six
years.
The
most
famous acquisition is of PICIC by NIB and Union Bank by

Standard Chartered Bank. The Samba Financial Group of
Saudi Arabia would be acquiring Crescent Commercial Bank,
and ABN Amro has already acquired Prime Commercial. Citi

Bank is also in the process of acquiring Soneri Bank.
The
banking
sector
would
definitely
be
taking
new
shape. Its recommended also. The banking sector needs to

fulfill the capital requirements of Basel II. Mergers and
acquisitions
is
the
only
solution
that
can
let
banks
sustain themselves. This would create some synergistic

benefits too. Mergers may have their own pros and cons
but it ensures survival of small banks too.
The strengthening of the financial and banking sector is
only ensured by mergers and acquisitions. This would also
affect and shrink the banking industry. The large pie
which was divided into 10 pieces would be now divided
into 5 pieces only. One most recent development is that
Barclays group is taking keen interest in acquiring stake
in banking sector in Pakistan.

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Impact of Basel II on Credit Risk in

Banking sector today is under immense pressure to sustain

limitations. Now State Bank of Pakistan has asked certain

Pakistani banks or not. The costs of implementation would

capital base did not have any problems.

performance, Pakistani banks and DFI will have to go for

First of all, all my heartiest thanks to the Almighty

Counsellor to Chief Risk Officer)

David Keefe (Consultant Global Risk Regulator)

Christopher Chu (The Global Consulting Group)

My account of acknowledgement would remain incomplete if

I.2 Research motivation and rational

I.3 Problem statement

I.7 Research objectives

I.8 Purpose of study

I.9 Unit of analysis

I.10 Data collection methods

I.11 Definition of terms

I.11.3 Capital Adequacy Ratio

I.11.4 Tier 1 Capital

I.11.5 Tier 2 Capital

I.11.6 Privatized Banks

I.11.7 Credit Portfolio (stochastic)

I.11.8 Confidence Interval

I.11.9 Value at Risk

I.11.10 Expected Loss

I.11.11 Unexpected Loss

I.11.12 Probability of Default

I.11.13 Exposure at Default

I.11.14 Off-Balance Sheet

I.11.15 Internal Based Rating

CHAPTER II THE LITERATURE REVIEW

CHAPTER III THE RESEARCH METHODOLOGY

III.2 The ratings based approach

III.3 Determination of risk variables

CHAPTER IV RESEARCH RESULTS AND DISCUSSIONS

IV.2 Basel II costs

IV.3 Impact on Local Banking System

IV.4 Challenges for Pakistani Banks

IV.5 Banks Qualification for Basel II

IV.6 Ratings Approach

IV.7 Mitigation of Credit Risk

IV.8 Rivalry among Banks

IV.9 Tools and Techniques

IV.10 Difference in Ratings Approach

IV.12 Research Results

IV.12.1 Difference between Basel I and II

IV.12.2 Deadline for Pakistani Banks

IV.12.3 Standardized versus IRB Approach

IV.12.4 Anticipated Benefits

IV.12.4.1 Impact on Competition

IV.12.4.2 Better Information Systems

IV.12.4.3 Cost Analysis

IV.13 Feedback Results

IV.13.2 The Approach

IV.13.3 Slow Process

IV.13.3.2 Employee training

IV.13.3.1 Expensive Software

IV.13.3.4 Need for a Big Investment

IV.14 Banks Paid-up Capital

IV.14.2 Allied Bank Limited

IV.14.3 United Bank Limited

IV.14.4 Muslim Commercial Bank