banking industry problem

8/8/2019 Banking Industry Problem

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Banking Industry Problem

The recession of 2008-09 exposed several problems in thebanking industry. In addition to numerous bank closings,

funds used by the Federal Depositors Insurance Corp.(FDIC) to insure bank deposits shrank by 40 percent,representing billions of dollars. Some of the problems in thebanking industry can be traced to the type of loans they weremaking.

Failed BanksDozens of banks failed in 2008 and 2009, many of whom

were heavy into commercial real estate loans, constructionloans and land loans. Commercial real estate loans financethe strip malls and shopping malls that saw decreasingnumbers of customers as the economy declined. Ownerswere not able to make the payments and may haveabandoned the property, leaving the banks on the hook. Thisled to undercapitalization at many banks, which caused themto be taken over by the FDIC.

Sub Prime LendingMany banks engaged in sub-prime mortgage lending. Theseloans were made to customers who did not qualify forstandard mortgage loans because of weak credit, insufficientincome or an unstablejob situation. A sub-prime customer ismuch riskier because of these factors. Many loans made tothese customers were adjustable rate mortgages, which aretied to certain indexes, plus a margin, that increase

periodically and raise the mortgage payment. Somecustomers saw their payments increase by hundreds ofdollars, making them unaffordable. Foreclosures reachedrecord levels when homeowners could not make thesepayments.
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ForeclosuresThe increase in foreclosures caused the value of homes todecline substantially. Many homeowners were left owingmore than their homes were worth. Faced with foreclosure,

they also were unable to sell the homes without goingthrough a short sale, which potentially could leave themowing a deficiency balance. The increase in foreclosuresalso caused a decrease in demand for housing.

Bad LoansSome banks made a lot of bad loans. Many customersshould not have been approved for loans in the first place.

Other banks invested in risky mortgage-backed securities.Then, when the recession hit, many people losttheir jobs and were unable to make loan payments.Delinquency rates for mortgage loans soared, as did lossesand bad debts.

Reserve RequirementsA lot of banks didn't have sufficient reserves. This is theportion of customers' deposits that banks are required tokeep on hand, in the cash vault or on deposit with theFederal Reserve. These reserves help offset losses andassist with everyday banking transactions. When banks don'thave enough reserves, they cannot lend money until the

reserves are replenished. Banks can borrow from otherbanks at the Fed Funds rate, which is 0.25 percent. Thesetype of loans are usually overnight borrowing.


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Mergers & Acquisition: Due to reserve requirementsimposed by statue bank mergers have taken place andsome banks are acquired by bigger banks to save themfrom liquidation.

Example of Acquisition and Mergers:

MCB Bank Limited

MCB is one of the leading banks of Pakistan incorporated in1947. MCB was nationalized in 1974 along with all other

private sector banks. MCB was privatized in 1991 whenNishat Group bought a majority stake in the bank. MCBsshares are traded on all three exchanges of Pakistan and itsglobal depositary receipts are listed on the London StockExchange.

During the last fifteen years, the Bank has concentrated on

growth through improving service quality, investment intechnology and people, utilizing its extensive branchnetwork, developing a large and stable deposit base andmanaging its non-performing loans via improved riskmanagement processes.

Maybank

Maybank was incorporated on 31st May 1960 andcommenced operations on 12th September 1960. On 17th

February 1962, Maybank was listed on the then KualaLumpur Stock Exchange (now known as Bursa Malaysia)and is today one of the largest companies by marketcapitalization in Malaysia.


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Maybank is the largest financial services group in Malaysiaand the Group offers a comprehensive range of financialservices and products ranging from commercial banking,investment banking, Islamic banking, offshore banking,leasing and hire purchase, insurance, factoring, trusteeservices, asset management, stock broking, nomineeservices, venture capital and Internet banking.

The Group has over 450 offices in the 14 countries namely,Malaysia, Singapore, Philippines, Brunei Darussalam,

Indonesia, Vietnam, Cambodia, Papua New Guinea, HongKong SAR, Peoples Republic of China, Bahrain,Uzbekistan, Pakistan, Great Britain and United States ofAmerica

Recent Happenings in Pakistans Financial Market

Pakistans Banking industry is the worlds third most

profitable banking industry.The probable acquisition deal of MCB Bank and the enteringof Barclays Bank into the country are seen as a majordevelopment in the local financial sector.The UK-based Barclays bank transferred 100 million dollarsto Pakistan to fulfill the requirement of maintaining minimumpaid-up capital limit before launching its operations inPakistan.

Maybank

Asia-Pacific's largest Islamic banking service provider

Foreign Stakes


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1. March 21st 2008: $ 136 million for 15% stake inVietnam's An Binh Bank

2. March 28th, 2008: $ 2.7 billion for 56% stake inIndonesias Bank Internasional Indonesia (BII) 1

4.6 times of its book value(510 rupiah per BII share)from Singapore's state-directed Temasek Holdings andSouth Korea's Kookmin Bank

Maybank is seeking another 44% stake of BII for $1.2

billion

3. June 2008: $ 680 million for 15% stake in PakistansMCB Bank (May 2008) from Nishat Group 2

PKR 470 per share

11% premium to the stocks last traded price

5.4 times of its book value (Reuters Data) 3

PE 18 times of 2007

Maybank secured the right to buy an additional 5%stake in MCB Bank for a maximum of $247 million from

1Maybank shares have fallen 11 percent since the Indonesian deal was announced. Credit-rating agencies

Fitch and Moody's have both put its ratings on a negative outlook, amid expectations that it would need to

raise funds to bolster its balance sheet.

2The stock was suspended on Friday, pending the MCB announcement. It last traded at 8 ringgit per share,

giving it a total market value of nearly $12.4 billion.

3Bank Muscat of Oman and Nomura Holdings of Japan paid 2.8 times book value for Saudi Pak Bank of

Pakistan in January. In 2006, Standard Chartered paid a lofty 5.6 times for Union Bank.


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three other institutional investors, potentially bringing itsownership up to 20%.

4. August 8th

, 2008: $ 217 million for 5% stake inPakistans MCB Bank

Maybank was obliged to buy up to another 5 percent ofMCB Bank shares within one year of the firsttransaction.

Stock:

January 2008 $3.24 per share

July 2008 $2.16 per share

With this drop in share prices, Malaysias Public Bank(Maybanks competitor in Malaysian market) overtookMaybank in market capitalization.

Maybank Public Bank

MarketCapitalization

$ 10.4 billion $ 11 billion

Profit Growth1 15% 23%

Loan Growth2

9.7% 22%Market Share

(as of December31st,2007)

23%

Customer Base 8.1 million


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NationwideDistribution in

Malaysia

(as of December31st,2007)

450 branches, 2478 ATMs.

1In fiscal 2007 over fiscal 2006.2For nine months ending Mar. 31, over same period previousyear.

Assets:

July 2008 $ 82 billion

Research Analysts Expected Results

Net profit to increase by 8.2%

S&P Ratings

After announcement of MCB acquisition, Standard &Poor affirmed its 'A-' long-term and 'A-2' short-termcounterparty credit ratings on Malaysia's Malayan

Banking Bhd. (Maybank) with a positive outlook afterthe company announced it will buy 15 percent ofPakistan's MCB Bank Ltd.

The rating affirmation on Maybank is based on itssound financial profile and strong domestic franchise as


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the largest commercial bank in Malaysia, underpinnedby continued improvement in asset quality and strongcore profitability, S&P said.

MCB Bank

Maybank is the ideal strategic partner for MCB Bankgiven its emerging markets heritage and strongconsumer and Islamic banking franchise.

MCB Industry Average

ROE 38% 23%

Net Interest Margin(NIM)

8% 6%

Source: Affin Investment Bank,Kuala Lumpur

MCB Bank

AssetsPKR 400 billion ($

6.14 billion)

Branches 1026

Islamic Banking14

(8 in Pakistan and6 abroad)

Deposit BasePKR 280 billion

($4.3 billion)

Asset BasePKR 300 billion

($4.6 billion)


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Source: MCB Bank Website

Maybank and MCB

The transaction represents the largest Foreign DirectInvestment into Pakistan in 2008

This transaction is also the largest ever private sectorcross border transaction in Pakistan.

The agreement underlines MCB commitment to enterthe next phase of growth by partnering with a leadingfinancial services group thereby expanding its productoffering and improving efficiency to better serve itscustomers.

Maybank is the ideal strategic partner for MCB Bankgiven its emerging markets heritage and strong

consumer and Islamic banking franchise. As Malaysiasfinancial services leader in the region, it seeks to buildits presence in key growth markets across the region.

Maybank is looking for the position MCB enjoys as oneof the leader in the Pakistan financial sector where ithas proven its performance and profitability throughconsistently high returns on equity and strong netinterest margins supported by a low cost funding base.

MCB and Maybank will enter into a businesscooperation arrangement which will focus on a numberof areas, including:

Islamic banking,

retail banking,


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credit cards,

asset management, and

SME banking.

Both Maybank and MCB Bank believe that significantrevenue synergies can be attained through thistransaction.

Merrill Lynch acted as advisor to Nishat Group.Aseambankers and JPMorgan acted as advisors to theMaybank Group for the transaction.

Maybank said it was buying the MCB stake from

existing shareholders, including individual investorsMian Umer Mansha, Mian Hasan Mansha andMuhammad Saleem. Other sellers were the bank'spension funds as well as the Nishat Mills EmployeesProvident Fund Trust and the Adamjee InsuranceCompany.

Conditions to the Deal

The deal includes the possibility of buying up toanother 5 percent of MCB Bank from the threeindividual investors. Under a separate agreementwith the trio, Maybank would buy the additionalshares at no more than 510 rupees per share.

If the deal is executed at the capped amount of Rs510 per share, the financial account would rise to

$226mn while, if the stake is sold at Rs 490 pershare, the transaction could provide the financialaccount with a minimum of $ 217mn.

Talking about the put option on shares salesanalyst also said, as per the agreement, some ofthe sponsors were granted a put option to sell


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further MCB shares (in addition to 15% alreadysold) up to a maximum of 5% (31.4mn shares)within one year from the date of completion (SellRight Period) of the sale of original 15% stake.

Since Maybank has already paid the US$680mnfor acquisition of 15% stake to the sponsors inJune 2008, the put option is exercisable at anexercise price of Rs490 plus holding cost cappedat Rs510.

In addition to the put option available to IndividualSellers, a call option has also been granted by the

individual sellers to Maybank. This option is in themoney if the sponsors sell less than 2.5% ofoutstanding MCB shares to Maybank during theSell Right Period and allows Maybank to increaseits holding upto a maximum of 20%. According tothe terms of this option, Maybank can onlyexercise its right within 5 business days in a singletransaction upon conclusion of the Sell Right

Period at the same strike price as the put option,he added.

The Deal

As part of the transaction Maybank will acquire fromNishat Group an immediate 15% stake in the Bank for apurchase price per share of PKR 470.

To facilitate close strategic cooperation, Maybank willhave the right over time to appoint two Directors torepresent its interest on the Board of MCB

Maybank fell 2.5 percent to 7.80 ringgit, off a low of7.55 ringgit, after announcing that it had agreed to pay2.17 billion ringgit ($680 million) for a 15 percent stake


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in MCB Bank, the fourth-largest bank in Pakistan byassets.

Citigroup cut its target price for Maybank to 7.60 ringgitfrom 8.38 ringgit, saying the MCB deal was expensiveand lacked synergies.

Maybank reiterated its commitment to paying out 60%of net profit as dividends. The final dividend would beannounced in August together with its full-year results.

The group planned to release its optimum capitalstructure plan by end-June, adding that it intended toachieve an ideal risk weighted capital ratio of 11% to

12%.

Financial institutions -- Problems and opportunities.

THE development financial institutions, which till recentlyworked with corporates and away from the gaze of thegeneral public, are attracting a lot of attention by their BigBang entry into the retail sector.

While this development is perhaps in keeping with radicalchanges happening in the financial sector, for the FIs, thepast holds the key to their success.

Long-term lending

The FIs are best placed to extend long-term loans. Armedwith expertise in project appraisal, and long-terminstruments, the FIs are best placed to finance big, long-gestation projects.

But to lend long-term in the current environment, the FIsthink that the Government ought to provide concessionalfinance. To get a better idea of the problem, it is necessary


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to understand the unique features of long-term lending andabout the FIs' experience.

The primary purpose for setting up the FIs was to build fixed

assets in the country by using financial intermediaries skilledin handling that kind of lending. Long-term lending is adifferent game because of the number of associateduncertainties traceable to unreliable information andunexpected developments. Typically, the farther one looks,less relevant the current information.

To handle this, the FIs used to get concessional funds till the1990s. With the dawn of the liberalisation era, the FIs wereasked to go to the market to raise resources.

The upshot of all this is that a number of loans made by FIsin the mid-1990s have gone bad because of the changes inthe industrial environment. The outcome: A worrying level ofnon-performing assets (NPAs) on the books of all the FIs.

Today, the number of new projects in the manufacturing

industry has fallen. But the importance of infrastructureprojects makes big-ticket long-term lending a viableproposition. But the uncertainties continue -- long gestation,confusion over the legal dimensions, and the looming threatof NPAs.

In a recent report, the FIs indicated that long-term financingwas linked to the availability of concessional finance. But thisdoes not look like happening at the moment.

But long-term lending is no longer the favourite way of goingabout things. The Basu Committee -- appointed by the IFCIto suggest ways out of the mess -- recommended that theIFCI cut back its exposure to project finance and balance itsportfolio through a suitable re-mix. Long-term finance may


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give high returns, but lately its the high risk that comes to theforefront.

NPAs: Determinant of valuation

For the equity market investor, the key to determining thestock market valuation of the FIs will be the NPAs -- real andimagined. Typically, a financial intermediary's stock pricehinges on the possibility that its borrowers will default. Whenthe fear of a default looms large, the stock price isdepressed.

Thus, the stock of the IFCI, which has the worst NPA record

among the three FIs, has seen little interest. ICICI, whichhas a high level of NPAs and managed to bolster its ownfunds through a equity issue last year, commands the bestvaluation.

The sectors where the FIs have the highest level of NPAs --textiles, manmade fibre, basic chemicals and steel -- have allseen sweeping changes in the recent past. All the sectors

have been, and will probably be, exposed to greatercompetition. Therefore, the milieu in these sectors,particularly in the companies where the FIs have a largeexposure, will have a bearing on the FIs' stock valuation.

Such is the fear of the NPAs that it has quite often affectedthe market valuation of ICICI despite all the dramaticchanges it has ushered in. Had the circumstances beendifferent, the market may have rewarded ICICI's moves with

better valuation.

For this year, things have not been made easy for the FIswhat with the Reserve Bank of India (RBI) tightening theprovisioning norms for NPAs. Thus, all the three FIs will


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have to make larger provision at the end of the year, therebydampening the net profit level.

`Evergreen' NPAs and the valuation problem

It is not just the NPAs that affect FI valuations, it is also thecamouflaged threat posed by deteriorating assets. However,the ICICI CEO, Mr K. V. Kamath, categorically stated that itwas not possible to ``evergreen'' bad loans and therebyavoid the fallout that follows classifying a loan as NPA.

However, the equity market valuation of FIs often impactedby the perceptions of the NPAs, in turn leading to a mark

down. One reason is that many of the problem projects,especially in steel and textiles, have suffered time and costoverruns. In the meantime, the environment has changed forthe worse, that is, companies are exposed to greatercompetition.

The FIs, or any lender for that matter, would be in adilemma. They may need to identify the projects that would

be eventually viable and perhaps provide them assistance.This raises fears of good money being wasted to conceal thereal state of affairs.

Recently, the FIs helped the Jindal Vijaynagar Steel project-- bogged down by time- and cost-overruns -- by convertinga portion of long-standing loans into equity. The Jindalproject, coupled with the increased exposure to textiles andsteel by the IFCI in 1999-2000, raises fears about the extent

of the NPAs. While the FIs may be justified in pumping inmore money into the project to save existing investments,the uneasy feeling that all is not in order remains.

Shrinking spreads


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Spreads (the difference between interest income andexpense) have begun to narrow across the financial sector inthe wake of rising competition. The other important cause,unique to the FIs, is that incremental lending is increasingly

directed through shorter-duration instruments.

Incremental lending through such instruments is evident inICICI's change in portfolio composition. ICICI's case isinteresting because its balance-sheet size grew at over 30per cent per annum in the last four years. Other thaninfrastructure, where huge advances have taken place, asignificant part of the incremental lending is directed towards

medium-term loans.Incremental lending for shorter durations has twoimplications. One, the level of associated risk is lower. Theother is of lower returns.

The way out...

Faced with the bad loans, shrinking spreads and the need to

reduce risk in incremental lending, the FIs have foundopportunities expanding significantly in the last few years.The way out, as they see it, is to provide every conceivablefinancial service to all kinds of customers.

While doing so, the FIs have been conscious of the need tokeep interest costs -- the most significant expense on theirincome statement -- low. Thus, there have a been a fewrecalls of high cost bonds issued earlier and an attempt to

access cheap funds through the commercial banking arm.

Universal banking

Simply put, universal banking means a complete breakdownof barriers between different categories of financial


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intermediaries such as commercial banks and FIs andNBFCs. A financial intermediary would strive to fulfill allneeds under one roof so as to make the most of theeconomies of size and business opportunities present by

catering to the different needs of a single customer.

As barriers break down on the lending side, there is a moveto achieve greater uniformity in raising deposits. The existingregulations do not allow a financial intermediary to carry outall functions. For instance, while there are hardly anyboundaries between the different kinds of financialintermediaries when it comes to lending, the restrictions on

raising resources create distinct categories.Banks have the lowest cost funds among financialintermediaries because they are allowed to raise cheapfunds through demand deposits such as the savingsaccount. NBFCs and the FIs can raise money only throughdeposits locked in for a fixed period. But there arerestrictions on banks about how they utilise their funds.Thus, there exist demarcating lines between different

institutions. But in this environment, financial entities such asICICI, IDBI and HDFC follow a system that classifies themas near universal banks because all the institutions havepromoted commercial banks. But the problem theseinstitutions face is they cannot borrow the cheap fundsraised by their group companies that act as commercialbanks.

Retail thrustThe big push by ICICI into retail is expected to diversify itsincome stream even while reducing the risk associated withincremental lending. While ICICI made its presence feltthrough a high-pitch advertising campaign to familiarisepeople with its brand-name, IDBI decided to follow suit and


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set as its long-term objective a ``one-stop financialsupermarket''.

The broad imperative of the move into retail finance is as

follows. Big-ticket lending carries a big default risk. But retaillending, with smaller-sized loans, reduces the impact ofdefault.

The advances in information technology has made possiblethe thrust into retail lending for the FIs which havetraditionally catered to corporate borrowers. The shrinking ofboundaries and the breaking down of barriers, thanks to IT,have triggered a revolution in financial services the worldover. India is no exception.

ICICI has been the most aggressive, among all financialintermediaries, in breaking into the retail market. Thecompany made its presence felt in housing and automobilefinance by capturing a significant share of the market. As ofnow the share of retail lending in ICICI's balance-sheet is amere 0.8 per cent of its total assets (1999-2000). But in a

relatively small market, ICICI's thrust has heightenedcompetition among lenders and brought benefits toconsumers in the form of more innovative products andlower interest costs.

ICICI has been able to move into the market by capitalisingon the progress in back-office automation and using the`spare' distribution capacities of other financialintermediaries. It is the possibility of scaling-up retailoperations at limited incremental cost that excites financialintermediaries, which is where ICICI has made its presencefelt.

But the company's retail thrust is viewed with scepticism insome quarters. For instance, some NBFC officials feel that


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Pakistan is a poor, heavily populated country on whichinternal political instability, phases of military dictatorship,and inefficient, corrupt governmental rule have taken a tollas much as the costly confrontation with neighboring Indiaever since partition in 1947. The economy is dominated byservices, but agriculture still plays an important role.Pakistan's most important industry is textiles, which alonerepresents about 60 percent of the country's exports. Aftergrowing at an average rate of over 6 percent per year from1980 to 1991, real gross domestic product (GDP) growthslowed during the 1990s and dropped to 1.3 percent in

1996-97 due to a poor cotton crop and related setbacks inthe textile industry. In 1997-98, growth hit 4.3 percentagainst a governmental target of 6 percent. Real GDP grewonly by 3.1 percent in 1998-99 but went up to 4.5 percentduring 1999-2000. Pakistan's GDP per capita was US$450in 1999, which puts it slightly above the South-Asian averageof US$440 per capita.

Since the late 1980s, Pakistan has pursued a program ofmarket-oriented economic adjustment, reform, anddevelopment. With the support of international financialinstitutionsmainly the International Monetary Fund (IMF)and bilateral donorsthis program has aimed atenhancingmacroeconomic stability, promoting the privatesectorand export-led industrial development, and reversingpast neglect of key social sectors such as health, education,

and population planning. Specifically, the government hassought to reduce monetary and external imbalances, reducetrade barriers, modernize the financialsector, privatize state-owned industries, and offer specificincentives to attract foreign investment. Unfortunately, the


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implementation of this program has mostly lagged behindexpectations.

Despite the availability of cheap labor, a large domestic

market, and access to regional markets, foreign investorshave shied away from investing their money in Pakistanbecause of its widespread corruption, lack of skilled labor,law and order problems (especially in Karachi, the industrialhub), and an outdated infrastructure . Domestic investmenthas also slowed in recent years. According to official figures,total investment has declined from an average of 17.1percent of GDP a year between 1984 and 1994 to 7.9

percent between 1994 and 2000. One reason is thatmanufacturers, who are traditionally served by the domesticbanking system (particularly yarn spinners and sugarrefiners), have often failed to honor their debts, contributingto a banking crisis.

Underlying most of the economic problems faced byPakistan is the "crisis of governance," as the World Bank

calls it. This phrase refers to the poor performance of thepublic institutions in terms of accountability, efficientmanagement, corruption, and tax collection. Among these,corruption is one of the most pressing problems.Transparency International, an international non-governmental organization monitoring governments, rankedPakistan 2nd, 5th, and 11th, in its annual reports on the mostcorrupt countries in the world between 1996 and 1998.

Corruption hurts the economy by raising transaction costs.Even if these payoffs are considered part of the cost of doingbusiness, there is an economic loss as these payments areneither available for expansion and improvement in thequality of public services, nor for private sector investment. A


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1994 survey conducted by the World Bank among 200business firms in Pakistan revealed that a significant amountof time and money was wasted in numerous unpredictableinteractions with petty and higher-level bureaucrats seekingbribes. Entrepreneurs reported spending about 12 percent oftheir time dealing with tax and regulatory requirements. Also,corruption depresses economic growth by lowering publicinvestment. Only a part of the amount appearing in budgetdocuments as expenditure on public projects may actuallyget spent on these projects; the rest is siphoned off bygovernment functionaries and contractors. One study

estimated that the value for money obtained in governmentconstruction of school buildings may be only 50 to 60percent.

Another major problem is Pakistan's huge external debt andits continued dependence on financial aid. Foreign loans andgrants provide approximately 25 percent of governmentrevenue, and debt service obligations total nearly 50percent of government expenditure, which means that asmuch as half of all government expenditures are used torepay loans. Defense and debt service together absorb morethan two-thirds of total federal expenditure, or almost allrevenues from federal taxes. Improving tax collection in themedium-to long-term is crucial if Pakistan is to maintainrepayments on its combined foreign and domestic debt ofabout US$62 billion, almost equivalent to Pakistan's annual

GDP. It is estimated that the country needs at least US$21billion of aid up to 2004 just for debt repayment, a largefigure for a nation with annual exports of less than US$9billion and very little foreign exchange reserves . In thecase of the provinces, the bulk of expenditure is taken up byestablishment costs (civil servants' salaries, benefits, and


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pensions), interest payments, and subsidies . Thegovernment under General Pervez Musharraf, whichoverthrew the government under Nawaz Sharif in 1999,faced US$32 billion in external debt. General Musharraf'sambitious economic agenda includes measures to widen thetax net, privatize public sectorassets, and improveits balance of trade position. Commitment to these reforms,however, has to withstand strong opposition from interestgroups such as employees of state-owned corporations,private traders, landlords, and government bureaucrats. It isunclear how the U.S. war against the Taliban regime in

neighboring Afghanistan, begun in 2001, will impactPakistan's economy.

banking industry problem

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