JAHANGIR KHAN'S VIEW

Jahangir Khan, the CFO, felt that the Bank needed to work out a basis to compare customer

profitability in order to maximize profitability. The ranking should be based on some

percentage profitability index rather than in rupee terms. Once this was achieved, the Bank

could identify the low profitability customers and concentrate on increasing its yield by

marginalizing them. As a first step, the risk-weighted return required by FCB could be

ignored. This could be introduced after resolving the issue of marginal customers. In order to

illustrate the importance of this issue Jahangir displayed FCB's abbreviated balance sheet (see

Exhibit 2). He pointed out that the bank aimed to establish a set of six desired standards,

which had been derived from the deposit base.

Cash management was a critical area, and Jahangir felt that "it was a constant battle to keep

cash on hand low so as to improve profitability, and yet low cash balances made the provision

of services difficult". Thus, the bank tried to maximize its profitability while ensuring

liquidity through positive intervention in the inter-bank (call money) market. FCB maintained

an internal cash cushion equal to 2% of total deposits, of which 1% was invested in overnight

call loans or on very short tenors, i.e., not exceeding one week. This was to help the Bank

raise liquidity quickly in the event of heavy withdrawals.

Jahangir pointed out that FCB had to maintain a cash balance that included both a statutory

Cash Reserve Requirement (CRR) as well as the 2% cushion. The former was currently 5% of

the demand & time liabilities (deposits) of the bank, and was maintained with the State Bank

of Pakistan, the country's central bank. 2 Pervaiz Ahmed, the Head of Treasury, interjected to

point out that FCB typically maintained a CRR of 7% to ensure that the bank was never short

of reserves 3 , and all sudden withdrawals could be met.

1 This was similar to working capital financing or a short-term credit line.

2 It earned a zero rate of return.

3 Running short of reserves, which were calculated on daily average balances, on settlement Saturday, entailed

high penalties.

10

ALI'S CONCERNS

Ali said that First Commercial had 20 branches spread over Pakistan. Fifty percent of the

branches were in Karachi and Lahore 4 , while over 75% of the deposits were mobilized in

Karachi and Lahore and 90% of the loans originated from there (see Exhibit 3). However, due

to regulatory constraints, the FCB had to abide by the State Bank of Pakistan's formula on

new branch openings. For every branch opened in one of three larger urban areas, a branch

also had to be opened in a smaller regional site. Hence, FCB could not open all the new

branches could be opened in Karachi and Lahore.

Ali pointed out that the bank had launched a variety of new products for the customers,

although not all of them were available throughout the country. A summary of the main

liability products is provided in Exhibit 4. Ali elaborated further on these products:

1. Current Accounts : These were checking accounts offering no profit. Such accounts

were not marketed independently, except in cities such as Turbat and Quetta in

Balochistan, and parts of Peshawar in the North West Frontier, where there was a

clientele which demanded non-interest products. All other current accounts were by-

products of facilities given to customers, such as receipts from exports or sales

proceeds. The market for current accounts was small, and in the annual deposit

mobilization plan, there was no expectation that these accounts would increase. They

were treated as complements of the marketing of advances.

2. Savings Accounts : These were accounts based on the profit-and loss-sharing (PLS)

formula introduced by the banking system in 1985. As such, banks did not 'sell' suc h

accounts, since the average rate of return of 6% was generally low for many

customers. However, savings accounts were preferred to current accounts, and

retained their liquidity and flexibility of withdrawal. Under PLS system, interest rates

could be cha nged every six months.

3. Classic Accounts: These were the key liability products of the bank, and FCB's sales

teams had estimated that at least 60% of fresh deposit mobilization would be in this

form. They were checking accounts on which interest was computed on a daily basis.

This rate of return varied with the balance that the clients maintained in the Classic

Accounts, although the average cost was about 10%.

Amount in Rupees Annual rate of return

(%)

Below 100,000 0.00

100,000-249,999 9.00

250,000-500,000 10.00

Above 500,000 10.50

4. Anchor Accounts: These were cash management deposits targeted at business

customers, so that surplus cash could earn higher returns. Interest was paid on the

4 These were the country's two largest cities with a combined population of some 18 million

inhabitants.

10

minimum balance in the account, which was based on the amount of the deposit

balances. The average cost of Anchor to FCB was 11.00%, while it was predicted that

at least 20% of fresh deposits would come from this source.

Amount in Rupees Annual rate of return

(%)

Below 500,000 0.00

500,000-999,000 10.00

1,000,000-2,499,000 10.50

2,500,000-4,999,0000, 10.75

Above 5,000,000 11.25

5. Term Accounts : These were fixed deposits varying in maturity from less than one

year to tenors exceeding a year. Typically the former maturities had an average cost of

10% for FCB, and the latter about 12%.

6. Foreign Currency Accounts (FCAs): FCB had mobilized some five billion rupees in

FCAs when they had been frozen by the Government of Pakistan in May, 1998. Two

years later, only 10% of this balance remained. Another Rs 200 million was expected

to be withdrawn by the end of the current year, especially since FCB was making no

attempt to retain these accounts, as there were a large number of regulations governing

them, and it was very costly to maintain them. Although no interest was paid on these

accounts, FCB paid an 8% percent fee to the State Bank of Pakistan to obtain foreign

exchange cover (hedging).

7. New Foreign Currency Accounts (FX): These had been introduced under Circular

(FE 25) issued by the State Bank of Pakistan, to satisfy a demand from customers for

the new foreign exchange accounts. FCB did not encourage FX accounts and paid

only 2% rate of return on them. Although FCB earned 4% by placing these funds in

Nostro 5 accounts outside Pakistan, the Bank generated no liquidity from them and was

unable to use them for lending purposes.

Ali argued that deposit mobilization was the critical area of any bank. However, the notion

that a bank having more long-term deposits also had more stable deposits was not true. While

long-term deposits allowed a bank to lock in interest rates, the capacity to do conventional

business was dependent on the ability to raise stable and low cost deposits and retain them.

This was a function of relationship building and efficient service.

LENDING

Sameer Chaudhry, FCB's Head of Credit was invited by Ali to discuss the loan portfolio (see

Exhibit 5). Sameer said that the most critical variable for FCB was the loans to deposits ratio,

commonly referred to as the Credit Deposit Ratio (CDR). Bankers traditionally looked at it

very carefully, and prudent bankers preferred a ratio as low as 60%. Sameer felt that "as a

rule of thumb, a rush on the bank would result in a 40% withdrawal. If the Bank could meet

this demand, the panic of hasty withdrawals would subside."

5 A nostro account is a foreign currency account held by a local bank with a correspondent overseas.

10

Surplus Funds = Deposits + Other Liabilities - (Cash + Advances + Other Assets)

FCB had set its CDR at 70%, which included both loans and refinance 6 facilities, although

refinance was not funded from the banks' deposits. The State Bank of Pakistan encouraged

commercial banks to provide loans with tenors up to 180 days at below- market rates of 8%. In

turn, the State Bank provided refinance to banks at 6% giving them a 200 basis point cushion.

However, experience indicated that up to 10% of refinance from the State Bank of Pakistan

was actually financed by FCB from its own funds. This was because borrowers were unable

to adjust the loans from their own cash flows after 180 days. Hence, the risk of providing

refinance was borne by the bank and not by the State Bank of Pakistan.

Jahangir, the CFO, interjected at this point to remind the group of the importance of operating

leverage and net assets, which included the mark-up 7 receivable from clients, as well as fixed

assets and deferred taxes. The lower this amount was, the more funds would be available to

the bank to invest in earning assets. The aim was to keep net assets below 5% of deposits,

although the slow recovery of mark-up as well as deferred tax had made it very challenging to

meet this target ratio.

THE TREASURY'S POSITION

As Head of Treasury, Pervaiz Ahmed, had a critical role in the placement of surplus funds as

well as mobilization of funds on a contingent basis. He believed that since "the Bank

maintained a CDR of 70%, then 30% of all deposits plus unutilized capital were placed with

the Treasury. The way the operation takes place is that the branches squared their positions

based on a certain formula shown below. These surplus funds are placed with the bank".

There were two issues regarding funds. The first was that of internal transfer pricing within

the bank. Pervaiz said that his department currently paid (charged) branches on funds they

placed (borrowed) at the rate of 13%. The second was that the Treasury mandate was to

maintain high level of liquidity and to act as a profit centre. So it had to balance security

through low risk investments, with returns generated from active portfolio management. This

was important, because strict limits had been placed on fund placements, and these were only

revised if there was a permanent change in the deposit base (at present Rs 800 million or

10%).

The aim was to have highly liquid instruments. Of this investment portfolio, 15% had to be

maintained as a Statutory Liquidity Reserve (SLR), which complemented the CRR as part of

the official reserves maintained with the State Bank of Pakistan. Pervaiz pointed out that the

Bank followed a policy of maintaining a 5% cushion on top of the SLR. Consequently, FCB

maintained 20% of the total demand and time liabilities in the form of gilt-edged, Government

6 Under the Government of Pakistan's special refinance facility, commercial banks were granted a notional

credit in a special deposit account, the yield on which was closely linked to the Market T-Bill rate.

7 The expected profit or return on loans.

10

of Pakistan securities, in the form of T-Bills, Pakistan Investment Bonds (PIBs) or Federal

Investment Bonds (FIBs).

Additionally, FCB's investment policy suggested that another 15% of the deposits could be

deployed in low-risk 'investment grade' securities which were primarily fixed-income

securities. These investments also included equity investments (both for trading purposes and

for long-term holdings). In a typical scenario, any surplus funds with the Treasury were

allocated according to the following priority: overnight (call) market, T-Bills, FIBs and

Certificates of Investment (COIs) 8 . Currently the bank maintained an equity portfolio in listed

and unlisted securities of about Rs 200 million.

Pervaiz mentioned that the Treasury was generating approximately 2% from positions that it

was creating in the funds markets. He illustrated the Treasury's profitability with a simple

example (see Exhibit 6). On a total portfolio of Rs 4.5 billion, the bank was earning Rs 436

million. This was adjusted in two ways: a reduction of Rs 20 million (2% of Rs 1 billion) due

to the cost on FE 25 placements reimbursed to branches for onward payment to customers.

This implied net earnings of Rs 416 million; at the same time, the Bank's own trading income

Rs 60 million (2%), generated earnings of Rs 476 million. The total funds available with the

Treasury were Rs 5 billion, of which Rs 1 billion was FX (FE 25), and Rs 500 million were

balances with the State Bank of Pakistan. Therefore, the yield worked out to 13.60% i.e.

Rs 436 million.

Rs 3,000 million

CONCLUSION

Following the discussion, Ali prepared an informal memorandum for the Asset and Liability

Committee (ALCO). In it he mentioned the salient features, and in particular he highlighted

one of the key points raised by Jahangir, namely that the Bank's operational flexibility was

circumvented by four constraints:

1. The minimum deposits that the bank could raise were 12 times the capital base, including

reserves; hence, the availability of funds was a big constraint for the bank, and 80% of all

marketing efforts were directed at increasing deposits.

2. The bank had an internal policy under which it maintained a CDR of 70%. This included

all type of funded facilities (including refinance); non- funded facilities like guarantees and

letters of credit were not included.

3. The State Bank of Pakistan had set a limit that the maximum amount of refinance that it

would service would be Rs 4 billion.

4. The maximum guarantees that the bank could issue were ten times its capital plus

reserves.

Ali ended the meeting by talking about some immediate practical problems he was facing. He

illustrated this with a few examples from his operational team. FCB evaluated customer

profitability with the objective of choosing the top "x" number of customers, in such a manner

that the bank would automatically maximize its profits. The formula for determining customer

8 These were issued by non-bank financial institutions.

10

Yield = Interest Income + Refinance- Commission - Cost of Funds

Loans - Deposits

profitability looked at interest and commission income from customers and adjusted it for

funding costs as well as commissions paid. It was calculated as a percentage of the loans

given in order to find the yields. In turn, this was adjusted for the deposits actually raised from

the individual customers.

Additionally, since the State Bank of Pakistan funded refinance, the FCB treated it as

commission. "We only take 8% less 6%, i.e., 2% effectively, and also we do not treat it as

part of the denominator in the equation", he explained. "Only those loans actually funded by

the Bank were considered. This is shown in the formula below."

Some managers were of the view, that deposit costs generated income, and

should be added back to determine customer profitability. Is there any

justification for this?