Question # 01 (06 + 04 Marks)

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