CASE STUDY # 1: STRATEGIC MANAGEMENT

Friday Section (Instructor: Faisal K. Qureishi)

BANKING INDUSTRY OF PAKISTAN

Over the last 20 years the banking industry has gone through some sweeping changes. Transformation, Consolidation and Outsourcing are just some of the most prominent buzzwords that are used to describe major trends afflicting the banking industry. Banking sector of Pakistan has been transformed within a short period of 10 years from a sluggish and government-dominated sector to a much more agile, competitive and profitable industry. Speed and sequencing of banking sector transformation and its role in promoting economic growth is now a leading story of a sector success. Within Pakistan it offers a story of what effective leadership of regulator and change management and corporate governance can achieve and offer. Outside Pakistan it is serving to offer rich lessons in what difference governance of regulator can make and how bank restructuring and privatization can change the landscape of the industry (Akhtar, 2006). The banking sector in Pakistan has undergone a comprehensive phase of restructuring since the year 1997 and is well positioned to meet the countrys banking and finance needs. The previous Government introduced far-reaching reforms during the last decade that strengthened the sector through an increase in private sector involvement. The stabilization of the economy and enhancement of the countrys image in the international community is expected to accord further growth opportunities to the banking sector. The level of financial intermediation in Pakistan is also lower at 48% (domestic credit provided by banks as a percentage of GDP) as compared to other developing countries. This demonstrates that the country still offers a large untapped market for banks. The banking sector in Pakistan comprises of Nationalized Commercial banks, privatized banks, branches of foreign banks, local private banks and specialized banks. The State Bank of Pakistan is the Central Bank of the country and is entrusted with the regulation of the banking sector.

The information contained in this case is updated to the year 2008

1. Nationalized Commercial Banks Before Privatization, Nationalized Commercial banks were Habib Bank Limited, United Bank Limited, Muslim Commercial Bank, Allied Bank and National Bank of Pakistan. These banks controlled a large share of the total advances and deposits of the sector. However, they suffered over the years due to political interference and inadequate management, which resulted in an increase in administrative costs and non-performing assets and decline in customer quality of service. The restructuring exercise has yielded positive results and all these banks have registered significant profits in the year 2007. The core issues faced by these banks in prior years on account of sizeable non-performing loan portfolios, surplus staff and inefficient processes have been addressed by making provisions for legacy loans, strengthening loan granting and monitoring processes, initiating active recovery drives, laying off surplus staff through voluntary separation schemes and undertaking a comprehensive process re-engineering exercise. 2. Privatized Banks Under the deregulation and privatization drive initiated as part of the financial sector reforms introduced by the Government, Muslim Commercial Bank Limited (MCB) and Allied Bank of Pakistan (ABL) were privatized in the early 1990s. The majority shareholding in MCB was offloaded in two trenches of 26% and 25% to a consortium of leading industrialists of the country. A syndicate of employees of ABL acquired the controlling interest of 51% in the bank during the same period. MCB has registered significant growth over the last eighteen years. It has consistently developed as one of the premier banks of the country and has been declared the best bank in Pakistan by Euromoney, a leading international magazine. The turnaround of the bank in the post-privatization era illustrates the potential benefits that can be realized from nationalized banks as a result of private sector dynamism. The privatized banks have a competitive advantage over the foreign banks and local private banks owing to their sufficient liquidity and low cost of deposits mobilized through their sizeable branch networks. These banks also enjoy an edge over nationalized banks on account of their operational flexibility under private sector management. These factors have ideally positioned these banks in the industry.

3. Foreign Banks Foreign banks have thrived over the years due to the inefficiencies of nationalized banks. However, due to the restrictions on their branch networks these banks cannot effectively compete with nationalized banks for retail business. Accordingly, foreign banks have concentrated mainly on catering to products and services that have traditionally not been effectively provided by nationalized banks. The forte of these banks has remained their qualified professional staff, customer oriented approach, advanced information technology infrastructure and foreign affiliation support. During the 1990s these banks have profited substantially from intermediating in foreign currency deposits, as the forward cover fee paid to the State Bank of Pakistan for obtaining cover against surrendered foreign currency deposits was lower than the loss due to the depreciation of the Pak Rupee. This subsidization by the State Bank was also evidenced by the difference between the level of forward cover fee and the significantly lower forward premium in the inter-bank market. Due to their heavy dependence on foreign currency deposits the profitability of these banks was significantly affected by the de-dollarisation of the economy and the subsequent focus on Rupee deposits. Some of the more prominent foreign banks in Pakistan include Standard Chartered, Citibank, Hong Kong Shanghai Bank, and the Royal Bank of Scotland. 4. Local Private Banks The banking sector reforms initiated in the early nineties deregulated the sector and resulted in a number of private sector banks entering the local banking industry. A number of these banks were established by prominent business families that had been at the helm of some of the Commercial banks at the time of nationalization of the sector in the 1970s. Accordingly, while these banks could not compete with nationalized banks due to their smaller capitalization, these banks focused on small and medium sized companies and commercial banking business and acquired some of the clientele of the larger banks in these markets. Due to the lower capitalization of the local private banks and the conservative approach adopted by their management these banks mainly undertake short-term trade related and working capital financing and have a lower infection ratio as

compared to the Nationalized Commercial banks. In addition, these banks also have capital adequacy ratios comfortably in excess of the minimum standard of 8% stipulated by the State Bank of Pakistan. Nearly a decade after the initiation of the financial sector reforms these banks are now in a stage of consolidation. The State Bank has also expressed its intention to strengthen the banking sector through mergers of smaller banks and has enhanced the requirement for minimum paid-up capital to one billion rupees. Growth in Banking Sector and its profitability is unprecedented. Banking assets rose three-fold over the last 5 years and industry size is reaching Rs4 trillion. The banking sectors assets to GDP ratio grew from 47.2% in CY00 to 55.6% in CY05 since the growth in banking assets outpaced the nominal GDP; these trends are in sharp contrast from the declining trend in banks assets to GDP ratio during the second half of the 1990s. Supported by privatization and consolidation, assets of the banking sector have shifted from public to private sector and there is a decline in asset concentration within the banking sector. This changing structure had farreaching implications for the banking sector profitability (Akhtar, 2006). Return on banking assets before taxes have grown to 2.6% (1.8% after tax) relative to 0.2% in CY00 and return on equity has been 25.4%. Improvement in profitability has been supported by high economic activity but it is important to recognize that sustained economic growth, rather than sporadic improvement in real GDP, helps the financial institutions to earn higher profits. In quantitative terms, one percent rise in the real GDP growth tends to improve the profitability by 113 basis points. In addition, low interest rates and inflation for most of the period in the last four years also supported the financial sector profitability, as one percentage point increase in real interest rates and inflation tends to reduce the ROA by 27 basis points in each case. Pakistans economy to a higher growth trajectory during the last four years contributed significantly towards the improved profitability of the financial sector. As per the latest study conducted by the World Bank, Pakistan has been ranked second in performance and efficiency indicators (India being the first) among the South Asian countries. Privatization has significantly contributed in improving profitability of privatized banks, though it has not reduced but enhanced the

intermediation spread. A recently released study conducted by the World Bank on Getting Finance in South Asia also evaluates Pakistan, after India, as having higher capital adequacy, lower non-performing loans and stable liquidity position among the South Asian countries. The way the financial sector scenario has emerged over the past few years with number of mergers and acquisitions, it is expected that the process would continue at least for the next 5 years. Pakistan would have even fewer banks than today owing to capital requirement of 6 billion rupees by the year 2009. A typical figure could be 25 to 30 banks by end of year 2010. Although number of small banks would reduce but the number of foreign institutions are likely to increase. Banking sectors long term sustainability requires a more fundamental change accompanied by: 1(i) Greater degree of consolidation to provide a stronger and robust banking system; 2(ii) A system that is well diversified and competitive; 3(iii) Stronger corporate governance and risk management aligned to principles of Basel II; and 4(iv) Financial system which is socially inclusive and facilitates access to financial services. Although finance has help promote economic growth, but its contribution to providing access to finance to poor and disadvantaged region is limited. HISTORY 1. 1947 - 1970 The banking sector in the indo sub-continent pre-dominantly consisted of branches of British banks. Habib Bank Limited, Allied Bank of Pakistan (formerly Australia Bank) and Muslim Commercial Bank Limited were among the first domestic banking institutions to emerge from this region and were established by prominent merchant families shortly before independence in 1947. The State Bank of Pakistan (SBP) was established as the Central Bank of the country in the year 1948 and was entrusted with the responsibility of supervising the banking sector. Of the remaining two big-five banks, National Bank of Pakistan, which was the first

government owned Commercial bank, was founded in the year 1949 and United Bank Limited was established in the year 1959 by a leading industrial family of the country. In the early years the economy maintained a healthy growth rate owing to the performance of the agricultural sector as the country possessed developed canal systems and had a strong agricultural base. However, in the sixties the country entered into an industrialization phase in line with the governments strategy to develop the countrys industrial structure and reduce dependency on the agricultural sector. The banking industry thrived on the economic growth witnessed during this period. The banks significantly expanded their branch networks and Pakistani banks also ventured into the international financial arena by opening branches in Europe and North America. 2. 1970 - 1990 The nationalization of domestic banks in the 1970s significantly altered the mechanics of the financial sector. In 1974, the Bank Amalgamation Scheme was enacted and 13 local banks were consolidated into five nationalized banks namely National Bank of Pakistan, Muslim Commercial Bank Limited, Habib Bank Limited, United Bank Limited and Allied Bank of Pakistan. In addition, the Pakistan Banking Council was established to formulate policies for the banking system. The nationalization of the banking sector was primarily aimed at ensuring efficient resource allocation amongst the various sectors of the economy. In addition, banks were prompted to open branches in rural areas in order to cater to their specific needs. However, the objectives of nationalization were not met due to political interference in the conduct of banking operations. Loans were granted to win political favors resulting in loan defaults that significantly infected the portfolio of the nationalized banks. In addition, political pressures induced hiring of inept personnel that impaired service quality and fuelled inefficiency. These factors resulted in a decline in profitability of the banking sector and significantly eroded the equity base of banks in the industry. Islamic banking was also introduced in this period as part of the move to eliminate interest from the financial sector in line with the principles of Islam.

However, the application of Islamic banking resulted in changes in the documentation of financial transactions rather than the transactions themselves. One of the consequences of Islamic banking was the emergence of modarabas, which are a form of an equity participation fund. 3. 1990 - 2007 The nineties brought radical changes to the Pakistani banking sector. The early nineties saw the introduction of major financial sector reforms, which included sector liberalization and deregulation, institutional strengthening, improvement of monetary and exchange controls, and development of capital markets. These tenets have remained a focus of all governments during this period. Sector liberalization and deregulation In 1991-92, the financial sector was deregulated and permission was granted for the establishment of banks in the private sector. The number of banks in the industry mushroomed as a result of new entrants from the private sector. In addition, Muslim Commercial Bank Limited and Allied Bank of Pakistan, two of the big five Nationalized banks, were privatized by the Government. The Pakistan Banking Council was also abolished and SBP was granted autonomous status as the sole regulator of banks. Accordingly, amendments were made to the existing law to prohibit government departments from issuing directives to banks that are inconsistent with those of the SBP. One of the key modifications made by SBP to facilitate the growth of the sector was to simplify the branch licensing policy as a result of which banks can seek approval for opening new branches on the basis of an annual branch expansion plan rather than approaching SBP for approval on a branch-by-branch basis. The privatization program also continued on track. Towards the end of the decade the Government sold majority of its shareholding in Habib Credit and Exchange Bank to the Al-Nahayan Group of Abu Dhabi. National Bank of Pakistan was also listed on the Stock Exchange amid overwhelming public response as the Government offloaded some of its shareholding to the public. In addition, United Bank Limited, another one of the big five Nationalized banks, has been privatized in 2002 and the majority shareholding in the bank has been offered to a Strategic Investor.

HABIB BANK LIMITED: BACKGROUND The bank was setup by the Habib Group, a prominent business family, in Bombay and was incorporated on August 25, 1941 with a paid-up capital of Rs. 2.5 million. The early years of the bank were characterized by strong growth and profitability. In the year 1947, the head office of the bank was shifted to Karachi. PRE-NATIONALIZATION YEARS (1941-1973) The operations of the bank commenced in the year 1941 and by the end of 1942, the first full year of operations, the bank had deposits and advances amounting to Rs 24 million and Rs 10.3 million respectively. During the initial period the bank continued to expand gradually and by the end of the year 1947 the deposits and advances of the bank had increased to Rs 266.2 million and Rs 63.7 million respectively. In addition, the number of branches of the bank increased from 2 in the year 1942 to 21 in the year 1947. The head office of the bank was transferred to Karachi on August 7, 1947. During the early years of the country, shortly after independence in the year 1947, the bank played a dominant role in the development of the structure of the banking industry. The bank forayed into the international arena in the year 1951 and opened its first overseas branch in Sri Lanka. Subsequently, the bank expanded its presence to Africa, America, Europe, Far East, South Asia and the Middle East. By the year 1973, the bank had established a strong foothold in the Pakistani banking sector and controlled a major share of the total deposits and advances of the banking industry. The advances and deposits of the bank at this time amounted to Rs 4,005 million and Rs 7,580 million respectively.

Table 3: HBLs Growth till 1973 Year Number of branches Deposits Advances Pre Tax Profit

------------------------- Rs in million ----------------------

1942 1947 1973

2 21 749

23.9 266.2 7,580

10.3 63.7 4,005

0.4 1.5 114

PUBLIC SECTOR MANAGEMENT The bank was nationalized under the Nationalization Act, 1974 on January 1, 1974. Habib Bank (Overseas) Limited and Standard Bank were also merged with the bank in June 1974 and June 1975 respectively. The concept behind the nationalization of Pakistani banks was to accord all necessary facilities to small industrialists, traders and farmers and to ensure that their interests were not compromised. During the early 80s the bank played its part in economic development and extended credit facilities to a number of sectors at subsidized rates under various arrangements including export finance, local manufactured machinery, government borrowing for commodity operations, mandatory production credit to small farmers and direct industrial investment. The profitability of the bank continued to grow at a gradual pace and by the year 1985 deposits and advances had increased to Rs 120,680 million and Rs 81,141 million respectively. The bank also acquired a major share of the inward remittance business and during the late 70s and early 80s, the share of the bank was as high as 60% of the total remittances routed through official banking channels. In addition, the bank also continued to expand its overseas network and opened branches in France, Belgium, Turkey, Netherlands, Maldives, Sudan, Seychelles, Bangladesh and the Fiji Islands. The financial position of the bank continued to strengthen during the period from 19831990 with strong growth in deposits and advances. However, during the nineties, despite almost regular increase in total deposits and advances the bank could not enhance its profitability. By this time the negative side effects of nationalization could be observed. The bank had surplus staff due to considerable appointments made on considerations other than merit. In addition, the non-performing loan portfolio increased significantly as a result of loans given due to political interference. The bank was also not properly run on Commercial lines, there were unnecessary time lags in processes and service quality deteriorated significantly.
Table 4: HBLs Growth - Post Nationalization Years till 1996

Year

Number of branches 1,084 1,888 1,894 1,879 1,934 1,992

Deposits

Advances

1974 1979 1984 1989 1994 1996

----------------------Rs -------------------8,211 5,864 23,169 13,479 61,933 35,786 105,243 62,086 178,647 105,502 213,595 121,909

Pre Tax Profit in million 212 349 828 956 666 (3,407)

PRIVATE SECTOR MANAGEMENT (1997- TO DATE) In the year 1996 the Government decided to address these issues and prepare the bank for privatization. Accordingly, senior experienced bankers were hired from reputable foreign banks to reinvigorate and restructure the bank. The professional management has introduced a number of initiatives to revamp the bank and to establish policies, procedures and systems in line with modern banking requirements. These initiatives have resulted in an increase in profitability from a loss before taxation of Rs 13.86 billion in the year 1997 to a profit before tax of Rs.2.2 billion in the year 2001 and a profit before tax of Rs 15.14 billion for the year 2007. 1.1.2.2 OWNERSHIP STRUCTURE The following table depicts the ownership structure of the bank:
Table 5: HBLs Ownership Structure

Shareholders State Bank Of Pakistan Government of Pakistan State Life Insurance Corporation of Pakistan National Bank of Pakistan (Trustee Department) Investment Corporation of Pakistan Pakistan Reinsurance Company Limited Privatization Commission Securities and Exchange Commission of Pakistan Total

No. of Shares 1,198,618,523 15,803,836 2,786,654 309,767 194,151 131,050 5,516 3 1,217,849,500

Percentage 98.42 1.30 0.23 0.03 0.02 0.01 0.0005 0.0000002 100

The Group comprises of Habib Bank Limited (HBL) and the following subsidiary and associated companies:
Table 6: Group Comprises of HBL

Subsidiaries

Associates

Habib Allied International Bank Plc. Habib Currency Exchange Limited. Habib Finance International Ltd.

First Habib Modarba. Himalayan Bank Ltd. Habib Bank Financial Services Limited

Large Domestic Network The nation-wide franchise of the bank is maintained through its network of 1,451 retail branches and 17 corporate centres, which are strategically located across the country. The region-wise distribution of the domestic branch network is as follows:
Table 7: HBL Branches Region Lahore N.W.F.P Karachi Faisalabad Islamabad Hyderabad Multan Azad Kashmir Baluchistan Total Retail Branches 431 209 145 137 128 128 108 89 26 1,405 Corporate Centers 2 1 11 1 4 1 20 Total Branches/Centres 433 210 156 138 132 128 109 89 26 Profit / (Loss) before taxation Pkr in 000
61,671 16,874 55,186 51,823 88,574 (15,193) (45,818) 129,228 162,796 61,311 (239,299) 25,101 21,378 18,736 241,401 10,989 236,657 904,174

Sizeable International Presence The international operations, comprising branches, subsidiaries and joint venture operations have a history of over 20 years. These operations have allowed the bank to maintain its presence in 25 countries including the United Kingdom, Europe, Middle East, South East and Far East Asia, Africa, and the United States.

1,425 Number Table 8: HBL World-wide of Region branches

Kenya Mauritius Seychelles Asia Bangladesh Maldives Singapore Sri Lanka KEPZ Middle East Bahrain Lebanon Oman UAE Europe Belgium France Turkey Netherlands USA 5 4 1 2 1 1 2 1 4 1 11 8 1 1 1 1 1 48

Total

An exhaustive restructuring exercise has been initiated in these operations in recent years as a result of which the profitability has been enhanced significantly.

Table 9: HBL Subsidiaries & Joint Ventures Subsidiaries/Joint Ventures Subsidiaries Habib Allied International Bank plc Habib Finance International Limited Habib Finance Australia Limited Joint Ventures Habib Nigeria Bank Limited Himalayan Bank Limited Location UK Hong Kong Sydney % Holding 90.5 100 100 Profit Pkr in 000 (35,910) (51,163) 2,522

Nigeria Nepal

40 20

891,202 346,188

RESTRUCTURING INITIATIVES

Reduction in head count from 31,099 personnel in the year 1996 to 19,352 personnel in the year 2001. Rationalisation of the branch network - unprofitable branches have been closed / merged as a result of which the branch network has been reduced from 1,992 branches in the year 1996 to 1,516 branches in the year 2001. The bank has been reorganized on functional lines and separate Business groups have been created. The Corporate and Investment Banking Group has been established and is now recognized as a market leader. An Economic and Sectoral Research unit was set up in the year 2001 to assist in proactive management of the loan portfolio. The Internal Audit Department has been strengthened and the Group Head of Audit and Business Risk Review now reports directly to the Audit Committee of the Board of Directors.

Global Compliance Group has been established and has a reporting line to the Board of Directors.

These support measures and initiatives have resulted in the following improvements:

Profit before tax of the bank has improved from a loss before taxation of Rs 13.86 billion in the year 1997 to a profit before tax of Rs 2.22 billion in the year 2001. In addition, the bank has posted a profit before tax of Rs. 2.005 billion for the half year ended June 30, 2002. Asset quality has improved due to a redistribution of the asset mix, identification of problem credits and significant recoveries made in recent years. Operational efficiency has improved as a result of the reorganisation of the bank along functional lines.

In September 1997, the bank was reorganised throughout its domestic and overseas operations on functional lines creating a matrix structure comprising of the following business groups and support groups to focus against the customer profile available to the bank.

Table 10: HBL Business & Support Groups

Business Groups Retail Banking (RBG) Corporate and Investment Banking (CIBG) International and Overseas Banking (IOBG) Global Treasury (GT)

Support Groups Global Operations (GO) Credit Policy Group (CPG) Asset Remedial Management (ARM) Information Technology Group (ITG) Audit, BRR and Investigation (Audit) Financial Control Personnel Global Compliance (GCG)

Under the matrix structure, the Business Group and Support Group reports to the President.

STAFF RATIONALIZATION The new management entrusted the Human Resource Division with a major task of Staff Rationalization schemes. The manpower reduction scheme was undertaken in two phases. The first Voluntary Golden Handshake Scheme (VGHS) was initiated in 1997, when the staff strength stood at 29,736. At that time 7,405 employees were retired under the VGHS and the total amount paid to the outgoing employees amounted to Rs 11.03 billion. Second Voluntary Separation Scheme (VSS) was introduced in May 2001 through which 3,461 employees were retired. Total cost incurred on VSS was funded by the Government of Pakistan, in the form of a grant amounting to Rs 4.8 billion. In addition, an amount of Rs 1.7 billion was paid to these employees in respect of retirement benefits. Details of the two staff rationalization schemes are given below:

Table 11: HBL Scheme 1

Grade Executives Officers Clerical & Clerical Total

Strength before VGHS 1997 2,213 14,521 13,002 29,736

VGHS Optees 1,067 4,230 2,108 7,405

Strength after VGHS 1997 1,146 10,291 10,894 22,331

Non-

Table 12: HBL Scheme 2

Grade Executives Officers Clerical & Non-Clerical Total

Strength before VSS 2001 1,447 9,799 10,523 21,769

VSS Optees 374 1,379 1,708 3,461

Strength after VSS - 2001 1,073 8,420 8,815 18,308

VSS Payment Statistics The payments under the Voluntary Separation Scheme (VSS) were calculated on the basis of:

An amount equal to 2.75 months basic pay for each completed year of service or; An amount equal to 1.25 months basic pay for each remaining month of service, whichever is less, subject, however to a maximum of 90 months basic pay.

The following table gives a detail of the total cost incurred by HBL on VSS in 2001.
Table 13: HBLs VSS
Rs in Million

Grade EVP SVP VP AVP OG I OG II OG - III Clerical NCS Total

No. of persons 3 29 130 213 242 490 649 421 1,292 3,469

Amount paid to Employees 12 86 364 549 509 873 927 390 1,169 4,879

Average amount paid

4.0 3.0 2.8 2.6 2.1 1.8 1.4 0.9 0.9 1.4

Current Employee Profile The table below gives a detailed grade-wise strength of the employees belonging to different employment categories.
Table 14: HBL Employee Strength

Category Regular Contracted Local Based Total

SEVP 3 8 0 11

EVP 20 9 0 29

SVP 132 16 0 148

VP 347 15 0 362

AVP 764 3 0 767

Officers 8,213 3 308 8,524

Clerical Staff 5,339 0 400 5,739

NCS 3,405 0 99 3,504

TOTAL 18,221 54 833 19,108

REQUIREMENT: 1. What were the Drivers of Change that led to HBLs and the Banking Industrys turnaround in Pakistan? How? 2. Which forces in the Competitive Environment and the Macro Environment are vital to HBLs Strategy? Why? 3. Apply the Five-Forces Industry Attractiveness Model from the perspective of Habib Bank Ltd. Analyze each force separately and then present a consolidated conclusion.