Lecture Retail and merchant banking – Lecture 18

gulations and
increasing competition from non-traditional
financial institutions.


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Profitability Management


Basic Lending Principles
Profitability Management
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Profitability management is a total
management process, rather than just an
accounting or analysis procedure.
In contrast to asset and liability
management, it places primary emphasis
on the profit and loss account and
secondary emphasis on the balance
sheet.


Basic Lending Principles
Profitability Management
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With profitability management, profitability
is not merely reported; it is planned,
measured and interpreted.
Planning ensures that efforts are directed
toward the achievement of corporate
objectives.


Basic Lending Principles
Profitability Management
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Measurement checks and adjusts
progress against plan by matching
revenue received with related expense
Interpretation develops a valid picture of
people and businesses, thereby serving
as a basis for the next planning cycle.


Basic Lending Principles
Profitability Management
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Profitability management involves the
monitoring of three distinct types of
profitability statistics. The profits of bank

can be measured in three ways;

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By organization

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By product

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By account


Basic Lending Principles
Profitability Management
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Organizational profitability is the most
familiar type since all banks have some
system for reporting the performance of
their major organizational units.
However, an effective profitability
management system will also measure the


Lecture 19

Basic Lending Principles

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Safety Issues


Basic Lending Principles
Safety Issues
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The persistent failures of banks to lend
sensibly in Pakistan and in many other
countries have brought the question of
safety in lending to the fore;
Why do banks persistently lend so
imprudently and how should lending be
done at minimum risk?


Basic Lending Principles
Safety Issues
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One essential problem is the human and
managerial challenge of motivating
employees of banks to cater to the interest
of the owners (shareholders) of the bank.
The history of banking is replete with
episodes of employees favouring friends
and relatives with loans.


Basic Lending Principles
Safety Issues
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In some countries, there are well-defined
market rates for bribes for obtaining loans
from banks.
This problem is also present in Pakistan,
though the record of Pakistan’s banking
system in this aspect is much better than
that of many other countries.


Basic Lending Principles
Safety Issues
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Another aspect of the problems of banks
concerns prudent levels of leverage.
A bank is a financial intermediary with
fairly small equity capital, which borrows
money from depositors and invest it into
risky assets. This involves a high degree
of leverage


Basic Lending Principles
Safety Issues
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Leverage, at the level of the bank, is
dangerous regardless of the quality of
credit analysis which has gone into each
loan.
High leverage generates high risk and
high returns. If high returns are obtained,
the bank takes the profits but it is
protected from high losses by the
government.


Basic Lending Principles
Safety Issues
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Regulators have tried many policy
initiatives aimed at obtaining a banking
system which has controlled leverage,
high quality lending and thus, a reduced
risk of failure.
These include capital adequacy
requirements based on clumsy
measurement of risk, prohibition of lending
against real estate, restrictions on lending


Basic Lending Principles
Safety Issues
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A riskless loan is one that is fully
collateralised using actively traded assets.
These assets should be traded objects so
that a ‘market to market’ can be done
daily, to ensure that the collateral is always
larger than the outstanding loan.
The value of the asset that is measured
when marking to market should be the

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Diversification of Risk


Basic Lending Principles
Diversification of Risk
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Diversification in banking has been a topic
of discussion in the literature for decades.
It effects on performance, risk, efficiency
and firm value have been examined
extensively.
Diversification does have a significant
impact on a bank’s risk as well as its
performance.


Basic Lending Principles

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Benefits of Diversification

Basic Lending Principles
Benefits of Diversification
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One of the most common benefits
associated with respect to diversification is
a lower cost of capital.
Banks, with some level of global
diversification have access to different
capital markets which could lead to a
lower cost of funds through a larger
deposit base.


Basic Lending Principles
Benefits of Diversification
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Furthermore, the potential for more
efficient internal capital markets is another
of cited benefit to diversification.
Another benefit associated with activity
diversification is the ability to gain
economies of scale / scope for the
organization.

Basic Lending Principles
Benefits of Diversification
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An example might be bank which collects
information credit information on potential
borrowers. With this information, the bank
may be able to offer these potential clients
insurance products or underwriting
services at a lower cost because much of
the information needed has already been
collected when evaluating the loan
application.


Basic Lending Principles
Benefits of Diversification
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Benefits associated with market power
have also been advanced. The argument
suggests that banks may diversify their
activities or their operations geographically
to gain or maintain market share.
Finally, an important benefit that has been
proposed by some is the ability for

organizations to reduce earnings volatility
by spreading operations across areas with