Factors affecting insolvency risk in Islamic and conventional banks of

Pakistan:

Wasiq Shaheen
 Abstract

The elementary standards of bank administration have tinted the required stability

among liquidity, asset, liability, capital adequacy, credit and interest rates risks, in order

to improve the failure in earnings. Thus, the features that could influence these risks are

important signs to put together suitable strategies for healthier bank management. It is

therefore the idea of this study to identify the aspects that contribute to the risks that are

facade by banks, particularly private in Pakistan. The factor examination will include

liquidity and interest, Risk management are the factors affecting banks’ risk exposure.

Consequently, banks will have to believe these factors in formulating an efficient risk

management strategy to reduce any prospect of loss in income and to avoid bank failure.

For this study, the data will collect through questionnaire. In addition, all private banks

will be chosen. After collecting the data it will be analyze through different.

Key Words: Insolvency risk, liquidity and interest, Risk Management

Chapter No.1

Introduction:

The fundamental values of bank management have highlighted the need to balance

between liquidity, asset, liability, capital adequacy, credit and interest rate risks, in order

to alleviate the loss in earnings. Thus, the factors that may affect these risks are important

indicators to put together suitable strategies for better bank management. It is therefore

purpose of this study to recognize the factors that contribute to the risks that are faced by

banks, particularly, commercial and Islamic banks in Pakistan. The factor analysis

conducted, and indicates that liquidity and interest, and credit are the factors affecting

banks’ risk exposure. Hence, banks have to consider these factors in formulating an

efficient risk management strategy to minimize any possibility of loss in income and to

avoid bank failure.

Why banks become insolvent?

According to central bank when contractual payments doesn’t fulfill due to insufficient

credit in bank’s treasury then insolvency may occur. (Gönderen Ahmet

Emir zaman) .When assets of the bank couldn’t meet to the liabilities. There are many

reasons behind bank insolvency such as liquidity and interest rates, mismanagement of

loans, inadequacy in capital, sales of bank are lesser, wrong policies and strategies, etc.

here I want to discuss some reason of bank’s insolvency in Pakistan.

1-Wrong decisions of investment: bank management should take incorrect investment

decisions, from last 10 years Pakistan’s economy gradually become down due to
terrorism, so there is no any outstanding investment made during these decades due to

which most of the banking industry has become down and vice versa.

2- Inappropriate response: lesser top management response, the top management doesn’t

response to the financial crises occurs in the current market so it can cause the insolvency

in bank.

3- Contradictions in the management: when the management of companies and banks

can’t take the decisions with mutual understandings it will create conflicts and

surprisingly it’ll be the reason of insolvency.

4- Management and employees conflicts: management and employees have conflicts on

daily basis as it is the part of the company’s matters. Insolvency can occur due to these

conflicts unless management will overcome the issues of employees.

Trade crises: if the country faces the trade crises the economy should affected because

there is no foreign or local investment in the current situation of trade so banking sector

also don’t have investment to take business and cant generate the profit.

No strength of competition: due to no investment the bank doesn’t have competitive

strength to capture the market.

Less skilled management: lack of skilled personnel can cause the insolvency.

Now, in this study I‘ll define some factors that can affect the insolvency risk in Islamic

and Conventional banks of Pakistan.

In the present age the banking sector has more focused on the insolvency risk and to

overcome such issue for the safety and sound banking in Pakistan. The analysts become

more curious about insolvency risk after the financial crises of 1997. Most of the studies

find the mismanagement of loan is cause of bank insolvency. Hanson et al. (2008)

suggests that if firm parameters come from different sectors, there will be further scope

for risk modification by changing the portfolio weights, even in the case of sufficiently

large portfolio.( Vol.4 No.2 December 2009, Pp.189-211 189 A. Rehman, 2nd Dec 2009;

M.Ibrahim,2nd Dec2009; A.Kameel,2nd Dec 2009; M.Meeera,2nd Dec 2009).

Brief history of Islamic banking:

Islamic banking sector founded on Islamic policies and strategies such as Shariah.

In Egypt the modern Islamic bank was established in 1963 rendering to the values of

Islamic finance. The Organization of Islamic Conference (OIC) also maintained the

Islamic financial system in 1973 at Jeddah, Saudi Arabia. Similarly a number of Islamic

banks were established as Philippine Amana Bank in 1973; Dubai Islamic Bank in 1975;

the Faisal Islamic Bank of Sudan in 1977; the Faisal Islamic Bank of Egypt in 1977; the

Bahrain Islamic Bank in 1979, and Meezan Islamic bank of Pakistan in 2002. In

Malaysia, Islamic Banking Act was passed in 1983 to convert the interest-based

conventional banks into Islamic banks. The Govt. of Pakistan has occupied a number of

creativities during 1979-1992 to introduce interest free products in the market particularly

in the banking sector. In 1979, National Investment Trust (NIT), Investment Corporation

of Pakistan (ICP) and House Building Finance Corporation (HBFC) started interest free

dealings. Correspondingly, during 1980 a number of arrangements were occupied as

Mudarbaha companies were recognized. Participatory Term Certificates (PTC) was

launched and Zakat ordinance was declared. In addition, nationalized banks were

required to open interest-free counters for their customers in 1981. However, Usher

ordinance came into force in 1983 throughout the Pakistan. In the same year, financial

services ordinance was modified to introduce non-interest system. SBP was dispensed the

duty for evolution of interest based financial institutions into interest-free financial

institution till 1985 (Zaidi, 1987; Hussain, 2006; Hassan, 2007).

Islamic banking is an asset and funding system, which is growing worldwide. The

Islamic banks are only been recognized from 30 years but the banking system is

grounded on long-term backgrounds inside Islamic investment. This arrangement is

initiated on accurate standards and highlights the well-being of civilization as an entire.

Islamic banking has low interest rate or having interest free business due to which

Islamic banks are more affected by insolvency as compare to conventional banks.

Conventional banking:

In 1947, after the independence of Pakistan state bank has came into existence as a first

bank of Pakistan that play role as a central bank of Pakistan. State bank of Pakistan has

taken the lot of initiatives to ensure the sound and transparent banking system. However,

the banking sector of Pakistan has positive influence on the whole economy of country.

At the time of partition State Bank has taken a step to replace the Reserve Bank of India

and issue the notes of PRs. 5, 10 and 100 in October 1948 under the state bank law of

currency o Pakistan.
State bank has established the national bank of Pakistan for banking functions and to

become more diversified and stable banking. Meanwhile, to extend the banking sector

and for the support of National Bank the state bank has created the Habib Bank limited.

NBP and HBL are the supportive bodies of State Bank since 1948 and they work as

agents of Central Bank.

National bank of Pakistan has founded in November 1949 with the small number of

offices. Governer of the state bank was appointed as head its board of directors in 1950

and it start practicing as sound financial institution. With the support of State bank the

new bank was growing rapidly and to cover its credit facilities in the country. In

December 1948 acccording to campanies act the State bank of Pakistan empowered to

control the operations and functions of the banking companies and also sponsored to

establish credit facilities in the agriculture industry. Moreover, after the establishment of

national bank of Pakistan, the State bank of Pakistan had decided to expand commercial

banking, so to accomplish the such purpose National Commercial Bank was came into

existence to promote the corporate and investment banking.

At the completion of the first decade of working in 1958 the state bank of Pakistan from

its establishment there were only 195 banks were existed, then at the end the number of

commercial banks increases up to 307 in June 1958. Moreover at the end of the 1958

Pakistani banks had 60% of total bank’s deposits and were responsible of 65 of bank

credit.

In the governing age of Ayub Pakistani trade has expended by import export, transfer of

business in food grains to the private sector. The rapid growth in the trade industry had
caused to increase the credibility of banking, due to that growth Pakistani banking system

kept another foundation of a new bank, namely the United Bank Limited.

In 1960-65 the rapid growth in the credit structure the banking system become expanded

to more number of banks i.e. up to 430 commercial banks worked in Pakistan. And also

many other banks opened to increase the credibility of banking in the country.

Liquidity:

Liquidity is a degree of the competence of a financial firm to replace an asset

into cash quickly, without capital loss or interest disadvantage. In this meaning, the

importance is on the asset side of the balance sheet, since a possible cause of fluidity is

achieved by trade, permanently or temporarily over repo procedures, financial assets that

are discussed in markets having definite characteristics in terms of depth, width and size.

Third, liquidity is somehow understandable as the competence of a bank to lift up funds

on the extensive financial markets - first of all on the unsecured interbank market - by

increasing its liabilities. In a comprehensive logic, liquidity can be measured as the

ability of a financial firm to obtain funds when these funds are needed.

However, credit risk is one of the oldest and most vital forms of risk faced by banks as

financial intermediaries (Broll, et al., 2002). Commercial banks are most likely to make a

loss due to credit risk (Bo, et al., 2005). Generally, the greater the credit risk, the higher

the credit percentages to be charged by banks, leading to an improvement in the net

interest boundary (Hanweck and These study offerings a supplement of past expansions

in banking sector of Pakistan to a very cultured banking system of new age. Originally,

Pakistan was incapable to control its financial system due to absence of comprehensive
banking system and ultimately it became the most attractive banking industry of the

globe. It is reported that banking and financial amenities are the essential part of services

industry and its contribution is increasing with the passage of time (Mishkin, 2001). But,

development of international and combined banking sector has to face many challenges

of legislature, scientific and mechanical variations (Angur et al. 1999). European Journal

of Social Sciences – Volume 17, Number 1 (2010) 13.

Interest Rate:

Interest rate is the expanse charged, stated as a proportion of prime, through an investor

to a debtor for the use of resources. Interest rates are naturally noted on a yearly base,

known as the annual percentage rate (APR). The asset hired might contain currencies,

consumer goods, fixed assets, e.g. automobile or property. Interest is basically a charge

over actual investment to the debtor. In the case of fixed asset like car or building the

interest rate is occasionally known as “lease rate”.

Interest Rate Risk:

The percentage that an investment’s rate will modify due to a change in the complete

level of interest rates, in the form of the produce curve or in any other interest rate

relationship. Such changes typically affect securities inversely and can be compact by

varying (investing in fixed-income securities with different periods) or hedging.

Kavita Sriram,TNN, Nov 18,2007,

Causes of interest rates to rise and fall:

The Federal Reserve Board controls the Federal funds mark rate (Fed funds rate),

which in turn impacts the market for shorter-term securities. The Fed funds rate is the rate

that banks charge other banks for overnight loans. The Fed strictly monitors the economy

and has the authority to increase or lesser the Fed funds rate to retain increase in check or

to help inspire the economy.

Commercial bonds may respond inversely, depending on the credit quality of the issuer.

For example, high-yield corporate bonds tend to be affected more by changes in company

essentials than by interest rate fluctuations, since credit quality is naturally more of a

factor.

Bond prices are affected by interest rate changes. Bond prices, and thus a bond fund's

share price; mostly change in the contradictory ways of interest rates. As the prices of

bonds in a deposit change to a rise in interest rates, the fund's share price may decline.

This and other risks are detailed in a fund catalog.

Risk management:

At single organizations’ level, this poses a growing risk to their capacity to have

control over their disclosure to risk in a different atmosphere. At a combined level, there

have been certain doubts that default by one firm could spread out to others in the same

country or even other countries, and develop a financial crisis of vast scopes. This is a

major concern not only for managers, but also for markets contributors’ overall. In this

framework, risk management has turn into an important part of firms’ and managers’
activities. A risk management system is a valued tool for measuring the exposure to risk

that members in the financial area in general are subject to.

Using such methods, managers can measure risk across markets in terms of their possible

impression on profit and loss, measure principal distribution to markets and merchants,

start expressive risk parameters and manage performance.

Risk systems also offer a degree of the amount of assets required to run a cushion

against probable coming losses, a vital part for both managers and regulators. The

financial marketplace assets eventually rest on upon separate organizations’ capability to

protect unpredicted losses with resources reserved. Even companies by means of the

greatest risk management systems are statistically matter to losses, and then appropriate

resources are important. Not unexpectedly, setting capital sufficiency standards is at the

essential of officials’ duties, together with effective Observation and regulation of market

contributors.

Credit risk is the not being rewarded a liability. An imperative class of credit risk is

insolvency risk. Insolvency risk can be silent as the risk of not being paid as a result of

insolvency.

Credit Risk:

The Credit Sanction method receipts place in several stages (i.e. Regional Group,

Wholesale Banking Head, Risk Management and CAD). Credit is revised by the Board’s

sub-committee on credit. In addition, there is an oldest management committee to oversee

and guide the Risk Management process on a consistent origin. The bank has executed a

method of delegation of experts. Strategies and measures have been rationalized in the

system of manuals and product programs, and these are to be revised at least yearly. A
Risk Asset Review unit has been format under internal audit. A federal Credit

Administration has been recognized. The bank has its personal credit ranking system. The

evaluation process is capable of detecting difficulties loans at a primary stage. The risk

management system for consumer products is in the development stage. A centralized

Special Asset Management Unit is responsible for classified Corporate/Middle

Market/SME portfolio and its recovery.

Problem statement:

The research plan is to examine the influence of liquidity and interest, and risk

management on the insolvency risk of Islamic and Conventional banks of Pakistan.

Objective of the study:

The purpose of the study is to:

1. Check the influence of different factors on the insolvency risk of banking sector.

2. Examine the difference between Islamic and Conventional banks.

Significance of study:

Now a day’s many researchers focused on the soundness of banking sector.

Therefore, it is essential to do more research on bank’s insolvency risk to minimize it. In

the previous studies, little empirical work is available at insolvency risk of banks and the

different researchers checked influence of different factors on the bank insolvency. The

study will check the influence of liquidity and interest, and risk management on the
insolvency risk. Previously the study had applied in Malaysian banks and now it will

apply in Pakistani banking sector to check the insolvency risk.

Scope of the study:

The study examines the influence of liquidity and interest and risk management on the

insolvency risk in the conventional and Islamic banks of Pakistan, this study will measure

the insolvency risk in banking sector of Pakistan.

Research Questions:

Q1: High liquidity and interest decreases the insolvency risk.

Q2: Stable risk management decreases the insolvency risk.

Research Hypothesis:

H1: High liquidity and interest rate decreases the insolvency risk.
Ho: Low liquidity and interest rate increases the insolvency risk.
H2: Better performance of Risk Management can control the Insolvency risk.
Ho: Low performance of Risk Management can not control the insolvency risk.
H3: There is significant difference between Islamic and conventional banks of Pakistan and
measurement of insolvency risk.
 Chapter No.2

Theoretical framework of the study:

Liquidity and interest:

 Inability to liquidate
quickly
 Capital inadequacy
 Interest rate
fluctuation
 Capital control
Insolvency risk

Risk management:
 Mismanagement of loans
 Credit control
 Credit Risk

Source: Research paper “Factors Affecting Banks’ Risk Exposure: Evidence

fromMalaysia”, (Yap, 2010; Ong, 2010; Chan, 2010; Ang, 2010).

The model description:

The model shows the research plan. Firstly, double audit is a factor that is closely

related to the insolvency risk. Internal audit report should assured to prepare external

audit report. The liquidity and interest rate factors are relate with the banks’ ability to

manage its level of liquidity, Capital adequacy, interest rate fluctuations, and capital

controls. It is important for banks to manage properly its liquidity level. Higher bank
capital means lower return on equity, the amount of capital is to be held by banks depend

largely on the market condition, such as interest rates fluctuations and capital controls.

Moreover, risk management is the next factor that will affect banks’ insolvency risk.

Inexperienced credit estimation officers, ineffective credit control and poor

administration of credit documentation are some of the internal elements that will affect

banks’ risk exposure In spite of that, economic crisis and recession will also have an

unfavorable effect on the ability of borrowers to service their loans, when condition

persisted, will finally cause non-performing and default of loans. Hence, credit risks are

largely affected by unfavorable economic condition and default in loans.

Chapter No.3

Literature review:

In the past two eras, the banking industry has progressed from a financial intermediation

between investors and borrowers, to a “one-stop” centre for a choice of financial service

area like assurance, reserves and common resources. The development of information

and communicative technology (ICT) is responsible for the development of banking

services, in precise, online banking. The expansion in ICT has not only provided huge

banking opportunities formerly beyond range, but also increases the competition and

risks tackled by banks in the financial system. The banks’ principal business in lending

and investment are risky business. Banks are unprotected to ambiguity and uncertainty of

the financial market as interest rate instabilities, exchange rate dissimilarity and monetary

unpredictability could all lead to liquidation, liquidation and financial disaster. The basic

requirement for fluidity, asset, accountability, capital capability, credit and interest rates

risks management are now more interesting than before (Mishkin, 2007). These

ideologies of bank organization are critical to preserve a strong and gainful banking

system. For instance, the banks’ liquidity management contains gaining satisfactory

liquid asset to meet the bank’s requirement to creditors. In the progression of doing so,

banks are showing to liquidity risk where the more liquidity is created, the superior are

the opportunity and cruelty of losses connected with having to arrange of illiquid assets to

meet the liquidity strains of depositor (Diamond 1999; Allen and Jagtiani, 1996).

However, besides stockholders, Gatev (2006) discovered that banks that make

commitments to offer are uncovered to the risk of unexpected liquidity demands from
their mortgagors. The liquidity assurance role of banks, though, assumptions them to the

risk that they will have untimely cash to leak chance demands from their depositors and

insolvents (Gatev, 2006). Although curiosity rates risk is a chief concern for banks due to

the nominal nature of their properties and the asset-liability maturity mismatch (Hasan

and Sarkar, 2002), some academics strained that higher curiosity rates had encouraging

inspiration on banks (Hanweck and Ryu, 2004; Hyde, 2007).” However, credit risk is one

of the oldest and most vital forms of risk faced by banks as financial intermediaries”

(Broll, et al., 2002). Commercial banks are most likely to make a loss due to credit risk

(Bo, et al., 2005). Generally, the bigger the credit risk, the higher the credit bonuses to be

charged by banks, principal to an enhancement in the net interest border (Hanweck and

Ryu, 2004). Even so, the increased celebrity of transactional activities at banks has

highlighted the banks’ experience to market risk, the risk of loss from contrary measure

in financial market rates and prices. A bank’s market risk introduction is determined by

both the unpredictability of underlying risk factors and the understanding of the bank’s

portfolio to activities in those risk factors (Hendricks and Hirtle, 1997).

Financial institutions in general and banks in precise have exposed to a variation

of risks, whereby the extent of these risks depends on the portfolio features of individual

banks (IMF, 2001). The variety of risks to which banks are exposed explains looking at

characteristics of bank operations. New studies have tried to expand our understanding of

the financial accuracy indicators that are more related for the study of financial solidity.

The fresh studies have intensive on the contemporary indicators of financial health. No

compromise has yet occurred, however, on a set of building actual early cautionary

systems. Nonetheless, the literature provides some experimental reasons for the use of
most of the variables that have recognized as provident indicators of financial soundness

(IMF, 2000).

Risk Determinants Factors:

The four economic risk factors were familiar using the study by Cheng and Ariff

(2007).That study uses twenty one financial accounting/financial ratios calculated from

the balance sheets evidence. The twenty one proportions were re-grouped as factors using

factor study. The factor investigation in the study acknowledged four economic or

financial risks. This study uses the shortest ratios that deputation for the four financial

risks.

The four financial risks identified are Interest risk factor, Liquidity risk factor, Credit risk

factor, and Solvency risk factor. In this study the following ratios used as the measures

for the four financial risks.

Deposits/ Loans: Interest risk factor,

Liquid assets/ Deposits: Liquidity risk factor,

Provision for bad and doubtful debts/Loans: Credit risk factor, and

Shareholder equity/Total assets: Solvency risk factor,

The relation between nonstandard earnings as reliant on flexible and uniform unexpected

salaries, interest rate risk, liquidity risk, credit risk and solvency risk as independent

variables is tested in the regression:

CAR i = a1 + a2 SUE i+ a3 Ir i+ a4 Lr i + a5 Cr i + a6 Sr i + i (5)

Where,

CARi: Collective abnormal returns over a 12 months window.

SUEi: Standardized Unexpected Annual Earnings,

Ir: Interest risk factor,

Lr: Liquidity risk factor, and

Cr: Credit risk factor,

Sr: Solvency risk factor,

The question arises from this study “whether these four identified “accounting financial

factors” have information content over and above the information from income

revelations (SUE). The relapses use section typical smallest square regression following

Wooldridge (2001): we assume few main features to be extremely count further

information to the worth elements, although prior studies of non-bank organizations

exposed no substantiation of any result after other than the incomes adjustable. The

research question is once again the original inquiry spoken by the past contributors to the

literature. But, we expect to locate facts for the banking businesses while alternative

study of non-bank organizations found no signal of info ahead of that from the revenue.
What are capital controls?

Assets controller confines the free movement of capital. Countries use these controls to

restrict unpredictable movement of capital inflows and present outflows their country.

These better explosive movements in capital can be recognized to the growing

international economy and a country’s willingness to liberalize its economic scheme by

allowing free convertibility of its currency. Limitations can be positioned on capital

arrivals and outflows. The IMF report states that most countries enforce controls on

inflows to retort to the macroeconomic suggestions of the growing size and instability of

capital inflows. Outflow controls are used to bind the descending compression on their

currencies. Such controls are largely functional to short-term capital transactions to

counter theoretical movements that threaten to destabilize the constancy of the exchange

rate and reduce foreign exchange funds.

Why capital controls?

The information states that many nations implement capital controls to help resolve

incompatible policy purposes when their exchange rate is immobile or seriously

achieved. The mutual argument for the application of capital controls is to reservation the

autonomy of fiscal policy, as well as to diminish compression on the exchange rate. An

associated argument is to protect economic and fiscal steadiness during determined

capital flows. This is mainly important when there are anxieties about the inflationary

significances of great capital inflows or when banks or the company area incompetently

measure their risk.

Types of capital control:

Capital controls incorporate an extensive series of expanded and repeatedly country

detailed dealings. These boundaries to capital activities usually take two comprehensive

methods: (a) “administrative” or direct controls and (b) “market-based” or secondary

controls. While these controls are regularly functional discretely during substantial

capital tides, they are often useful in tandem.

Managerial or straight controls restrict capital dealings and related expenses and

handovers of assets through absolute exclusions. These controls are considered to in a

straight line move the capacity of cross-border fiscal contacts. They classically execute

managerial requirements on a country’s investment scheme to control the movements of

money.

Secondary controls make dealings additional expensive thereby depressing capital

undertaking and the connected trades. These capital controls may take the method of

double or numerous exchange rate systems, obvious assessment of cross-border financial

flows and other indirect supervisory controls.

In most of the experimental works there are no differences between controls on outflows

and controls on arrivals: these movements suffer from the similar difficulties as the de

jure international Monitory Fund (IMF) arrangement of exchange rate measures. Even

after dissimilarity occurred between arrivals and outflows, controls can and organize

choice from the unambiguous to the indirect, from the market sociable to the forced.

Additionally, when bearing in mind the impressions and usefulness of capital controls
one cannot knob together the practices of nations that have not significantly opened with

countries that really expired the trail of monetary and capital account liberalization and

definite at particular facts to reestablish controls, as the latter have established

establishments and applies that are combined in fluctuating degree to worldwide capital

markets.

Objective of Capital Controls:

Specify the several goals that capital controls are anticipated to accomplish, we move

toward each study with a series of enquiries. We inquired, whether, according to each

paper, capital controls were capable to

 Decrease the capacity of capital streams

 Modify the arrangement of capital flows

 Decrease actual exchange rate compressions

 Allow for a supplementary autonomous fiscal strategy

The current past of the global economic marketplaces are categorized by frequent money

emergencies. Several nations about the world have come below compression or tackled a

crisis at dissimilar opinions in period. The modern counts were the disasters in Mexico in

1976 and Argentina, Brazil, Peru and Mexico in the initial and mid-80s, the calamities in

Chile and Argentina in 1980s and ERM in 1992, then the one in Mexico in 1995. Now, in

1997 and 1998, a main part of Asia is beneath a economic calamity. Economists, who are

doing selected, catching-up work, are annoying to offer investigation of these crises. So

faraway, maximum effort emphases on three diverse but associated parts:

  Academic investigation of the sources and possessions of money calamities:

Certainly, maximum work on money calamity concentrations on illumination the

grounds and properties of money crisis. Previous exertion by Salant and Henderson

(1978), Krugman (1979), and Flood and Garber (1984), which frequently is named as

the first-generation representations, carefully facts available how insistent

management inexpensive arrears might lead to capital flight and money disaster. The

crises in Chile and Argentina in the 1980s and ERM in 1992 led to the progress of

second-generation models, which emphasize the reality of numerous balances in the

external exchange markets and the opportunity of having crises as self-fulfilling

consequences.

Types of RISK:

The examination of the financial accuracy of mortgagors has been at the fundamental of

banking movement since its commencement. This study rises to what now a days is

known as credit risk, that is, the risk that a counterparty fails to complete an

responsibility retained to its creditor. It is immobile a main apprehension for banks, but

the choice of credit risk has been massively inflamed with the evolution of results

markets. Additional definition deliberates credit risk as the cost of trading a cash flow

when the complement defaults. As far as byproducts are troubled, credit risk is much

minor in businesses concluded in prepared exchange, because of the intermediation of

reimbursement communities, their promises characterized by limitations and daily

marking to market and the harsh watching of clearing members’ experience.

The unexpected advancement and globalization of the fiscal markets, particularly,

byproducts markets, has carried about additional sort of hazard nearly unnoticed of not

many years back: Market Risk, or the risk that adversative activities in assets charges

will outcome in loss for the firm. Here the description incorporates not only fiscal and

securities firms, but all types of firms, even governmental bodies, which might be

involved in results.

By a cumulative level, the risk that a defaulting by one separate firm causes a tendency of

letdowns crossways the market is known as Systematic Risk. Dependent on the detailed

environments of a specific failure, and a market of influences during that period,

systematic risk could convert a material risk to huge shares of the financial system. The

more markets interlace transversely parts and limitations, the superior the methodical risk

becomes.

Extra outcome of the increasing complication of fiscal markets and devices is cumulative

importance of Operational Risk, that is, the risk of harm due to human blunder or

shortages in organizations systems and controls. In the equal way, more compound

measures and promises take about Legal Risk, or the risk that a firm smarts a loss as a

result of agreements being unenforceable or ineffectively recognized. Finally, Liquidity

Risk, is the risk that a deficiency of complements plants a firm incapable to discharge or

balance a situation, or incapable to do so at or nearby the earlier market price.

Price data involving to the mechanisms of a selection are composed for a selected opinion

period. Instabilities or characteristic nonconformities of assets prices and relationships

between assets price activities are intended. Numerical study combines all these data and

permits the assessment of an intermission for the value of the collection in reply to

vagaries in the prices of machineries, with a positive possibility. It also offers a spreading

of ethics for sufferers or improvements that would happen if the existing positions were

apprehended for a quantified holding period. A confidence intermission is then functional

to the circulation to assess the extreme loss that would be predictable, not to be beaten

with a certain probability, thereby determining the Value-at-risk of the current portfolio.

In other words, this empowers administration to calculate the likely currency

denominated maximum loss for a certain period, and the numeral is articulated in

relations of a confidence level. A confidence interval of 99% means that the risk

executive can express the extreme loss at 99 % prospect, that is, the loss that should be

exceeded only one day out of a hundred.

In Pakistan’s banking sector problem exist due to failure in the governance and

undisciplined financial processes coz of political interference in the financial institutions

that can’t manage the loan process properly. Pakistani banking modifications have

purpose to give more strength to the mediums of supremacy and financial institutions to

manage the banking sector, such as bank controllers, markets, the courts and bank

owners, by improving the authority and skills of the State bank to administer the banks

and impose principles, encouraging market mixing and opposition, cultivating the lawful
and justice procedures for imposing bonds, and introducing corporate governance

reorganizations in the NCBs and DFIs.

MCB and ABL were privatized in 1991; it was the start of financial structure in Pakistan.

Bank failure:

When a bank is near to financial downfall, then a bank insolvency or failure will occurs.

The Federal Deposit Insurance corp: will help the troubled banks and takes over them

from the financial crises. In that process the agents of FDI come to the bank without

warning or info and seal off the bank’s branches and headquarter and they will reconcile

the remaining assets without the interference of bank’s employees and management.

After the completion of reconciliation process, the FDIC sells the troubled bank to

another competent bank and run its operations itself.

The FDIC is the bank insurance companies it insuring the bank’s assets and managing the

troubled banks since 1933, after the Great Depression.

Micheal H Krimminger presents the theory in his study that bank insolvencies and other

financial institutions downfalls create problems. Often the short-term liabilities become

the reason of bank insolvencies other than primary liabilities and lack of public

investments also will be the causes of bank insolvency. The bigger banks have the

substitutes in the shape of investments in markets through market instruments. However,

failure of large banks also depends on the market for funding may find itself successfully

excepted from the market by the better costs of securities. Well, critics have observed, the

subsequent “market run” as counterparties settled agreements and enforce extra costs on

the failing bank may raise the speed of its downfall.

Against the huge probable losses and troubles there is less time available for planning to

overcome such losses. In that cases, there is low confidence in one bank has bitter

interference in the confidence of overall banking system.

The fundamental requirements for liquidity, asset, liability, capital adequacy, credit and

interest rates risks management are now more interesting than earlier (Mishkin, 2007).

These values of bank administration are critical to preserve a well and moneymaking

banking organization. For example, the banks’ liquidness administration comprises

buying adequate fluid resources to meet the bank’s responsibility to creditors.

In such process banks are showing to liquidity risk where the more liquidity is produced,

the superior are the probability and harshness of sufferers connected with having to

position of illiquid assets to encounter the liquidity strains of creditor (Diamond 1999:

Allen and Jagtiani, 1996).

Though, also investors, Gatev (2006) exposed that banks that type recruits to advance are

visible to the risk of unanticipated liquidity request from their mortgagors.

The liquidity insurance role of banks, however, exposes them to the risk that they will

have insufficient cash to meet random demands from their depositors and borrowers

(Gatev, 2006). While interest rates risk is a major concern for banks due to the nominal

nature of their assets and the asset-liability maturity mismatch (Hasan and Sarkar, 2002),

some researchers emphasized that higher interest rates had positive impact on banks

(Hanweck and Ryu, 2004; Hyde, 2007). However, credit risk is one of the oldest and

most vital forms of risk faced by banks as financial intermediaries (Broll, et al., 2002).

Commercial banks are most likely to make a loss due to credit risk (Bo, et al., 2005).

Generally, the greater the credit risk, the higher the credit premiums to be
charged by banks, leading to an improvement in the net interest margin (Hanweck and

Ryu, 2004).

Even so, the increased prominence of trading activities at banks have highlighted the

banks’ exposure to market risk, the risk of loss from adverse movement in financial

market rates and prices. A bank’s market risk exposure is determined by both the

volatility of underlying risk factors and the sensitivity of the bank’s portfolio to

movements in those risk factors (Hendricks and Hirtle, 1997).

(Deposit Insurance and Bank Insolvency in a Changing World: Synergies and Challenges

Michael H. Krimminger1International Monetary Fund Conference May 28, 2004.)

Chapter 4:

Methodology:

Research design:

Four banks will be chosen in which two banks will be Islamic and two conventional.

Tools of data collection:

Data will collect through financial statements (balance sheet, net income

statement) and the questionnaire.

Dependent variable: Insolvency risk

Independent variable:

Liquidity and interest

Inability to liquidity quickly

Capital inadequacy

Interest rates fluctuations

Capital controls

Risk management

Mismanagement of loans
Credit control

Credit risk

Statistical analysis:

Data will analyzed through E-Views and different test will apply to check the

relationship between variables because every independent variable will show different

influence on the dependent variable.

References:

1- Yap.V.C, ISSN 1450-2275 Issue 19 (2010) “Factors Affecting Banks’ Risk; Exposure:

Evidence from Malaysia.”

2- Ong.H.B, ISSN 1450-2275 Issue 19 (2010) “Factors Affecting Banks’ Risk; Exposure:

Evidence from Malaysia.”

3- Chan.K.T, ISSN 1450-2275 Issue 19 (2010) “Factors Affecting Banks’ Risk;

Exposure: Evidence from Malaysia.”

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Evidence from Malaysia.”

5- A.Rahman, Vol.4 No. 2 December 2009, Pp.189-211 “Lending Structure and Bank

Insolvency Risk: A Comparative Study between Islamic and Conventional Banks.”

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Insolvency Risk: A Comparative Study between Islamic and Conventional Banks.”

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10- (Bo, et al., 2005).

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(2010) 13.

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2007; Sole, 2007; Jobst, 2007).

16- ( Sundararajan and Errico, 2002; World Bank and IMF, 2005; Ainley and others,

2007; Sole, 2007; Jobst, 2007).

17- ( Yudistira, 2004; and Moktar, Abdullah, and Al-Habshi, 2006).

18- (Zaidi, 1987; Hussain, 2006; Hassan, 2007).

19- (Ahmad et al., 2010).

20- (Najajmabadi, 1991).

21- (Abratt & Russell, 1999).

22- (Ebrahim & Joo, 2001).

23- (Kotler, 2003).

24- (Duncan and Elliot, 2002)

25- (Economic Survey of Pakistan, 2007-08).

26- (Ahmad,Rehman & Saif, 2010).

27- (Banking Developments in Pakistan: A Journey from

Conventional to Islamic Banking

28- Ashfaq Ahmad

Corresponding Author: Assistant Professor, Department of Business Administration

University of Sargodha, Sargodha, Pakistan

E-mail: ashfaquos@gmail.com

29- Muhammad Imran Malik

PhD Scholar, (FUIEMS) Foundation University, Islamabad, Pakistan

30- Asad Afzal Humayoun

PhD Scholar, (FUIEMS) Foundation University, Islamabad, Pakistan)