pakistan banks primer 11apr07

Asia Pacific Equity Research 11 April 2007

Pakistan Banks

Attractive growth and profitability

Pakistan Banks

Khalid Iqbal SiddiquiAC

(92-21) 5635033 [email protected]

Sunil Garg (852) 2800-8518 [email protected]

Sriyan Pietersz (662) 684 2670 [email protected]

www.morganmarkets.com J. P. Morgan Pakistan Broking (Pvt.) Ltd

See page 82 for analyst certification and important disclosures, including investment banking relationships. JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Pakistan banks’ price performance

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BOP MCB NBP MSCI Pakistan

Source: Bloomberg, MSCI.

Top Pick:

Bank of Punjab (BOP PK)

• We initiate on the sector with overweight: The combination of strong economic growth backed by regulatory reform and expectations of easing monetary policy form the key drivers of our positive view. While the 55% CAGR in earnings (past four years) may be a tough act to repeat, a three-year forward CAGR of 20% ranks among the best in Asia. We initiate on MCB and BOP with an Overweight, and on NBP with a Neutral rating.

• Reasons to buy: (1) Exposure to a consumption-led, services-driven economy, which is among the fastest growing in Asia. (2) An under-penetrated consumer banking segment (14% of loans). (3) Deepening investment as a portion of GDP, thus driving corporate loan growth. (4) Credit cycle revival on expectations of easier monetary policy. (5) Strong operating outlook backed by balance sheet growth, large spreads, and robust asset quality. (6) Regulatory efforts to boost capitalization, which we think could spur consolidation. The renewed interest by foreign bank institutions provides continuing M&A support to valuations.

• Pakistan in an Asian context: Growth dynamics and prospects for Pakistan’s banks rival those in fast growing Asian economies (China, India, and Vietnam). Pakistan’s banks have an edge in terms of large spreads (particularly on deposit taking) and solid profitability. A strong regulatory framework adds to investor comfort.

• Valuations, you get what you pay for: High ROEs and growth prospects justify what may appear to be rich multiples. We expect upside potential of 33% for BOP and 20% for MCB. NBP currently trades 3.5% above our Dec-07 price target.

• Risks and challenges: The days of relatively easy profit growth are closing and we believe banks need to be wary of: (1) delays in easing monetary policy; (2) credit deterioration (mostly unsecured in retail segment); and (3) more competition from foreign players.

Pakistan banks: Valuations

Bank Name Rating Bloomberg Price

target Upside/ Mkt cap Avg.

volume P/E (x) P/B (x) ROE

PKR Downside

potential US$MM US$MM 2007E 2008E 2007E 2008E 2007E 2008E MCB Bank OW MCB PK 335 20% 2,864 37.8 11.8 9.4 3.3 2.7 31.3% 31.7% National Bank Neutral NBP PK 235 -3.5% 3,268 68.7 8.9 8.0 2.0 1.6 19.9% 18.5% Bank of Punjab OW BOP PK 125 33% 595 13.3 7.7 5.9 1.7 1.4 25.4% 26.1% Source: Company reports, Karachi Stock Exchange, JPMorgan estimates. Note: Share prices and valuations are as of April 09, 2007.

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Khalid Iqbal Siddiqui (92-21) 5635033 [email protected]

Table of Contents Investment Summary ...............................................................3 Share price performance ..............................................................................................3 Stock ratings and top picks ..........................................................................................4 Outlook and key themes in 2007 & 2008.....................................................................5 Valuing Pakistani banks...............................................................................................7 Risks and challenges for the sector ..............................................................................8 Valuations ...............................................................................10 Two-stage DDM-driven P/BV...................................................................................10 Regional valuation comparisons ................................................................................13 Target prices ..............................................................................................................13 Valuation sensitivities................................................................................................13 Investment case for Pakistan’s banks..................................15 Consumption-driven economic growth......................................................................15 Deepening investment: Investment/GDP denotes potential .......................................17 Consumer lending only 14% of total loan book.........................................................19 Interest-based earnings potential................................................................................21 Non-interest income potential....................................................................................24 Policy push from SBP................................................................................................28 Sector outlook for 2007 & 2008 .............................................30 Key 2007 and 2008 themes........................................................................................30 Operating outlook ......................................................................................................33 Asset quality outlook .................................................................................................37 Risks and challenges for the sector .....................................38 Delay in easing of monetary policy ...........................................................................38 Secured lending still only 48% of total consumer lending.........................................39 Influx of foreign-owned banks and their takeover spree............................................40 Industry overview...................................................................42 Market structure.........................................................................................................42 Pakistan banking sector – Competitive positioning ...................................................47 Regulatory framework ...............................................................................................48 Financial analysis...................................................................52 Balance sheet analysis................................................................................................52 Profitability analysis ..................................................................................................61 Asset quality analysis.................................................................................................69 Appendix 1 - Role of State Bank of Pakistan in regulatory reform ...........................70 Appendix 2 - Economic outlook ................................................................................72 Appendix 3 – Sector dynamics ..................................................................................73 Appendix 4 – History of banking sector in Pakistan..................................................76 Appendix 5 – Banking sector regulations regionally .................................................77

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Investment summary Share price performance Pakistan’s banking sector has been the best performing listed sector (via both local and foreign, and portfolio and strategic participation) in the last 5 years. Since the beginning of the bull-run in Pakistan's stock market in 2002, the banking sector has outperformed the market more than any other listed sector.

Figure 1: Banking sector has provided shareholders with highest returns

0% 500% 1000% 1500% 2000% 2500% 3000%

Modarabas

Other Tex tiles

Leasing Companies

Transport & Communication

Vanaspati & Allied

Sugar & Allied

Food & Allied

Tex tile Weav ing & Composite

Chemical & Pharmaceuticals

Paper & Board

Glass & Ceramics

Insurance

Others

Engineering

Jute

Cables & Electrical Goods

Auto & Allied

Cement

Fuel & Energy

Banks & Inv . Companies

Source: Karachi Stock Exchange. Best-performing sector since 2002 Pakistan’s banking sector has consistently been the dominant holding of stock market investors and has been the best performing sector in terms of returns to shareholders since 2002.

• Direct exposure to one of the fastest growing Asian economies.

• Consumption-driven, services led, the Pakistan growth story can be well captured through exposure to the banking sector.

• Largest listed sector, with sector capitalization amounting to PKR806B (US$13.3B), which is 26% of total stock market capitalization. Under-penetrated banking sector (loans/GDP = 26.6%); consumer loans = 3.6% of GDP

• Monetary easing to revive the credit cycle

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Figure 2: MCB, NBP, and BOP have easily outperformed MSCI Pakistan Index

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BOP MCB NBP MSCI Pakistan

Source: Karachi Stock Exchange, MSCI. In terms of multiples, Pakistan’s banks currently trade at 2007E P/E multiple of 10.2x and P/BV of 2.0x.

Outperformed even during consolidation last year Banking stocks outperformed the benchmark KSE-100 and MSCI Pakistan indices during 2006. In a period when the broad market returned only 5.1% (based on KSE-100 Index performance in 2006), listed banks provided investors with a return of 34%. MCB, NBP, and BOP were also in the limelight gaining 81%, 36%, and 22% last year.

Sector outlook: The way forward Banks can continue to outperform the broader market, in our view, driven by the confluence of strong economic growth backed by regulatory reform and expectations of easing monetary policy. While the 55% CAGR in earnings (last 4 years) may be a tough act to repeat, a 3-year forward CAGR of 20% ranks as amongst the best in Asia.

Reasons to buy are: (1) exposure to a consumption-led, services-driven economy which is amongst the fastest growing in Asia; (2) under-penetrated consumer banking (14% of loans); (3) deepening investment as a % of GDP driving corporate loan growth, (4) credit cycle revival on expectations of easier monetary policy; (5) strong operating outlook backed by balance sheet growth, large spreads and robust asset quality; and (6) regulatory efforts to boost capitalization will likely spur consolidation. The renewed interest by foreigners provides continuing M&A support to valuations.

Stock ratings and top picks We are initiating coverage on three banks—The Bank of Punjab (BOP PK, Overweight), MCB Bank Ltd. (MCB PK, Overweight), and National Bank of Pakistan (NBP PK, Neutral). Our top pick amongst the three is BOP.

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Bank of Punjab (OW, Dec-07 PT PKR125): Best growth prospects, dynamic management BOP is our top pick because it has been one of the fastest growing banks in the country, as its loan book has grown from just around PKR7 billion at end-2002 to its current level of over PKR100 billion. We believe that the dynamic management is taking the bank in the right direction through a mix of differentiated retail lending, and focus on agriculture and SME lending. BOP is majority-owned (51%) by the government of the Punjab province, and is classified as a public sector bank by SBP. It has an asset base of PKR165 billion (US$2.7 billion), with a loan book of PKR101 billion (US$1.7 billion) and deposit base of PKR138 billion (US$2.3 billion).

MCB (OW, Dec-07 PT PKR335): Highest profitability, now increasing retail presence MCB also earns one of the highest ROEs in the industry, and its higher spreads, higher ROE, and one of the best management teams, justify our liking for the bank. MCB’s greatest asset is its low-cost deposit franchise, which accounts for close to 85% of total deposit base, and allows the bank to earn the highest spreads in the industry at close to 7%. Management has made an aggressive entry into the retail lending segment this year, and this is expected to help keep spreads high in the future as well. It is majority-owned by the Nishat group through its various associated companies and family members, which also owns the largest listed integrated textile unit in the country, and the second-largest cement company in the country. MCB has an asset base of PKR343 billion (US$5.7 billion), loan book of PKR198 billion (US$3.3 billion) and deposit base of PKR257 billion (US$4.2 billion).

National Bank of Pakistan (N, Dec-07 PT PKR235): Long-term potential, but lacks near-term catalysts. Buy below PKR195. We have a Neutral rating on NBP, but are not negative on its longer-term potential. Its public sector status brings in a few inefficiencies, and its weak IT infrastructure and HR-related issues are likely to keep the bank from achieving its potential in the near term. NBP also has a low-cost deposit base to fall back on, with close to 70% of its deposit base having a cost of just 1.0-1.5%. The potential for improvement going forward is immense, but will require significant cost outlays in the way of IT and HR improvements. Therefore, we would recommend buying NBP at a deeper discount of close to 20% to our Dec-07 target price of PKR235. NBP is the largest bank in Pakistan in terms of assets, and is the only remaining large bank whose control rests with the federal government. NBP is 76% owned by the government of Pakistan, with 75% shareholding being held through the central bank, SBP. NBP has an asset base of PKR635 billion (US$10.5 billion), loan book of PKR316 billion (US$5.2 billion) and deposit base of PKR502 billion (US$8.3 billion).

Outlook and key themes in 2007 and 2008 Outlook for Pakistan’s banks is positive over the next two years, in our view, as profit growth is expected to continue, albeit at a slower pace than the last four years’ CAGR of 55%. Positive drivers include high spreads (NIM expansion), re-ignition of the credit cycle following likely reduction in interest rates, and the central bank’s support to create few, strong players from a group of many, fragmented players.

Table 1: MCB, NBP, BOP valuation highlights

Target price (MCB 335 NBP 235 BOP 125 Source: JPMorgan estimates.

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Table 2: Profit growth estimates for MCB, NBP, and BOP % 2006 2007E 2008E 2009E BOP 62% 24% 30% 13% NBP 34% 31% 12% 10% MCB 41% 18% 26% 11% Source: Company reports, JPMorgan estimates. Key themes to consider in the next two years Capital requirements and the move towards consolidation SBP’s roadmap for all commercial banks to increase their paid up capital to PKR6 billion (US$100 million) by the end of 2009 has already ignited a series of mergers and acquisitions in the banking sector. The move is likely to create stronger balance sheets and improve adequacy ratios.

Expected monetary easing in 4Q2007 to reinvigorate credit cycle With inflation (especially core inflation) on the way down, SBP is likely to ease interest rates from 4Q2007. We expect the current policy rate of 9.50% to be brought down by about 100-150bps in about a year’s time from 4Q2007onwards. Private sector credit growth, which has fallen by the wayside over the last year-and-a-half, can receive a boost through this measure.

M&A interest by foreign banks Standard Chartered’s acquisition of Union Bank for close to US$500 million, and ABN AMRO’s recent US$234 million acquisition of Prime Commercial Bank are testaments to genuine direct investment coming into the banking sector. Widely reported unfulfilled interest from players like Temasek, Barclay’s, etc. is likely to continue to feed the M&A story in Pakistan’s banking sector.

Operating outlook Stable loan growth We expect loan growth to remain stable in 2007 and 2008 following a few years of rapid credit expansion. We expect overall loan growth for Pakistan’s banks to be 14% for 2007 and 15% for 2008. The push for the sector is likely to emanate from consumer and SME lending, which remains a largely unexplored area for quite a few of the large banks. Larger banks are expected to grow their loan books at a rate of 12% for 2007E and 13% for 2008E. Smaller banks usually tend to outpace industry growth, and are expected to post 18% and 20% loan growth for 2007E and 2008E, respectively.

Margins to remain higher than region as in the past Spreads for Pakistan’s banking sector have tended to remain high in a regional context. Spread on overall loans-deposits book still remains high at 7.5%; however, spread on new loans-deposits has already narrowed to 5.5% for the whole sector. The larger banks are expected to continue with their extraordinarily low cost deposit base, while smaller banks are expected to face pressures on their margins.

Non-interest income to be driven by fees, dividends, and capital gains Fee income growth for the sector has also been good as the size of the economy has grown, and overall trade for Pakistan has also grown substantially in the last five years. Future growth in fee income, dividend income, and opportunities to book capital gains bring our non-interest income growth estimate to 20% and 15% for 2007 and 2008, respectively, for the banking sector.

Stable loan growth and high margins to drive profitability going forward

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Efficiency ratios We expect Pakistan’s banking sector cost/income ratio to reduce slightly going forward, as we believe the current level of close to 41% is nearer to the trough. The public sector banks with average cost/income ratios of 30% have had a central role to play in this lower cost/income ratio. If public sector banks are excluded, cost/income for the rest of the sector rises to around 45%.

Valuing Pakistan banks The banking sector multiples compare well within the region, given that banks earned an average ROE of 26% during 2006. Investors are attaching a premium to a few banks in the sector, and judging from the multiples, continue to remain optimistic about better returns going forward.

For valuation purposes, we have used a two-stage DDM in which we assign a fair P/B multiple on PV of terminal book value, adding the present value of the sum of three years of expected dividends.

Table 3: Valuation parameters for MCB, NBP, and BOP MCB NBP BOP Normalized ROE 33.5% 22.6% 24.2% Cost of equity 16.2% 16.8% 17.0% Terminal growth 11.2% 11.2% 11.2% Source: JPMorgan estimates. Note: Normalized ROE for MCB and NBP is on adjusted equity/assets due to overcapitalization. Discussed in detail in next section Sustainable ROE Sustainable ROE in the case of Pakistan’s banks is likely to end up being lower than the current high levels being seen. We have calculated normalized ROE and have used it as a benchmark for valuation. Table 3 shows the sustainable ROE levels we have estimated for MCB, NBP, and BOP. These are on adjusted equity/assets, with overcapitalization being adjusted for in MCB and NBP, and slight undercapitalization being adjusted for in BOP.

Cost of equity Our cost of equity estimates shown in Table 3 have been derived using the CAPM, with risk free rate of 10.2% (long-bond yield) and equity risk premium of 6.0% (in line with other emerging markets). Beta used is fundamental beta rather than market beta. The sensitivity on valuations for 50bps change in cost of equity and terminal growth rate is 2.7-4.6% change in target prices.

Terminal growth rate We believe Pakistan’s real GDP growth rate may stabilize at about 5% in the long run once the high-growth phase is over. Adding on an inflation rate of close to 5-6% means that a nominal GDP growth rate of 10-11% seems viable.

This is also in line with the current long-bond yield for the 10-year PIBs of 10.2%. We have assumed an 11.2% terminal growth rate for dividends going forward. As economic growth evens out in the long run, terminal growth rate assumptions may have to be revised downward. However, that will also necessitate a reduction in the cost of equity, thus affecting valuations positively from that aspect.

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Risks and challenges for the sector Even though the sector is well-positioned to reap benefits from economic growth and continue with its higher spreads, there are a few risks that investors should be aware of.

Delay in easing of monetary policy may delay credit growth acceleration Pakistan’s private sector credit growth rate has slowed down in the last year-and-a-half due to tight monetary policy being followed by SBP. SBP’s inflation targeting suggests that with inflationary pressures consistently below 2005 peak levels, and on the way down, a shift to slightly easy monetary policy may occur by 4Q2007. However, the risk remains that the central bank may choose to continue with a stable-tight monetary policy where rates may not increase, but may not decrease either. This could cause a delay in credit growth acceleration, and also lead to downward revisions in 2008 loan growth estimates.

Secured consumer loans 48% of total consumer book, unsecured growing faster Even though consumer lending is still in its nascent stages in Pakistan, growth in uncollateralized loans is rising at a faster pace, highlighting potential default risk. Banks’ focus continues to be on unsecured lending where it is easier to get customers, i.e. credit cards and personal loans. Figure 3: Consumer lending distribution in Pakistan

Personal Loans40%

Mortgage16%

Credit Cards11%

Auto loans32%

Consumer Durables1%

Source: State Bank of Pakistan. Mortgage loans have not grown as robustly in Pakistan owing to high property prices, and higher interest rates. Also, homebuyers tend to favor personal equity over debt to avoid the higher levels of documentation and disclosure implied by taking on mortgage debt.

Consumer lending is mainly focused in the unsecured lending segment, consisting mainly of personal loans and credit cards, comprising 52% of total consumer lending.

Influx of foreign-owned banks and their takeover spree Rising competition Following the interest being shown by foreign banks in either entering Pakistan or expanding their businesses through acquisitions, competitive pressures are likely to increase within the industry. Foreign banks with better technical skills and processes, as well as higher levels of product innovation, are likely to provide stiff competition to medium-sized banks. While so far, the foreign M&A activity has been in the mid-sized banks, large bank acquisitions could spell a paradigm shift in the level of competition within the industry.

Interest of foreign banks in Pakistan is at an historic high, with three acquisitions already having taken place in the space of nine months

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Shortage of skilled HR to become apparent In an economy where technically sound financial institution specialists may not be available, foreign institutions would end up choosing for the best available human resources (HR). In most cases, with smaller operations and higher efficiency, they would not hesitate to pay premiums for skilled HR. This could leave the local banks contending with a ‘brain drain’ that would further retard their ability to compete with the foreign banks.

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Valuations Pakistan’s banks are currently trading at 2.0x 2007E P/B and P/E of 10.2x (consensus for whole sector). Banks under JPMorgan coverage (MCB, NBP, and BOP) trade at 2007E P/B of 2.5x and P/E of 10.1x. These valuations are at a discount to the regional banks.

Two-stage DDM-driven P/BV The valuation model used for Pakistan’s banks is the same as we use for other banks within the region. We have used a two-stage DDM model. This can be simplified as follows:

Fair value = PV of 3 years of expected dividends + terminal value

The calculation of terminal value for the valuation model requires the calculation of a few key components within the CAPM. Here we list the details of the various parameters used for valuation.

Cost of equity Long-bond yield In Pakistan, the most liquid long-bond is the 10-year Pakistan Investment Bond (PIB). This is usually used as the risk-free rate for valuation in Pakistan. The yield has been relatively stable in the last year or so and has hovered in the vicinity of 10%. It touched a maximum level of 10.5% in the second to last PIB auction held in 2H2006. At present, the latest auction has yielded a rate of 10.2%. Even though the secondary market yield has fluctuated within a 25-30bps range following the auction, we still take 10.2% as the risk free rate as that is the last rate declared by the government, and is not materially different from the secondary market yield.

Beta For the valuation of banks, we use fundamental beta across the Asia-Pacific region rather than market beta. Fundamental beta takes into account some risk factors which may not be captured by the market beta. Through this mechanism, we have arrived at fundamental betas of 1.00, 1.10, and 1.13 for MCB, NBP, and BOP, respectively.

Table 4: Fundamental betas for MCB, NBP, and BOP Stock Fundamental beta MCB 1.00 NBP 1.10 BOP 1.13

Source: JPMorgan estimates. Market risk premium We have used a 6% market risk premium for Pakistan’s banks as well, in line with other emerging markets in the JPMorgan universe.

Terminal growth Pakistan’s current long-bond yield of 10.2% reflects quite closely the long-term growth rate in the economy. Its long-term real GDP growth rate estimate stands at 5%, while average inflation historically has remained in the range of 6%. We believe

CAPM has been applied using fundamental beta instead of market-based beta

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that during the next two to three decades, the country’s economic growth can follow this long-term growth trajectory of nominal GDP growth of 11%.

We have factored in 11.2% terminal growth for MCB, NBP, and BOP. These rates have been taken in accordance with the banks’ business prospects and overall linkage of profitability with economic growth.

Normalized ROE Estimating normalized ROE is one of the most important calculations carried out for the valuation of banks. We estimate normalized ROE in the range of 22.6-33.5% for MCB, NBP, and BOP. This is based on ROA estimates of 2.6-3.7%, and a normalized equity/assets ratio of 11.2-11.5%.

We have adjusted equity/assets for MCB due to surplus over and above a tier-1 threshold of 16% for the bank. Normalized ROE for MCB would have been 24.9% if equity/assets was not adjusted for overcapitalization. Normalized ROA of 3.74% for MCB, in fact, is lower than the 3.92% ROA earned in 2006, and lower than our forecast range of 4.0-4.5% for 2007E-2009E.

We have adjusted equity/assets for NBP due to surplus over and above a tier-1 threshold of 12.5% for the bank. Normalized ROE for NBP would have been 17.1% if equity/assets was not adjusted for overcapitalization. Normalized ROA of 2.61% for NBP, in fact, is lower than the 2.75% ROA expected to be earned in 2007E.

Table 5: DuPont breakdown of normalized ROE for MCB, NBP, and BOP MCB NBP BOP NIM (as % of assets) 7.43% 5.25% 3.47% Non-int. income/revenue 18.50% 22.50% 35.00% of which Fee/revenue 11.00% 17.50% 7.50% Revenues/Avg. Assets 9.11% 6.77% 5.33% CIR 31.83% 31.00% 23.45% C/Assets 2.90% 2.10% 1.25% Operating ROA 6.21% 4.67% 4.08% LLP/Loans -1.00% -1.20% -0.80% Loan/Assets 62.50% 60.00% 65.00% Other-Prov;Inc./Avg. Assets 0.00% 0.00% 0.00% Pre-tax ROA 5.59% 3.95% 3.56% Tax Rate -33.00% -34.00% -25.00% ROA 3.74% 2.61% 2.67% ROE 33.45% 22.62% 25.32% Source: JPMorgan estimates. Note: Sustainable ROEs based on adjusted equity/assets for overcapitalization in MCB and NBP. Net interest margin NIMs for Pakistan’s banks (especially the large ones) have already been very high to complement the fast-growing asset books of the banks over the last few years. We

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have factored in stable NIMs for Pakistan's banks from 2009E onwards. We expect interest rates in the economy to ease off beginning 4Q2007 and into 2008E as well, with a 100-150bps reduction expected overall in about a year’s time starting 4Q2007. This would cause re-priced loans to incorporate the interest rate decline mostly in 2H2008 and into 2009E as well.

Non-interest income Non-interest income contribution to banks’ total revenues was 22% during 2006. In particular, strong fee income, dividend income, and capital gains have spurred non-interest income. We continue to expect similar contribution from non-interest income for Pakistani banks, with not much of a major change in composition going forward. Fee upside from rising consumer business and strong dividend income expectations are expected to be offset by rising net interest income to keep the overall contribution to revenue relatively stable.

Efficiency ratios Pakistan’s banks have seen consistent decline in cost/income ratios due to rising net interest and non-interest income. We believe the smaller banks are likely to see a quicker rise in cost/income ratios, as the race for skilled HR intensifies going forward. Larger banks’ cost/income ratios (especially public sector banks) have bottomed, in our view, as HR needs and IT-related expenditures are expected to push up costs going forward.

Credit costs Pakistan’s economic growth has enabled banking sector credit to filter through to where it has been needed. Meanwhile, action on legacy NPLs has resulted in considerable improvement in the net NPL ratio over the last few years, and there appear to be no major credit issues due to economic strength. Net NPLs ratio for the sector has improved considerably from over 10% in 2001 to close to 1.3% in 2006. Going forward, we see a gradual increase to a more normalized level of slightly above 2%. This is due to the influx of consumer lending, which is still in the initial phases of its growth cycle.

Tax rates Tax rates for Pakistan’s banking sector have been gradually reduced to 35% from a level of 50% over a five-year period. We have assumed that the corporate tax rate is likely to continue at 35% for banks, with no taxes on capital gains, and the usual 5% tax on dividend income.

Adjusted book value We have adjusted book values of banks to account for overcapitalization and undercapitalization where needed. Even though minimum overall CAR for Pakistan’s banks is 8%, we have taken a minimum threshold of 16.0%, 12.5%, and 10%, respectively, for MCB, NBP, and BOP to account for conservative risk management. However, MCB and NBP remain slightly overcapitalized and BOP remains close to our estimated threshold level. We have stripped out surplus capital from MCB and NBP’s book values when adjusting book values.

The fair P/B for MCB, NBP, and BOP stand at 4.45x, 2.04x, and 2.44x, respectively, following this exercise.

Net NPLs ratio is at an historic low at 1.3%

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Regional valuation comparisons Pakistan’s banks trade at more attractive multiples as compared to some of the regional peers. We believe that a growing economy and high ROEs can justify higher multiples for Pakistan’s banks.

Table 6: Pakistan banks—Regional comparison on P/E and P/B P/E P/B 2007E 2008E 2007E 2008E HK 16.6x 15.4x 2.6x 2.5x India 13.2x 10.5x 2.0x 1.7x Indonesia 16.3x 13.3x 3.1x 2.7x Korea 9.0x 9.3x 1.5x 1.4x Malaysia 14.9x 13.1x 2.3x 2.2x Philippines 17.8x 14.6x 2.2x 2.0x Singapore 16.5x 15.0x 1.9x 1.8x Taiwan 18.5x 16.0x 1.9x 1.8x Thailand 10.5x 8.9x 1.3x 1.2x Pakistan 10.2x 8.5x 2.0x 1.6x Asia 12.9x 11.8x 2.1x 2.0x Source: IBES, JPMorgan estimates.

Target prices Based on our valuation approach, we have arrived at the following price targets for MCB, NBP, and BOP for December 2007.

Table 7: Price targets and ratings for MCB, NBP, and BOP Target price (PKR) Rating Upside MCB 335 OW 20% NBP 235 N -3.5% BOP 125 OW 33% Source: JPMorgan estimates

Valuation sensitivities Table 8 gives a snapshot of how sensitive Pakistan banks’ valuations are to changes in key variables used for valuation.

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Table 8: Valuation sensitivity on key parameters for MCB, NBP, and BOP MCB NBP BOP Normalized ROE 33.5% 22.6% 25.3% Ke 16.2% 16.8% 17.0% G 11.2% 11.2% 11.2% Fair P/BV 4.45x 2.04x 2.44x NIM 2007E 7.11% 5.17% 3.09% Avg. of last four years 4.39% 3.68% 3.35% Normalized estimate 7.43% 5.25% 3.47% LLP/Loans 2007E 0.64% 1.01% 0.55% Avg. of last four years 0.59% 0.87% 0.31% Normalized estimate 1.00% 1.20% 0.80% Long-term growth 2007E EPS growth 18.1% 30.6% 24.1% Average of last four years 52.7% 68.2% 93.8% Perpetual G 11.2% 11.2% 11.2% Valuation Sensitivity - change in fair P/B for 10bps change in NIM 3.0% 5.6% 7.5% for 10bp reduction in LLP/Loans 1.7% 2.6% 3.3% for 1% point change in loan growth estimates 0.6% 0.5% 1.0% for 50bps reduction in both Ke and G 2.7% 4.6% 4.3% Source: Company reports, JPMorgan estimates.

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Investment case for Pakistan’s banks Pakistan’s banking sector has evolved at a very rapid pace since the 1990s. Financial sector liberalization and reforms were introduced in the 1990s. Commercial banks nationalized in the 1970s began to be privatized in the 1990s, as the government realized the importance of an independent and privatized banking sector.

Also, in the 1990s, several new licenses for operating a commercial bank were issued to local entrepreneurial groups. The likes of Union Bank and Prime Bank, which have now been taken over by Standard Chartered and ABN AMRO, respectively, are products of this very process. The government also brought in seasoned bankers from multinational banks to reform the sinking giants such as Habib Bank (HBL) and United Bank (UBL). Both now stand privatized, with UBL sold to a consortium of Bestway Group of UK and Abu Dhabi Group of Shaikh Nahayan, and HBL sold to the Aga Khan Foundation.

The investment case for Pakistan’s banks centers around their exposure to one of the fastest growing economies in Asia, with strong private consumption trends. In addition, investment/GDP is deepening after decades of chronic under-investment. Banks are likely to continue to see stable loan growth, and with one of the highest NIMs in the region, profitability is likely to remain strong. The larger banks are expected to continue to enjoy the NIM advantage, as the fight for deposits is mainly expected to play out between the small and medium-sized banks.

The non-interest portion of revenues is also something to watch out for, with increasing economic activity likely to push up fee income. Positive performance from the country’s capital markets is also expected to boost dividend income and capital gains opportunities for commercial banks.

Consumption-driven economic growth Rapid economic expansion, in the same league as China and India, is the setting for Pakistani banks’ operations. Economic growth over the last five years has been fully exploited by banks, most of the time at the cost of depositors, and profitability numbers speak for themselves.

Figure 4: Private consumption driving GDP growth

-20%0%

20%40%60%80%

100%

FY01 FY02 FY03 FY04 FY05 FY06

Priv ate Consumption Gov t. Ex penditure Fix ed Capital Formation Net ex ports

Source: Economic Survey of Pakistan.

Financial sector reforms took hold in the 1990s and several new private banks came into being

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Pakistan’s economic growth has mainly emanated from the industrial and services sectors.

Figure 5: Contribution to GDP from the producer side

0.010.020.030.040.050.060.0

FY02 FY03 FY04 FY05 FY06

Agriculture Industry Serv ices

Source: Economic Survey of Pakistan. The real change in economic fundamentals has been possible through a combination of factors. The current government’s policies, along with the aftermath of the events of September 9, 2001, have propelled the economy. As has been the case in the past (1960s and 1980s), the economy has yet again performed well under a military ruler with GDP growth touching a 20-year high in FY05 at 8.6%. With the absence of any political compulsions, the current government team has set about improving the problematic institutional framework in Pakistan.

The global oil boom and the resulting surge in activity in the Middle East, where Pakistani migrant workers are employed in large numbers, helped to bring in increased workers’ remittances into the country. These emanate mainly from the US and the Middle East.

Figure 6: Breakdown of growth in workers’ remittances US$MM

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1000

2000

3000

4000

5000

FY04 FY05 FY06

USA UK Saudi Arabia UAE Other Middle East EU Others

Source: State Bank of Pakistan. These remittances boosted domestic money supply, and played a key role in raising private consumption in Pakistan, especially in the early part of the economic revival. Credit growth during 2003 and 2004 was a result of low interest rates. Interest rates were raised in Pakistan in 2005 (policy rate raised by 150bps in April 2005) after inflation reached double-digit levels. However, with inflation having peaked, a new rate easing cycle should stimulate a second wave of credit growth.

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Pakistan’s industrial and services sectors are likely to continue to fuel growth in the medium term, as the reliance on agriculture decreases. Funding requirements for these sectors continue to grow, and Pakistan’s nascent consumer lending market is also well set for growth going forward. The larger banks are expected to finally make an entry into this segment (we have seen glimpses already with NBP’s Advance Salary product and MCB’s aggressive marketing of its credit card), which should make these products more accessible to the general public owing to the extensive branch networks of these banks.

Deepening investment: Investment/GDP denotes potential Pakistan’s investment/GDP ratio has lagged the Asian region over the last few years, and has only recently started to pick up. Gross fixed capital formation is still only 20% of total GDP (FY06 numbers), but is rising on the back of improving public finances and FDI inflows. We expect the banking sector to benefit from this rising investment in the form of increased corporate loan demand.

The potential for increase in investment is likely to become a key driver for corporate loan growth in the future, as Pakistan’s 20% investment/GDP ratio falls short of other emerging regional economies with investment/GDP ratios at or above 25%. Low loan/deposit ratios position banks will support large investment projects looking for bank loans. NBP is well positioned with a loan/deposit ratio of 63%, which we have estimated will increase to 71% by 2009. An example of this is NBP’s participation in a lending facility for Engro’s (fertilizer manufacturer) US$1 billion expansion in collaboration with Habib Bank (2nd largest bank in Pakistan in terms of assets).

FDI is a key part of economic revival A key portion of Pakistan’s economic revival has been foreign direct investment. From FY05 onwards, Pakistan has seen a paradigm shift in the foreign investment component of its balance of payments. Direct investment, including privatization flows, was pushed up beyond US$3bn in FY06. FY07 seems to be going even better with FDI already up 95% Y/Y for 8MFY07 (Jul 06 - Feb 07) despite the absence of any large-scale privatization.

Figure 7: FDI has ramped up US$MM

-500

1,0001,5002,0002,5003,0003,5004,000

FY02 FY03 FY04 FY05 FY06 8MFY07

Source: State Bank of Pakistan.

Investment to GDP ratio is still lagging the region at 20% of GDP and its growth potential is a key future driver for corporate loan growth

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FDI in Pakistan has mainly centered in the services and oil and gas exploration sectors. Manufacturing has, up until now, not received a huge contribution of FDI flows. However, as perceptions about Pakistan’s economic revival continue to change, and foreign investors gain confidence in the economy’s long-term prospects, we anticipate greater flows into manufacturing.

Table 9: Sector-wise FDI inflows in 8MFY07 vs. 8MFY06 US$MM Sector 8MFY06 8MFY07 Communications 440.1 1,281.4 Financial Business 243.8 572.8 Oil & Gas Explorations 190.4 352.7 Trade 75.8 117.3 Power 298.5 113.8 Construction 48.5 92.8 Source: State Bank of Pakistan. With several companies willing to set up shop in Pakistan, funding requirements from the banking sector are likely to increase. The local banking sector, with its consolidation and growing balance sheets, is expected to compete with international fund providers (e.g. GDR investors, Eurobond investors). Large banks have an edge as the small and medium-size banks are unable to take huge exposures to certain projects due to limited balance sheet size and per party exposure limits.

Domestic private investment activity also picking up Pakistan’s industrial sector has performed well in the last few years with double-digit growth rates seen up until FY06. This was when monetary tightening and capacity constraints took their toll on industrial sector growth rates. Domestic investment is also ramping up, with the following industrial sectors currently implementing new capex plans:

• Cement: Plan to almost double current capacity by FY10.

• Fertilizer: Engro’s US$1 billion expansion plan.

• Automobiles: Pak Suzuki, Indus Motor, and Honda Atlas all expanding, not to mention, the motorcycle assemblers as well.

• Paper and board: Companies like Packages Ltd. and Century Paper moving up capacity two to threefold.

With the type of expansion schedule in place for Pakistan’s key industries, the banking sector is likely to play a key role in these expansion plans. Already, Engro has availed a local facility through HBL and NBP. Development of industries with only two or three major players is also an opportunity for the government. An example is the automobile assembly sector, which has thrived due to the availability of liquidity to consumers. New entrants in this industry will not only help in generating employment, but are also likely to help fuel demand for banking sector credit.

SMEs identified as engine of economic growth Small and medium-size enterprises (SMEs) are another key area for future business growth. The SME sector encompasses key industries like textile products, sports goods, food processing, surgical instruments, paper and board, leather manufacturing, etc.

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Pakistan has a competitive advantage in a few of these areas, all of which account for significant foreign exchange earned by the country. We expect further investment in these industries going forward. A live example is the food processing industry, which has seen investments from various industrial groups in the last couple of years. Pakistan is the fifth-largest producer of milk in the world, with more than five new entrants in the milk processing business in the last year-and-a-half.

We expect more such ventures to pick up entrepreneurial interest in the economy. Currently, 16% of banking sector loans has been disbursed to SMEs.

Consumer lending only 14% of total loan book This represents one of the most promising avenues for future credit growth for commercial banks in Pakistan. We expect consumer lending to conservatively grow to 18% of total banking sector loans by FY09 from the current 14%.

Figure 8: Past and future (estimated) trend of consumer lending in Pakistan PKRB

0.0100.0200.0300.0400.0500.0600.0700.0

FY03 FY04 FY05 FY06 FY07E FY08E FY09E

Credit Cards Auto Loans Consumer Durables Housing Loans Personal Loans

Source: State Bank of Pakistan, JPMorgan estimates. Figure 9: Pakistan's consumer lending still only 3.6% of GDP %

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%

Korea

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Source: JPMorgan estimates, State Bank of Pakistan. Note: Data for India as of 2004, for China as of 2005. When compared to the region, Pakistan still has one of the most under-penetrated consumer loan books. Consumer credit has only begun to pick up in the current decade. Unlike a normal consumer lending pattern that begins with penetration of secured loan products such as mortgages, Pakistan’s has been more focused on

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unsecured lending which includes personal loans and credit cards. Auto loans have been the key growth area for secured consumer loans.

Growing per capita income, trickling through to lower classes Pakistan’s per capita income has risen at four-year (FY03-FY06) CAGR of 13.9% despite the country’s annual population growth rate of 2.5-3.0%.

Figure 10: Growing per capita income conducive for consumer financing growth US$

0

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Source: Economic Survey of Pakistan. Initially, the income effect was mainly positive for the upper and elite classes; however, gradually Pakistan’s middle class has grown, and even the lower classes are now more attuned to a better lifestyle. The overall gap between the rich and poor may have increased; however, the proportion of those living below the poverty line has decreased from 33% to around 25% in the last 6 years.

It is this growth in per capita income which has allowed Pakistani citizens to undergo a lifestyle change and reduce their aversion to leverage.

Personal loans, auto loans, and credit cards dominate The largest portion of consumer lending in Pakistan emanates from unsecured personal loans. These account for about 52% of total consumer loans. Even though some may see this as a point of concern going forward, we believe SBP has dealt with this issue with its strict provisioning requirements. All banks are required to take a loan loss provision (LLP) of 5% of all unsecured consumer lending each year in their income statement to create a reserve for possibility of NPLs in this segment.

Auto financing has been the key reason behind the boom in car sales in Pakistan over the last four years. Car sales, which are expected to reach 200k this year, are forecast by the government to reach close to 500k in five more years. This will continue to provide banks the opportunity to grow their auto loan portfolios. MCB continues to be one of the top three players in auto loans, with an estimated 1,500 cars financed each month.

Credit card penetration in Pakistan is also still quite low, despite being 11.5% of total consumer lending. A total of close to 1.5mn credit cards have been issued in the country. However, since several people tend to hold more than one credit card, the actual number of credit card holders in Pakistan is estimated at only 0.85 million.

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Mortgage finance still a fledgling industry Mortgage loans in Pakistan have been unable to make real inroads into banks’ lending portfolios and comprise only 16% of total consumer lending. Pakistan’s real estate market is mostly cash driven and people have still not gotten used to leveraging their properties. The asset boom encompassed real estate as well, with property prices sky-rocketing in 2003-2005 across the board. Following monetary tightening in 2005, property prices also went through a consolidation phase in 2006, just like other asset markets in Pakistan. However, property prices in Pakistan still remain high and out of the reach of most of the middle class. We believe that once the monetary policy begins to be eased, mortgage financing could rise substantially. High interest rates are one of the major reasons for the slow development of Pakistan’s mortgage finance industry.

Banks have begun to focus on mortgage lending, illustrated by the rapid growth of 248% and 59% in FY05 and FY06, respectively. This has taken mortgage lending from 6% of the consumer loan book in 2004 to 16% in 2006.

The government is currently in talks with multilateral lending agencies like Asian Development Bank and IFC to try and develop the housing finance industry in Pakistan. It has been suggested that these multilateral lenders lend a pool of funds to Pakistan’s central bank, which then lends the money to banks at subsidized rates. The banks can then keep a small spread of their own, and allow for single-digit lending rates for consumers to access mortgage finance.

The most active mortgage lender of the three banks covered in this report, NBP, is estimated to grow its mortgage book from a current level of PKR5 billion to around PKR7.5 billion (+50%), in 2007.

Interest-based earnings potential One of the highest NIMs in the region Pakistan’s banks have, until the extraordinary profit spurt in the last five years, gone unnoticed while earning high NIMs. However, the fact that the initial part of this profit surge came with low spreads, has put the current spreads in the limelight.

Figure 11: Loan-deposit spreads have traditionally been high in Pakistan %

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Pakistan’s banks have historically earned high NIMs (Figure 11). The low NIMs seen in the 2003-2004 period were driven by the lowest ever interest rates in the country’s history. The main reason for these structurally high NIMs lies in the country’s large low cost deposit base.

Therefore, we have estimated that Pakistan’s banks will continue to enjoy NIMs which would seem high on a regional/global basis. This, we believe, would be especially true for the large banks which continue to monopolize a captive, low-cost deposit base.

Figure 12: NIM estimates for MCB, NBP, and BOP %

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4.00%

6.00%

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2006 2007E 2008E 2009E

MCB NBP BOP

Source: Company reports, JPMorgan estimates. The push into consumer banking is also expected to help banks sustain NIMs on the higher side as interest yields rise. As can be seen in Figure 12, we estimate NIMs to fall in a couple of years as interest rates are expected to reenter the easing cycle.

Deposits not used as an investment avenue by masses, thus the lower rates Carrying forward the theme of high spreads, Pakistan’s large banks continue to enjoy the benefit of a massive low-cost deposit base. Banks with large branch networks, especially the Big Five (NBP, HBL, UBL, MCB, and ABL), still have a considerable low-cost deposit base to fall back on.

Figure 13: Deposit rates for banking sector segments %

-1.002.003.004.005.006.00

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The main reason that banks in Pakistan continue to enjoy low-cost deposits even when interest rates are rising is that the masses still do not consider deposits as an avenue for investment. Banks have close to 26 million depositors, and with total deposits of PKR3,034 billion, the average deposit size comes to PKR0.12 million (US$1,922). And just to put things in perspective, if considering just the Big Five, their average deposit size stands close to US$1,000.

Due to the lack of awareness, Pakistan’s depositors still consider bank deposits for safe-keeping of money, and they definitely have considerations of convenience (branch network) while choosing a bank. Even though term deposit schemes offering higher rates have been introduced by a number of banks, they still continue to be limited by the conditions placed on these deposits. Usually, there is a minimum deposit limit, and there is a general aversion to locking up deposits in a time-bound bank deposit.

Figure 14: Real deposit rates (vs. CPI) have continued to remain negative in Pakistan %

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Source: State Bank of Pakistan, Federal Bureau of Statistics. This is why Pakistan’s depositors now continue to earn negative real rates, and banks (especially the large ones) are not compelled to change this situation. In fact, real deposit rates becoming positive due to reduced inflation is more likely than due to rising nominal deposit rates.

NPL formation still low Despite the loan-book having grown at a 20% CAGR in the last five years, NPLs have not grown nearly as quickly.

Negative real returns have persisted on deposits in Pakistan

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Figure 15: Net NPL ratio has fallen over successive years %

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Source: State Bank of Pakistan. The net NPL ratio is unlikely to rise alarmingly, in our view, as loans continue to grow along with profits, and banks continue to provide for any loan losses in their income statements. With the strict provisioning requirements in place by SBP, particularly the high provisioning threshold placed on unsecured consumer loans, banks are expected to see low growth in NPL formation.

Figure 16: NPL coverage estimates for MCB, NBP, and BOP %

0.0%

50.0%

100.0%

150.0%

2006 2007E 2008E 2009E

MCB NBP BOP

Source: Company reports, JPMorgan estimates.

Non-interest income potential Fee-based income Bank cards (credit and debit) Pakistan’s banks have gradually increased credit card exposure. However, against 26 million depositors for the sector as a whole, the banks have issued only 1.5 million credit cards. Therefore, there remains a huge untapped market for credit cards.

Most banks’ credit cards continue to be issued with an initial charge, followed by the levy of an annual fee. Only Bank Al Falah, MCB, and UBL are currently issuing credit cards without any annual fee. Therefore, there is still potential for charging an annual fee on credit cards as there has not been wholesale migration to the three banks’ cards mentioned here.

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Debit card penetration is also limited. Most of Pakistan’s purchase transactions continue to be executed on a cash basis. The total number of card merchants is also still low, and this may have kept credit card penetration low in Pakistan.

An example of potential for card issuance is MCB’s latest credit card launch. The bank is the ninth bank to launch credit cards in Pakistan, and has seen a good response, with about 20,000 cards issued already in three months.

Growing international trade Banks traditionally earn fee-based income on total trade in a country’s economy. Pakistan’s total trade volume has grown at a five-year CAGR of 18%, with banks also benefiting in terms of higher fee-based income with a five-year CAGR of 25%. The increase in oil prices, with Pakistan being a net crude oil importer, is expected to cause the country’s total imports to cross US$30 billion in FY07E.

We estimate Pakistan’s total trade to grow at a 10% annual rate in 2007-2009 (mainly due to expectations of falling oil prices in the long run), which should continue to support banks’ revenues from this line of business.

Mutual funds distribution Another opportunity area for banks to explore and benefit from is the distribution of mutual funds through their branch networks. A number of new asset management companies have set up shop during the last couple of years. These companies are now launching mutual funds at a brisk pace.

Banks like MCB and NBP have their own asset management companies, and are likely to use their branch networks to cross sell these companies’ units. Banks like BOP, which do not yet have their own asset management companies, are using the opportunity to distribute units of other asset management companies.

We expect fee income from mutual funds distribution to account for below 10% of banks’ total fee incomes.

Investment banking and M&A With improvement in economic fundamentals, Pakistan’s investment banking industry has also benefited. M&A activity, privatizations, fund raising for expansions, and new equity offerings, have presented banks the opportunity to earn strong fee income.

Table 10: Privatizations in the pipeline Pakistan State Oil Pakistan Petroleum United Bank (through GDRs) National Bank (through GDRs) Sui Southern Gas Sui Northern Gas National Investment Trust State Life Insurance (through IPO) Pakistan Steel Mills

Source: Privatization Commission. Note: In random order.

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Table 11: Recent M&A in Pakistan Standard Chartered Bank Union Bank ABN AMRO Bank Prime Bank Phillip Morris Lakson Tobacco China Mobile Paktel Temasek (through NIB Bank) PICIC Saudi American Bank (SAMBA) Crescent Bank

Source: Company announcements, Karachi Stock Exchange.

NBP and MCB are expected to use their large balance sheets to good effect in this regard. A prime example is NBP’s latest funding arrangement for Engro Chemicals’ urea plant expansion in collaboration with HBL.

M&A in Pakistan is expected to continue to ramp up going forward, especially in the services sector, which continues to grow robustly. Pakistan’s open attitude to foreign investment, being one of the few countries where foreigners can own 100% of assets in any sector, is likely to keep M&A activity high as economic growth accelerates. Target industries could include telecom, banking, and oil and gas. Banks like MCB have invested heavily in developing strong investment banking teams, and NBP continues to have the strongest relationship with the government. BOP also, being a provincial government bank, continues to enjoy indirect government support in its activities.

We expect the share of investment banking revenues in total fee income for Pakistan’s banks to rise and estimate it to settle at around 20% in total fee-based earnings.

Bancassurance opportunities Bancassurance in Pakistan is a relatively under-penetrated market. Banks have not yet started to realize the fee potential available through this avenue. Insurance penetration in Pakistan still remains very low when compared on a regional basis, with only 0.5% of GDP as the current level.

Banks like MCB, which have their own insurance companies, can take advantage of this. However, other banks are likely to tie up with other insurance companies to try and build a cross-sell relationship.

We expect this source of fee income to remain very small in banks’ overall fee-based incomes in the next two to three years. It is simply an opportunity right now, which can be availed of. Religion is another issue with selling insurance in Pakistan. Some citizens consider conventional insurance to be against the ‘Shariah’, which is an impediment to developing retail bancassurance products.

Dividend income a function of continued corporate earnings growth Dividend income continues to be a key component of banks’ non-interest incomes. According to 2006 numbers, dividend income accounted for 17% of banks’ non-interest income.

Open foreign investment regime a boost to M&A

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Figure 17: Contribution of dividend income to MCB, NBP, and BOP non-interest incomes %

0%10%20%30%40%50%60%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports.

Corporate profitability expected to grow at close to nominal GDP growth rate Corporate profits in Pakistan have grown at a very swift pace in the last five years, benefiting from overall economic improvement. While the pace has been extraordinary over the last five years, we expect a more moderate rate of growth in the next two years.

Figure 18: Corporate profit growth continues %

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Source: Karachi Stock Exchange, IBES estimates. Pakistan’s nominal GDP growth rate of 12-13% is also expected to be the rate at which corporate profits grow going forward. This, we believe, is still decent growth, in spite of the base effect.

Close to 20% of banks’ investments in the stock market SBP’s amended prudential regulations in 2003 put a limit on banks’ holdings in the stock market. Banks are not allowed to own a stock portfolio whose value exceeds 20% of the value of their own equity. However, holdings in open-end mutual funds like NIT are exempted from this restriction.

As of end-2006, banks have close to 20% of their investment portfolios invested in the stock market. This includes investment in mutual funds as well. Banks like NBP

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and BOP hold significant quantities of the country’s largest open-ended mutual fund, NIT. This comes to about 4% of assets, and 38% of total equity.

Dividend payout ratio of close to 60% for Pakistani companies On average, Pakistan’s listed companies pay out cash dividends in the range of 60% in terms of earnings. This phenomenon is despite the low payout ratios of the banks themselves. We expect this trend to continue going forward as well, with high dividend payout ratios to be maintained by companies in 2007 and 2008.

Capital gains, albeit lower than before, being booked each year Pakistan’s banks booked huge capital gains on their investments in 2003 and 2004, when interest rates were on a downward spiral. The absolute numbers for capital gains earned have reduced since then, but these still continue to account for a significant portion of banks’ non-interest incomes.

Figure 19: Capital gains as portion of pre-tax incomes for MCB & NBP %

0%10%20%30%40%50%60%

2002 2003 2004 2005 2006

MCB NBP

Source: Company reports. Note: BOP only began to earn significant capital gains in 2006. We believe that the possibility of interest rates coming down once again is likely to allow banks the freedom to book more capital gains going forward.

Policy push from SBP Pakistan’s central bank has been instrumental in straightening out several issues facing the banking sector of the 1990s. They now stand much stronger, and are much more efficient, given that only NBP, among the large banks, remains under direct government control.

Stronger balance sheets Capital requirements for each year till 2009 SBP requires all banks to increase their paid-up capital to PKR6 billion by the end of 2009. This exercise has to be carried out in PKR1 billion increments each year till then. Therefore, the minimum paid-up capital requirement for commercial banks operating in Pakistan at end-2007 stands at PKR4 billion.

This is expected to strengthen the balance sheets and improve their capital adequacy ratios. A gradual consolidation has also taken place in the sector, and we also expect the number of banks in the sector to reduce with time. This will give the sector a stronger outlook, with fewer, stronger banks, as compared to several small banks

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which keep finding it difficult to meet the annual minimum paid-up capital requirements.

Capital adequacy tiers created by SBP SBP has also created an internal rating system for banks, whereby it determines the minimum capital adequacy ratios for specific banks. It is basically a five-tier system with capital adequacy ratio ranging from 8% to 14%. The SBP finds the weaker bank, and a higher minimum CAR is set for that bank.

Limits on exposure to equity markets As discussed in the previous section, SBP has placed limits on banks’ exposure to the stock market. This 20% limit in terms of total equity of the banks has been placed to improve the risk management of the overall banking system, and to reduce volatility in earnings.

5% general provisioning on unsecured consumer loans Unsecured consumer loans (personal loans and credit cards) account for 52% of total consumer financing. Since a bulk of the banks’ consumer loan portfolio falls in this bracket, SBP has enforced strict provisioning regulations. A 5% provision on the total unsecured consumer loan portfolio is to be taken annually in the banks’ income statements to account for possible delinquencies.

Gradual move towards Basel II reforms The SBP is taking a gradualist approach to implementing Basel II reform in Pakistan. Banks still remain technologically backward, especially the large government-owned NBP. A core banking solution is still conspicuous by its absence in the major banks.

SBP has been holding workshops and seminars to try and get banks to learn more about Basel II and eventually work towards implementing the salient features of this accord. SBP has also embarked on a roadmap to having Basel-II specifications implemented in Pakistan by 2010. In this regard, the Standardized Approach for credit risk and operational risk would be adopted from January 1, 2008. Following this, the Internal Ratings based approach for credit risk is to be adopted from January 1, 2010.

Issuance of Islamic banking licenses only No new conventional commercial banking licenses being issued The only way Pakistan’s commercial banking sector can see new entrants is either through acquisitions/consolidation or through the setting up of a new Islamic bank. Based on its policy of consolidation within the sector, SBP has refrained from issuing any new conventional commercial banking license in the last few years.

Development of Islamic banking a priority The SBP governor has been quoted in the local media on several occasions as having said that there exists immense potential for Islamic banking in Pakistan. All commercial banks now have Islamic banking divisions, while the SBP itself has overseen the issuance of four Islamic banking licenses in the recent past.

Prudential regulations revised in line with changing times Since 2003, SBP has issued revised prudential regulations for the banking sector. After initially issuing revised regulations for corporate banking, SBP has also issued revised regulations for consumer, agricultural, SME, and microfinance banking.

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Sector outlook for 2007 and 2008 Our outlook for Pakistan’s banking sector is positive overall. Key themes to consider are:

(1) Capital requirements. The SBP has made it mandatory for each bank to have a paid-up capital of PKR6 billion by the end of 2009. The catch is that capital needs to be increased by PKR1 billion each year-end till that time. The requirement for end-2006 was to have capital at PKR3 billion.

(2) Monetary easing expected from 4Q2007. We expect this easing to reinvigorate credit growth, which has slowed down following monetary tightening in 2005.

(3) M&A activity. Last year was characterized by private M&A activity in Pakistan’s banking sector. Interest of foreign banks in this growing sector with high spreads, and the enhanced capital requirements are bound to make for some interesting M&A activity going forward.

We believe larger banks will continue to reap the benefits of their low-cost deposits at a time when the smaller ones may be competing hard for new deposits. The smaller ones may be easier acquisition targets; however, the options are dwindling fast as Standard Chartered, ABN AMRO, Temasek and SAMBA have already made their moves.

Key 2007 and 2008 themes Capital requirements and the move towards consolidation SBP has tried to eliminate the major structural weaknesses in Pakistan’s banking sector to try and avoid any banking debacles like those seen in the 1990s. The 1990s saw the demise of the BCCI empire, a financial cooperatives scandal, and the closure of Mehran Bank amidst allegations of misappropriation in 1994, with its operations being amalgamated into NBP eventually. The latter part of the 1990s also unfolded the scandal of Bankers’ Equity Ltd.

In 2005, SBP issued a new capital regulation, whereby all commercial banks operating in Pakistan (be they local or foreign) would have to raise their paid-up capital by PKR1 billion each year to take it to a minimum of PKR6 billion by end-2009. Investors should keep in mind that the regulation was for paid-up capital and not total shareholders’ equity. Therefore, it was important for banks to have enough retained earnings to transfer through to paid-up capital via stock dividends (bonus issues).

The other course of action available to banks is to issue right shares to raise new capital. The current trend, however, seems towards issuance of GDRs by banks and seeking listings in foreign stock markets to meet capital requirements. MCB has already issued US$150 million GDRs last year, while BOP’s management has already hinted at a US$100 million GDR issue sometime in 2007. This has also allowed local banks to take advantage of the improving risk appetite of global investors. And of course, if all else fails, direct injection of funds by sponsors and/or merging into or being taken over by another bank would do the trick.

Increased capital requirements, possibility of easing of monetary policy, and M&A activity are the key themes to consider

Pakistan’s banks are required to increase their paid up capital to PKR6B by the end of 2009

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Table 12: Listed banks’ current paid up capital levels Bank Bloomberg Code Paid up capital Compliance with requirement as of (PKRMM) 2007 2008 2009 Allied Bank ABL PK 5,386 Y Y N Askari Bank ACBL PK 3,007 N N N Atlas Bank ATBL PK 3,126 N N N Bank Al Habib BAHL PK 3,681 N N N Bank Al Falah BAFL PK 6,500 Y Y Y Bank of Khyber BOK PK 4,004 Y N N Bank of Punjab BOP PK 3,846 N N N Faysal Bank FABL PK 4,237 Y N N Habib Metropolitan Bank HMB PK 3,005 N N N JS Bank JSBL PK 3,004 N N N KASB Bank KASBB PK 2,522 N N N MCB Bank MCB PK 6,279 Y Y Y MyBank MYBL PK 3,086 N N N NIB Bank NIB PK 3,362 N N N National Bank NBP PK 8,154 Y Y Y Saudi Pak Commercial Bank SPCB PK 5,002 Y Y N Soneri Bank SNBL PK 3,429 N N N United Bank UBL PK 8,094 Y Y Y Source: Karachi Stock Exchange. Note: Y = Yes, N = No, Banks in the process of being taken over have been excluded from this list.

We expect the smaller banks, especially those with weaker profitability prospects, to be sold off as capital requirements take their toll on standalone operations. An example of this is the merger between Habib Bank AG Zurich and Metropolitan Bank to form Habib Metropolitan Bank in 2006. The two banks were owned by the same sponsor group, but one was incorporated in Switzerland while the other in Pakistan.

Other such cases of consolidation have been the takeover of Crescent Commercial Bank (CCBL PK) by SAMBA from Saudi Arabia. The Saudi giant will inject PKR6 billion into the bank in exchange for 68% of the total shareholding. Other banks that could be potential candidates after looking at Table 12 may be My Bank (MYBL PK), Bank of Khyber (BOK PK) (currently owned by the government of the North West Frontier Province), and KASB Bank (KASBB PK). This could signify a buying opportunity in such small banks as they could become acquisition targets going forward.

Possible monetary easing in 4Q2007 may reinvigorate credit cycle Pakistan is heading into a new monetary easing cycle. Inflation is on the way down after having peaked in 2005 at close to 11% (based on Consumer Price Index). After having raised the discount rate first in April 2005 to 9% (+150bps), and then in July 2006 to 9.5% (+50bps), SBP stated that it will maintain the current policy.

Capital requirements are likely to spur consolidation as banks with prospects of lower earnings growth may be sold off or merged

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Figure 20: Credit offtake and lending rates

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%

FY02 FY03 FY04 FY05 FY06 FY07*0

100

200

300

400

500

Priv ate sector credit offtake (PKR bn) Av erage lending rate

Source: State Bank of Pakistan. Note: FY07 private sector credit offtake has been annualized from latest available figures. Private sector credit in Pakistan got a big lift when interest rates declined sharply in 2003. That was when money supply (M2) growth was lifted by Net Domestic Assets’ (NDA) growth, which in effect was a function of the money multiplier driven by credit growth. After hitting 32% in FY05, private sector credit growth fell to 20% in FY06.

This strong inverse correlation between interest rate movements and credit growth has allowed banks in Pakistan to build up their interest earning assets (mainly loans). This more than countered lower spreads in 2003 and 2004 when banks booked huge capital gains on their bond and stock portfolios, while also benefiting from volume growth in their loan portfolio.

Figure 21: Inflating loan book compensated for falling spreads PKR bn

0

100

200

300

400

500

2002 2003 2004 2005 2006

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

Profits (PKR bn) Loan grow th (PKR bn) Spreads (%)

Source: State Bank of Pakistan. The next wave of credit growth is expected to come from yet another round of monetary easing expected to kick off at the earliest by 4Q2007. This is likely to benefit all the banks, both, in terms of the continuation of the consumer lending boom and the recommencement of the corporate and SME borrowing cycle.

Our expectations for private sector credit growth for FY07E, FY08E, and FY09E stand at 13%, 14%, and 16%, respectively.

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M&A interest by foreign banks With no foreign ownership limits for banks in Pakistan, foreigners have begun to see bank acquisitions as a good way to gain exposure to the broader economic growth in the country.

Table 13: Recent acquisitions in banking sector Bank Acquisition type Acquired in Acquisition P/B United Bank Privatization 2002 2.8x Habib Bank Privatization 2003 2.0x Allied Bank Privatization 2005 2.1x Union Bank Acquired by Standard Chartered 2006 5.9x Prime Bank Acquired by ABN AMRO 2007 3.9x Source: Privatization Commission, Company notices. The kind of multiples used for takeovers by the likes of Standard Chartered and ABN AMRO for acquisitions tell only a part of the growth story available to investors in Pakistan. Temasek, through its already-owned bank in Pakistan, NIB Bank Ltd. (NIB PK), has provisionally agreed to acquire Pakistan Industrial Credit & Investment Corporation (PICIC). SAMBA of Saudi Arabia has also purchased a 68% stake in Crescent Commercial Bank.

We believe that this foreign acquisition trend will continue in the next couple of years as well. Barclays Bank has reportedly (in local newspapers, Dawn and Business Recorder) been interested in acquiring a bank in Pakistan. However, with Barclays currently in talks with ABN AMRO for a takeover, we believe this will not be its top priority. Other reports in the same newspapers have also named MayBank of Malaysia and BNP Paribas of France as those interested in setting up shop in Pakistan. However, there has been no official statement from any of these banks regarding their interest in an acquisition in Pakistan.

As SBP has stopped issuing new conventional commercial banking licenses, acquisitions are currently the only way for foreigners to actually enter Pakistan’s banking industry. Islamic banking licenses are still available; however, four of those have already been issued in the last couple of years.

Operating outlook Direction of NIM Spreads for Pakistan's banks have been trending upwards in the last two years; however, 2007E is likely to be more of a stable year in terms of direction of spreads. We expect interest rates in Pakistan to move downward in 4Q2007, but the magnitude isn’t likely to be too much.

This is likely to take NIM a bit lower than its current levels. The trend is already visible in the fresh loans to fresh deposits spread.

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Figure 22: Spreads of bank segments on total outstanding loans and deposits %

4.005.006.007.008.009.00

10.00

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07


Source: State Bank of Pakistan. Figure 23: Spreads of bank segments on fresh loans and deposits (monthly) %

1.00

3.00

5.00

7.00

9.00

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07


Source: State Bank of Pakistan. Competition for deposits is rising, not only amongst the smaller banks, but among larger banks as well. On an individual basis, MCB and NBP are likely to be better positioned to defend spreads, given their large low cost deposit franchises. BOP, on the other hand, is likely to see its spreads compress more than the former two.

Figure 24: NIM estimates for MCB, NBP, and BOP %

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

2006 2007E 2008E 2009E

MCB NBP BOP


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Asset-liability management Pakistan’s banks rode the credit wave in 2003 and 2004; not many of them had focused on the problems that may arise given the eventual exhaustion of the loans-deposits ratio.

Loan growth We expect the overall banking sector to post a loan growth in the low to mid teens in percentage terms in the next couple of years. This is likely to remain in line with the trend in the past couple of years.

Table 14: Loan growth estimates % 2006 2007E 2008E 2009E MCB 9.9% 13.4% 15.7% 16.8% NBP 17.6% 12.7% 13.6% 13.0% BOP 59.2% 22.5% 21.7% 19.7% All Banks 17.9% 13.0% 14.0% 16.0% Source: Company reports, State Bank of Pakistan, JPMorgan estimates. Loan growth is likely to be driven by consumer lending, and with the credit cycle likely to be revitalized in 2008 following an expected decline in interest rates, corporate lending is also likely to maintain stable growth.

Deposit growth Pakistan’s banks have seen strong deposit growth in the last few years with a five-year CAGR of 17%. With monetary tightening instituted by SBP since 2005, the competition for deposits has heated up amongst the small and medium-size banks. Larger banks still remained cushioned due to their low-cost deposit bases, as a result of their extensive branch networks.

Table 15: Deposit growth estimates % 2006 2007E 2008E 2009E MCB 12.1% 14.0% 13.9% 13.9% NBP 8.3% 7.8% 8.6% 9.4% BOP 55.7% 20.4% 20.2% 15.5% All Banks 12.7% 12.5% 12.2% 13.0% Source: Company reports, State Bank of Pakistan, JPMorgan estimates. Loans to deposits ratio has reached 78% for the banking sector as at February 2007. With banks looking to expand their loan book further, growth in deposits remains the key. We expect deposit growth to maintain a stable trend in the next couple of years for the sector.

Non-interest income Growth in non-interest income for Pakistan’s banks is likely to flow in through higher fee income, dividend income, and capital gains on investments.

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Table 16: Non-interest income growth estimates % 2006 2007E 2008E 2009E MCB -4.5% 20.5% 22.0% 21.8% NBP 36.4% 18.4% 18.6% 15.7% BOP 92.8% 28.3% 20.0% 20.4% Source: Company reports, JPMorgan estimates. Increasing economic activity and consumer spending is likely to result in rising fee incomes going forward. This is likely to be complemented by higher income from investment banking activities, and through other services like mutual fund distribution and bancassurance products.

Dividend income is a function of the respective equity portfolios of each of the banks. The three banks we have covered in this report have equity investments as 20-25% portion of their investment portfolios.

Table 17: Equity investment portfolios of MCB, NBP, and BOP Equity Portfolio % of total investments PKRMM

MCB 12,887 20% NBP 35,559 25% BOP 7,116 25% Source: Company reports. Expected decline in interest rates from 4Q2007 onwards is also likely to provide banks with incentives to book capital gains on their bond and equity portfolios. Pakistan’s stock market is also expected to continue to provide double-digit returns to shareholders (capital gains + dividends) in the next couple of years, thus further supporting capital gains income.

Operating expenses Cost to income ratio for Pakistan’s banks has been falling consistently over the last three years. This is a direct result of rising NIM, as well as non-interest income. We expect no major improvement going forward, and expect the ratio to stabilize at close to current levels.

Figure 25: Cost/Income ratios for MCB, NBP, and BOP %

0.0%

20.0%

40.0%

60.0%

80.0%

2003 2004 2005 2006 2007E 2008E 2009E

MCB NBP BOP


37



Cost/asset ratios have remained relatively stable for the larger banks, as their assets have grown at a pace slower than the overall industry. Medium-size banks have seen improvements in their cost/asset ratios, illustrated by BOP, given their speedy asset growth. We expect slight increases in cost/asset ratios for Pakistan's banking sector in 2007E-2009E, but still expect ratios to remain below 3% for MCB and NBP, while remaining below 1.3% for BOP.

Figure 26: Cost/Asset ratios for MCB, NBP, and BOP %

0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%

2003 2004 2005 2006 2007E 2008E 2009E

MCB NBP BOP


Asset quality outlook Quality of loans is less of an issue than in the 1990s for Pakistan’s banks. SBP’s efforts to get banks to clean up their books, along with an economic revival in Pakistan have worked well and now only 1.3% of banks’ total net loans portfolio is classified as net NPLs (end-Dec 2006). Gross NPLs amount to 6.4% of total loans for Pakistan’s commercial banks. SBP, in a regulation issued in 2005, now requires banks to recognize a loan as a total loss when non-payment reaches the 1-year mark.

The case of NBP is unique, being a government bank. The bank has inherited a number of ‘legacy’ NPLs from the 1990s and still carries them on its balance sheet due to a few political compulsions. Even though there is no official directive not to write off these loans, NBP still carries them, as being a public sector bank, it is accountable to parliament in its affairs. This is because write-offs in Pakistan are viewed with suspicion on the basis of corruption.

SBP has also seen to it that a consumer lending boom does not lead to a large build-up in NPLs. General provisioning has to be taken at 1.5% for secured consumer lending, while a general provision of 5% has to be taken for unsecured consumer loans like personal loans, credit cards, etc.

Overall, we do not see a major asset quality issue for Pakistan's banks. NPLs are likely to grow at a faster pace on the consumer book as opposed to the corporate book; however, strict provisioning requirements are likely to take care of any major delinquency issues.

More stringent loss recognition and write-off requirements

Public sector banks like NBP have inherited ‘legacy’ NPLs, which have been difficult to write off due to political considerations

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Risks and challenges for the sector Things have gone quite well for Pakistan’s banks in the last five years, mainly driven by easy money availability coupled with high spreads. There are a few risks and challenges that the sector faces at this critical juncture. As mentioned earlier, Pakistan’s banking sector has seen falling credit growth rates in the last year-and-a-half as a result of tight monetary policy. Although there is an expectation that interest rates may be lowered in 4Q2007, Pakistan’s central bank may hold back on the rate cut for a while longer.

On the consumer lending front, Pakistan’s banks have seen a boom mainly in unsecured lending, which necessitates 5% general provisioning. We believe the smaller component of secured consumer loans is something which the banks should be looking to grow going forward. The private banks have worked on improving customer services, however, issues still remain, especially with public sector banks like NBP and some of the Big Five banks.

Where consolidation and M&A activity has its advantages, there are also some key challenges for local banks to face. With foreign banks looking to invest heavily in Pakistan, the level of competition will go up a few notches, as most foreign banks aim to become medium-size banks.

Delay in easing of monetary policy In the last long-bond auction, yields fell by about 30bps, which signifies a slight shift in thinking. However, on the shorter end of the yield curve, SBP recently raised the 1-year T-bill yield by close to 4bps.

There is a possibility that SBP may delay the expected reduction in interest rates and may want to monitor inflation levels for a slightly longer period to be absolutely sure of sustainability of low inflation rates. Even though it would be good for banking spreads that rates remain high, it is likely to further reduce the private sector credit growth rate going forward.

Credit growth acceleration may be delayed We believe that the longer SBP takes beyond 4Q2007 to reduce interest rates, there would be that much of a lag effect in terms of credit growth accelerating once again.

Several manufacturing sector companies have begun to feel the pinch of higher interest rates. Cement companies, for example, have borrowed heavily to finance industry-wide capacity expansions. Several other sectors that are looking to expand capacity consistently, e.g. telecoms (wireless carriers) have also leveraged themselves through bank borrowing.

Pakistan’s banks are likely to face lower credit growth in future as long as interest rates remain high.

The fledgling mortgage market, which holds huge potential, especially given the shortage of close to 300,000 housing units per annum, may not develop as long as banks face the double-edged sword of higher interest rates and high property prices.

Even though conditions have been supportive of Pakistan’s banks over the last five years, the future hinges on a few critical details: (1) Monetary policy being loosened, (2) high portion of unsecured lending in retail segment, and (3) expanding operations by foreign banks, which would increase competitive pressures

Loan growth to slow down and is likely to only be spurred through decline in interest rates going forward

39



Secured lending still only 48% of total consumer lending Another issue that Pakistan’s banks may have to potentially deal with going forward is the slow creation of secured consumer loans. Overall, consumer lending continues to flourish, however, it is mainly the unsecured portion that has a sharper growth trajectory.

Growth mainly in personal loans and credit cards As can be seen from Figure 27, growth in unsecured retail lending has been faster than the growth in secured retail lending.

Figure 27: Breakdown of consumer lending PKRB

0.050.0

100.0150.0200.0250.0300.0350.0

FY03 FY04 FY05 FY06

Credit Cards Auto Loans Consumer Durables Housing Loans Personal Loans

Source: State Bank of Pakistan. Apart from the quick growth spurt seen in the auto loans business, with a three-year CAGR of 73%, Pakistan’s banks have been unable to push up secured consumer lending.

Although regulatory requirements are for a 5% provision against the unsecured consumer loan portfolio, the danger may not really lie in the sudden delinquencies that may arise. An issue with the profit and loss statements and balance sheets of banks may arise when following consistent growth, a 5% annual provision may take its toll on profits and book values.

Therefore, the banks do need to work on growing the secured portion of consumer loans. There, they are not only protected due to the security of the asset in question, but also through the lower provisioning requirement of 1.5% of the outstanding portfolio.

Housing loans: Victim of high interest rates and high property prices Pakistan’s mortgage finance has been unable to receive the required kick start in the last few years, and it still stands at only 16% of total consumer lending. It is only in the last couple of years, that banks have seen some semblance of growth in mortgage lending. The government-run House Building Finance Corporation has also been unable to provide a catalyst.

Pakistan’s banks need to focus on increasing exposure in the secured retail loans segment to better manage their risk profiles

The push can come from mortgage loans, but it is still only 0.6% of GDP in Pakistan, as a result of high property prices and high interest rates

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Figure 28: Mortgage penetration only 0.6% of GDP in Pakistan

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%

Korea

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Hongkon

g

Singapo

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aChin

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dInd

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Source: State Bank of Pakistan, JPMorgan estimates. Note: Data for India as of 2004, and for China as of 2005. We believe that as long as the middle class continues to be unable to participate in mortgage borrowing, this segment cannot see viable and sustainable progress. There has been some talk of subsidizing home loans in collaboration with multilateral lenders like Asian Development Bank and the IFC, but nothing concrete has come out of it so far.

Guarding against a rise in NPLs Banks’ foray into consumer lending needs to be closely monitored as any sudden surge in NPL formation is likely to dent future profit growth and balance sheet strength. Banks need to set up separate risk management divisions for consumer lending, as this is a more fragmented and risky area, especially with over half the lending being unsecured.

Credit collection is another issue which needs special attention. Even though there have been no serious defaults in consumer loans to-date, banks need to possess the ability to withstand any negative developments. SBP’s provisioning requirements are part of the solution, and banks themselves have to be more vigilant in their lending.

Influx of foreign-owned banks and their takeover spree Pakistan’s banking sector has seen a sudden rise in interest from foreign-owned banks. The takeovers have not been small by any means for the market. The floodgates were opened when Standard Chartered announced the takeover of Union Bank for a sum of close to US$500 million. ABN AMRO has also just announced the takeover of Prime Commercial Bank for a sum of US$234 million. The interest shown by Temasek in PICIC Commercial Bank and the acquisition of Crescent Commercial Bank by SAMBA of Saudi Arabia have suddenly made potential targets out of all of Pakistan’s small private banks.

There has also been widespread speculation about Barclays Bank and Citigroup being interested in such acquisitions in the Pakistan market. However, with the ongoing discussions with ABN AMRO, its interest in Pakistan’s banking sector may not be a top priority for now. There have, however, been no official statements from either of these banks on such takeover plans.

Foreign banks’ entry is good for the consumers, but competitive pressures are likely to result in greater cost outlays

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Competition to increase With the influx of foreign-owned banks on a greater scale, the banking sector is likely to see an increase in competition. Foreign banks are likely to bring in better operational expertise, and with acquisition of local human resources, are likely to also be equally adept at being aware of local consumer trends.

We believe that Pakistan’s local private banks would need to gear up better in order to face competition. Foreign-owned banks, with better resources to commit, can end up taking greater market share, in both, deposits, and the high-growth consumer lending market.

Technological requirements to increase The entry of foreign banks is likely to raise competition at the technological level. None of the banks can currently boast a completely implemented core banking solution.

The increased presence of foreign banks is likely to spur investments on the technology front. Local banks may have to spend more on IT, and spend it quicker than they might have anticipated.

Large takeover could spell a paradigm shift in competition Plenty of speculation has centered around the possibility of the foreign takeover of a large bank in Pakistan in recent times. Although nothing has materialized as yet, we believe it is quite possible for a foreign giant to make a large entry in Pakistan. Possibility of takeover of banks along the lines of Bank Al Falah, UBL, or MCB could spell a paradigm shift in competition for larger banks in Pakistan.

As of now, there is no definitive threat for the likes of MCB, UBL, HBL, and Allied Bank (ABL), yet we believe that the possibility of a large foreign takeover cannot be ruled out. The need for technological advancement would be even more pressing for large local banks in case of such an occurrence. Even though there may seem to be a buying opportunity in these banks due to the possibility of either one of them being taken over, we think that the remaining will have to contend with a new level of competition.

Shortage of skilled HR to become more pronounced With foreign banks more able to pay a premium to take the best skilled HR away from local banks, the latter have to beware this threat as well. Pakistan’s financial sector is already facing a shortage of skilled HR. Almost every management has stated that the lack of skilled HR is probably the biggest impediment it currently faces.

This has already been seen with the arrival of Dubai Islamic Bank, which has taken away key top management figures from various local banks. Several middle management positions have also been filled in this way. We think that this could be a key risk that banks may currently need to address.

The possibility of sponsoring professional colleges’ MBA and Finance programs is something which can be looked at. However, local banks are also likely to see an increase in staff costs going forward as they seek to retain their key personnel, rather than theirs getting poached by foreign entrants.

The biggest thing to fear for large banks is the possibility of a large takeover, which may expose their inefficiencies

Skilled HR shortage is being faced not only in Pakistan’s financial sector, but also across the region. It will be exacerbated due to the entry of foreign banks which can afford to pay higher premiums

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Industry overview Pakistan’s banking system, in terms of total assets, is still quite small when compared to other regional economies. Total assets of nearly US$65 billion are lower than most of the countries within the region. Pakistan’s banking sector has grown at a CAGR of 13.6% in the last five years.

Figure 29: Regional comparison of banking sector assets US$B

-500

1,0001,5002,0002,5003,0003,500

China

Taiwan

Hong Kong Kore

a Ind

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Source: Company reports, State Bank of Pakistan.

Market structure Pakistan’s banking sector had historically been dominated by the Big Five banks. These Big Five are National Bank of Pakistan (NBP), Habib Bank Ltd. (HBL), United Bank Ltd. (UBL), MCB Bank Ltd. (MCB), formerly Muslim Commercial Bank Ltd., and Allied Bank of Pakistan Ltd. (ABL). These Big Five have now been joined by a sixth, Bank Al Falah (BAFL), which has accumulated total assets greater than ABL.

There are a total of 32 commercial banks (excluding Islamic banks) currently operational in Pakistan. Of these, only two are state-owned (NBP and First Women’s Bank), two are provincial government-owned banks (BOP and Bank of Khyber), 20 are local private banks, and 8 are foreign banks. Figure 30 presents an overview of how the banking system’s assets are broken down into these various segments.

Figure 30: Pakistan's commercial banking assets—Share of each segment

21%

69%

10%



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At the start of this decade, the Big Five controlled approximately 65%, 60%, and 70% of Pakistan’s total banking assets, loans, and deposits, respectively. However, the surge in the share of smaller private banks and regional banks like BOP, in the past six years has seen the share of the Big Five reduce to 56%, 54%, and 59%, respectively.

Figure 31: Domination of top 5 banks within each country’s banking assets %

0.00%

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40.00%

60.00%

80.00%

100.00%

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Hong Kong

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Source: Company reports. Shift from public to private ownership Pakistan’s banking sector presents a classic case for the proponents of private enterprise, as the growth spurt has mainly been possible due to privatization of a majority of the sector’s assets.

In the 1970s, the banking sector, along with most of the country’s corporate sector, was brought under government control. Starting in 1991, MCB was privatized and its control was taken over by the Nishat Group. Following a couple of unsuccessful privatization attempts for UBL, the current administration finally managed to successfully privatize the bank in 2002. HBL was privatized at the end of 2003, while ABL made it to the list of private banks in 2004. Thus, out of the Big Five, four banks have now been transferred to the private sector.

During the 1990s, several new banking licenses were issued, which really brought about the structural change in the banking sector. Financial sector reforms were also initiated in the 1990s, as the government tried to bring some semblance of sanity to the loss-making Big Five banking institutions.

Foreign banks: To Pakistan and back again Pakistan has generally been an attractive venue for foreign banks to operate in. This is mainly because of the attraction of absence of foreign ownership limits in the sector. Banks like Citibank, Standard Chartered, and ABN AMRO have continued to maintain a presence in Pakistan.

The five large banks of the pre-privatization era dominate the sector with 56% share of total banking system asset base

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Table 18: Foreign banks’ presence diminished following 1998 FY98 FY06 ABN AMRO ABN AMRO American Express Bank of Tokyo ANZ Grindlays Citibank Bank of America Deutsche Bank Bank of Ceylon HSBC Bank of Tokyo Oman International Bank Citibank Standard Chartered Credit Agricole Indosuez Deutsche Bank Doha Bank Emirates Bank Habib Bank AG Zurich HSBC IFIC Bank Mashreq Bank Oman International Bank Rupali Bank Societe Generale Standard Chartered Source: State Bank of Pakistan. Foreign banks in Pakistan have also had a history of pulling out whenever there has been a perceived increase in political and geo-political risk in the country.

Figure 32: Foreign banks’ loan-deposit spreads %

0246

81012

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

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Jan-07


Currently, Pakistan is seeing a renewed interest by foreign banks for setting up their operations here. The takeover wave with Standard Chartered, ABN AMRO, Temasek, and SAMBA is something which really has not been seen in Pakistan’s banking sector before. Banking and telecom are easily the top two sectors in terms of FDI attraction into Pakistan in the first eight months of this fiscal year (Jul 06 - Feb 07).

Role of National Bank of Pakistan National Bank of Pakistan (NBP) is the only large government-owned bank left in the country after the culmination of the privatization wave in 2005.

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Figure 33: NBP’s diminishing share in overall banking sector loans, assets, and deposits

0%5%

10%15%20%25%30%

2001 2002 2003 2004 2005 2006

Loans Assets Deposits

Source: Company reports, State Bank of Pakistan. With private enterprise enabling the overall banking sector to grow at a quicker pace than NBP, its share in Pakistan’s overall banking sector assets, deposits, and loans has reduced gradually.

NBP finds itself in the unique position of being the only bank to represent SBP all over the country where SBP’s offices are not present. Although SBP holds NBP’s 75% shareholding on behalf of the government, the central bank does not exert any influence in the bank’s operational matters.

Around 30% of NBP’s deposit base is the government’s or the public sector enterprises’ money. Being the only government-owned bank, a portion of its deposit base is captive in this way.

NBP’s government-owned nature also gives it a certain disadvantage. Its loan portfolio, in the past, has more often than not been used for political favors. This is, both, in terms of loan disbursement at favorable terms and in terms of bad loans being accumulated on to NBP’s balance sheet as write-offs would cause an uproar amongst the general public.

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Figure 34: Pakistan banks—Competitive positioning Source: JPMorgan.

Threat from new entrants • Foreign players • New local owners with banking expertise

Threat of substitutes • Islamic banking • Capital market, corporate debt market • DFIs, specialized financial institutions • Government’s National Savings Schemes

Bargaining power of suppliers

• Co branding in consumer lending products

Opportunities

• Consumer lending co branding opportunities to be pursued

Bargaining power of customers

• Borrowing directly from local and international debt markets

Opportunities

• Investment banking fee opportunities

Competition within industry • Segment and business-wise • Stiffer among small and medium sized banks • Shortage of skilled HR in financial sector

Opportunities

• Develop HR through sponsorship of MBA programs • Develop niches, e.g. BOP in agriculture, Union Bank

in consumer lending, etc.

47



Pakistan banking sector: Competitive positioning Applying Porter’s model for assessing a sector’s competitive and operating environment always throws up a few insightful details. We have devised a snapshot of Pakistan’s banks based on Porter’s five criteria for assessing an industry.

Competition within industry • Segment and business-wise (e.g. consumer lender vs. consumer lender and large

bank vs. large bank).

• Stiff competition amongst smaller and medium-size banks (for deposits). Deposit costs for term deposits range between 8% and 11%.

• Strong competition for skilled human resources.

Threat of substitutes • Islamic banking, for which four new licenses have recently been issued. Dubai

Islamic Bank is very aggressive in this domain.

• Capital market, which includes asset management companies’ mutual funds. This also includes the infamous ‘badla’ system where several institutions and individuals lend money at rates ranging from 12-18%.

• Development finance institutions, especially in large project finance deals.

• Specialized financial institutions like House Building Finance Corporation (HBFC), which provides housing finance.

• Property market, with impending issuance of REITs by few companies.

• Corporate debt market, or as they are called in Pakistan, Term Finance Certificates (in terms of substitute for bank deposits).

• Government’s National Savings Schemes offering attractive rates of return.

Threat of new entrants • Foreign players, either through acquisition or through special license grants.

• New local owners for existing players, who have better skills at managing a bank. Case in point, turnaround experts like Mr. Shaukat Tarin, who was president of Union Bank before it was taken over by Standard Chartered.

Bargaining power of customers • Borrowing directly from corporate debt market (issuing TFCs – Term Finance

Certificates) rather than coming to banks.

• Companies are also beginning to place debt in international bond markets, e.g. Pakistan Mobile Communications Ltd. which recently issued a US$250 million bond.

• Government borrowing through long-term bonds more than short-term treasury bills, which would involve borrowing from longer-term players like insurance companies, pension funds, etc.

Bargaining power of suppliers • Co-branding in consumer lending products.

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Regulatory framework Pakistan’s banking sector is under the control of the central bank, State Bank of Pakistan (SBP). The SBP, however, was until this very decade not declared to be an autonomous body. Interference by the Ministry of Finance was the norm in the 1980s and 1990s in banking sector regulations, as the government itself owned the Big Five banks.

The current structure for Pakistan’s banking sector and economic regulation is shown in Figure 35.

Figure 35: State Bank’s functional hierarchy

Source: State Bank of Pakistan. Monetary policy As the regulator, SBP is also responsible for the monetary policy in the country. SBP, in recent times, has been more market based in setting monetary policy rather than trying to deal with a situation where the currency was devalued through the government announcement in the 1990s.

Table 19: Various monetary policy tools used by SBP Discount rate Set at 9.5% in July 2006 Cash Reserve Requirement 7% on demand deposits, 3% on time deposits Statutory Liquidity Requirement 18% on demand and time liabilities Open Market Operations As and when needed T-bill auctions Indirectly signals interest rate policy

Source: State Bank of Pakistan. Interest rates The movement of interest rates in Pakistan’s economy used to be at the behest of the Ministry of Finance in the 1990s. This has changed with the declaration of SBP as an autonomous body. Interest rate setting on the shorter end of the yield curve, and for policy purposes, is the sole domain of the SBP now. Interest rates on the long-term bonds are set by the Ministry of Finance through Pakistan Investment Bond (PIB) auctions as and when the government requires long-term funding.

State Bank of Pakistan

Economic Policy & Research Corporate Treasury Banking sector

Economic Advisor, Monetary Policy

Research Supervision Policy Development Finance

Internal services MM & FX markets

49



T-bill auctions in Pakistan are conducted on a fortnightly basis, through which not only does the government borrowing take place, but the SBP also gives its directional policy for interest rates. SBP also reviews the policy discount rate (overnight repo rate for commercial banks using SBP’s discount window) as and when necessary. SBP, since the last couple of years, has started announcing a formal Monetary Policy Statement (MPS) semi-annually (in January and July). This allows market participants and all other stakeholders to know SBP’s view on interest rates and other monetary policy tools regularly.

Open market operations SBP also conducts open market operations (OMOs) whenever it feels the need to inject, or remove, liquidity into/from the banking system. This tool has been used quite frequently by SBP to yet again give a signal about how liquid it would like to keep the banking system.

Table 20: Number of OMOs conducted to manage interbank liquidity FY03 FY04 FY05 FY06 Absorptions 6 24 46 62 Injections 4 6 5 30 Total 10 30 51 92 Source: State Bank of Pakistan. More recently, SBP has raised the daily CRR requirements (from 4% to 6% on demand deposits and from 1% to 2% on term deposits) while keeping the weekly average constant (7% on demand deposits and 3% on time deposits). Through this announcement, we believe that the SBP has tried to reduce the frequent need for OMOs.

Reserve and liquidity requirements Pakistan’s banking sector also has certain statutory liquidity requirements (SLR) and cash reserve requirements (CRR) that it needs to fulfill. SBP sets these requirements and adjusts them as and when necessary.

Even though T-bill auctions are not really a monetary policy tool, Pakistan’s banks take interest rate signals from these, as the central bank decides the yields for these auctions

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Table 21: History of CRR and SLR changes by SBP Effective From CRR (as % of DTL) SLR (% of DTL)

July 1, 1948 5% of Demand and 2% of Time Liabilities 15% July 25, 1963 5% 15% April 1, 1965 6.25% 15% May 1, 1965 7.5% 15%

August 21, 1965 6.25% 15% September 17, 1965 5% 15%

June 16, 1967 6.25% 15% September 1, 1967 6.25% 20% January 19, 1968 5% 20%

June 9, 1972 5% 25% August 16, 1973 5% 30% August 13, 1992 5% 35%

December 19, 1992 5% 40% October 27, 1993 5% 30%

March 1, 1994 5% 25% May 28, 1997 5% 20% July 28, 1997 Average 5%, Minimum 4% 20%

January 2, 1998 Average 5%, Minimum 4% 18% June 22, 1998 3.75% Rupee, 5% Foreign 15%

September 5, 1998 Average 5%, Minimum 4% 15% May 19, 1999 Average 3.5%, Minimum 2.5% 13% July 12, 1999 Average 5%, Minimum 4% 15%

October 7, 2000 Average 7%, Minimum 6% 15% December 16, 2000 Average 5%, Minimum 4% 15% December 30, 2000 Average 5%, Minimum 3% 15%

January 5, 2006 Average 5%, Minimum 4% 15% July 22, 2006 7% of Demand and 3% of Time Liabilities 18%

Source: State Bank of Pakistan. The current requirements are 18% SLR on demand and time deposits, and 7% CRR on the same. The breakdown for CRR is 7% on demand deposits and 3% on time deposits. This, we believe, has been done to provide an indirect incentive to banks to allow customers more market-based deposit rates. These are weekly averages. However, on a daily basis, banks may maintain as low as 6% of demand deposits and 2% of time deposits, as long as the week’s average does not fall below the stipulated levels.

Banking regulation Prudential regulations It was in 2003 that SBP decided to review these regulations on a wholesale basis, and come out with a completely new set of regulations for: (1) corporate and commercial banking, (2) consumer banking, (3) agricultural finance, (4) SME financing, and (5) micro finance banks.

Through the prudential regulations, SBP has also tried to reduce volatility in banks’ investment portfolios. It has set a limit of 20% of the bank’s total equity for banks’ exposure to the stock market. NIT units do not fall within this limit. However, more recently, banks have been allowed to invest a further 10% of their equity in the stock market, provided that is done through the stock futures market.

Provisioning requirements The provisioning requirements for Pakistan’s banks were previously based on a 4-category classification. However, now the criteria have been made more strict, and banks now operate on a 3-category classification.

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Table 22: Stricter provisioning requirements for banks Overdue Provisioning Substandard 3 months 25% Doubtful 6 months 50% Loss 1 year 100% Source: State Bank of Pakistan. Investment classification Classification of investments and their reporting in banks’ balance sheets is also regulated by SBP.

Table 23: Classifications of investments held on balance sheet Classification Time limits Carrying value Treatment of surplus/deficit Held for Trading To be sold within 90 days Carried at market value Surplus/Deficit taken to P&L Available for Sale All other than HFT and HTM Carried at market value Surplus/Deficit taken to balance

sheet Held to Maturity To be held till maturity Carried at amortized cost Source: State Bank of Pakistan. Capital adequacy requirements Minimum capital adequacy ratio in Pakistan is based on SBP’s classification criteria. SBP has a five-tier internal rating system through which it categorizes banks for capital adequacy purposes. The minimum ratio is 8% and the highest minimum capital requirement is at 14%.

Table 24: Calculation of credit risk weighted assets Assets Risk weight 1 Cash (including approved foreign currencies and gold bullion) 0% 2 Balances held with scheduled banks and banks abroad 20% 3 Claims on the SBP, government, and other central banks 0% 4 Claims on or guaranteed by banks that are rated 'A' or equivalent by a rating agency 20% 5 Claims covered by cash collateral, or guarantee of the government or SBP 0% 6 Loans to staff 0% 7 Claims on domestic entities owned or controlled by government 20% 8 Claims on domestic entities owned or controlled by government that operate commercially 50-100% 9 Loans fully secured by mortgage of residential or commercial property 50%

10 Loans including bills purchased/discounted to private sector entities 100% 11 Investments in shares and other capital instruments of companies in private sector 100% 12 Fixed assets net of depreciation 100% 13 Other assets 100%

Source: State Bank of Pakistan. Credit concentration Banks in Pakistan are restricted in their lending to a single borrower through a 20% cap in terms of their equity. Banks are allowed to bypass these regulations in exceptional cases, where permission from the SBP is required. Since Pakistan’s small and medium-size banks are not deep enough (i.e. while staying within stipulated per-party exposure limits) to fund large expansions or takeovers, such one-time permissions are usually granted on a case by case basis.

Business scope control Banks in Pakistan, up until this decade, were not allowed to undertake other businesses without special approval from SBP or the government. However, now the guidelines have been set. Banks can now have wholly owned subsidiaries for asset management, stock brokerage, and insurance business. Several banks have recently come out with their own insurance companies with UBL, Bank Al Falah, Saudi Pak Commercial Bank, to name a few.

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Financial analysis The status of Pakistan’s banking sector balance sheet has undergone a complete transformation during the current decade. From a weak sector operating in a dwindling economy, the sector’s performance has improved commendably over the last six years. Banks have moved on from being spoon-fed returns through T-bill and long-term bond investments, and have begun to realize the benefits of lending money in a growing economy.

In the last six years, the sources of revenue for Pakistan’s banks have undergone great diversification. Banks now do not rely only on interest income from their investments in T-bills and long-term government bonds, but are also earning good spreads on their loans portfolio. Non-interest income in the form of fee income, dividend income, and capital gains income is also supporting profit growth and high ROEs throughout the sector.

Balance sheet analysis Asset structure Pakistan’s banks have seen a marked shift in the ongoing decade in their asset structure. From being treasury-dominated, banks have gone on to increase their loan portfolios to such an extent that loans to asset ratios have gone up to 57%. Banks have become much more than just vehicles for placement of government securities, as loan portfolios have not only grown, but have also become quite diversified with the advent of consumer lending.

Figure 36: Loans to assets on the rise during this decade %

0%10%20%30%40%50%60%70%

2001 2002 2003 2004 2005 2006


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Figure 37: Loans to assets evolution of MCB, NBP, and BOP %

0%10%20%30%40%50%60%70%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Evolution of the banks' asset structure can be seen in Figure 36 and Figure 37. Loans now account for 57% of banks’ total assets.

Figure 38: Asset structure in 2002 Figure 39: Asset structure in 2006

Loans38%

Inv estments27%

Liquid Assets11%

Other assets24%

Loans57%Inv estments

19%

Liquid Assets16%

Other assets8%

Source: State Bank of Pakistan. Source: State Bank of Pakistan.

Funding structure Pakistan’s banks fulfill their funding requirements mainly through deposits. Deposits account for 88% of banks’ total funding liabilities as at end-2006. Deposit growth has tracked M2 growth in the economy over the ongoing decade.

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Figure 40: Close to 88% of funding liabilities are in the form of deposits

85%86%87%88%89%90%91%92%93%

2002 2003 2004 2005 2006

Source: State Bank of Pakistan. Table 25: Cost of each deposit type % Cost Current (non-remunerative) 0% Current (remunerative) 3-6% Savings 1-2.5% Fixed 8-12% Source: Company reports. Majority of the deposits kept in Pakistan’s banks belong to the retail sector. Larger banks, with well spread out branch networks, have benefited from a bulk of the retail deposit base. Thus, these larger banks now have a much lower cost of funds as compared to other banks within the sector.

Figure 41: MCB deposit structure over the years PKRMM

-50,000

100,000150,000200,000250,000300,000

2001 2002 2003 2004 2005 2006

Current Accounts Sav ings Accounts Fix ed Deposits


55



Figure 42: NBP deposit structure over the years PKRMM

-

100,000

200,000

300,000

400,000

500,000

2001 2002 2003 2004 2005 2006


Source: Company reports. Figure 43: BOP deposit structure over the years PKRMM

-20,00040,00060,00080,000

100,000120,000140,000

2001 2002 2003 2004 2005 2006


Source: Company reports. Balance sheet gearing Loans to deposits ratio in Pakistan’s banking sector has surged dramatically in the last five years. From being investment-focused, banks have experienced the wave of falling interest rates and have adapted by focusing more on lending. Loans to deposits ratio has risen to 78% as at end-Feb 2007, from a low level of 65% at end-2002.

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Figure 44: Loans to deposits ratio in the 1970s %

55%

60%

65%

70%

75%

80%

2001 2002 2003 2004 2005 2006

Loans to deposits

Source: State Bank of Pakistan. Figure 45: MCB, NBP, and BOP loans to deposits ratio trend %

10%

30%

50%

70%

90%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Capitalization Pakistan’s banks, especially the Big Five, were mired with weak capital bases in the 1990s. That was the time when the government continuously kept injecting funds into the Big Five for them to meet capital adequacy requirements.

Since 2003, banks have been increasing their paid-up capital in at least increments of PKR1 billion to meet SBP’s minimum capital requirements regulation. SBP has directed banks to increase their paid-up capital to at least PKR6 billion by the end of 2009.

As far as capital adequacy is concerned, Pakistan’s banks need to keep at least a minimum capital adequacy ratio of 8% (varies according to SBP’s internal rating system for banks).

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Figure 46: MCB—Capital adequacy ratios

0.0%

5.0%

10.0%

15.0%

20.0%

2001 2002 2003 2004 2005 2006

Tier 1 Ratio CAR

Source: Company reports. Figure 47: NBP—Capital adequacy ratios

0.0%

5.0%

10.0%

15.0%

20.0%

2001 2002 2003 2004 2005 2006

Tier 1 Ratio CAR

Source: Company reports. Figure 48: BOP—Capital adequacy ratios

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

2001 2002 2003 2004 2005 2006

Tier 1 Ratio CAR

Source: Company reports. Banks in Pakistan have taken to capital injections by promoters, stock dividends (bonus issues), rights issues, and consolidation (M&A) to try and meet the minimum capital requirements imposed by SBP. We expect this trend to continue up until the end of 2009, at least.

Loans Pakistan’s banks lend mostly to the corporate sector (53% share in total lending), with SMEs (16% share), agriculture (6% share), and consumer (14% share) making

58



inroads into the overall loans portfolio composition. The top exposure for almost all commercial banks operating in Pakistan is to the textile sector, as that forms the largest industrial sector base in the country.

Consumer lending, although overall forms close to 14% of banks’ total lending, makes up higher proportions of loan portfolios for some (e.g. Bank Al Falah), and much lower for some (e.g. PICIC Commercial Bank).

Table 26: MCB—Loan portfolio composition at end-2006 PKRMM

Sector Loans % of Total Textile 30,017 15.1% Commerce/Trade 29,994 15.1% Agribusiness 1,109 0.6% Energy prod. & transmission 8,536 4.3% Financial sector 4,156 2.1% Individuals 17,428 8.8% Others 107,556 54.1% Total 198,796 100.0%


Table 27: NBP—Loan portfolio composition at end-2006 PKRMM

Sector Loans % of Total Textile 56,453 16.2% Oil & Gas 24,107 6.9% Agribusiness 20,268 5.8% Public Sector Commodity 20,273 5.8% Financial sector 12,771 3.7% Individuals 61,219 17.6% Others 153,280 44.0% Total 348,370 100.0%

Source: Company reports. Table 28: BOP—Loan portfolio composition at end-2006 PKRMM

Sector Loans % of Total Textile 25,066 24.5% Commerce/Trade 16,111 15.7% Agribusiness 5,888 5.7% Construction & Real estate 11,423 11.1% Cable, Elec., Engineering 8,794 8.6% Individuals 3,328 3.2% Others 31,861 31.1% Total 102,471 100.0%

Source: Company reports. Loan growth rates for banks in Pakistan have been relatively high as compared to history, due to the circumstances faced by banks (low interest rates, high liquidity, influx of consumer loans).

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Table 29: Regional loan growth comparisons % China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Pakistan 2002 16.90% -4.97% 23.69% 18.80% 28.19% 4.59% 1.94% -1.01% -2.08% 7.06% 3.0% 2003 21.10% -1.99% 13.16% 19.85% 13.64% 4.77% 5.97% 6.30% 6.48% 2.15% 16.9% 2004 12.08% 5.93% 33.47% 26.40% 5.17% 8.46% 1.72% 4.46% 11.47% 8.08% 35.9% 2005 9.26% 7.25% 29.88% 24.59% 8.28% 8.60% 2.80% 2.25% 8.42% 8.01% 28.6% 2006 15.71% 6.74% 30.08% 14.13% 14.33% 6.25% 8.45% 6.27% 2.68% 3.98% 17.9% Source: State Bank of Pakistan, Company reports.

Going forward, we expect loan growth to settle in the mid to early teens, which is expected to be mainly driven by a thrust towards consumer and SME lending.

Deposits Bank deposits, like loans, have seen robust growth during the early part of this decade. Bank deposits have grown at a five-year CAGR of 17% to reach PKR2,999 billion at the end of 2006. This figure has now surpassed PKR3,000 billion at the end of February 2007.

The 1990s saw a huge influx of small private banks in the country, with the government’s policy of opening up the sector to private parties. However, they were never really able to compete with the larger banks up until the high M2 growth period seen in this decade.

Figure 49: Deposit growth has tracked M2 growth % growth

0%

5%

10%

15%

20%

25%

2002 2003 2004 2005 2006

M2 grow th Deposit grow th

Source: State Bank of Pakistan. Pakistan’s banking sector has a total of close to 26 million depositors, out of which the Big Five hold the major share. This is plainly due to their presence in the far reaches of the country, which also keeps their deposit per customer ratio lower than the foreign and smaller local banks.

A major chunk (close to 70%) of Pakistan’s deposit base comprises demand deposits as the masses still do not see bank deposits as an investment avenue. It is mostly seen as a safe-keeping device for their savings, with easy access available through extensive branch networks.

However, as competition for deposits now heats up amongst the smaller and medium-size banks, there is a marked shift towards term deposits. Larger

60



corporations tend to keep their funds (even for the short term) in high-yielding term deposits.

Investments The 1990s were characterized by banks being spoon-fed higher interest rate returns through government securities, as investments accounted for a large portion of total interest-yielding assets.

Figure 50: Investments to assets ratio trend %

0%5%

10%15%20%25%30%35%

2001 2002 2003 2004 2005 2006

Source: State Bank of Pakistan. The more enterprising private sector banks have tended to have much lower investments to assets ratios, as their core focus has remained on lending, both corporate and retail. However, the larger banks have only more recently accentuated their shift from investments to loans, as the loans yield higher returns.

Figure 51: MCB, NBP, and BOP investments to assets ratio trend %

0%

10%

20%

30%

40%

50%

2001 2002 2003 2004 2005 2006

MCB NBP BOP


As yields on government securities trended downwards, several banks booked huge capital gains on those investments, and began the transition towards loans. However, just last year, due to lower credit demand Y/Y (private sector credit offtake down from PKR326bn in 8MFY06 to PKR240bn in 8MFY07), Pakistan’s banks have seen an increase in investments in absolute terms. Also, SBP’s higher SLR at 18%

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(previously 15%) has played its role in increasing overall investments of the banking sector.

Figure 52: Total investments relatively stable in the last couple of years PKRMM

0

200,000

400,000

600,000

800,000

1,000,000

2001 2002 2003 2004 2005 2006

Source: State Bank of Pakistan. We expect that once the easy portion of the monetary cycle comes into effect once again, the banks’ focus on investments is likely to reduce once again.

Profitability analysis Pakistan’s banks have seen tremendous growth in profitability statistics over the last five years. Record profitability has been on show every year, with returns on equity rising into the abnormal growth range.

Figure 53: ROA trend for Pakistan’s banks %

00.5

11.5

22.5

33.5

2002 2003 2004 2005 2006

Public Priv ate Foreign All Commercial banks


62



Figure 54: ROE trend of Pakistan’s banks %

05

1015202530

2002 2003 2004 2005 2006

Public Priv ate Foreign All Commercial banks

Source: State Bank of Pakistan. Figure 55: Pakistan’s banks profitability trend PKRB

-20

0

20

40

60

80

100

2001 2002 2003 2004 2005 2006


We expect the four-year profit CAGR of 55% for Pakistan’s banks to slow down going forward. This growth trajectory is likely to be more subdued going forward, as banks face reduced spreads and the higher base-effect comes into play. However, we expect profits to grow at CAGR of 20% over the next three years.

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Table 30: DuPont breakdown for MCB, NBP, and BOP for 2007E % MCB NBP BOP NIM (as % of assets) 7.11% 5.17% 3.09% Non-int. income/revenue 16.78% 19.20% 37.06% of which Fee/revenue 9.32% 15.00% 6.93% Revenues/Avg. Assets 8.55% 6.40% 4.91% CIR 32.63% 30.64% 24.67% C/Assets 2.79% 1.96% 1.21% Operating ROA 5.76% 4.44% 3.70% LLP/Loans -0.64% -1.01% -0.55% Loan/Assets 60.52% 55.73% 63.10% Other-Prov;Inc./Avg. Assets 0.68% 0.29% 0.13% Pre-tax ROA 6.05% 4.16% 3.48% Tax Rate -33.00% -34.00% -25.00% ROA 4.06% 2.75% 2.61% ROE 31.28% 19.94% 25.42% Source: JPMorgan estimates. Net interest margin Pakistan’s banks have enjoyed spectacular NIMs in the recent past, especially since 2005. This has been possible due to monetary tightening enforced by SBP to counter inflationary pressures. However, with deposit rates not moving in tandem with lending and investment returns, banks have seen a sharp increase in spreads to complement a growing asset base.

Figure 56: Loans to deposits spreads for banking sector segments %

4.005.006.007.008.009.00

10.00

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Public Priv ate Foreign All Banks


64



Figure 57: NIM trend for MCB, NBP, and BOP %

0.00%

2.00%

4.00%

6.00%

8.00%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Note: NIM calculated on average Interest Earning Assets. NIM for the larger banks still remains higher, as the large banks have benefited from a large captive demand deposits base. Smaller banks have not been able to enjoy the same NIM expansion as the larger banks, as they have had to compete for deposits, given their easily exhausted Loans-to-Deposits ratios.

However, smaller banks have tried to enter the consumer lending space to try and thwart the effect of rising deposit costs. Larger banks like MCB are only more recently making an aggressive entry into the retail lending business, as they seek to take advantage of this lucrative, high-yielding business. Standard Chartered, we believe, has used the first-mover effect to full advantage by acquiring one of the most well-branded consumer lending franchises in Union Bank. Union Bank was the only bank in Pakistan with exclusive rights to distribute the American Express credit cards. Other banks that have been quite active in the high-yielding consumer lending space are Citigroup, ABN AMRO Bank, Bank Al Falah, and UBL.

We expect NIM expansion to stabilize by 2009, as the impact of lower interest rates begins to set in, especially for the larger banks.

Non-interest income Non-interest income has contributed quite well to banks’ profitability in the last five years. Growing fee income due to greater economic activity through higher trade and increased investment banking revenues has continued to benefit banks.

The stock market boom from 2002 to 2005, when the local benchmark KSE-100 Index provided a cumulative return of 651%, has helped in shoring up banks' capital gains and dividend incomes. Capital gains have also been a function of lower interest rates prevalent during the last five years.

65



Figure 58: Non-interest income contribution to revenues for MCB, NBP, and BOP %

0%

10%

20%

30%

40%

50%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Figure 59: Components of non-interest income for MCB PKRMM

-

1,000

2,000

3,000

4,000

5,000

2001 2002 2003 2004 2005 2006

Net Fee income Trading income Div idend Income Other operating income

Source: Company reports. Note: Gains on disposals excluded from calculation.

Figure 60: Components of non-interest income for NBP PKRMM

-2,0004,0006,0008,000

10,00012,000

2001 2002 2003 2004 2005 2006



66



Figure 61: Components of non-interest income for BOP PKRMM

-500

1,0001,5002,0002,5003,000

2001 2002 2003 2004 2005 2006



We expect banks’ incomes going forward to continue to receive good support from non-interest income. The potential exists through higher fee income, dividend income, and steady capital gains income.

Costs Costs for Pakistan’s banks have trended upwards, as growing asset bases have necessitated greater spending on human resources and IT. Costs have risen slower than overall revenues, which is primarily positive, hence boosting underlying profitability.

Figure 62: Costs trend for MCB, NBP, and BOP PKRMM

-

5,000

10,000

15,000

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Note: MCB’s write for pension liability excluded from this calculation. Cost to asset and cost to income ratios for banks have trended downwards in the last five years.

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Table 31: Cost/income and cost/asset ratios for MCB, NBP, and BOP % 2001 2002 2003 2004 2005 2006 MCB Cost/Income 62.7% 70.1% 75.8% 69.7% 39.3% 33.1% Cost/Assets 4.0% 3.8% 3.0% 2.7% 2.8% 2.6% NBP Cost/income 51.6% 53.1% 43.7% 40.4% 35.9% 33.2% Cost/Assets 2.2% 2.2% 1.7% 1.7% 2.0% 2.3% BOP Cost/Income 64.5% 62.6% 49.8% 38.1% 26.9% 26.4% Cost/Assets 0.8% 3.3% 2.7% 2.0% 1.4% 1.3% Source: Company reports. Note: MCB’s write back for pension liability excluded from this calculation. Gains on disposals excluded from this calculation. Figure 63: Cost to asset comparisons for regional banking sectors %

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

Indone

sia

Philippi

ne

Thailan

dInd

ia

Pakista

nKore

a

Malaysi

aTaiw

anChin

a

Singapo

re

Hong Kong

Source: Company reports. The larger banks, especially MCB, which has seen its NIM expand from 2.7% to 6.8% in the last two years, have seen improving cost to income ratios at a better rate as compared to the overall sector. A captive deposit base also continues to aid the larger banks in this regard.

Figure 64: Cost/income ratio trend for banking sector segments %

010203040506070

2002 2003 2004 2005 2006

Public Priv ate Foreign Total

Source: State Bank of Pakistan. Staff remuneration for Pakistan’s banks has grown at five-year CAGR of 3%, 9%, and 16%, respectively, for MCB, NBP, and BOP. Shortages of skilled HR have become even more pronounced now in Pakistan's financial sector. Competition from

68



foreign banks which continue to expand their presence in Pakistan, is also likely to be a cause of concern for the local banks.

Cost/income ratios for banks have improved over the last five years due to rising revenues, which have outpaced increases in costs. Cost/income ratios are lower for public sector banks, which include NBP and BOP, with an average of close to 30%. However, private and foreign banks continue to maintain cost/income ratios at close to 45%. This discrepancy is a result of better quality HR acquired at a premium by these private and foreign banks due to the flexibility in their pay structure.

Pakistan’s banks have also benefited from a falling tax rate in the last five years. The corporate tax rate levied on banking sector profitability has been reduced from a level of 58% in 2000 to the market norm of 35% now. The tax rate in the last five years has been reduced from 50% to 35% in decrements of 3 percentage points each year.

Figure 65: Effective tax rates for MCB, NBP, and BOP %

0%10%20%30%40%50%60%70%

2001 2002 2003 2004 2005 2006

MCB NBP BOP

Source: Company reports. Provisioning Higher profitability has enabled Pakistan’s banks to improve their loan loss coverage ratios. Higher provisioning has been possible annually, as banks look to cover their NPLs portfolios.

Figure 66: Credit costs (LLP/Loans) have reduced %

0.00%0.50%1.00%1.50%2.00%2.50%3.00%

2001 2002 2003 2004 2005 2006

MCB NBP BOP


69



Figure 67: Provisioning to PPOP trend for MCB, NBP, and BOP %

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%

2003 2004 2005 2006 2007E 2008E 2009E

MCB NBP BOP

Source: Company reports, JPMorgan estimates. Banks like NBP still continue to carry a sizeable amount of ‘legacy’ NPLs, which continues to show a distorted picture of the loan book. Going forward, with consumer lending expected to be one of the main drivers of loan growth, provisioning expenditures are also expected to trend upwards slightly.

Asset quality analysis Pakistan’s banks had a tough time during the 1990s in terms of maintaining asset quality. A government-influenced sector during political reigns caused a couple of collapses (albeit small) in the sector. The cases of Mehran Bank, Indus Bank, and Bankers’ Equity Ltd. are still quite fresh in the minds of several local bankers.

Figure 68: Gross NPLs to total loans ratio for banking sector segments %

05

1015202530

2002 2003 2004 2005 2006

Public Priv ate Foreign Total

Source: State Bank of Pakistan. Legacy loans of a number of commercial banks were transferred to an organization called Corporate and Industrial Restructuring Corporation (CIRC), prior to their privatization. Out of the Big Five, four banks were privatized and their legacy NPLs portfolios were transferred to CIRC. CIRC has been successful in disposing off those cases, following which CIRC itself has been closed down.

Going forward, we believe that Pakistan’s banks would continue to enjoy robust asset quality ratios, especially since the overall net NPLs ratio still remains at 1.3% (gross NPLs to total loans at 6.4%).

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Appendix I: Role of State Bank of Pakistan in regulatory reform Pakistan’s financial sector liberalization reforms were initiated in the 1990s, with several new licenses being given to private parties to set up commercial banks. The change in the economic scenario during the Musharraf regime has been handled well by the SBP from a banking sector regulation point of view. Reforms have been fast-paced, and the regulator’s independence has never come under the microscope since 2000. SBP governor reports directly to the country’s president (President Musharraf, in this case), with no interference from the Ministry of Finance or any other political body.

Strengthening the balance sheets to avoid 90s-like debacles The 1990s witnessed a few banks going under, with clouds of scandal hanging over their heads. Therefore, the SBP would rather see fewer, stronger banks operating in Pakistan, rather than several, small banks. In a directive issued on October 28, 2005, SBP has asked all commercial banks operating in Pakistan to increase their paid-up capital to PKR6 billion (US$100 million) by the end of 2009. This is likely to add cushion in case of any untoward economic or bank-level shock. Minimum capital adequacy ratios also vary based on a tiering system devised by SBP, where minimum capital adequacy ratios range from 8% to 14% depending on respective banks’ positions on the SBP scale.

Privatizations to optimize business model Among the various sectors, the banking sector went through the ignominy of nationalization in the 1970s. SBP, along with the Ministry of Privatization, undertook privatizations in the sector over a period spanning 1990-2004. Starting with MCB Bank (MCB PK) and ending with Allied Bank (ABL PK), the large banks were privatized. Efficiencies derived through privatizations are reflected in rising profitability of these banks and also in the overall approach to banking. If one were to walk into a branch of MCB Bank of the 1990s, and the MCB Bank of today, the difference is there for all to see.

Introduction of foreign players to channel expertise to locals Pakistan’s banking sector currently comprises 10 foreign banks, and this number continues to grow. The first foreign bank to commence operations in Pakistan was ABN AMRO in 1948. The latest acquisition spree and interest being shown by foreign banks can help local banks develop expertise previously not available. Several instances in the 1990s and early 2000s have seen top management staff leaving foreign banks and then turning around small private banks. A prime example is Union Bank, which was run by a former Citibanker before being sold off to Standard Chartered in 2006.

Dealing with ‘legacy’ NPLs Pakistan’s banking sector had seen a number of politically motivated defaults in the 1990s, especially in the banks owned by the government at the time. These included National Bank of Pakistan, Habib Bank Ltd., United Bank Ltd., Allied Bank Ltd., and others like National Development Finance Corporation (NDFC) and Industrial Development Bank of Pakistan (IDBP). SBP and government constituted a Corporation for Industrial Restructuring of Companies (CIRC), which was handed

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over the bad loans. The government also had to inject funds into these banks to keep them afloat in times when NPLs were as high as 20-30% of the total loan book. Most of these have now been cleared up following privatization of the banks, while some legacy NPLs still remain on National Bank’s books.

New prudential regulations introduced SBP introduced a net set of prudential regulations in 2004 and 2005 in order to replace the old regulations. This was done mainly to allow the sector to develop in line with the changing requirements of the time. New regulations for corporate, consumer, microfinance, and agricultural lending have been introduced in the last couple of years.

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Appendix II: Economic outlook We expect Pakistan’s economy to continue its growth trajectory, and grow by 6.5% in FY07E and maintain 6%-plus growth rate in FY08E. Pakistan’s economic growth has been driven mainly by private consumption, with close to 80% of GDP coming from that head.

2007 is also an election year in Pakistan, where President Musharraf is expected to retain ascendancy. Prime Minister Shaukat Aziz has already announced his intention to return to Parliament in the next elections. This should result in further confidence in Pakistan’s economic prospects going forward. The main reason for the prime minister to continue for another five years would be to see through the economic reforms initiated in the last seven years.

On the monetary front, interest rates appear to have peaked out following a bout of monetary tightening instituted in the last couple of years. SBP’s discount rate is currently 9.5%, which we expect can show a modest downward movement in, or following, 4Q2007. Long-bond yields have already started to edge downward, and the yield curve has gotten increasingly flatter with 1-year T-bill yielding 9% and 10-year PIB yielding 10.2%. We expect M2 growth of close to 12% annually in the next two years, while consumer price inflation is expected to remain close to 6-7% per annum.

Fiscal pump priming seems to be the order of the day for this election year, as the government has set a hefty 4.9% of GDP development budget for FY07. Budget deficit target of 4.2% of GDP is likely to be met easily by the government. However, structurally, an issue remains with the tax-GDP ratio, which has been slipping downward. Widening of the tax base and further documentation of the economy is likely to be beneficial for the banking sector as well.

We believe FDI flows should remain strong and support the balance of payments going forward as well. FDI is expected to surpass US$5 billion in FY07E, with banks, telecom, and oil and gas sectors being the major beneficiaries.

GDP growth of 6%-plus, driven by private consumption

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Appendix III: Sector dynamics Table 32: Pakistan’s banking system balance sheet As at March 17, 2007 PKRMM Assets Cash & other liquid instruments 468,241 Interbank lending 171,238 Investments 921,834 Net Loans 2,151,855 Fixed assets 115,185 Other assets 217,395 TOTAL ASSETS 4,045,748 Liabilities Bills payable 49,632 Interbank borrowings 316,734 Deposits 3,081,011 Subordinated loans 24,359 Other liabilities 136,185 TOTAL LIABILITIES 3,607,921 Equity Paid up capital 154,840 Retained earnings 216,514 Revaluation surplus 66,476 TOTAL EQUITY 437,830 Source: State Bank of Pakistan. Figure 69: Loans to deposits ratio for Pakistan's banking sector %

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006


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Figure 70: Loans to assets ratio for Pakistan’s banking sector %

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006


Figure 71: Loan growth in Pakistan’s banking sector PKRB

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Source: State Bank of Pakistan. Figure 72: Deposit growth in Pakistan’s banking sector PKRB

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Figure 73: ROAs for banking system %

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Figure 74: ROEs for banking system %

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Figure 75: Capital adequacy of banking sector %

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Appendix IV: History of banking sector in Pakistan Pakistan’s banking sector dates back to the country’s independence in 1947. The central bank, SBP, was formed in July 1, 1948 as a regulatory authority for all banking activities in Pakistan. The first commercial bank to be set up in Pakistan was Habib Bank Ltd. (HBL), followed by National Bank of Pakistan (NBP) in 1949. ABN AMRO was the first foreign bank to be granted a license in Pakistan, and began its operations in the country in 1948.

Other large banks, namely Muslim Commercial Bank (MCB), United Bank Ltd. (UBL), and Allied Bank Ltd. (ABL) were set up during the early years following Pakistan's independence. These local banks along with HBL and NBP formed the Big Five of Pakistan's banking sector.

In the 1970s, Pakistan’s industries, including the banking sector were nationalized by the government at the time. This dealt a telling blow to the potential of progress in Pakistan's financial sector.

The 1990s saw a wave of privatization and financial sector liberalization in Pakistan. MCB was the first bank to be privatized with the Nishat group of Mian Mansha taking control of the bank's operations.

Several new licenses were also issued during the 1990s for the setting up of private commercial banks in Pakistan. Banks like Union Bank and Prime Bank, which have now been taken over by foreign banks, are products of this licensing regime.

The government also appointed renowned banking experts to top positions in HBL and UBL to try and turn around the banks. Public sector banks were becoming known for making losses and being a burden on the national exchequer, as SBP (on behalf of the government) kept injecting funds into these banks to try and keep their operations afloat.

The privatization wave was intensified during the current decade with UBL being privatized in 2002, followed by HBL in 2003, and ABL in 2004. This has left only NBP from the Big Five to still be under government control.

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Appendix V: Banking sector regulations regionally Table 33: Differences in banking sector regulations across region

Korea Hong Kong Singapore Australia China Pakistan India Basic Regulatory body Financial Supervisory

Commission HK Monetary Authority Monetary Authority of

Singapore APRA China Banking Regulatory

Commission State Bank of Pakistan (SBP)

Reserve Bank of India(RBI)

Financial Supervisory Service People's Bank of China Business scope Basic Auxiliary

Ownership Ownership restriction Financial entities : up to 10%

No restrictions, but require HKMA approval Financial Sector (Shareholdings) Act 1998 - Ownership cannot exceed 15% without approval from the Federal Treasurer.

No restrictions, but require SBP approval

No single entity or group of related entities can have shareholding or control in excess of 10 % of the paid up capital of the private sector bank. However in the case of Banks, the limit is 5%.For SOE banks, the minimum government holding to be 51%.

Non-financial entities : up to 4% Foreign ownership limit None None None Single foreign ownership

no more than 20% None In case of private banks,

the aggregate foreign investment is capped at 74%. Total FII investment limit is capped at 49%.In the case of SOE banks 20% is total foreign holding limit

Combined no more than 25% Reporting of shareholding acquisition 5% At 5%, 12% and 20% Substantial shareholder

notice >5% ownership (and tracking of increasing / decreasing positions thereafter until ceasing to hold >5%)

5% 5% and above to be reported to SBP

Above 5% to be reported to RBI

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Investment Investment to subsidiaries

Investment limit: 30% of regulatory capital Pvt Eq/ Venture Cap: 10% of capital limit

None Investment by a bank in a subsidiary company, financial services company, financial institution, stock and other exchanges should not exceed 10% of the investing banks net worth. In all such companies put together, the investment should not exceed 20% of the banks' net worth.

Investment in other entities None Investment in non-banking business not allowed Property investment not for own use not allowed

Stability Capital adequacy Minimum BIS CAR : 8% Minimum BIS CAR : 8% Tier 1: 6% Minimum BIS CAR : 8% Mininum Total CAR 8% Minimum total CAR 8% Minimum BIS CAR : 9% Tier 1 CAR : 4% The MA does not

stipulate a minimum tier 1 liquidity ratio but will assess the adequacy of each institutions ratio in light of its own particular circumstances as well as by comparison with its peers

Total CAR: 10% Tier 1 CAR : 4% Tier-1: 4% Tier 1 CAR : 4.5%

Debenture issuance Issuance limit of 3x a bank's shareholders' equity None The total amount raised by a bank through IPDIs* capped at 15% of total tier 1 capital.

- For Industrial Bank of Korea (10x) Deposits Deposit reserves None Required reserve level at

central bank (PBOC) at 10% for Rmb deposits, 3% for FX deposits

18% of demand & time liabilities to be maintained as statutory liquidity reserve (SLR); CRR of 7% on demand liabilities, and 3% on time liabilities to be maintained with SBP

Required to maintain 25% of net demand and time liabilities as statutory liquidity ratio(SLR).; Cash Reserve Ratio(CRR) of 6% of NDTL has to maintained with RBI

Depositor protection W50 million limit per

person for an individual depositor bank

Coverage limit of HK$100,000 per depositor per bank

S$20,000 - per depositor, per institution - only for individuals and charities

None Depository insurance in plan, may start in late 2007 Rs0.1 million limit per person for an individual depositor bank

Deposit insurance fee: 0.25% of deposits Deposit insurance fee: 0.3% of insured deposits

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Others Deposit Insurance Scheme started in April 2006

None

Operations Credit limit Lending to single entity

up to 25% of shareholders equity

Guideline: 10% of capital for individual borrower

Single borrower limit of 25% of capital funds, Substantial loan limit of 50% of total credit facilities - BUT MOVING TO TOTAL EXPOSURE (ON AND OFF B/S) GOING FWD

Lending to external parties - 25% of capital base

Single borrower limit of 10% of regulatory capital (15% maximum for a group).

Lending to single borrower up to 15% of capital funds and 40% of capital funds in case of borrower group.(Capital funds= Tier1+Tier2 capital)

Lending to subsidiary up to 20% of shareholders equity Lending to unrelated ADI's - 50% of capital base

Top 10 borrowers no more than 50% of regulatory capital.

Lending to foreign parents and their subsidiaries - 50% of capital base Related ADIs

- Exposure to individual related ADI - 50% of Level 1 Capital Base - Aggregate exposure to all related ADIs - 150% of Level 1 Capital Base

Other Related Entities - Exposure to other individual related entity - 25% of Level 1 Capital Base - Exposure to individual unregulated related entity - 15% of Level 1 Capital Base - Aggregate exposure to all related entities - 35% of Level 1 Capital Base

Branch opening Authorized institutions under the Banking Ordinance comprise banks, restricted license banks and deposit-taking companies, creating a licensing system with three distinct tiers. Restricted license banks and deposit-taking companies are restricted in the amounts and terms of deposits they may accept, and only banks may operate current and savings accounts. No distinction is made, however, in the types of lending or investment business in which the different tiers of authorized institutions may engage

None Banks need to apply to CBRC for each tier-1 branch opening and depending on capital adequacy, banks can add a few branches every year. Above 8% but no more than 9%, 3+1 (3 branches in eastern coastal provinces and 1 additional in northeastern or western provinces). If above 9%, 3+2 branches. Sub-branches with each city also needs to be approved by CBRC's local offices

Annual plans subject to SBP approval

Annual Plans subject to RBI approval

Others None Priority Sector lending at

40% of aggregate bank advances. Within this limit, 18% should go to the agricultural sector.

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Asset quality

Delinquency Impaired: 90 days past due 90 day NPL classification 90 day NPL classification

Asset quality

classification Normal Pass: Loans for which

borrowers are current in meeting commitments and for which the full repayment of interest and principal is not in doubt.

Pass - Loan can be serviced by normal income

Individually Assessed Provision: All provisions for impairment assessed by an ADI on an individual basis in accordance with AIFRS

Normal: Borrowers can honor the terms of their loans, There is no reason to doubt ability to repay principal and interest in full on a timely basis

Normal Normal

Precautionary: 1~3 mths delinquent

Special Mention: Loans with which borrowers are experiencing difficulties and which may threaten the authorized institution's position.

Special Mention - Pass but risk to normal income source

Collective Provision: Incurred but not yet reported in the current portfolio

Special Mention: Borrowers currently are able to service their loans, although repayment may be adversely affected by specific factors

Special Mention Sub-standard: <=12 mths delinquent

Substandard: 3~6 mths delinquent

Substandard: Loans in which borrowers are displaying a definable weakness that is likely to jeopardize repayment.

Sub-Standard - Collateral enough

General Reserve for Credit Losses: Represents a reserve established under the Prudential Standard that, as a minimum, covers credit losses prudently estimated but not certain to arise over the full life of all the individual facilities making up the business of the ADI.

Substandard: Borrowers' abilities to service their loans are in question as they cannot rely entirely on normal business revenues to repay principal or interests. Losses may ensue eve when collateral or guarantees are enforced

Substandard: 90 days delinquent

Doubtful: > 12 mths delinquent

Doubtful: 3~12 mths delinquent

Doubtful: Loans for which collection in full is improbable and the authorized institution expects to sustain a loss of principal and/or interest, taking into account the net realizable value of collateral.

Doubtful - Collateral value significant but not enough / indeterminable

Doubtful: Borrowers cannot repay principal and int. in full and significant losses will needs to be recognized even when collateral or guarantees are enforced

Doubtful: 180 days delinquent

Loss: Determined by auditors/management/central bank

Estimated loss: Over 12 mths

Loss: Loans that are considered uncollectible after all collection options (such as the realization of collateral or the institution of legal proceedings) have been exhausted.

Loss - Amount not recoverable by collateral Loss: Only a small portion or no principal and interest can be recovered after taking all possible measures and exhausting all legal remedies.

Loss: 12 months delinquent

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General provisioning 1% before 2006. Collective assessment since 2006 based in historical loss experience.

Min 1% of gross loans (MAS allowed exemptions from FRS 39)

Under AIFRS, there is no longer a general provision. This has been replaced by a collective provision, as well as a non-distributable General Reserve For Credit Losses held directly against equity for APRA requirements.

1% on normal loans (from 2006 onward no longer necessary

25% coverage on substandard, 50% on doubtful, and 100% on loss

40 bps on standard loans, 100 bps on residential housing loans above Rs 2 mn,200 bps on personal loans, loans and advances qualifying as capital market exposure and commercial real estate loans.

Instead bank needs to appropriate some earnings to a general reserve account until it reaches 1% of int. earning assets

at least 2% coverage on special mention, 25% on substandard, 50% on doubtful and

100% on loss

Evaluation Evaluation method None Evaluation criteria None

Extraordinary regulations Mortgage loan measures

LTV 70% 50% Risk Weighting, but if LTV > 85% and no LMI, Risk Weighting is 100%.

generally 70%

unless primary mortgage that meets certain requirement (for own use non-luxury property) 80%

Debt-to-income 50% All banks have their own

individual policies. 50%

Investments Can invest up to 20% of

bank's equity in stock market. Open-ended funds like NIT are over and above this 20% limit

Max 25% of total investments in HTM category, rest in mark to market investments

Source: Banking sector regulatory authorities of each country.

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Companies Recommended in This Report (all prices in this report as of market close on 10 April 2007) MCB Bank Ltd (MCB.KA/PKR277.85/Overweight), National Bank of Pakistan (NBPK.KA/PKR245.00/Neutral), The Bank of Punjab Ltd (BOPU.KA/PKR93.15/Overweight)

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures

• Analyst Position: The following analysts (and/or their associates or household members) own a long position in the shares of National Bank of Pakistan: Khalid Siddiqui.

• Client of the Firm: MCB Bank Ltd is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service and non-securities-related services. National Bank of Pakistan is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-investment banking securities-related service.

• Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from MCB Bank Ltd, National Bank of Pakistan. An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from MCB Bank Ltd, National Bank of Pakistan.

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MCB Bank Ltd (MCB.KA) Price Chart

OW

Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends.Initiated coverage Apr 10, 2007. This chart shows JPMorgan's continuing coverage of this stock; the current analyst mayor may not have covered it over the entire period.JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight.

Date Rating Share Price (PKR)

Price Target (PKR)

10-Apr-07 OW 277.10 -

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National Bank of Pakistan (NBPK.KA) Price Chart

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10-Apr-07 N 243.50 235.00

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The Bank of Punjab Ltd (BOPU.KA) Price Chart

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10-Apr-07 OW 93.95 -

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.

Coverage Universe: Khalid Iqbal Siddiqui: MCB Bank Ltd (MCB.KA), National Bank of Pakistan (NBPK.KA), The Bank of Punjab Ltd (BOPU.KA)

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JPMorgan Equity Research Ratings Distribution, as of March 30, 2007

Overweight (buy)

Neutral (hold)

Underweight (sell)

JPM Global Equity Research Coverage 42% 41% 17% IB clients* 49% 51% 38% JPMSI Equity Research Coverage 38% 48% 14% IB clients* 68% 64% 53%

*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Valuation and Risks: Please see the most recent JPMorgan research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your JPMorgan representative.

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Revised March 30, 2007.

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