Overview of the Banking Sector of Pakistan

7/28/2019 Overview of the Banking Sector of Pakistan

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BANKING PROBLEMSIN PAKISTAN

PROJECT OF BANKING LAW

Ali Imam

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Abdullah Khalid

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Umar Farooq

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Javeria Khan

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ContentsPREFACE ....................................................................................................................................................... 3

Overview of the Banking Sector of Pakistan................................................................................................ 4

Description of the Banking Sector in Pakistan ......................................................................................... 4

List of Operational Banks in Pakistan .......................................................................................................... 8

Common Problems of Banks ....................................................................................................................... 10

Technical Expertise .................................................................................................................................. 10

Infrastructure Development .................................................................................................................... 10

Operational Aspects.................................................................................................................................. 11

Human Resource Development ............................................................................................................... 11

Consumer-Durable Demand .................................................................................................................... 12

Equity Stock Investment .......................................................................................................................... 12

Islamic Banking ........................................................................................................................................ 12

Fast changing pattern and demand ........................................................................................................... 13

Large and scattered market ....................................................................................................................... 13

Problem Loans and Cost Efficiency in Commercial Banks ...................................................................... 14

First ............................................................................................................................................................ 14

Second ........................................................................................................................................................ 14

Pakistani Banking Main Problems.............................................................................................................. 16

First ............................................................................................................................................................. 16

Second ........................................................................................................................................................ 16

Third: ......................................................................................................................................................... 17

Fourth ........................................................................................................................................................ 17

DEVELOPMENTS, CHALLENGES AND OPPORTUNITIES.............................................................. 21

BANKING SECTOR REFORMS ........................................................................................................... 21

CHALLENGES......................................................................................................................................... 27

OPPORTUNITIES ................................................................................................................................... 28

Legal issues: Pakistan................................................................................................................................... 29

The nature and the effectiveness: ............................................................................................................ 29

Civil unsecured debt collection remedies............................................................................................ 29

Secured property enforcement remedies. ........................................................................................... 29

Any special debt collection or secured property remedies that are available to banking sector

creditors ................................................................................................................................................. 30


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Recommendations......................................................................................................................................... 32

REFERENCES ............................................................................................................................................. 34


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PREFACE

Banks of all sorts or all kinds are the troubled institutions in any country. The cost of

the bank is the main issues in any banks the create miner or major problems for anybank.

So, it is necessary to find out these question

What is the problem with banks? And

Why in any time problems are create in any banking system or in any banking age?

This is the main purpose if this research to find out the main issues of that generate

the problems and how to resolve it with examines banking activity in Pakistan andhow specific historical circumstances of banking in Pakistan and the factors that

transformed banks' behaviour and attitude to risk and also know the government

constraint or rules on banks.


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Overview of the Banking Sector of Pakistan

Description of the Banking Sector in Pakistan

The banking sector in Pakistan has witnessed drastic changes over a period of 64 years since

countrys independence in 1947. Initially it suffered from acute shortage of resources and

uncertainty due to prevailing political and socioeconomic conditions. Lack of trained human

resource and professionals resulted into poor quality of products and services. However, State

Bank of Pakistan was established as the central bank on July 1, 1948 to control the financial

sector. Subsequent amendments were made to extend the control and functions of SBP through

State Bank of Pakistan Act 1956. SBP encouraged the private sector to establish banks and

financial institutions in the country. It resulted into unhealthy competition and unlawful practices

due to bribe and corruption during the decades of 1950s and 1960s. In 1974, all the existing

banks were nationalized by the Government. The performance of nationalized banks deteriorated

due to government protection to employees, resulting into the provision of inferior products and

poor services. It also discouraged the private investors and foreign financial institutions. The

poor performance of nationalized banks caused the reforms/privatization of banking sector in

early 1990s. Today, the Banking sector of Pakistan is playing pivotal role in the growth of

countrys economy. In accordance with the State Bank of Pakistan Act, the banking system of

Pakistan is a two-tier system including the State Bank of Pakistan (SBP), commercial banks,

specialized banks, Development Finance Institutions (DFIs), Microfinance banks and Islamic

banks. As of June 2010, the banking sector comprised 36 commercial banks (including 25 local

private banks, 4 public sector commercial banks and 7 foreign banks) and 4 specialized banks

with a total number of 9,087 branches throughout the country. Among the banks, there are 6

fully fledged Islamic banks as at end of June 2010.

In addition to the above, the SBP has granted licenses to the Industrial and Commercial Bank of

China (ICBC) and Sindh Bank in December 2010. The ICBC aims to exploit opportunities in

trade and project finance generated by a growing number of Chinese companies working in

Pakistan while Sindh Bank aims to promote agricultural development and small scale businesses.

Besides the commercial banks, 8 Microfinance banks and 7 Development Finance Institutions


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(DFIs) are operating in the banking industry of Pakistan. Due to closing down of a number of

Development Financial Institutions (DFIs) during the last decade, the government is currently re-

considering to set-up either an Infrastructure Bank or Infrastructure Institution as this is

requirement of the country. The banks in Pakistan provide settlement and cash services to

individuals and companies, including correspondent-banking. Banks also offer domestic and

cross-border remittance services to the population. Furthermore, they provide depository services

for the accounting and safekeeping of securities. During the last few years, banks have been

paying great attention to the expansion of services rendered to households and the enhancement

of their quality and efficiency. New forms and channels of making payments have also been

introduced. The services of State Bank of Pakistan include payments to banks, to and on behalf

of the Federal and Provincial Governments, the Treasury and some other public institutes

including collection of revenues etc., through its 16 field offices as well as through a

countrywide network of currency chest/sub-chest branches of National Bank of Pakistan. As

mentioned earlier that the financial landscape of the country which was significantly altered in

early 1970s has been transformed - through sector reforms initiated in the early 1990s - into an

efficient, sound and strong banking system. The reforms have resulted in an efficient and

competitive financial system. In particular, the predominantly state-owned banking system has

been transformed into one that is predominantly under the control of the private sector. The

legislative framework and the State Bank of Pakistans supervisory capacity have been improved

substantially. As a result, the financial sector is sounder and exhibits an increased resilience to

shocks. Today, almost 80 percent of the banking assets are held by the private sector banks and

the privatization of nationalized commercial banks has brought about a culture of

professionalism and service orientation in place of bureaucracy and apathy. Banking Technology

that was almost non-existent in Pakistan until a few years ago has revolutionized the customer

services and access on-line banking, Internet banking, ATMs, mobile phone banking/ branchless

banking and other modes of delivery have made it possible to provide convenience to the

customers while reducing the transaction costs to the banks. The Credit Cards, Debit Cards,

Smart Cards etc. business has also expanded. The foreign exchange market that was highly

regulated through a system of direct exchange controls over suppliers and users of foreign

exchange has been liberalized and all purchases and sales take place through an active and

vibrant inter-bank exchange market. All restrictions have been removed with full current account


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convertibility and partial capital account convertibility. Since 1st July 2008 Real-Time Gross

Settlement (RTGS) payment system has been put in place. The RTGS in Pakistan has been

named as Pakistan Real-time Inter-bank Settlement Mechanism (PRISM). Using this system, the

banks holding accounts at SBP are able to operate their accounts in real time from their own

premises via computerized network between SBP and the participating Banks. Prior to the recent

financial crisis, the excess liquidity and competition among the banks prompted them to move

away from the traditional limited product range of credit to the government and the public sector

enterprises, trade financing, big name corporate loans, and credit to multinationals to an ever-

expanding menu of products and services. The borrower base of the banks expanded many folds

as the banks diversified into agriculture, SMEs, Consumers financing, mortgages, etc. The

middle class that could not afford to buy cars or houses/apartments as they did not have the

financial strength for cash purchases had been the biggest beneficiaries of these new products

and services. Since late 2007, Pakistan faced a difficult macroeconomic environment, not as such

due to the global crisis but rather due to a confluence of factors which had been brewing for a

while, particularly due to the gradual build up of macroeconomic imbalances which led the

country to embark on a macroeconomic stabilization program in November 2008 with the

support of the IMF SBA. The Global Financial Crisis (GFC) had an indirect impact in Pakistan

which became evident in 2009 and manifested itself in various forms in the real sector of the

economy. However, as said earlier, the major challenges facing the domestic economy can only

be partly attributed to the GFC. Indeed there was a decline in exports due to recession in

economies which are Pakistans major trading partners, and there was pressure on capital flows

where strained liquidity position in global financial markets impacted foreign portfolio

investment.

However, factors such as the power shortages leading to under utilization of industrial capacity

and rise in the cost of production, the longstanding issue of inter

corporate circular debt,

considerable decline in foreign direct investment due to weak economic fundamentals, high

inflation, security concerns and above all, the mounting fiscal deficit breaching previous records

in the countrys economic history, all had a role to play in keeping the process of economic

recovery in Pakistan weak at best. The leading evidence of these various pressures on domestic


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firms and industries is that their loan repayment capacity has been compromised, with a

consequent rise of non-performing loans (NPLs) on the banks balance sheets.

Furthermore, due to the deteriorated fiscal situation, public sector borrowed heavily from banks

for budgetary support, financing needs of Public sector Enterprises (PSEs) and commodity

operations. Accordingly, there has been a shift in banks asset-mix towards credit to the public

sector along with increased performance for top rated corporations over Small and Medium

Enterprises (SMEs) and consumer that are generally less resilient to economic slowdown and

fragility in operating environment. The heightened credit risk is reflected in a noticeable and

persistent increase in NPLsdoubling over two years by the end of calendar year 2009.

Nevertheless, it has tested the resilience of the banking sector in that banks have been forced to

build contingency reserves and provide for infected assets. Such requirements have been

affecting their dividend payments and consequently putting pressure on their share prices.


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List of Operational Banks in Pakistan

Sr. No. Name of Bank Branches Website

A. Public Sector Commercial Banks 1,621

1 First Women Bank Ltd. 39 www.fwbl.com.pk

2 National Bank of Pakistan 1,267 www.nbp.com.pk

3 The Bank of Khyber 42 www.bok.com.pk

4 The Bank of Punjab 273 www.bop.com.pkB. Local Private Banks 6,850

1 Allied Bank Ltd. 786 www.abl.com.pk

2 Arif Habib Bank Ltd.* 36 www.summitbank.com.pk

3 Askari Bank Ltd. 204 www.askaribank.com.pk

4 Atlas Bank Ltd.* 40 www.atlasbank.com.pk

5 Bank Al-Falah Ltd. 309 www.bankalfalah.com

6 Bank Al-Habib Ltd. 267 www.bankalhabib.com

7 BankIslami Pakistan Ltd 70 www.bankislami.com.pk8 Dawood Islamic Bank Ltd. 42 www.dawoodislamic.com

9 Dubai Islamic Bank Pakistan Ltd 36 www.dibpak.com

10 Emirates Global Islamic Bank Ltd. 58 www.egibl.com

11 Faysal Bank Ltd. 136 www.faysalbank.com.pk

12 Habib Bank Ltd. 1,457 www.habibbankltd.com

13 Habib Metropolitan Bank Ltd 120 www.hmb.com.pk

14 JS Bank Ltd. 40 www.jsbl.com

15 KASB Bank Ltd. 70 www.kasbbank.com

16 MCB Bank Ltd. 1,085 www.mcb.com.pk

17 Meezan Bank Ltd. 180 www.meezanbank.com

18 mybank Ltd. 80 www.mybankltd.com

19 NIB Bank Ltd. 204 www.nibpk.com

20 Samba Bank Ltd. 28 www.samba.com.pk

21 Silk Bank Ltd. 85 www.silkbank.com.pk

18
http://www.fwbl.com.pk/http://www.fwbl.com.pk/http://www.nbp.com.pk/http://www.nbp.com.pk/http://www.bok.com.pk/http://www.bok.com.pk/http://www.bop.com.pk/http://www.bop.com.pk/http://www.abl.com.pk/http://www.abl.com.pk/http://www.summitbank.com.pk/http://www.summitbank.com.pk/http://www.askaribank.com.pk/http://www.askaribank.com.pk/http://www.atlasbank.com.pk/http://www.atlasbank.com.pk/http://www.bankalfalah.com/http://www.bankalfalah.com/http://www.bankalhabib.com/http://www.bankalhabib.com/http://www.bankislami.com.pk/http://www.bankislami.com.pk/http://www.dawoodislamic.com/http://www.dawoodislamic.com/http://www.dibpak.com/http://www.dibpak.com/http://www.egibl.com/http://www.egibl.com/http://www.faysalbank.com.pk/http://www.faysalbank.com.pk/http://www.habibbankltd.com/http://www.habibbankltd.com/http://www.hmb.com.pk/http://www.hmb.com.pk/http://www.jsbl.com/http://www.jsbl.com/http://www.kasbbank.com/http://www.kasbbank.com/http://www.mcb.com.pk/http://www.mcb.com.pk/http://www.meezanbank.com/http://www.meezanbank.com/http://www.mybankltd.com/http://www.mybankltd.com/http://www.nibpk.com/http://www.nibpk.com/http://www.samba.com.pk/http://www.samba.com.pk/http://www.silkbank.com.pk/http://www.silkbank.com.pk/http://www.silkbank.com.pk/http://www.samba.com.pk/http://www.nibpk.com/http://www.mybankltd.com/http://www.meezanbank.com/http://www.mcb.com.pk/http://www.kasbbank.com/http://www.jsbl.com/http://www.hmb.com.pk/http://www.habibbankltd.com/http://www.faysalbank.com.pk/http://www.egibl.com/http://www.dibpak.com/http://www.dawoodislamic.com/http://www.bankislami.com.pk/http://www.bankalhabib.com/http://www.bankalfalah.com/http://www.atlasbank.com.pk/http://www.askaribank.com.pk/http://www.summitbank.com.pk/http://www.abl.com.pk/http://www.bop.com.pk/http://www.bok.com.pk/http://www.nbp.com.pk/http://www.fwbl.com.pk/


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22 Soneri Bank Ltd. 156 www.soneri.com

23

Standard Chartered Bank (Pakistan)

Ltd. 162

www.standardchartered.co

m

24 The Royal Bank of Scotland Ltd. 79 pwkww.rbs.com.pk

25 United Bank Ltd. 1,120 www.ubl.com.pk

C. Foreign Banks 80

1 Al-Baraka Islamic Bank B.S.C (E.C) 29 www.albaraka.com.pk

2 Barclays Bank PLC 15 www.barclays.pk

3 Citibank N.A 17 www.citibank.com.pk

4 Deutsche Bank AG 3 www.db.com

5 HSBC Bank Middle East Ltd. 12 www.hsbc.com.pk

6 Oman International Bank S.A.O.G 3 www.oiboman.com

7

The Bank of Tokyo-Mitsubishi UFJ,

Ltd. 1 www.btm.co.jp

D. Specialized Banks 536

1

Industrial Development Bank of

Pakistan 15 www.idbp.com.pk

Ltd.

2

Punjab Provincial Cooperative Bank

Ltd. 159 www.ppcbl.punjab.gov.pk

3 SME Bank Ltd. 13 www.smebank.org

4 Zarai Traqiati Bank Ltd. 349 www.ztbl.com.pk

Commercial

Banks

(A+B+C) 8,551

All Banks (A+B+C+D) 9087

Source: State Bank of Pakistan
http://www.soneri.com/http://www.soneri.com/http://www.standardchartered.co/http://www.ubl.com.pk/http://www.ubl.com.pk/http://www.albaraka.com.pk/http://www.albaraka.com.pk/http://www.barclays.pk/http://www.barclays.pk/http://www.citibank.com.pk/http://www.citibank.com.pk/http://www.db.com/http://www.db.com/http://www.hsbc.com.pk/http://www.hsbc.com.pk/http://www.oiboman.com/http://www.oiboman.com/http://www.btm.co.jp/http://www.btm.co.jp/http://www.idbp.com.pk/http://www.idbp.com.pk/http://www.ppcbl.punjab.gov.pk/http://www.ppcbl.punjab.gov.pk/http://www.smebank.org/http://www.smebank.org/http://www.ztbl.com.pk/http://www.ztbl.com.pk/http://www.ztbl.com.pk/http://www.smebank.org/http://www.ppcbl.punjab.gov.pk/http://www.idbp.com.pk/http://www.btm.co.jp/http://www.oiboman.com/http://www.hsbc.com.pk/http://www.db.com/http://www.citibank.com.pk/http://www.barclays.pk/http://www.albaraka.com.pk/http://www.ubl.com.pk/http://www.standardchartered.co/http://www.soneri.com/


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Common Problems of BanksThe 21st century challenges for the Pakistani banking industry are broadly of internal and

external nature. Internal challenges are the one that stem from within the banking industry and

carry a profound effect on the long run robustness of the banking industry. External challenges

are somewhat exogenous, being generated from the external environment of the bankingindustry, and require shrewd management for adaptability.

I would like to start with the internal challenges first.

Technical Expertise: Acquiring the technical expertise should be the focus of future human

resource management given the changing paradigm of banking sector regulations. For instance,

the implementation of the new Capital Accord (Basel II) whereby capital adequacy requirements

have been made more risk-oriented by linking capital to operational risk and changing the risk

measurement approaches for credit and market risks. However, its implementation is not going

to be an easy task especially in countries (including Pakistan) where risk management systems

are at nascent stage. This is because of one of the prerequisite for Basel II implementation which

requires that the banking institutions should have a robust risk management setup which is

capable of effectively managing all major risks that an institution is exposed to.

Similarly, the banking institutions are also required to carry out stress testing, a technique used

around the globe by financial institutions to assess risk exposures across the institution and to

estimate the changes in the value of the portfolio, if exposed to various risk factors. Initially,

although, SBP has advised banks to carry out the simple sensitivity analysis keeping in the

view the varying levels of skill and available resources among banks; however, going forward

more sophisticated techniques will be adopted. Certainly, this process would require technical

expertise at least in three areas: identifying, analyzing and proper recording of the assumptions

used for stress testing; adjusting the situation or shocks applied to the data and interpreting the

results; and an effective management information system that ensures flow of information to the

senior management to take proper measures to avoid certain extreme conditions. Therefore,

going forward, the focus of human resource management should be to acquire technical expertise

if the institutions intend to go along with the changing regulatory environment.

Infrastructure Development: All around the world the share of private sector participation is

increasing tremendously in the area of infrastructure development. Through most of 1990s, the

investment in infrastructure projects with private participation rose steadily and of these the most

successful projects were implemented in 136 low and middle income countries. In Pakistan, the

conventional form of financing infrastructure projects only through Public Sector Development

Programme has resulted in congestions and bottlenecks that have raised the need to find

alternative way of fostering private-public partnership in the areas of infrastructure development.

This success story of private sector in infrastructure development has also set challenges to the

local banking industry to learn from the experience of other emerging market economies and


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innovate and design the different modes of infrastructure financing and the associated risk

management systems.

Development of Liability Products: It should be noted that although new products have been

introduced in preceding three years on asset side, including, consumer finance, SME finance, etc,

but little attention has been paid on developing and innovating the liability products. This onesided approach has proved adverse for the local banking industry as these are the savers and

depositors that provide financial resources to the banks to perform their intermediation business.

The stagnant financial savings in the economy for last few years is an outcome of this neglect

and this has raised the need to design the lucrative savings products in the country so as to look

after the interest of the small savers and mobilize their savings in an efficient way. Anti-Money

Laundering: As a result of increased integration in the global financial industry, the misuse of

banking industry has been observed in recent years. These include the use of banking services

for activities like, terrorist financing, drug trafficking and money laundering. In few countries

although there is a comprehensive legislative systems and well defined enforcement mechanism;

but there are a number of countries where the entire regulatory framework is at initial stage. In

such countries, banking institutions are exposed to adverse consequences of these activities in the

form of reputational, operational, legal and concentration risks. For instance, the institutions

have to pay the investigations or the penalty charges, decline in the stock value, assets seizures,

temporary termination of correspondent banking facilities, etc. the tackling of this issue requires

a coordinated effort of the banking institutions, regulators, law enforcement agencies, etc. In this

regard, SBP has already taken some viable steps to prevent the use of banking institutions for

illegal activities.

Operational Aspects: It has been observed over time that banks put their focus on treasury &

corporate business while the operational side is often ignored. I would like to emphasize that the

importance of operational side should not be underestimated. It is as important as other segments

of banking and banks should strengthen and give incentives to those persons who are under

taking operational business.

Human Resource Development: According to the Labor Force Survey 2003-2004, the over all

labor force participation rate is 30.41 percent. In todays era human resources are as important as

financial resources to any organization. The Banks need to develop their human resources for

future challenges and produce professionals having the desired expertise for specialized banking

like Treasury functions, SME financing and Islamic Banking etc. This is the need of the hour that

banks should develop their own Human Resources. To deal with this issue, Banks may enhance

their collaboration with the educational institutions.

These challenges, ladies and gentlemen, as I mentioned before are crucial in determining the

long run robustness of the banking industry. In addition to this, there are a number of challenges

that have emerged following the most recent macroeconomic developments in the domestic and

global economy. These are what I would like to call as external challenges.


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Interest Rate Variations: Interest rates have been at historic low levels during the last three years

and were therefore providing a conducive environment for the expansion of overall real

economic activities. More importantly, smaller business entities which earlier could not afford

bank financing were able to do so in this environment. However, since last fiscal year (2004) the

interest rate structure is changing gradually. It has to be seen, therefore, whether banks would be

able to continue the expansion in their businesses given that the fact in preceding three years,

low financial charges were one of the major factors for credit demand in the economy. In

addition, the repayment capacity of the borrowers who borrowed at floating rates has also put a

question mark on the asset quality of the banks.

Consumer-Durable Demand: The robust growth of auto and mortgage finance in preceding

two years has significantly increased the prices of these assets, and thus has created inflationary

pressures in the economy. The probability of default on these loans has a direct relation with the

value and the nature of the underlying collateral as most of the consumer lending is secured.

This said, asset prices play a crucial role in determining the size of the losses incurred by banks

in case of default. In order to avoid such problems, banks have to rely more on the future

income streams of the borrowers in making their credit assessment instead of the collateral value,

until such time that the asset prices are rationalized.

Equity Stock Investment:Given the volatile nature of the equity markets, banks investment in

equity stocks needs a cautious approach. E-Banking: Another area where still a lot of progress

should be made is the E- banking. Although small and medium banks are now offering on-line

services to their customers, the large banks, with more expanded branch network and number of

customers, are required to move more expeditiously so as to optimally utilize the E- banking

network. This will not only lower the transaction costs but will also help in improving the

customer services. The ATM penetration ratio is still quite low in Pakistan and the efforts are

needed to not only further expand the ATM network more aggressively but also to improve upon

the security standards.

Islamic Banking: Islamic banking is a relatively new concept in our banking system. More and

more banks are seeking license to open Islamic bank Branches. At present two full fledged

Islamic banks having 37 branches are operating in Pakistan. SBP has also issued license to three

more full fledged Islamic Banks, named as: BankIslami Pakistan Limited, Emirates Global

Islamic Bank Limited and Dubai Islamic Bank Pakistan Limited. Moreover, there are 34 stand

alone branches of different banks which are operating successfully throughout Pakistan. The

banks should be fully prepared to run Islamic branches with the help of their Shariah Board,

Shariah Advisors, Auditors and trained staff. The Banking Industry should understand that

Islamic Banking is still underdeveloped and we should not work half-heartedly towards the

growth of Islamic Banking. This is a sector where growth is expected and the banks should

capture this opportunity.


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Fast changing pattern and demand

During the last decade the rural consumers were in need for low end products which would meet

their basic demands and necessities. But of lately due to change in technology rather

advancement in technology the demand for people have also changed and the buying pattern

which initially comprised of basic products have now shifted to luxurious products

Large and scattered market

In the 1stplace, in terms of number of consumers, the rural market of India is every large market

it consists of more the 600 million consumers. The second aspect is that geographically, it is a

vast market. Practically the role of Pakistan, barring the metropolitan cities and towns constitute

the market.

It is also highlyscattered market: the consumers are scattered over 5, 70,000 villages spread

through the length and breadth of the country. In terms of business generated too, it is a big

market; 22000 core rupees worth of non-food consumer goods are being sold per year in

the market at present.


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Problem Loans and Cost Efficiency in Commercial BanksOver the last several years, two strands of research in the field of financial institutions have

received great amounts of attention. One strand investigates the issue of problem loans.

Virtually all research on the causes of bank and thrift failures find that failing institutions have

large proportions of nonperforming loans prior to failure, and that asset quality is a statistically

significant predictor of insolvency. The other strand of research investigates the productive

efficiency of financial institutions. These studies almost always find that the average institution

incurs high costs and generates low profits relative to institutions on the best practice efficient

frontier. Various studies of mergers, agency problems, corporate governance, branching

strategies, foreign ownership, etc. offer support for a number of explanations of this inefficiency.

On the surface, these two topics might appear to be largely unrelated, because operations

personnel typically do not participate in screening and monitoring loan customers, and because

loan officers and review personnel typically do not participate in overseeing operations costs.

Despite this apparent dichotomy, issues of problem loans and cost efficiency are in fact related in

several important ways.

First: a number of researchers have found that failing banks tend to be located far from the

best-practice frontier. Thus, in addition to having high ratios of problem loans, banks

approaching failure also tend to have low cost efficiency. A number of other studies have found

negative relationships between efficiency and problem loans even among banks that do not fail.

Cost-inefficient banks may tend to have loan performance problems for a number of reasons.

For example, banks with poor senior management may have problems in monitoring both their

costs and their loan customers, with the losses of capital generated by both these phenomena

potentially leading to failure. Alternatively, loan quality problems may be caused by events

exogenous to the bank, such as regional economic downturns, in which case extra expensesassociated with the nonperforming loans (e.g., monitoring, negotiating workout arrangements,

seizing and disposing of collateral, diverted senior managerial focus) can create the appearance,

if not the reality, of low cost efficiency.

Second:empirical link between problem loans and productive efficiency appears in studies that

use supervisory examination data found measured cost efficiency to be positively related to

examiners' ratings of bank management quality. Moreover, the latter study found that banks

management ratings were more strongly related to their asset quality ratings than to any of their

other examination ratings. A relationship between asset quality and cost efficiency (via

management quality) is consistent with the failed bank data cited above, and suggests that the

negative relationship between problem loans and cost efficiency holds for the population of

banks as well as for the subset of failing banks.

Third: some recent studies of bank efficiency have directly included measures of

nonperforming loans in cost or production relationships. The stated purposes of this adjustment

are to control for the extra costs associated with nonperforming loans and/or to control for


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underwriting and monitoring expenditures that influence loan quality. Nonperforming loans in a

nonparametric study of bank production and others have applied the concept to parametric

estimations of bank cost functions and efficiency. As discussed below, whether or not this

procedure improves the estimation of cost efficiency depends upon the underlying reason for the

relationship between costs and nonperforming loans.

Thus, a number of important policy and research issues -- discovering the primary cause of

problem loans and bank failures, determining the most important supervisory focus for

promoting bank safety and soundness, and deciding how to estimate the cost efficiency of

financial institutions -- rest on identifying the underlying relationship between problem loans and

measured cost efficiency. We attempt to shed some light on these important questions by using

Granger-causality analysis to test a set of hypotheses that describe the intertemporal relationships

among problem loans, cost efficiency, and financial capital. We refer to these hypotheses with

the mnemonics 'bad luck,' 'bad management,' 'skimping,' and moral hazard.' As we will see

below, several of these hypotheses yield identical predictions for the contemporaneous

relationships between problem loans and cost efficiency, but strikingly different intertemporal

predictions. Granger-causality analysis can distinguish among these alternative cases in a way

that standard cross-section econometric analysis cannot. We acknowledge that the intertemporal

relationships that we measure are gross statistical associations that do not necessarily prove

economic causation. Nevertheless, these associations may help reveal which among these

alternative hypotheses is most compatible with the bank data.

Portfolio managers ('bad management')


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Pakistani Banking Main Problems

Pakistans banking sector has been faced with at least several problems and difficulties. The

main problems faced by the sector are:-

(1) Most of the financial assets and deposits are owned by nationalized commercial banks

(NCBs) which suffer from a highly bureaucratic approach, overstaffing, unprofitable branches

and poor customer service.

(2) NCBs along with specialized banks such as ADBP, IDBP and Development financial

institutions such as NDFC have a high ratio of non-performing loans.

(3) Banking industry faces a high tax rate which affects its profitability and attractiveness for

new entrants.

(4) There is a proliferation of banks and some of them are undercapitalized, poorly managed with

a scanty distribution network.

(5) Agriculture, small and medium enterprises, Housing sectors are underserved and have limited

access to credit.

(6) Banks have typically focused on trade and corporate financing with a narrow range of

products and have not diversified into consumer and mortgage financing for which there is an

ample unsatisfied demand. Despite these problems and difficulties it is fair to say that a lot of

progress has been made to improve the health and soundness of the banking sector in recent

years. Although a lot more needs to be done and there are few weak and vulnerable institutions

the banking sector in Pakistan is much stronger today compared to five years ago or in

comparison to other countries in the region. What are the factors responsible for thisimprovement? A large number of reforms have either been undertaken or under way.

First: the nationalized commercial banks are being privatized and their domination of the

banking sector is likely to be reduced from almost 100 percent in 1991 to about 20 percent by

December 2002. Muslim Commercial Bank and Allied Bank have already been privatized. The

final bidding for United Bank is scheduled for next week. The short list for Habib Bank has

been finalized and the plans are for completion of privatization by October 2002. Ten percent of

shares of National Bank have been floated through Stock Market and another ten percent will be

offered in near future for small retail investors.

Second: strong corporate governance is absolutely essential if the banks have to operate in a

transparent manner and protect the depositors interests. The SBP has taken several measures in

the last two years to put in place good governance practices to improve internal controls and

bring about a change in the organizational culture. The salient features of this structure are:


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(a) Banking license of one of the commercial banks which was found fulfilling in meeting the

prudential rules and norms was cancelled for the first time in the history of Pakistan.

(b) Ownership and management were changed at another commercial bank which had committed

breach through unauthorized transfer of funds from the bank to associated companies.

(c) The appointments of Board members and Chief Executive Officers of all banks have to be

screened so that they meet the fit and proper test prescribed by the SBP.

(d) Family representation on the Board of Directors of the banks where they hold majority

ownership has been limited to 25 percent of the total membership of the Board.

(e) To avoid possible conflict of interest and use of insider information the Directors, executives

and traders working in Brokerage companies will no longer serve on the Boards of Directors of

the banks.

(f) External auditors are evaluated annually and classified in various categories based on theirperformance and other prescribed criteria.

Two large audit firms were debarred from auditing the banks and only after showing

improvement in their performance placed in a category lower than they originally belonged to.

(g) A detailed set of guidelines for the Board of Directors to effectively oversee the management

of the banks and develop policies has been issued.

Third: capital requirements of the banking sector are adequate in relation to the risk weighted

assets and conform to the Basle accord. To further strengthen their competitive ability, both

domestically and internationally and to encourage the economies of scale, the minimum paid-up

capital requirements of the banks have been raised. The banks are required to increase their

paid-up capital from Rs 500 million to Rs 1 billion by 1 st January 2003 failing which the bank

will be converted into a non-scheduled bank with restricted activities. The banks have been

authorized to issue Term Finance Certificates (TFCs) as subordinated debt to raise their capital.

Fourth: the stock of non-performing loans (NPLs) is being tackled in several ways. Although

gross NPLs amount to Rs 260 billion and account for 25 percent of the advances of the banking

system and DFIs there has been aggressive provisioning carried out during the last three years.

Almost 56 percent of the NPLs are fully provided for and net NPLs to total advances ratio has

thus declined to 11 percent. Efforts are being made to further reduce this ratio through the

\active involvement of Corporate Industrial Restructuring Corporation (CIRC) and the

Committee on Revival of Sick Units (CRSU). While the CRSU attempts to bring about financial

restructuring with the help of banks and existing owners the CIRC auctions the units to general

public divesting the ownership from the existing shareholders. Further guidelines to write off

NPLs are being developed to enable them to get rid of the old stuck-up loans.


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Program lending, for example, can help up gradation of power looms to shuttle-less looms in

Faisalabad area and contribute to the achievement of goal set under Textile Vision 2005.

Eleventh: the corporate tax rates on banks were exorbitantly high in Pakistan thus adversely

affecting their profitability and attractiveness as an avenue for investment and new equity

injection. The Government has already reduced the tax rate from 55 percent to 47 percent during

the last two years and it is envisaged that the rate will be reduced gradually and brought at par

with the corporate tax rate of 35 percent in the next three years. This will in turn help in

reducing the spread between the deposit rate and lending rate and benefit financial savers.

Twelfth: a complete revamping of Agriculture Credit Scheme has been done recently with the

help of commercial banks. The scope of the Scheme which was limited to production loans for

inputs has been broadened to the whole value chain of agriculture sector. We have, with the

grace of Allah, become a surplus country in food grains, livestock etc. and thus the needs of

agriculture sector have also expanded. The SBP has included financing for silos, god owns,

refrigerated vans, agro processing and distribution under the cover of this scheme.

This broadening of the scope as well the removal of other restrictions have enabled the

commercial banks to increase their lending for agriculture by 24 percent in fiscal year 2001-02

for the first time. Unlike the previous years when they were prepared to pay penalties for

underperformance they have set up higher targets for this year. The private commercial banks

have also agreed to step in and increase their lending to agriculture.

Thirteenth: the banks are being encouraged to move towards Electronic banking. There is a

big surge among the banks including NCBs to upgrade their technology and on-line banking

services. During the last two years there has been a large expansion in the ATMs throughout thecountry. The recent decision mandating the banks to join one of either two ATM switches

available in the country will provide a further boost. Progress in creating automated or on-line

branches of banks has been quite significant so far and it is expected that by 2004 a majority of

the bank branches will be on-line or automated. Utility bill payment and remittances would be

handled through ATMs, Kiosks or Personal Computers reducing both time and cost. Investment

in information technology is being undertaken by the banks to enhance efficiency, reduce

transaction costs and promote E-Commerce. It has been estimated that a banking transaction

through

ATM costs one fourth as much a transaction conducted over the counter in a traditional branch and the similar transaction over the internet costs a mere 1% of the traditional teller costs.

Fourteenth: the banks have recently embarked on merit based recruitment to built up their

human resource basean area which has been neglected so far.


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The private banks have taken lead in this respect by holding competitive examinations,

interviews and selecting the most qualified candidates. The era of appointment on the basis of

sifarish and nepotism has come to an end. This new generation of bankers will usher in a culture

of professionalism and rigour in the banking industry and produce bankers of stature who will

provide the leadership in the future.

Fifteenth: to facilitate the depositors to make informed judgments about placing their savings

with the banks, it has been made mandatory for all banks to get themselves evaluation by credit

rating agencies. These ratings are then disclosed to the general public by the SBP and also

disseminated to the Chambers of Commerce and Trade bodies. Such public disclosure will allow

the depositors to choose between various banks. For example, those who wish to get higher

return may opt for banks with B or C rating. But those who want to play safe may decide to stick

with only AAA or AA rated banks.

Finally: the countrys payment system infrastructure is being strengthened to provide

convenience in transfer of payments to the customers. The Real-Time Gross Settlement (RTGS)

system will process large value and critical transactions on real time while electronic clearing

systems will be established in all cities.

These reforms will go a long way in further strengthening the Banking sector but a vigilant

supervisory regime by the State Bank will help steer the future direction.


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DEVELOPMENTS, CHALLENGES AND OPPORTUNITIESPakistans banking sector like many other developing countries had been faced with several

problems and difficulties such as:

(1) Most of the financial assets and deposits were owned by nationalized commercial banks

(NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable branches

and poor customer service.

(2) NCBs along with specialized banks such as ADBP, IDBP and Development financial

institutions such as NDFC had a high ratio of non-performing loans.

(3) Banking industry faced a high tax rate, which affected its profitability and attractiveness for

new entrants.

(4) There was a proliferation of banks and some of them were undercapitalized, poorly managed

with a scanty distribution network.

(5) Agriculture, small and medium enterprises, Housing sectors were underserved and the middle

class and low income group had limited access to bank credit.

(6) Banks had typically focused on trade and corporate financing with a narrow range of

products and had not diversified into consumer and mortgage financing for which there is an

ample unsatisfied demand.

(7) Poor quality of human resources, weak internal controls, non-merit based recruitments, high

administrative costs and undue interference of unions in decisions making process affected the

performance of public sector financial institutions adversely.

BANKING SECTOR REFORMS

Banking sector reforms were aimed at addressing these and other constraints. Although there is

no room for complacency and a lot needs to be done it is fair to say that substantial progress has

been made to improve the health and soundness of the banking sector in recent years. There are

still few weak and vulnerable institutions but overall the banking sector in Pakistan is much

stronger today compared to five years ago or in comparison to other countries in the region.

What are the factors responsible for this improvement? A large number of reforms have either

been undertaken or under way.

(i) Privatization of NCBs The nationalized commercial banks are being privatized and their

domination of the banking sector is likely to be reduced from almost 100 percent in 1991 to

about 20percent by December 2003. The shares of Muslim Commercial Bank are all in the

private sector. United Bank has been sold to a consortium of private investors. Privatization of

Habib Bank Ltd., is under way and is scheduled to be completed by end December, 2003. 23.5

percent of shares of National Bank have been floated through Stock Market mainly aimed at


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small retail investors. The NCBs have been restructured and professional management inducted

which works under the supervision of independent Boards of Directors drawn from the private

sector.

(ii) Corporate governance. Strong corporate governance is absolutely essential if the

banks have to operate in a transparent manner and protect the depositors interests. The SBP has

taken several measures in the last four years to put in place good governance practices to

improve internal controls and bring about a change in the organizational culture. The salient

features of this structure are:

a. Banking license of one of the commercial banks which was found in violation of theprudential regulations and norms was cancelled for the first time in the history of

Pakistan after following the due process. This decision was upheld by Peshawar High

Court. b. Ownership and management were changed at two private commercial banks,

one of which had committed breach through unauthorized transfer of funds from the bank

to associated companies. c. A number of cases of willful bank defaulters were referred toNational Accountability Bureau (NAB) for taking legal actions and recovering the

amounts due. d. The appointments of Board members, Chief Executive Officers and key

Executives of all banks have to be screened so that they meet the fit and proper test

prescribed by the SBP. e. Family representation on the Board of Directors of the banks

where they hold majority ownership has been limited to 25 percent of the total

membership of the Board. f. To avoid possible conflict of interest and use of insider

information the Directors, executives and traders working in Brokerage companies will

no longer serve on the Boards of Directors of the banks. g. External auditors are

evaluated annually and classified in various categories based on their performance and

other prescribed criteria. Two large audit firms were debarred from auditing the banks

and only after showing improvement in their performance placed in a category lower than

they originally belonged to. h. A detailed set of guidelines for the Board of Directors to

effectively oversee the management of the banks and develop policies has been issued. A

training course on Corporate Governance was organized for the members of the Boards

of banks and their Chief Executives. i. The disclosure requirements for banks have been

strengthened and now they are required to prepare their annual financial statements in

accordance with the International Accounting Standards. They are also required to

publish quarterly and half-yearly accounts to provide information to their stakeholders for

taking well informed decisions. j. In order to institutionalize the decision making processand to provide guidance to staff, the banks are required to formulate and implement well-

defined policies in credit, investment, recovery of write-offs, human resources, audit and

compliance, risk management, etc.

b. To provide guidance to banks in identifying, measuring, monitoring and controllingvarious risks and to make them proactive, a detailed set of guidelines on risk management

has been issued.


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(iii) Capital Strengthening. Capital requirements of the banking sector have to be adequate

in relation to the risk weighted assets and conform to the Basle Accord. To further strengthen

their competitive ability, both domestically and internationally and to encourage the economies

of scale, the minimum paid-up capital requirements of the banks have been raised. The banks

were required to increase their paid-up capital from Rs 500 million to Rs 1 billion by 1st January

2003 failing which they will no longer be allowed to carry out full banking activities as

scheduled banks. This has resulted in mergers and consolidation of many financial institutions

and weeding out of several weaker banks from the financial system.

(iv) Improving Asset quality. The stock of non-performing loans (NPLs) has been tackled

in several ways. The gross NPLs amount to Rs 252 billion and account for 22 percent of the

advances of the banking system and DFIs. However, there has been aggressive provisioning

carried out during the last three years. More than 60 percent of the NPLs are fully provided for

and net NPLs to net advances ratio has thus declined to less than 10 percent. Efforts are being

made to further reduce this ratio through the active involvement of Corporate & IndustrialRestructuring Corporation (CIRC) and the Committee on Revival of Sick Units (CRSU). The

settlement reached between loss category loan holders and banks under State Bank circular

No.29 will further reduce the volume of NPLs and allow the sick industrial units to revive while

at the same time enable the banks to clean up their balance sheets. The positive development is

that the quality of new loans disbursed since 1997 has improved and recovery rate is 95 percent.

(v) Liberalization of foreign exchange regime. Pakistan has further liberalized its

foreign exchange regime and ensured partial Capital account Convertibility by allowing foreign

exchange companies to operate and Pakistani Corporate sector to acquire equity abroad.

(vi) Consumer Financing The State Bank has removed restrictions imposed on nationalized

commercial banks for consumer financing. The positive experience of auto financing gives a lot

of hope that the middle class of this country will be able to access consumer durables through

banks. This will at the same time boost the manufacturing of TVs, air-conditioners, VCRs,

washing and drying machines, deep freezers etc. in the country. Credit and Debit Cards are also

gaining popularity and the numbers of card holders have doubled during the last two years.

(vii) Mortgage Financing a number of incentives have been provided to encourage

mortgage financing by the banks. The upper limit has been raised from Rs 5 million to Rs 10

million. Tax deduction on interest payments on mortgage have been allowed up to a ceiling ofRs.500,000. The new recovery law is also aimed at expediting repossession of property by the

banks. The banks have been allowed to raise long term funds through rated and listed debt

instruments like TFCs to match their long term mortgage assets with their liabilities.

(viii) Legal Reforms. Legal difficulties and time delays in recovery of defaulted loans have

been removed through a new ordinance i.e. The Financial Institutions (Recovery of Finances)


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Ordinance, 2001. The new recovery laws ensures expeditious recovery of stuck up loans by the

right of foreclosure and sale of mortgaged property with or without intervention of court and

automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission is

reviewing, revising and consolidating the banking laws and drafting new laws such as

bankruptcy law.

(ix) Prudential Regulations The prudential regulations in force were mainly aimed at

corporate and business financing. The SBP in consultation with the Pakistan Banking

Association and other stakeholders has developed a new set of regulations which cater to the

specific separate needs of corporate, consumer and SME financing. The new prudential

regulations will enable the banks to expand their scope of lending and customer outreach.

(x) Micro financing To provide widespread access to small borrowers particularly in the

rural areas the licensing and regulatory environment for Micro Credit and Rural financial

institutions have been relaxed and unlike the commercial banks these can be set up at district,

provincial and national levels with varying capital requirements. There is less stringency and

more facilitative thrust embedded in the prudential regulations designed for this type of

institutions. Khushali Bank and the First Microfinance Bank in the private sector have already

started working under this new regulatory environment. Khushali Bank has already reached a

customer base of 125,000 mainly in poorer districts of the country and its recovery rate is above

95 percent.

(xi) SME Financing. The access of small and medium entrepreneurs to credit has been a

major constraint to expansion of their business and up gradation of their technology. A Small and

Medium Enterprise (SME) Bank has been established to provide leadership in developing new

products such as program loans, new credit appraisal and documentation techniques, and

nurturing new skills in SME lending which can then be replicated and transferred to other banks

in the country. Program lending, for example, can help upgradation of power looms to shuttleless

looms in Faisalabad area and contribute to the achievement of goal set under Textile Vision

2005. The new prudential regulations for SMEs do not require collateral but asset conversion

cycle and cash flow generation as the basis for loan approval. The State Bank is also

contemplating to develop capacity building among a select group of banks for SME lending.

This will revitalize the lending to SMEs particularly export oriented ones.

(xii) Taxation the corporate tax rates on banks were exorbitantly high in Pakistan thusadversely affecting their profitability and attractiveness as an avenue for investment and new

equity injection. The Government has already reduced the tax rate from 58 percent to 44 percent

during the last three years and it is envisaged that the rate will be reduced gradually and brought

at par with the corporate tax rate of 35 percent in the next three years. This will in turn help in

reducing the spread between the deposit rate and lending rate and benefit financial savers.

5


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(xiii) Agriculture Credit a complete revamping of Agriculture Credit Scheme has been

done recently with the help of commercial banks. The scope of the Scheme which was limited to

production loans for inputs has been broadened to the whole value chain of agriculture sector.

We have, with the grace of Allah, become a surplus country in foodgrains, livestock etc. and thus

the needs of agriculture sector have also expanded. The SBP has included financing for silos,

god owns, refrigerated vans, agro processing and distribution under the cover of this scheme.

This broadening of the scope as well the removal of other restrictions have enabled the

commercial banks to increase their lending for agriculture by a multiple of four times compared

to FY 1999-00 thus mainstreaming agriculture lending as part of their corporate business. Unlike

the previous years when they were prepared to pay penalties for under performance they have set

up higher targets for this year. The private commercial banks have also agreed to step in and

increase their lending to agriculture.

(xiv) E-Banking The banks are being encouraged to move towards Electronic banking. There

is a big surge among the banks including NCBs to upgrade their technology and on-line bankingservices. During the last three years there is a large expansion in the ATMs has been witnessed

and at present about 500 ATMs are now working throughout the country. The decision

mandating the banks to join one of either two ATM switches available in the country will

provide a further boost. Progress in creating automated or on-line branches of banks has been

quite significant so far and it is expected that by 2004 a majority of the bank branches will be on-

line or automated. Utility bills payment and remittances would be handled through ATMs,

Kiosks or Personal Computers reducing both time and cost. Investment in information

technology is being undertaken by the banks to enhance efficiency, reduce transaction costs and

promote E-Commerce. It has been estimated that a banking transaction through ATM costs one

fourth as much a transaction conducted over the counter in a traditional branchand the similartransaction over the internet costs a mere fraction of the traditional teller costs.

(xv) Human Resources. The banks have recently embarked on merit-based recruitment to

build up their human resource base an area which has been neglected so far. The private banks

have taken lead in this respect by holding competitive examinations, interviews and selecting the

most qualified candidates. The era of appointment on the basis of sifarish and nepotism has come

to an end. This new generation of bankers will usher in a culture of professionalism and rigour in

the banking industry and produce bankers of stature who will provide the leadership in the

future.

(xvi) Credit Rating To facilitate the depositors to make informed judgments about placing

their savings with the banks, it has been made mandatory for all banks to get themselves

evaluated by credit rating agencies. These ratings are then disclosed to the general public by the

SBP and also disseminated to the Chambers of Commerce and Trade bodies. Such public

disclosure will allow the depositors to choose between various banks. For example, those who


27/36

wish to get higher return may opt for banks with B or C rating. But those who want to play safe

may decide to stick with only AAA or AA rated banks.

(xvii) Supervision and Regulatory Capacity. The banking supervision and regulatory

capacity of the Central Bank has been strengthened. Merit based recruitment, competency

enhancing training, performance linked promotion, technologydriven process, induction of

skilled human resources and greater emphasis on values such as integrity, trust, team work have

brought about a structural transformation in the character of the institution. The responsibility for

supervision of non-bank finance companies has been separated and transferred to Securities

Exchange Commission. The SBP itself has been divided into two parts one looking after

central banking and the other after retail banking for the government.

(xviii) Payment Systems. Finally, the countrys payment system infrastructure is being

strengthened to provide convenience in transfer of payments to the customers. The Real-Time

Gross Settlement (RTGS) system will process large value and critical transactions on real time

while electronic clearing systems will be established in all cities.

These reforms will go a long way in further strengthening the Banking sector but a vigilant

supervisory regime by the State Bank will help steer the future direction.

OUTCOMES:

What have been the results of the above reforms? These can be evaluated through a set of

banking soundness indicators. These indicators show the following outcomes:

a) There has been consolidation, liquidation and merger of banks particularly with investment

banks and DFIs that has resulted in reduction in number of institutions but fortified the capital

base.

b) The share of private sector in banking assets has already declined to 60%. Once HBL is

privatized this share will rise to 80 percent.

c) Capital adequacy ratios look much stronger in 2002 compared to five years ago. By the end of

CY-02 the overall CAR stands at 8.8 percent which is well above minimum requirement of 8

percent. Commercial banks have much stronger Capital base and then CAR has resin from 6% in

FY-97 to 12.6% in FY-02. Thirty two out of 40 banks have ratios in access of 10 percent.

d) Asset quality has improved stemming the flow of non-performing loans. NPLs on all- banks

basis have gone down by 7 percent from FY-02 to FY-03. Net NPLs of Commercial banks are

down to 7.5%.

e) Not only the lending rates have witnessed historic low of single-digit mark-up but also the

spread has squeezed substantially from 700 bases points to 350 bases points.


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f) As a result of strong deposit growth and heavy investment in government securities banks are

having system-wide abundant liquidity and with robust indicators. The liquid assets to total

assets ratio changed from 39.9 percent (CY-01) to 47 percent (CY-02).

g) Credit to private sector has multiplied more than three times to PKR 133.2 billion, in FY03 as

compared to PKR 41.7 billion in FY-02.

h) Earnings and profitability have taken remarkable turn upwards. Earning assets to total assets

ratio climbed from 77.6 percent (CY-01) to 84.1 percent (CY-02). Part of the profitability has

resulted from substantial decline in tax rate (64 percent in FY-95 to 47 percent in FY-2003). The

profit after tax of the commercial banks increased to Rs 14.8 billion in 2002 from a loss of Rs

16.2 billion in 1997. Resultantly, the return on assets (ROA) improved to positive 0.8 percent

from negative 1.3 percent.

CHALLENGES:

Soundness of financial system requires its constituent institutions to be efficient, having an

optimal size and relatively healthy portfolio; and the financial system itself of being the optimal

size. These requirements call for persistent and continued efforts for privatization, drastic

restructuring of DFIs, a more effective tackling of the problem of bad debts, and the elimination

of fragmentation, and ultimate consolidation of financial system.

In state owned banks, we have a history of deteriorating governance and credit discipline, finally

eroding their capital, which has largely been compensated through capital injections by SBP.

Remaining agenda for Privatization needs to be fulfilled as promised. These banks should be

sold, as being done currently, through competitive bidding and through listing on Stock

Exchanges. This would bring in transparency in the process, fetch a realistic price to the

government exchequer and it would help deepen the capital market.

The risk to the banks solvency may arise out of banks hyper activism in areas like real estate

financing (reduction in debt-equity ratio from 60:40 to 80:20 for housing finance has heightened

market risk) and equity investment. Although banks indirect lending to equity market against

their scrips picked up yet remained miniscule in relation to total portfolio. SBP has been

monitoring all this very closely.

When the banks are flush with liquidity, it becomes a challenge that they carefully guard

themselves against spiraling effect of excess liquidity on their loan to valuation ratio and makerigorous sensitivity analysis before making credit decisions. This will help them to properly

evaluate the impact of shocks such as upward swing in interest rate structure on their portfolio as

well as individual borrowers cash flow projections.

Enhancing efficacy of Supervision. Strengthening of supervisory and regulatory capabilities of

governing institutions (SBP and SECP) not only requires enhancement of their own skills but


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also those of institutions being supervised. This requires installation of good governance,

placement of effective legal infrastructure, and clear demarcation of supervisory responsibilities

in case of multiplicity of supervisors.

Strengthening of Legal Infrastructure. Although legal and judicial reforms have facilitated

financial contract dispute resolution, implementation of court judgments is still ineffective, partlydue to remaining weaknesses in the law and its enforcement. The implementation of new

foreclosure law is still beset with some teething problems which need to be tackle.

Simultaneously, the implementation of court judgment could be facilitated by providing courts

with adequate resources to effect loan recovery. A Bankruptcy law is under formulation and

needs to be put in place. So is the need to approve the Anti-money laundering law.

Another challenge is restructuring of DFIs. DFIs in Pakistan have failed in reaching the targeted

sectors and in achieving sustainability mainly because of large defaults.

Other issues include modernization of Payment System, arresting bad debts, Continuousimprovement in Corporate Governance of banks/DFIs, up-gradation of risk management system.

OPPORTUNITIES:

At the national level the biggest opportunity is to integrate into international financial market.

Foreign investors in the banking industry are welcome in Pakistan as they bring not only the

precious foreign exchange but also the skills and techniques of modern banking system,

innovative products and services and networking into global chain.

As the competition in domestic banking system has become fierce and the profit margins on

traditional modes of Corporate and trade financing are under pressure the banks are moving intonew business areas Consumer loans, mortgage financing, SME financing and agriculture

lendingThese New areas require expertise, systems and procedures, controls, technology and

risk management technique. The banks have to strike a balance between prudent lending and a

rapid buildup of risky portfolio. The gradual transition from prudential regulations to a guideline

driven framework would require in-house risk management capacity within the banks and further

elimination of weaker banks from the system. Derivatives and options provide excellent tools for

risk management and the Central bank is encouraging the banks to move in this direction. But

creating awareness, educating the counter parties, building up local expertise, introducing proper

controls and disclosures standards are some of the pre-requisites that have to be put in place.

Finally: as foreign exchange regime is being gradually liberalized and partial capital account

convertibility has been achieved further measures would be undertaken to open up the market for

cross-border risk products to private wealth managers and well established corporate houses.


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Legal issues: Pakistan

Pakistan has a comprehensive debt recovery and corporate restructuring and insolvency

legislative framework. Debt recovery is governed largely by the Code of Civil Procedure 1908.

Banking companies are covered by special legislation, the Banking Companies (Recovery of

Loans, Advances, Credits and Finances) Act 1997. Corporate restructuring and insolvency laws

are based almost entirely on the equivalent English laws and are found in the Companies

Ordinance 1984. In an attempt to keep pace with developments in other jurisdictions, the

legislature has promulgated other new laws including the Corporate and Industrial Restructuring

Ordinance 2000 (concerning the restructuring and management of the non-performing assets of

certain banks and financial institutions) and the Companies (Rehabilitation of Sick Industrial

Units) Rules 1999.The issue in Pakistan is not the lack of an adequate and comprehensive

legislative framework, but rather the lack of a speedy and efficient implementation

process. Legal proceedings are generally protracted, partly due to the caseload.

The nature and the effectiveness:

Civil unsecured debt collection remedies

Legal proceedings may be instituted against the debtor by the creditor. These will be governed

by the provisions of the Code of Civil Procedure 1908 (the Code). After hearing the suit in

accordance with the Code, the court passes judgment. The creditor must then commence

execution proceedings to obtain enforcement. Legal proceedings, however, are generally slow.

There is a backlog of approximately 20 years on the original jurisdiction side of the High Court

of Sindh and the appeal process can take up to five years.

Secured property enforcement remedies.

A secured debt may also be recovered by initiating a suit for damages against the debtor as

discussed in Section 1a. In addition, legal proceedings may be commenced against the person

providing the security. The nature of the enforcement proceedings will differ according to

the nature of the security. If the debt is secured by a mortgage, then the mortgagee may (at any

time after the debt becomes due) institute a suit for foreclosure or sale of the mortgaged property

against the mortgagor. Both suits give the mortgagor an opportunity to pay the creditor the

amount due to him. If payment is not made within the prescribed time period, then, in the case of

a suit for foreclosure, the mortgagor is debarred from redeeming the mortgaged property and is

required to give possession of the mortgaged property to the creditor (where necessary). In thecase of a suit for sale, if payment is not made within the prescribed time period then

the mortgaged property may be sold and the proceeds applied for the repayment of the debt. If

the proceeds of sale are insufficient, then the court may pass a decree for the recovery of the

balance amount from the mortgagor. The creditor may also institute a suit for the recovery of the

amount secured by the mortgage against the mortgagor in a number of different circumstances.

If the debt is secured by a pledge or hypothecation of goods and the debtor makes default in the


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payment of the debt, or in the performance of the promise for which the goods were pledged,

then the creditor may either initiate a suit against the debtor upon the debt or promise and retain

the goods pledged as collateral security, or sell the pledged goods (having given the debtor

reasonable notice of the sale). If the proceeds of the sale are insufficient, the debtor is liable to

pay the balance amount due and any proceeds in excess of the amount due must be paid by the

creditor to the debtor. The comments in Section 1a above on the protracted nature of legal

proceeding equally applicable here.

Any special debt collection or secured property remedies that are available to banking

sector creditors.

Banks seeking to recover debts benefit from special legislation in Pakistan. The banking

company may institute an action in a banking court if a borrower or customer (including a surety

or indemnifier) defaults on a loan or finance provided by a banking company. The advantage of

proceedings before banking courts (as opposed to the ordinary courts) is that the banking courts

are specialized and follow procedure geared to the expeditious disposal of debt recovery suits. Ifthe debt is secured by a mortgage and the suit filed before the banking court is for its

enforcement, the mortgagor is not given the opportunity to pay the creditor the amount due to

him rather, the court will pass a decree for foreclosure or sale at the first instance. If the banking

company is seeking to recover the debt through the sale of any property pledged, mortgaged,

hypothecated, assigned or otherwise charged as security for the debt, the banking court may at

any stage of the proceedings do one of the following:

Restrain or injunction the sale, creation or transfer of an interest or charge or lease or disposal

of the property.

Attach the property or appoint a receiver for the property. Also, a banking company may, having

obtained a decree in its favor, sell pledged or mort-gaged property with or without the

intervention of the banking court, either by public auction or by inviting sealed tenders. The

proceeds can then be appropriated towards satisfaction of the decree. If the banking company

sells or seeks to sell such property, but is unable to obtain voluntary possession for this purpose,

the banking court will give possession of such property to the purchaser, or to the banking

company, as the case may be. The Corporate and Industrial Restructuring Corporation has been

entrusted with the acquisition, restructuring, rehabilitation, management, disposition and

realization of the non-performing asset(s) of certain banks and financial institutions in

whichthe Federal Government holds 85 percent or more of the shares. Any financial asset(suchas a loan) which is held as an asset in the books of the relevant bank or financial institution

and with respect to which the obligor has been in arrears on any payment obligation for a period

of more than 365 days, and with respect to which the obligors outstanding payment obligation

exceeds PRs10 million, is a non-perform-ing asset. The corporation may proceed in respect of

the non-performing assets of certain banks and financial institutions in which the federal

government holds 85 per-cent or more of the shares. The corporation is empowered, amongst


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other things, to acquire, manage, restructure, rehabilitate, sell and dispose of non-performing

assets and to initiate actions for the recovery of non-performing assets including filing suits and

appeals, entering into settlements through the courts or outside. The corporation also has, for the

purposes of the rehabilitation, management and restructuring of the obligor in respect of whom

any non-performing assets and col-lateral are held by it or on its behalf, been empowered to do

the following:

Request the relevant regulatory body to appoint an administrator to manage the obligors affairs.

Apply to the relevant regulatory body to initiate the sick industrial companys process


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Recommendations

Financing to negative area residents should be made available and term & policies should be

designed accordingly to reduce the chances of defaults.

Markup charged on consumer financing should be reduced to a substantiallevel so the spread

between bank loans and deposit could be reduced andcustomer could easily pay off the loans

Better returns should be provided on deposit accounts

To facilitate the customers new products and services should be introducedcontinuously

SBP should continuously update its regulations according to need of peopleand economic

situations of the country

Increase consumer awareness, give clear instructions and guidance

Markup charge on loans & interest given on deposits should be regularlymonitored and guided

by SBP


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REFERENCES

1 M. Akram Khan. (1989). A Survey of Critical Literature on Interest-free Banking.

Journal of Islamic Banking and Finance (6:1). Karachi.

2 M. Akram Khan. (1994).

An Introduction to Islamic Economics. International Institute of Islamic Thought andInstitute of

Policy Studies. p. 80-81.

3 Mangla, I. U. and Uppal, J. Y. (1990).

Islamic Banking: A Survey and Some Operational Issues. The InternationalInstitute of Islamic

Thought. P. 194-95.

4 Ibid.

5 Ibid. p. 197.

6 Khan, M. S. Islamic Interest-Free Banking. Staff Papers, 33 (International Monetary Fund,

March 1986). p. 1-27.

7 Jarhi, A. (1980) The Relative Efficiency of Interest-Free Monetary Economies: The Fiat

Money Case. Pp. 85-118 in

Studies in Islamic Economics, edited by K. Ahmed (Islamic Foundation, Leicester).

8 Kaufman, G.G. (1986). Federal Bank Regulatory Policy: Comment on Kareken.

Journal of Business, 59(1986). pp. 69-77.

9 Ahmad, Ziauddin (1994). Islamic Banking: State of the Art. In

Islamic Economic Studies, Vol. 2, No. 1. IslamicResearch and Training Institute, Islamic

Development Bank.

10 Homoud, Sami Hasan (1994). Progress of Islamic Banking: The Aspirations and

theRealities. In

Islasmic Economic Studies,Vol. 2, No. 1. Islamic Research and Training Institute,IslamicDevelopment Bank. pp.74-75.

11 Ibid.

12 M. Azizul Hoque. Islamic Banking in Bangladesh with a brief overview of

operationalproblems, paper presented in the seminar held at BIBM on June 24, 1996. P. 9

(unpublished).


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13 Akkas, S. M. Ali (1996).

Relative Efficiency of Conventional and Islamic Banking System in Financing Investment.

Ph.D. thesis. mimeo

Overview of the Banking Sector of Pakistan

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