The banking sector in
Pakistan is going
through a fast-paced transitory process. New groups
are buying out Pakistan operations of foreign banks and number of listed
banks is also increasing. While the income from core banking activity is
increasing due to higher business volume, earnings are also expected to
further improve due to venturing into consumer finance, housing finance
and enhanced lending to agriculture sector. However, there are growing
apprehensions about the profitability from the new businesses because of
absence of any track record.
The financial sector in Pakistan comprises of Commercial
Banks, Foreign Banks, Development Finance Institutions (DFIs), Micro
Finance Banks (MFBs), Non-banking Finance Companies (NBFCs) (Leasing
Companies, Investment Banks, Discount Houses, Housing Finance Companies,
Venture Capital Companies, Mutual Funds), Modarabas, Stock Exchange and
Under the prevalent legislative structure, the supervisory
responsibilities in case of Banks, Development Finance Institutions (DFIs),
and Microfinance Banks (MFBs) falls within legal ambit of State Bank of
Pakistan, while the rest of the financial institutions are monitored by
other authorities such as Securities and Exchange Commission and
Controller of Insurance. Under the Banking Companies Ordinance 1962, the State Bank of
Pakistan is fully
authorized to regulate and supervise banks and development finance
During the year 1997, some major amendments were made in the
banking laws, which gave autonomy to the State Bank in the area of
banking supervision. The Ordinance made the responsibility of State Bank
to systematically monitor the performance of every banking company to
ensure its compliance with the statutory criteria, and banking rules &
regulations. In every case in which the management of a bank is failing
to discharge its responsibility in accordance with the applicable
statutory criteria or banking rules & regulations or is failing to
protect the interests of the depositors or for advancing loans and
finance without due regard for the best interests of the bank or for
reasons other than merit, the State Bank is empowered to take necessary
The State Bank is empowered to determine Statutory Liquidity
and Cash Reserve Requirements for banks/DFIs. Presently the Cash Reserve
Requirement is 5% on weekly average basis subject to daily minimum of 4%
of Time & Demand Liabilities. In addition to that banks are required to
maintain Statutory Liquidity Requirement (SLR) @ 15% of their Time &
Demand Liabilities. Similarly, DFIs are required to maintain SLR of 14%
and Cash Reserve of 1% of their specified liabilities. The banks have to
maintain a Capital Adequacy Ratio in a way that their capital and
unencumbered general reserves are, at the minimum 8% of their risk
weighted assets, and effective from
1st January, 2003
banks are required to maintain a minimum paid up capital level of Rs.1
At present there are 34 scheduled banks, 6 DFIs, and 2 MFBs
whose activities are regulated and supervised by State Bank of Pakistan.
The commercial banks comprise of 3 nationalised banks, 3 privatised
banks, 15 private sector banks, 7 foreign banks, 2 provincial scheduled
banks, and 4 specialized banks. The number of listed banks has gone up
to 17 in year 2004 as a result of mergers and acquisition. Five banks
are still not listed, which are Habib Bank, United Bank, Allied Bank of
Pakistan, Bank Alfalah, Dawood Bank. The leading foreign banks having
the intention to stay in Pakistan in the long-run are Standard Chartered
Bank, Citibank, Deutsche Bank and ABN AMRO Bank.
Therefore, it may be said that in nearly one and a
half-decade the proportion has virtually reversed. However, it is also a
fact that these four banks continue to enjoy a significant share in the
market, both in terms of deposits and advances.
The forecast of these banks staying in the country is based
on the fact that the management has been not only expressing their
intentions to stay in
but also supporting the words by acts. They have been investing heavily
in technology to overcome branch limitation as well as launching new
products and services and often emerge as the market leaders. Their
strength is evident in credit card business, consumer finance and
The transition in banking sector
is taking place at faster than expected rate. The growth in advances has
started matching growth in deposits. The quality of asset as well as
liability products have been improving that is evident from declining
non-performing loan portfolio. However, the real impact of enhanced
consumer finance, housing finance and lending to agriculture sector is
yet to be seen. The only fear is that some of the banks are not
following prudent policies, which is evident from
increasing provisions against
non-performing loans. It may be true that for the time being the
provisions may be a small percentage when compared with total advances
but it is the responsibility of the central bank to ensure that banks
follow the appropriate risk management policies. This can be ensured
through strict monitoring and imposing heavy penalties for the lapses.
It is the depositors' money and the custodians have no right to misuse
The recent wave of liberalization and financial reforms has
raised questions about the future prospects of the financial industry in
general and the banking industry in particular. In just four years the
banking industry has expanded tremendously and now there are more than
two dozen commercial and investment banks functioning in the country.
Over the last couple of years banks have been suffering from 'surplus
liquidity crisis' mainly due to low demand for credit. As a make shift
arrangement and taking the advantage of the bullish capital market some
of the banks increased their exposure in equities. This became a cause
of concern for the central bank and it issued the instructions to follow
the Prudential Regulations in letter and spirit.
However, some of the critics were
of the view that instead of asking the banks to meet the prevailing
benchmark, the central bank should have enhanced the limit. Lately, some
of the banks following pro-active strategy started investing in equities
to overcome 'surplus liquidity crisis'. However, it raised some concerns
and the central bank was quick in advising the banks to bring down their
investment in equities within
the limits stipulated in
Prudential Regulations. Banks have been given the timeframe to meet the
Still, costs remain extremely high in the public sector
banks. Inefficiencies and a carefree and indifferent attitude as service
is concerned are matters that have yet to be controlled by the top
management of most of
public sector banks. Foreign banks do have a small share, but this is
more by choice than by chance. The policy in general is to maintain
efficiency and keeping costs at a minimum.
The savings rate in the country is at about 15% which remains
one of the lowest compared to other emerging economies like
India (22%), Thailand
(30%) and Indonesia (40%). For a stable deposit base, which is
imperative for the smooth functioning of the financial sector to extend
affordable credit to different sectors of the economy, the country must
have a satisfactory savings rate. At the same time deposits are becoming
increasingly expensive and lending rates, with or without a cap on them
cannot be raised by banks beyond a certain limit. Blue chip clients, who
constitute the major portion of most of the banks' borrowers, do not pay
beyond a certain level of interest and hence banks are facing a tight
squeeze. The prime lending rates vary from 3 to 5 percent. The rate of
returns on government securities is fairly attractive, where all
scheduled commercial banks are required by prudential regulations to
keep 20 percent of their time and demand liabilities.
The five large scheduled commercial banks are, namely
National Bank of Pakistan, Habib Bank Limited and United Bank Limited
are owned by the Government of Pakistan. Although two other banks,
Muslim Commercial Bank and Allied Bank Limited were privatised in 1992,
the GoP still has significant stakes in them. These five large banks are
dominant in terms of total number of branches, deposits and advances,
collectively accounting for 78% and 77% of total deposits and advances
respectively. However, they are relatively less profitable than private
sector banks and foreign banks.
Private sector banks are relatively new compared to public
sector banks. The Sharif government opened up banking to the private
sector in 1991. The new banks formed as a result of this liberalisation
policy included Askari Commercial Bank, Bank Al Habib, Soneri Bank,
Prime Bank, Bolan Bank, Metropolitan Bank, Union Bank and KASB Bank.
There have been problems along
the way though as the corporate banking culture was still new to the
country and there were fiascos like Mehran Bank. These banks
are still very small in terms of
branch network and level of operations. They focus on very selective
market segments where they are quite successful. Despite a lower profile
in total deposits and advances, these banks account for 22% of the total
profitability of the sector.
Owing to the inefficiencies of the public sector scheduled
banks which stem from their nationalisation in the 70s, the relatively
lower standing of the private sector banks and the dollarisation of the
economy, foreign banks have been able to perform extremely well by
exploiting gaps in the local banking sector.
In times of slow economic activity and high inflation as is
the case with
the financial sector as a whole is likely to experience depression with
shrinking interest margins and troubled assets because of bad debts.
The paradigm shift in the commercial banking seems to have
started positive results. Growing deposits and ever increasing appetite
for credit by the private sector have provided the added impetus. Low
interest rates are encouraging the existing players to expand their
installed capacities as well as to undertake greater value addition. The
vibrant equities market also allows the bank to make large capital gains
as well as draw substantial dividend income from their investment
portfolios. The financial accounts released by commercial banks shows
that despite low interest rates and persistently growing operating
expenses, all the players have been able to post results better than
previous years. One of the factors contributing to improved profits was
the reduction in tax rate applicable on banking companies.
Commercial banks operating in
Pakistan can be divided into four
Nationalized Commercial Banks (NCBs),
2) Privatized Banks,
3) Private Banks and
4) Foreign Banks. The central
bank has been following a supervisory framework, CAMEL, which involves
the analysis of six indicators, which reflect the financial health of
financial institutions. These are
1) Capital Adequacy,
2) Asset Quality,
3) Management Soundness,
4) Earnings and Profitability,
5) Liquidity and
6) Sensitivity to Market Risk.
The commercial banks in the private sector have so far given
a satisfactory performance since their inception, registering an overall
growth in the deposit base and profits and are maintaining healthy
credit portfolios, the question that needs to be answered is about
future profitability of the industry in times of intense competition for
chasing cheap deposits and risk worthy borrowers.
Commercial Banks faced an
increase in operating expenses that can be attributed to the ongoing
branch expansion program. Another factor responsible for higher
operating expenses is the massive investment being made in upgrading the
existing branch network and substantial investment being made in
technology. The private
banks have been fully cognizant
of their limited branch work. To overcome this limitation they are
relying heavily on technology. The concept of 'bricks and mortar' branch
is being replaced by e-banking.
Another emerging phenomenon is 'dying commercial banks and
emerging financial super market'. Historically, commercial banks in
been maintaining checking accounts, providing working capital loans and
offering international trade related services and financing. However,
over the last decade they also ventured into leasing, housing and
consumer finance. Though the quantum of income generated through these
activities is still low, the growth in business volume has been very
significant. Since the market size is very large only the policies of an
institution limits its share.
The key to success for commercial banks is their deposit base
and this is where the real crunch is expected, particularly for the
newer banks. The deposit base is expected to grow but will probably not
be able to maintain a rate of 20 percent while the established banks
should not have a problem. The new commercial banks like Al Habib,
Union and Bank of Punjab are not expected to be any major competitors
for the established banks and their share in the national deposit base
is expected to stay meagre at around 5% with the share of foreign banks
at less than 25%. The nationalised banks have the lions share and along
with ABL and MCB account for about 80 per cent of the national deposit
Pakistan witnessed the
establishment of a commercial bank offering commercial banking based on
Sharia. The response has been overwhelming to the extent that most of
the banks have either established separate window for Islamic Banking or
are in the process of opening dedicated branches. Most of the banks were
not able to identify the size of Islamic Banking market and the
potential response from the clients, despite pressure for eliminating
Riba from banking. They chose to offer Islamic Banking in parallel with
conventional banking and allowed the clients to make their own choice.
The response has been beyond expectations.
At present the minimum paid-up capital requirement for listed
commercial banks is Rs 1,000 million. This should be enhanced to Rs
1,500 million by
December 31, 2004 and
to Rs 2,000 million by December 31, 2005. This can be achieved with
complete ease as shareholders' equity of most of the banks was around
this amount at the end of year 2002. Looking the financial results of
the banks for the year ended December 2003 it can be said with complete
confidence that meeting the enhanced capital requirement does not pose
any problem. However, meeting the requirement may be difficult for
couple of banks. These are the banks where there was a management change
The paradigm shift in commercial banking, resulting from
freezing of foreign currency accounts (FCAs) in May 1998 has affected
the foreign banks operating in
— to a large extent adversely. The recovery process, through changed
strategy, has started yielding positive results. Foreign banks are
expected to emerge stronger in the near future as
moves towards Internet-based banking. Still, the competition with
domestic banks is expected to remain ferocious.
Over the last many years, foreign banks have continued to
command nearly three-quarters of the overall profitability of the
banking sector in
in spite of the tight manacles on their expansion. Foreign banks chiefly
thrived on business from top-tier multinational corporations and blue
chip companies. The business of foreign banks operating in
in the past, also flourished due to FCAs and swap dollar funds — which
are no longer there.
The withdrawals from resident FCAs in the shape of rupee, was
quite dramatic during the second half of 1998, which continued in 1999 —
though at a lower pace. The bulk of converted amount eventually showed
up in the banking system but the share of foreign banks in total
deposits reduced. Domestic banks were able to increase their deposits
and advances mainly due to an elaborate branch network. The lottery
schemes of Habib Bank, United Bank and Muslim Commercial Bank drained
desposit's virtually from both domestic and foreign banks. With the loss
of low cost deposits and advances, profitability of a number of key
players in the financial sector came under pressure in 1998.
Bank of America was the first to decide to close its
As a result of global merger of ANZ Grindlays Bank into Standard
Chartered Bank, the amalgamated bank is expected to emerge financially
the strongest foreign bank in Pakistan. Many banking sector analysts
expect a few more closures and more mergers and acquisitions. They
estimate that within next five years the number of foreign banks in
Pakistan will come down to less than a dozen. However, these mergers and
acquisitions will be aimed at attaining synergy rather than due to
declining profit margin.
There are 6 foreign banks presently operating in the
Pakistan: ABN Amro,
American Express, Standard Chartered, Citi Bank, HSBC and Habib Bank AG.
The foreign banks have a strong presence in all the major cities and are
targeting high net worth individuals and blue chip companies. Their
strategy is quite successful as they account for 34% of total sector
profits, despite having only 15% of deposits and 16% of advances. To
achieve constant growth in size they have been using innovative
approach. Keeping in view the changing demands, the emphasis is more on
personalized service, electronic transfer of funds and sophisticated
financial products, etc. They offer innovative deposit schemes to remain
competitive in resource mobilisation.
Foreign banks have consolidated their edge in phone banking,
ATM network and on-line banking. Offer of these services has become a
norm at almost all the large-size foreign banks. While some of the banks
have installed their own ATMs, others have entered or are entering into
strategic alliance with other domestic and foreign banks. Offering such
facilities is capital intensive, however, helps in reducing human
resource cost, improving quality of services and above all bringing a
bank outside the four walls of conventional branch network. As foreign
banks largely cater to multinational companies and blue chip
corporations they would be able to offer better services and also cater
to larger number of clients.
Another important development, over the years, is that small
foreign banks have developed their own niche market. The foreign banks
of Middle East
origin concentrate more on handling remittance and international trade.
Even the large-size banks have added other services. Standard Chartered
Bank and Citibank provide custodian service to foreign investors in
capital markets. They have also started financing of cars and other
durable. Earlier, Citibank had established two separate entities, a
housing finance company and an investment bank. However, later on, it
sold its stake in investment bank to Jahangir Siddiqui and Company.
Citibank has also become a little more selective in distributing credit
According to some analysts foreign banks share about a
quarter of deposits and total advances within the banking system.
Traditionally, the foreign banks have focused on short-term trade
finance, targeting mainly low risk blue chip corporations and high
networth individuals. A couple of year's back, these banks began making
foray into merchant banking, capital market operations and
consumer/retail banking. The resources and expertise of their global
operations proved a valuable asset in these areas and many of them were
able to quickly capture large share in the capital market operations and
Foreign banks have enjoyed years of robust profitability,
however, to survive in the changed environment they will have to come up
with real innovative financial products. At the same time they will have
to identify new clients — other than multinational companies and blue
chip corporations. In the face of stagnant private sector industrial
growth and poor demand for credit, competition with domestic banks is
getting tougher with the passage of time. Domestic banks are also
fighting for their existence and are determined to intrude into an area
considered to be an exclusive domain of foreign banks in the past.
Leasing is an Islamic mode of
financing and is being widely practised throughout the world. Companies
have been mostly extending short and medium term credit
facilities to industries and
consumers, but still there is room for improvement, since many sectors
of the economy remain unexplored and neglected.
Lease finance by all means is the most suitable financing
arrangement for developing countries and especially
Pakistan. Despite the
fact that most banks of the country are facing surplus liquidity crises
and have unutilised funds, they are still not catering to the needs of
micro enterprises in an effective and efficient manner. The growth in
leasing companies has come in the backdrop of their ability to provide
mid-term financing to the industrial sector. The concept of leasing
gained acceptance and as a result a number of companies ventured into
Leasing has grown at about 20 percent in the last five years
and is expected to see a dramatic reduction in this growth rate because
of funding constraints faced by this sector. With an interest margin of
around 3 percent, the rise in US interest rates and the increase in the
local forward cover fee, leasing companies may find it hard to mobilise
lower cost funds from abroad in future. Companies having access to local
as well as foreign credit lines and backed by reputable groups could
outperform the market but these are few and far between.
However, competition is strict
and not just from banks but from leasing modarabas and now term finance
certificates being introduced by corporate. Less than half of the
leasing companies so far have
permission to issue certificates of investment and this further hampers
their ability to mobilise funds.
Those that have launched Certificates of Investments have had
a fair amount of success, which is a ray of hope for the sector.
Offshore credit lines were at one time a good source of low cost funds
but now the cost of drawing on these lines has increased tremendously.
The major problem faced by leasing companies is that of
mismatching maturities. Leasing companies will have to maintain a
sustainable growth rate for which they will need a perpetual flow of
funds. Mobilisation of funds is the main issue facing leasing companies.
In the prevailing circumstances, it will be a testing time for the
lessors. Innovative thinking is required to come up with new projects
for fund raising. Asset scrutinization as a vehicle to induct funds in
leasing companies has not traversed beyond the conceptual stage.
If leasing companies are to survive, they will need a change
in the regulatory and taxation framework. They do not have the customer
base that can ensure the growth of the industry as a whole. However, we
believe that as the concept of lease financing gains wider acceptance, a
trend that has seen favourable growth in the past few years, the
conditions for the sector should improve.
With the commencement of process of Islamization in mid
saw the dawn of Modarabas. The first ever Modaraba was listed in 1985
and the decade of nineties witnessed the largest number of listing. Over
the years, the total number of listed Modarabas touched as high as 48.
Modarabas are the most regulated financial sector with
several restrictions to the source of their funds and controls over
payoff timetables as well. Strict regulations implemented by the State
Bank of Pakistan (SBP) and the Securities and Exchange Commission of
Pakistan (SECP) have contributed substantially to dampening the future
prospects for this financial instrument, introduced by the Pakistan
government in the early eighties. It does not hold as much promise as it
once did now being hastily overshadowed by the rapid emergence of
Subdued economy during nineties, growing competition and
constraints in resource mobilization, which was one of the most serious
constraints, brought the balance sheet of a number of Modarabas into
red. Not only that the situation was a source of concern for the
Modaraba certificate holders, but regulators were also perturbed.
Modarbas has proved to be inadequate and the interests of the investors
and certificate holders have not been adequately protected.
Modarabas have not been able to diversify their products or
differentiate from other market players such as leasing companies. Today
75% of their business is concentrated on leasing which does not provide
any market niche or comparative advantage to them. The leasing portfolio
mostly covers traditional industries such as textiles, light
engineering, cement etc. New activities have by-passed the leasing
sector so far.
As an overall slowdown in the economy took place, Modarabas
appeared to be the most adversely affected, having to rely mostly on
borrowed resources from financial institutions for expansion.
Historically, Modarabas possess the best performing financial sector
stocks but without the financial backing or access to regular funding
lines from Islamic banks they are finding it difficult to sustain
earnings growth and operating income momentum. Since 1992, modarabas
have been facing a shortage of funds because of the SBP's regulation,
which directs the banks. At the same time Modarabas like other
investment financial institutions, have suffered a lot on their stock
holdings due to the below average performance of the stock markets.
The other constraints faced by
the Modarabas pertain to regulatory environment. The
Modarba Association of Pakistan is
actively pursuing with the regulators, the SECP and State Bank of
Pakistan (SBP). The Association has asked the regulators to specifically
amend the rules pertaining to borrowing of Modarabas from commercial
bank under Musharika arrangements. As per existing rules, Modarabas that
enjoy B3 credit rating are eligible for borrowing from the commercial
In late 1998, when some crucial measures were taken for the
restructuring of financial institutions and revival of economy, efforts
were also made to revitalize this important mode of Islamic financing.
Management of a number of ailing Modarabas was handed over to better
managed entities. Around the same time the process of mergers and
acquisitions was seriously looked into and since then a number of weaker
entities have been merged into financially strong Modarabas.
The single largest contribution of Modarabas is that they are
playing a dynamic role in the process of Islamization of financial
system in the country. They have the capacity to bring the change as an
appropriate infrastructure is in place with more than twenty years of
experience. Modrarabas are capable of undertaking any kind of business
that is in conformity with the Shariah. A large number of Modarabas are
engaged in the leasing business. Others are engaged in trading and
management. One modaraba is in
Modarabas are contributing towards the economic development
of the country. The close liaisons of the regulators with the MAP have
helped in improving working environment and capacity building of the
players. The recent mergers and acquisitions indicate the general shift
towards consolidation, much needed to usher in greater financial
stability and operational flexibility.
The major sources of funds are Morabaha and Musharika
financing. In Morabaha financing the modaraba sells it's assets to a
bank or other financial institution with an agreement to repurchase at a
higher price at some fixed time in the future. In Musharika financing
the modaraba and the concerned party, for example a bank, each
contributes capital on a profit and loss sharing understanding on the
basis of contributed capital. The Modaraba provides around 20 percent
capital up front with the bank generally providing the rest.
Local banks have a large network of
locations, including remote areas of the country, where the consumers
can access bank facilities. Foreign banks might have not seen investing
in remote areas as profitable, but it gives the local banks a clear-cut
edge in larger market share and consumer base.
The central bank policies are aimed at
strengthening commercial banks in general. They helped domestic banks
more while supporting foreign banks marginally. Some policies were
recovery of non-performing loans, exemption of accrued income at the
time of calculating tax liability and rules governing provisions against
Due to stringent corporate governance
standards, as well as lack of commitment when tackling the problem of
non-performing loans, the banking industry has never been able to
perform to its utmost potential.
Inefficiencies and a carefree and
indifferent attitude as service is concerned are matters that have yet
to be controlled by the top management of most of Pakistan's public
Adjudicating on an appeal filed by the State
Bank against the November 1991 decision of the Supreme Court against
interest-based banking, the Shariat Appellate bench upheld the original
verdict, which had declared the charging of interest as un-Islamic. Even
as of now, the government's response is not clear. As Pakistan is an
Islamic state, its banking sector has a few hurdles, which it has to
cross. This, in turn, has slowed down the progress of this sector.
Political instability through out the
existence has always been a major influence on the development of its
banking sector. Lack of investments in projects, trade sanctions,
freezing of foreign accounts and a feeling of insecurity amongst general
population, are a few significant reasons, which highlight the weakness
of today's banking sector of Pakistan.
There are a large number of banks and some
of them are undercapitalised, poorly managed with a scanty distribution
* 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.
Family-owned businesses and small businesses
are reluctant to disclose information to banks to obtain loans, which
may result in frauds or money laundering.
The local banks need to diverge more of
their time and resources towards electronic banking. There is a surge of
demand amongst local population to use online banking, as it is hassle
free and saves time. Local banks need to upgrade their technology and
utilize this opportunity, because at the moment, no bank has fully
exploited this venture.
Agriculture, small and medium enterprises
and housing sectors are underserved and have limited access to credit.
It is potentially a huge market which local banks can reach into. With
good marketing and careful planning, local banks can make the most of
this opportunity, especially in the agricultural sector, as local banks
have the infrastructure already in place, to reach remote places within
The biggest threat to local bank comes
from foreign banks and the competition they bring into the banking
sector. Automation and greater use of technology by foreign banks has
improved the standards and quality of services. If local banking sector
does not react to this situation quickly enough, soon the foreign banks
will take over their market share.
Pakistani banks have a majority of the market share, but one needs to
look at profit margins of both foreign and local banks to really assess
the inefficiencies or the lack thereof. If the local banks do not make
themselves more efficient and introduce some drastic cost cutting
measures, they will soon loose not only their market share but also
their own capacity to operate.
FIVE LARGE LOCAL BANKS
Habib Bank Ltd
Habib Bank AG
The essential feature of Islamic Banking is that it is
interest-free. Although it is often claimed that there is more to
Islamic Banking, such as contributions towards a more equitable
distribution of income and wealth, and increased equity participation in
the economy, it nevertheless derives its specific rationale from the
fact that there is no place for the institution of interest in the
Islamic order. The Islamic ban on interest does not mean that capital is
costless in an Islamic system. Islam recognises capital as a factor of
production but it does not allow the factor to make a prior or
predetermined claim on the productive surplus in the form of interest.
At the deposit end of the scale, Islamic banks normally
operate three broad categories of account, mainly current, savings, and
investment accounts. The current account, as in the case of conventional
banks, gives no return to the depositors. It is essentially a
safekeeping (alwadiah) arrangement between the depositors and the bank,
which allows the depositors to withdraw their money at any time and
permits the bank to use the depositors' money.
Modaraba and Musharaka constitute, at least in principle if
not in practice, the twin pillars of Islamic Banking. The Musharaka
principle is invoked in the equity structure of Islamic banks and is
similar to the modern concepts of partnership and joint stock ownership.
In so far as the depositors are concerned, an Islamic bank acts as a
Mudarib, which manages the funds of the depositors to generate profits
subject to the rules of Modaraba as outlined above. The bank may in turn
use the depositors' funds on a Modaraba basis in addition to other
lawful modes of financing. In other words, the bank operates a two-tier
Modaraba system in which it acts both as the Mudarib on the saving side
of the equation and as the rabbulmal on the investment portfolio side.
The bank may also enter into Musharaka contracts with the
users of the funds, sharing profits and losses. The savings account is
also operated on an al-wadiah basis, but the bank may at its absolute
discretion pay the depositors a positive return periodically, depending
on its own profitability. The investment account is based on the
Modaraba principle, and the deposits are term deposits, which cannot be
withdrawn before maturity. The profit-sharing ratio varies from bank to
bank and from time to time depending on supply and demand conditions.
Pakistan, it was the government's initiative and covered all banks in
the country. The government took steps in 1981 to introduce
interest-free banking. In Pakistan, effective January 1, 1981 all
domestic commercial banks were permitted to accept deposits on the basis
of profit-and-loss sharing (PLS). New steps were introduced on January
1, 1985 to formally transform the banking system over the next six
months to one based on no interest. From July 1, 1985 no banks could
accept any interest bearing deposits, and all existing deposits became
subject to PLS rules. Yet some operations were still allowed to continue
on the old basis.
One of the main selling points of Islamic Banking, at least
in theory, is that, unlike conventional banking, it is concerned about
the viability of the project and the profitability of the operation but
not the size of the collateral. Good projects which might be turned down
by conventional banks for lack of collateral would be financed by
Islamic banks on a profit-sharing basis. It is especially in this sense
that Islamic banks can play a catalytic role in stimulating economic
development. In many developing countries, of course, development banks
are supposed to perform this function. Islamic banks are expected to be
more enterprising than their conventional counterparts. In practice,
however, Islamic banks have been concentrating on short-term trade
finance which is the least risky.
The main problem, both for the banks and for the customers,
seems to be in the area of financing. Bank lending is still practised
but that is limited to either no-cost loans (mainly consumer loans)
including overdrafts, or loans with service charges only. Both these
types of loans bring no income to the banks and therefore naturally they
are not that keen to engage in this activity much. That leaves us with
investment financing and trade financing. Islamic banks are expected to
engage in these activities only on a profit and loss sharing (PLS)
basis. This is where the banks' main income is to come from and this is
also from where the investment account holders are expected to derive
their profits. And the latter is supposed to be the incentive for people
to deposit their money with the Islamic banks. And it is precisely in
this PLS scheme that the main problems of the Islamic banks lie.
With only minor changes in their practices, Islamic banks can
get rid of all their cumbersome, burdensome and sometimes doubtful forms
of financing and offer a clean and efficient interest-free banking. All
the necessary ingredients are already there. The modified system will
make use of only two forms of financing — loans with a service charge
and Modaraba participatory financing — both of which are fully accepted
by all Muslim writers on the subject.
The only exception in Islamic Banking from conventional banks
seems to be in the case of letters of credit where there is a
possibility for interest involvement. However, some solutions have been
found for this problem — mainly by having excess liquidity with the
foreign bank. On the deposit side, judging by the volume of deposits
both in the countries where both systems are available and in countries
where law prohibits any dealing in interest, the non-payment of interest
on deposit accounts seems to be no serious problem. Customers still seem
to deposit their money with interest-free banks.
The main problems faced by the Banking Sector in
Most of the financial assets and deposits are owned by nationalised
commercial banks (NCBs) which suffer from a highly bureaucratic
approach, overstaffing, unprofitable branches and poor customer service.
NCBs along with specialized banks such as ADBP, IDBP and Development
financial institutions such as NDFC have a high ratio of non-performing
Banking industry faces
a high tax rate which is at 50%, which affects its profitability and
attractiveness for new entrants.
There is a
proliferation of banks and some of them are undercapitalised, poorly
managed with a scanty distribution network.
Agriculture, small and medium enterprises, housing sectors are
underserved and have limited access to credit.
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.
The recent mushrooming of banks in the country could have
become a boon if the growth in the economy had been proportional.
Unfortunately, the growth in the industry has been slow and hence banks
have had to fight for customers. The financial sector has failed to keep
pace with other markets in the region. The race for intensifying
deposits has already started and the trend in 1996 shows that people are
moving away from long -erm deposits making it increasingly difficult for
the smaller banks to develop a strong deposit base. With the economy so
far not showing any substantial and fundamental improvement and with
retardation in industrial growth, banks should not be looking at a
significant growth in the short-term. However, with prospects of an
improvement in the operational side as well as the hope that industrial
growth will pick up, banking is looking at a bright future in the
In comparison with other emerging economies,
Pakistan has a
relatively underdeveloped financial sector in terms of the depth of the
financial system and the extent of financial intermediation. The depth
of a financial institution refers to the use of money and close money
substitutes such as savings and time deposits, which is very low in
Many of the newer banks have no provisions in their
portfolios for bad debts, which might not appear important at present
but in a period of say three to four years, when loan recovery starts
this shortcoming in the portfolio could become a serious threat to
earnings. The prospective investor should definitely keep this in mind
when playing the Stock Market. Perhaps it would be prudent if the State
Bank of Pakistan
makes it mandatory for all banks to make their portfolios public.
With the steps being taken to improve financial
infrastructure in the country, the drive to streamline the large public
sector banks has a greater probability of being implemented. The
steadily growing economy will also create a more dynamic role for banks'
policies. Human capital is adequately placed to assume its role in this
reform process. Although there are concerns in certain areas that the
outlook for the sector is positive.
To effectively carry out banking reforms, problems related to
non-bank financial institutions (NBFIs), corporate governance;
accounting and audit practices have to be addressed simultaneously.
Without a legal environment that enables the enforcement of contracts
banking sector reforms do not work. However, since the 1997 banking
sector reforms situation is improving now. The system of risk-weighted
capital was introduced and banks advised to maintain capital at least 8
per cent of risk-weighted assets effective from December 1997. The
Capital Adequacy Ratio (CAR) for commercial banks was at 12.1 per cent
at the end of 2003, far higher than the International Basel Capital
Pakistan, 90 per cent of total bad loans are loans of government banks,
which historically granted loans at government behest and which in
general, performed much more poorly than private sector banks. Stringent
provisioning standards, however, have helped bring down the net NPL
ratio steadily to the present single-digit levels in both India and
During 2003, Pakistani banks made handsome gains, showing
major recovery in deposits and advances, and booked huge capital gains
on their equity and fixed income investments. After tax profits of the
banking sector grew by 76 per cent (an increase of Rs 12.1 billion) in
2003 to reach Rs 28.2 billion, as compared to Rs 16 billion in 2002.
Before tax profits reached Rs 46.3 billion in 2003, showing growth of 51
per cent (Rs 15.7 billion) over Rs 30.6 billion last year. Net interest
income of the banking sector increased by Rs 7.5 billion (13 per cent),
and reached Rs 65 billion in 2003. Non-interest income reached Rs 44.7
billion in 2003, an increase of Rs14.8 billion (49 per cent). Total
expenses of the banks increased to Rs 62.9 billion, an increase of Rs
6.4 billion or 11 per cent.
Due to the emerging need of quality management system
implementation in banking industry now is the time for to move about
"paradigm shift." The commercial banks must pay attention to this shift
and start thinking strategically for providing high quality products and
services to customers. They should determine where improvement is
needed, how service can be improved and where operating system
breakdowns occur, why they occur and how they can be avoided.