NEW SHAPE OF BANKING

The initiative of players is fully supported by the regulators

By SHABBIR H. KAZMI
Oct 25 - 31, 2004

The financial sector in Pakistan has emerged stronger and exhibits an increased resilience to shock. In the early nineties it was dominated by state-owned banking system that has been transformed in to one that is predominantly under the control of the private sector. The legislative framework and the State Bank of Pakistan's supervisory capacity have been improved substantially. The banks have learnt that by broadening their client base, adding new products to their portfolio and offering new types of services, they can diversify their risks as well as earn higher returns.

The economies of scale and economies of scope make these goals quite feasible. However, it is necessary to remember the words of Dr. Ishrat Husain. He was right is saying that only those who have imagination, agility and capability will be successful while others will fail. Reckless lending or optimistic forecasting that the current low interest rate environment will remain unchanged in times to come is bound to get their institutions into deep trouble. He urged them to be enterprising but prudent, strategic but not risk averse and flexible but not too indulgent in reaching out to the small farmers, small firms or individuals with microfinance or consumer financing needs.

Financial sector has been paying adequate attention on developing new products on the asset side but neglecting the savers and depositors. It is myopic approach to follow one-sided approach as it is the savers and depositors who provide the wherewithal for the industry to perform its basic function of intermediation. The banks and non-bank institutions have to come up with innovative solutions tailored to the needs of millions of depositors and savers. It is a wake-up time to begin looking after the interest of this vast majority of small savers and mobilize and utilize their savings in a much better way than the way it has been done in the past. Development of new liability products should be on the top of the agenda.

At the national level the biggest opportunity is to integrate into international financial market. Entry of foreign investors in the banking industry of Pakistan is very important 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 into new business areas Consumer loans, mortgage financing, SME financing and agriculture lending.

These 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 build up 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. 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.

With foreign exchange regime being gradually liberalized and partial capital account convertibility has been achieved further measures need to be undertaken to open up the market for cross-boarder risk products to private wealth managers and well established corporate houses.

Capital requirements of the banking sector have to be adequate in relation to the risk weighted assets and conform to the Basel 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 one billion rupees to one and a half billion rupees by this year end and to further enhance to two billion rupees by end of 2005. Otherwise, they will no longer be allowed to carry out full banking activities as scheduled banks. This is expected to lead to mergers and acquisitions for consolidation and weeding out of weaker players.

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.

A number of incentives have been provided to encourage mortgage financing by the banks. The upper limit has been raised and tax deduction on interest payments on mortgage has been allowed. 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.

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. The SBP has included financing for silos, godowns, refrigerated vans, agro processing and distribution under the cover of this scheme. This broadening of the scope as well the removal of other restrictions has enabled the commercial banks to increase their lending for agriculture. 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.

The banks are adopting electronic banking as a norm. There is a big surge among the banks including NCBs to upgrade their technology and on-line banking services. In the recent past a large expansion in the ATMs number has been witnessed and the number is increasing at a very fast pace.

The decision mandating the banks to join one of either two ATM switches available in the country has provided 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 branch and the similar transaction over the Internet costs a mere fraction of the traditional teller costs.

The banking supervision and regulatory capacity of the central bank has been strengthened. Merit-based recruitment, competency-enhancing training, performance-linked promotion, technology-driven 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 and 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.

The banking sector, which was fully dominated by state-owned entities, has been opened up to the private sector. Four out of five largest NCBs have been privatized. While the ownership and management of the banks by private sector is one pillar of the reforms, the other pillar is a strong regulatory environment. The private banks are prone to taking excessive risks in their lending as their own capital is much lower in relation to the depositors' money. They can realize the large upside potential from high-risk assets while the defaults and losses in event of downside scenario are borne disproportionately by the depositors.

It is the responsibility of the central bank as a regulator to be extremely vigilant and take prompt timely action to prevent the bank managers and owners from assuming excessive risks. The central bank has strengthened its capacity by acquiring new skills, upgrading the quality of the existing human resources base, adopting technology and re-engineering business processes. The banking regulation and supervision are risk-based and are fully compliant with the international standards and codes prescribed by Basel Committee. The risk management practices are being modified to conform to Basel II rules. The financial soundness indicators show a healthy and sound banking system with high degree of financial stability.

The banking sector has now diversified its product base and carried out a lot of innovation. They have expanded their reach to agriculture, SMEs, mortgage financing and consumer financing. Not only that this diversified lending portfolio mitigates risks but it also raises the purchasing power of a large segment of population that was completely shut out from credit markets. Pakistan's auto industry has expanded its car production by a multiple of five times in the last four years as auto financing enabled a vast number of middle class income earners to purchase the cars on monthly installments.

The affordability of these new products by the middle class became possible as the prudent fiscal and monetary policies pursued by the Government left a lot of liquidity in the banking system. The healthy competition among banks, lower taxation and reduction in non-performing loans brought about a lowering of average interest rates. The Government, by reducing its fiscal deficit and public sector enterprises by making cash profits, freed up loan-able funds for the use of the private sector. The central bank by pursuing an accommodating monetary policy did not mop up excess liquidity and helped the businesses and consumers to access funds at historically record low levels.

Pricing and remuneration for most of the financial services are now determined by banks on a competitive basis. There are no directions or interventions by the State Bank of Pakistan or the Government. Prior to the reforms, there were subsidized lending rates for priority sectors and the rate paid by the Government on its borrowing through banking system was artificially pegged at below market rates. Banks and other financial institutions are free to set their own lending and deposit rates. Government and public sector enterprises have to pay market-based interest rates on debt raised through the banking system.

The State Bank of Pakistan has adopted a new system of monitoring, surveillance and supervision of banks and development finance institutions. The system formally known as 'Institutional Risk Assessment Framework' (IRAF) is aimed at ensuring continuous and proactive monitoring of these entities.

With the privatization of Habib Bank almost 80 percent of banking has been placed in the hands of private sector. Therefore, the central bank has to step up its vigilance and watchdog functions in order to protect the interests of the depositors, prevent possible emergence of systemic problems in the financial sector, discourage private banks from taking excessive and unmanageable risks and take timely remedial measures. The previous system of monitoring and supervision served its purpose well when the banks were owned by the government but market based transactions, promotion of healthy competition and, improving the efficiency and services to customers require a different and new approach.

Under the new system, the central bank has to follow a cohesive supervisory approach whereby the findings from on-site inspection, periodic reports from off-site surveillance and market information will be integrated to produce a comprehensive assessment and composite internal risk rating of each banking institution. The banks which have low ratings or show high probability of deterioration in financial soundness will then be taken up for prompt corrective action.

In this regard one of the major moves has been the change of ownership of Allied Bank of Pakistan. The Ibrahim Group, which has injected Rs.14.2 billion into capital of the Allied Bank of Pakistan (ABL) for acquiring its 325 million additional shares, assumed the control of the Bank. Speaking on the occasion, the SBP Governor has termed the successful reconstruction of ABL as beneficial both for the organization as well as for the banking industry. He expressed the hope that the transfer of the management of ABL to a strategic investor will turnaround the bank and usher in a new era of growth and stability in the banking sector. The Ibrahim Group were the successful bidder as they offered the highest bid of Rs.14.2 billion for acquiring these additional shares, which constitute 75.35% of the revised capital of ABL.

Yet another move to facilitate masses in borrowing from the organized system has been the establishment of micro finance institutions in the country. The State Bank of Pakistan has issued a licence to Rozgar Micro Finance Bank to undertake the business of micro financing in Karachi. The licence of this new micro finance bank was handed over to Mr. Badr-ud-Din Khan, Chairman, Rozgar Micro Finance Bank in Karachi recently. This is the fourth Micro Finance Bank, licensed by the Central Bank. Out of the three already licensed micro finance banks, Khushhali Bank and First Micro Finance Bank have a nationwide operations network whereas Network Microfinance Bank and Rozgar Micro Finance Bank are district based.

The story will be incomplete without talking about Islamic banking initiative of the central bank that is fully supported by the government. The latest addition to the list of conventional banks opening up designated Islamic banking branches is Bank Al Habib. With the issuance of this licence, the total number of conventional banks that are having stand-alone Islamic Banking branches has increased to six (6). Five other banks that have been issued licences for Islamic Banking Branches include Muslim Commercial Bank (3 branches), Bank Alfalah (7 branches) and one branch each of Habib Bank AG Zurich, Bank of Khyber and Standard Chartered Bank. One full-fledged Islamic Bank, viz. Meezan Bank with licence for 14 branches is already operating since March, 2002. Yet another bank, Bank Islami is expected to commence its operation by next year.

The central bank is now issuing licences for setting up of Islamic Banks, Islamic Banking subsidiaries and Islamic banking branches. The addition of new players in the market will ensure better services to the customers of Islamic Banking. The future of Islamic Banking industry in Pakistan is extremely promising due to growing demand from the customers. It is heartening to note that the State Bank in promoting Islamic Banking in the country is following a proactive approach.

Commercial banks in Pakistan are emerging stronger. However, the growth also poses challenges. As a whole, Pakistan's financial sector has to scale up its activities in catering to the needs of the middle and poor income groups. The broad direction in which the sector need to move are:

1) The client base has to expand from 2 million to at least 5 million borrowers in the next five years.

2) New products have to be introduced particularly for consumer, SME and agriculture financing.

3) Loans for education and health, both at the individual level as well as for providers of services, have to be stepped up.

4) Infrastructure loans to District and Union Council levels will fill in the community needs at the grassroots level.

5) Leasing and modaraba companies have to extend their geographical coverage to rural and peri-urban areas.

6) Widespread use of electronic and mobile banking channels will reduce the transaction costs while extending the outreach to a large segment of population.