COMMERCIAL BANKS

Emerging stronger under the new regulatory regime

By SHABBIR H. KAZMI
Feb 07 - 13, 2005

Today the financial sector of Pakistan is far stronger than that of nineties. The growing strength is attributed to the overall improvement in the macroeconomic conditions. However, it is also true that the central bank has been following a very pragmatic approach, with the aim that only a stronger financial sector can help in ushering economic growth in the country.

According to Dr. Ishrat Husain, Governor, State Bank of Pakistan, banking sector reforms cannot be successfully implemented and sustained in the absence of a favorable and stable macroeconomic environment. Pakistan's track record in macroeconomic management and governance during the 1990s was dismal. However, the present economic managers led by President, General Pervez Musharraf, , which came to power in October 1999, embarked upon a serious program of macroeconomic stabilization, structural reforms, good governance and the establishment of credibility with international financial institutions. Despite several major exogenous shocks, including September 11, the mobilization of troops on the Indian border, severe drought and incidents of terror attacks, the country has been able to make a dramatic turnaround in its economic indicators.

The positive indicators include increase in GDP growth rate and a primary surplus on budget, inflation rate effectively managed and the current account pointing a surplus. The debt servicing has become sustainable and foreign exchange reserves grown from as low as US$1 billion to well above US$12 billion. In addition, this period witnessed the lowering of the interest rate structure, the appreciation of the exchange rate rather than following the historical 10 percent annual depreciation and a record growth in remittances. All this amply demonstrates the seriousness of efforts made.

The GDP growth has very encouraging. The sustained growth rate of about 6 percent had a positive impact on the level of poverty, which had doubled during the decade of the 1990s. The progress in trade and tariff reforms, tax administration, financial sector, privatization and deregulation was quite significant, but it has still some way to go before it makes a visible difference. Corruption at higher levels of decision making has come down significantly. The strong accountability mechanism was able to secure successful convictions of politicians, senior bureaucrats and businessmen who were previously considered untouchable. Poverty targeted interventions and social sector developments were given high priority and poverty reduction was recognized as a major policy objective.

Pakistan successfully completed its stand-by program with the IMF in 2000-01, drawing all the three tranches on time. It also successfully completed the medium-term Poverty Reduction and Growth Facility (PRGF). It is for the first time that the country, known as single tranche country has demonstrated such a high degree of responsible performance and adhered to the course steadfastly, notwithstanding most difficult internal and external conditions.

Pakistan offers a wide spectrum of financial institutions commercial banks, specialized financial institutions, national savings schemes, insurance companies, development finance institutions, investment banks, stock exchanges, corporate brokerage houses, leasing companies, discount houses, micro-finance institutions and Islamic banks. All these offer a wide range of products and services both on the assets and the liabilities side. Financial deepening intensified during the last several years but the commercial banks are by far the predominant players accounting for 90 percent of the total financial assets of the system.

The commercial banks, both foreign and domestic, together hold bulk of the banking system assets a feat that is unparalleled among developing countries. Foreign banks enjoy the same facilities and same access as the domestic banks and there is no preferential treatment for domestic institutions. Unlike many other countries, foreign banks are allowed to have 100 percent ownership, can open their branches or establish local subsidiary with full ownership. Foreign companies are also provided level playing fields as they can raise all types of finances and tenures from the domestic banking system.

The present structure of banking system has emerged from a number of deep-rooted reforms that have taken place over the years. The banking sector, which was fully dominated by Nationalized Commercial Banks (NCBs) until a few years ago, 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. 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 case of downside scenario are disproportionately higher for 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 in Pakistan 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 out 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 shunted out from credit markets. One of the exhibits of the success is Pakistan's auto industry, which has expanded its car production by a multiple of five times over the years. The auto financing enabled a vast number of middle class income earners to purchase the cars on monthly installments.

One may say thousands of words praising the success of but it only become credible when properly acknowledged by the international donors. Most of the agencies have been critical in the past. However, their perceptional about the country has also changed. A joint IMF-World Bank Mission consisting of 16 experts drawn from all over the world visited Pakistan in February and April 2004 to carry out a comprehensive assessment of the Financial Sector in Pakistan. The Mission, which reported its findings to the Executive Board of IMF, was very positive about Pakistan's banking system and the central bank. The Mission concluded, "Far reaching reforms have resulted in a more efficient and competitive financial system. In particular, the predominantly state-owned banking system 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. As a result, the financial sector is sounder and exhibits an increased resilience to shock".

These reforms undertaken in the recent past have created a healthy competitive environment and at the same time, strengthened the capacity of the regulator to oversee and supervise the banking system in an effective and efficient manner. The agenda for future reforms is even more daunting and challenging than whatever modest achievements have been made so far.

At this juncture, it is necessary to examine the role of the State Bank of Pakistan in these reforms and also to evaluate its performance. The State Bank of Pakistan has four major functions to perform under the law: 1) Ensuring Soundness of the Financial Sector, 2) Maintaining Price Stability with Growth, 3) Prudent Management of the Exchange Rate and 5) Strengthening of the Payment System.

It was felt and agreed between the Government and the State Bank of Pakistan that major deep-rooted reforms had to be undertaken as cosmetic changes have not yielded tangible results. As a regulator and supervisor as well as adviser to the Government, the SBP carried out diagnostic studies, prioritized the constraints facing the banking sector, designed the reform strategy and action plan, sought the assistance of the Government of Pakistan and international financial institutions, monitored the progress and made policy, regulatory and institutional changes to facilitate the process. The continuity of reforms and sound policies that transcend political partisanship and survive political regime changes has yielded positive results. It may take pages to explain the various initiatives but can be summarized as follows:

PRIVATIZATION OF NCBS

All the nationalized commercial banks, except one, have been privatized. As a consequence their domination of the banking sector has been reduced from almost 100 percent in 1991 to about 20 percent by June 2004. Even in the case of National Bank of Pakistan 23.5 percent shares have been floated through Stock Market mainly aimed at small retail investors.

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 and enforce good governance practices to improve internal controls and bring about a change in the organizational culture.

CAPITAL STRENGTHENING

Capital requirements of the banking sector have to be adequate to ensure a strong base, ability to compete and withstand unanticipated shocks. The minimum paid up capital requirements of the banks have been raised from Rs500 million to one billion and have again been raised to Rs2 billion (by December 31, 2005). This has already resulted in mergers and consolidation of many financial institutions and weeding out of several weaker banks from the financial system.

IMPROVING ASSET QUALITY

The stock of gross non-performing loans (NPLs) that amounted to Rs252 billion and accounted for 22 percent of the advances of the banking system and DFIs have been reduced to Rs225 billion i.e. 14 percent of advances. More than two-third of these loans are fully provided for and net NPLs advances ratio has come down to as low as 5 percent for the commercial banks. The positive development is that the quality of new loans disbursed since 1997 has improved and recovery rate is 95 percent.

LIBERALIZATION OF FOREIGN EXCHANGE REGIME

Pakistan has further liberalized its foreign exchange regime and set up foreign exchange companies to meet the demands of Pakistani citizens. Pakistan's corporate sector companies have also been allowed to acquire equity abroad. Foreign registered investors can bring in and take back their capital, profits, dividends, remittances, royalties, etc. freely without any restrictions.

CONSUMER FINANCING

By removing restrictions imposed on nationalized commercial banks for consumer financing, the State Bank of Pakistan has given a big boost to consumer financing. Middle class employees can now afford to purchase cars, TVs, air conditioners, VCRs, etc. on installment basis. This, in turn, has given a large stimulus to the domestic manufacturing of these products.

MORTGAGE FINANCING

A number of incentives have been provided to encourage mortgage financing by the banks. The upper limit has been raised from Rs5 million to Rs10 million. Tax deduction on interest payments on mortgage have been allowed up to a ceiling of Rs1 million. The new recovery law is 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.

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) Ordinance, 2001. The new recovery laws ensures 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.

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.

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.

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 is the most appropriate method to assist the SME financing needs. 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.

TAXATION

The Government has already reduced the corporate tax rate on banks from 58 percent to 41 percent during the last four 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 two years. This will, in turn, help in reducing the spread between the deposit rate and lending rate and benefit financial savers.

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. The broadening of the scope as well the removal of other restrictions have enabled the commercial banks to substantially 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 achieved consistently rising higher targets every year. The private commercial banks have also agreed to step in and increase their lending to agriculture.

ISLAMIC BANKING

Pakistan has introduced Islamic banking system to operate in parallel with the conventional banking providing a choice to the consumers. A large number of Pakistanis have remained withdrawn from commercial banking because of their strong belief against riba-based banking. These individuals and firms mainly middle and low class will have the opportunity to invest in trade and businesses by availing of loans from Islamic banks and thus expand economic activity and employment. A full-fledged Islamic bank has already opened the doors for business and several banks have branches exclusively dedicated to Islamic banking products and services. The State Bank of Pakistan has set up a full-fledged Islamic Banking Department and a Shariah Advisory Board which will help in the promotion of Islamic banking in the country.

E-BANKING

There is a big surge among the banks including NCBs to upgrade their technology and on-line banking services. During the last three years, there has been a large expansion in the ATMs and at present about 700 ATMs are working throughout the country. The decision mandating the banks to join one of either two ATM switches available in the country has provided a further boost. Progress in creating automated or online branches of banks has been quite significant so far and it is expected that by 2005 almost all the bank branches will be online or automated. Utility bills payment and remittances would be handled through ATMs, Kiosks or Personal Computers reducing both time and cost.

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 almost come to an end as the private owners want to attract and retain the best available talent which can maximize their profits. 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 leadership in the future.

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 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.

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, 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 Exchange Commission. The SBP itself has been divided into two parts one looking after central banking and the retail banking for the government.

PAYMENT SYSTEMS

Finally, the country's 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.

THE OUTCOME

The State Bank has been working for the last five years to contain the lending rates to the extent that middle and low-income professionals, who have no other source than their monthly income, may get a home or a car on installments from the banks. If he/she is a small entrepreneur he/she can get loans from SME. Agriculture, the largest sector of economy, which the commercial banks had neglected, has now begun to receive large allocations. The commercial banks are giving more agriculture loans than the ZTBL. If this trend persists, the rural households will be able to intensify the use of modern inputs and raise their productivity and income.

Credit cards, debit cards, personal loans and consumer durable loans are catching up fast. Refrigerators, air conditioners, VCRs, Televisions are now available on credit. The consumers are forced to save when a specific amount is cut from their salary every month to pay the installment. Mortgage financing is one way in which wealth is created. In this way, growth of the middle class wealth takes place through judicious use of bank credit. As the lending rates have come down drastically from 21% to 5% the banks find it profitable to extend the customer base for mortgage and auto loans, agriculture credit, small business and consumers.

For the first time in the history of Pakistan, the middle class is beginning to benefit from the banking system. Before these reforms, only 400,000 farmers used to get loans from the Agriculture Development Bank, but this year, more than one million farmers have been extended loans by the banking system.

For the poor, who don't have anything to mortgage, microfinance banks have been established where no collateral is required. They can get up to twenty five thousand rupees as micro loans. Many people have availed this opportunity, some bought a cow, some bought a buffalo or opened a small shop and female borrowers bought sewing machines. They have started income-generating activities and recovery is no problem from the micro-finance banks. Approximately, 125,000 poor people have been given loans in the last two years.

One of the adverse effects of lower interest rates in the country has been erosion of rates of returns on bank deposits. Small depositors who keep their savings in the banks have been badly hurt as they hardly get a decent return these days. The Government, therefore, had to come up with some scheme to safeguard the most vulnerable groups of our society whose only source of livelihood is their savings. To compensate the senior citizens, pensioners and widows "Behbood Scheme" has been launched through which they get 10.25% per annum.

As interest rates move up in the economy, it will be the depositors who will get the benefit while the borrowers will have to a pay higher price. This is the normal cycle through which market-based economies work. If the country decides to live with this type of economy, it has to bear the costs along with its benefits. But it is the responsibility of the government to protect the poor and vulnerable groups of the society.

In a nutshell, banking sector reforms have brought in competition within the system, improved internal efficiency, reduced the lending rates significantly and broadened access to the middle class. While these results are encouraging, a lot more needs to be done. The government has spelt its agenda for the second generation reforms in the financial sector covering the period 2005-2010.