Second generation reforms are aimed at further strengthening the system and extending its outreach

Mar 21 - 27, 2005

In the nineties it was often felt that commercial banks were there to serve the government and the corporate sector to some extent. However, in the new millennium the landscape seems to have changed completely. All the banks operating under the state control, except National Bank of Pakistan, are now working in the private sector. Areas like agriculture loans and consumer finance, grossly ignored in the past are driving the growth of commercial banks. The credit for this transformation goes to the central bank.

Under the able guidance of its Governor, Dr. Ishrat Husain, the State Bank of Pakistan, launched the first generation reforms. The successful implementation gave the courage to undertake second generation reforms. The process has already started and the positive point is that all the players are actively participating to strengthen the financial system of the country. The regulatory framework is not being altered by the central bank unilaterally. Rather the rules are being amended in full consultation. This gives a sense of ownership and change is not being resisted.

A question may come to the minds, why at all these reforms are needed? To find the reply one has to peep into the history, particularly the performance of commercial banks under the state control. The fact is, under the state control banks were catering basically to the needs of government and subsidizing the fiscal deficit but no attention were paid to small and medium enterprises, housing finance and agriculture sector. The financial system suffered from political interference in lending decisions.

In those days, government's fiscal deficit was so high that most of the deposits the banks had, were loaned to the government and public sector enterprises. This was considered risk-free lending and was also yielding good returns. Banks were least interested in lending to the private sector. On top of this bureaucratic approach, overstaffing, unprofitable branches and poor customer service led to very high administrative cost, leading to low profits. Recovery rate was so low that almost 25% of total loans were delinquent. Due to lending on political considerations, borrowers also became habitual defaulters. All these factors pushed the interest rates beyond 20% per annum and it became almost impossible for the middle cast borrowers to get credit and pay it back.

Therefore, there was no option but to undertake grass-root reforms to overcome the ailment, which was not only bad for the financial system but also affecting economic growth of the country. The philosophy behind the banking sector reforms is 'financial sector development and economic development are inter related'. No economy can grow and improve the living standards of the population in the absence of a well functioning and efficient financial sector. Banks in Pakistan account for 95% of the financial sector. Therefore, economic development and growth of the country is directly dependent on a vibrant banking system.

The most encouraging fact is that banking sector has undergone basic transformation. Far reaching reforms have resulted in a more efficient and competitive financial system. The pre-dominantly state-owned banking system has been transformed into one that is now mostly working under the private sector. The legislative framework and the State Bank's supervisory capacity have been improved substantially. Even the critics acknowledge that the financial system is sounder and exhibits and increased resilience to shocks. However, there is no room for complacency and a lot remains to be done.

Arriving at the conclusion that there has been overall improvement, it may also be necessary to examine the role being played by the central bank. The State Bank of Pakistan has four functions to play: 1) Ensuring soundness of the financial sector, 2) Maintaining price stability with growth, 3) Prudent management of the exchange rate and 4) Strengthening of the payment system.

Before undertaking the reforms, it was agreed between the government and the central bank that deep rooted reforms had to be undertaken to achieve the tangible results. As regulator and supervisor as well as advisor to the government, the central bank carried out diagnostic studies, prioritized the constraints facing the banking sector, designed the reform strategy and action plan, sought the assistance of the government and international financial institutions, monitored the progress and made policy. Regulatory and institutional changes were also brought in place to facilitate the process.

A most crucial policy decision was made by the government that it would not keep the banks under state control but privatize them. It was a tough decision particularly because closure of loss making branching and retrenchment of work were the two haunting issues. On top of this, a lot of money had to be injected to clean the slate. The government injected more than 30 billion rupees to offset the losses. And to bring change in management style, professional bankers were appointed as CEOs and representatives from the private sector were brought on the Board of Directors.

According to Dr. Ishrat Husain, the reforms implemented over the years are: 1) Privatization of NCBs, 2) Emphasis on corporate governance, 3) Strengthening of capital structure, 4) Improvement in asset quality, 5) Liberalization of exchange regime, 6) Initiating consumer financing, 7) Introduction of mortgage financing, 8) Revamping recovery system, 9) Improvising of legal framework, 10) Initiating micro financing, 11) Undertaking SME financing, 12) Reducing tax, 13) Emphasis on agriculture credit, 14) Creation of enabling environment for Islamic banking, 15) Facilitating e-banking, 16) Mandatory credit rating, 17) Improving supervisory and regulatory capacity and 18) Development of human resources to achieve the desired objectives.

On the initiatives that need specific mention is, enhancement of minimum paid-up capital requirement of commercial banks. In nineties commercials banks, sponsored by the private sector, were allowed to commence operation with less than quarter of a billion rupees. They were required to meet enhanced requirement of 1.5 billion rupees by 31st December 2004. They are required to meet two billion rupees by 31st December 2005. Now a proposal to raise minimum paid-up to six billion rupees is under consideration.

Some of the critics are of the view that the central bank is raising the minimum requirement at too fast a pace, which deprives the shareholders from getting dividend. However, Dr. Ishrat has been justifying the need. His point of view is that capital requirement of the banking sector have to be adequate to ensure a strong base, ability to compete and withstand unanticipated shocks. This has resulted in mergers and consolidation of many financial institutions and weeding out of several weak players.

However, many analysts are of the view that banks should not be allowed to increase their paid-up capital through issue of Bonus Shares. The central bank must insist on issue of Right Shares. The logic behind issue of Right Shares is that it will not only increase the free float but will also bring in more funds into equities market. In the past, it was feared that Right issues would not be subscribed. Keeping in view the quoted prices of shares of listed banks, this could be said with full confidence that market has the appetite and investors are willing to pay a premium also.

It is also observed that some of the banks are issuing term finance certificates (TFCs) to meet the capital adequacy requirement. The objective is to meet the requirement without raising the paid-up capital. There are two opinions about this strategy. One group believes that issue of TFCs is good because it helps in meeting the requirement without affecting the payout to shareholders. Whereas other group strongly believes that the central bank should not encourage issue of TFCs for raising second tier capital as it does not help in increasing the free float of commercial banks.

For a considerably long time the debate about viability of Islamic banking continued in the country. The perception was that it had a limited market and it also suffered from certain limitations. However, the government made a decision to allow establishment of Islamic banks and also allow the conventional banks to open up dedicated branches. The objective was to allow the two systems in parallel and give a choice to the consumers. The results have been very encouraging as the size of Islamic banking is growing at a very fast pace.

There is a big surge among the banks to upgrade their technology and online banking services. During the last three years there has been a large expansion in the ATMs and at present more than 700 such machines are working in the country. The decision mandating the banks to join one of the either two ATM switches available in the country has provided further boost. The biggest advantage is that utility bills payment and remittances are being handled through ATMs, kiosks and personal computers, reducing both time and cost.

The review of the progress over the years shows various improvements which include: 1) Reduction in non-performing loans and provisioning by the banks 2) Decrease in average interest rates, 3) Enhanced availability of funds for those who were ignored in the past, 4) Greater use of plastic money, 5) Higher disbursement of credit to agriculture sector and 6) Revival of the sick units. All these factors are helping in enhancing per capital income and poverty alleviation.

However, some of the cynics said that banking reforms are also promoting consumerism. But it is also a fact that a loan given to an individual has a snowball effect. Consumer financing has helped in improving quality of life on the one hand and boosting capacity utilization of the industrial units. Till recently it was said that a number of industries were suffering from poor capacity utilization. Now the situation is that industrial units are busy in expanding capacity. Economies of scale has also helped in boosting exports because made-in-Pakistan products have become competitive in the global markets. Higher exports have also helped in containing exchange rate vulnerability.

As a result of enhanced activity in the construction sector, new job opportunities are being created. The construction industry alone drives 50 different industries. Cement units, suffering from poor capacity utilization in the past, are now busy in expanding their capacities. Availability of credit on softer terms allowed the cement manufacturers to move away from furnace oil consumption to coal, which in turn has helped in reducing the cost of production.

One of the adverse effects of lower interest rates has been erosion of rates of return on bank deposits. Small depositors, who keep their savings in the banks, have been badly hit. A closer look shows that returns on bank deposits have turned negative because of higher inflation rate. Another complaint is that banking spreads are still high. According to certain estimates the average spread is still above seven percent. While the bankers continue to say that spreads are justified, depositors do not accept their rationalization.

The common complaint is that the operating cost of all the commercial banks is too high. In the name of technology up-gradation and branch network expansion a lot of money is being spent. However, the banks also collect all types of charges, be it use of ATM or clearing of cheques. On top of this, the Board of Directors is always willing to approve distribution of substantial dividend among its share holders but never seem to be ready to improve return on deposits.

However, bankers have a different point of view. They say return on deposit is dependent on a number of factors that include T-Bills yield and KIBOR as well as average lending rates. If the average lending rates are less than 10% then the return on deposit has to be half of this. However, depositors' point of view is that banks charge about 18% on lending to SMEs, interest rate for roll-over of credit on credit cards is above 2% per month, mark-up on consumer finance and auto finance is around 10%, average rate on agriculture loans is also above 15%. Therefore, linking return to depositors with T-Bills is totally unjustified. If there is no incentive for savings, it will only encourage consumerism in the country.


The banking infrastructure is still mostly confined to urban areas. This often gives an impression that Pakistan is an over-banked country. In reality, bulk of the population still does not have access to banking facility. This becomes a serious problem because bulk of the workers' remittances pertains to rural areas. While the banks are able to use funds for their use, the recipients have to wait for days to get the money.

One of the significant improvements in the financial system of the country is that while the size of non-performing loans is on the decline, the quality of new loans disbursed since 1997 has been improving and recovery rate is about 95%. The amendments in Prudential Regulations, issue of regulations for NBFCs, SME and micro finance banks and strict compliance to code of corporate governance are adding to the strengths of the financial system in the country.

In the past, commercial banks were ready to pay penalty rather than extending the allocated amount of credit to the agriculture sector. The situation has changed entirely. According to the latest data available from the central bank, the quantum of such disbursements is on the rise and actual disbursement would be above the target this year. However, it is often felt that small farmers still have a limited access to agriculture loans.

Though, there are efforts to improve the quality of human resource involved in the financial sector, a lot more needs to be done. The orthodox bankers are slow in learning the new rules of the game, and often resist the change. The new entrants are often carried away and become a little adventurous. Indiscriminate distribution of credit cards is on record and it is often feared that consumer finance bubble is also growing.

There are billions of rupees worth distressed loans lying with the commercial banks. Investment banks can acquire these loans at a discount, restructure the underlying assets by creating sustainable debt capacity and make the units operational. This will help the revival of the industry and clean up the balance sheets of the banks.

The first generation reforms have yielded encouraging results and the objective of second generation reforms is to further strengthen the financial sector and integrate into global economy. The Roadmap for 2005-10 prepared by the central bank is ambitious but doable. The autonomous status granted to the central bank and minimum interference by the government is expected to yield even better results.

The advent of Basel II regime imposes a sense of urgency on both the regulators as well as the financial sector to put their acts together as far as risk management is concerned. According to Dr. Ishrat, "Although we all have been talking about Basel II for sometime, our response in preparing ourselves has been at best patchy." The central bank has installed capacity for risk management within the institution and we intend to keep on expanding this capacity." However, a lot more needs to be done at individual banks' level.

Last but not the least, while regulators and players are busy in constant consultation, the response from general public has been very poor. People have complaints but they hardly approach the regulators for the ramification. This attitude has developed because the perception is that regulators have given a free hand to the players in developing and implementing the policies, though those may be bad for the public.

Therefore, it is suggested that the government should also establish the institution of 'Banking Ombudsman'. It is believed that such a proposal is under consideration but the institution must be established at the earliest for resolving the common complaints of the depositors, borrowers and even employees of the banks. It may be true that the central bank has been playing its role, as regulator, efficiently and effectively. However, there is need for an institution, which has the authority to hear the grievances and also to give the ruling. The rulings of Banking Ombudsman should be accepted by the regulators as well as the players.