Pakistan: Financial Sector Assessment

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1 Pakistan: Financial Sector Assessment State Bank of Pakistan Research Department

2 The Team Leader Riaz Riazuddin Researchers Mahmood-ul-Hasan Khan Mohib Kamal Azmi Muhammad Amin Khan Lodhi Muhammad Farooq Arby Muhammad Mazhar Khan Muhammad Waheed Salman Ahmed Syed Sajid Ali Talat Anwar Tasneem Alam Data/Information Support Abdul Faheem Bashir Ahmed Mazhar Hussain Research Assistance Abid Qamar Aneeqa Aqil Asma Khalid Fida Hussain Sadia Hafeez Ahmed Sardar Shah Syeda Sabina Batul Kazmi

3 Acknowledgements The team of this Report is greatly indebted to Dr. Ishrat Husain and Mr. Khalid Siraj for their continuous guidance and support. Special thanks to Securities and Exchange Commission of Pakistan, Dr. Mushtaq Ali Khan, Mr. Shahid Kardar, Mr. Mohammad Mansoor Ali, and Dr. Abdul Razzaque Azmi for their comments on the earlier draft, which were very useful in revising the document. The contribution of Mr. Anwar Saeed, Joint Director, Banking Supervision Department, is deeply appreciated. In addition, the assistance from other members of the Research Department, particularly the support staff who facilitated this study indirectly, is also acknowledged. The team is especially thankful to the participants of Conference on Financial System held on 18 th June 2002 in Karachi. Feedback from the participants enabled the team to add new insights and improve the analytical content of this report. However, the team bears the responsibility for all errors and omissions. As a final point, observations made in this report are entirely those of the working team, these do not necessarily represent the views of the conference participants or those of the SBP management.

4 Preface Last three decades have witnessed several economic policy changes in Pakistan with far reaching consequences: 1970s faced a large-scale nationalization process encompassing trade, industry and financial sectors; 1980s witnessed a beginning of its reversal in non-financial sector; and last part of 1980s and early 1990s saw a surge in economic measures including trade, fiscal and financial reforms. Since then, a number of measures have been implemented, and would continue to be initiated in future. With this backdrop, there is a need to take stock of measures undertaken so far; assess their usefulness in terms of development of financial sector; analyze their impact on growth and welfare of the economy; and outline the future direction of reforms. Such a task will be massive and complex; even so a beginning has to be made to trigger this process of assessment. With this objective at the forefront, Dr. Ishrat Husain, Governor, State Bank of Pakistan took the initiative to undertake a comprehensive study, first of its kind by SBP. The study reviews the process of financial sector reforms since 1990 and focuses on following objectives: 1) To highlight the financial structure at the beginning of reform process; 2) To make an inventory of financial reform measures during 1990s; 3) To evaluate the performance of banking institutions; 4) To evaluate the performance of non-bank financial institutions; 5) To evaluate the performance of financial markets; 6) To analyze the impact of reform measures; and 7) To suggest a direc tion for future reforms. Outline of the study closely follows above objectives. These objectives also set the nature of discussion in each chapter: descriptive (chapters: 1 and 2); analytical (chapters: 3, 4 and 5); and a combination of analysis and synthesis (chapters: 6 and 7). Although, various alternatives were possible, the outline of the study was chosen for its simplicity. It also enables the reader to connect various types and stages of reforms, almost automatically. Draft of this study was discussed in the Conference on Financial System organized by the National Institute of Banking and Finance, Islamabad at the Institute of Bankers, Karachi on 18 th June Feedback from the participants have been incorporated, where possible, in this ver sion. Proceedings of the conference have been released separately by the organizer. It is hoped that this study will serve as the basis for charting the nature and content of future reforms in the financial sector. In addition, it is likely to promote further research not only in the area of financial sector reforms but also the reforms in economic and social sectors.

5 Contents Executive Summary 1 Chapters 1. Pre-Reform Structure in Pre-Reform Financial Structure Banks Non-bank Financial Institutions (NBFIs) Central Directorate of National Savings (CDNS) Supervisory Authorities State Bank of Pakistan Pakistan Banking Council Corporate Law Authority Financial Markets Money Market Capital Market Foreign Exchange Market Financial Repression High Government Borrowing Credit Controls Sectoral Credit Allocation Administered Interest Rates Implicit Risk Insurance Other Factors Financial Sector Reforms During 1990s Institutional Reforms Financial Liberalization Institutional Strengthening of NCBs and DFIs Strengthening of Self Governance Restructuring of Banks and DFIs Strengthening of Prudential Measures Strengthening of Loan Recovery Process Institutional Strengthening of SBP Restructuring Consolidation of Regulatory Functions Computerization Debt Management Reforms Replacing Tap System with Auction Based System Promotion of Secondary Market Measures Relating to National Savings Schemes Measures Relating to Bearer Instruments Monetary Management Measures Reorientation of Monetary Policy Instruments Rationalization of Subsidized Credit Schemes Interest Rate Rationalization Banking Law Reforms Reforms in SBP Act, Amendments in Banks (Nationalization) Act, Reforms in Banking Companies Ordinance, Banking Companies (Recovery of Loans, Advances, i

6 ii Credit and Finance) Act, Exchange and Payment Reforms During 1990s Reforms During February May Measures Undertaken During May December Capital Market Reforms Privatization of State-owned Enterprises Opening of Capital Market to Foreigners Creation of SECP Other Measures Performance of Commercial Banks During 1990s Overview State-owned Banks Capital Adequacy Asset Quality Management Soundness Earnings and Profitability Liquidity and Sensitivity to Market Risk Private Banks Capital Adequacy Asset Quality Management Soundness Earnings and Profitability Liquidity and Sensitivity to Market Risk Foreign Banks Capital Adequacy Asset Quality Management Soundness Earnings and Profitability Liquidity and Sensitivity to Market Risk The Banking Industry Conclusion Performance of NBFIs and CDNS During 1990s Non-bank Financial Institutions Development Finance Institutions Investment Banks Leasing Companies Modaraba Companies Housing Finance Companies Mutual Funds Discount Houses Venture Capital Companies Performance of CDNS in 1990s Savings Mobilization Yield Structure of National Savings Schemes Transformation of Financial Markets During the Reform Process Evolution of Money Market Pre-reform Inter-bank Money Market Primary Market of Treasury Bills Government Bond Market Post-reform Secondary Market SBP Repo Window Open Market Operations 85

7 5.2 Development of Capital Market Performance of Equity Market Performance of Term Loan Market Corporate Debt Market Securities and Exchange Commission of Pakistan Performance of Foreign Exchange Market Foreign Exchange Market Prior to 21 st July Foreign Exchange Market After 21 st July The Kerb Market Crisis Management Credit Allocation System Transformation of Payment and Settlement System Impact Analysis of Financial Reforms Role of Macroeconomic Factors Economic Growth National Savings Inflation Balance of Payments Fiscal Position Impact on Financial Structure, Deepening and Intermediation Impact on Financial Structure Financial Depth Financial Intermediation Financial Savings Impact on Financial Efficiency Interest Rate Spread Credit Allocative Efficiency Impact on Domestic Debt Management Impact on Cost and Sustainability of Debt Impact on Reorientation of Monetary Policy Impact on SBP s Conduct of Monetary Policy Pre-reform Transmission Mechanism Post-reform Transmission Mechanism Impact on Banking Supervision Impact on Non-performing Loans Financial Development in Peer Countries Macroeconomic Environment Financial Deepening and Intermediation Future Direction of Reforms Soundness of Financial System Remaining Agenda for Privatization Restructuring of DFIs Arresting Bad Debts Consolidation of Financial Sector Efficacy of Supervision Improving Corporate Governance Strengthen Legal Infrastructure Enhance Capabilities of Supervision Demarcation of Supervision and Regu lation Responsibilities Effectiveness of Monetary Policy Ensuring Autonomy of SBP Rationalization of Interest Rate Structure Unification of Foreign Exchange Market Development of Secondary Market for Long-Term Government Paper 132 iii

8 7.4 Deepening of Financial System and Services Minimizing the Role of Government Promote Micro-finance Institutions Modernization of Payment System Enhancing Financial Services Conclusion 133 Annexes 135 Acronyms 185 iv

9 List of Tables 1. Pre-Reform Structure in FY Structure of Financial Sector in Structure of Banks in Structure of NBFIs in Non-bank Financial Institutions in Profile of KSE Sanctions and Disbursements by Selected DFIs in FY Net Sales of NIT Units ICP Mutual Funds Fiscal Deficit and Financing Selected Indicators of Financial Sector Performance of Commercial Banks During 1990s 3.1 Assets and Liabilities of Banking Sector during 1990s 40 State-owned Banks 3.2 Share of State-owned Banks in Banking Sector Capital Adequacy Indicators Asset Quality Indicators Management Soundness Indicators Earnings and Profitability Indicators Liquidity and Sensitivity Indicators 47 Private Banks 3.8 Share of Private Banks in Banking sector Capital adequacy Indicators Asset Quality Indicators Management Soundness Indicators Earnings and Profitability Indicators Liquidity and Sensitivity Indicators 50 Foreign Banks 3.14 Share of Foreign Banks in Banking Sector Capital Adequacy Indicators Asset Quality Indicators Management Soundness Indicators Earnings and Profitability Indicators Liquidity and Sensitivity Indicators Performance Indicators of Banking Industry Performance of NBFIs and CDNS During 1990s 4.1 Assets of NBFIs Deposits of NBFIs Loans and Advances CAMELS Indicators of DFIs CAMELS Indicators of Investment Banks Performance Indicators of Leasing Companies Performance Indicators of Modaraba Companies Asset Shares of Housing Finance Companies CAMELS Indicators of Housing Finance Companies Key Statistics of NIT Open-end Mutual Fund Key Statistics of Closed-end Mutual Funds Discount Houses 77 v

10 4.13 Venture Capital Companies National Savings Schemes Interest Rate Structure in Pakistan Transformation of Financial Markets During the Reform Process 5.1 Six-month T-bill Auction Summary Three and Twelve-month T-bill Auction Summary Federal Investment Bond Auction Summary FIB Auction Performance Spreads in Term Repo Market Secondary Market Transactions and FIB Holdings OMO Injections Performance of Karachi Stock Exchange Performance of LSE and ISE Sanctions and Disbursements by Selected DFIs and Specialized Banks Corporate Debt Indicators of Turnover in Clearing House Impact Analysis of Financial Reforms 6.1 Macroeconomic Factors Affecting the Financial Sector Dynamics of Banking Sector during 1990s Dynamics of Financial Sector during 1990s Indicators of Financial Sector Deepening Components of Financial Savings Indicators of Financial Efficiency Allocation of Credit Among Different Sectors and their Share in GDP Allocation of Gross Domestic Credit among Different user Groups Burden of Domestic Debt Expansion Rates of Domestic Debt Servicing Burden of Domestic Debt Expansion Rates of Domestic Debt Servicing Fiscal Indicators Basel Core Principles: Implementation Status Volume and Concentration of NPLs Macroeconomic Indicators Indicators of Financial Depth and Efficiency Financial Deepening and Efficiency in Pakistan vis-à-vis Peer Countries 126 vi

11 List of Figures 1. Pre-Reform Structure in FY Real Return on Deposits Performance of Commercial Banks During 1990s 3.1 Bank Deposits vs NSS 39 State-owned Banks 3.2 Capital to Liability Ratio Earning Assets to Total Assets Ratio Non-performing Loans Expenditure to Income Ratio Net Interest Margin Return on Equity Return on Asset s Liquidity Indicators RSA/RSL 47 Private Banks 3.11 Capital to Liability Ratio Earning Assets to Total Assets Ratio Non-performing Loans Expenditure to Income Ratio 50 Foreign Banks 3.15 Capital to Liability Ratio Earning Assets to Total Assets Ratio Non-performing Loans Expenditure to Income Ratio Performance of NBFIs and CDNS During 1990s Development Finance Institutions 4.1 Capital to Liability Ratio NPLs to Gross Advances NPLs and Capital to Asset Ratio Management Soundness Earnings and Profitability Liquidity and Sensitivity 63 Investment Banks 4.7 Capital to Liability Ratio Asset Quality Management soundness Earnings and Profitability Liquidity and Sensitivity 67 Housing Finance Companies 4.12 Capital to Liability Ratio Asset Quality Management Soundness Earnings and Profitability Liquidity and Sensitivity Share of NSS in Domestic Debt and National Savings Transformation of Financial Markets During the Reform Process 5.1 Average Annual Call Rates Money at Call and Short Notice Cash Accommodation per Day SBP 3-Day Repo Rate 85 vii

12 5.5 Open Market Operations Merchandise Trade Home Remittances Direction of Causation Impact Analysis of Financial Reforms 6.1 Growth in Real Sector Monetary Assets to GDP Ratio Money Multiplier and Currency to Deposit Ratio Bank Deposits National and Financial Savings Interest Rate and Banking Spread Interest Expenditure (as percent of GDP) Transmission Mechanism of Monetary Policy in Pakistan T-bill and Lending Rates Non-performing Loans 123 viii

Pakistan: Financial Sector Assessment

Pakistan: Financial Sector Assessment 2003 State Bank of Pakistan Research Department The Team Leader Riaz Riazuddin Researchers Abid Qamar Abdul Faheem Adil Mahboob Asma Khalid Fida Hussain Iffat Mustafa