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MGT604 - Management of Financial Institutions - Lecture Handout 18

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Asset composition

Assets of banking sector, as per cent of GDP, have been on the decline. Slowdown in asset growth was also accompanied by changing share of different groups. Negative growth in the assets of foreign banks during 1998 and 1999 was the prime reason behind declining growth in overall assets of the banking sector. Share of NCBs have been decreasing since private
banks were allowed to operate in 1992. In terms of asset share, private banks are now as large as foreign banks.

Problem bank management

The central bank is the sole authority to supervise, monitor and regulate financial institutions. It is also responsible to safeguard the interest of depositors and shareholders of these institutions. Lately, SBP took actions against two private banks which became a threat to viability of the financial system in the country. These were Indus Bank and Prudential
Commercial Bank. On the basis of detailed investigations, the license of Indus Bank was cancelled on September 11, 2000. After successful negotiations, management and control of Prudential Bank handed over to Saudi-Pak group.


Commercial banks have been going through the process of restructuring. There are efforts to reduce lending rates. The SBP has been successful in implementing its policies. Most of the banks have been able to adjust to new working environment. The proposed increase in capital base will provide further impetus to financial system in the country.
In the post September 11 era, the GoP borrowing from SBP and commercial banks is expected to come down substantially and private sector borrowing to increase. However, a temporary decline in repayment ability of borrowers may increase provisioning for the year 2001. The situation is expected to improve in year 2002. Unless efforts are made by banks to shrink spread, depositors will not be able to get return which corresponds with the rate of inflation in the country. Privatization of NCBs is expected to be delayed due to external factors. However, it is an opportunity for the banks to further clean their slate. Pakistan’s banking sector like many other developing countries had been faced with several problems and difficulties such as:
Most of the financial assets and deposits were owned by nationalized commercial banks (NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable branches and poor customer service.

  1. NCBs along with specialized banks such as ADBP, IDBP and Development financial institutions such as NDFC had a high ratio of non-performing loans.
  2. Banking industry faced a high tax rate, which affected its profitability and attractiveness for new entrants.
  3. There was a proliferation of banks and some of them were undercapitalized, poorly managed with a scanty distribution network.
  4. Agriculture, small and medium enterprises, Housing sectors were underserved and the middle class and low income group had limited access to bank credit.
  5. Banks had typically focused on trade and corporate financing with a narrow range of products and had not diversified into consumer and mortgage financing for which there is an ample unsatisfied demand.
  6. Poor quality of human resources, weak internal controls, non-merit based recruitments, high administrative costs and undue interference of unions in decisions making process affected the performance of public sector financial institutions adversely.


Banking sector reforms were aimed at addressing these and other constraints. Although there is no room for complacency and a lot needs to be done it is fair to say that substantial progress has been made to improve the health and soundness of the banking sector in recent years. There are still few weak and vulnerable institutions but overall the banking sector in Pakistan is much stronger today compared to five years ago or in comparison to other countries in the region. What are the factors responsible for this improvement? A large number of reforms have either been undertaken or under way.

1. Privatization of NCBs

The nationalized commercial banks are being privatized and their domination of the banking sector is likely to be reduced from almost 100 percent in 1991 to about 20 percent by December 2003. The shares of Muslim Commercial Bank are all in the private sector.
United Bank has been sold to a consortium of private investors. Privatization of Habib Bank Ltd., is under way and is scheduled to be completed by end December, 2003. 23.5 percent of shares of National Bank have been floated through Stock Market mainly aimed at small retail investors. The NCBs have been restructured and professional management inducted which works under the supervision of independent Boards of Directors drawn from the private sector.

2. 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 good governance practices to improve internal controls and bring about a change in the organizational culture. The salient features of this
structure are:

  • Banking license of one of the commercial banks which was found in violation of the prudential regulations and norms was cancelled for the first time in the history of Pakistan after following the due process. This decision
    was upheld by Peshawar High Court.
  • Ownership and management were changed at two private commercial banks, one of which had committed breach through unauthorized transfer of funds from the bank to associated companies.
  • A number of cases of willful bank defaulters were referred to National Accountability Bureau (NAB) for taking legal actions and recovering the amounts due.
  • The appointments of Board members, Chief Executive Officers and key Executives of all banks have to be screened so that they meet the fit and proper test prescribed by the SBP.
  • Family representation on the Board of Directors of the banks where they hold majority ownership has been limited to 25 percent of the total membership of the Board.
  • To avoid possible conflict of interest and use of insider information the Directors, executives and traders working in Brokerage companies will no longer serve on the Boards of Directors of the banks.
  • External auditors are evaluated annually and classified in various categories based on their performance and other prescribed criteria. Two large audit firms were debarred from auditing the banks and only after showing
    improvement in their performance placed in a category lower than they originally belonged to.
  • A detailed set of guidelines for the Board of Directors to effectively oversee the management of the banks and develop policies has been issued. A training course on Corporate Governance was organized for the members of
    the Boards of banks and their Chief Executives.
  • The disclosure requirements for banks have been strengthened and now they are required to prepare their annual financial statements in accordance with the International Accounting Standards. They are also required to publish
    quarterly and half-yearly accounts to provide information to their stakeholders for taking well informed decisions.
  • In order to institutionalize the decision making process and to provide guidance to staff, the banks are required to formulate and implement welldefined policies in credit, investment, recovery of write-offs, human resources, audit and compliance, risk management, etc.
  • k. To provide guidance to banks in identifying, measuring, monitoring and controlling various risks and to make them proactive, a detailed set of guidelines on risk management has been issued.

3. Capital Strengthening.

Capital requirements of the banking sector have to be adequate in relation to the risk weighted assets and conform to the Basle 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 Rs 500 million to Rs 1 billion by 1st January 2003 failing which they will no longer be allowed to carry out full banking activities as scheduled banks. This has resulted in mergers and consolidation of many financial institutions and weeding out of several weaker banks from the financial system.

4. Improving Asset quality.

The stock of non-performing loans (NPLs) has been tackled in several ways. The gross NPLs amount to Rs 252 billion and account for 22 percent of the advances of the banking system and DFIs. However, there has been aggressive provisioning carried out during the last three years. More than 60 percent of the NPLs are fully provided for and net NPLs to net advances ratio has thus declined to less than 10 percent. Efforts are being made to further reduce this ratio through the active involvement of Corporate & Industrial Restructuring Corporation (CIRC) and the Committee on Revival of Sick Units (CRSU). The settlement reached between loss category loan holders and banks under State Bank
circular No.29 will further reduce the volume of NPLs and allow the sick industrial units to revive while at the same time enable the banks to clean up their balance sheets. The positive development is that the quality of new loans disbursed since 1997 has improved and recovery rate is 95 percent.

5. Liberalization of foreign exchange regime

Pakistan has further liberalized its foreign exchange regime and ensured partial Capital account Convertibility by allowing foreign exchange companies to operate and Pakistani Corporate sector to acquire equity abroad.

6. Consumer Financing

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. Credit and Debit Cards are also gaining popularity and the numbers of card holders have doubled during the last two years.

7. Mortgage Financing

A number of incentives have been provided to encourage mortgage financing by the banks. The upper limit has been raised from Rs 5 million to Rs 10 million. Tax deduction on interest payments on mortgage have been allowed up to a ceiling of Rs.500, 000. 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.

8. 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 expeditious recovery of stuck up loans by 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.

9. 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.

10. 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.

11. 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, for example, can help up gradation of power looms to shuttle less looms in Faisalabad area and contribute to the achievement of goal set under Textile Vision 2005. 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.