B A N K IN G SE C T O R R E F O R M S L E SSO N S F R O M P A K IST A N IS H R A T H U S A IN

This paper is aimed at drawing lessons from the recent experience of Pakistan in the implem entation of Financial Sector Reform s. Indonesia has also made m any im pressive strides during the past several years in strengthening its financial sector. I believe learning is a tw o w ay process and learning from each other's experiences is a very useful w ay of assim ilating and adopting good practices and know ledge. Pakistan can learn a lot from Indonesia's experiences and I look forw ard to listening to your interventions this m orning. Before I get into the contents of the reform s I would like to begin b y addressing the follow ing three questions: W hat are the benefits of a robust financial sector for the real econom y? W hy did we need reform s in the banking sector in the first place? W hat is the exact role of the Central Bank in the reform process?
a) Financial sector and real economy

Financial Sector D evelopm ent and Econom ic D evelopm ent are inter-related. No econom y can grow and improve the living standards of its population in the absence of a w ell functioning and efficient financial sector. Banks in Pakistan account for 95 percent of the financial sector and hence a sound and healthy banking system is directly related to economic growth and developm ent of Pakistan. The modern growth theory identifies tw o m ain channels through which the financial sector m ight affect long-run growth in a country: first, through catalyzing the capital accum ulation (including both hum an and physical capital) and second by increasing the rate of technological progress. Financial interm ediaries perform five basic functions that affect the real econom y. (i)
(ii)

m obilizing savings from dom estic households and corporates pooling and managing risk acquiring and dissem inating inform ation about investm ent opportunities m onitoring borrow ers and exerting corporate control and facilitating the exchange of goods and services.

(iii) (iv) (v)

Invited Lecture delivered at the Bank Indonesia Executive Leadership program at Jakanta on July 4, 2006.

These functions of an efficiently w orking financial sector allow the above tw o channels to w ork for prom oting grow th by: a) c) m obilizing savings for investm ent allocating the capital efficiently am ong com peting uses b) facilitating and encouraging capital inflow s and

Em pirical studies have dem onstrated preponderance of evidence suggesting a positive relationship betw een financial developm ent and econom ic grow th. b) W hy w ere reform s needed? W hat w as w rong w ith the Pakistani banking system that such m assive reform s had to be undertaken? Banks in Pakistan have been catering basically to the needs of the G overnm ent, public sector to sm all and m edium enterprises, to the housing sector or to the agricultural sector, w hich create m os

organizations, serving a few large corporations and engaging in trade financing. There w as no lending

of the grow th and em ploym ent in Pakistan. M ost im portant, the financial system suffered from

political interference in lending decisions and also in the appointm ent of the Boards and Chief the banking sector. There w ere several legitim ate reasons for such an errant behavior. First, the governm ent's fiscal deficit w as so high that m ost of the deposits the banks used to

Executives. The m iddle class w hich is the backbone of any econom y w as not given due attention by

get w ere loaned to the governm ent and governm ent corporations. This w as safe lending w hich

fetched good returns and the banks m ade good profit out of it. N aturally, there w as little incentive for rem unerative. Secondly, the governm ent ow ned m ost of the banks. In the governm ent banks the staff w orked like typical governm ent em ployees, coming to office at 9:00 a.m ., checking files; having nothing im portant to do and leaving at 5.00 p.m . w ithout doing m uch work. These banks suffered from a high bureaucratic approach, overstaffing, unprofitable branches and poor custom er service. Adm inistrative costs were high reducing profits of depositors.
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them to do anything else except lend to the G overnm ent w hich w as both risk free and highly

Thirdly, recovery rate w as so low that alm ost 25% of the loans w ere stuck up. A large num ber of loans to the private sector borrow ers w ere not given on the m erit of the proposal but on political considerations. These influential borrowers hardly repaid their loans. Fourth, banking industry faced a high tax rate of 58 percent w hile the rest of the corporate sector paid only 35 percent. This high punitive rate along w ith the burden of stuck loans and inefficiency of the staff w as passed on to the custom ers in form of high lending rates and low deposit rates. The banking industry w as not attractive for new entrants w ho could foster com petition and im prove efficiency. Because of these factors, i.e. high adm inistrative costs, burden of stuCk-up loans and excessive tax rates, the average interest rate for lending was about 21% per annum . The m iddle class borrow ers could not afford to get credit on such high interest rates and pay it back. Banking sector reform s were thus needed badly to address these and other constraints so that the banks could play their due role in the econom ic developm ent of the country. Although, there is no room for com placency and a lot still needs to be done, even the w orst critics concede that if there is one sector w hich has undergone basic transformation that is the banking sector. The IM F and the W orld Bank w ho are not alw ays very generous or effusive in their praise had this to say about the Banking sector in Pakistan after com pleting a com prehensive and thorough review in early2004.
Quote: "far reaching reform s have resulted in a m ore efficient and com petitive financial system . In particular, the pre-dom inantly ned banking system has state-ow been transform ed into one that is predom inantly under the control of the private sector. The legislative fram ework and the State Bank of Pakistan's supervisory capacity have been im proved substantially. As a result, the financial sector is sounder and exhibits an increased resilience to shocks". U nquote. c) Role of the State Bank of Pakistan.

W hat was the role of the State Bank of Pakistan (SBP) in these reform s and how did it go about perform ing this role? The SBP is both the Central Bank as well as the financial sector supervisory authority. As a m atter of fact, it has four m ajor functions to perform under the law: Ensuring Soundness of the Financial Sector. M aintaining Price Stability with G rowth. Prudent M anagem ent of the Exchange Rate. Strengthening of the Paym ent System.
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It was felt and agreed betw een the G overnm ent and the State Bank of Pakistan that m ajor deep rooted reform s had to be undertaken as cosm etic changes have not achieved anything tangible. A s a regulator and supervisor as well as adviser to the Governm ent, 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 Governm ent of Pakistan in making legal and policy changes and international financial institutions for technical and financial resources, m onitored the progress and ensured im plem entation of policy, regulatory and institutional changes required to m ove the process forw ard. The task of the SBP was highly facilitated by a critical policy decision taken by the M usharraf G overnm ent i.e. they will not keep the banks under G overnm ent ownership and control but privatize them . Politically tough problem s such as reducing the labour force and closing down redundant and unprofitable branches were dealt w ith boldly. The G overnm ent injected R s. 30.7 billion ($ 600 m illion) to offset the losses incurred by these nationalized com m ercial banks and recapitalize them. Professional bankers w ere appointed as Chief Executives and persons from private sector enjoying reputation of com petence and integrity w ere taken on the Board of Directors of the state-owned banks. These new com er/ outsiders were com m itted to the restructuring of the banks prior to their privatization and indeed carried out serious preparatory w ork that proved to be extrem ely useful subsequently in the successful sale of the banks.

R E F O R M S IM P L E M E N T E D
W hat were the major reform s that had been implem ented during the last seven years? I w ould not go into the details of each one of them , but sum m arize some of the salient features:
(i) Privatization of NCBs:

A ll the N ationalized Com m ercial Banks (N CBs) under the public sector, except one, have been privatized. As a consequence the private sector owns, m anages and controls about 80 percent of the banking assets in the country - a reversal of the situation since early 1990s when N CBs held 80 percent of total assets. Even in the case of N ational Bank of Pakistan 23.5 percent shares have been floated through Stock M arket m ainly aimed at sm all retail investors.
(ii) Corporate Governance:

Strong corporate governance prom otes transparency, accountability and protects 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, ensure strong oversight and bring about a change in the organizational culture.
(iii) Capital Strengthening:

Capital requirem ents of the banking sector have to be adequate to ensure a strong base, and w ithstand unanticipated shocks. The m inim um paid-up capital requirem ents of the banks have been gradually raised from0 m illion to reach100 million by 2009. $1 $ This has already resulted in m ergers and consolidation of m any financial institutions and weeding out of several weaker banks from the financial system .
(iv) Improving Asset Quality:

The stock of gross non-perform ing loans (N PLs) that am ounted to 2S percent of total advances of the banking system and DFls has been reduced to 9 percent by M arch 2006. M ore than two-thirds of these loans are fully provided for and net N PLs to net advances ratio has com e down to as low as 2 percent for the com m ercial banks. The positive developm ent is that the quality of new loans disbursed since 1997 has im proved and recovery rate is 97 percent.
(v) Liberalization of Foreign Exchange Regime:

Pakistan has further liberalized its foreign exchange regim e and allowed setting up of foreign exchange com panies in the private sector to m eet the dem ands of Pakistani citizens for foreign exchange transactions. Pakistani Corporate sector com panies have also been allowed to acquire equity abroad. Foreign registered investors can bring in and take back their capital, profits, dividends, rem ittances, royalties, ete. freely w ithout any restrictions. There are no restrictions on the entry to any sector of the econom y. Banking, insurance, real estate, retailing and all other sectors can be ow ned upto 100 percent by foreigners.
(vi) Consumer Financing: 5

By rem oving restrictions im posed on nationalized com m ercial banks for consum er financing, the State Bank of Pakistan has given a big boost to consum er financing. M iddle incom e groups can now afford to purchase cars, TVs, air conditioners, VCRs, ete. on installm ent basis. This, in turn, has given a large stim ulus to the dom estic m anufacturing of these products. (vii)M ortgage Financing: A num ber of incentives have been provided to encourage m ortgage financing by the banks. The upper ceiling has been raised, tax deduction on interest paym ents on m ortgage has been allowed, and a new recovery law aimed at expediting repossession
of property by the banks has been prom ulgated. The banks have been allowed to raise long term funds through rated and listed debt instrum ents to m atch their long term m ortgage assets with their liabilities. (viii) Legal Reform s: Legal difficulties and tim e delays in recovery of defaulted loans have been removed through a new ordinance Le. The Financial Institutions (R ecovery of Finances) O rdinance, 200 1. The new recovery law s ensure the right of foreclosure and sale of m ortgaged property with or without intervention of court and autom atic transfer of case to execution proceeding. A Banking Laws Reform s Com m ission has review ed and revised several pieces of legislations and is drafting new laws such as bankruptcy law. (ix) Prudential Regulations: The prudential regulations in force were mainly aim ed at corporate and business financing. The SBP in consultation with the Pakistan Banking A ssociation and other stakeholders has developed a new set of regulations which cater to the specific separate needs of corporate, consum er and SM E financing. The new prudential regulations have enabled the banks to expand their scope of lending and custom er outreach. (x) M icro Financing: SBP has brought m icrofinance urider the purview of its regulatory and supervisory ambit. However, the licensing and regulatory requirem ents for M icro Credit and Rural financial institutions have been relaxed and have been m ade sim ple to facilitate
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w idespread access to sm all borrow ers particularly in the rural areas. U nlike the com m ercial banks, the M icrofinance Institutions (M Fls) can be set up at district, provincial and national levels w ith varying capital requirem ents. There is less stringency and m ore facilitative thrust em bedded in the prudential regulations designed for this type of institutions. Six m icrofinance institutions are already operating and then outreach has crossed half a m illion custom ers. But in this field w e have to learn a lot from the Indonesian experience particularly the BRI and the regulatory set up in the B ank of Indonesia.
(xi) SME Financing:

The access of sm all and m edium entrepreneurs to credit has been a m ajor constraint to expansion of their business and up gradation of their technology. A Sm all and M edium Enterprise (SM E) B ank has been established to provide leadership in developing new products such as program loans, new credit appraisal and docum entation techniques, and nurturing new skills in SM E lending w hich can then be replicated and transferred to other banks in the country. Program lending is the m ost appropriate m ethod to assist the SM E financing needs. The new prudential regulations for SM Es do not require collateral but asset conversion cycle and cash flow generation as the basis for loan approval. The State Bank is also helping the banks in developing their credit appraisal capacity for SM E lending. Indonesian experience in this field w ill also be particularly helpful to us. (xii)Taxation: The G overnm ent has already reduced the corporate tax rate on banks from 58 percent to 35 percent during the last six years and brought at par w ith the general corporate tax rate. This has m ade banking a highly profitable business and the banks have earned about $1 billion of profits in 2005 - a big jum p from the huge losses incurred until a few years ago.
(xiii)Agriculture Credit:

A com plete revam ping of A griculture C redit Schem e has been done recently w ith the help of com m ercial banks. The scope of the Schem e w hich w as lim ited to production loans for inputs has been broadened to the whole value chain of agriculture sector. The broadening of the scope as well the rem oval of other restrictions have enabled the
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com m ercial banks to substantially increase their lending for agriculture by a m ultiple of five tim es com pared to FY 1999-00 thus mainstream ing agriculture lending as part of their corporate business. U nlike the previous years when they were prepared to pay penalties for under performance under m andatory credit scheme the banks have achieved consistently rising higher targets every year. Sm all private com m ercial banks have also accelerated their agriculture lending as they face large unm et dem and at rem unerative m argins.
(xiv) Islamic Banking:

Indonesia and Pakistan have begun their journey in Islam ic banking only recently. Pakistan has allow ed Islamic banking system to operate in parallel w ith the conventional banking providing a choice to the consum ers. A large num ber of Pakistanis have rem ained withdraw n from com mercial banking because of their strong belief against riba-based banking. These individuals and firm s - m ainly m iddle and low class - will have the opportunity to invest in trade and businesses by availing of loans from Islam ic banks and thus expand econom ic activity and em ploym ent. Several fullfledged Islam ic banks have already opened the doors for business and m any conventional banks have branches exclusively dedicated to Islam ic banking products and services.
(xv) E-Banking:

There is a big surge am ong the banks to upgrade their technology platform , on-line banking services and m ove towards E-banking. During the last four years has been a large expansion in the A TM s and at present more than 1000 A TM s are working throughout the country. Progress in creating automated or on-line branches of banks has been quite significant so far and it is expected that by 2007 almost all the bank branches w ill be on-line or autom ated. (xvi)Human Resources: The banks have recently em barked on m erit-based recruitm ent to build up their hum an resource base - an area w hich has been neglected so far. The private banks have taken a lead in this respect by holding com petitive exam inations, interview s and selecting the
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m ost qualified candidates. The era of appointm ent on the basis of connections and recom m endations from the politicians has alm ost com e to an end as the private ow ners w ant to attract and retain the best available talent w hich can m axim ize their profits. This new generation of bankers w ill usher in a culture of professionalism and rigour in the banking industry and produce bankers of stature w ho w ill provide leadership in the future.
(xvii) Credit Rating:

To facilitate the depositors to m ake inform ed judgm ents about placing their savings w ith the banks, it has been m ade m andatory for all banks to get them selves evaluated by credit rating agencies. These ratings are then disclosed to the general public by the SBP and also dissem inated to the C ham bers of C om m erce and Trade bodies. Such public disclosure w ill allow the depositors to choose betw een various banks.
(xviii) Supervision and Regulatory Capacity:

The banking supervision and regulatory capacity of the C entral Bank has been strengthened. M erit - based recruitm ent, com petency - enhancing training, perform ance linked prom otion, technology - driven process, induction of skilled hum an resources and greater em phasis on values such as integrity, trust, team w ork have brought about a structural transform ation in the character of the institution. The responsibility for supervision of non-bank finance com panies has been separated and transferred to Securities Exchange Com m ission. The SSP itself has been into two parts - one divided looking after central banking and the other after retail banking for the governm ent.
(xix) Paym ent System s:

Finally, the country's paym ent system infrastructure is being strengthened to provide convenience in transfer of paym ents to the custom ers. The Real-Tim e Gross Settlem ent (RTG S) system will process large value and critical transactions on real tim e while electronic clearing system s will be established in all cities. These reform s w ill go a long w ay in further strengthening the Banking sector but a vigilant supervisory regim e by the State Bank w ill help steer the future direction.
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O U TC O M ES:

W hat have been the results of the above reform s? Pakistan's economy was stuck in a low equilibrium trap in the decade of t 990s. Per-capita grow th rates were anem ic and stagnant. Incidence of poverty w as on the rise, so was unem ploym ent rate. Fiscal imbalances, high debt ratios, large external im balances, depleting foreign reserves and a depreciating currency had made m acroeconom ic managem ent extrem ely difficult. The structural reform s introduced since 2000 in a w ide variety of sectors im proved econom ic governance and prudent econom ic m anagem ent have brought about a turnaround in the econom y. Last year the econom y grew at 8.4 percent - the second to China and all m acroeconom ic indicators are showing positive movem ent and stable levels. Incidence of poverty has declined from 34 percent in FYO 1 to 24 percent in FYO S. U nem ploym ent rate has recorded a fall. Financial soundness indicators are all healthy and robust. The banking business is no longer confined to m eeting governm ent's budgetary deficit and the losses of public enterprises or catering to the requirem ents of big houses and big corporate nam es in business. The custom er base for loans has expanded from 1 million to 4 m illion during the last six years. Agricult.ure, the largest sector of econom y, which the comm ercial banks had neglected, has now begun to receive large allocations. The com m ercial banks are giving m ore agriculture loans than even in the history of Pakistan If this trend persists, the rural households w ill be able to intensify the use of modern inputs and raise their productivity and income. Credit cards, debit cards, personal loans and consum er durable loans are catching up fast. R efrigerators, air conditioners, VCR s, Televisions are now available on credit. The consum ers are forced to save w hen a specific am ount is cut from their salary every m onth to pay the installm ent. M ortgage financing is helping the m iddle class fam ilies to own apartm ents and residential houses. For the first tim e in the history of Pakistan, the m iddle class is beginning to benefit from the banking system. M icrofinance institutions are expanding their branches and providing credit without any collateral or security to poor households. M any people have availed this opportunity, some bought a cow, som e bought a m ilk buffalo or opened a sm all shop and fem ale borrow ers bought sew ing m achines. They have started income-generating activities and recovery is no problem from the
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m icro-finance banks. A pproxim ately, 500,000 poor household have benefited from these loans in the last few years. The banking system which had recorded negative returns on assets (RoA) and negative returns on equity (RoE) six years ago is now showing im pressive RoAs and RoEs com parable to best international banks. Capital base is strong, quality of assets has im proved, m anagement practices are sound, corporate governance standards are being followed and risk m anagem ent is m uch better. Rapid credit grow th in consumer segment and repricing of loans at higher interest rates are the new challenges that the banking industry is currently facing. But I am sanguine that they will be also to m eet these challenges prudently and wisely.
LESSO NS LEA RNT

W hat are the lessons we have learnt in im plem enting the financial sector reform s in the last seven years? 1. Banking reform s cannot be successfully im plem ented and sustained in the absence of a favourable and stable m acroeconom ic environm ent. Pakistan's track record in m acroeconom ic m anagem ent and governance during the 1990s was dism al. The M usharraf governm ent, w hich cam e to power in October 1999, em barked upon a serious program of macroeconom ic stabilization, structural reform s, good governance and the establishm ent of credibility w ith International Financial Institutions. Despite several m ajor exogenous shocks, including Septem ber 11, the m obilization of troops on the Indian border, severe drought incidents of terror attacks and oil price shocks the country has been able to m ake a dram atic turnaround in its econom ic indicators. This include fiscal retrenchm ent and a prim ary surplus on budget, inflation contained to low level for the first four years the current account turning surplus, debt indicators moving in the direction of sustainability and foreign reserves rising about tw elve tim es. In addition, this period w itnessed the low ering of the interest rate structure, the appreciation of the exchange rate and a record grow th in workers' rem ittances. All this amply dem onstrates the seriousness of efforts made during the last six years. G DP grow th has averaged m ore than 6 percent since 2002. 2. Financial sector reform s can only be im plem ented if there is political will, ownership and com m itm ent of governm ent. Once this becom es obvious a broad
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consensus has to be built up on the direction, contents, phasing and sequencing by intensive consultation of all the stakeholders. The banking industry, the regulatory authorities and the M inistry w ith Finance have to work together in building such a consensus, otherwise the reform s can prove to be short lived without sustainability in the long run. But to achieve such a consensus there has to be a cham pion that can push the reform s through the legal, parliam entary and institutional m easures, fine tune them and correct the course during the im plem entation process, m onitor and evaluate the im pact of the reforms and ensure that the unintended consequences are properly tackled. There m ust be proactive com m unication with the public at large and m edia and the cham pion has to respond to their concerns. In absence of sllch a cham pion, inertia and passivity would overw helm the reform process and derail it. 3. A private sector owned and m anaged financial system can provide large benefits to the econom y only if som e pre-requisites are in place. These pre-requisites are healthy competitive, environm ent, efficiently functioning m arkets, sound financial infrastructure but m ost important a strong and effective regulator. In cases w here the Central Bank or the R egulatory Authority is weak and not upto the m ark in skills, com petencies and system s the collusive and anti-com petitive behavior of the private sector can create serious systemic problems for the financial sector and for the econom y. W e have witnessed in Pakistan that the w eak capacity of regulator has given rise to cartelization in goods m arket for sugar, cem ent ete. 4. The service standards, product offerings, system improvem ent, technology transfer and skill upgradation in the dom estic banking system s can be facilitated by exposing the dom estic banks to com petition from foreign banks. As the state owned com m ercial banks had becom e highly politicized and lost their professional rigor it w as by draw ing upon the hum an resources and Pakistani m anagers w orking in international banks that w e were able to restructure and strengthen our banking system s. These m anagers introduced culture, system s and procedures, and technology platform that has m ade it possible for the dom estic private banks to expand, becom e efficient and highly profitable and revive professionalism . The apprehension that the foreign banks w ill displace the dom estic banks in the m arket place and capture m arket share is in fact highly exaggerated. As a m atter of fact ten out of tw enty foreign ow ned
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banks have packed up and w ound up their operations in Pakistan because they could no longer com pete w ith the dom estic banks that have a large netw ork and have now becom e m ore efficient. The share of foreign banks in the banking assets and deposits has, as a m atter of fact, shrunk com pared to the 1990s. Foreign banks w ere earning huge rents because of the inefficiencies of the dom estic banks. But as the dom estic banks have become strong and a competitive environm ent exists that favours scale of operations, netw ork and a variety of product and service offerings, the foreign banks have lost their m arket share.
5.

State-owned banks can be successfully privatized only if com petent

professionals and m en and wom en of highest integrity from outside the banks are brought in as Chief Executives and m em bers of the Boards of Directors. M ost insiders have vested 14

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6.

interests to perpetuate the status-quo and therefore offer a lot of

resistance during the process vitiating, negating or retarding the progress. These insiders may sincerely believe in the efficacy of public sector banks and may therefore have serious conflict of interest with the government decision of privatization. The outsiders should be given a performancebased contract for limited time period to complete the task assigned to them.

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TABLE -1

C H A N G E S IN K E Y M A C R O E C O N O M IC IN D IC A T O R S

1999-2000
GDP Growth Rate Inflation Fiscal Deficit /GDP Current Account/ G DP Domestic Debt/ GDP External Debt/ G DP Remittances (per month) Exports (Annual flows) Tax Revenues Foreign Direct Investment Foreign Exchange Reserves Unemployment rate Poverty Incidence Real effective exchange rate 4.2% 5.7% 6.1% -3.2% 41.5% 51.7%

20052006
6.6% 8.0% 4.2% -3.7% 29.2% 28.3%

$ 82 million $ 7.8 billion

Rs.406 billion

$ 353 million
17 billion Rs.700 billion

$ 470 million $ 2.0 billion

7.8 % 32% 100 (2000)

$ 3.5 billion $ 13 billion

6.5% 24% 93.7

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