History of Banking in Pakistan

History Banking
Pakistan.
of

in

Assignment for:
Money & Banking
Written by:
Muhammad Qasim
BM-26464

Muhammad Qasim (BM-26464)

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History of Banking in Pakistan

Contents
HISTORY:..................................................................................................................... 4
BANKING IN PAKISTAN................................................................................................ 5
The Humble beginnings, 1947 1970.....................................................................5
A legacy of public control, 1970 1980...................................................................6
The Business as usual, 1980-1990..........................................................................6
Causes of nationalization:.................................................................................... 9
Result of nationalization:...................................................................................... 9
Privatization, 1990 1997....................................................................................... 9
Development Banks in Pakistan...............................................................................10
Weaknesses of Banking System............................................................................ 10
Limited Number of Banks...................................................................................... 10
Ignorance of Backward Areas................................................................................ 11
Undeveloped Money Market..................................................................................11
Misdistribution of Loans......................................................................................... 11
Access of People toward Loans.............................................................................. 11
Default Ratio......................................................................................................... 11
a) The government owned banks till 2009:........................................................12
b) The banks which are privatized by the government:.....................................12
c) Banks which are already private:...................................................................12
d) Foreign banks in Pakistan:............................................................................. 13
e) Investment Banks:......................................................................................... 13
f) Causes of privatization:.................................................................................. 13
g) Result of privatization:................................................................................... 14
SBPs Role................................................................................................................. 14
ADMINISTRATIVE ORGANISATION OF SBP..............................................................14
SERVICE TENURE OF GOVERNOR AND MEMBERS:.................................................15
MAIN DEPARTMENTS OF STATE BANK OF PAKISTAN:..............................................15
1.

AGRICULTURAL CREDIT AND MICRO FINANCE DEPARTMENT:.......................15

2.

BANKING INSPECTION DEPARTMENT (BID):.................................................15

3.

BANKING POLICY AND REGULATION DEPARTMENT (BPRD):.........................15

4.

EXCHANGE POLICY DEPARTMENT (EPD):.....................................................15

5.

FINANCE DEPARTMENT:...............................................................................16

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6.

ISLAMIC BANKING DEPARTMENT (IBD):........................................................16

Current situation....................................................................................................... 16

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HISTORY:
Before independence, Reserve Bank of India was the central bank of sub-continent.
It was not easy to setup a central bank from the day of independence, therefore, at
the time of partition reserves of central bank were divided between both the
countries i.e. India and Pakistan with a ratio of 70:30. Further, Reserve Bank of India
continued its duties as central bank for both the countries. However, working for
own central bank had been started in Pakistan and finally on July 01, 1948 Quaid-eAzam Mohammad Ali Jinnah inaugurated State Bank of Pakistan at Karachi since
then it is working as Central Bank of the country.
Initially, under State Bank of Pakistan order 1948, SBP was charged with the duty
related to issuance of currency notes and keeping reserves with a view of securing
monetary stability in the country.
As a new country without resources it was difficult for Pakistan to run its own
banking system immediately, so it was decided that the Reserve Bank of India
should continue to function in Pakistan until 30 th September 1948, and Pakistan
would take over the management of public debt and exchange control from Reserve
Bank of India on 1st April, 1948. By 30th June 1948, the number of offices of
scheduled banks in Pakistan declined from 487 to only 195, because registered
banks transferred from Pakistani territories to India.
At that time there were 19 non-Indian (foreign banks) and only 2 Pakistani banks
(Habib Bank, Australian Bank). In 1 July 1948, of the total bank deposits of Rs.
1.1081 billion held in Pakistan, as much as 73% was held by foreign banks whose
activities were largely confined to foreign trade.
By December 1949, there were 35 scheduled banks in Pakistan of which:
1. 4 were Pakistani Banks
2. 23 were Indian Banks

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3. 8 were Exchange Banks

Most of the banking business was in the hands of Hindus of British people and only
two banks were in the hands of Muslims and one bank was already in Pakistan.
There were 19 non-Indian foreign banks in Pakistan before independence whose
policies and operations were controlled by their head offices abroad. These banks
were engaged in export of crops from Pakistan.
Established just few months before independence

Habib bank was established in early 1947 in Bombay(India), shifted in

Pakistan after independence

Muslim commercial bank was established in July 1947, in Calcutta (India),

shifted in Pakistan after independence.

Australian Bank renamed Allied bank in 1942 lahore (Pakistan)

BANKING IN PAKISTAN
At the time of independence, the areas which now constitute Pakistan were
producing only food grains and agricultural raw material for Indo-Pakistan
subcontinent. There were practically no industries, and whatever raw material was
produced was being exported from Pakistan. However, commercial banking facilities
were provided fairly well here. There were 487 offices of scheduled banks in the
territories now constituting Pakistan.

The Humble beginnings, 1947 1970

Our financial sector evolved very differently from banks in the developed world. For
nearly a year after partition, Pakistan had no central bank. Habib Bank established
in 1941 filled this gap initially, until the State Bank of Pakistan (SBP) was set up in
1948 under quasi-government ownership. The role of domestic banks was
particularly limited at the time, accounting for only 25 of the total 195 bank
branches in the country. Therefore, the SBP was initially mandated to develop

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commercial banking channels, and maintain monetary stability so trade and

commerce could flourish in the newly-created state. Subsequently, Habib Bank,
Allied Bank and National Bank were amongst the first to start operations with strong
support from the central bank.
Nationalization of banks was considered necessary so that the nation as a whole
could benefit from the better channeling of resources. So the government of
Pakistan decided to nationalize all scheduled banks as well as State Bank of
Pakistan through the ordinance of Nationalized 1974. All this was done on Jan 1,
1974.

A legacy of public control, 1970 1980

Commercial banking grew favorably in Pakistan until 1974. Under the
nationalization policy implemented by Zulfiqar Ali Bhuttos government, thirteen
banks were brought under full government control, and consolidated into six
nationalized banks. The Pakistan Banking Council was set up to monitor nationalized
banks, marginalizing the SBPs role as a regulator. These measures were meant to
improve lending to prioritized industries. However, while directed lending was
viewed favorably at the time, little can be said of the long-term gains that have
been achieved.
This was the first phase of developments of Pakistans commercial
banking system. In subcontinent, Reserve bank of India was central bank. The
bank of India closed down most of its offices in Pakistan, which had been working as
the agent of Reserve Bank of India was not willing to purchase even token amounts
of the government of Pakistan. Securities and Indian reserve banks issued notes
were not marketable declared by India government. The Reserve Bank of India was
hardly of any help. It refused to help the govt. of Pakistan so salaries and other
obligations did not fulfill.
After independence of Pakistan 1947,On December 1948 British government decide
to divide the reserves of India central bank 30 percent reserves for Pakistan and
70 percent reserves for India. After taking this reserve
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In May 1948 Muhammad Ali Jinnah immediately establish state bank

of Pakistan.
After one year in November 1949, national bank of Pakistan was
established in Dacca (East Pakistan). The main purpose was to act as an
agent of state bank of Pakistan.
Numbers of more banks were established according to the need of a country with
passage of time.

The Business as usual, 1980-1990

In Bhutto government nationalized the banking system. Thus
through the Nationalization Bank Act 1974, SBP and all commercial banks in
Pakistan and carrying on business in or outside the country were brought under the
government ownership with effect from January 1974. The ownership and
management of all Pakistan banks stood transferred and rested in the federal
government. The chairman, director and chief executive of various banks were
removed from their offices other than those appointed by the federal government
and the state bank.
At the time of nationalization there were 30 scheduled banks in the country. 15 were
Pakistani while other were foreign banks. Pakistani banks were having 2902
branches. 70 branches were in foreign countries. There was 36 branches of foreign
banks in the country. Only the branches of Pakistani banks were nationalized. All the
property rights were transferred to the Federal Government.
Through a notification all smaller banks were amalgamation with bigger banks and
five units were formed.
1. National Bank of Pakistan
2. Habib Bank Limited
3. United Bank Limited
4. Muslim Commercial Banks

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5. Allied Bank of Pakistan Limited

During 1988 to 2000, 5 banks are privatized by government
Banks

% of shares offered to

UBL
MCB
NPB
NIT
ABL

private people
51%
16.6%
5.10%
58%
49%

Source: privatization Commission

Banks

% of shares offered

Date of

*HBL

to private people
51%

bidding
1st Oct. 2003

Source: privatization Commission

At the time of Nationalization, there were following 14 Pakistani commercial banks
with 3323 offices allover Pakistan and 74 offices in foreign countries:
1. National banks of Pakistan

2. Habib bank limited

3. Habib bank (overseas) limited

4. United bank

limited
5. Muslim commercial bank limited

6.Commerce bank

limited
7. Standard bank limited

8.Australia bank

limited
9. Bank of Bahawalpur limited

10. Premium bank

limited
11. Pak Bank limited

12. Sarhad bank

limited

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13. Lahore commercial limited

14.Punjab provincial co-

operative bank limited

A Pakistani banking counsel was established for nationalized commercial banks to

co-ordinate their activities. The Pakistan banking council prepared a scheme for the
recognition of banks. This scheme was notified in 1974, according to it small banks
combined with big banks so these five banks or units were established:
1. National bank limited
2. Habib bank limited
3. United bank limited
4. Muslim commercial bank limited
5. Allied bank of Pakistan limited

In 30th June, 1974. The bank Bahawalpur was merged with the National Bank
of Pakistan. The premier Bank Limited merged with Muslim Commercial Bank
limited and Sarhad Bank Limited , Pak bank limited merged with Australia
bank limited (Allied Bank of Pakistan limited)

In 31st Dec.1974, the commerce bank limited merged with the United Bank
limited.

In 30th June, 1975 when the standard bank limited was merged with Habib
Bank limited.
Causes of nationalization:
Distribute equal amount of wealth b/w peoples of country
To remove unhealthy competition among banks it was thought they created
financial and economic problems

Result of nationalization:
Although there are doubts about the positive results of the nationalization but we
can say that

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The banking facilities expanded in the rural areas.

Bank deposits rose very substantially during a period

Emphasized lending policies, national building projects, discouraged nonproductive and unhealthy activities like hoarding.

increase in the number of foreign branches of Pakistani banks

Over time, the financial sector grew to serve primarily large corporate business,
politicians and the government. Board of Directors and CEOs were not
independently appointed. Lending decisions were not always commercially
motivated, and many billions of rupees were unsurprisingly funneled out of the
financial system as bad loans. Banks were essentially not in control of their
destinies during this period.
Interest was an important target in this phase. The Islamic bank was made and it
receives deposit without guaranteeing any return. The Islamic bank cannot finance
the project of an investor; the bank will have to be a partner in the project.

Privatization, 1990 1997

By 1991, the Bank Nationalization Act was amended, and 23 banks were established
of which ten were domestically licensed. Muslim Commercial Bank was privatized
in 1991 and the majority ownership of Allied Bank was transferred to its
management by 1993. By 1997, there were still four major state-owned banks, but
they now faced competition from 21 domestic banks and 27 foreign banks. More
importantly, administered interest rates were streamlined, bank-wise credit ceilings
removed and a system of auctioning government securities was established, forcing
the government to borrow at market determined rates.

Development Banks in Pakistan

The food shortage compelled the government to embark upon agricultural credit
and the agricultural development bank was setup to attend to agricultural finance.

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All these measures, and the devaluation of Pakistani rupee on 1 August 1955, had a
very favorable effect on commodity market and the balance of payments position in
1955-56,
Development of agriculture largely depends on agricultural finance, but the
scheduled banks were not very willing to undertake this risky venture. Therefore the
SBP sponsored to establishment of agriculture development bank to attend
exclusively to agricultural finance. Moreover, the functions of the State Bank were
also broadened by facilities for both agriculture and industry. All these measures
had positive effects on Pakistans economy during 1956-58.
In 1958 government liberalized imports which increase the demand of funds, so in
1959-60 two more Pakistani banks namely Eastern Merchantile Bank limited and the
United Bank Limited were established and scheduled and more Pakistani banks
continued to be established, which included Commerce Bank Limited and the
Standard Bank Limited. By June 1965 the number of scheduled banks stood at 36. In
1964 NBP also came forward and established a peoples credit department to allow
credit facilities to small borrowers.
Weaknesses of Banking System
Although there was development in this sector after independence, but there were
many weaknesses in this system.
Limited Number of Banks
There was little number of banks. For 10,000 people there was only a single branch.
In developed nations this ratio is 4000. Therefore the saving ratio is very less, and
same is the case of investment.
Ignorance of Backward Areas
Banks were opening branches only in developed areas, they were ignoring
backward areas. People of rural areas were not getting banking facility.
Undeveloped Money Market

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The money market was not very much developed, so the banks were not getting
sufficient information and therefore they were not advancing enough loans.
Misdistribution of Loans
Banks were issuing loans to manufacturers and businessmen. They were ignoring
agriculture, mining, fisheries and transportation.
Access of People toward Loans
Banks were advancing loans only to large manufacturers who were getting 63% of
total loans but they were 222 in number. Each was getting more then Rs. 1million.
Default Ratio
Since the loans were given to large manufacturers they were defaulting due to their
approaches.
These were few of the weaknesses in this sector and the government efforts were
not fruitful. So in 1974 banks were nationalized.
In 1991, the government of Prime Minister Mr. Nawaz Sharif was not fully satisfied
with the performance of nationalized. He took step towards privatization of banks,
industries. So Pakistani banking sector is categories as State Bank of Pakistan,
Nationalized Scheduled Banks, Private Scheduled Banks, Foreign Banks, investment
banks, specialized banks.

a) The government owned banks till 2009:

1. First Women Bank Limited

2.Industrial Development Bank of

Pakistan
3. Khushhali Bank Limited

4.National Bank of Pakistan

5. SME Bank Limited

6.The Bank of Khyber

7. The Bank of Punjab

8. Zarai Taraqiati Bank Limited

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9. The Punjab Provincial Cooperative Bank Limited

b) The banks which are privatized by the government:

1. Allied Bank Limited (privatized in1993)
3. MCB Bank Limited (1991)

2. Habib Bank Limited (2003)

4.United Bank Limited (2002)

c) Banks which are already private:

1. Al Baraka Bank (Pakistan) Limited (established in 1991) 2. Askari Bank Limited
(1992)
3. Bank Alfalah Limited (1997)

4. Bank AL Habib Limited (1991)

5. BankIslami Pakistan Limited (2005)

6. Dawood Islamic Bank Limited

(2007)
7. Dubai Islamic Bank Pakistan Limited
9. Habib Metropolitan Bank Limited (1992)
11. KASB Bank Limited (1994)
13. Mybank Limited (2005)

8. Faysal Bank Limited (1995)

10. JS Bank Limited (2006)
12. Meezan Bank Limited (1997)
14. NIB Bank Limited (2003)

15. Samba Bank Limited (Formerly Crescent Commercial Bank Limited)

16. Silkbank Limited (Formerly Saudi Pak Commercial Bank Limited)
17. Soneri Bank Limited (1992)

18. Standard Chartered Bank (Pakistan) Limited

(2006)
19. Summit Bank Limited (Formerly Arif Habib Bank Limited)

d) Foreign banks in Pakistan:

1. ABN Amro Bank

2. N.V Albaraka Islamic Bank

BSC (EC)

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3. American Express Bank Limited

4. Bank of Tokyo Mitsubishi Limited

5. Citibank N.A

6. Deutsche Bank A.G.

7. Hong kong & Shanghai Banking Corp Limited

8. Oman International Bank

S.O.A.G
9. Rupali Bank Limited

10. Standard Chartered Bank

Limited
11. Habib Bank A.G. Zurich. etc

e) Investment Banks:
1. Crescent Investment Bank Limited

2. First International Investment Bank

Limited
3. Atlas Investment Bank Limited

4. Security Investment Bank Limited

5. Fidelity Investment Bank Limited

6. Prudential Investment Bank Limited

7. Islamic Investment Bank Limited

8.Asset Investment Bank Limited

9. Al-Towfeek Investment Bank Limited

10.Jahangir Siddiqui Investment Bank

Limited
11. Franklin Investment Bank Limited

12.Orix Investment Bank (Pak)

Limited.etc

f) Causes of privatization:
The falling standard of banking services delay in home remittances, bad
debts of the banks etc.
Discourage entrepreneurial activities within the country , did not provide
small loans to small savers so living standard of people were decline.etc

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g) Result of privatization:
The number of bank branches were 3397 on Dec31, 1973, reached on 7661
by end June.
Small loans for buy house, cars, land are provided to nation
Everyone can start business easily after showing their business plans, banks
provide loan to them and every financial help to businessman/ woman.
Quality products are marketed at reasonable price so living standards are
improving.
More competition b/w banks they are trying to provide more bank services
thats why nation become much satisfied.etc

SBPs Role
However, State Bank of Pakistan Act 1956 further strengthened the bank by giving
it authority to regulate the credit and monetary policy of the country. In 1997, State
Bank of Pakistan was given full autonomy through an amendment ordinance in the
Act of 1956. After these amendments SBP has full and exclusive authority to
regulate the banking sector, conduct an independent monetary policy and set limits
on government borrowings from State Bank of Pakistan. In 2005, an ordinance has
given the money exchange companies a legal status in the country and now all
money exchange companies are also working under the umbrella of SBP. Hence,
since 2005 central bank of Pakistan is acting as a regulatory and controlling
authority for money exchange companies just like commercial banks of the
country.
ADMINISTRATIVE ORGANISATION OF SBP
State Bank of Pakistan is governed by a central board of directors consisting of nine
members, appointed by Federal Government of the country. The board is chaired by
Governor, SBP. Secretary Finance, Federal Government is also a member of the
board. Further it has seven directors, including one director from each province
ensuring representation of banking, agricultural and industrial sector of the country.

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SERVICE TENURE OF GOVERNOR AND MEMBERS:

President of Pakistan, with consent to the Prime Minister, appoints Governor, SBP for
a tenure up-to three years. However governors service tenure can be extended for
further three years subject to the approval of President. Mr. Yaseen Anwar is
presently working as the Governor, State Bank of Pakistan. All the directors are
nominated by Federal Government of the country for a tenure up-to three years.
MAIN DEPARTMENTS OF STATE BANK OF PAKISTAN:
Following are the main departments of State Bank of Pakistan.

1. AGRICULTURAL CREDIT AND MICRO FINANCE DEPARTMENT:

The department is mainly responsible to meet the credit requirements of
agricultural sector of Pakistan. As an agricultural country, Pakistan needs a great
support in terms of credit and guidance in this sector. Agricultural Credit
department is not only playing a vital role for the development of agricultural sector
but is also a major source of foreign exchange earnings.

2. BANKING INSPECTION DEPARTMENT (BID):

It is one of the core departments of SBP. BID plays an important role in meeting
main responsibility of State Bank i.e. supervising financial institutions of the country.
Banking inspection department conducts on-site inspection on regular basis of all
the commercial banks and DFIs hence ensuring soundness of economic system and
protecting the interest of depositors as well.

3. BANKING POLICY AND REGULATION DEPARTMENT (BPRD):

SBP, as a regulatory authority, is responsible to make consistent and workable
policies and regulations in order to support countrys economy and build trust of
commercial banks and depositors. BPRD has been assigned the task of achieving
this objective. It not only makes or amends the policies according to the current
scenario but also provides complete guidance to all the commercial banks and

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financial institutions about policies and procedures through circulars and prudential
regulations.

4. EXCHANGE POLICY DEPARTMENT (EPD):

EPD is responsible for overall activities of foreign exchange market in the country. To
achieve this objective it not only formulates but also implements foreign exchange
policies in order to get results accordingly. EPD makes sure the availability of foreign
exchange manuals and circulars about foreign exchange to all authorized dealers,
exchange companies and investors providing them a clear understanding about
rules, regulations and policies of SBP about foreign exchange.

5. FINANCE DEPARTMENT:
Another important department of SBP is the finance department as it not only
manages financial issues such as maintenance of government and provincial
accounts and preparation of financial statements, but, on the other hand it also
controls working of issue department which includes management of currency
operations like designing, printing and circulation of currency notes.

6. ISLAMIC BANKING DEPARTMENT (IBD):

After the judgment of Shariah Court about interest based banking, SBP was advised
to implement and promote the Shariah compliant Islamic banking as a compatible
and parallel system in the country. As a result IBD was established on September
15, 2003, basic objective of which is to develop a sound and compatible Islamic
banking system in the country through developing Shariah complaint Islamic
banking products and services so as to achieve equitable economic growth.

The Situation (in the first decade of year

2000)
Pakistans banking sector reforms which were initiated in the early 1990s have
transformed the sector into an efficient, sound and strong banking system. The

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most recent comprehensive assessment carried out jointly by the World Bank and
the IMF in 2004 came to the following conclusion:

For reaching reforms have resulted in a more efficient and competitive

financial system In particular, the predominantly state-owned banking system
has been transformed into one that is predominantly under the control of the
private sector. The legislative framework and the State Bank of Pakistans
supervisory capacity have been improved substantially. As a result, the
financial sector is sounder and exhibits an increased resilience to shocks.

The major changes that have occurred in the banking sector during the last
decade or so can be summarized as follows:

(a)

80 percent of the banking assets are held by the private sector banks and
the privatization of nationalized commercial banks has brought about a
culture of professionalism and service orientation in place of bureaucracy
and apathy.

(b)

The banks that were losing money due to inefficiencies, waste and limited
product range have become highly profitable business. These profits are,
however, being used to strengthen the capital base of the banks rather
than paying out to the shareholders. The minimum capital requirements
have been raised from Rs. 500 million to Rs. 6 billion over an extended
period in a phased manner. The consolidation of the banking sector into
fewer but stronger banks will lead to better management of risk.

(c)

The banks that were burdened with the non-performing and defaulted
loans have cleared up their balance sheets in an open transparent, across-

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the-board manner. Contrary to the popular myth the main beneficiaries of

the wirite-offs of the old outstanding and unrecoverable loans have been
from almost 25 percent to 6.7 percent by Dec. 2005. Small individual
borrowers the ratio of non-performing loans of the Commercial Banks to
total advances has declined.

(d)

The quality of new assets has improved as stringent measures are taken
to appraise new loans, and assure the underlying securities. Online Credit
Information Bureau reports provide updated information to the banks
about the credit history and track record of the borrowers. Loan approvals
on political considerations have become pass. Non-performing loans
account for less than 3 percent of all new loans disbursed since 1997.

(e)

The human resources base of the banks has been substantially upgraded
by the adoption of the principles of merit and performance throughout the
industry. Recruitment is done through a highly competitive process and
promotions and compensation are linked to training, skills and high
performance. The banks now routinely employ MBAs, M.Coms, Chartered
Accountants, IT graduates, economists and other highly educated persons
rather than Clerical and Non Clerical Workers. The banking industry has
become the preferred choice of profession among the young graduates.

(f)

Banking Technology that was almost non-existent in Pakistan until a few

years ago is revolutionizing the customer services and access online
banking, Internet banking, ATMs, mobile phone banking and other modes
of delivery have made it possible to provide convenience to the customers
while reducing the transaction costs to the banks. Credit Cards, Debit
Cards, Smart Cards etc. are a thriving and expanding business in Pakistan.

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Once the RTGS is put in place the payment system in Pakistan. Would
enter a new phase of modernization.

(g)

Competition among the banks has forced them to move away from the
traditional limited product range of credit to the government and the
public sector enterprises, trade financing, big name corporate loans, and
credit to multinationals to an ever-expanding menu of products and
services. The borrower base of the banks has expanded four fold in the
last six years as the banks have diversified into agriculture, SMEs,
Consumers financing, mortgages, etc. The middle class that could not
afford to buy cars or apartments as they did not have the financial
strength for cash purchases are the biggest beneficiaries of these new
products and services.

(h)

Along with strong regulation, supervision and enforcement capacity of the

State Bank of Pakistan a number of measures have been taken to put best
corporate governance practices in the banking system. Fit and proper
criteria have been prescribed for the Chief Executives, members of the
Boards of Directors, and top management positions. Accounting and audit
standards have been brought to the International Accounting Standards
(IAS) and the International Audit Codes. External audit firms are rated
according to their performance and track record and those falling short of
the acceptable standards are debarred from auditing the banks. These
practices were put in place in Pakistan long before the scandals of
Enercon, World Call and Pramalat had shaken the corporate world.

(i)

The foreign exchange market that was highly regulated through a system
of direct exchange controls over suppliers and users of foreign exchange
has been liberalized and all purchases and sales take place through an

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active and vibrant inter-bank exchange market. All restrictions have been
removed with full current account convertibility and partial capital account
convertibility. Foreign investors can now bring in and take back their
capital, remit profits, dividends and fees without any prior removal and
directly through their banks. Similarly, foreign portfolio investors can also
enter and exit the market at their own discretion.

The main lesson learnt from the last decade suggest that financial sector
functions effectively and efficiently only if the macroeconomics situation is
favorable and stable. The need to maintain macroeconomic stability will thus
remain paramount in the years to come.

The agenda for further reforms in the financial sector is still quite
formidable and the challenges to spread the benefits of financial liberalization
among the middle and low income households and small and medium farms and
enterprises are still enormous.

There are several areas of dissatisfaction with the banking sector that
need to be addressed.

The most serious complaint against the banking system in Pakistan today
is that the depositors are not getting adequate return on their bank deposits.
The difference between the monthly weighted average rates of lending and
deposits is taken as an indicator of the spreads earned by the banks. It is true
that these spreads have widened in the recent months land this phenomenon
has caused resentment among those whose only source of income is their
returns from bank deposits. But it is important to examine the facts and their
form judgments

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The monthly comparisons are meaningless because PLS deposit rates are
changed every six months, while the lending rates are continuously adjusting
because they are automatically linked to T-bills or KIBOR rates.

During the last eight months the weighted average deposit rate has risen
from 1.6 percent in July Feb, 2005 to 3.9 percent in July Feb, 2006. This trend
reflects that the return on the new deposits mobilized is much higher than what
the average rate indicates. The old deposits are earning much lower rate
because they were lodged at the time when the overall structure of interest
rates had come down significantly. This lag is adjustment between the deposit
and lending rates is due to the costs incurred by the depositor in shifting
deposits from one bank to the other.

The additional deposits mobilized in the last twelve months amounted to

Rs. 382 billion i.e. a growth rate of 16.8 percent. This growth rate took place
despite deceleration in the volume of Resident Foreign deposit accounts. So if
the deposit rates were unattractive then this high growth rate in deposits
mobilized by the banks appears to be puzzling. The reason for this high growth is
that the fresh deposits were fetching an average return of 6.2 percent in March,
2006 compared to 3.5 percent in July, 2005 rise of 270 basis points in nine
months. In the coming months the average rate is likely to move further upwards
bringing them to positive real interest rates.

Why have the profits of the banks risen so sharply in the last few years?
There are several reasons that need to be understood:

First, the drag of non-performing loans has been eased considerably

reducing the need for setting aside the provisions for loan losses. As these
provisions were made at the expense of the profits the banks are now reaping

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the benefits of building up substantial provisions and taking the hit on their
profits in the past.

Second, the corporate income tax rate on banks profits has gradually
come down from 58 percent to 38 percent saving on their tax deductions. These
savings not only get translated in to higher profits but also act as incentives for
better performance because the tax rate no longer acts as a penalty.

Third, the diversification of the banks assets into new and so far
underserved segments such as agriculture, mortgage, auto, SMEs, Consumer
and Credit Cards have raised their net interest margins. As competition has
become quite tough in the corporate segment the margins on corporate loans
have been squeezed considerably. But the spreads earned in these new
segments are quite attractive. Thus a large part of the profits originate from
lending to these underserved segments of the population. This is a Win- Win
situation as small farmers, small businesses and middle class consumers, who
had so far been denied access to bank credit, are able to get financing the banks
are able to earn higher spreads.

Fourth, there has been a shift in the maturing profile of both the banks
deposits and banks loans. Half of the total deposits are now placed for short
term duration earning negligible rates of return compared to the past where the
distribution of deposits were concentrated in medium to long duration earning
much higher returns.

On the assets side, more of the bank loans are being disbursed for fixed
investment purposes. These have long maturity structure and pay higher
interest rates in double digits.

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This shift in the composition of deposits and advances has helped earn the
banks a higher spread boosting their profitability.

As the majority of the banks are operating in the private sector they will
remain guided by the bottom line considerations i.e. the profits. Consolidation
and market competition will act as a deterrent on abnormal profits but it is the
responsibility of the regulator to ensure that these profits are not made by taking
excessive risk with the depositors money or by banks indulging in collusive
practices. The regulator has to ensure that the access to credit is further
broadened and small farming households, small and medium businesses and
middle classes are able to meet their legitimate credit needs. At the same time
the regulator has to take stringent action against those banks found guilty of
anti-competitive or collusive practices.

Another popular indictment against the banking sector is that they are
financing speculative activities such as stock market trading, real estate,
commodities, auto etc. The facts do not support this indictment. Direct and
indirect exposure by banks in stock market equities has been limited to 20
percent of their capital i.e. the maximum amount all the banks can collectively
provide for this activity is only 40 billion. The outstanding stock of bank
advances in March, 2006 stood at Rs. 2063 billion. Thus the bank credit allocated
for stock market equity trading is less than 2 percent of the total advances of the
banking system. If we further assume that some amounts are diverted from
consumer loans or corporate loans also the exposure of the banks may double to
as much as 4 percent but the securities and collaterals against the diverted
loans may not necessarily be the scrips themselves.

Real estate financing by banks is restricted to mortgage loans only and

the purchase of plots cannot be financed by the banks. Mortgage loans can be
disbursed in installments after physical verification of the various phases of

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construction. The total disbursements of loans for mortgage amounted to Rs.

11.4 billion in FY 05.

Commodity financing and its prevailing rates are not attractive for the
borrowers as there has been net retirement of commodity loans in the first nine
months of the current fiscal year.

The regulatory environment for the banks to indulge in lending for

speculative purposes is not very propitious. The State Bank of Pakistan
supervisors are not only vigilant in their on-site inspection but they monitor the
banks on a continuous basis and can detect irregularities and violations fairly
quickly. The more deterrent effect of strong oversight by the supervisors is
enough to discourage such activities. The penalties imposed by the supervisors
on recalcitrant banks are quite severe.

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