Shamshad Akhtar: Financial sector - ten-year vision and strategy
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the inauguration
of the Development Finance Conference on "Expanding Frontiers of Financial Access in
Pakistan", organised by State Bank on the eve of 60th Anniversary of the State Bank of
Pakistan, Karachi, 1 July 2008.
* * *
Pakistan's financial system grew significantly in the last few years. At present, total financial
assets have reached $175 billion (110% of GDP). The banking system constitutes 95% of
the total assets of financial institutions and bank shares constitute 40% of the stock market
capitalization. Among different segments of financial markets, banking sector has gained
dynamism, profitability, respectability and strength. Deposit base rose to $60 billion and
advances to $47 billion. Supported by growing financial intermediation process, banks
aggregate profitability rose to $1.8 billion. Recapitalization and prudent lending has lowered
net non-performing loans (NPLs) to below one percent of assets. Banks capitalization and
quality of assets have helped raise the risk weighted capital adequacy ratio to 13.2 percent.
These achievements are impressive, however:
(i) A large segment of population and geography is still under served from the existing
financial markets and this gap will grow as Pakistan's population rises further.
(ii) The financial system has to gear itself to meet the growing requirements of the
economy in particular infrastructure which conservatively requires almost $150
billion over next few years;
(iii) New types of risks have emerged as banks acquired different types of nonbank
financial (NBF) institutions including investment finance, brokerage, asset
management and insurance companies etc. Some of these have been merged into
the banks while others remain as subsidiaries. Banks are beginning to cross-sell
different financial products through their branch networks. This is a market driven
development but does pose systemic risks and supervisory challenges. Some banks
have also acquired strategic and non strategic stakes in nonfinancial companies.
These create a different set of risks that will need to be thought through and dealt
with carefully.
(iv) Financial sector needs to be diversified as bulk of the country's financing
requirements is currently met by the banks. While market capitalization of stock
market has increased significantly, new issuance of capital is small. Similarly, the
debt markets constitute largely of government securities, while the corporate paper
market is limited.
(v) Finally, within regional context Pakistan's financial system despite its growth is still
small. For instance, the financial system of other Asian emerging financial market
countries twice or three times larger in relative terms and the Gulf States have now
geared themselves into regional financial hubs.
Keeping in view these considerations, the State Bank of Pakistan's (SBP) is now launching a
ten year Financial Sector Strategy. This strategy has been developed based on (i) a
comprehensive assessment and evaluation of the banking system that helps draw key
lessons; (ii) Pakistan's forward looking economic development strategy and vision; and (iii)
learning from the emerging changes in global and regional financial architecture and financial
advancement and innovation. This paper aims to capture the objectives and broad elements
of the financial sector strategy which will be finalized and adopted by the third quarter of the
2008 after consultation with stakeholders. The scope of the paper is confined principally to
reforms of banking sector and regulatory architecture which would require some principal
changes or new legislation.
The objective of the financial sector strategy will be to broaden and deepen the financial
system to help Pakistan:
(i) Achieve higher and sustainable economic growth,
(ii) Develop a dynamic, robust and stronger system,
(iii) Mobilize the domestic and foreign resources for private investment (which has to be
the key driver of the economy), and
(iv) Deepen financial penetration for poor and underserved regions.
Prerequisite for financial sector growth is, however, macroeconomic and political stability and
augmentation of the enabling policy environment in the real sector. Assuming these
preconditions are restored, the ten year strategy will
(i) Stimulate growth in financial assets to 165% of GDP, growth in deposit base by 13%
to reach $217 billion, and advances to allow private sector credit/GDP ratio to rise
from 27% to 42%;
(ii) Be financially inclusive supporting the small savers and meeting the requirements of
small borrowers in agriculture, housing, small and medium enterprises (SME) and
microfinance sectors by raising financial penetration ratio through enabling policy
environment and outreach expansion (coverage of per bank branch to improve from
19,000 to 15,000 persons).
(iii) Developing financial infrastructure and automation to enhance the coverage of
automated teller machines (ATMs) to 10,000; and
(iv) Reduce the systemic risks of the financial system by developing an adequate safety
net for the small depositors and the central bank's lender of last resort functions as
well as a framework for dealing with failing banks.
To achieve these goals, SBP is in process of putting together a comprehensive reform
program. SBP has developed and has full ownership of this reform agenda and received
technical assistance from the International Monetary Fund, the Asian Development Bank and
the DFID of United Kingdom to draw from international experience and expertise.
Central bank governance
Principal driving factor for the formulation and implementation reform is the autonomy and
competence of the organization. Over the years, emerging evidence has confirmed the
significant benefits of central bank autonomy (not just de jure autonomy but de facto
autonomy too) for macroeconomic performance as central banks play a primary role in price
stability, while also ensuring financial stability. This role has been supported by assigning
requisite powers to central banks not only in monetary policy formulation, conduct and
implementation but in effective enforcement of fiscal discipline. This has been achieved in
several jurisdictions without any real additional costs or sacrifices in terms of output volatility
or reduced economic growth. Further, central banks in number of jurisdictions have
performed the role of regulator of the full or part of the financial system. The recent financial
market turmoil has also brought under scrutiny the models and governance structures of
central banks/financial regulators, while bringing to forefront the risks of leaving nonbank
financial (NBF) sector virtually unattended. In absence of proper regulatory and supervisory
oversight, the NBF sector's overleveraging of the financial systems has exposed the global
financial system to multiple risks. As defaults emerged the financial institutions lacked ability
to service obligations. This episode has generated unprecedented liquidity crisis and bank
losses whose undervaluation/closures/liquidation impacted the financial markets at large.
Rescue operations and economy wide and household losses have not only impacted
advanced countries but taken a toll on global financial system and send warning signals on
need for change in financial regulatory architecture and its landscape. These attributes of
central banks helps cushion the impact of political cycles on economic cycles.
SBP over the years has acquired not only the required autonomy to steer the monetary
policy and financial stability mandates, but has regulated and supervised well the banking
sector reforms. Notwithstanding, SBP set up under the State Bank of Pakistan Act, 1956 has
been amended occasionally to strengthen its powers and mandate but now it needs to be
modernized in line with the international best practices. The key issues with SBP Act are that
(i) it contains outdated provisions that have lost their validity in light of the administrative and
structural changes at the economy level; (ii) governance structure of central bank which over
the years has undoubtedly served well the interest of autonomy and accountability of central
bank but does still contain provisions which undermine the functioning of central bank, (iii) if
price stability is to be upheld, in line with the mandate adopted by other central banks, than
provisions pertaining to the monetary and fiscal coordination need to be re-examined to
ensure proper enforcement of fiscal discipline through more explicit restriction on central
bank borrowings, (v) it ought to now include appropriate provision for the financial stability
defining explicitly mandate of central bank in financial safety net, bank exit and lender of last
resort functions and (iv) it includes provisions which ought not to be in primary legislation but
in supportive regulations etc.
In addition to modernizing the SBP Act, as a part of financial sector reforms central bank has
reviewed the supportive laws such as the Banking Companies Ordinance, 1962 and other
principal laws. In parallel, SBP has been working on a host of new laws to develop adequate
financial safety nets such as the Deposit Protection Scheme (to be discussed later in this
paper) and Consumer Protection and financial crimes law.
The sections below further outline the major areas of thrust of the financial sector reforms,
but do not as yet cover the full reform agenda.
Financial Inclusion Program
In Pakistan the level of financial exclusion is quite steep: only 17% of the population (30
million) has bank accounts and less than 4% (5.5 million) are borrowers. Moreover only 25%
of the total bank deposits and 17% of the total borrowers are from rural areas. In value terms
their shares are even smaller, 10% and 7% of the total value of deposits and advances,
respectively. Limited access to services is captured by the low level of branch penetration,
especially in rural areas and this has held back the growth of savings and impacted credit
distribution system.
To address issues of access, SBP has established a Development Finance Group which has
developed a comprehensive Financial Inclusion Program (FIP) that aims to promote access
to development finance for all small and underserved markets. In Pakistan context there is
need to encourage shift in banks' focus away from large companies to smaller companies
and the household sector. Most credit to the enterprise sector goes to manufacturing, which
receives a disproportionately large share of bank credit compared with this sector's
contribution to GDP (20%). Aggregate data for all credit by borrower size shows an
extremely skewed distribution: 22,000 or 0.4% of all 5.2 million banks' borrowers account for
65% of all bank credit-and the remaining 5+ million borrowers for the remaining one third.
At the very top there is even more concentration; the largest 50 borrowers account for 37%1
of all credit outstanding. Given that the manufacturing sector is the predominant recipient of
credit, it is safe to assume that most of the large borrowers are concentrated in that sector.
The FIP, to be supported by DFID and other donors, is quite broad based and will help
enhance the outreach. To start off, SBP and Pakistan Microfinance Network (PFM) has
developed a multi-faceted microfinance strategy to triple the number of microfinance (MF)
beneficiaries from 1 million to 3 million by 2010 and then to 10 million. To support this
program, SBP has encouraged commercialization of microfinance industry so that it is
financially and socially sustainable. Some of the specific actions being launched to facilitate
this involves encouraging:
(i) Microfinance institutions (MFIs) to develop commercially viable operations that are
financially and socially sustainable operations and transform them into MFB to
provide holistic services. Tax holiday for five years has been provided to MFIs once
they transform themselves into full-fledged microfinance banks (MFBs).
(ii) Development of partnership between commercial banks and MF providers and the
post office (PO) network and MF providers. (POs already manage over 4 million
savings accounts, mainly small accounts below Rs 10,000, through more than
12,000 branches.) There is scope for the PO and MF providers to join forces with
the latter acting as intermediaries for funds from the PO, especially as many MF
providers are constrained in their operations by limited funding.
(iii) Flexible regulatory regime for MFBs to allow innovation and organic growth without
compromising prudential objectives. Limits for MFBs (and MFIs) will be adjusted at
least in line with inflation and a two-tier regime is to be considered under which
MFBs (and MFIs) with track record of prudent governance, risk management and
financial success could be given more room to operate. This includes capital
adequacy requirements, which will be reviewed so as not to put MFBs (and MFIs) in
a competitive position substantially worse than that of banks.
(iv) Mobile phone-based banking services which is a cost effective way of bringing
financial services even to the most remote areas of the country. This is an option
with enormous potential as there already are almost two times as many mobile
phone owners (some 80 million) than there are depositors. Mobile phone services
reach almost every part of the country and would be an extremely cheap way for
banks and other financial institutions to extend their reach.
(v) Development of domestic and international MFI partnership.
(vi) Financial literacy and customer awareness program.
In parallel, SBP has been promoting Islamic Banks (IBs) to appeal to the population which
has thus far excluded itself for faith reasons. A separate Islamic Finance Strategy paper has
been developed which projects that given the growth rate in IBs businesses, Islamic Finance
is expected to constitute almost 12% of the Pakistan financial system in next five years or so.
To encourage sound growth SBP has laid out an elaborate prudential regulatory and
supervisory framework which conforms to the International Islamic Financial Service Board's
(IFSB) framework in whose development Pakistan has played a key role. To ensure proper
due diligence of the IF development SBP has constituted Shariah Advisory Board which
approves broad policy and regulatory framework and new products etc. SBP is working to
develop proper liquidity management framework and instruments to allow the IBs progress in
a prudent and sound manner.
SME sector faces a host of both demand and supply side constraints impeding delivery. On
demand side, lack of planning and entrepreneurial skills and problems with SME policy
framework remain a major hindrance, while on supply side banks perceive financing these
entities as high risk in absence of credit history and collateral. Notwithstanding the growth in
the SME financing has been significant and its share in total outstanding advances is close to
14.5% and the number of borrowers in the sector is around 185,000. In line with international
best practice, SBP plans to promote SME financing through supportive mechanisms. This
would involve help in designing specific products, and developing credit scoring system for
SME finance and SME financial reporting system. In addition, banks are being encouraged to
facilitate program based lending - in which banks establish general criteria for meeting the
specific financing requirements of businesses - and cash flow based lending rather than
collateral based lending. Work is underway to develop an appropriate credit enhancement
mechanism which will facilitate bank lending to the sector. Also, SBP is exploring with
industry possibility of development of venture capital funds focusing on SME promotion and
offering training to commercial bankers on SME lending methodology and approaches.
Agriculture lending has received a significant boost with the banks meeting the target of
Rs200 billion set for 2007/2008. Outstanding agriculture advances account for 6% of total
advances. However, the current flow of credit meets only 45% of the agriculture credit
requirements. SBP strategy for agriculture credit focuses on doubling the number of
borrowers from 2 million to 4 million and meeting 75-80% of the agriculture credit
requirements. SBP has encouraged a revolving credit scheme for three years - under which
farmers can borrow for one year and can continue to borrow without providing documentation
each year; guidelines have been issued lending for livestock, fisheries and horticulture
subsectors and programs are being launched for dairy sector. In addition, a small farmer
financing scheme has been promoted based on group based lending and a crop loan
insurance scheme has been structured which is now being offered by some insurance
companies. Work has been completed on promoting agriculture Islamic finance and also
providing capacity building both to farmers and bankers in regional languages.
Finally, to promote rural areas, SBP has mandated banks to establish 20% of their new
branches in rural areas. As competition for deposits grows and lending is backed by
adequate margins, banks will find their rural operations to be more attractive. Innovative
products and methods of selling them will also increase banks' reach and may change the
"brick-and-mortar" nature of branch operations.
Strengthen consumer protection and financial education
Over time competition backed by financial literacy and awareness will impose the right
pressure on banks to upgrade their customer services. SBP on its part is focusing on
effective compliance with customer service regulations and following it up with proper
enforcement to motivate banks to render good service and deal fairly with customers. To
supplement and reinforce this, SBP plans to:
(i) Introduce a Consumer Protection Bill, in line with international best practices, which
would among others provide guidance on issues of transparency, confidentiality,
availability of statements, account servicing, protection against fraud, unfair
contracts and lending practices, methods of debt collection, arbitrary penalties, etc.
Supported by the legislation an appropriate dispute settlement mechanism will be
established. Currently consumer protection is codified in SBP regulations but this
will have to be also reviewed and updated in line with the new legislation.
(ii) Encourage Pakistan Banks' Association (PBA) to adopt a Banking Code to commit
banks to fairness, disclosure and ethical standards.
(iii) Strengthen the newly established Consumer Protection Department of SBP to
monitor compliance with such new laws, regulations and codes.
(iv) Introduce a depositor protection scheme to protect small depositors.
(v) Transform and strengthen the role and functions of Banking Ombudsman, which will
remain an independent body from the regulators, to be better aligned with the above
developments.
(vi) A long-term campaign to enhance financial literacy will be launched in rural and
urban areas both by the commercial banks and SBP with the support of the IBP,
NIBAF and PBA.
Consolidate and strengthen the banking sector
Further consolidation is necessary to ensure presence of stronger and well capitalized banks
that can support diverse financial services and client requirements, while adequately
managing risks. Even though the number of conventional commercial banks has declined
from 41 to 29 through mergers and acquisitions and closures, there remain some banks with
lagging performance. As the most attractive mergers already have been consummated, the
pace of additional mergers requires SBP to further enhance the banks' minimum capital
requirement (MCR). Moratorium for issuance of new licenses, extended now to Islamic banks
too,2 will remain - exceptions, if any, will require new banks to comply with $300 million
capital requirements. Meanwhile all existing banks will be provided with a time frame to
comply with the new MCR. Outside the ambit of moratorium will be MFBs but licensing for
these will henceforth be at the national and provincial levels. New institutional arrangements
such as introduction of credit unions that aim to serve the lower tier markets will be examined
favorably.
In the banking sector, specialized government-owned banks have only made limited
contribution in their niche markets. They have out-served their purpose and/or their dismal
performance has impacted the SBP balance sheet (requiring regular provisioning for the
losses). Compensating their losses is not an option given the fiscal stress. In view of this,
proper resolution program is being worked out for these institutions. For instance: SME bank
is being privatized, the House Building Finance Corporation (HBFC) will be restructured and
privatized and the Zarai Taraqiati Bank Ltd. (ZTBL), a highly strategic case, needs to be
restructured financially and operationally. The Industrial Development Bank has now been
incorporated as a public company and will be available for sale. Privatization agenda should
also be extended to insurance sector as this sector is quite critical for Pakistan's overall
financial sector development.
Strengthen competition and efficiency
Competition drives a market-based financial system that helps bring about efficiencies and
innovations by encouraging price discovery and formation process. In Pakistan, banks with
substantive market power and access to low cost funds by virtue of their age old captive
clients have ended up distorting price mechanism as they are principal price setters. As a
result, real returns have been negative for the bulk of deposits, which has deterred effective
fund mobilization and distorted the yield curve and pricing for loans and advances.
To assess the degree of competition in financial markets, SBP examines market structure
indicators (such as the number of institutions) or concentration (Herfindahl or other indexes)
as well as the performance measures such as bank margins or profitability - though it has to
be acknowledged that these variables are influenced by multiple factors ranging from
macroeconomic conditions to bank specific factors such as scale of operations and risk
preferences etc.
To enhance competitiveness, SBP will primarily focus on continuing to broaden and deepen
financial system further. Notwithstanding, efforts are under way to (i) review the actual
behavior and conduct of banks related to structure of banking industry and take the required
actions, (ii) encourage contestability by allowing entry and (iii) promote development of NBF
intermediation to improve bank competition, . Furthermore, competition in banking system is
likely to grow as demand for advances results in need for higher deposit mobilization which
would then alter the pricing for both advances and deposits.
Taking advance action, SBP has sought to remove structural distortions that have impeded
competition. A case in point is the minimum deposit rate of 5% on all PLS savings product as
banks had for quite some time enjoyed ample access to a pool of excessively cheap savings
deposits. In addition, SBP regulations require greater transparency and disclosure in interest
rates and rate setting. As market matures, competition will encourage better alignment of
interest rates both on deposits and advances. Large corporate borrowers that have largely
dependent thus far on banks, may over time find it more attractive raise financing from debt
markets. In other countries such financing is typically cheaper than bank borrowing.
Strengthen prudential regulation and supervision
SBP has a broad set of prudential regulations that aim to strengthen risk management,
internal controls and corporate governance in banks, while providing effective guidance for
promotion of development finance and consumer related matters. The regulatory framework
for banks is now quite complete, although it needs constant updating and upgrading to
conform to evolving international best practices. Some challenges remain: (i) loan
concentration, (ii) emergence of financial conglomerates and their supervision, and (iii)
implementation of the Basel II regime.
Given high concentration of credit to the manufacturing sector, there is need to re-examine
the regulation relating to exposures of large company/borrowers and related companies.
High exposure has developed as banks and companies have been reluctant to go to seek
alternate sources of financing and instead seek relaxation of SBP prudential regulations to
borrow from banking system. Excessive exposure poses a threat to broader financial
stability, while deterring growth in nonbank finance sector. Stricter limitations on bank
exposures to large companies would drive those companies to raise capital from debt and/or
equity markets. This would support financial sector and risk diversification and contribute to
financial stability.
In developing prudential regulatory framework SBP will draw on the debate between the
Rules versus Principle based regulatory regime. The former takes a legalistic approach in
attempting to codify all prudential requirements into either primary law or regulations. This
approach is common in Spanish speaking countries as well as the United States. While this
approach provides certainty to the industry, it limits the flexibility of the supervisor to adapt to
changing circumstances and experience. Thus it puts a high premium on thinking through
every possible practical variation and also on having near perfect legal drafting. The problem
with this approach is that financial regulation is more of an art than a science. Many of the
rules that are introduced for prudential purposes need continuing modification and
refinements based on experience. The danger of relying too heavily on detailed rule
books/regulations is that the principle gets lost in the details. There is also a danger that the
industry becomes unduly focused on avoiding the wording of the rules rather than the intent.
The principles-based approach attempts to limit hard-coded law and regulations to broad
statements of principle. For example, the law might identify the need for banks to implement
sound risk management frameworks. However, rather than trying to identify every feature of
such a system, the principles-based approach allows the supervisor to develop its framework
and its own understanding of best practice in line with the principles.
Given the pros and cons of two approaches, SBP will try to strike a balance between these
two philosophies. The industry is still evolving and, as such, needs some guidance in the
form of detailed rules. At the same time, the need to adapt quickly to changing circumstances
and to learn from experience means that we need to retain flexibility around the detail that
supports our principles.
Basel II implementation
SBP has initiated the implementation of the new Basel II minimum capital adequacy
requirements. The Standardized Approach to credit risk and the Basic Indicator Approach to
operational risk became effective at the beginning of 2008 after running the new regime in
parallel with the old one last year (2007). Banks have made major advances in
implementation of the new framework, though many are facing challenges in areas like
integrated risk management policy, collateral management and the limited availability of
credit ratings for counterparts. Almost one half of banks' on-balance sheet exposures require
external credit ratings but only one sixth of those exposures have ratings. Of those that have
been rated, most are banks, while only a small portion of corporate exposures are rated.
The policy issue for SBP is how fast to allow or require implementation of the more advanced
approaches. Given the dearth of external ratings, banks will reap the full benefit of the new
Basel II regime only when they can apply the advance approaches based on internal credit
ratings. For this they need further improvements in their risk management systems. To push
the reforms, SBP has made it mandatory for banks to carry out internal risk ratings though
banks will be provided lead time for implementation.
The application of the basic Basel II approaches is not likely to result in any major change in
banks' capital adequacy ratios (CARs). The impact studies done so far indicate that lower
capital requirements against credit risk are offset by the new capital charge against
operational risk, when compared against the previous Basel I regime. Only by moving to the
advanced approaches can banks expect to lower their CARs.
Financial conglomerates
Commercial banks are de facto moving into conglomerate modes by venturing into other
sectors. Some banks have acquired or merged NBF institutions such as investment finance,
brokerage, asset management and insurance companies into the banks, while others remain
as subsidiaries. Conglomerates have become the norm, as banks broaden their product
offerings and seek cross-selling opportunities. Presently, 5 banks (and one DFI) own shares
in insurance companies, 12 banks have interests in asset management companies and
mutual funds, and many are involved in other areas like leasing, financial advisory and
brokerage services, modaraba management and foreign exchange.
Financial conglomerates present a major challenge for the SBP. It is generally acknowledged
that financial conglomeration makes good business sense, and that these developments
should be regulated but not stifled by regulation. The main challenges that financial
conglomerates pose for regulators are:
•
First, unless there is strict implementation of sound banking practices, there is a
danger that a bank can become a cheap source of finance to the other members of
a group without proper recognition and management of the risks involved.
•
Second, failures elsewhere in the group can expose the bank to contagion risk.
•
Third, especially where the conglomerate group includes commercial businesses,
there is a risk that the bank depositors end up carrying the residual risk for
nonfinancial businesses.
Regulators address these concerns through consolidated supervision which places a
supervisory net around all members of the group. The primary intention is to prevent an
otherwise sound bank from being impaired by association. As a part of supervisory reform
agenda, SBP will be moving towards consolidated supervision system in compliance with
Basle Core Principles. To allow for this appropriate structural change in financial sector
regulatory architecture would be required and legislated.
Regulatory architecture
The emergence of financial conglomerates has had an impact on the shape of regulatory
architectures around the world. Internationally there has been a marked trend towards
regulatory amalgamation and, within that trend, towards creation of a single or minimum two
agencies with responsibility for all regulation within the financial sector. The reason most
commonly cited for this trend is the need to better cope with the regulation of financial
conglomerates.
Our current architecture in Pakistan is not well suited for consolidated supervision. Some
members of financial conglomerates are under-regulated and no agency has power to
regulate financial groups as a whole. At the centre of the case for reform in this area is the
need for the SBP to regulate and supervise banking groups on a consolidated basis and to
apply prudential norms to all aspects of the business of groups that include banks.
This can be achieved in Pakistan context best by ensuring that all deposit and lending
institutions are under oversight of SBP and the responsibility of lead supervisor for
consolidated supervision be entrusted fully to SBP. The basic rationale for this proposal is to
protect depositors and public liability from the contagion that can arise from financial
conglomeration. This case is strengthened by the role that SBP plays in financial system
stability and the independence and skill base it has to carry out this function effectively.
Financial safety net framework
Depositor protection scheme. Aside from yield, safety of depositors is one criterion for
enhancing deposit mobilization. Since private banks, which form the bulk of the financial
system, are outside the Banks' (Nationalization) Act, 1974 SBP is developing a blue print for
a limited deposit protection scheme (DPS) to protect small depositors. DPS increases
depositor confidence in all banks and comforts small savers and helps the competitive
position of small private banks in relation to large banks or government owned banks, which
typically are viewed as