Shamshad Akhtar: Pakistan - financial stability
Address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Institute of
Bankers Pakistan (IBP) Convocation, Karachi, 23 February 2008.
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1. Recent and recurrent episodes of financial crisis have magnified the significance of
financial stability and its dimensions. Every crisis - be it economic, currency, banking or,
more recently, liquidity - has resulted in huge financial and banking losses and adverse
economic consequences that transcend beyond national boundaries. Learning from the
crisis, globally, there has been incremental understanding and build up of knowledge of what
disrupts and promotes financial stability. New approaches and methodologies have evolved
to assess different dimensions of the risks facing different segments of financial markets and
their implications.
I. Financial stability: approach and dimension
2. Mishkin in 19911 defined financial stability to ensure and promote, in a lasting way and
without major disruptions, an efficient allocation of savings to investment opportunities.
Generally, maintenance of financial stability depends on effective financial regulation, which
aims to provide right incentives for prudential conduct and risk behavior by financial
institutions. Primary objective of financial stability policies and assessment should be to
provide early warning signals for crisis prevention as distinct from crisis mitigation. Stability of
financial system benefits and promotes (i) smooth and efficient financial intermediation
processes that allocate savings to profitable investment opportunities; (ii) balanced
development of different segments of financial system; and (iii) proper transmission of
monetary policy, whose effective conduct and implementation in turn facilitates price stability.
3. Price stability and financial stability tend to mutually reinforce each other in the long run.
High inflation creates financial instability since it generates misperceptions and creates
problems in predicting real returns. It can also worsen the asymmetry of information available
to lenders and borrowers. A business cycle boom accompanied with high inflation is
traditionally considered as the typical environment in which real over-investment and asset
price bubbles blossom. Excess liquidity provided by the central bank is one of the main
factors responsible for the development of inappropriately lax lending standards. Credit
growth, which is excessive in view of realistic return expectations, is often the foundation for
financial instability. Hence, monetary policy focused on price stability plays an important role
in ensuring stable financial markets.
4. Keeping in view these considerations, most countries have developed elaborate
frameworks designed to measure, monitor and safeguard financial stability. It is prudent to
assess macroeconomic and financial sector vulnerabilities and to judge the implications of
these two so that appropriate corrective actions and policies may be put into place to prevent
a crisis. A number of advanced countries have adopted sophisticated models to conduct
macroeconomic and financial sector surveillance. However, other developing countries,
given the data limitations and size of financial sector, have adopted simpler frameworks for
assessment of financial stability.
5. In assessing macroeconomic vulnerabilities it is standard to examine the sustainability of
the fiscal and external accounts - any drift in these two principal modules of the economy
creates monetary complications and can generate instability in both domestic and foreign
exchange markets. Depending on the intensity of disruptions, there may be implications for
the financial sector, often resulting in repricing of assets and affecting the growth of private
sector including banking business.
6. To comprehensively assess the financial sector vulnerabilities, there is a need to assess
the risks associated with (a) financial institutions relying on a range of financial soundness
indicators that help assess credit, liquidity, market, exchange rate, operational and
reputational risks etc.; (b) financial markets that may face counterparty risks, contagion or
asset price misalignments; and (c) financial infrastructure risks ranging from legal and
regulatory risks to the clearance, payments and settlement system.
7. While assessing the key risks and vulnerabilities in the economic and financial system, it is
critical to adopt analytical approaches to:
(i) identify, assess and measure the source of risks and track the channels through
which they may propagate and ultimately affect the financial system;
(ii) developing an understanding of financial stability transmission mechanism; and
(iii) aggregate the risks and properly stress test the impact of potential shocks on
different institutions and markets.
II. Pakistan Financial Stability Review
8. State Bank of Pakistan (SBP), the central bank and primary regulator of financial sector, is
responsible for conducting financial stability review given its dual mandate of monetary policy
and financial regulation and supervision. SBP has a hand on the pulse of economy and as
such is able to decipher monetary transmission mechanism and its impact on the economy
and the financial sector. At the same time, vigilance on banking sector helps SBP to
understand the financial transmission mechanism which assists in the formulation of overall
policy stance for both monetary and banking sector.
9. SBP has been conducting financial stability analysis for the last 5 years or so. However,
the framework for financial stability is still evolving. Starting in 2004, SBP conducted an
annual Financial Sector Assessment Program dovetailed with quarterly and annual Banking
Surveillance Reports. Integrating these reports, in 2007, SBP launched its first
comprehensive Financial Stability Review (FSR) that offers a rich assessment of risks and
vulnerabilities of financial sector and macroeconomic challenges.
10. Among other components, the main component of FSR is the assessment of banking
sector as it constitutes the largest segment of financial system. Banking sector has managed
to grow substantially and its stability can be assessed in a number of ways:
(i) Solvency of banking system is safeguarded if the banks' capital offers necessary
cushion to absorb unexpected losses. Rising profitability coupled with SBP's policy
to strengthen the capital of banks has contributed to rise in the risk based capital
adequacy of banking system to 13.6% by September 2007 (relative to 8.8% in
2001). Quality of capital has also improved (with the rise in risk weighted assets to
Tier 1 capital) and the share of risk based capital now constitutes close to 80% of
core capital.
(ii) Profitability: Performance of banks has been good converting the commercial
banks' losses, registered until early 2000, to positive: return on assets is now 2%
and return on equity 20%. Although, net interest margins have increased from 59%
in CY03 to 70.5% in September 2007 and cost to income ratio, an important ratio to
measure operating efficiency, has improved from 62.4% to 42.3% from CY01 to
September 2007, there is substantial scope to enhance efficiency in financial
intermediation process. Structural change in ownership structure, with private sector
now holding almost 79% of total banking assets, has augured well to enhance
profitability of banking sector while ensuring professionalism in the management of
banks. Growing foreign ownership and acquisitions have paved way for
strengthening the capital base of banks and is helping to enhance competition. In
addition, in line with the empirical evidence in other countries, it is expected that
entry and growth of foreign banks will contribute to higher average loan growth,
better risk management practices, greater provisioning and loan loss absorption
capacity.
(iii) Asset quality has benefited from loan restructuring and write offs, stronger
regulations, prudent lending and growth in advances. Non-performing loans (NPLs)
to gross loans fell from 17% in CY03 to 7.7% by September 2007 and net NPLs
from 7% to 2.3% over this period. Concurrently, provisions to NPLs ratio improved
from 64% to 72%. Bank's capacity to absorb losses has grown as net NPLs to
capital ratio declined from over 150.5% in CY01 to merely 11.4% in September
2007. Furthermore growth and sector diversification of loan portfolio has helped to
reduce the risk of overexposure.
(iv) Market risk has different dimensions as banks are engaged in a variety of
businesses that expose them to interest rate, foreign exchange and equity market
risks etc. The principal market risk facing banks is interest rate risk. The duration of
assets and liabilities offers an accurate indicator of interest rate risk. With banks
primarily raising short term deposits and lending for longer maturity the asset-liability
mismatches are significant, though banks are being encouraged to raise long tenor
deposits through exemption of cash reserve requirements.
(v) Liquidity risk: Liquidity management is a key banking function and it helps banks
withstand shocks and losses. Liquidity risk, as measured by liquid assets to total
assets and other indicators, has remained stable over the last 5 years albeit a
modest decline recently along with decline in liquid asset to deposit ratio while
advance to deposit ratio rose modestly.
11. While these indicators allow us to gauge the soundness on selective basis, the Financial
Soundness Index (FSI) indicator offers a more holistic measure. FSI is calculated as an
aggregate index assigning 0.25 weights to four key financial soundness indicators including
capital adequacy, asset quality, profitability and liquidity. This index was negative for a
number of years but since CY02 it has been positive and has consistently improved.
12. Another major aspect of effective surveillance is checking the resilience of the banking
system to various shocks through stress testing exercise. SBP performs stress testing
through a set of exceptional, but plausible, assumptions using simple sensitivity analysis.
The shocks cover different risk factors namely interest rate, forced sale value of collateral,
NPLs, stock prices and foreign exchange rate in addition to liquidity, credit and market
shocks. The stress testing exercise allows SBP to gauge the possible adverse impact on the
banking system and provides basis for taking future regulatory measures. In principle,
fortifying capital base has lent greater resilience to the banking system against the adverse
shocks. As of September 2007, capital of all banks can fairly absorb the impact of a shock of
10% in increase in total NPLs. None of the groups would experience a fall in its CAR to
below 8%. In consumer finance category, however, a rise in NPL-to-loan ratio to 10% (which
is at 4.4% as of 30 Sep 2007) of total consumer loans can have adverse impact on some
banks. Individually, four banks holding a share of 11% in the assets of the banking system
would experience a decline in their CAR to below 8% under this sensitivity test. The impact
of interest rate, exchange rate and equity price shocks can also be well absorbed by the
healthy capital base of banks.
III. Key policy drivers of financial stability
13. Financial stability in Pakistan has benefited from structural transformation of banking
sector and wide ranging policy initiatives of the central bank. In particular, Pakistan's
prudential regulatory regime has been crafted to promote and preserve financial sector
stability. Regulatory framework encourages
(i) financial sector growth, diversification, and innovation;
(ii) healthy competition and risk taking to ensure a sustainable and aggressive income
stream;
(iii) opportunities for enhancing the franchise value of banks;
(iv) prudent behavior and effective risk management to discourage infection of loan
portfolio; and
(v) safeguarding social obligations and consumer interests.
14. Promoting sound banking practices, SBP has implemented exhaustive guidelines for
corporate governance and on risk management, business continuity plan, internal controls
and stress testing. In 2007, SBP has been stringent in overseeing the Management and
Board conduct and their conformity to fit and proper criterion. Furthermore, two major sets of
new regulations were introduced under which banks were required to induct independent
Board members and adopt umbrella risk management guidelines. A survey is currently
underway to assess corporate governance practices of banks.
15. Financial stability has been further fostered by the strengthening of banks' system-wide
capital base to Rs 372 billion. Process of consolidation has been catalyzed by 30 odd
mergers and acquisition (both domestic and foreign-led), moratorium on licensing of
conventional banks and rise in minimum capital requirements for banks and DFIs. To
streamline capital with risks, banks have initiated implementation of the standardized
approach, as prescribed under Basel II regulations. Over the period, this is expected to
augment the economies of scale and improve efficiency as competition and innovation
grows.
16. Enhanced push from SBP for delivery of development finance will help diversify the credit
portfolio and will alter risk profile as there is relatively low correlation of the inherent risk
factors among different sectors.
17. Financial stability will further benefit from SBP's operationalization of the Real-Time
Gross Settlement System (RTGS) named PRISM (Pakistan Real Time Inter-bank Settlement
Mechanism) in June 2008 which will allow shift from traditional paper-based, end-of-the-day
settlement system to electronic payment system for large value, low volume inter-bank fund
transfers and settlements.
18. Money market stability has improved with SBP's efforts to develop an effective market
determined yield curve for government securities which sets the stage for development of the
corporate debt market. Moreover, derivatives market, which is an important pillar for effective
risk management, though still in its infancy, has taken off. Presently there are five banks
which have been given the status of Authorized Derivative Dealers by SBP. The derivatives
market is being regulated under SBP's Financial Derivatives Business Regulation and covers
interest rate swaps and forward rate agreements, in Pak Rupee and other currencies (after
SBP approval).
IV. Risks to financial stability
19. The financial sector of Pakistan has experienced an extraordinary growth in recent years.
Financial assets have grown to $180 billion and are now equivalent to 125% of GDP
(compared to 95% of GDP at end-1997) reflecting strong growth in banking sector assets
and stock market capitalization. The substantial growth in financial sector brings with it
associated risks. Results for banking sector surveillance, as highlighted above, give comfort
that financial risks are well contained though growing macroeconomic imbalances, unless
addressed urgently, could threaten the financial stability.
20. A principal risk to financial stability is often country's economic structure and the
macroeconomic framework. Country's with high concentration in one or two sectors often
face risks to financial sector, if there is an over-exposure of the system to these sectors.
Similarly, macroeconomic imbalances introduce economic vulnerabilities which in turn induce
inflationary pressures and/or exchange rate volatility. These factors do pose system wide
challenge to financial stability.
21. Another risk to Pakistan's financial stability is its overall lack of financial sector
diversification. Of particular concern is the size and issues surrounding the nonbank sector.
Of the total financial sector assets, insurance companies account for barely 3%, mutual
funds 3% (and are largely sponsored by banks) while other non-bank finance companies
(NBFCs) are 2% of the system and holders of listed private bonds are less than 1%.
Furthermore, NBFCs are fragmented and weakly capitalized. For financial sector stability, it
is critical that such institutions be better capitalized and a conducive environment is created
for the growth of promising segments (collective investment schemes, including mutual
funds), niche markets and products are introduced for leasing companies, modarabas,
housing finance and venture capital, and penetration is enhanced in the insurance industry. It
is also important to consider that while market capitalization has grown impressively, its role
in raising long term risk capital or debt for new industry over the last several years has been
limited.
22. There is further scope for enhancing banking sector stability too. Although competition is
emerging with the growth of mid-sized banks and foreign acquisitions, five largest banks hold
50.6% of total banking sector assets; though there has been a clear reduction in the level of
concentration which was at 63.2% in 2000. While this is a concern, the presence of
undercapitalized small banks is likely to pose risks particularly during periods of adverse
economic cycles.
23. Another area where there is scope for strengthening financial sector stability is greater
credit diversification. Over 50% of the bank credit portfolio is concentrated in corporate sector
serving fewer industries. Diversification of bank's loan portfolio to support more retail and
infrastructure financing will be critical for the growth of banking sector. SBP needs to develop
its capacities to monitor financial position and probability of default of the corporate and
household sectors within the stability framework.
24. Cognizant of maturity mismatches, SBP has introduced different cash reserve
requirements (CRR) for demand and time liabilities to encourage banks to mobilize long term
deposits. Specifically, while the demand liabilities (including time liabilities of less than one
year maturity) attract CRR of 8%, time liabilities of more than one year maturity are
exempted from CRR.
25. Finally, now predominantly private sector-owned financial sector presents its own
challenges. SBP is working towards developing adequate policy framework for consumer
protection, development of Financial Safety Nets such as Deposit Insurance and a well-laid
out "Lender of Last Resort" procedure to strike a balance between enhancing consumer
protection and minimizing moral hazard. At the same time, there is need to encourage
efficiency of financial intermediation by reducing banking spreads. SBP is further developing
capacities to monitor operational risks associated with weak internal control systems, delays
in adoption of information technology solutions and outsourcing of processes by banks.