Shamshad Akhtar: Pakistan - regulatory and supervisory framework
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Institute of
International Bankers Annual Washington Conference, Washington DC, 5 March 2007.
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I. Introduction
Pakistan's financial sector has undergone a phenomenal structural change. Key elements of this
change are:
(i) Privatization of banking industry which only 6 years or so back was 90% in public
sectorprivatization was accompanied by significant debt and labor resolution and restructuring,
(ii) Free and flexible entry of foreign banks raising foreign shareholding to almost half of the
banking sector assets,
(iii) Development of a strong banking system as capital base has strengthened and the ratio of
Net NPLs to Net Loans today is at an all time low of 1.8% for all banks and 1.3% for
commercial banks.
(iv) Enhancement in financial depth and private credit ratio - there is however considerable room
for further expansion of these indicators,
(v) Substantial credit diversification at sector levels which is helping support broad based
economic activity,
(vi) Strengthening of regulatory and supervisory framework along with the stricter enforcement
by a vigilant and strong central bank that is fully independent and accountable to its Board,
and
(vii) Changed perception and approaches to safety net for depositors and prompt corrective
actions. With most banking system now in private hands, the government's implicit
guarantee for deposit no longer exists and now the owners and the Board of Directors as
wells as top management of a bank are liable for their actions. Notwithstanding, central
banks surveillance system plays a key role in identification of the problems, e.g. threat to
capital, liquidity crisis at the earliest stage, and execution of prompt corrective action - the
objective being to curb the problem at the onset, and if required appointing official liquidators
for settlement of depositors' claims in a timely manner, in cases where the corrective actions
result in liquidation/restructuring of the bank.
The trends and performance of banking sector has been influenced by a variety of factors, in particular
higher and sustainable economic growth supported by effective macroeconomic management and
comprehensive and sophisticated prudential regulatory and supervisory (PRS) framework. In
designing PRS, central bank has been realistic and rigorous, while recognizing need for flexibility so
critical given the characteristics, structure and state of financial sector and the prevailing governance
and market practices. Adopted effective January 2004, the PRS has since continuously been updated
substantively to respond to the emerging developments in the sector and to conform to the
International standards.
Pakistan's PRS aims to: promote and preserve financial sector stability, encourages banks to function
purely on market principles and operate in a fair and efficient manner guided by high standards of
corporate governance with emphasis on complete disclosure and transparency. To ensure
effectiveness of this framework, central bank has now put in place an elaborate framework of banking
surveillance and supervision.
In setting this PRS, the main challenge has been to evolve and develop a well balanced PRS which
allows for (i) an open, liberal and competitive neutrality of regulatory framework that promotes financial
sector growth, diversification, and innovation, (ii) healthy competition and risk taking to ensure a
sustainable and aggressive income stream, and (iii) opportunities for enhancing the franchise value of
banks. On the other hand, it is critical for regulatory framework to recognize the need for augmenting
more prudent behavior and ensuring effective risk management especially critical in fast expanding
financial markets and also safeguarding social obligations and consumer interests. By and large
Pakistan's PRS is now market friendly and all credit and lending cum deposit rate prescriptions and
dictates have been withdrawn and banks are now free to operate as long as they comply with
regulatory framework.
II. Regulatory framework
Recognizing the ground realities, Pakistan's financial regulatory framework at this stage restricts
banks from engaging in non-related commercial activities to avoid conflicts of interest between banks
and diverse businesses such as securities and insurance underwriting, and real estate investment etc.
This is largely done to avoid at this stage the complexities emerging from cross ownership and large
conglomerates. Except in case of multilateral borrowings, banks are generally prohibited from
assuming any obligation or guarantees on behalf of Non-bank Financial Institutions (NBFIs).
Banks and development finance institutions (DFIs) exposure to equity market is governed by a PR
which disallows exposures against the security issued by the bank itself or those by prospective
borrowers themselves or provide unsecured credit to finance the floatation of securities or take
exposure against non-listed securities and sponsor directors' shares. Banks investment in any single
scrip is limited to 5% of their own equity with total investment in listed shares is capped at 20%. The
margin requirement against the security of shares of listed companies has been set at 30%.
Notwithstanding these broader restrictions banks are allowed to set up or take higher stakes in their
subsidiaries that can be formed for specified purposes like asset management, brokerage, etc.. This
allows banks to diversify their business interests but operating as a separate business entity.
Consistent with normal practices, the regulatory framework for banks is all encompassing and covers
a broad spectrum of elements which can be classified in six different categories defining; (i) entry
requirements, (ii) risk management guidelines, (iii) corporate governance framework, (iv) industry
specific guidelines, (v) operational guidelines and (iv) anti money laundering regime.
Bank entry and licensing requirements. SBP has the sole authority to set criteria and approve or
transfer ownership of bank licensing. Presently, banks/DFIs are required to, in a phased manner, to
meet capital requirements which have reached $50 million as of December 2006 and will be doubled
to $100 million by 31 December 2009. Among others, higher capital requirements are intended to
accelerate the process of banking sector consolidation. Of 39 institutions, 32 banks are well on their
way to meeting stipulated capital requirements with 8 banks already complying with the 2009 capital
requirements. To the extent capital of banks is being enhanced through M&A process it has facilitated
a degree of consolidation among conventional banks.
SBP has now for few years invoked partial suspension of issuance of new bank licenses. After a
period of liberal licensing, SBP is no longer issuing conventional bank licenses in order to encourage
sector consolidation. Responding to this, market has been dynamic as evident from the wave of
aggressive 25 odd mergers and acquisitions some of them led by strategic foreign banks.
Foreign interest in Pakistani banks is driven by strong business prospects given thus far financial
penetration ratio has been considerably low and there exists large potential untapped retail market as
well as high profitability with return on equity close to 25%. Foreign banks can either conduct business
in branch mode or set up a wholly owned locally incorporated subsidiary provided they are member of
a regional group or association or if foreign banks have a global tier-1 paid up capital of US$5 billion or
more. Other than these categories a foreign corporate/ body desirous of conducting banking business
in Pakistan should set up local subsidiaries with a maximum of 49% share holding. Currently of the 39
banks in the country, almost 14 have foreign shareholding with few of them either fully or partially
foreign owned or other smaller strategic stakes. Foreign interest in banking system has been
substantial and since 2002 cumulatively has attracted foreign capital inflow of over $2 billion (including
funds raised and expected to be raised from GDRs floatation of banks in international markets).
Standard Chartered Bank acquisition of mid size Union bank itself has mobilized significant proceeds.
Besides, ABN-Amro, Citibank, HSBC, Saudi American Bank and Temasak all have an interest in
expanding businesses and/or acquiring domestic stakes, while three banks are offering GDRs in
international markets. Foreign interest in Islamic banks is quite strong with four of six banks being
foreign owned.
Not only is entry easy through M&As in Pakistani banking sector, but license are being issued for
Islamic banks as well as microfinance banks - two areas which hold phenomenal prospects for
augmenting financial penetration, while serving the development needs particularly for the
underserved segments of population. Thus far 6 Islamic banks and 6 microfinance banks have been
allowed with former expected to constitute at least 10% of total banking sector by 2010 and
microfinance reach to enhance to additional 3 million customers. Evading licensing restrictions, the
Government has continued to set up bilateral government-to-government joint venture-DFIs.
Risk management. Banks are allowed to take appropriate and diversified individual, group and sector
risk exposures, while nurturing effective governance standards that would ultimately set the stage for a
more stable and mature financial market, which can then be allowed greater flexibility. Aside from
standard limits on single and group exposures ( limited to 30% and 50% (including 20% and 35% fund
based exposure), respectively), banks exposure on contingent liabilities cannot exceed 10 times of its
own equity. Likewise, clean lending to single persons is limited to Rs0.5 million and in aggregate it
cannot exceed the equity of the banks. Furthermore, Banks/DFIs exposure to a company cannot
exceed 10 times of borrowing entities' equity and the entities current ratio cannot be lower than 1:1.
Corporate's subordinated loans are included in their equity determination. Banks are required to obtain
CIB reports for loan transaction above a limit (currently set at Rs500,000) and audited balance sheet
from borrowers whose transactions value exceeds Rs10 million.
Since consumer financing is still relatively an emerging area, SBP lays down an elaborate risk
management framework for it. Although banks are allowed clean lending for personal and consumer
loans within limits (Rs 500,000), these loans cannot be used for real estate purchase or subscription of
IPOs. New entrants in the first and second year are not allowed to lend more than 2 and 4 times their
bank equity, respectively. For subsequent years, so long as classified loans under consumer finance
are 3%, banks can offer up to 10 times their equity and if these classified loans rise up to and above
10% the limits is scaled down to 2 times the equity of bank. Banks are expected to develop effective
MIS reporting and risk management system for consumer financing. Subject to adequacy of these
system and experience in consumer financing, SBP has relaxed the exposure limits on consumer
financing. However, banks not meeting these requirements or illustrating poor track record of
consumer financing could face restricted exposure limits. Banks have adapted well to these prudential
norms and NPLs related to consumer loans have been low (3% of total NPLs) despite the share of
consumer financing in total outstanding advances has risen to about 14%.
These stringent PRs were instituted to ensure prudent risk behavior, however, in cases where justified,
central bank can relax these exposure limits for temporary period, if financial strength of company's
balance sheet is expected to improve or there is need to finance a strategic project backed by public
sector guarantees. Banks are free to extend loans against hypothecation of stocks and/or receivables
and to set margin financing requirements on financing facilities keeping in view risk profile of borrower.
Classification and provisioning for assets conforms to international norms. Loans overdue by 90 days
are subject to 25% provision (up from 10%) - effective 31 December 2006 and those overdue by 180
days require 50% provisioning and those above 360 days have to be fully provisioned for.
Corporate governance. A recent World Bank study on South Asia "Access to Finance" ranked
Pakistan corporate governance standards highest among South Asia. This is further supplemented by
the 2005 ROSC assessment of corporate governance standards which have given higher points,
relative to the world average, to Pakistan on majority of its principles.
Among other efforts, this is an outcome of effectiveness of an elaborate Corporate Governance
Framework laying down specific corporate governance guidelines for banks which further has infused
greater discipline among bank-finance dependent corporate sector. Besides the legislative stipulations
of Banking Companies Ordinance (BCO), 1962 that provide rules for fit and proper criteria of
Management and Board of Directors (BoD) as well as their appointments/dismissal, disclosure of
share ownership, dividend policy, and appointments of external auditors etc., SBP has introduced a
Handbook of CG for Banks which, among others, defines the role and responsibilities of BoDs; the fit
and proper test criteria prescribed for Chief Executive Officers, Board members and key executives;
restriction on shareholdings by the director; dealings of the banks with directors; and requirement of
credit rating.
Furthermore SBP, in collaboration with the ICAP (the premier accounting body of the country) and the
commercial banks, has facilitated adoption of International Accounting standards (IAS) by the banks.
In 2006 (Feb) the reporting formats were revised to incorporate the significant regulatory
developments and the modifications in the International Financial Reporting Standards (IFRS). With
these changes, the quality of disclosure by banks in their annual accounts is at par with international
best practices.
To ensure the quality of external auditors for banks SBP requires an audit firm to be approved from
SBP Panel of Auditors. The firm is classified in categories A, B, and C depending on a criterion
developed internally and the criteria takes into account the number of qualified accountants,
international affiliation, quality review by ICAP, and past experience. The classification also prescribe
the size of the bank a firm can audit, e.g. large banks can only be audited by firms in category A.
Industry-specific PRs. Replacing all prescribed sector ceilings or subsidized lending, SBP
encourages competition amongst banks to meet the diverse set of development requirements. Given
the gap in supply and demand for credit delivery, SBP has formed consultative groups to identify
issues impeding the outreach of financial services for agriculture and rural sector, SME and
microfinance sectors. Agriculture sector financing has more than doubled over the last few years, but
remains below the overall credit requirements of the sector. Commercialization of agriculture financing,
crop loan insurance program and improvements in land registration and passbook system in rural
areas have been found to be more effective mechanisms to retail agriculture credit, though flow of
non-farm credit has remained low.
Recognizing commercialization of microfinance businesses is key to its financial and social sector
sustainability; SBP has set up a regulatory regime for Microfinance banks (MFBs). Currently about 6
MFBs are governed and regulated by the MFIs Ordinance, 2001 that encourages a paradigm shift in
microfinance industry, while laying foundation for systematic growth of the sector. MFBs capital
requirements are set lower than commercial banks (Rs250 million) and they are required to maintain
equity equivalent to at least 15% of its risk-weighted assets. Under PRs, MFBs are required to set
10% of deposit liabilities in liquid assets and transfer 20% of its annual profits after tax into reserve
fund until it reaches equivalent to its capital base after which this allocation is reduced to 5%. MFBs
have to set up Depositors' Protection Fund or scheme for the purpose of mitigating risk of its
depositors, to which MFB/MFI shall credit not less than 5% of its annual profit after taxes. MFBs have
to set aside general provision of 2% besides other stringent provision requirements. MFBs need to
lend maximum loan size of Rs150, 000. SBP has further issued NGOs/Rural Support
Programs/Cooperative Transformation guidelines for their upgradation to MFBs. Fit and proper criteria
have been laid down for CEOs and Management of MFBs. Guidelines have been issued for
commercial banks interested in engaging in microfinance business. SBP unique and rich regulatory
framework offering a model of development of MF.
Under SBP regulatory framework, banks can offer new financing schemes and innovative products to
meet the financial requirements of SMEs, while providing themselves a viable and growing lending
outlet. Under PRs, banks are encouraged to extend cash flow based lending and they can take clean
exposure secured only against personal guarantees of SMEs owners for up to Rs 3 million, however,
clean funded exposure should not exceed Rs 2 million. For eligibility SMEs ought to declare that it has
not availed clean facilities from any other bank/DFI. The maximum exposure of a bank / DFI on a
single SME shall not exceed Rs 75 million. The total facilities (including leased assets) availed by a
single SME from the financial institutions should not exceed Rs 150 million provided that the facilities
excluding leased assets shall not exceed Rs 100 million.
Operational instructions. Supplementing its PRs, SBP has issued guidelines on risk management,
business continuity plan, internal controls, and stress testing. Both PRs and guidelines form the basis
of our regulatory framework that enables SBP to carry out a proactive role. As the business is
expanding and banks are positioning themselves to take advantage of emerging opportunities, the
technology adoption becomes imperative to get a competitive edge to deliver services in an efficient
and cost effective manner. Accordingly, almost all the banks in Pakistan have embarked upon major IT
projects that will improve their operational efficiency and strengthen internal controls.
Anti-money laundering and Combating Financing of Terrorism (AML/CFT). Pakistan like other
jurisdictions has adopted a comprehensive set of PRs to enhance its vigilance on money laundering
and terrorist financing. PRs for AML require banks to ensure Know-your-customers (KYC) before
establishing banking relationships, conduct due diligence on an ongoing basis, identify and provide
Suspicious Transaction Reports (STRs), ensure maintenance and retention of records, and fulfill
specific requirements for compliance officers and wire transfers etc. In July 2006, SBP updated and
strengthened these PRs and aligned them further with FATF recommendations.
Under KYC-PRs banks have to: ensure true identity of prospective account holders, ascertain nature
of the business, obtain introduction of account holder and determination of beneficial ownership of
accounts while enhanced due diligence is carried out for high risk customers. At the same time,
regulation facilitate interception of transactions, which are, prima facie, associated with money derived
from illegal activities by ascertaining customer's status and source of earnings and investigating
transactions that deviate from account history. Banks are required to retain information about each
account for a minimum period of five years, of all records of transactions, both domestic and
international along with the records on the identification data obtained through KYC/ CDD (NIC, driving
license, passport etc.) and record of STR has to be maintained for longer period and can be destroyed
only with the prior permission of State Bank.
Banks/ DFIs are prohibited to establish correspondent banking relationship with institutions whose
KYC/CDD practices are not in order or who are located in jurisdiction identified by Financial Action
Task Force (FATF) as "non-cooperative countries and territories." Banks/ DFIs have been alerted
against misuse of correspondent account by third parties e.g. payable through accounts. Approval for
establishing new correspondent relationship has to be taken from senior management. Banks are
expected to investigate unusually large transactions and all unusual patterns of transactions to identify
any suspicious transaction that is required to be reported to concerned authorities. The information to
be reported by banks/ DFIs include title, type of account, numbers of accounts involved, detail of
transactions, reasons of suspicion. The employees of banks/ DFIs are strictly prohibited from
disclosing the fact to any person that certain transaction has been or is being reported for
investigation.
SBP has established an AML/CFT unit to deal with the issues of money laundering and CFT. This unit
monitors and investigates STRs An AML law is under consideration and its promulgation will
strengthen further the legislative and institutional framework for AML. Under the Law, SBP will house a
Financial Monitoring Unit (FMU) which will be responsible for overseeing and coordinating all activities
related to AML in the financial system. Oversight of AML will further benefit as linkages and
information exchange among countries is enhanced.
III. Banking supervision
Like other central banks and supervisory authorities, SBP conducts regular onsite inspections of all
financial institutions under its jurisdiction. This involves assessment of banks overall financial health,
evaluation of quality of management and role of Boards and sponsors and verification of compliance
with legal and regulatory requirements. The inspections are conducted on CAMELS-S methodology
whereby inspection team assesses and rates each component viz. Capital Adequacy, Assets Quality,
Management, Earning, Liquidity, Sensitivity to Other Risks and Systems and Controls. Increase in size
and complexity of financial sector and introduction of new and innovative financial products, has
required SBP to enhance the sophistication of approach and methodology of its inspections. Capacity
building is being launched to develop SBP skills in risk management, Islamic Banking, treasury,
foreign exchange, IT etc. In addition, work is underway to strengthen further its capacities for oversight
of Basel 2.
Off-site supervision & surveillance. In response to changing realities, lessons learnt and peculiar
financial conditions, the off-site monitoring system at SBP has undergone substantive changes since
its introduction in 1997. The off-site monitoring system (i) monitors the overall and individual banks
financial health, (ii) helps in early problems detection for appropriate corrective action, and (iii) focuses
on-site supervisory resources to high risk areas or activities. Off-site monitoring is conducted based on
periodical returns of banks. On line submission of the Report of Chart of Accounts will enhance
efficiency and quality of offsite supervision. SBP is to start building capacities for more integrated
supervision where industrial groups and NBFIs relationship with banks is growing. At this stage, SBP
is coordinating with the Securities and Exchange Commission of Pakistan (capital market supervisory
agency) for exchange of information of transactions that cut across sectors and involve both banks
and NBFIs.
Institutional Risk Assessment Framework. Driving inspiration mainly from the Supervisory
Framework Rating Assessment criteria of the Office of the Superintendent of Financial Institutions
(OSFI) of Canada, SBP has introduced an Institutional Risk Assessment Framework (IRAF) to
enhance its supervisory vigilance by integrating and consolidating the information collated through its
regular supervisory and surveillance mechanisms. IRAF engenders a risk rating taking into
consideration the information available regarding a bank from various sources. It not only embraces
the offsite and onsite feedback, it also takes management of banks on board, to establish their rating
regarding their compliance with standards, codes and guidelines issued by SBP. To make the
supervisory process an all-inclusive exercise, market information regarding the health of banks has
also been incorporated in the framework.
The supervisory process of onsite inspection, offsite surveillance and IRAF culminates into
enforcement actions. The enforcement actions that can be taken by SBP range from imposition of
pecuniary penalties to removal of management, board of directors and cancellation of banking license.
The results of stringent enforcement actions taken have been encouraging as majority of the banks
have displayed extraordinary operational performance over the past five years.
IV. Emerging challenges and Issues
The increasing growth and complexity in banking sector have now given rise to new issues and
challenges. While initially preoccupied with their own primary business of banking, the banks have
now cross ownership where industrial and brokerage companies own banks and banks own
subsidiaries and associate companies that handle asset management, brokerage, insurance, housing
and telecommunications businesses. These close linkages and cross ownership structure among
corporate and FIs expose the banks to related party transactions risks. At the same time, growing
foreign acquisition and entry of new regional and global players as well as growing domestic banks
presence oversees requires SBP to deal with home and host regulator issues. Responding to these
structural changes in financial sector, SBP is positioning and equipping its inspection and supervision
department to deal more effectively with the emerging supervisory challenges.
Consolidated and cross border supervision. Besides developing in-house capacities for joint
conglomeration and consolidated supervision, SBP is developing greater interface with other central
banks and has signed about 15 Memorandum of Understandings (MoUs) with various central
banks/supervisors. These MoUs have a wide variation in scope, ranging from provisions for exchange
of information to sharing license criteria, on-site inspection, supervisory cooperation, combating money
laundering, nature of action to be taken in case of any irregularity etc. Even where MoUs are not in
existence, SBP shares information with the host country supervisors as and when necessary.
However, there is scope for greater effective relationship among regulators.
Complexities of implementing effective risk management. SBP's elaborate risk management
framework has helped contain effectively all sources and types of risks. To monitor resilience of
banking system towards shocks to risk factors, SBP calibrates alternate scenarios subject the overall
banking system and individual banks to different degrees of credit, market and liquidity shocks. This
stress testing is conducted every quarter. Based on September 2006 data, all banks were generally
found to be resilient to credit risks and after shock capital adequacy ratio was found to remain above
11%. For one bank, capital adequacy would decline below these levels if either benefit of forced sale
value is withdrawn due to banks exposure to mortgage collateral and for couple of banks shocks to
credit quality of consumer portfolio may increase consumer sector NPLs and impact capital adequacy.
Banks were equally resilient to interest rate shocks for movement upto 200bp and equity price
movements in the range of 20%. Liquidity coverage ratio would come down in case of 10% decline in
liabilities. In case of exchange rate depreciation banks are found to actually gain as their foreign
currency assets are in excess of foreign currency liabilities.
While stress testing results offer broader comfort about banking sector strengths, there is need to
recognize that there remain some areas of concerns. For example, banks do face (i) maturity
mismatches, of special concern in the rising interest rate scenario; (ii) potential risk of loan defaults in
the backdrop of rising consumer finance portfolios and equity markets exposure of the banking
system; and (iii) risks posed by weaknesses in internal control system and lack of effective mechanism
for containing operational risks. Commercial banks are launching substantive efforts to address these
problems and adoption of technological solutions and connectivity of all branches with headquarters of
banks will help in this area.
Implementation of Basel II Accord. Pakistan adopted a road map for implementation of Basel II
Accord. Under this, banks will be adopting the standardized approach from January 2008 based on
the spade work conducted since July 2006. There are number of issues in adoption of standardized
approach. First, only a small proportion of corporate sector is rated by the rating agencies. In absence
of the rating of borrowers, banks may end up allocating more capital than warranted. To ensure
coordinated approach to Basel II implementation, SBP has set up a Working Group under the
guidance of SBP to remove obstacles in its smooth implementation. Effective preparation for Basel II
requires development of allied and support infrastructure that facilitates need for strengthening and
enhancing role of credit rating agencies and development of internal controls and IT systems. In
absence of credit rating agencies, Pakistan is developing further role of private sector Credit
Information Bureaus, and independent debt/financial advisories etc. The gaps in the rating agencies
are of particular concerns for SBP, given its heavy reliance of Standardized approach under Basel II.
SBP has to further upgrade its capacity for supervisory review (Pillar II) and a core group of
supervisors will be trained in this shortly.
Lastly, there is need for more intensive capacity building of industry and SBP. Greater
international cooperation in strengthening the capacities of developing markets in risk management
and emerging supervisory approaches would be key to enhancing effectiveness of vigilance and
oversight both at bank and central bank level.
Conclusion. Being autonomous and effectively empowered under the Banking Companies
Ordinance, 1962 SBP has adopted a rigorous but flexible regulatory framework which helps to keep
banks exposure within tolerable range, while allowing them opportunities to enhance and diversify
their businesses. Banking sector has played a key role in supporting real sector development whose
performance and macroeconomic stability have together re-inforced banking sector performance. All
time high profitability and structural transformation of banking sector has attracted substantial foreign
capital in banks which given its innovations and practices will augur well for strengthening and
sustaining banking sector performance. Proper enforcement of regulatory framework has been helped
by a strong SBP's independent supervisory and surveillance mechanism and validation process of the
external auditors. Effective oversight has induced banks to enhance their corporate governance and
compliance with laws and regulations that also follow international accounting and disclosure
standards. Despite these achievements, both central bank and banks have to continue with
broadening and deepening of structural reforms to help enhance financial services penetration and
address the outstanding vulnerabilities in the system, while facilitating industry smooth adoption of risk
measurement and management systems advocated under Basle II.