Shamshad Akhtar: Financial sector of Pakistan - the roadmap
Inaugural address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Dawn Asia
Finance Conference - Asian Banking: A Paradigm Shift, Karachi, 13 May 2006.
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The financial system in Pakistan has grown substantially, benefiting from multi-pronged financial
reforms. These reforms have been pursued persistently and vigorously over a decade or so and have
supported economic growth. The inefficiencies and weaknesses, which were typical of banks'
operations in the pre-reforms era, have been reduced radically. We have now started to realize the
dividends of reforms in the form of a healthier, sounder and stronger banking system. Liberalization
and deregulation, core pillars of the reform measures, have served to enhance the size of the banking
system both in terms of the number of banks and growth in credit, besides instilling a degree of
competition in the banking industry.
However, the task of financial sector reforms is far from accomplished. Given the changing dynamics
of the economy and its growing complexities and accompanying associated risks, the financial industry
has to remain responsive and supportive of the broader economic ambitions and agenda. The country
can neither afford slippages nor can we visualize the future dispensation of the banking system of
Pakistan. All the major players and stakeholders in the banking system will have to strive for
continuity, broadening and deepening of reforms, build and sustain the already implemented reforms
and fill the remaining fissures. The growing competition along with increasingly diversified services,
both across the regions and sectors, and improved access to customer-base on the back of
progressive reliance on technology, are the harbingers of the changing and efficient intermediation
role of banks in the days ahead.
In order to develop the future outlook, I will now examine both the emerging domestic and external
trends, which potentially impact the future financial sector architecture: its structure, texture and the
operations of financial institutions. In this respect, eight factors are generally believed to have been the
major drivers of change in the financial industry the world over. They include:
1) Macroeconomic performance and priorities
2) Deregulation and market forces
3) Product innovation
4) Globalization
5) Technological advancements
6) Universal banking
7) Risk Management and Mitigation
8) Changing Role of and demands on the Regulator
These forces, to a varying degree, will play a more dominant role in shaping the future complexion of
the financial sector and its institutions and entail far reaching implications in terms of stimulating
increased competition, greater consolidation, increased diversification and enhanced dynamism in the
financial players and markets. The central bank, along with major players in the market, will continue
to develop and refine the mutual vision and plan for the financial system of Pakistan. All key players
will have to correspondingly position themselves, change their attitudes, and be responsive to
collectively transform the financial system of Pakistan into a dynamic and efficient arm of the
economy. This can be attained if the financial system meets the divergent needs of all segments of the
economy by providing a wide array of financial services based on the use of globally competitive
technology, highly skilled human resources and harnessing global best practices. Equally critical for
regulators, are the aspects of the stability and robustness of the financial system and as such there
will have to be further refinements in the domestic regulatory and supervisory framework to align it
more closely with international standards, while taking due notice of the attendant and emerging global
and domestic challenge and risks.
I will now elaborate on the forces and factors which might be directly or indirectly related to the future
performance and standing of the financial system of Pakistan.
Macroeconomic performance and priorities
Financial system of any country has an intrinsic relationship and needs to be shaped in accordance
with the broader economic needs, structure and policies. Considering this interdependence, it is
imperative to assess the behavior and trends of the key macroeconomic indicators while drawing the
emerging contours of the financial system. In this respect, the major indicators of the economy during
the last few years have shown robust performance. GDP growth shot up to over 8 percent in FY05 and
the current year also promises higher than 6 percent growth. Undoubtedly, consistent and stable
economic policies provided the businesses with confidence. However, easy availability of funds on the
back of historically low level of interest rates proved to be the real catalyst for the subsequent sharp
growth in credit to the manufacturing sector and eventually proved to be the real determinant of high
GDP growth. Strong credit demand of the manufacturing sector translated into a sharp increase in the
interest income of the banking system, giving rise to unprecedented profits and healthier balance
sheets during the last two years. Redeployment of these profits to augment financial services will help
meet the growing economic requirements.
The near term economic prospects are promising. The continued strong pace of economic activities,
and plans to launch widespread infrastructure reforms offer strong business prospects for the financial
sector. Real interest rates remain at tolerable limits. Notwithstanding, there will be demand pressures
in particular if the trade deficit grows out of proportion and inflationary tendencies continue to persist. A
consequent fall in demand for credit or a possible impairment of the debt repayment capacity of
borrowers does carry the risk of reversing the current gains enjoyed by the banking system. But these
risks are being well managed and if the economy continues the growth momentum for the next decade
or so, the financial system of Pakistan is expected to reap benefits out of rising incomes, consumption
and emerging investment demands.
Traditionally, infrastructure projects fell in the public sector's domain of activities. However, recent
years have seen a paradigm shift in this area, with the growing interest of the private sector to
undertake such projects. There exists immense potential for the financial institutions to finance such
infrastructure projects built on public-private partnerships or even exclusively in the private sector. This
will help diversify their activities as well as enhance their earnings. Similarly, financial institutions can
take advantage of the changing demographic patterns, rising incomes and enhancement of policy
priorities for various sectors. These trends are already visible as reflected by the increasing proportion
of urban population, rising literacy rates, and the increasing share of the industrial and services
sectors in GDP.
The financing to SME, Agriculture, and Micro finance segments of the economy carries special
importance with respect to future economic growth and diversification of banks' loan portfolios. The
State Bank will accord further priority to improving access of development finance to these segments
and will work with the provincial and local governments to facilitate a conducive environment, and
supportive financial and legal infrastructure to give impetus to economic growth and poverty
alleviation. The banks will have to strengthen their systems to meet the challenges and opportunities
arising out of their venture into these segments.
Deregulation, market forces and consolidation
The spate of liberalization and deregulation measures in recent years has unleashed strong forces of
competition. These are fast defining the future course of Pakistan's financial sector. Emerging role of
the private sector has displaced the public sector from its dominant position, giving rise to aggressive
competition across the market operators, and the market pressure by the stakeholders to perform is
going to result in fiercer competition. This is expected to change the business landscape and
chemistry of the competition as market players will have to use fresh thinking on financial products and
the structure of the market, and focus on value creation to survive.
The stiffening licensing policy and regulatory capital requirements are already posing a great
challenge to the small banks, and with gradual enhancement of the minimum capital requirements in
the coming years, they will have to either inject more capital to become compliant or amalgamate with
other financial institutions, or as a last option, exit the market. The current trend depicts that new
entrants, only allowed by way of strategic partnership in existing banks and/or new Islamic banks, are
coming in with higher capital. More so, consolidation of financial institutions is well underway and is
likely to lead to the emergence of fewer but stronger institutions to meet the challenges of the
increasingly complicated financial environment of the future. The competitive environment might also
force financial institutions to specialize in offering certain types of services based on their respective
expertise and market niches.
Product innovation
In a sharp contrast to international trends, the financial system of Pakistan has been lacking in
developing innovative products to meet the diversified needs of different customers. However, the
emerging financial scenario characterized by intense competition leaves little room for complacency in
developing new and attractive products on both the asset and liability sides. Product innovation and
developing brand loyalty by creating specialized products will decide the volumes of business and
market shares in the future. Presently, the absence of specialized liability products is most
conspicuous. The growing awareness among investors and the expected development of other
avenues of funds' deployment e.g. the long term fixed income and mutual funds market provide
attractive alternatives. Thus the financial institutions which take initiative of these kinds are likely to
grab greater market share of funds in the future.
Ideally, greater liberalization with ensuing competition should have led to a narrowing down of
spreads. However, in case of Pakistan, there appears to exist a somewhat paradoxical situation,
where banks are able to widen their spreads mainly because they enjoy comparative advantage in
offering unique banking services, primarily because of the almost non-existent competition from
nonbank finance companies and a dormant institutional finance industry as pension and insurance sector
reforms have yet to catch up with other financial sector reforms. However, the future promises
emergence of competitive non-bank companies which offer alternative sources of investments. And
banks will need to generate fee-based income to fill the gap created by declining interest incomes.
Pakistan's market has a huge room for the development of derivatives and synthetic products. The
growing financial engineering of services and products requires greater attention to the hedging of
risks. Financial institutions need to increase their role as risk managers to corporate and other entities
by offering a variety of derivative products.
Financial institutions are also expected to employ processes and practices, which could help them to
become more cost effective and efficient. Certain traditional services might also be outsourced to gain
efficiency and focus on core areas as competition might not be the only rule of the game. The financial
institutions might also cooperate in offering certain types of services. Presently, this is reflected in the
networking of ATMs. This co-optation is expected to become the order of the day as banks seek to
enlarge their customer base and at the same time realize cost reduction and greater efficiency.
Globalization
With the falling barriers to capital mobility and opening up of financial services in the wake of WTO,
globalization of financial services is expected to accelerate in coming days. As the financial institutions
gains size, competitive edge and develop their systems at par with the global practices, it would be
profitable to seek greater opportunities offered by the large financial markets around the globe.
Particularly, opportunities in emerging and regional future economic power hubs are bright. Moreover,
higher trade activities are also likely to give boost to banks' role in forex business and their support to
corporate customers to expand their business across the borders.
So far, Pakistani banks have performed fairly well against the foreign banks operating in the country.
Lately, under the intense competition put up by the local banks due to significant improvement in their
processes, foreign banks have been on the retreat even in the areas where they used to enjoy virtual
monopoly. However, with the increasing trade volumes in relation to GDP and growing overseas
business opportunities for Pakistani corporates, as well as increasing capital flows, the large foreign
banks would find considerable scope to capitalize on their expertise due to their established global
position and awareness of different markets around the world.
Technology
Technology helps to catalyze efficiency in the provision of financial services and ultimately in
determining the winners in the intensely competitive financial markets of the future. Technological
breakthroughs have forced fundamental changes in the financial industry: strategic business plans
have taken into account new ways of doing businesses, launching e-banking, and using information
and technology for developing better internal controls, more sophisticated risk management systems
and better and convenient customer services. Hence it is critical that Pakistan's financial industry
adopts an appropriate organizational model that supports a customer-centric approach and
reengineers business processes to exploit technology to derive economies of scale and create cost
efficiencies.
The use of ATMs and e-banking products is gaining currency and almost all banks have established
networking of their ATMs with the interconnectivity of switches. Better outreach offered by ATMs will
enhance the customer base and offer more alternatives and choices to customers. Further
development on e-banking and internet banking will open up new avenues like on-line banking.
Among others, the relatively smaller size banks will be able to compete with the large banks and retain
their market presence by using technology more effectively.
Technology tends to have a high degree of obsolescence. Thus, the financial institutions will have to
invest heavily in the development of their IT systems, which might initially burden their resources. For
this purpose, the financial industry will have to optimize its resources for technology applications. The
immediate solution might lie in sharing of facilities. Banks in Pakistan are already cooperating
extensively in using ATMs services. The future areas of cooperation might involve payment and
settlement, back-office processing, data warehousing etc. At the same time, financial institutions will
also have to raise adequate safeguards to deal with the associated operational risks. This would invite
special focus of their management in the future.
Universal banking
Universal banking has gained sharp acceptance as traditional boundaries of financial service provision
have become blurred. In addition to their conventional commercial banking services, banks have
withdrawn from specialization to offering a broad menu of services. This presents the banks with
opportunities as well as challenges and requires constant development of their expertise in the new
areas of their operations.
The idea of universal banking, which is still evolving in Pakistan, is likely to galvanize the non-banking
financial sector in developing competitive products and use modern technology to secure themselves
against banks making inroads into their traditional areas of operations. This is likely to give further
impetus to competition in the financial sector for the provision of quality financial services.
At the same time this might catalyze mergers among banks and non-bank financial institutions for their
mutual survival. This trend may lead logically to promoting the concept of a financial super market
chain, making available all types of credit and non-fund facilities under one roof or in terms of
specialized subsidiaries under one over-arching organization. Consolidated accounting and
supervisory techniques would have to evolve and appropriate firewalls built to address the risks
underlying such large organizations and banking conglomerates.
Risk management
The above-mentioned forces of change have significantly increased the importance of strengthening
the risk-management practices of the financial system. With the proliferation of new techniques and
financial institutions venturing into new areas, a whole range of market related risks have surfaced.
This will render the traditional risk-management techniques obsolete as new derivative products and
off-balance sheet operations become more common. The hitherto neglected area of operational risk
management has also come to assume greater importance and the pervasive use of technology has
multiplied the importance of managing this risk in tomorrow's more volatile banking environment. The
financial institutions now have to have enough paraphernalia to tackle these risks in line with the
international best practices. In this respect, risk-management tools built upon the latest technology
would provide the financial institutions to manage the host of new risks in a more efficient manner.
This will enable them to deploy resources more effectively.
The importance of sophisticated risk-management practices will become even more pronounced as
the banks strive to implement the Basel II accord. The smooth switch over to Basel II will be a
challenging task before the banks, and this has far-reaching implications for the future structure of the
banking system. Basel II would require a heavy investment in technology and development of MIS
tools to incorporate the internal risk-based approach. The risk-based approach to capital allocation will
be the inherent theme, as each asset will be allocated a rating both externally and internally. This will
ultimately influence the capital charge for each asset and would thus help minimize the reckless
risktaking by banks on account of the heavy capital charge.
As financial innovation becomes ubiquitous and new technology and standards evolve to make
financial transactions more complex and volatile, the role of the regulators is going to become tougher
in the days ahead. This brings me to the concluding, but not the least important section, i.e. the
changing role of and expectations and demands for regulators.
Changing role of regulator
The central bank has been transformed substantially. It is today a very user friendly institution, based
on feedback of the industry. It is candid in putting forth its views, and over the years has withstood a
number of political challenges.
Over the next few years, we plan to : First, with the support of the Government, launch adequate
initiatives to strengthen the governance of the central bank. In this context, SBP is in the process of
benchmarking itself with the other central banks that have attained good governance standards. The
evaluation of central banks' governance practices is judged on the basis of the roles and
responsibilities of the Management and the Board of Directors, and the appropriate interaction and
interface between the central bank and the government. In deciding an appropriate balance in these
roles and responsibilities, it is critical that central bank's independence is not compromised in terms of
the conduct of monetary policy as well as the oversight of the financial sector. In all contexts, it has to
be recognized that independence has to be accompanied by effective accountability of the central
bank. The institution has to be accountable to the Parliament and the Senate, and work in conformity
with the Federal Government's goals, as the central bank, among other functions, also serves as an
advisor to the Government.
Second, SBP needs to examine where there is further need for internal strengthening. Few areas
where SBP will gear itself further would be in terms of increased responsive to industry changes in
order to align prudential regulations accordingly. Among others, SBP needs to be equipped to assess
banks when they adopt higher standards of risk management which will be promoted when Basel II is
introduced. Another area would be for the central bank to strengthen its oversight and supervision,
with particular emphasis on closer supervision of the emerging conglomerate structures in the banking
industry as some of the commercial banks are now owned by industrial groups and brokers.
Third, in conclusion, the central bank should energize itself to finance the under-served areas, regions
and segments. And, the central bank would like to promote the Islamic Banking Industry, as it has the
potential to introduce innovations in the market. As part of the reorganization of the central bank,
which is currently in process, we plan to set-up a separate department for development finance, which
will push for this objective.
Having assumed office in January, I am in the midst of developing a strategy for the next ten years of
the financial sector, and my talk today presents some ideological thoughts on the long-term vision
paper for the central bank, which will be developed in consultation with the stakeholders. We then
need to set up an implementation task force, which will be a combined effort of the banking industry
and the central bank to take forward these reforms. There has been tremendous change in the
banking industry in the last few years and we need to fine-tune our strategic direction as we go
forward.