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.