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Foreign Investment in Pakistan - Developments in the Banking and Finance Sector Towards An Enabling Environment

Presented by
Mr. M. Ali Shah
Country Director, ADB
Pakistan Resident Mission

27 April 2003
Islamabad, Pakistan

Distinguished Guests, ladies and gentlemen,

It gives me great pleasure to be invited to this important event and to share with you my observations on Foreign Investments in Pakistan and in particular the Developments in the Banking and Finance Sector - towards an enabling environment.

In Pakistan, the integration of the Banking and Finance Sector with the international finance community is a high priority of the Government to attract foreign investments in the development of the country's economy.

My presentation will be in two parts: The first on the Banking Sector to be followed by the Finance sector, which is represented by the Non-Bank Financial Institutions (NBFIs). The presentation will highlight the issues being faced and the actions taken to tackle these issues.

The Banking Sector

The financial structure in Pakistan can broadly be categorized into Scheduled Banks and NBFIs. At present, there are 14 private commercial banks, 2 privatized commercial banks, 4 nationalized commercial banks, and 19 foreign banks (State Bank of Pakistan Annual Report 2000-2001). The NBFIs are composed of investment banks, leasing companies, mutual funds, Modarabas, Development Financial Institutions (DFIs) and housing finance companies. The State Bank of Pakistan regulates the banking sector, consisting of the commercial banks, along with all NBFIs, except for Modarabas and leasing companies.

The banking sector has endured many ups and downs. In late 1996, the banking system was on the verge of a crisis. Non-performing loans had reached alarming proportions. Liquidity problems surfaced as dis-intermediation spread and banking losses accumulated. Majority of loan defaults remained caught in an ineffective court system. These were caused by deep-rooted problems, embedded in failure of governance and lack of financial discipline. The NBFIs and DFIs experienced continuous political interference, resulting in bad loans, which accounted for 90 percent of the non-performing loans in the entire system. Such a situation was not sustainable.

In the face of a difficult external situation, and recognizing the institutional and governance problems being faced, the authorities, in particular, the State Bank of Pakistan and the Ministry of Finance in early 1997 embarked on a "home-grown" banking reform program.

In the same year, the World Bank financed a loan of $250 million (co-financed with another $250 million by Japan) under the Banking Sector Adjustment Loan, which supported the initial stages of Pakistan's national banking reform program. By 1999, the reform program had advanced significantly. Around one third of the value of defaulted loans had been recovered. Nationalized commercial banks, which still account for the majority of loans in the country, had stemmed operating losses. A new banking court system had processed nearly half of pending loan default cases at an unprecedented rate. Higher quality new loans combined with improved loan recovery and resolution of problem loans had helped the banking system achieve improvements in capital adequacy, asset quality, efficiency and profitability. Disclosure standards, fundamental to the reform program, had become much more stringent.

Subsequently, the crisis eased and financial institutions began to heal, the reform process substantially slowed down and in several respects, stalled. In mid - 1999, interference in the banking system through new centrally mandated credit programs increased. Loan recovery slowed down, except for the dramatic gains as a result of the accountability campaign that was started in October 1999 by the military government. Loan collateral foreclosure and bankruptcy procedures were not further strengthened as planned. Market reforms to reduce segmentation were not pursued completely. Most importantly, bank privatization did not materialize as planned, due on the one hand, to weak market conditions, the country's deteriorating foreign investment climate and lack of sustained efforts, and on the other, the distressed conditions of the banks with high cost structures and depleted balance sheets.

To assist and ensure the sustainability of the banking sector reform process, the World Bank approved the Banking Sector Restructuring and Privatization Project Loan for $300 million in 2001. The Project's objective is to assist Pakistan in the implementation of its banking reform program started in 1997. The Project focuses on further restructuring of the NBFIs to improve their prospects for sale to qualified strategic investors, and completing the privatization of the partially privatized banks. The Project also includes liberalizing bank branching and at the same time reducing the loss making institutions by almagating the largest DFI with one of the NBFIs. The Project is also deepening the banking market by reducing the taxation on financial intermediation and the cost of loan recovery by facilitating foreclosure on loan collaterals.

Some of the major reforms achieved in the Banking Sector to-date include:

• Nationalized commercial banks are being privatized and their domination of the banking sector is targeted to be reduced from almost 100 percent in 1991 to 20 percent by 2003. Muslim Commercial Bank and Allied Bank have been privatized. The Government completed the privatization process of United Bank in 2002 and privatization is ongoing with Habib Bank. In addition, 10 percent of National Bank shares have been floated through the stock market and another 10 percent will be offered in the near future for small retail investors.
• Strong corporate governance by SBP's enforcement of Banking license regulations, transparent financial transactions, independent appointment to Board positions and Chief Executive positions, arms length transactions for Board family member representations, insider trading, regulations of external auditors' profession, and prudential guidelines for Board of Directors.
• Strict monitoring and reduction of non-performing loans by active involvement of the Corporate Industrial Restructuring Corporation (CIRC) and Committee of Revival of Sick Units (CRSU).
• SBP's removal of restrictions imposed on nationalized NCBs for commercial financing and incentive schemes for encouragement of mortgage financing by the banks.
• Implementation of the Financial Institutions (Recovery of Finances) Ordinance, 2001, and relaxation of licensing and regulatory environment for Micro-Credit and Rural finance institutions, encouraging their establishment at district, provincial and national levels with varying capital requirements; and
• Mandatory requirement for all banks to get themselves evaluated by credit rating agencies in order to facilitate depositors to make informed judgments about placing their savings with the banks.

The Financial Sector

The Financial Sector represents NBFIs which could be segregated into DFIs, 14 investment banks, 33 leasing companies, 41 modaraba companies, 4 asset management companies, 2 finance companies, 2 discount houses and 2 ventures capital companies.

The sector is characterized by the following: (i) a shallow and narrow sector structure; (ii) heavy government involvement; (iii) inefficient banking system; and (iv) mixed performance of equity markets.

• Shallow and Narrow Sector Structure: Pakistan's financial sector is not very large and diversified. Deposits amount to only about 56 percent of GDP. The money to GDP ratio - which is an indicator for financial sector deepening - at only about 44 percent, suggests that a major portion of the economy is still not monetized.
• Heavy Government Involvement: Despite the number of reforms initiated by the Government in the past, which have sought to reduce its operational involvement in the financial sector, the Government still plays a predominant role, and much financial intermediation is driven by its financing needs. Examples include the, National Saving Schemes (NSS), the State Life Insurance Corporation (SLIC) and the Employees Old-Age Benefits Institution (EOBI); remain Government controlled. This raises governance concerns, as most of the funds they are entrusted with belong to private individuals.
• Inefficient Banking System: Financial intermediation is dominated by the banking system, which accounts for 60% of deposits. About 34% of deposits are with the NSS, and only 5% are mobilized through NBFIs. Non-performing loans (NPLs) average around 24% for all banks, and more than 50% for specialized financial institutions, including development finance institutions.
• Mixed Performance of Equity Markets. Pakistan's equity market, which is dominated by the Karachi Stock Exchange (KSE) but also include exchanges in Lahore and Islamabad, has seen some impressive growth over the past decade. But the economic impact of the equity market, despite the development, has been negligible. Market capitalization is still only around 11% of GDP. Many companies sought listing primarily for tax without subsequent trading taking place and little interest in investor relations or dividend payouts. Both the issuer and investor base is very narrow, with trading being heavily concentrated on a few scrips only. Factoring in the devaluation of the Pakistan rupee and economic uncertainties, as well as the high guaranteed returns offered by the NSS, investing in the stock markets has not been a very attractive proposition.

All this has deterred long-term and foreign investors, and valuations of some economically sound companies are often very low. This environment is not very attractive for companies with serious economic ambitions to raise capital from the equities markets, and there have been only 13 new listings on all three exchanges over the past 5 years.

To counter the trend, the Securities and Exchange Commission of Pakistan (SECP) has, since its inception in 1999, and within the framework of the Government's first ADB financed Capital Market Development Program (CMDP) (see below), taken credible steps to restore investor confidence. In particular, SECP has been improving risk management and is vigorously enforcing compliance with rules and regulations, including delisting of defaulting companies. These measures will need to be enhanced further but constitute an important basis for more sustainable market development.

In order to address the above problems, Pakistan has since the mid-1990 embarked on comprehensive financial sector reforms. Key reforms include: (i) liberalization of the foreign exchange market and interest rates; (ii) increased autonomy of the central bank and its focus on monetary policy and banking supervision; (iii) establishment of an independent regulator for capital markets and NBFIs; (iv) upgrading of legal and regulatory frameworks; (v) reduction of NPLs in the banking sector, and (vi) restructuring of government-owned financial institutions including privatization, merger, closure, and enhanced management autonomy.

Yet, the reform agenda is far from complete, and reforms are ongoing at various levels to further reduce the Government's involvement in financial sector operations and enhance private sector participation on market-based principles.

ADB's Capital Market Development Program

The ADB's Capital Market Development Program (approved by the Bank in 1997 for $250 million) was the first major intervention to reform the non-bank financial sector implemented over 1997-2001. The reforms were carried out under a difficult macroeconomic environment and subdued investor and issuer interest. The main achievement under the CMDP has been the establishment of an effective regulator in SECP as well as improvements in the technological market infrastructure. Progress was also made in improving investor protection, governance of the stock exchanges, and development of the primary corporate debt market, as well improving prudential norms for NBFIs. The ambitious reforms addressed some of the problems and established a good basis for further market development. However, a number of important areas within the financial sector need further attention to bring about the full impact of these reforms. In many ways, the achievements under the CMDP have been necessary but not sufficient.

The opportunities and challenges facing the financial market include:

1. Potential for Growth and Development: Given the underdeveloped state of Pakistan's non-bank financial markets relative to the size of its economy as well as other emerging markets, and the inefficiencies and structural problems within the banking system to finance the much-needed capacity expansion of the economy, there is good reason and scope for growth in the sector. Capital markets, in particular, can play an important role for sustainable investment and mobilization of long-term savings. Direct financial intermediation through markets can improve funding and investment management of companies, and thus their productivity, while offering better return for savers. Further reduction in government involvement in the sector would also stimulate allocation of resources according to market-based principles.
2. Improving Investor Confidence is Key. While a good foundation has been established through the CMDP, functioning of financial markets cannot be mandated by the Government or any other party. Their efficiency and effectiveness depends on building credibility with private sector investors and issuers, which needs to be sustained over time in a dynamic environment. Within this context, strengthening investor confidence through policy consistency, a strong and credible regulator, and effective dialogue among various stakeholders is of paramount importance.
3. Increase Corporate Governance and Transparency. The development and sustainability of financial markets will depend highly on the framework of corporate governance adopted and the degree of adherence to the framework in practice. Poor governance, wide information asymmetry, and lack of confidence in the integrity of transactions and internal control mechanisms are the biggest investor concerns in Pakistan. Thus, governance frameworks need to be improved and vigorously adhered to at various levels. Key ingredients are adequate information disclosure and the right of key stakeholders to influence behaviour or change management according to a set of rules.
4. Building a Level Playing Field by Removing Policy Distortions. Key distortions on the policy level remain, primarily with regard to tax and interest rates. There has been differential tax treatment among financial instruments, which has worked to the advantage of some instruments and investors while discriminating against other. Moreover, tax rates and assessment modalities have been changed frequently in the past. This has created confusion among investors and unintended distortions, in addition to an administrative burden in tax assessment and collection. Streamlining tax treatment can stimulate financial market activity.
5. Streamline Policy Making, Regulation and Supervision: The integration of financial markets witnessed globally has only been partly matched with institutional responses in Pakistan. Policy making remains fragmented, involving diverse ministries, in particular with regards to contractual savings and institutional investments, which are poorly developed and Government dominated. In such an environment, policy consistency is less likely to be achieved, and coordination administratively more cumbersome. Further clarification and a strong mandate to key institutions including SBP and SECP, in line with international best practices, are needed to provide a clear perspective to investors.
6. Upgrade Market Structure and Infrastructure: Few areas are more affected by the rapid advancements in information technology than financial markets. While a good technological base has been established under the CMDP with automation of trading and creation of central securities deposit, clearing, and settlement systems, the development of internet-based technology in particular has created new opportunities and challenges to increase the access to capital markets by retail investors. Further systems are needed to accommodate new instruments and market segments. This requires institutional responses by the stock exchanges, in particular. There is increasing competition and integration among international exchanges, and Pakistan must respond to those trends to offer an attractive and competitive market place. Integration of the domestic exchanges into a national market, demutualization of exchanges, as well as introduction of new over-the-counter market segments will be required.
7. Improve Risk Management and Enforcement: The increasing sophistication of financial markets carries high inherent risks that must be adequately addressed. There is an increasing awareness internationally that concept of self-regulation need to be complemented through strong regulatory regimes and credible enforcement as well as adequate risk management systems and tools. This must also include mechanisms of investor compensation and market stabilization during times of stress on markets.

The Financial (Non Bank) Markets and Governance Program

In December 2002, the ADB, reacting to the Government's request for further assistance in the restructuring of the Financial Sector, approved the $260 million Financial (non-Bank) Markets and Governance Program (FMGP) loan.

The immediate objectives of the Program are to: (i) strengthen investor confidence through improved governance, transparency, and investor protection; (ii) increase the depth and diversity of financial intermediation through new capital market issues for saving and investment; (iii) improve operational efficiency and risk management of intermediaries; and (iv) reduce financial sector vulnerabilities. The FMGP Program period extends to December 2005.

The FMGP reform agenda is structured around five components: (i) improvement of the fiscal, interest rate and investment policy environment; (ii) improvement of governance of market participants and transparency in information disclosure; (iii) increase in supply of financial instruments and improvements in market infrastructure; (iv) increase in demand for financial instruments through promotion of contractual savings and institutional investment; and (v) development of complementary financial services and institutions.

The Program reform agenda is supported by two TA loans for strengthening regulation, enforcement and governance of non-bank financial markets; and strengthening of pension, insurance and saving systems. The first $4.4 million TA will ensure sustainable development of non-bank financial markets and protection of investors and policy holders through capacity building of SECP's enlarged mandate for regulation and supervision of non-bank financial institutions, insurance and pensions, restructuring of stock exchanges; and mechanisms for skills development and training. The second $4.5 million TA will develop solutions to improve Pakistan's pension system and capacity building of EOBI, strengthen the capacity of key government institutions including the Central Directorate of National Savings, mobilization and management of contractual savings and capacity building for investment management in State Life insurance Corporation.

The FMGP Program is complemented further through non-lending initiatives including ADB's guarantee products to ensure greater private sector involvement in the development of non-bank financial markets and services; and to ensure continued availability of insurance for non-commercial risks following the terrorist events in the United States on 11 September 2001 and its implications on the international insurance industry.

The Partial Risk Guarantee (PRG) is to guarantee international investors for payment of proceeds from eligible investments if that payment is not made as a result of a guaranteed risk, including restriction on foreign exchange convertibility and transferability blockage. The PRG will, however, not cover any risks that affect the value of the investment itself. The PRG will be counter-guaranteed and indemnified by the Government. The maximum aggregate liability under the PRG covered by ADB at any time will not exceed $25 million, but the PRG may be enhanced through co-guarantee arrangements with the private sector. It is envisaged to leverage the ADB investment by a factor of up to ten times, for total cover of about $250 million.

Conclusion:

In response to the financial crisis of 1996, implementation of the Government's banking and non-bank financing institution's program began with earnest in 1997 and is well advanced.

The ADB program is in agreement with Pakistan's financial systems - a market-oriented, predominantly private owned banking and financial system that operates under a strong regulatory framework, supported by an effective legal and judiciary system, mobilizing the capital needed to finance rapid private sector growth, and improving access to financial services by the poor.

ADB and the World Bank have been actively supporting the reform strategy by adjustment lending, restructuring and privatization of operations, technical assistance for capacity building of SECP operations, strengthening financial institutions and expanding the micro finance sector.

ADB will support the emergence of NBFI's through development of new financial products to better meet the needs of the private sector, (e.g. long term financing for infrastructure, guarantees for SME finance) and expansion of access to financial services to new clients (access to bankable poor through micro-finance institutions) and to under-served SMEs.

Ladies and Gentlemen, this brings me to the end of my presentation.

Thank you.