MONEY AND BANKING ASSIGNMENT

PRESENTED TO: Sir Zahid Iqbal

GROUP MEMBERS: Zainab Salman Zunaira Mumtaz Maryam Majid Fatima Khalid Roll No 19 Roll No 22 Roll No 39 Roll No 52

BBAE (2009-13) 4th Semester Institute of Business Administration, University of the Punjab

SUMMARY OF 10 YEAR PLAN OF BANKING REFORMS

Summary
A growing and dynamic banking sector is essential for economic growth in Pakistan. Many important structural reforms already have taken place in Pakistans financial sector but many more remain to be implemented. Our Banking Sector has gained profitability and strength. Deposit base(Rs 4.1 trillion) and banks aggregate profitability(Rs 63.3 billion in 2005 to Rs 73.3 billion by 2007) rose, banks net non performing loans lowered but along with these achievements, many challenges are faced by the banking sector, and this paper maps out a strategy for banking sector reforms over the next decade. This strategy is formulated by the State Bank of Pakistan. In June 2008, Pakistans financial sector assets totaled to Rs 7.6 trillion. On a net basis the amount of financial assets is substantially smaller. Among different segments of the financial sector, the banking sector has grown most in relative terms. The overall assets of the banking sector have also increased from Rs. 3.6 trillion in December 2005 to Rs. 5.5 trillion by June 2008, but some liquidity problem has been seen in the second half of 2008. Although financial assets have grown in nominal terms, but they have not grown that much in relation to the real economy as measured by GDP. Some important constraints that limit the scope for banking sector development in the absence of further reforms are: (1) Large segments of the economy still remain underserved by the formal financial system (2) There is a need for further improving the investment infrastructure and incentives for the Non-Resident Pakistanis (3) Lack of consumer protection and low level of financial literacy (4) Keener competition in consumer lending that policy makers expected from the privatization of banks have yet to materialize for the benefit of the real economy (5) Small numbers of weak banks in the market (6) There is a need reconsider DFIs ownership structures (7)Competition and continuous market innovations raise challenges for SBP (8) Banks and NBFIs have been developing conglomerate structures but it does introduce new systemic risks as well as regulatory and supervisory challenges (9) There is a need for financial safety net to deal with contagion and systemic risks (10)The financial sector needs to become more diversified and the financial infrastructure needs to be improved. Financial sector growth and real economic growth reinforce each other thus a faster growth of the financial sector might result in increased and sustained economic growth. There is an enormous potential for financial sector growth in Pakistan but if it is to be developed, then other financial institutions also need to be developed. The growth of our financial system should also be based on private sector intermediation. Not only the assets of our banking sector are expected to increase but this will lead to an increase in credit to the private sector. If opportunities are utilized then the banking sector has the capacity to support every type of economic activity. Increases in financial assets and credit to the private sector are some of the targets of reforms but this is not possible unless these banking sector reforms are accompanied by reforms to the debt and equities markets. The 10 year Banking Sector Reform Strategy (BSS) that has been developed by SBP with external technical assistance is based on: (i) an extensive study of the banking and financial sector to identify issues limiting this sectors development (ii) Pakistans forward looking economic development strategy; and (iii) experiences of other emerging countries. The broad objectives of the BSS are to make the banking sector: (i) more responsive to the needs of the economy and thus help achieve a more rapid and sustainable economic growth; (ii) financially stronger and stable (iii) Better regulated and supervised (iv) More efficient and stable. Banking sector growth and development are only possible if macroeconomic and political stability is there. The BSS focuses on reforms in ten key areas. These key topics are to:

Create a more diverse banking sector. Banks are more suitable to deal with smaller and start-up companies and with the household sector therefore their focus should shift from large to small companies to diversify risk, whereas larger companies should be financed away from banks. Implement a financial inclusion program for banks. The formal sector includes different types of banks and other types of financial institutions, but There is a large number of companies mainly SME yet to be included in the formal financial sector. The number of depositors living in rural areas is very small; this has held back the growth of savings and access to credit. As a solution to these issues SBP has developed a comprehensive Financial Inclusion Program (FIP) to meet the needs of underserved economic subsectors, including outreach programs to meet the requirements of the agriculture, housing, SME and microfinance sectors. The protection of consumers and financial literacy in Pakistan is slowly improving. To accelerate this process several reforms are being introduced. For consumer protection SBP has issued guidelines related to problem resolution in 2004, an online complain system has been introduced, consumers are made aware of the complain process, half yearly review on complains is issued, rules and laws have been introduced that will protect consumers against fraud or unfair contracts, etc. To increase financial literacy SBP has introduced Financial Literacy Program (FLP) aimed at families, adults, children, entrepreneurs, etc. so that they can manage their own finances and also SBP requires the support of not only banks but also of NGOs and organizations like the National Institute of Banking and Finance (NIBAF) and Institute of Bankers Pakistan (IBP). To consolidate banking sector SBP now requires that the Minimum Capital Requirement (MCR) of the Banks should increase to Rs.6 billion by 2009 and up to Rs.23 billion by 2013. This has forced a large number of small banks to merge and hence there is a decline in the number of commercial banks from 41 to 23. SBP is also encouraging NGOs to restructure as Microfinance Banks (MFB) e.g. KASHF Foundation as KASHF Microfinance Bank. To fulfill the gap between banks and MFBs, the commercial banks that are unable to meet the MCR may be converted into institutions that will serve SME business. Commercial Banks that are owned by the federal or provincial government will be merged, recapitalized or liquidated if they are unable to meet the MCR. Due to weak performance the SME Bank is being privatized, the HBFC restructured prior to privatization and the IDBP will be available for sale. Zarai Taraqiati Bank Ltd. (ZTBL) needs financial and operational restructuring. The average risk-based capital adequacy ratio (CAR) for all commercial banks have increased and therefore strengthened the banking sector. SBP has increased the CAR from 8% to 10% in 2009 which has forced small banks to merge. The development of a liquidity management framework will enable SBP to modulate short-term liquidity in order to ensure stable conditions in the short term money market and for this purpose Specific Treasury Bills will be created. To analyze competition, SBP has examined the market structure of the banking sector, including the number of banks, concentration indicators, contestability, and performance measures such as margins or profitability and it has concluded that the banking sector is monopolistically competitive. This is true in case of low- banked areas, where the big banks dominate due to their branch networks, economies of scale and relationships built over the years. SBP has also included that banking sector is reasonably competitive. This is due to increase in number of new Islamic Banks (IB) and MFB. Since 2000 the market shares of five biggest banks have declined and their market share has been captured by the next five banks. So, to increase competition the actual behavior and conduct of banks are reviewed, entry of new banks is encouraged and non-bank financial intermediaries are promoted. The interest rates and competition govern a market-based financial system. Large banks had market power which has caused real returns to be negative but now with the increase in competition Weighted Average Deposit Rate (WADR) has increased. High interest rate spreads have allowed the largest banks to keep their funding costs down and generate substantially higher profits than banks without branch networks. In early 2008 the banks offered approx. 2% p.a. on saving deposits and to deal

with this SBP introduced a minimum deposit rate of 5% p.a. for all PLS savings product. Due to this interest rate spreads have also lowered. Explicit interest rates are not known to the depositor and therefore interest rates are non-transparent and so a market cannot be competitive. This requires financial literacy. To increase transparency SBP is of the view that there should be differentiation between Islamic and conventional deposits, restriction on banks to change lending rates, presentation of rates in annualized percentage rates (APR) and requirement to publish their deposit rates on saving deposits in the newspapers. In order to strengthen the regulatory framework the new Banking Act (BA) has been drafted that will protect and supervise the banks. It also states SBP as the sole supervisor of banking sector. Basel -2 , comprising ,standardized approach to credit and operational risk was made obligatory in 2008 for commercial banks along with Basel -1 of 2007 which had already caused certain challenges in the integrated risk management and collateral management policies. However bank CARS could not be lowered down without moving to its advanced approaches .For this state bank of Pakistan has required all banks to review management system and capabilities .Liquidity risk in domestic banking is another issue to be reviewed by the Basel committee. S.B.P would get any such regulations, implemented with all its framework under the rule based approach and develop best practices among banks under the principle based approach. Again S.B.P would ensure balance among these two philosophies. State bank should also adjust its supervisory role under the legal and regulatory framework. Inordinate compensation packages for senior executives of banks have been a major issue since global financial crisis. Regulatory guidelines of state bank would help in framing performance based packages. there is a successful trend among todays bank of financial conglomerations of multinational business such as investment brokerage, asset management and insurance .technology measures such as electronic payments have added much to the marketing and efficiencies in service delivery .so, for the consolidated supervision of conglomerates, S.B.P has developed framework for the transparencies in structural ownership of the consolidated units , with reference to proper criteria, negation of commercial enterprises definition of investments restriction over cross shareholdings and determining bank and non bank activities .S.B.P would also set rules for board of management with at least one outside director and a single auditor. However, under the based care principles, S.B.P being leading supervision should have licensing power for banks and holding companies. With the privatization of most banking sector, certain safety measures have to be developed. Under the act of nationalization of 1974 all depositors are protected by government .but this not applicable in private owned banks. Even the state owned national bank of Pakistan comprises private shareholders, so the rule needs amendment to provide limited protection to depositors. So a depositor protection fund is likely to be established, separately by S.B.P to be managed by a board with fixed premium by bank, in order to make instant payments to depositors in case of bank closure. Presently, S.B.P with its on and off site monitoring mechanisms provides liquidity for temporary solvent banks, on a limited scope under the act. So S.B.P should be given broad powers of liquidity with a fair amount of discretion to deal with even the abnormal situation. S.B.P is seeking legal powers and making rules for the borrowing banks. Removal of available banks due to insolvency unprudent pricing or risk management taking practices etc woul strengthens the system. The exit process would treat unprotected depositors and creditors, raise the value of assets reduce systemic risk. This law would also ensure that the S.B.P decisions are not put on hold or set aside by courts. The D.P.S, LOLR and bank exit will be managed by S.B.P. the managers and supervisors would share data confidentially and on timely basis with the help of coherent team of professionals. S.B.P would handle individual bank problems on its own but would keep the Govt. Informed for possible solvency support. But in case of outright crisis, Govt. would be involved for a broader policy coordination framework. To Strengthen SBP autonomy, accountability and governance, many aspects of the SBP Act have become outdated and require reconsideration. It is important that the law give SBP a clear focus and

necessary powers to ensure monetary and financial stability. There is consensus that changes to the SBP Act are needed. Modern laws give autonomy to central banks and make them accountable. The new SBP Act would complement the new Banking Act discussed above. The new SBP Act would strengthen SBP's ability to conduct an independent monetary policy. The new SBP Act would define SBP's role in other areas of the financial sector reform agenda. To Develop a More Balanced and Diversified Financial System The financial sector in Pakistan is too bank-centered and there is a need to develop other financial intermediaries and markets. The development of non-bank financing will require a combination of official policies, market competition and business opportunities. Non-bank financial intermediaries have substantial growth potential. With the exception of mutual funds, the growth of most NBFIs has been anemic in recent years. The equity market has provided little new corporate financing in recent years. It has tremendous scope to grow, as indicated by the fact that its market capitalization in relation to GDP is less than half the size of that in its peers in other EMCs. Private debt securities have the biggest growth potential, as seen from the above comparisons with other countries. The basic structures for issuing and trading private securities already exist but need to be updated and strengthened. Government financing in the domestic debt market and through NSS needs to be reviewed to make it more efficient and market-based. The above reforms in the broader financial system require actions by the SECP and GOP. In the Infrastructure under control of SBP the wholesale payment system is being upgraded and renewed. The retail payment system is next in line to be modernized. The electronic Credit Information Bureau (ECIB) of SBP has already helped strengthen credit risk management in all financial institutions. In Infrastructure outside the direct control of SBP the Human Recourse Base needs to be developed to meet the needs of an expanded financial system. SBP is planning to take some initiatives to support a broadly based effort to train financial sector professionals. Credit Rating Agencies need to be promoted. Land and Property Registries need modernization. The Judicial system needs reform for the efficient functioning of the financial system. Annexure A table 1 shows Number and Ownership of Banks. The data concludes that since 1997 -2008 All banks which includes commercial banks (largest 10, Islamic, MBF and other) and specialized sum up to 46 which includes your public sector banks, local private banks and foreign banks. This number has decreased to 39 in 2008 and Annexure A table 2 gives the indicators for banks since 20002008. Annexure B shows McKinsey Definition of Financial Assets .The global capital market is defined as the cumulative collection of markets where global capital supply is matched by global capital demand through bank and securities market intermediaries. The data base covers more than 100 countries. Debt securities are further divided into private and government. The database includes GDP data for each country to allow calculation of the value of financial assets relative to the size of the underlying economy. To measure bank intermediation, the value of deposits rather than the value bank loans are used because of difficulties in measuring lending volumes on a comparable basis in all countries. Annexure C shows objectives of draft Banking Act. The draft Banking Act has been prepared in line with the Basel Core Principles. Detailed provisions regarding reorganization of problem banks has been provided in the draft Act to avoid systemic risk. There is Framework for Payments System and ebanking, Enforcement powers to check illegal banking and deposit taking. SBP's powers to issue prudential regulation. A new part has been included in the draft Act which outlines framework for conducting banking business based on Islamic principles. There is clear and transparent criteria have been provided for entering into the business of banking. Detailed provisions regarding ownership and management of banks have been provided in the draft Act. Detail of permissible and prohibited business by banks has been further elaborated with power to SBP to declare any business as banking business. Powers of SBP in relation to its assigned functions have been greatly enhanced based on international best practices. Fit and proper criteria for Board members and Chairman have been provided in the draft law which was otherwise applied through regulations. It Enables provisions for anti-money laundering

have been provided in the draft Act. Provisions relating to inspection, audit and reporting have been upgraded with enhanced powers of SBP to take action against banks, auditors. Provision relating to deposit protection fund have been incorporated to protect the interest of depositors of banks. Legal basis for cooperation between SBP and SECP has been provided. Regulatory powers of SBP have been enhanced in all the regulatory areas under the draft Act. Schedules provide activities which bank can undertake and penalties for violations of draft Act.

ANALYSIS OF TABLE 2.5 MONETARY AGGREGATES

Developments in Monetary Aggregates

The growth in broad monetary aggregate (M2) accelerated to 5.7 percent during Jul-Feb FY10 from 2.0 percent in the corresponding period of FY09 (see Table 4.1). However, these broad numbers do not capture the shift in composition of M2 growth after the first quarter of FY10. While the growth in M2 during Q1-FY10 was driven largely by an improvement in NFA of the banking system, the sharp acceleration in M2 growth thereafter is explained largely by an uptrend in seasonal credit demand from the private sector mainly visible in Q2-FY1).

Moreover, during Oct-Feb FY10, the government borrowed more from the central bank to meet budgetary expenses compared to Q1-FY10 (though monetization remained within the quarterly target agreed with the IMF). On the other hand, the improvement in NFA, visible since December 2008, has shown reversal October 2009 onwards.

Net Foreign Assets (NFA)

Net Foreign Assets (NFA) was driven largely by an improvement in NFA of the banking system, the sharp acceleration in M2 growth thereafter is explained largely by an uptrend in seasonal credit demand from the private sector mainly visible in Q2-FY10. The trend improvement in NFA of the banking system, visible since December 2008, reversed as pressures on external account re-emerged October 2009 onwards (see Figure 4.4). As a result, the NFA of the banking system showed a depletion of Rs 80.7 billion in Oct-Feb FY10. The depletion in the NFA of the banking system during Oct-Feb FY10 was mainly evident in the SBP NFA. The contraction in SBP NFA was despite the lower net intervention in the forex

market as SBP completely shifted the financing of oil imports to the interbank market by mid December 2009. Indeed, the increased repayment of official loans, particularly Sukuk bond in January 2010, overshadowed the receipt of a second IMF tranche of US$ 374 million for budgetary support in December 2009 as well as other official inflows. The NFA of scheduled banks witnessed a depletion of Rs 21.4 billion during Jul-Feb FY10 in contrast to a net expansion of Rs 4.3 billion in the corresponding period a year earlier. The high oil import payments fall in foreign investments inflows, substantially lower net inflows under foreign private loans, and low retirement of foreign currency loans by traders were major factors responsible for this reversal in NFA of scheduled banks. These factors were strong enough to offset improvements arising from higher inflows under FE-25 deposits.

Net Domestic Assets (NDA)

The NDA growth changed dramatically after Q1-FY10. During Q1-FY10, NDA had a negative contribution to M2 growth. However thereafter, NDA experienced a sharp increase, mainly due to: (1) A strong rise in private sector credit, and (2) Increased recourse of the government to borrow from the banking system (see Figure 4.5