ROLE OF COMMERCIAL BANKS:Problem bank management, BANKING SECTOR REFORMS

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Management of Financial Institutions - MGT 604

Lecture # 18

ROLE OF COMMERCIAL BANKS

Asset composition

Assets of banking sector, as per cent of GDP, have been on the decline. Slowdown in asset

growth was also accompanied by changing share of different groups. Negative growth in the

assets of foreign banks during 1998 and 1999 was the prime reason behind declining growth

in overall assets of the banking sector. Share of NCBs have been decreasing since private

banks were allowed to operate in 1992. In terms of asset share, private banks are now as

large as foreign banks.

Problem bank management

The central bank is the sole authority to supervise, monitor and regulate financial

institutions. It is also responsible to safeguard the interest of depositors and shareholders of

these institutions. Lately, SBP took actions against two private banks which became a threat

to viability of the financial system in the country. These were Indus Bank and Prudential

Commercial Bank. On the basis of detailed investigations, the license of Indus Bank was

cancelled on September 11, 2000. After successful negotiations, management and control of

Prudential Bank handed over to Saudi-Pak group.

Outlook

Commercial banks have been going through the process of restructuring. There are efforts

to reduce lending rates. The SBP has been successful in implementing its policies. Most of

the banks have been able to adjust to new working environment. The proposed increase in

capital base will provide further impetus to financial system in the country.

In the post September 11 era, the GoP borrowing from SBP and commercial banks is

expected to come down substantially and private sector borrowing to increase. However, a

temporary decline in repayment ability of borrowers may increase provisioning for the year

2001. The situation is expected to improve in year 2002. Unless efforts are made by banks

to shrink spread, depositors will not be able to get return which corresponds with the rate of

inflation in the country. Privatization of NCBs is expected to be delayed due to external

factors. However, it is an opportunity for the banks to further clean their slate. Pakistan's

banking sector like many other developing countries had been faced with several problems

and difficulties such as:

(1) Most of the financial assets and deposits were owned by nationalized commercial banks

(NCBs) which suffered from a highly bureaucratic approach, overstaffing, unprofitable

branches and poor customer service.

(2) NCBs along with specialized banks such as ADBP, IDBP and Development financial

institutions such as NDFC had a high ratio of non-performing loans.

(3) Banking industry faced a high tax rate, which affected its profitability and attractiveness

for new entrants.

(4) There was a proliferation of banks and some of them were undercapitalized, poorly

managed with a scanty distribution network.

(5) Agriculture, small and medium enterprises, Housing sectors were underserved and the

middle class and low income group had limited access to bank credit.

Management of Financial Institutions - MGT 604

(6) Banks had typically focused on trade and corporate financing with a narrow range of

products and had not diversified into consumer and mortgage financing for which there is

an ample unsatisfied demand.

(7) Poor quality of human resources, weak internal controls, non-merit based recruitments,

high administrative costs and undue interference of unions in decisions making process

affected the performance of public sector financial institutions adversely.

BANKING SECTOR REFORMS

Banking sector reforms were aimed at addressing these and other constraints. Although

there is no room for complacency and a lot needs to be done it is fair to say that substantial

progress has been made to improve the health and soundness of the banking sector in recent

years. There are still few weak and vulnerable institutions but overall the banking sector in

Pakistan is much stronger today compared to five years ago or in comparison to other

countries in the region. What are the factors responsible for this improvement? A large

number of reforms have either been undertaken or under way.

(i) Privatization of NCBs

The nationalized commercial banks are being privatized and their domination of the

banking sector is likely to be reduced from almost 100 percent in 1991 to about 20 percent

by December 2003. The shares of Muslim Commercial Bank are all in the private sector.

United Bank has been sold to a consortium of private investors. Privatization of Habib Bank

Ltd., is under way and is scheduled to be completed by end December, 2003. 23.5 percent

of shares of National Bank have been floated through Stock Market mainly aimed at small

retail investors. The NCBs have been restructured and professional management inducted

which works under the supervision of independent Boards of Directors drawn from the

private sector.

(ii) Corporate governance.

Strong corporate governance is absolutely essential if the banks have to operate in a

transparent manner and protect the depositors' interests. The SBP has taken several

measures in the last four years to put in place good governance practices to improve internal

controls and bring about a change in the organizational culture. The salient features of this

structure are:

a. Banking license of one of the commercial banks which was found in violation of the

prudential regulations and norms was cancelled for the first time in the history of Pakistan

after following the due process. This decision was upheld by Peshawar High Court.

b. Ownership and management were changed at two private commercial banks, one of

which had committed breach through unauthorized transfer of funds from the bank to

associated companies.

c. A number of cases of willful bank defaulters were referred to National Accountability

Bureau (NAB) for taking legal actions and recovering the amounts due.

d. The appointments of Board members, Chief Executive Officers and key Executives of all

banks have to be screened so that they meet the fit and proper test prescribed by the SBP.

Management of Financial Institutions - MGT 604

e. Family representation on the Board of Directors of the banks where they hold majority

ownership has been limited to 25 percent of the total membership of the Board.

f. To avoid possible conflict of interest and use of insider information the Directors,

executives and traders working in Brokerage companies will no longer serve on the Boards

of Directors of the banks.

g. External auditors are evaluated annually and classified in various categories based on

their performance and other prescribed criteria. Two large audit firms were debarred from

auditing the banks and only after showing improvement in their performance placed in a

category lower than they originally belonged to.

h. A detailed set of guidelines for the Board of Directors to effectively oversee the

management of the banks and develop policies has been issued. A training course on

Corporate Governance was organized for the members of the Boards of banks and their

Chief Executives.

i. The disclosure requirements for banks have been strengthened and now they are required

to prepare their annual financial statements in accordance with the International Accounting

Standards. They are also required to publish quarterly and half-yearly accounts to provide

information to their stakeholders for taking well informed decisions.

j. In order to institutionalize the decision making process and to provide guidance to staff,

the banks are required to formulate and implement well-defined policies in credit,

investment, recovery of write-offs, human resources, audit and compliance, risk

management, etc. k. To provide guidance to banks in identifying, measuring, monitoring

and controlling various risks and to make them proactive, a detailed set of guidelines on risk

management has been issued.

(iii) Capital Strengthening.

Capital requirements of the banking sector have to be adequate in relation to the risk

weighted assets and conform to the Basle Accord. To further strengthen their competitive

ability, both domestically and internationally and to encourage the economies of scale, the

minimum paid-up capital requirements of the banks have been raised. The banks were

required to increase their paid-up capital from Rs 500 million to Rs 1 billion by 1st January

2003 failing which they will no longer be allowed to carry out full banking activities as

scheduled banks. This has resulted in mergers and consolidation of many financial

institutions and weeding out of several weaker banks from the financial system.

(iv) Improving Asset quality.

The stock of non-performing loans (NPLs) has been tackled in several ways. The gross

NPLs amount to Rs 252 billion and account for 22 percent of the advances of the banking

system and DFIs. However, there has been aggressive provisioning carried out during the

last three years. More than 60 percent of the NPLs are fully provided for and net NPLs to

net advances ratio has thus declined to less than 10 percent. Efforts are being made to

further reduce this ratio through the active involvement of Corporate & Industrial

Restructuring Corporation (CIRC) and the Committee on Revival of Sick Units (CRSU).

The settlement reached between loss category loan holders and banks under State Bank

circular No.29 will further reduce the volume of NPLs and allow the sick industrial units to

revive while at the same time enable the banks to clean up their balance sheets. The positive

Management of Financial Institutions - MGT 604

development is that the quality of new loans disbursed since 1997 has improved and

recovery rate is 95 percent.

(v) Liberalization of foreign exchange regime

Pakistan has further liberalized its foreign exchange regime and ensured partial Capital

account Convertibility by allowing foreign exchange companies to operate and Pakistani

Corporate sector to acquire equity abroad.

(vi) Consumer Financing

The State Bank has removed restrictions imposed on nationalized commercial banks for

consumer financing. The positive experience of auto financing gives a lot of hope that the

middle class of this country will be able to access consumer durables through banks. This

will at the same time boost the manufacturing of TVs, air-conditioners, VCRs, washing and

drying machines, deep freezers etc. in the country. Credit and Debit Cards are also gaining

popularity and the numbers of card holders have doubled during the last two years.

(vii) Mortgage Financing

A number of incentives have been provided to encourage mortgage financing by the banks.

The upper limit has been raised from Rs 5 million to Rs 10 million. Tax deduction on

interest payments on mortgage have been allowed up to a ceiling of Rs.500,000. The new

recovery law is also aimed at expediting repossesssion of property by the banks. The banks

have been allowed to raise long term funds through rated and listed debt instruments like

TFCs to match their long term mortgage assets with their liabilities.

(viii) Legal Reforms

Legal difficulties and time delays in recovery of defaulted loans have been removed through

a new ordinance i.e. The Financial Institutions (Recovery of Finances) Ordinance, 2001.

The new recovery laws ensures expeditious recovery of stuck up loans by the right of

foreclosure and sale of mortgaged property with or without intervention of court and

automatic transfer of case to execution proceeding. A Banking Laws Reforms Commission

is reviewing, revising and consolidating the banking laws and drafting new laws such as

bankruptcy law.

(ix) Prudential Regulations

The prudential regulations in force were mainly aimed at corporate and business financing.

The SBP in consultation with the Pakistan Banking Association and other stakeholders has

developed a new set of regulations which cater to the specific separate needs of corporate,

consumer and SME financing. The new prudential regulations will enable the banks to

expand their scope of lending and customer outreach.

(x) Micro financing

To provide widespread access to small borrowers particularly in the rural areas the licensing

and regulatory environment for Micro Credit and Rural financial institutions have been

relaxed and unlike the commercial banks these can be set up at district, provincial and

national levels with varying capital requirements. There is less stringency and more

facilitative thrust embedded in the prudential regulations designed for this type of

institutions. Khushali Bank and the First Microfinance Bank in the private sector have

Management of Financial Institutions - MGT 604

already started working under this new regulatory environment. Khushali Bank has already

reached a customer base of 125,000 mainly in poorer districts of the country and its

recovery rate is above 95 percent.

(xi) SME Financing.

The access of small and medium entrepreneurs to credit has been a major constraint to

expansion of their business and up gradation of their technology. A Small and Medium

Enterprise (SME) Bank has been established to provide leadership in developing new

products such as program loans, new credit appraisal, and documentation techniques, and

nurturing new skills in SME lending which can then be replicated and transferred to other

banks in the country. Program lending, for example, can help up gradation of power looms

to shuttle less looms in Faisalabad area and contribute to the achievement of goal set under

Textile Vision 2005. The new

Prudential regulations for SMEs do not require collateral but asset conversion cycle and

cash flow generation as the basis for loan approval. The State Bank is also contemplating to

develop capacity building among a select group of banks for SME lending. This will

revitalize the lending to SMEs particularly export oriented ones.

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