Overview

Commercial banks have, for the past several years, been operating in an environment
fraught with economic and financial problems. These include bad real estate loans in
portfolios already burdened with borrowings for takeovers and for third world loans, the
failure of a number of well-known financial institutions, the aftermath of the savings and
loan crisis, and finally the economic downturn of 1990-91. The problems have given rise
to numerous corrective suggestions from the Administration, Congress, banking
regulators, and the commercial banking community itself.

These suggestions cover a wide range of options, such as establishing new ratios for
capital, liquidity, earnings, risk concentration, and asset quality, as well as modifications
in regulatory and supervisory procedures, limitations on deposit insurance, authorizing of
new bank activities in securities and insurance, and expansion into interstate banking.

In an effort to be more competitive both domestically and internationally, many large

banks have decided to join forces with other large banks, creating new combinations of
giant financial institutions with more capital and assets, and larger branch networks. This
trend of mergers and acquisitions will most likely spread over the next few years to
medium and small banks, as they, too, try to face one of the principal weaknesses of the
U.S. banking system, namely the lack of product and geographic diversification. Product
diversification would involve abolishing the National Banking Act of 1973, known as the
Glass-Seagull Act, which separates banking and commerce, while geographic
diversification would involve abolishing the McFadden Act of 1927 and the Douglas
Amendment to the Bank Holding Company Act of 1956, which prohibit banks and bank
holding companies from interstate deployment.

A Brief History of Banking

In the recent era, the story of "the elite" commences with the development of the modern
banking system in Middle Ages Europe. At that time, disposable wealth was usually held
in the form of gold or silver bullion. For safety, such assets were kept in the safe of the
local goldsmith, he usually being the only individual who had a vault on his premises.
The goldsmith would issue a receipt for the deposit and, to undertake financial
transactions, the buyer would withdraw his gold and give it to the seller, who would then
deposit it again, frequently with the same goldsmith. As this was a time-consuming
process, it became common practice for people to simply exchange smiths' receipts when
conducting financial transactions.

As time passed, the goldsmiths began to issue receipts for specific values of gold, making
buying and selling easier still. The smiths' receipts thus became the first banknotes. The
goldsmiths, now fledgling bankers, noticed that at any one time only a small proportion
of the gold held with them was being withdrawn. So they hit upon the idea of issuing
more of the receipt notes themselves, notes that did not refer to any actual deposited
wealth. By giving these receipts to people seeking capital, in the form of loans, the
goldsmiths could use the money deposited with them by others to make money for
themselves. It was found that, for every unit of gold held by the goldsmith, ten times the
sum could be safely issued as notes without anyone usually becoming any the wiser. If a
goldsmith held, say, 100 pounds of other people's gold in his vaults, he could issue
banknotes to the value of 1000 pounds. As long as no more than 10 percent of the holders
of those notes wanted their gold at any one time, no one would realize the fraud being
perpetrated. This practice, known as "fractional reserve lending," continues to this day
and is actually the backbone of the modern banking industry. Banks typically loan ten
times their actual financial holdings, meaning 90% of the money they lend does not now,
never has, and never will exist.

Loans issued by the goldsmiths had to be paid back to them with interest, meaning non-
existent money slowly became converted to tangible assets in the form of goods and
labour. Should the loan be defaulted upon, the banker had the right to seize the defaulter's
property. As time passed, therefore, the goldsmiths became wealthier and wealthier. They
had devised a scheme to create money out of thin air and then convert this money into
real goods, labour, or property. A loan of money at 12% interest recouped not merely
12% for the banker, but 112%, as it does to this day.

As the industrial era began, so the potential for furthering this scheme increased
exponentially. The goldsmiths were now fully-fledged bankers, and their ability to create
money out of thin air and then convert it into tangible assets enabled them to begin to
control whole industries to the point where the worlds of banking and industry became, to
all intents and purposes, seamless entities. Extended family banking structures, such as
the Rothschild, acquired so much power in this manner that the various monarchies and
fledgling governments of the time soon began to seem quite feeble by comparison.

To increase their power and influence still further, these elite banking families would
subtly buy influence within governments or monarchies and utilise this influence to
strategically stir up unrest between nations. When the inevitable disputes broke out, they
would then lend vast sums of money, usually to both sides, so that war could be waged.
Any armaments purchased would be those manufactured by the industrial wing of the
banking-industrial cartel, and by regulating the loan of money and the timing of the
delivery of weapons, the outcome of any conflict could effectively be controlled. If
deemed necessary, monarchies and governments could further be destabilized by
generating poverty through regulating the money supply, and by using agent-provocateur
tactics to fuel any latent desire for revolution. With such power it was easy to control the
fledgling governments of Europe and ensure that only those politicians who would do the
will of the banking families came to power.

As the twentieth century dawned, the banking families hit upon a new means to
consolidate and increase their gains. They discovered that by periodically restricting the
money supply crashes within the emergent stock exchanges of the world could easily be
engineered. The most notable example of this was the famous Wall Street Crash of 1929.
What the history books usually fail to record is that, in a crash, wealth is not actually
destroyed, but merely transferred. The "Crash of '29" allowed the most powerful of the
banking and industrial families to absorb the weaker elements, generating even greater
levels of centralized control.

As the technological revolution progressed, so the buying up of TV stations and

newspapers allowed the creation and control of the mass media. This served to ensure
that only a portrayal of events that suited the interests of the elite banking families would
get to public attention - invariably one that all but denied their very existence.

Modernizing the System

In response to these competitive changes, the Administration and Congress in 1991
considered sweeping new proposals to modernize and strengthen the U.S. financial
system. The proposals represent the most far-reaching restructuring of the industry since
the series of banking and financial regulatory acts of the 1930's. Here are some of the
main proposals, as embodied in the Administration bill entitled, Financial Institutions
Safety and Consumer Choice Act:

* Deposit Insurance: The bill limits coverage for an individual to $100,000 per
institution, plus an additional $100,000 per institution for a retirement account.

* Too Big to Fail: It authorizes the Treasury and the Federal Reserve to jointly determine
if, in order to protect the nation's financial system, the coverage of uninsured depositors
is warranted.

* Bank Insurance Fund: Leaves the FDIC with its existing $5 billion credit line from
the Treasury, permits it to borrow up to $25 billion from the Federal Reserve Bank, and
places a cap on the maximum aggregate assessment rate to be charged to Fund members.

* Risk-Based Premiums: Requires the FDIC to develop a risk-based assessment system

that would base premiums upon the capital adequacy of a bank. Categories of risks will
be established using the ratio of capital to risk-weighted assets.

* Interstate Banking: Amends the McFadden Act to permit national banks to branch
interstate. It would also repeal three years after enactment the Douglas Amendment to the
Bank Holding Company Act, thus removing restrictions on interstate acquisitions of
banks by bank holding companies. A state would still be able to restrict interstate
branching of all state and national banks operating within its borders.

* New Activities: Repeals some key elements of the Glass-Steagall Act. It requires all
bank holding companies to become financial services holding companies (FSHC). Well
capitalized FSHC'S could engage in securities, insurance, and mutual fund activities
through affiliates. A number of strict firewalls would be erected to separate the bank from
its new affiliates.

* Foreign Banks: Foreign banks in the United States that wish to engage in the new
financial activities would be required to establish a FSHC. If they did not wish to engage
in such activities, they would be able to continue to operate through agencies or branches.
Any grandfathered nonbanking activities authorized under the International Banking Act
of 1978 will be terminated three years after enactment of the bill.

* Banking and Commerce: Allow a commercial firm or a financial service firm to own
a well-capitalized FSHC through a diversified holding company (DHC). These
diversified holding companies would have no limits on the types of activities in which
they could engage. However, a bank owned by a diversified holding company would be
separated from commercial activities by stronger firewalls than those between the bank
and financial affiliates.

* Regulation and Supervision: The existing four Federal regulators, i.e., Federal
Reserve, Office of Comptroller of the Currency (OCC), Federal Deposit Insurance
Corporation FDIC), and Office of Thrift Supervision (OTS), will become two: the
Federal Reserve and a new Office of Depository Institutions (ODIS) in the Treasury. The
Federal Reserve will be responsible for all state-chartered banks and their FSHCS and
DHCS, while the ODIS will be responsible for all national banks and their FSHCS and
DHCS. Regulatory functions of the FDIC relating to state-chartered non-member banks
will be transferred to the Federal Reserve. OTS and OCC activities will be taken over by
ODIS.

These provisions seek to address many of the problems afflicting the U.S. banking
industry, an industry in some turmoil today. They would, when enacted into law,
strengthen the deposit insurance system, broaden the choice of financial products offered
by banks to consumers, while also ensuring the safety and stability of U.S. financial
markets through improved capitalization and regulation. At the same time, the
restructuring is aimed at putting U.S. banks on a more competitive footing with foreign
institutions, and with domestic retail entities. The next one or two years will be crucial in
establishing the framework that will affect the operations of U.S. financial institutions in
the closing years of this century.

Structure

Structure of banks will be discussed in Pakistan3, first in terms of

number of banks and size of banks (as measured by assets, deposits,
etc), then in terms of concentration ratios
(Lorenz curve, Gini co-efficient, Herfindahl index and Concentration
Ratio).
In 1990, seven domestic banks and seventeen foreign banks were
doing business in
Pakistan. All the domestic banks were owned by the government. Entry
of domestic
private sector in the banking business had been banned since the
promulgation of Banks
Nationalization Act 1974. However, as a part of financial liberalization
strategy of 1990s,
private sector was allowed to open commercial banks in 1991. At that
time fifteen banks
were opened. During the next ten years the process of entering of new
banks and exiting
of inefficient banks continued. Moreover, in order to go some step
further to make the
banking sector competitive, the government also denationalized a
couple of commercial
banks. In 1999, there were 19 domestic banks and seventeen foreign
banks in Pakistan
(see Annex for list). Of the domestic banks, four were owned by the
federal government,
two were privatized, two were owned by the provincial governments
and the rest were in
the private sector. The government has also minimized its
interventions in the business of
its own banks in order to ensure that a competitive environment
prevails in the industry.
Along with the growth of banks in numbers, their business also shows a
reasonable
growth during 1990s. Total assets of commercial banks grew at a
compound annual
growth rate of 15 percent, from Rs 419 billion at the beginning of
decade to Rs 1,469
billion by the end of 2003.
Amongst different groups, assets of private banks showed fastest
growth during 1990s,
followed by foreign banks. A similar trend is witnessed in the advances
and deposits of
the banks (Table 1).
The distribution of assets, deposits, advances, etc., of commercial
banks has been worked
out on the basis of Herfindahl Index and Concentration Ratio.

Herfindahl Index
It is also a measure of industrial concentration. To obtain the index,
individual market
share (in fraction) of each bank in terms of equity, assets, deposits,
advances, and
employment is squared. The sum of squared shares gives the
Herfindahl Index, as given
below;
The Herfindahl index has an advantage over the Gini coefficient that it
takes into account
both the number of banks and their size differences. The value of H will
be 1 when there
is single firm in the industry, and tends to 1 when the number of firms
decreases and/or
inequality in shares increases. Table 3 shows Herfindahl index and co-
efficient of
variation for different variables relating to banking firms.

Table 3: Herfindahl Index & Co-efficient of Variation

The table shows that Herfindahl index has slightly declined over the
years. This may be
due to increase in number of banks during this period. However, as
size inequality was
still very high (as evident from Gini co-efficient) the gain from increase
in number of
banks was not very significant. The table also gives the co-efficient of
variation which
has been increased for capital (equity). It implies there are more
variations in terms of
paid up capital of new entrants in the industry.
Concentration Ratio
Concentration Ratio is another useful measure of the dimension of the
market structure. It
gives the percentage of total industry size accounted for by the few
largest firms in the
industry. We have calculated 4-bank CR, 8-bank CR, and 20-bank CR.
Table shows
that 40 to 50 percent equity was concentrated in the largest 4 banks.
These four banks
were not only capturing two thirds of the banking business in terms of
deposits, assets,
and advances, but also were providing employment to 80 percent of
the labor force in the
industry. The other 32 banks were providing employment to only 20
percent of bankers.
All the indicators of concentration, i.e. Gini coefficient, Herfindahl index
and
Concentration Ratio, show that distribution of banking business is
highly skewed in
Pakistan. It implies the absence of competitive environment in its true
sense in the
industry. This result is contrary to the claim of the State Bank of
Pakistan that the
banking sector in Pakistan has become competitive in recent years
Table: concentration ratio
A Closer Look at Government
The vision we're usually given of how political power is manifest in our society typically
runs something like this: government at the top, banking, industry, media and military,
beneath, and the people beneath this. However, an independent examination of the
development of modern political power is more likely to reveal the following
arrangement: extended family banking groups at the top, government beneath, facilitating
the wishes of this hierarchy, and the media beneath portraying the work of the
government to the people as "democracy in action."
It can thus be seen that, in truth, most governments are little more than front
organizations for the elite banking cartels. They interface with the public via the media,
acting to facilitate social change in a manner that maintains relative social stability, while
ensuring that our culture stays in line with any course the elite wish it to pursue. Western
governments do not usually allow the public to actually pick who becomes their political
representative, merely to choose between individuals selected by the party hierarchy.
Neither do the public get to pick the policies the representative will pursue, this is also
under the control of the party. To say that this system is open to abuse is a considerable
understatement.

Macro -Economic effects:

Real Economy
1. The economy of Pakistan has grown on an average of 7.5 percent over the period
2003-07, whereas during the current year 2006-07 a growth rate of 7 percent has been
achieved. The size of GDP increased three times from Rs 2,938 billion in 1998-99 to Rs
8,716 billion in 2006 -07, while per capita income increased more than two times from $
438 to $ 926, investment by five times from Rs 409 billion to Rs 2,004 billion and national
savings 4.6 times from Rs 344 billion to Rs 1,572 billion in the same period. On the basis
of rapid and sustained growth achieved in the recent past, Pakistan has joined the fastest
growing economies of the Asian region. Impressive growth of Pakistan’s economy is
attributed to the continuity and consistency of policies initiated by the present regime
within the overall framework of deregulation, privatization and liberalization.

2. Efficient management and structural reforms introduced in the recent past have
brought about healthy changes in almost all sectors of the economy. A major breakthrough
has been achieved in managing the domestic and external debt. Total debt (domestic and
external), which was 100.3 percent of the GDP in 1998-99, has been reduced by half to
51.1 percent by 2006-07. The ability of the country to borrow from international and
regional capital markets at relatively low rates and long maturities has improved
substantially. The recent floatation of Euro-Bond in the international market was
subscribed by seven times to over $ 3.5 billion. The steep decline, both in the stock of debt
and debt-servicing as a ratio to GDP has provided ample fiscal space to pursue
expansionary economic policies.

3. Total investment has increased substantially and reached an all time record of Rs
2,004 billion (23.0 percent of GDP) in 2006 -07. The confidence of foreign investors in
Pakistan economy has improved as non –debt creating capital inflows have touched the
level of $ 8.4 billion during 2006-07. The foreign direct investment has risen from $ 485
million in 2001-02 to $ 5.1 billion in 2006-07. The economy has also witnessed a sharp
rise in the workers’ remittances, which increased to $ 5.5 billion during 2006 -07, showing
a five times increase from a level of $ 1.1 billion in 1998-99.

4. As a consequence of tight monetary policy, inflation has marginally decline from

8.0 percent in 2005-06 to 7.8 percent in 2006-07. High economic growth, targeted poverty
reduction, social protection programs and increase in pro-poor spending has created
gainful employment opportunities and lifted millions of people out of poverty in the rural
and urban areas. The unemployment rate has declined from 8.3 percent in 2001-02 to 6.2
percent in 2005-06. The poverty measured on head count basis, decreased from 34.4
percent in 2000-01 to 23.9 percent in 2004-05. The trend of poverty reduction is more
pronounced in the rural areas.

5. GDP and GNP Development: The size of GDP

increased three times from Rs. 2938 billion in 1998-99 to Rs. 8716 billion in 2006-07. The
investment climate improved significantly. Total investment increased substantially and
reached an all time record of Rs 2 trillion (23.0 percent of GDP) in 2006-07. The public
sector development expenditure (PSDP) witnessed a sharp increase, from 2.2 percent of
the GDP in 2002-03 to 4.2 percent in 2006-07 (excluding allocation for earthquake). The
GNP has touched the level of $ 146 billion, and per capita income has reached to $ 926 in
2006-07.

6. Composition of GDP and Sectoral Growth: The 7 percent real GDP growth in
2006-07 has been supported by the robust growth in agriculture and services sectors. The
agriculture sector is estimated to record a growth rate of 5.0 percent. However, the growth
of large-scale manufacturing (LSM) is likely to be around 8.8 percent.

10. Investment and Savings: The total investment in 2006-07 is expected to increase
by 21.4 percent (23 percent of GDP) and fixed investment by 21.9 percent to Rs 1864
billion (21.4 percent of GDP).

11. Price Development and Inflation: The underlying inflationary pressures in the
economy continued to ease in 2006-07, with Consumer Price Index (CPI) inflation during
July-April 2007 declining below 8 percent. The non-food inflation witnessed an increase
of 6.2 percent as compared to 8.8 percent increase in the corresponding period in 2005 -06.
However, the annualized increase in food prices accelerated to 10.2 percent from 7.0
percent in the same period of 2005 -06.
Fiscal Policy
20. The Budget 2006-07 estimated an overall fiscal deficit of Rs 373.5 billion (4.2 percent
of GDP). Tax revenues collected by the Central Board of Revenue (CBR), during July-
April 2006-07 increased more than 18 percent to touch the level of Rs 646.9 billion as
against collection of Rs 547.0 billion for the corresponding period of 2005-06. It
constitutes 77.5 percent of the full year target of Rs 835.0 billion. The direct taxes at Rs
2993.3 billion recorded the highest growth of 48.8 percent, followed by federal excise
(17.8 percent) and sales tax (6.2 percent).

21. External Debt: Pakistan’s external debt stood at US $ 38.6999 billion on 30th
June 2007. The debt burden for the previous two years i.e as on 30th June 2005 and 30th
June 2006 was US $ 34.037 billion on and 35.655 billion respectively. There is an increase
of 3.044 billion which represents a 8.5 percent increase in external debt over the stock at
the end of FY 2006. Majority of the EDLs are in the form of medium and long term
borrowing from multilateral and bilateral lenders which accounts for 80 percent of
outstanding debt. The share of short-term debt is extremely low at 0.1 percent.

22. During the financial year 2005-06 external debt and liabilities declined from 32.7
percent of GDP in FY 2004-05 to 29.4 percent of GDP in 2005-06. Pakistan has succeeded
in reducing the rising trend in external debt and foreign exchange liabilities. The external
debt and liabilities as percentage of foreign exchange earning declined from 120.6 at the
end of June 2006 to 119.7 at the end of March 2007.

Financial Policy
23. The tight monetary policy stance pursued by the SBP during the fiscal year 2004-
05 and 2005-06 was further tightened in July 2006 by raising policy discount rate by 50
basis points to 9.5 percent, the Cash Reserve Requirement (CRR) from 5 to 7 percent on
demand liabilities, and the Statutory Liquidity Requirement (SLR) from 15 to 18 percent,
for the scheduled banks. At the same time, in order to give incentives to banks to mobilize
long-term deposits, SBP reduced the CRR on their time liabilities from 5 to 3 percent.

24. The Credit Plan for the fiscal year 2006-07 envisaged growth in money supply
(M2) at 13.5 percent (Rs. 459.9 billion), which was based on the assumption of a GDP
growth target of 7.0 percent and inflation rate target of 6.5 percent for the year. The net
domestic assets estimated to grow by Rs. 450.1 billion or 13.2 percent. The credit to
government sector for budgetary support was targeted at Rs. 120.1 billion and credit to
private sector at Rs. 390 billion. The net foreign assets of the banking system were
envisaged to exert an expansionary effect to the tune of Rs. 9.8 billion.

25. The monetary expansion during July 1, 2006 to June 30, 2007 stood at Rs. 658.3
billion (19.3 percent) as against the full year target of 13.5 percent and an expansion of
15.1 percent during the corresponding period last year.

26. The net bank credit to the government, used for financing budgetary expenditure
and commodity operations, amounted to Rs. 92.8 billion during the year against the annual
target of Rs. 130.1 billion. The government borrowing for budgetary support from the
banking system amounted to Rs. 102 billion against the annual target of Rs. 120.1 billion
and Rs. 67.1 billion during 2005-06. Demand for the private sector credit amounted to Rs.
356.3 billion is 91.35 percent of the target. Private sector credit registered a sharp slow
 down during 2006-07 compared with 2005-06 (Rs. 401.8 billion) due to tight monetary
policy during the year. The net foreign assets expanded to the tune of Rs. 285.8 billion as
against Rs. 51.5 billion during the corresponding period last year.

27. The utilization of bank credit by various segments of the private sector during July
06-May 07 remained broad based. The manufacturing sector as usual continued to
dominate the consumption of bank credit as it consumed 45 percent of the bank credit
while consumer financing was second largest as its share was 15.35 percent.

28. The reserve money expanded by 20.9 percent in 2006-07 compared with an
expansion of 10.2 percent in 2005-06.

30. Interest rates of central bank & banking system: State Bank of Pakistan
continued to exercise tight monetary policy stance and frequently intervened in the inter-
bank market to achieve the desired results by Open Market Operations. Cut-off yields on 6
month and 12 month treasury bills since July 2006 to June 2007 rose from 8.48 percent to
8.9 percent and 8.79 percent to 9.16 percent, respectively. The interest rates in the
secondary market increased marginally. The short-term interest rates of 6 months Karachi
inter-bank offered rate (KIBOR) since July 2006 to June 2007 rose from 9.92 percent to
10.02 percent and 10.35 percent to 10.45 percent, respectively. Tight monetary conditions
also led the banking industry to raise the average deposit rate from 3.09 percent in July
2006 to 3.98 percent in June 2007. However, this rise was not enough as the banking
spread (average lending rate minus average deposit rate) increased from 7.15 in July 2006
to 7.5 percent in December 2006. Although, it declined to 6.34 percent in June 2007 but it
is still very high.

Failures and Problem Banks

Despite the problems that banks continue to face with their loan portfolios, fewer banks
failed in 1990 than in each of the three previous years. The failure total for 1990 was 168,
compared to 206 in 1989, 200 in 1988, and 184 in 1987. Any sustained improvement,
however, is unlikely, although much will depend on the strength of the overall economy.
Projections by the Federal Deposit Insurance Corporation (FDIC) put bank failures at 180
in 1991 and 160 in 1992.

Banks on the problem list of the FDIC also fell in 1990. This decline, which started in
1987, continued into 1990 when 1,045 banks made the list. This compares to 1,110 in
1989, 1,415 in 1988, 1,443 in 1987, and 1,484 in 1986.

As a consequence of the bank failures, the Bank Insurance Fund, which totaled $8.4
billion at the end of 1990, is expected to fall to $4 billion at the end of 1991, and $3.5
billion at the end of 1992. To make up for the losses, the FDIC in mid-1990 boosted the
insurance premiums banks pay, from 19.5 to 23 cents for each $100 of domestic deposits.

Profitability of Banks
The profitability of insured commercial banks declined once again in 1990 from the
already depressed level of 1989, according to the Federal Reserve (Table 1). The
weakness in earnings reflected substantial additions to loss provisions by medium and
large banks for commercial real estate and domestic business loans. Specifically, the
average return on assets, measured by net income as a percentage of average fully
consolidated assets, went from 0.51 to 0.50 percent for all banks, although the drop was
more pronounced for larger banks.

The average return on equity, measured by net income as a percentage of average equity
capital, also decreased for the industry as a whole, going from 7.94 in 1989 to 7.77
percent in 1990. As with the return on assets, the decline was more pronounced for larger
banks.

The profitability of several large banks continued to be depressed in the first half of 1991
due mainly to mounting real estate loss provisions and declining performance of loans to
highly leveraged firms.

4. Conclusion
Commercial banks undertake business of risk in an environment of asymmetric
information.On the basis of key indicators of inequality viz.Herfindahl index and
Concentration Ratio, we have found that distribution of banking
business is highly skewed in Pakistan. All the main variables like equity, assets, deposits,
advances, and employment are distributed unequally across the banks. It implies absence
of competitive environment in its true sense in the industry. Our results are in
contradiction to the claim of the State Bank of Pakistan that banking industry has become
competitive.