History of Banking in Pakistan

History Banking Pakistan.

of in

Assignment for:
Money & Banking

Written by:
Muhammad Qasim
BM-26464

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 History of Banking in Pakistan

Contents
HISTORY: ....................................................................................................................................................... 4
BANKING IN PAKISTAN .................................................................................................................................. 5
The Humble beginnings, 1947 – 1970....................................................................................................... 5
A legacy of public control, 1970 – 1980 .................................................................................................... 6
The Business as usual, 1980-1990 ............................................................................................................ 6
Causes of nationalization: ..................................................................................................................... 9
Result of nationalization: ...................................................................................................................... 9
Privatization, 1990 – 1997 ........................................................................................................................ 9
Development Banks in Pakistan .................................................................................................................. 10
Weaknesses of Banking System .............................................................................................................. 10
Limited Number of Banks ....................................................................................................................... 10
Ignorance of Backward Areas ................................................................................................................. 11
Undeveloped Money Market .................................................................................................................. 11
Misdistribution of Loans ......................................................................................................................... 11
Access of People toward Loans............................................................................................................... 11
Default Ratio ........................................................................................................................................... 11
a) The government owned banks till 2009: ........................................................................................ 12
b) The banks which are privatized by the government: ..................................................................... 12
c) Banks which are already private: .................................................................................................... 12
d) Foreign banks in Pakistan: .............................................................................................................. 13
e) Investment Banks:........................................................................................................................... 13
f) Causes of privatization: ................................................................................................................... 13
g) Result of privatization: .................................................................................................................... 14
SBP’s Role .................................................................................................................................................... 14
ADMINISTRATIVE ORGANISATION OF SBP.............................................................................................. 14
SERVICE TENURE OF GOVERNOR AND MEMBERS: ................................................................................. 15
MAIN DEPARTMENTS OF STATE BANK OF PAKISTAN: ............................................................................ 15
1. AGRICULTURAL CREDIT AND MICRO FINANCE DEPARTMENT: .................................................... 15
2. BANKING INSPECTION DEPARTMENT (BID): ................................................................................ 15
3. BANKING POLICY AND REGULATION DEPARTMENT (BPRD): ....................................................... 15
4. EXCHANGE POLICY DEPARTMENT (EPD): ..................................................................................... 15
5. FINANCE DEPARTMENT: ............................................................................................................... 16

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6. ISLAMIC BANKING DEPARTMENT (IBD): ....................................................................................... 16

Current situation ......................................................................................................................................... 16

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HISTORY:

Before independence, Reserve Bank of India was the central bank of sub-continent. It was not easy to
setup a central bank from the day of independence, therefore, at the time of partition reserves of central
bank were divided between both the countries i.e. India and Pakistan with a ratio of 70:30. Further,
Reserve Bank of India continued its duties as central bank for both the countries. However, working for
own central bank had been started in Pakistan and finally on July 01, 1948 Quaid-e-Azam Mohammad Ali
Jinnah inaugurated State Bank of Pakistan at Karachi since then it is working as Central Bank of the
country.

Initially, under State Bank of Pakistan order 1948, SBP was charged with the duty related to issuance of
currency notes and keeping reserves with a view of securing monetary stability in the country.

As a new country without resources it was difficult for Pakistan to run its own banking system
immediately, so it was decided that the Reserve Bank of India should continue to function in Pakistan
until 30th September 1948, and Pakistan would take over the management of public debt and exchange
control from Reserve Bank of India on 1st April, 1948. By 30th June 1948, the number of offices of
scheduled banks in Pakistan declined from 487 to only 195, because registered banks transferred from
Pakistani territories to India.

At that time there were 19 non-Indian (foreign banks) and only 2 Pakistani banks (Habib Bank, Australian
Bank). In 1 July 1948, of the total bank deposits of Rs. 1.1081 billion held in Pakistan, as much as 73%
was held by foreign banks whose activities were largely confined to foreign trade.

By December 1949, there were 35 scheduled banks in Pakistan of which:

1. 4 were Pakistani Banks

2. 23 were Indian Banks
3. 8 were Exchange Banks

Most of the banking business was in the hands of Hindus of British people and only two banks were in
the hands of Muslims and one bank was already in Pakistan. There were 19 non-Indian foreign banks in

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Pakistan before independence whose policies and operations were controlled by their head offices
abroad. These banks were engaged in export of crops from Pakistan.

Established just few months before independence

 Habib bank was established in early 1947 in Bombay(India), shifted in Pakistan after
independence
 Muslim commercial bank was established in July 1947, in Calcutta (India), shifted in Pakistan
after independence.
 Australian Bank renamed Allied bank in 1942 lahore (Pakistan)

BANKING IN PAKISTAN
At the time of independence, the areas which now constitute Pakistan were producing only food grains
and agricultural raw material for Indo-Pakistan subcontinent. There were practically no industries, and
whatever raw material was produced was being exported from Pakistan. However, commercial banking
facilities were provided fairly well here. There were 487 offices of scheduled banks in the territories now
constituting Pakistan.

The Humble beginnings, 1947 – 1970

Our financial sector evolved very differently from banks in the developed world. For nearly a year after
partition, Pakistan had no central bank. Habib Bank – established in 1941 – filled this gap initially, until
the State Bank of Pakistan (SBP) was set up in 1948 under quasi-government ownership. The role of
domestic banks was particularly limited at the time, accounting for only 25 of the total 195 bank
branches in the country. Therefore, the SBP was initially mandated to develop commercial banking
channels, and maintain monetary stability so trade and commerce could flourish in the newly-created
state. Subsequently, Habib Bank, Allied Bank and National Bank were amongst the first to start
operations with strong support from the central bank.

Nationalization of banks was considered necessary so that the nation as a whole could benefit from the
better channeling of resources. So the government of Pakistan decided to nationalize all scheduled

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banks as well as State Bank of Pakistan through the ordinance of Nationalized 1974. All this was done on
Jan 1, 1974.

A legacy of public control, 1970 – 1980

Commercial banking grew favorably in Pakistan until 1974. Under the nationalization policy
implemented by Zulfiqar Ali Bhutto’s government, thirteen banks were brought under full government
control, and consolidated into six nationalized banks. The Pakistan Banking Council was set up to
monitor nationalized banks, marginalizing the SBP’s role as a regulator. These measures were meant to
improve lending to prioritized industries. However, while directed lending was viewed favorably at the
time, little can be said of the long-term gains that have been achieved.

This was the first phase of developments of Pakistan’s commercial banking system. In
subcontinent, Reserve bank of India was central bank. The bank of India closed down most of its offices
in Pakistan, which had been working as the agent of Reserve Bank of India was not willing to purchase
even token amounts of the government of Pakistan. Securities and Indian reserve bank’s issued notes
were not marketable declared by India government. The Reserve Bank of India was hardly of any help. It
refused to help the govt. of Pakistan so salaries and other obligations did not fulfill.

After independence of Pakistan 1947,On December 1948 British government decide to divide the
reserves of India central bank 30 percent reserves for Pakistan and 70 percent reserves for India. After
taking this reserve

 In May 1948 “Muhammad Ali Jinnah” immediately establish “state bank of Pakistan”.
 After one year in November 1949, national bank of Pakistan was established in Dacca (East
Pakistan). The main purpose was to act as an agent of state bank of Pakistan.
Numbers of more banks were established according to the need of a country with passage of time.

The Business as usual, 1980-1990

In Bhutto government nationalized the banking system. Thus through the

Nationalization Bank Act 1974, SBP and all commercial banks in Pakistan and carrying on business in or

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outside the country were brought under the government ownership with effect from January 1974. The
ownership and management of all Pakistan banks stood transferred and rested in the federal
government. The chairman, director and chief executive of various banks were removed from their
offices other than those appointed by the federal government and the state bank.

At the time of nationalization there were 30 scheduled banks in the country. 15 were Pakistani while
other were foreign banks. Pakistani banks were having 2902 branches. 70 branches were in foreign
countries. There was 36 branches of foreign banks in the country. Only the branches of Pakistani banks
were nationalized. All the property rights were transferred to the Federal Government.

Through a notification all smaller banks were amalgamation with bigger banks and five units were
formed.

1. National Bank of Pakistan

2. Habib Bank Limited
3. United Bank Limited
4. Muslim Commercial Banks
5. Allied Bank of Pakistan Limited

During 1988 to 2000, 5 banks are privatized by government

Banks % of shares offered to private

people
UBL 51%
MCB 16.6%
NPB 5.10%
NIT 58%
ABL 49%

Source: privatization Commission

Banks % of shares offered to Date of bidding

private people

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*HBL 51% 1st Oct. 2003

Source: privatization Commission

At the time of Nationalization, there were following 14 Pakistani commercial banks with 3323 offices
allover Pakistan and 74 offices in foreign countries:

1. National banks of Pakistan 2. Habib bank limited

3. Habib bank (overseas) limited 4. United bank limited

5. Muslim commercial bank limited 6.Commerce bank limited

7. Standard bank limited 8.Australia bank limited

9. Bank of Bahawalpur limited 10. Premium bank limited

11. Pak Bank limited 12. Sarhad bank limited

13. Lahore commercial limited 14.Punjab provincial co-operative bank limited

A Pakistani banking counsel was established for nationalized commercial banks to co-ordinate their
activities. The Pakistan banking council prepared a scheme for the recognition of banks. This scheme
was notified in 1974, according to it small banks combined with big banks so these five banks or units
were established:

1. National bank limited

2. Habib bank limited
3. United bank limited
4. Muslim commercial bank limited
5. Allied bank of Pakistan limited

 In 30th June, 1974. The bank Bahawalpur was merged with the National Bank of Pakistan. The
premier Bank Limited merged with Muslim Commercial Bank limited and Sarhad Bank Limited ,
Pak bank limited merged with Australia bank limited (Allied Bank of Pakistan limited)
 In 31st Dec.1974, the commerce bank limited merged with the United Bank limited.

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 In 30th June, 1975 when the standard bank limited was merged with Habib Bank limited.

Causes of nationalization:

 Distribute equal amount of wealth b/w peoples of country

 To remove unhealthy competition among banks it was thought they created financial and
economic problems

Result of nationalization:

Although there are doubts about the positive results of the nationalization but we can say that

 The banking facilities expanded in the rural areas.

 Bank deposits rose very substantially during a period
 Emphasized lending policies, national building projects, discouraged non-productive and
unhealthy activities like hoarding.
 increase in the number of foreign branches of Pakistani banks

Over time, the financial sector grew to serve primarily large corporate business, politicians and the
government. Board of Directors and CEOs were not independently appointed. Lending decisions were
not always commercially motivated, and many billions of rupees were unsurprisingly funneled out of the
financial system as “bad loans”. Banks were essentially not in control of their destinies during this
period.

Interest was an important target in this phase. The Islamic bank was made and it receives deposit
without guaranteeing any return. The Islamic bank cannot finance the project of an investor; the bank
will have to be a partner in the project.

Privatization, 1990 – 1997

By 1991, the Bank Nationalization Act was amended, and 23 banks were established – of which ten were
domestically licensed. Muslim Commercial Bank was privatized in 1991 and the majority ownership of
Allied Bank was transferred to its management by 1993. By 1997, there were still four major state-

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owned banks, but they now faced competition from 21 domestic banks and 27 foreign banks. More
importantly, administered interest rates were streamlined, bank-wise credit ceilings removed and a
system of auctioning government securities was established, forcing the government to borrow at
market determined rates.

Development Banks in Pakistan

The food shortage compelled the government to embark upon agricultural credit and the agricultural
development bank was setup to attend to agricultural finance. All these measures, and the devaluation
of Pakistani rupee on 1 August 1955, had a very favorable effect on commodity market and the balance
of payments position in 1955-56,

Development of agriculture largely depends on agricultural finance, but the scheduled banks were not
very willing to undertake this risky venture. Therefore the SBP sponsored to establishment of agriculture
development bank to attend exclusively to agricultural finance. Moreover, the functions of the State
Bank were also broadened by facilities for both agriculture and industry. All these measures had positive
effects on Pakistan’s economy during 1956-58.

In 1958 government liberalized imports which increase the demand of funds, so in 1959-60 two more
Pakistani banks namely Eastern Merchantile Bank limited and the United Bank Limited were established
and scheduled and more Pakistani banks continued to be established, which included Commerce Bank
Limited and the Standard Bank Limited. By June 1965 the number of scheduled banks stood at 36. In
1964 NBP also came forward and established a people’s credit department to allow credit facilities to
small borrowers.

Weaknesses of Banking System

Although there was development in this sector after independence, but there were many weaknesses in
this system.

Limited Number of Banks

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There was little number of banks. For 10,000 people there was only a single branch. In developed
nations this ratio is 4000. Therefore the saving ratio is very less, and same is the case of investment.

Ignorance of Backward Areas

Banks were opening branches only in developed areas, they were ignoring backward areas. People of
rural areas were not getting banking facility.

Undeveloped Money Market

The money market was not very much developed, so the banks were not getting sufficient information
and therefore they were not advancing enough loans.

Misdistribution of Loans

Banks were issuing loans to manufacturers and businessmen. They were ignoring agriculture, mining,
fisheries and transportation.

Access of People toward Loans

Banks were advancing loans only to large manufacturers who were getting 63% of total loans but they
were 222 in number. Each was getting more then Rs. 1million.

Default Ratio

Since the loans were given to large manufacturers they were defaulting due to their approaches.

These were few of the weaknesses in this sector and the government efforts were not fruitful. So in
1974 banks were nationalized.

In 1991, the government of Prime Minister Mr. Nawaz Sharif was not fully satisfied with the
performance of nationalized. He took step towards privatization of banks, industries. So Pakistani
banking sector is categories as State Bank of Pakistan, Nationalized Scheduled Banks, Private Scheduled
Banks, Foreign Banks, investment banks, specialized banks.

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a) The government owned banks till 2009:

1. First Women Bank Limited 2.Industrial Development Bank of Pakistan

3. Khushhali Bank Limited 4.National Bank of Pakistan

5. SME Bank Limited 6.The Bank of Khyber

7. The Bank of Punjab 8. Zarai Taraqiati Bank Limited

9. The Punjab Provincial Cooperative Bank Limited

b) The banks which are privatized by the government:

1. Allied Bank Limited (privatized in1993) 2. Habib Bank Limited (2003)

3. MCB Bank Limited (1991) 4.United Bank Limited (2002)

c) Banks which are already private:

1. Al Baraka Bank (Pakistan) Limited (established in 1991) 2. Askari Bank Limited (1992)

3. Bank Alfalah Limited (1997) 4. Bank AL Habib Limited (1991)

5. BankIslami Pakistan Limited (2005) 6. Dawood Islamic Bank Limited (2007)

7. Dubai Islamic Bank Pakistan Limited 8. Faysal Bank Limited (1995)

9. Habib Metropolitan Bank Limited (1992) 10. JS Bank Limited (2006)

11. KASB Bank Limited (1994) 12. Meezan Bank Limited (1997)

13. Mybank Limited (2005) 14. NIB Bank Limited (2003)

15. Samba Bank Limited (Formerly Crescent Commercial Bank Limited)

16. Silkbank Limited (Formerly Saudi Pak Commercial Bank Limited)

17. Soneri Bank Limited (1992) 18. Standard Chartered Bank (Pakistan) Limited (2006)

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19. Summit Bank Limited (Formerly Arif Habib Bank Limited)

d) Foreign banks in Pakistan:

1. ABN Amro Bank 2. N.V Albaraka Islamic Bank BSC (EC)

3. American Express Bank Limited 4. Bank of Tokyo Mitsubishi Limited

5. Citibank N.A 6. Deutsche Bank A.G.

7. Hong kong & Shanghai Banking Corp Limited 8. Oman International Bank S.O.A.G

9. Rupali Bank Limited 10. Standard Chartered Bank Limited

11. Habib Bank A.G. Zurich…. etc

e) Investment Banks:

1. Crescent Investment Bank Limited 2. First International Investment Bank Limited

3. Atlas Investment Bank Limited 4. Security Investment Bank Limited

5. Fidelity Investment Bank Limited 6. Prudential Investment Bank Limited

7. Islamic Investment Bank Limited 8.Asset Investment Bank Limited

9. Al-Towfeek Investment Bank Limited 10.Jahangir Siddiqui Investment Bank Limited

11. Franklin Investment Bank Limited 12.Orix Investment Bank (Pak) Limited….etc

f) Causes of privatization:

 The falling standard of banking services delay in home remittances, bad debts of the banks etc.
 Discourage entrepreneurial activities within the country , did not provide small loans to small
savers so living standard of people were decline….etc

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g) Result of privatization:

 The number of bank branches were 3397 on Dec31, 1973, reached on 7661 by end June.
 Small loans for buy house, cars, land are provided to nation
 Everyone can start business easily after showing their business plans, banks provide loan to
them and every financial help to businessman/ woman. Quality products are marketed at
reasonable price so living standards are improving.
 More competition b/w banks they are trying to provide more bank services that’s why nation
become much satisfied…….etc

SBP’s Role

However, State Bank of Pakistan Act 1956 further strengthened the bank by giving it authority to regulate
the credit and monetary policy of the country. In 1997, State Bank of Pakistan was given full autonomy
through an amendment ordinance in the Act of 1956. After these amendments SBP has full and exclusive
authority to regulate the banking sector, conduct an independent monetary policy and set limits on
government borrowings from State Bank of Pakistan. In 2005, an ordinance has given the money exchange
companies a legal status in the country and now all money exchange companies are also working under
the umbrella of SBP. Hence, since 2005 central bank of Pakistan is acting as a regulatory and controlling
authority for money exchange companies just like commercial banks of the country.

ADMINISTRATIVE ORGANISATION OF SBP

State Bank of Pakistan is governed by a central board of directors consisting of nine members, appointed
by Federal Government of the country. The board is chaired by Governor, SBP. Secretary Finance,
Federal Government is also a member of the board. Further it has seven directors, including one director
from each province ensuring representation of banking, agricultural and industrial sector of the country.

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SERVICE TENURE OF GOVERNOR AND MEMBERS:

President of Pakistan, with consent to the Prime Minister, appoints Governor, SBP for a tenure up-to
three years. However governor’s service tenure can be extended for further three years subject to the
approval of President. Mr. Yaseen Anwar is presently working as the Governor, State Bank of Pakistan.
All the directors are nominated by Federal Government of the country for a tenure up-to three years.

MAIN DEPARTMENTS OF STATE BANK OF PAKISTAN:

Following are the main departments of State Bank of Pakistan.

1. AGRICULTURAL CREDIT AND MICRO FINANCE DEPARTMENT:

The department is mainly responsible to meet the credit requirements of agricultural sector of Pakistan.
As an agricultural country, Pakistan needs a great support in terms of credit and guidance in this sector.
Agricultural Credit department is not only playing a vital role for the development of agricultural sector
but is also a major source of foreign exchange earnings.

2. BANKING INSPECTION DEPARTMENT (BID):

It is one of the core departments of SBP. BID plays an important role in meeting main responsibility of
State Bank i.e. supervising financial institutions of the country. Banking inspection department conducts
on-site inspection on regular basis of all the commercial banks and DFI’s hence ensuring soundness of
economic system and protecting the interest of depositors as well.

3. BANKING POLICY AND REGULATION DEPARTMENT (BPRD):

SBP, as a regulatory authority, is responsible to make consistent and workable policies and regulations in
order to support country’s economy and build trust of commercial banks and depositors. BPRD has been
assigned the task of achieving this objective. It not only makes or amends the policies according to the
current scenario but also provides complete guidance to all the commercial banks and financial
institutions about policies and procedures through circulars and prudential regulations.

4. EXCHANGE POLICY DEPARTMENT (EPD):

EPD is responsible for overall activities of foreign exchange market in the country. To achieve this
objective it not only formulates but also implements foreign exchange policies in order to get results

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accordingly. EPD makes sure the availability of foreign exchange manuals and circulars about foreign
exchange to all authorized dealers, exchange companies and investors providing them a clear
understanding about rules, regulations and policies of SBP about foreign exchange.

5. FINANCE DEPARTMENT:
Another important department of SBP is the finance department as it not only manages financial issues
such as maintenance of government and provincial accounts and preparation of financial statements,
but, on the other hand it also controls working of issue department which includes management of
currency operations like designing, printing and circulation of currency notes.

6. ISLAMIC BANKING DEPARTMENT (IBD):

After the judgment of Shariah Court about interest based banking, SBP was advised to implement and
promote the Shariah compliant Islamic banking as a compatible and parallel system in the country. As a
result IBD was established on September 15, 2003, basic objective of which is to develop a sound and
compatible Islamic banking system in the country through developing Shariah complaint Islamic banking
products and services so as to achieve equitable economic growth.

The Situation (in the first decade of year 2000)

Pakistan’s banking sector reforms which were initiated in the early 1990s have transformed the sector
into an efficient, sound and strong banking system. The most recent comprehensive assessment carried
out jointly by the World Bank and the IMF in 2004 came to the following conclusion:

“For reaching reforms have resulted in a more efficient and competitive financial system In
particular, the predominantly state-owned banking system has been transformed into one that is
predominantly under the control of the private sector. The legislative framework and the State
Bank of Pakistan’s supervisory capacity have been improved substantially. As a result, the financial
sector is sounder and exhibits an increased resilience to shocks.”

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The major changes that have occurred in the banking sector during the last decade or so can be
summarized as follows:

(a) 80 percent of the banking assets are held by the private sector banks and the privatization of
nationalized commercial banks has brought about a culture of professionalism and service
orientation in place of bureaucracy and apathy.

(b) The banks that were losing money due to inefficiencies, waste and limited product range have
become highly profitable business. These profits are, however, being used to strengthen the
capital base of the banks rather than paying out to the shareholders. The minimum capital
requirements have been raised from Rs. 500 million to Rs. 6 billion over an extended period
in a phased manner. The consolidation of the banking sector into fewer but stronger banks
will lead to better management of risk.

(c) The banks that were burdened with the non-performing and defaulted loans have cleared up
their balance sheets in an open transparent, across-the-board manner. Contrary to the
popular myth the main beneficiaries of the wirite-offs of the old outstanding and
unrecoverable loans have been from almost 25 percent to 6.7 percent by Dec. 2005. Small
individual borrowers the ratio of non-performing loans of the Commercial Banks to total
advances has declined.

(d) The quality of new assets has improved as stringent measures are taken to appraise new
loans, and assure the underlying securities. Online Credit Information Bureau reports provide
updated information to the banks about the credit history and track record of the borrowers.
Loan approvals on political considerations have become passé. Non-performing loans account
for less than 3 percent of all new loans disbursed since 1997.

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(e) The human resources base of the banks has been substantially upgraded by the adoption of
the principles of merit and performance throughout the industry. Recruitment is done
through a highly competitive process and promotions and compensation are linked to
training, skills and high performance. The banks now routinely employ MBAs, M.Coms,
Chartered Accountants, IT graduates, economists and other highly educated persons rather
than Clerical and Non Clerical Workers. The banking industry has become the preferred choice
of profession among the young graduates.

(f) Banking Technology that was almost non-existent in Pakistan until a few years ago is
revolutionizing the customer services and access online banking, Internet banking, ATMs,
mobile phone banking and other modes of delivery have made it possible to provide
convenience to the customers while reducing the transaction costs to the banks. Credit Cards,
Debit Cards, Smart Cards etc. are a thriving and expanding business in Pakistan. Once the
RTGS is put in place the payment system in Pakistan. Would enter a new phase of
modernization.

(g) Competition among the banks has forced them to move away from the traditional limited
product range of credit to the government and the public sector enterprises, trade financing,
big name corporate loans, and credit to multinationals to an ever-expanding menu of
products and services. The borrower base of the banks has expanded four fold in the last six
years as the banks have diversified into agriculture, SMEs, Consumers financing, mortgages,
etc. The middle class that could not afford to buy cars or apartments as they did not have the
financial strength for cash purchases are the biggest beneficiaries of these new products and
services.

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(h) Along with strong regulation, supervision and enforcement capacity of the State Bank of
Pakistan a number of measures have been taken to put best corporate governance practices
in the banking system. ‘Fit and proper’ criteria have been prescribed for the Chief Executives,
members of the Boards of Directors, and top management positions. Accounting and audit
standards have been brought to the International Accounting Standards (IAS) and the
International Audit Codes. External audit firms are rated according to their performance and
track record and those falling short of the acceptable standards are debarred from auditing
the banks. These practices were put in place in Pakistan long before the scandals of Enercon,
World Call and Pramalat had shaken the corporate world.

(i) The foreign exchange market that was highly regulated through a system of direct exchange
controls over suppliers and users of foreign exchange has been liberalized and all purchases
and sales take place through an active and vibrant inter-bank exchange market. All restrictions
have been removed with full current account convertibility and partial capital account
convertibility. Foreign investors can now bring in and take back their capital, remit profits,
dividends and fees without any prior removal and directly through their banks. Similarly,
foreign portfolio investors can also enter and exit the market at their own discretion.

The main lesson learnt from the last decade suggest that financial sector functions effectively
and efficiently only if the macroeconomics situation is favorable and stable. The need to maintain
macroeconomic stability will thus remain paramount in the years to come.

The agenda for further reforms in the financial sector is still quite formidable and the
challenges to spread the benefits of financial liberalization among the middle and low income
households and small and medium farms and enterprises are still enormous.

There are several areas of dissatisfaction with the banking sector that need to be addressed.

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The most serious complaint against the banking system in Pakistan today is that the
depositors are not getting adequate return on their bank deposits. The difference between the
monthly weighted average rates of lending and deposits is taken as an indicator of the spreads earned
by the banks. It is true that these spreads have widened in the recent months land this phenomenon
has caused resentment among those whose only source of income is their returns from bank deposits.
But it is important to examine the facts and their form judgments

The monthly comparisons are meaningless because PLS deposit rates are changed every six
months, while the lending rates are continuously adjusting because they are automatically linked to
T-bills or KIBOR rates.

During the last eight months the weighted average deposit rate has risen from 1.6 percent in
July – Feb, 2005 to 3.9 percent in July – Feb, 2006. This trend reflects that the return on the new
deposits mobilized is much higher than what the average rate indicates. The old deposits are earning
much lower rate because they were lodged at the time when the overall structure of interest rates
had come down significantly. This lag is adjustment between the deposit and lending rates is due to
the costs incurred by the depositor in shifting deposits from one bank to the other.

The additional deposits mobilized in the last twelve months amounted to Rs. 382 billion i.e. a
growth rate of 16.8 percent. This growth rate took place despite deceleration in the volume of
Resident Foreign deposit accounts. So if the deposit rates were unattractive then this high growth
rate in deposits mobilized by the banks appears to be puzzling. The reason for this high growth is that
the fresh deposits were fetching an average return of 6.2 percent in March, 2006 compared to 3.5
percent in July, 2005 – rise of 270 basis points in nine months. In the coming months the average rate
is likely to move further upwards bringing them to positive real interest rates.

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Why have the profits of the banks risen so sharply in the last few years? There are several
reasons that need to be understood:

First, the drag of non-performing loans has been eased considerably reducing the need for
setting aside the provisions for loan losses. As these provisions were made at the expense of the
profits the banks are now reaping the benefits of building up substantial provisions and taking the hit
on their profits in the past.

Second, the corporate income tax rate on banks’ profits has gradually come down from 58
percent to 38 percent saving on their tax deductions. These savings not only get translated in to higher
profits but also act as incentives for better performance because the tax rate no longer acts as a
penalty.

Third, the diversification of the banks assets into new and so far underserved segments such
as agriculture, mortgage, auto, SMEs, Consumer and Credit Cards have raised their net interest
margins. As competition has become quite tough in the corporate segment the margins on corporate
loans have been squeezed considerably. But the spreads earned in these new segments are quite
attractive. Thus a large part of the profits originate from lending to these underserved segments of
the population. This is a Win- Win situation as small farmers, small businesses and middle class
consumers, who had so far been denied access to bank credit, are able to get financing the banks are
able to earn higher spreads.

Fourth, there has been a shift in the maturing profile of both the banks’ deposits and banks’
loans. Half of the total deposits are now placed for short term duration earning negligible rates of
return compared to the past where the distribution of deposits were concentrated in medium to long
duration earning much higher returns.

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 History of Banking in Pakistan

On the assets side, more of the bank loans are being disbursed for fixed investment purposes.
These have long maturity structure and pay higher interest rates in double digits.

This shift in the composition of deposits and advances has helped earn the banks a higher
spread boosting their profitability.

As the majority of the banks are operating in the private sector they will remain guided by the
bottom line considerations i.e. the profits. Consolidation and market competition will act as a
deterrent on abnormal profits but it is the responsibility of the regulator to ensure that these profits
are not made by taking excessive risk with the depositors’ money or by banks indulging in collusive
practices. The regulator has to ensure that the access to credit is further broadened and small farming
households, small and medium businesses and middle classes are able to meet their legitimate credit
needs. At the same time the regulator has to take stringent action against those banks found guilty of
anti-competitive or collusive practices.

Another popular indictment against the banking sector is that they are financing speculative
activities such as stock market trading, real estate, commodities, auto etc. The facts do not support
this indictment. Direct and indirect exposure by banks in stock market equities has been limited to 20
percent of their capital i.e. the maximum amount all the banks can collectively provide for this activity
is only 40 billion. The outstanding stock of bank advances in March, 2006 stood at Rs. 2063 billion.
Thus the bank credit allocated for stock market equity trading is less than 2 percent of the total
advances of the banking system. If we further assume that some amounts are diverted from consumer
loans or corporate loans also the exposure of the banks may double to as much as 4 percent but the
securities and collaterals against the diverted loans may not necessarily be the scrips themselves.

Real estate financing by banks is restricted to mortgage loans only and the purchase of plots
cannot be financed by the banks. Mortgage loans can be disbursed in installments after physical
verification of the various phases of construction. The total disbursements of loans for mortgage
amounted to Rs. 11.4 billion in FY 05.

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 History of Banking in Pakistan

Commodity financing and its prevailing rates are not attractive for the borrowers as there has
been net retirement of commodity loans in the first nine months of the current fiscal year.

The regulatory environment for the banks to indulge in lending for speculative purposes is not
very propitious. The State Bank of Pakistan supervisors are not only vigilant in their on-site inspection
but they monitor the banks on a continuous basis and can detect irregularities and violations fairly
quickly. The more deterrent effect of strong oversight by the supervisors is enough to discourage such
activities. The penalties imposed by the supervisors on recalcitrant banks are quite severe.

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