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Executive Summary

Since its inception in 1947, Pakistan has relied on


the private sector as the primary producer of goods
and services. The early 1970s, however, witnessed a
crippling shift towards a command economy and a
subordinated private sector manifested through a
policy of nationalization. The 1980s and onwards
witnessed a reversal of this pattern and the private
sector again began to emerge and lead investment and
economic activity. Beginning in the early 1990s, the
Government of Pakistan pursued a strategy of
privatization, deregulation, liberalization and good
governance to promote private sector development.

However, macroeconomic instability and political
disorder and uncertainty stood in the way of the
successful implementation of this strategy. Under a
new Government in 1999, major structural, governance,
and economic reforms began to be implemented with a
focus on generating macroeconomic stability and
creating an environment to encourage the private
sector to become the growth engine in the economy.

The Privatization Act 2000, creation of a Ministry of
Privatization and Investment, setting up of a Board
of Investment, legislative changes to the State Bank
of Pakistan (SBP) Act empowering the SBP/SBP Central
Board to formulate, conduct and implement monetary
policy, the creation of a Monetary and Fiscal Board
to ensure formal monetary and fiscal policy
coordination, and a Fiscal Responsibility and Debt
Limitation Act 2005 mandating reduction in revenue
deficit and reducing total public debt were important
steps that underscored the Governments recognition
of the importance of macroeconomic stability and a
clear and transparent legislative framework to
support a conductive business environment in the
country. The improved economic conditions and
investment climate generated both the fiscal space as
well as opportunities for private sector led economic
growth through acceleration of the process of
privatization, enhanced private sector investment,
and greater foreign direct and portfolio investment.

As a result of the successful experience with
privatization, in Pakistan today, over 77% of the
commercial banking sector is in the private sector.
In the financial sector, in addition to commercial
banking, the domestic capital markets have also
developed at a rapid pace with the Karachi Stock
exchange (as on June 29, 2007) emerging as the most
important institution of capital formation in
Pakistan and voted as the most strongly performing
stock market in emerging Asia. Privatization of
government owned banks and other liberalization
measures introduced was the keystone of the financial
sector reforms initiated in the early nineties in
order to revitalize the financial system of the
country. As part of this policy, in 1991 two of the
publicly owned banks, the Muslim Commercial Bank
(MCB) and Allied Bank (ABL) were privatized. At the
same time permission was granted for setting up of
new banks in the private sector with 10 new banks
getting licenses to commence their operations in
1991. Consequently, towards the end of 2002, the
structure of the banking sector in Pakistan had
changed considerably, as a result of the
privatization/liberalization policies pursued in the
broader picture of financial sector reforms.














The Effect of Privatization and
Liberalization on Banking Sector
Performance in Pakistan
2002 - 2010





















Ch 1 Introduction
Privatization is the process of divesting the
government stake both in terms of money and control
from public companies. In Pakistan this process has
been kicked off from a long time and is moving in
steady albeit slow pace with the government divesting
its stake in public enterprises and offering it to
the common public and private investors.
Privatization is the general process of involving,
the private sector in the ownership or operation of a
state owned enterprise. Privatization includes the
following three sets of measures.
Transferring ownership of public enterprises either
fully or partially to private enterprises.
Injecting the spirit of commercialization in public
sector enterprises through the grant of autonomy in
decision making provision of incentives for workers
etc.
Contracting and the public enterprises for a certain
period of private enterprises.
A well functioning financial system is necessary for
enhancing the efficiency of intermediation, which is
achieved by mobilizing domestic savings, channeling
them into productive investment by identifying and
funding good business opportunities, reducing
information, transaction, and monitoring costs and
facilitating the diversification of risk. This
results in efficient allocation of resources,
contributing to a more rapid accumulation of physical
and human capital, and faster technological progress,
which in turn lead to higher economic growth. Anxious
to achieve higher growth, policy makers in many
developing countries saw public ownership of banks
and other financial institutions as necessary in
order to direct credit towards priority sectors.
It was in this backdrop that the financial sector in
Pakistan was nationalized in the early 1970s under
the framework of the Banks Nationalization Act 1974.
The nationalized domestic banks were consolidated
into 6 major national commercial banks and several
specialized credit institutions were established. The
objective of the nationalization was to direct bank
credit towards specific developing sectors and to
provide a source of funding to the government. By the
end of the 1980s, it became, however, quite clear
that the socio-economic objectives, sought through
the nationalization of the banking sector were not
being achieved. Instead, the pre-dominance of the
public sector in banking and Non-Bank Financial
Institutions (NBFIs), joined with the instruments of
direct monetary control, were becoming increasingly
responsible for financial inefficiency leading to the
crowding out of private sector investment.
The Government of Pakistan is not at all satisfied
with the performance of nationalized banks or the
dominance of public sector banks; the banking system
of Pakistan has witnessed highly positive financial
results during the year under review, adding further
strength to its key financial soundness indicators.
The areas which are severely criticized are the
falling standard of banking service,
though the profitability has maintained its upward
trend, factors such as the changing ownership
structure, transformation in the banking system
composition, emergence of more compatible banking
institutions, venturing of banks into relatively
newer and riskier areas, growing market competition,
technological advancement and implementation etc.
Demand positive observation, effective risk
management and enhanced focus on corporate governance
culture, thus making the role of SBP more
challenging.
The Government, therefore, decided to privatize the
banks. A Privatization Commission was set up on
January 22, 1991. The Commission has transferred two
banks namely MCB and ABL to the private sector. The
Allied Bank has been divested to the Allied
Management Group formed by the workers of the Bank.
The Government has also off-loaded its 51% stake in
HBL through bidding.
The process of privatization of banks and DFIs are
going on at a fast speed since the privatization of
HBL in 2004 Shares of National Bank were also offered
to the people through local stock exchanges. The
management of ABL was formally handed over to them on
August 20, 2004 UBL shares have also been offered to
the public through local stock exchanges in June
2005. As a result of privatization more than 30% of
the banking assets are now owned and managed by the
private sector. The strict enforcement of prudential
regulations by the SBP has improved the efficiency
and profitability of the banking sector. The ratio of
non performing loans to total advances has come down
to less than 5%. In Fiscal Year 2004, successful
privatization process has been completed and over 77%
of Pakistans banking sector had come under private
ownership, and their sluggish performance in the
post-nationalization period, developed greater
efficiency and rising profitability. In 90s when
80% of the banking sector was in the public sector
with that of Fiscal Year 2004 when only 20% was left
in the public sector post privatization, the growth
in the consumer banking industry, in particular, has
been spectacular and provided opportunities to the
middle class to avail housing and automobile loans at
affordable rates. However, starting in the Fiscal
Year 2007, with rising interest rates, the
performance of the consumer banking has been
affected, and some banks have developed higher
infection rates in their consumer loan portfolios.
Overall profitability of the banking industry has,
however, continued to remain robust.













Number Amount (Rs. Billion) Share (%)
2002 2010 2002 2010 2002 2010
Assets

Public 5 5 877.6 1365.59 41.3

10
Private 16 23 968.3 5373.8 45.5 80
Foreign 17 6 280.9 233.25 13.2 10
Total 38 34 2126.8 6972.64 100 100

Deposits

Public 5 5 721.9 1087.51 43.5

20
Private 16 23 754.2 4188.18 45.4 77
Foreign 17 6 184.1 156.33 11.1 3
Total 38 34 1660.2 5432.02 100 100

















As to the reference of the Case study of The Effect
of Privatization and Liberalization on Banking Sector
Performance in Pakistan (SBP Bulletin, Volume 2,
November 2, 2006), Mr. Umer Khalid defines the
financial system of banking Sector performance of
Privatization employing the CAMELS framework of
financial indicators between the periods 1990-2002.
(The results obtained show little evidence of
improvement in most of the indicators of financial
health as a result of the privatization and
liberalization policies pursued so far in the banking
sector of the country. In particular, the performance
of the privatized banks has been less than
satisfactory due mainly to the poor showing of the
Allied Bank, the ownership of which was transferred
to its employees group. However, a marked improvement
in a majority of the CAMELS indicators for the entire
banking sector as well as for all the 4 groups of
banks is seen during the last year of observation,
i.e., 2002. This would suggest that the benefits of
privatization in the form of improved performance
indicators are likely to emerge over a longer period
of time. Furthermore, by the end of 2002)

As this study is based on the CAMELS Framework for
the effects of privatization and liberalization on
the performance of the banking sector in Pakistan, We
uses the same framework & their policies pursued
since the 2003s in the banking system, using banking
data from 2003 to 2010. This CAMELS Framework is used
by all Banking supervisors for financial indicators
to oversee the performance of their respective
banking systems.
The five following subsections describe the
components of the CAMEL framework and recommend
appropriate performance measures.

CAPITAL ADEQUACY RATIO
1).Capital Adequacy is a measure of an FI's financial
strength, in particular its ability to cushion
operational and abnormal losses.
2).The CAR indicator is derived by comparing the
ratio of an entity's equity to its assets-at-risk.

3). Equity is defined as the total of:
Unimpaired paid-up capital.
Retained earnings.
Reserves available to meet any losses that may be
incurred through the non- recovery of assets.
All other capital and revenue reserves, including
provisions for bad and doubtful debts and provisions
for loan and lease losses.

4). Assets-at-risk are defined as the total of the
impaired values of assets at the date of making the
advance to the sub borrower. Assets are typically
classified as:
Risk-free;
Minimum risk;
General risk;
Substandard;
Workout (or minimal chance of recovery)
Fixed assets,
5. The BCBS of the BIS recommends a mandatory minimum
CAR of 8% for banks in OECD countries. However, the
emerging banking regulatory and supervision system in
most ADB DMCs, combined with an emphasis on directed
lending, results in poor portfolio quality. As such,
these Guidelines recommend a minimum Capital Adequacy
Ratio (CAR) of 12%.
ASSESSING ASSET QUALITY
Asset quality has direct impact on the financial
performance of an FI. The quality of assets
particularly, loan assets and investments, would
depend largely on the risk management system of the
institution.
ASSESSING MANAGEMENT QUALITY
The performance of the other four CAMEL components
will depend on the vision, capability, agility,
professionalism, integrity, and competence of the
FI's management.
ASSESSING EARNING PERFORMANCE
The quality and trend of earnings of an institution
depend largely on how well the management manages the
assets and liabilities of the institution. An FI must
earn reasonable profit to support asset growth, build up
adequate reserves and enhance shareholders' value.
ASSESSING LIQUIDITY
An FI must always be liquid to meet depositors' and
creditors' demand to maintain public confidence. There
needs to be an effective asset and liability management
system to minimize maturity mismatches between assets and
liabilities and to optimize returns.
CAMEL Framework will be explained with their Ratios
future in Methodology.

Year 2003 2004 2005 2006 2007 2008 2009 2010
Public Sector Bank
Capital
to
liability
4.72% 6.93% 10.56% 11.55% 12.74% 10.63% 11.30% 9.88%
Privatized bank
Capital
to
liability
4.46% 5.96% 7.21% 9.61% 9.82% 9.70% 16.23% 11.35%
Domestic private bank
Capital
to
liability
50.29% 7.36% 7.81% 8.79% 9.22% 9.56% 6.78% 7.89%
Foreign Banks
Capital
to
liability
10.61% 9.74% 10.46% 11.88% 13.18% 17.136% 17.57% 17.27%
Banking System
Capital
to
liability
4.17% 6.42% 7.88% 9.27% 9.88% 9.77% 10.22% 9.73%



In 2006 the financial performance of the banking system of Pakistan remained outstanding-
witnessed an extension of the last couple of years trends. The robust profitability, strong
solvency profile, managed asset quality; better risk management practices and ongoing
consolidation of banking system have witnessed further improvement in almost all the key
financial performance and sound indications.

The growth trends of all the key components, to some extent, continued to maintain the recent
years performances, as a result, total assets exceeds Rs4 trillion levels and pre-tax profit set
another milestone by crossing Rs100 billion mark. This has placed Pakistan among the top half
in a group of 44 emerging economies in terms of capital adequacy and asset quality while, in
terms of profits, Pakistani banking System has been ranked among the top ten. The banking
system continued to invite the foreign investors interest in Pakistan and attract significant share
of direct foreign investment. On the back of excellent results, banks maintained their
dominance in the capital markets as their market capitalization has rushed to one third of the
total capitalization of KSE, Karachi Stock Exchange.

Profitability of the banking system kept its momentum largely on the back of persistent growth
in high yield earning assets and expanded business volumes. During the year under review, pre-
+tax and after-tax profit of the banking system raised to Rs123.6 billion and Rs84.1 billion
respectively. Resultantly, all the key profitability indicators kept on healthy trends. ROA of the
banking system has further improved to 2.1 percent. ROE, however, slightly dropped to 24.2
percent from 25.6 percent over the year due to proportionately greater increase in the banks
equity base as a result of high retention of profits and fresh capital injections.

0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
2003 2004 2005 2006 2007 2008 2009 2010
Public Sector Bank
Privatized Bank
Domestic Private Bank
Foreign Banks
Banking System
Though the non-interest income continued to provide support to the earnings, it was the Net
Interest Income (NII) which extended a greater contribution to the higher profitability. The
recent upward movement in cost of deposits put some strain on growing NII as interest rate
variance on deposits of the commercial banks has increased to Rs39.3 billion as against Rs26.3
billion in CY05. While on the income side, the contribution of interest rate variance on loans
decreased to Rs36.2 billion as compared to Rs50.2 billion in CY05. Further, the contribution of
volume variance in interest income increased in CY06, thus increasing the NII by Rs36.7 billion.

In addition to the outstanding profits the fresh capital injections have further added strength to
the solvency profile of the banking system. Capital adequacy ratio (CAR) of all banks increased
to 12.7 percent in CY06 from 11.3 percent in CY05. Cross-sectional analysis showed that capital
position of individual banks also strengthened and the number of banks having CAR at more
than 10 percent increased to 32 from 30 in CY05.
On credit risk front, the banking system was able to contain the key asset quality indicators.
Total NPLs of the banking system declined to Rs175 billion from Rs177 billion in CY05.
However, the commercial banks (CBs) witnessed an increase in their NPLs by around Rs2
billion to Rs138 billion during CY06. NPLs to loans and net NPLs to net loans ratio of all banks
remained close to 7% and 2 % respectively. The banking system continued to broad-base its
loans portfolio to diversify their credit risk and increased the financial services access besides
generating more productive alternative opportunities of earnings.


















Ch 2 Literature Review
In this Literature Reviews, we have collect two broad
views about government involvement in financial
systems around the world, i.e., the development
view and the political view.
Development View:
The development view as advocated by Gerschenkron
(1962) states that governments can intervene through
their financial institutions to direct savings of the
people towards developmental sectors in countries
where financial institutions are not adequately
developed to channel resources into productive
sectors. Gerschenkrons view was part of a broader
consensus in development economics that privileged
government ownership of enterprises in strategic
economic sectors. Realizing this importance of
financial sector in economic development, governments
in developing countries sought to increase their
ownership of banks and other financial institutions
in the 1960s and 1970s, in order to direct credit
towards priority sectors.
Political View:
In recent years a new political view of government
ownership has evolved which asserts that state
control of finance through banks and other
institutions politicizes resource allocation for the
sake of getting votes or bribes for office holders
and thereby results in lower economic efficiency.
Barth et al. (2001) using cross country data on
commercial bank regulation and ownership from over 60
countries find that state ownership of banks is
negatively associated with bank performance and
overall financial sector development and does not
reduce the likelihood of financial crises.
Another study La Porta et al. (2002), based on data
of government owned banks from 92 countries around
the world, finds that government ownership of banks
is high in countries which are characterized by low
levels of per capita income, underdeveloped financial
systems, interventionist and inefficient governments
and poor protection of property rights. This also
finds that the government ownership of banks is
associated with slower subsequent financial
development, lower economic growth and especially
lower growth of productivity.
How privatization can improve the performance of a
state owned enterprise?
In the case for privatization the state owned
enterprises can be grouped around three main themes,
i.e,
1). Competition,
2). Political intervention and
3). Corporate governance.

i).The competition argument states that privatization
will improve the operat1ion of the firm and the
allocation of resources in the economy, if it results
in greater competition. Privatization can improve
efficiency even without changing market structure if
it obstructs involvement by the politicians and
bureaucrats who would like to use the SOEs to further
their political or personal gains. It is also argued
that corporate governance is weaker in state owned
enterprises than in private firms because of agency
problems. SOEs have multiple objectives and many
principals who have no clear responsibility of
monitoring Clark et al. (2003).
ii). Second reason for SOEs to have poorer corporate
governance is the weak incentive structure for
managers to perform efficiently. They do not face a
market for their skills or the threat of losing their
jobs for non-performance. Thus, less competition,
greater political intervention and weaker corporate
governance are strong theoretical arguments against
state ownership Clark et al. (2003).
Clarke et al. (2003) using a combination of country
case studies and cross country analyses conclude that
privatization of banks improves performance as
compared to continued state ownership. However,
continued state ownership even in minority shares of
privatized banks is found to have negative effects on
their performance. Privatization of state owned banks
through public share offerings produces lower gains
than direct sales to strategic investors in countries
where the institutional environment is weak. Lastly,
they find that the benefits accruing are reduced if
foreign banks are not allowed to participate in the
privatization process.
Otchere (2003) presents a comprehensive analysis of
the pre and post privatization performance of
privatized banks and their rival banks in low and
middle-income countries. The author does not find any
significant evidence of improvements in the
privatized banks post privatization performance. In
fact, the privatized banks have a higher proportion
of bad loans and appear to be overstaffed relative to
their competitor, in the post privatization period.
The continued government ownership of privatized
banks is found to be responsible for their
underperformance, as it hinders managers ability to
restructure them effectively.
Using a comprehensive dataset of bank privatizations
in 101 countries during the period 1982-2000,
Boehmer et al. (2003) examine the economic and
political factors that are likely to effect
governments decision to privatize a state owned
bank, in both developing and developed countries.
Their findings indicate that in developing countries,
a bank privatization is more likely the lower the
quality of the countrys banking sector, the more
right wing the countrys government is, and the more
accountable the government is to its people.

As this study is based on the CAMELS Framework for the effects of privatization and liberalization on the
performance of the banking sector in Pakistan. We use the same framework & their policies pursued since the
2003s in the banking system, using banking data from 2003 to 2010. This CAMELS Framework is used by all
Banking supervisors for financial indicators to oversee the performance of their respective banking systems. The
five following subsections describe the components of the CAMEL framework and recommend
appropriate performance measures.
1). Capital Adequacy is a measure of an FI's financial strength, in particular its ability to cushion
operational and abnormal losses. An FI should have adequate capital to support its risk assets in
accordance with the risk-weighted capital ratio framework. It has become recognized that capital
adequacy more appropriately relates to asset structure than to the volume of liabilities. This is
exemplified by central banks' efforts internationally to unify the capital requirements of commercial
banks and to generate worldwide classification formulae such as the one proposed here. This indicator
requires that assets be classified by reference to their demands on the equity (or capital) structure of
the FI.

2). The CAR indicator is derived by comparing the ratio of an entity's equity to its assets-at-risk.
The covenant specifies that the borrower/EA/FI should not make an advance to a subborrower, if after
making the advance, the ratio (the performance indicator) of its equity to its assets-at-risk would be
greater than that specified in the covenant.

3). Equity is defined as the total of:
(i) Unimpaired paid-up capital;
(ii) retained earnings;
(iii) Reserves available to meet any losses that may be incurred through the non- recovery of assets
(iv) All other capital and revenue reserves, including provisions for bad and doubtful debts and
provisions for loan and lease losses.

4). Assets-at-risk are defined as the total of the impaired values of assets at the date of making the
advance to the sub borrower. Assets are typically classified as:
Risk-free;
Minimum risk;
General risk;
Substandard;
Workout (or minimal chance of recovery)
Fixed assets,
furniture and office equipment, computers, etc. To each of these classifications is awarded a
percentage of their values for which an FI's capital is needed to cover risk of losses.
5. The BCBS of the BIS recommends a mandatory minimum CAR of 8% for banks in OECD countries.
However, the emerging banking regulatory and supervision system in most ADB DMCs, combined
with an emphasis on directed lending, results in poor portfolio quality. As such, these Guidelines
recommend a minimum Capital Adequacy Ratio (CAR) of 12%.
Assessing Asset Quality
Asset quality has direct impact on the financial performance of an FI. The quality of assets particularly,
loan assets and investments, would depend largely on the risk management system of the institution.

The value of loan assets would depend on the realizable value of the collateral while investment assets
would depend on the market value.
Assessing Management Quality
The performance of the other four CAMEL components will depend on the vision, capability, agility,
professionalism, integrity, and competence of the FI's management.
As sound management is crucial for the success of any institution, management quality is generally
accorded greater weighting in the assessment of the overall CAMEL composite rating.
Assessing Earning Performance
The quality and trend of earnings of an institution depend largely on how well the management
manages the assets and liabilities of the institution. An FI must earn reasonable profit to support asset
growth, build up adequate reserves and enhance shareholders' value.
Good earnings performance would inspire the confidence of depositors, investors, creditors, and the
public at large.
Assessing Liquidity
An FI must always be liquid to meet depositors' and creditors' demand to maintain public confidence.
There needs to be an effective asset and liability management system to minimize maturity mismatches
between assets and liabilities and to optimize returns.
As liquidity has inverse relationship with profitability, an FI must strike a balance between liquidity and
profitability.

6.4.3.5.2. Current and quick ratios are inappropriate for measuring FI liquidity. A loan-to-deposit ratio is
more relevant. However, an FI's liquidity and solvency are directly affected by portfolio quality.
Consequently, financial analysts (investment officers) should carefully analyze the FI's portfolio quality
on the basis of collectability and loan-loss provisioning.Section 6.4.3.2 suggests appropriate measures in
this respect.



This study would attempt to investigate the effects of privatization and liberalization on the performance of
the banking sector in Pakistan. We would be employing the CAMELS framework of financial indicators to
gauge the effects of privatization and liberalization policies pursued since the 1990s in the banking system,
using bank level data from 1990 to 2002. Banking supervisors all over the world are using the CAMELS
framework of financial indicators to oversee the performance of their respective banking systems. Recent
studies indicate that substantial performance and efficiency gains can be achieved by transferring ownership
of banks/ financial institutions from the public sector to private hands; a summary of these is given in the
next section.
The paper is divided into 5 sections. Section 1 presents the introduction; second section gives an overview of
the relevant literature. In the third section the methodology employed and the data used are discussed while
Section 4 contains the detailed analysis. The paper is ended by Section 5, which gives some concluding
remarks.

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