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.
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.