## 1. Pakistan: Structure of the Banking Sector, 1999-2003

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### Structure of the banking sector — ownership, entry, and Islamic banking
- Privatization and ownership shifts
  - In 1990, the banking system was dominated by five commercial banks which were all state-owned.
  - The 1990 amendments to the Banking Companies Ordinance allowed privatization of state-owned banks.
  - Muslim Commercial Bank (MCB) and Allied Bank (ABL) were privatized between 1991 and 1993.
  - United Bank (UBL) was privatized in 2002, ending domination by state-owned banks.
  - As of September 2003, the asset share of local private banks and public sector commercial banks was 47 percent and 41 percent respectively.
  - Habib Bank (HBL) completed privatization in February 2004; following this privatization the share of banking system assets held by public sector commercial banks decreased to less than 25 percent.
  - National Bank of Pakistan (NBP) remained state-owned with a market share of approximately 20 percent; the government divested approximately 25 percent of its capital in 2001-03, but privatization prospects were uncertain.

- Market structure and entry controls
  - Number of commercial banks increased to more than 40 by 1995, prompting a moratorium on the establishment of new banks in 1995 that remained in force.
  - Minimum capital requirement increased from PRs 500 million to PRs 750 million from end-December 2001 and to PRs 1 billion (around US$17 million) from end December 2002.

- Islamic banking developments
  - The SBP exempted Islamic commercial banks from the moratorium; the first full-fledged Islamic bank, Meezan Bank, was licensed in 2002.
  - Several conventional banks opened branches providing only Islamic financial services.
  - The SBP estimates total assets of Islamic banking institutions equal approximately 1 percent of the total banking sector assets.

- Ownership structure (selected datapoints)
  - Figure 1 (1990): Public Sector Commercial Banks 92%, Foreign Banks 8%, Local Private Banks 0%.
  - Figure 1 (2003): Public Sector Commercial Banks 41%, Local Private Banks 47%, Foreign Banks 12%.

### Structure and size — selected balance sheet and income figures (end-September 2003)
- Aggregate totals (All Commercial Banks)
  - Total Assets: 2,379.6 PRS billions
  - Customer Deposits: 1,796.7 PRS billions
  - Capital: 143.0 PRS billions
  - Profit/Loss Before Taxation: 37.5 PRS billions
  - Net Income After Taxes: 23.0 PRS billions

- Asset composition (All Commercial Banks, end-September 2003)
  - Cash and Balances with SBP and Other Banks: 300.3 PRS billions (12.6 percent of total assets)
  - Investments: 811.6 PRS billions (34.1 percent of total assets)
    - Of which: government securities 688.5 PRS billions (28.9 percent of total assets)
    - Of which: other securities 123.1 PRS billions (5.2 percent of total assets)
  - Gross Advances: 997.0 PRS billions (41.9 percent of total assets)
    - Of which: in local currency 845.3 PRS billions (35.5 percent of total assets)
    - Of which: in foreign currency 151.7 PRS billions (6.4 percent of total assets)
  - Provisions for NPLs: 101.3 PRS billions (4.3 percent of total assets)
  - Lending to Financial Institutions: 140.5 PRS billions (5.9 percent of total assets)
  - Other Assets: 130.3 PRS billions (5.5 percent of total assets)

- Income statement (All Commercial Banks, end-September 2003)
  - Interest Income: 82.6 PRS billions
  - Interest Expense: 31.2 PRS billions
  - Non-Interest Income: 36.9 PRS billions
  - Non-Interest Expense: 44.5 PRS billions
    - Of which: administrative expenses 43.6 PRS billions
  - Taxes Paid: 14.5 PRS billions

### Performance, capital adequacy, and asset quality — system trends and distributions
- Aggregate improvements and drivers
  - Aggregate financial soundness indicators improved in recent years, reflecting favorable external and macroeconomic developments, structural changes, and policy initiatives.
  - Policy measures included recovery drives, a foreclosure law, write-off settlement guidelines, establishment of the Corporate and Industrial Restructuring Corporation (CIRC), retrenchment of personnel, and closure of unprofitable branches.
  - Newly privatized banks face challenges: developing a credit culture for prudent lending to new sectors (housing and consumer goods), timely recovery of defaulted loans, and maintaining loss-making branches in “unbanked” areas.

- Capital adequacy (system averages)
  - Regulatory capital to risk-weighted assets:
    - Dec-99: 12.2
    - Dec-00: 11.4
    - Dec-01: 11.3
    - Dec-02: 12.6
    - Sep-03: 13.1
  - Tier I capital to risk-weighted assets:
    - Dec-99: 10.3
    - Dec-00: 9.8
    - Dec-01: 9.7
    - Dec-02: 9.7
    - Sep-03: 10.9
  - Capital to total assets:
    - Dec-99: 5.0
    - Dec-00: 4.9
    - Dec-01: 4.6
    - Dec-02: 6.1
    - Sep-03: 6.2
  - The average capital adequacy ratio (capital-to-risk weighted assets) was 13.1 percent in September 2003, up from 11.3 percent in December 2001.
  - The average capital ratio (capital-to-gross assets) for commercial banks stood at 6.2 percent.
  - Contributing factors to improved capital adequacy: better profitability, fresh injections of capital (including recapitalization prior to privatization), and an increasing share of government securities in bank portfolios (zero risk weight).
  - Revaluation effects:
    - For the four largest banks, surplus on revaluation accounts averaged 36.5 percent of their capital as of end-2002.
    - Surplus on revaluation of investments was on average 24.5 percent of capital for the four largest banks as of end-2002.
    - Only 50 percent of revaluation accounts may be included in Tier II Capital; large revaluation surpluses are vulnerable to market reversals.
  - As of September 2003, overall capital of the banking system stood at PRS 143 billions.
  - 12 banks were not complying with the minimum capital requirement (PRS 1 billion), and one of these banks was insolvent.
  - The SBP expected the number of non-compliant banks to be reduced via mergers of several small institutions.

- Asset quality
  - NPLs to gross loans:
    - Dec-99: 22.0
    - Dec-00: 19.5
    - Dec-01: 19.6
    - Dec-02: 18.0
    - Sep-03: 16.1
  - Provisions to NPLs:
    - Dec-99: 46.6
    - Dec-00: 53.9
    - Dec-01: 53.2
    - Dec-02: 58.3
    - Sep-03: 63.0
  - NPLs net of provisions to capital:
    - Dec-99: 117.4
    - Dec-00: 96.7
    - Dec-01: 100.7
    - Dec-02: 54.5
    - Sep-03: 41.8
  - The downward trend in total NPLs reflects both an increase in gross loans and SBP write-off guidelines issued in October 2002 enabling more aggressive clearing of old NPLs.
  - Ratio of NPLs to total loans ranges from 0.4 percent to 35.1 percent across individual banks.
  - Asset quality of the five largest banks: gross NPLs to total loans ranging from 15 percent to 35 percent.
  - Provisions to NPLs in foreign banks: 79.5 percent (system average: 63.0 percent).

### Liquidity and profitability indicators (selected)
- Liquidity ratios (percent)
  - Liquid assets to total assets:
    - Dec-99: 38.7
    - Dec-00: 37.5
    - Dec-01: 39.9
    - Dec-02: 47.0
    - Sep-03: 48.6
  - Liquid assets to total deposits:
    - Dec-99: 48.2
    - Dec-00: 48.0
    - Dec-01: 50.3
    - Dec-02: 60.2
    - Sep-03: 59.4

- Profitability (percent)
  - ROA (after tax):
    - Dec-99: -0.3
    - Dec-00: 0.0
    - Dec-01: 0.0
    - Dec-02: 0.8
    - Sep-03: 1.4
  - ROE (after tax):
    - Dec-99: -6.2
    - Dec-00: -0.3
    - Dec-01: -0.3
    - Dec-02: 13.8
    - Sep-03: 22.1
  - Net interest income to gross income:
    - Dec-99: 54.3
    - Dec-00: 61.2
    - Dec-01: 68.9
    - Dec-02: 67.4
    - Sep-03: 58.2
  - Non-interest expenses to gross income:
    - Dec-99: 76.9
    - Dec-00: 71.6
    - Dec-01: 62.7
    - Dec-02: 57.3
    - Sep-03: 50.4
  - Personnel expenses to noninterest expenses:
    - Dec-99: 57.0
    - Dec-00: 54.3
    - Dec-01: 52.6
    - Dec-02: 51.4
    - Sep-03: 50.1
  - Non-interest income to total income:
    - Dec-99: 17.6
    - Dec-00: 16.5
    - Dec-01: 14.5
    - Dec-02: 18.1
    - Sep-03: 30.9

### Bank credit to the private sector — growth, risks, earnings, and liquidity
- Credit growth and risks
  - Outstanding stock of credit to corporate sector has been generally stable (or even declining in the case of credit to public sector enterprises).
  - Bank lending to small and medium enterprises, and especially consumer financing, have all been increasing rapidly.
  - The share of personal loans (particularly, auto loans, house loans, and credit cards) has grown from virtually nothing in the mid-1990s to 12 percent of the total bank credit in September 2003.
  - Rapid consumer credit growth, if sustained, could lead to a deterioration in banks’ loan portfolios.
  - The SBP increased the general provisions against unsecured consumer loans to 5 percent from early 2004; the general provisions against secured consumer loans are set at 1.5 percent.
  - Rapid consumer lending growth requires careful monitoring.

- Earnings
  - Profitability indicators have registered a visible improvement.
  - Returns on assets and equity are beginning to approach international norms after years of poor performance.
  - Measured profitability in the past was distorted by lax provisioning.
  - Recent strengthening in the profit position of banks has largely resulted from an increase in interest income and from expanded business volumes facilitated by macroeconomic stabilization.
  - Net interest income somewhat slowed down in 2003, mainly due to contraction in interest margins likely stemming from increased competition.
  - Banks reported strong gains on sale of securities and other non-interest income.
  - The share of net interest income in gross income declined to 58 percent in September 2003, from 69 percent in December 2001.

- Liquidity
  - Liquidity in the banking sector has become abundant, helped by a substantial increase in workers’ remittances following the events of September 11, 2001.
  - Liquid assets as a percentage of total assets increased to 49 percent by the end-September 2003, from 40 percent in December 2001.
  - Liquidity held by banks was more than double the amount of required liquid assets last year.
  - The excess liquidity has led to a decline in interest rates and may be contributing to rapid increases in asset prices in the real estate and equity markets.

- Preserving stability and soundness
  - Although the condition of the banking system has been improving in recent years and most of the banks appear resilient to shocks, the stress tests results should not cause complacency.
  - Weaker banks experience capital adequacy problems in the face of relatively modest NPL increases, suggesting that banks on the lower end of the capital adequacy and asset quality spectrum deserve closer attention of supervisors.
  - In the new environment of private sector dominated banking, sensitivity analysis based on historical experience of shocks needs to be interpreted with caution.

### General recommendations to maintain and enhance financial stability
- Privatization and divestiture
  - Government and SBP should develop a strategy to privatize the remaining public sector commercial banks (especially NBP) and continue divestiture from the capital of other banks.
  - The FSAP team welcomes the divestiture of government from the capital of several large banks in recent years, as well as the reported reduction in the government’s interference in corporate governance of banks with minority or even majority public stake.

- Moratorium on new conventional banks
  - The effectiveness of the moratorium on the licensing of new conventional banks should be reassessed.
  - The current minimum capital requirement is already sufficiently high which together with adequate fit and proper criteria should be enough to prevent a proliferation of small and weak institutions.
  - The abolishment of the moratorium may thus contribute to a more competitive environment and a more efficient functioning of the market.

- Islamic banking supervision and stress testing
  - The development of Islamic financial institutions and the risks associated with them should be closely monitored.
  - SBP should ensure a proper coordination of regulation, off-site supervision, and on-site inspections of Islamic financial institutions.
  - BSD should continue working on the design of the stress testing framework, and use the stress testing exercise on a routine basis in the future.
  - Further progress in the stress testing programm, especially improvement in technical capacities, is needed.

- Provisioning and credit growth
  - Consideration may be given to tighten requirements for specific provisions in light of the recent credit expansion.
  - A tightening of these rules would bring regulations more in line with those in other countries and help to limit credit growth.

### Recent developments in Islamization of the financial system — overview and policy implications
- Legal status and timeline (key points)
  - From July 1985 commercial banking transactions in local currency have been on interest-free profit and loss sharing (PLS) and mark-up basis. (Footnote: Except foreign currency deposits and on-lending of foreign loans, which continued to operate on conventional banking principles.)
  - November 1991: PLS-based system declared un-Islamic by the Federal Shariat Court; PLS/mark-up-based banking continued in parallel with conventional banking until 2001.
  - 1999: Shariat Appellate Bench of the Supreme Court ordered government to do away with interest in financial transactions; ordered revocation of laws governing interest payments by March 30, 2000 and other laws by June 30, 2001.
  - June 2001: Supreme Court extended the deadline to June 30, 2002.
  - June 2002: Banks appealed to review earlier decision; government supported appeal; Supreme Court referred case back to Federal Shariat Court. Outcome: earlier Supreme Court rulings of 1999 and 2000 are not considered valid; legal uncertainty remains and process could take several years.
  - Meanwhile, authorities moved to allow provision of Islamic banking services in parallel with conventional banking:
    - December 2001: SBP issued detailed guidelines for establishment of Islamic commercial banks.
    - November 2002: Banking Companies Ordinance (1962) amended to allow formation of banking subsidiaries dedicated to Islamic banking services.
    - January 2003: Detailed criteria for setting up subsidiaries and/or stand-alone branches for conducting Islamic banking issued.
    - Banks are not allowed to conduct Islamic banking transactions in units involved in conventional operations.
  - SBP measures:
    - New banking licenses for domestic banks are issued only for Islamic banks.
    - Islamic Banking Department (IBD) set up in SBP in September, 2003; responsible for approving opening of Islamic banks, branches, and subsidiaries.
    - A Shariah Board within SBP established with five members: two Shariah scholars, a charter accountant, a lawyer, and a representative of the SBP.
    - SBP designed Islamic government securities which will be reviewed by the Ministry of Finance; legal basis for these instruments still needs to be finalized.

- Recent developments in institutions, products, and scale
  - Scale:
    - Combined assets of the Islamic commercial banks and Islamic branches represented 0.5 percent of the entire banking system’s assets as of September 30, 2003.
    - The only full-fledged Islamic bank (Al-Meezan Bank Limited) first license issued in January 2002.
    - Al-Baraka Islamic Bank in process of converting from a conventional to an Islamic bank.
    - Two more full-fledged Islamic banks are expected to open by 2005.
    - As of February 27, 2004, four commercial banks had established a total of eight branches for conducting Islamic banking.
  - Al-Meezan Bank had PRs 8.8 billion on June 30, 2003.
  - Al-Meezan Bank products include riba-free rupee and dollar saving accounts and certificates of Islamic investment; main asset modes used are Murabaha and Ijarah.

- Funding sources and product features
  - Three basic sources: equity capital, transaction deposits, and investment deposits.
  - Investment deposits: do not ex-ante specify a rate of return or guarantee return of principal; ex-post returns tied to performance; typically cannot be withdrawn prior to maturity; depositors are not shareholders and do not have voting rights.
  - Depending on contract, depositors face risk of loss of their principal; Islamic banks do not provide explicit guarantee of deposits. (Footnote: In some countries, however, all types of deposits are implicitly guaranteed to maintain reputation of the Islamic financial institution.)
  - April, 2004: SBP Shariah Board approved the Essentials of Islamic Modes of Financing to ensure compliance with minimum Shariah standards by banks conducting Islamic banking; these Essentials proposed to be enforced as Prudential Regulations for Islamic banks in due course.

- Essentials of Islamic Modes of Financing (as approved) — list of contracts
  - Murabaha facility agreement
  - Musawamah
  - Ijarah (leasing)
  - Salam (advance payment – deferred delivery sale)
  - Musharakah
  - Mudarabah
  - Istisna

- Regulation, supervision, and outstanding issues
  - General approach: Existing prudential requirements are applicable; SBP developing framework for regulating and supervising Islamic banks; Islamic banks must comply with conventional regulations plus additional requirements for Islamic banking.
  - Work underway:
    - Introducing Shariah compliant Audit and Accounting Standards.
    - Requirement that an Islamic bank should have a Shariah Board or at least a Shariah Advisor who is not allowed to work in another Islamic bank. (Note: Two members of the SBP Shariah Board are also Shariah advisors for Islamic banks; they must abstain from Board meetings when related banks are under consideration.)
    - Treatment of funds in the investment pool: shareholders’ funds in such pools required to be at least 10 percent of the total investment of a specific pool.
  - Accounting and audit standards:
    - Committee of the Institute of Chartered Accountants of Pakistan (ICAP), with SBP representation, reviewing AAOIFI standards for adaptation.
    - Currently, audit regulations for conventional banks are applied to Islamic banking institutions.
    - First Shariah Audit for Al-Meezan Bank to be conducted by Sedat Audit Company in 2004; company chosen by SBP from 4 audit companies on a competitive basis.
  - Taxation and other measures:
    - SBP’s Export Finance Scheme revised to be on a Musharakah basis for Islamic banks.
    - Taxation laws under review to ensure banks do not bear additional burden due to trading and leasing activities.
  - Minimum capital and investment limits:
    - Minimum capital requirement for a full-fledged Islamic bank or subsidiary is PRs1 billion and for an Islamic banking branch is PRs 50 million—the same as for conventional banks.
    - Current regulations allow Islamic banking institutions to make investment in shares up to 30 percent of the equity; investment in a single company’s scrip should be limited to 5 percent of the equity of a banking institution.
  - Liquidity requirements:
    - Liquidity requirements are 11 percent for Islamic banks compared to 15 percent for conventional banks.
    - Rationale: lack of Shariah compliant financial securities; conventional banks can meet systemic liquidity with government securities whereas Islamic banks can only meet them in cash.
  - Capital adequacy:
    - Capital adequacy and related definitions for Islamic banks are the same as for conventional banks, although for the musharakah contracts the measurement of the capital is an outstanding issue. The Islamic Banking Department of the SBP is working on this issue.
  - Lender of last resort and support issues:
    - At present SBP does not apply traditional lender of last resort policies to Islamic banking institutions.
    - How such support could be provided in accordance with Islamic principles is being considered.
    - Issue of support from a conventional parent bank to its stand-alone Islamic banking branch needs to be addressed.
    - Banks may repay depositors funding a modarabah investment pool that suffers losses out of their own resources to contain reputational risk; this issue deserves an explicit and comprehensive lender of last resort policy for Islamic banks.
  - Risk management:
    - At present there are no specific risk management requirements for Islamic banking institutions.
    - Islamic banking sector faces specific risks because Islamic banks share risks in profit outcomes with depositors.
    - Ongoing discussion on classification of risk sharing funds placed with Islamic banks; uncertainty on whether these funds are capital certain or should be defined as investments in a collective investment scheme.

- Monetary policy issues for Islamic banking
  - Government Shariah-compliant securities not yet available; Islamic banks cannot use government securities to meet liquidity requirements.
  - SBP proposals:
    - Two Islamic government securities proposed: Ijarah and Salam.
    - Islamic interbank market can be established on Shariah compliant principles as soon as there will be 5-6 participants.
  - Ijarah details:
    - Long-term leasing instrument with maturity of one year and above.
    - Benchmark for rate of rental will be 6-month KIBOR.
    - Instrument will be repriced every half a year.
    - KIBOR of 6-month maturity plus a margin will be used for repricing.
    - SBP planning to introduce Ijarah with 3 and 5 years of maturity.
  - Salam:
    - 3-month prepayment arrangement, commodity based, to be introduced by the government.
  - Implementation considerations:
    - Plans for introducing Ijarah are being finalized and will need government approval.
    - Proper regulatory framework needed for introduction of Islamic securities through the stock exchange.
    - Legal issues include role of SBP and clarification of ownership status of particular assets.
  - Monetary policy perspective:
    - Because of its small size, Islamic banking does not yet pose a problem.
    - As Islamic securities become more mature, they may have significant effect on monetary policy.
    - Newly introduced Islamic banking instruments need to be consistent with the Shariah Code as well as with the monetary policy of the SBP.

### Conclusions — key findings and policy implications for Islamic banking
- Current influence and potential
  - Islamic banking does not yet influence much the Pakistani economy, but there is potential for rapid growth in the foreseeable future.

- Policy needs
  - Growth needs to be supported by an appropriate regulatory framework.
  - Accounting and auditing standards need to be in place.
  - Legal status of the dual—Islamic and conventional—banking system has to be resolved to provide clear legal basis for banking activities.

- SBP vision and recommended actions
  - SBP conceives the financial system in Pakistan as dual system, where Islamic banking co-exists with conventional banking to give users choice of instruments compatible with religious beliefs.
  - Conventional banking remains dominant, consistent with Pakistan’s position as an emerging market integrated into the global economy.
  - SBP’s vision of co-existence of the two type of banking activities in parallel is judged appropriate.
  - Islamic banking products and contracts and Islamic financial instruments may bring welfare benefits—especially for rural households—and should be developed and standardized to increase transparency and ease accounting and auditing.
  - Risk management in Islamic banks should receive closer attention and a specific framework needs to be developed.
  - Lender of last resort arrangements for Islamic banking sector should be developed.

*Source: SBP (data and analysis as presented in the document).*

### 1. Pakistan: Structure of the Banking Sector, 1999-2003 ..........................................................3

### 1. Pakistan: Structure of the Banking Sector, 1999-2003

### Structure of the Banking Sector
- Privatization and ownership shifts
  - In 1990, the banking system was dominated by five commercial banks which were all state-owned.
  - The 1990 amendments to the Banking Companies Ordinance allowed privatization of state-owned banks.
  - Muslim Commercial Bank (MCB) and Allied Bank (ABL) were privatized between 1991 and 1993.
  - United Bank (UBL) was privatized in 2002, ending domination by state-owned banks.
  - As of September 2003, the asset share of local private banks and public sector commercial banks was 47 percent and 41 percent respectively.
  - Habib Bank (HBL) completed privatization in February 2004; following this privatization the share of banking system assets held by public sector commercial banks decreased to less than 25 percent.
  - National Bank of Pakistan (NBP) remained state-owned with a market share of approximately 20 percent; the government divested approximately 25 percent of its capital in 2001-03, but privatization prospects were uncertain.

- Market structure and entry controls
  - Number of commercial banks increased to more than 40 by 1995, prompting a moratorium on the establishment of new banks in 1995 that remained in force.
  - Minimum capital requirement increased from PRs 500 million to PRs 750 million from end-December 2001 and to PRs 1 billion (around US$17 million) from end December 2002.

- Islamic banking developments
  - The SBP exempted Islamic commercial banks from the moratorium; the first full-fledged Islamic bank, Meezan Bank, was licensed in 2002.
  - Several conventional banks opened branches providing only Islamic financial services.
  - The SBP estimates total assets of Islamic banking institutions equal approximately 1 percent of the total banking sector assets.

- Ownership structure (selected datapoints)
  - Figure 1 (1990): Public Sector Commercial Banks 92%, Foreign Banks 8%, Local Private Banks 0%.
  - Figure 1 (2003): Public Sector Commercial Banks 41%, Local Private Banks 47%, Foreign Banks 12%.

### Structure and Size (end-September 2003; selected balance sheet and income figures)
- Aggregate totals (All Commercial Banks)
  - Total Assets: 2,379.6 PRS billions
  - Customer Deposits: 1,796.7 PRS billions
  - Capital: 143.0 PRS billions
  - Profit/Loss Before Taxation: 37.5 PRS billions
  - Net Income After Taxes: 23.0 PRS billions

- Asset composition (All Commercial Banks, end-September 2003)
  - Cash and Balances with SBP and Other Banks: 300.3 PRS billions (12.6 percent of total assets)
  - Investments: 811.6 PRS billions (34.1 percent of total assets)
    - Of which: government securities 688.5 PRS billions (28.9 percent of total assets)
    - Of which: other securities 123.1 PRS billions (5.2 percent of total assets)
  - Gross Advances: 997.0 PRS billions (41.9 percent of total assets)
    - Of which: in local currency 845.3 PRS billions (35.5 percent of total assets)
    - Of which: in foreign currency 151.7 PRS billions (6.4 percent of total assets)
  - Provisions for NPLs: 101.3 PRS billions (4.3 percent of total assets)
  - Lending to Financial Institutions: 140.5 PRS billions (5.9 percent of total assets)
  - Other Assets: 130.3 PRS billions (5.5 percent of total assets)

- Income statement (All Commercial Banks, end-September 2003)
  - Interest Income: 82.6 PRS billions
  - Interest Expense: 31.2 PRS billions
  - Non-Interest Income: 36.9 PRS billions
  - Non-Interest Expense: 44.5 PRS billions
    - Of which: administrative expenses 43.6 PRS billions
  - Taxes Paid: 14.5 PRS billions

### Performance of Commercial Banks — Financial soundness and trends
- Aggregate improvements and drivers
  - Aggregate financial soundness indicators improved in recent years, reflecting favorable external and macroeconomic developments, structural changes, and policy initiatives.
  - Policy measures included recovery drives, a foreclosure law, write-off settlement guidelines, establishment of the Corporate and Industrial Restructuring Corporation (CIRC), retrenchment of personnel, and closure of unprofitable branches.
  - Newly privatized banks face challenges: developing a credit culture for prudent lending to new sectors (housing and consumer goods), timely recovery of defaulted loans, and maintaining loss-making branches in “unbanked” areas.

- Capital adequacy (system averages and notes)
  - Regulatory capital to risk-weighted assets:
    - Dec-99: 12.2
    - Dec-00: 11.4
    - Dec-01: 11.3
    - Dec-02: 12.6
    - Sep-03: 13.1
  - Tier I capital to risk-weighted assets:
    - Dec-99: 10.3
    - Dec-00: 9.8
    - Dec-01: 9.7
    - Dec-02: 9.7
    - Sep-03: 10.9
  - Capital to total assets:
    - Dec-99: 5.0
    - Dec-00: 4.9
    - Dec-01: 4.6
    - Dec-02: 6.1
    - Sep-03: 6.2
  - The average capital adequacy ratio (capital-to-risk weighted assets) was 13.1 percent in September 2003, up from 11.3 percent in December 2001.
  - The average capital ratio (capital-to-gross assets) for commercial banks stood at 6.2 percent.
  - Contributing factors to improved capital adequacy: better profitability, fresh injections of capital (including recapitalization prior to privatization), and an increasing share of government securities in bank portfolios (zero risk weight).
  - Revaluation effects:
    - For the four largest banks, surplus on revaluation accounts averaged 36.5 percent of their capital as of end-2002.
    - Surplus on revaluation of investments was on average 24.5 percent of capital for the four largest banks as of end-2002.
    - Only 50 percent of revaluation accounts may be included in Tier II Capital; large revaluation surpluses are vulnerable to market reversals.

- Capital compliance and concentration
  - As of September 2003, overall capital of the banking system stood at PRS 143 billions.
  - 12 banks were not complying with the minimum capital requirement (PRS 1 billion), and one of these banks was insolvent.
  - The SBP expected the number of non-compliant banks to be reduced via mergers of several small institutions.

### Asset quality
- NPL trends and policies
  - NPLs to gross loans:
    - Dec-99: 22.0
    - Dec-00: 19.5
    - Dec-01: 19.6
    - Dec-02: 18.0
    - Sep-03: 16.1
  - Provisions to NPLs:
    - Dec-99: 46.6
    - Dec-00: 53.9
    - Dec-01: 53.2
    - Dec-02: 58.3
    - Sep-03: 63.0
  - NPLs net of provisions to capital:
    - Dec-99: 117.4
    - Dec-00: 96.7
    - Dec-01: 100.7
    - Dec-02: 54.5
    - Sep-03: 41.8
  - The downward trend in total NPLs reflects both an increase in gross loans and SBP write-off guidelines issued in October 2002 enabling more aggressive clearing of old NPLs.
  - Banks historically retained NPLs indefinitely, even after 100 percent provisioning, due to concerns that write-offs might compromise legal recovery efforts.

- Variation across banks
  - The ratio of NPLs to total loans ranges from 0.4 percent to 35.1 percent across individual banks.
  - Asset quality of the five largest banks is generally poor, with the ratio of gross NPLs to total loans ranging from 15 percent to 35 percent.
  - Smaller banks, especially foreign banks, report very small ratios of NPLs to total loans.
  - Provisions to NPLs in foreign banks: 79.5 percent (system average: 63.0 percent).

### Liquidity and profitability indicators (selected)
- Liquidity ratios (percent)
  - Liquid assets to total assets:
    - Dec-99: 38.7
    - Dec-00: 37.5
    - Dec-01: 39.9
    - Dec-02: 47.0
    - Sep-03: 48.6
  - Liquid assets to total deposits:
    - Dec-99: 48.2
    - Dec-00: 48.0
    - Dec-01: 50.3
    - Dec-02: 60.2
    - Sep-03: 59.4

- Profitability (percent)
  - ROA (after tax):
    - Dec-99: -0.3
    - Dec-00: 0.0
    - Dec-01: 0.0
    - Dec-02: 0.8
    - Sep-03: 1.4
  - ROE (after tax):
    - Dec-99: -6.2
    - Dec-00: -0.3
    - Dec-01: -0.3
    - Dec-02: 13.8
    - Sep-03: 22.1
  - Net interest income to gross income:
    - Dec-99: 54.3
    - Dec-00: 61.2
    - Dec-01: 68.9
    - Dec-02: 67.4
    - Sep-03: 58.2
  - Non-interest expenses to gross income:
    - Dec-99: 76.9
    - Dec-00: 71.6
    - Dec-01: 62.7
    - Dec-02: 57.3
    - Sep-03: 50.4
  - Personnel expenses to noninterest expenses:
    - Dec-99: 57.0
    - Dec-00: 54.3
    - Dec-01: 52.6
    - Dec-02: 51.4
    - Sep-03: 50.1
  - Non-interest income to total income:
    - Dec-99: 17.6
    - Dec-00: 16.5
    - Dec-01: 14.5
    - Dec-02: 18.1
    - Sep-03: 30.9

*Source: SBP (data and analysis as presented in the document).*

### 11.      Bank credit to the private sector has been growing steadily in recent years. While

### Bank credit to the private sector has been growing steadily in recent years.

### Credit growth and risks
- Outstanding stock of credit to corporate sector has been generally stable (or even declining in the case of credit to public sector enterprises).
- Bank lending to small and medium enterprises, and especially consumer financing, have all been increasing rapidly.
- The share of personal loans (particularly, auto loans, house loans, and credit cards) has grown from virtually nothing in the mid-1990s to 12 percent of the total bank credit in September 2003.
- The rapid consumer credit growth, if sustained, could lead to a deterioration in banks’ loan portfolios.
- The SBP increased the general provisions against unsecured consumer loans to 5 percent from early 2004; the general provisions against secured consumer loans are set at 1.5 percent.
- Rapid consumer lending growth requires careful monitoring.

### Earnings
- Profitability indicators have registered a visible improvement.
- Returns on assets and equity are beginning to approach international norms after years of poor performance.
- Measured profitability in the past was distorted by lax provisioning.
- Recent strengthening in the profit position of banks has largely resulted from an increase in interest income and from expanded business volumes facilitated by macroeconomic stabilization.
- Net interest income somewhat slowed down in 2003, mainly due to contraction in interest margins likely stemming from increased competition.
- Banks reported strong gains on sale of securities and other non-interest income.
- The share of net interest income in gross income declined to 58 percent in September 2003, from 69 percent in December 2001.

### Liquidity
- Liquidity in the banking sector has become abundant, helped by a substantial increase in workers’ remittances following the events of September 11, 2001.
- Liquid assets as a percentage of total assets increased to 49 percent by the end-September 2003, from 40 percent in December 2001.
- Liquidity held by banks was more than double the amount of required liquid assets last year.
- The excess liquidity has led to a decline in interest rates and may be contributing to rapid increases in asset prices in the real estate and equity markets.

### Preserving stability and soundness
- Although the condition of the banking system has been improving in recent years and most of the banks appear resilient to shocks, the stress tests results should not cause complacency.
- Weaker banks experience capital adequacy problems in the face of relatively modest NPL increases, suggesting that banks on the lower end of the capital adequacy and asset quality spectrum deserve closer attention of supervisors.
- In the new environment of private sector dominated banking, sensitivity analysis based on historical experience of shocks needs to be interpreted with caution.

*Source: _cr05157 - 11.      Bank credit to the private sector has been growing steadily in recent years.*

### 15.      The mission has the following general recommendations aimed at assisting the

### 15.      The mission has the following general recommendations aimed at assisting the authorities to maintain and enhance the current financial stability and soundness

### General recommendations
- Government and SBP should develop a strategy to privatize the remaining public sector commercial banks (especially NBP) and continue divestiture from the capital of other banks.
  - Public ownership of commercial banks has generally proved to be inferior to private ownership in many countries worldwide.
  - The experience of Pakistan also confirms that public sector commercial banks are less effective in intermediating financial resources than privately owned banks, except prehaps in remote areas where access to banking services would otherwise be unavailable.
  - The FSAP team welcomes the divestiture of government from the capital of several large banks in recent years, as well as the reported reduction in the government’s interference in corporate governance of banks with minority or even majority public stake.
- The effectiveness of the moratorium on the licensing of new conventional banks should be reassessed.
  - The establishment of this drastic measure might have been justified in the conditions of the mid-1990s.
  - Since then, however, the system has been consolidated and the regulatory and supervisory frameworks have been strengthened.
  - The current minimum capital requirement is already sufficiently high which together with adequate fit and proper criteria should be enough to prevent a proliferation of small and weak institutions.
  - The abolishment of the moratorium may thus contribute to a more competitive environment and a more efficient functioning of the market.
- The development of Islamic financial institutions and the risks associated with them should be closely monitored.
  - SBP should ensure a proper coordination of regulation, off-site supervision, and on-site inspections of Islamic financial institutions.
- BSD should continue working on the design of the stress testing framework, and use the stress testing exercise on a routine basis in the future.
  - The stress testing team of the SBP has already achieved a good level of proficiency in various aspects of the stress testing framework.
  - Further progress in the stress testing programm, especially improvement in technical capacities, is needed in order to make the stress tests as a valuable instrument of monitoring financial stability.
- Consideration may be given to tighten requirements for specific provisions in light of the recent credit expansion.
  - As discussed in Section C of this note, the SBP’s current loan provisioning rules are less tight than in many other countries.
  - A tightening of these rules would not only bring the regulations in line with the those in other countries, but perhaps more importantly would also help to limit credit growth.

### RECENT DEVELOPMENTS IN ISLAMIZATION OF THE FINANCIAL SYSTEM IN PAKISTAN — overview
- Islamization of the financial system has received considerable attention in Pakistan in recent years.
- Drivers include underlying demand for Shariah-compliant services and judicial rulings: a Shariat Court ruling in 1991 and affirmation by the Shariat Appellate Bench of the Supreme Court in 1999 that existing banking practices did not conform to Islamic principles.
- Dedicated institutions and SBP work on prudential and regulatory framework are underway.

### A. Legal Status of Islamic Banking — key points and timeline
- From July 1985 commercial banking transactions in local currency have been on interest-free profit and loss sharing (PLS) and mark-up basis.
  - Footnote: Except foreign currency deposits and on-lending of foreign loans, which continued to operate on conventional banking principles.
- November 1991: PLS-based system declared un-Islamic by the Federal Shariat Court; PLS/mark-up-based banking continued in parallel with conventional banking until 2001.
- 1999: Shariat Appellate Bench of the Supreme Court ordered government to do away with interest in financial transactions; ordered revocation of laws governing interest payments by March 30, 2000 and other laws by June 30, 2001.
  - Government appealed for delay; offered parallel banking system as compromise.
- June 2001: Supreme Court extended the deadline to June 30, 2002.
- June 2002: Banks appealed to review earlier decision; government supported appeal; Supreme Court referred case back to Federal Shariat Court.
  - Outcome: earlier Supreme Court rulings of 1999 and 2000 are not considered valid; legal uncertainty remains and process could take several years.
- Meanwhile, authorities moved to allow provision of Islamic banking services in parallel with conventional banking:
  - December 2001: SBP issued detailed guidelines for establishment of Islamic commercial banks.
  - November 2002: Banking Companies Ordinance (1962) amended to allow formation of banking subsidiaries dedicated to Islamic banking services.
  - January 2003: Detailed criteria for setting up subsidiaries and/or stand-alone branches for conducting Islamic banking issued.
  - Banks are not allowed to conduct Islamic banking transactions in units involved in conventional operations.
- SBP measures:
  - New banking licenses for domestic banks are issued only for Islamic banks.
  - SBP developing framework for regulation, supervision and liquidity and monetary management arrangements for Islamic banks.
  - Islamic Banking Department (IBD) set up in SBP in September, 2003; responsible for approving opening of Islamic banks, branches, and subsidiaries.
- A Shariah Board within SBP established with five members: two Shariah scholars, a charter accountant, a lawyer, and a representative of the SBP.
  - Board approves financial instruments for conformity to Islamic principles.
  - Banks need Shariah advisors to adapt instruments for Shariah compliance and bank-specific circumstances.
  - SBP designed Islamic government securities which will be reviewed by the Ministry of Finance; legal basis for these instruments still needs to be finalized.

### B. Recent Developments in Islamic Banking — institutions, products, and scale
- Scale:
  - Combined assets of the Islamic commercial banks and Islamic branches represented 0.5 percent of the entire banking system’s assets as of September 30, 2003.
  - The only full-fledged Islamic bank (Al-Meezan Bank Limited) first license issued in January 2002.
  - Al-Baraka Islamic Bank in process of converting from a conventional to an Islamic bank.
  - Two more full-fledged Islamic banks are expected to open by 2005.
  - As of February 27, 2004, four commercial banks had established a total of eight branches for conducting Islamic banking.
- Asset structure example:
  - Al-Meezan Bank products include a riba (interest)-free rupee saving account, a riba-free dollar saving account, and certificates of Islamic investment.
  - On the asset side, Al-Meezan bank mainly uses the modes of Murabaha and Ijarah.
- Funding sources for Islamic banks:
  - Three basic sources: equity capital, transaction deposits, and investment deposits.
  - Equity capital: owners’ investment, same as conventional banking.
  - Transaction deposits: equivalent of demand deposits but do not pay a rate of return.
  - Investment deposits: similar to equity investment—do not ex-ante specify a rate of return or guarantee return of principal; main source of funding.
    - Ex-post returns on investment deposits may be tied to overall performance of the institution or a specific pool of projects.
    - Such deposits typically cannot be withdrawn prior to maturity.
    - Risk profile differs: no contractual claim associated with deposit or return; depositors are not shareholders and do not have voting rights; they cannot influence investment policy.
    - Deposit specifies ex-ante ratio for distribution of profits (losses) between depositors and bank; balance sheet risks shared in proportion to shares of losses.
    - Depending on contract, depositors face risk of loss of their principal; Islamic banks do not provide explicit guarantee of deposits.
      - Footnote: In some countries, however, all types of deposits are implicitly guaranteed to maintain reputation of the Islamic financial institution.
    - Profit is determined on actual outcome of projects; each period profit is announced and distributed; depositors are given performance records of similar products.
- Size indicators:
  - Al-Meezan Bank had PRs 8.8 billion on June 30, 2003.
  - Data on total assets of eight stand-alone Islamic branches are not available.
- SBP action:
  - April, 2004: SBP Shariah Board approved the Essentials of Islamic Modes of Financing to ensure compliance with minimum Shariah standards by banks conducting Islamic banking.
    - These Essentials proposed to be enforced as Prudential Regulations for Islamic banks in due course.

### Essentials of Islamic Modes of Financing (as approved)
- Murabaha facility agreement (agreed profit margin sale with cash or deferred payment of price): contract of sale where seller discloses cost and profit; once sale concluded, selling price cannot be changed.
- Musawamah: general sale where price is stipulated without reference to seller’s cost; seller not obliged to reveal cost; other Murabaha conditions valid.
- Ijarah (leasing): leased commodity remains ownership of lessor; lessor retains title and bears risks and rewards; unilateral promise to buy/sell on expiry may be made.
- Salam (advance payment – deferred delivery sale): seller supplies specific goods at a future date in consideration of a price fully paid in advance; equivalent to a future contract.
- Musharakah: partnership sharing profits and losses; profits distributed per contract; losses shared proportionally to capital invested.
- Mudarabah: partnership where one party provides funds and the other expertise (Mudarib); profit shared on pre-agreed basis; loss borne by capital provider.
- Istisna: contractual agreement for manufacturing goods allowing cash payment in advance and future delivery or future payment and future delivery; buyer cannot transfer ownership before possession.

### C. Regulation and Supervision of Islamic Banking Institutions — status and issues
- General approach:
  - Existing prudential requirements are applicable; SBP developing framework for regulating and supervising Islamic banks.
  - SBP applies sound banking principles, keeping in view accounting and auditing standards recommended by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI, Bahrain) and international best practices.
  - General principle: Islamic banks must comply with regulations for conventional banks plus additional requirements designed for Islamic banking.
- Work underway:
  - Introducing Shariah compliant Audit and Accounting Standards.
  - Requirement that an Islamic bank should have a Shariah Board or at least a Shariah Advisor who is not allowed to work in another Islamic bank.
    - Note: Two members of the SBP Shariah Board are also Shariah advisors for Islamic banks; they must abstain from Board meetings when related banks are under consideration.
  - Treatment of funds in the investment pool where customers’ deposits together with shareholders funds are invested: shareholders’ funds in such pools required to be at least 10 percent of the total investment of a specific pool.
- Accounting and audit standards:
  - Committee of the Institute of Chartered Accountants of Pakistan (ICAP), with SBP representation, reviewing AAOIFI standards for adaptation.
  - Currently, audit regulations for conventional banks are applied to Islamic banking institutions.
  - First Shariah Audit for Al-Meezan Bank to be conducted by Sedat Audit Company in 2004; company chosen by SBP from 4 audit companies on a competitive basis.
- Taxation and other measures:
  - SBP’s Export Finance Scheme revised to be on a Musharakah basis for Islamic banks.
  - Taxation laws under review to ensure banks do not bear additional burden due to trading and leasing activities.
- Minimum capital and investment limits:
  - Minimum capital requirement for a full-fledged Islamic bank or subsidiary is PRs1 billion and for an Islamic banking branch is PRs 50 million—the same as for conventional banks.
  - Current regulations allow Islamic banking institutions to make investment in shares up to 30 percent of the equity; investment in a single company’s scrip should be limited to 5 percent of the equity of a banking institution.
- Liquidity requirements:
  - Liquidity requirements are 11 percent for Islamic banks compared to 15 percent for conventional banks.
    - Rationale: lack of Shariah compliant financial securities; conventional banks can meet systemic liquidity with government securities whereas Islamic banks can only meet them in cash.
    - Islamic banks can invest the difference of liquidity requirements of four percent into profitable assets to compensate for foregone return on government securities.
- Capital adequacy:
  - Capital adequacy and related definitions for Islamic banks are the same as for conventional banks, although for the musharakah contracts the measurement of the capital is an outstanding issue. The Islamic Banking Department of the SBP is working on this issue.
- Lender of last resort and support issues:
  - At present SBP does not apply traditional lender of last resort policies to Islamic banking institutions.
  - How such support could be provided in accordance with Islamic principles is being considered.
  - Issue of support from a conventional parent bank to its stand-alone Islamic banking branch needs to be addressed.
  - Banks may repay depositors funding a modarabah investment pool that suffers losses out of their own resources to contain reputational risk; this issue deserves an explicit and comprehensive lender of last resort policy for Islamic banks.
- Risk management:
  - At present there are no specific risk management requirements for Islamic banking institutions.
  - Islamic banking sector faces specific risks because Islamic banks share risks in profit outcomes with depositors.
  - Scope of activities confronts broader supervisory tasks than conventional banks: issues on definition of capital and capital adequacy ratio; nature of asset contracts brings additional risks; different balance sheet structure raises issues on uniform standards for income/loss recognition, adequacy of reserves, and overall operational risk.
  - Ongoing discussion on classification of risk sharing funds placed with Islamic banks; uncertainty on whether these funds are capital certain or should be defined as investments in a collective investment scheme.

### D. Monetary Policy Issues for Islamic Banking
- Government Shariah-compliant securities not yet available; Islamic banks cannot use government securities to meet liquidity requirements.
- SBP proposals:
  - Two Islamic government securities proposed: Ijarah and Salam.
  - Islamic interbank market can be established on Shariah compliant principles as soon as there will be 5-6 participants.
- Ijarah:
  - Long-term leasing instrument with maturity of one year and above.
  - Benchmark for rate of rental will be 6-month KIBOR.
  - Instrument will be repriced every half a year.
  - KIBOR of 6-month maturity plus a margin will be used for repricing.
  - Government must provide assets for Ijarah government securities; those assets to be defined.
  - SBP planning to introduce Ijarah with 3 and 5 years of maturity.
- Salam:
  - 3-month prepayment arrangement, commodity based, to be introduced by the government.
- Implementation considerations:
  - Plans for introducing Ijarah are being finalized and will need government approval.
  - Proper regulatory framework needed for introduction of Islamic securities through the stock exchange.
  - Legal issues include role of SBP and clarification of ownership status of particular assets.
- Monetary policy perspective:
  - Because of its small size, Islamic banking does not yet pose a problem.
  - As Islamic securities become more mature, they may have significant effect on monetary policy.
  - Newly introduced Islamic banking instruments need to be consistent with the Shariah Code as well as with the monetary policy of the SBP.

### E. Conclusions — key findings and policy implications
- Current influence:
  - Islamic banking does not yet influence much the Pakistani economy, but there is potential for rapid growth in the foreseeable future.
- Policy needs:
  - Growth needs to be supported by an appropriate regulatory framework.
  - Accounting and auditing standards need to be in place.
  - Legal status of the dual—Islamic and conventional—banking system has to be resolved to provide clear legal basis for banking activities.
- SBP vision:
  - SBP conceives the financial system in Pakistan as dual system, where Islamic banking co-exists with conventional banking to give users choice of instruments compatible with religious beliefs.
  - Conventional banking remains dominant, consistent with Pakistan’s position as an emerging market integrated into the global economy.
  - SBP’s vision of co-existence of the two type of banking activities in parallel is judged appropriate.
- Benefits and risks:
  - Islamic banking products and contracts and Islamic financial instruments may bring welfare benefits—especially for rural households—and should be developed and standardized to increase transparency and ease accounting and auditing.
  - While similar to some conventional investment products, Islamic instruments entail specific risks requiring closer attention as the sector grows.
  - Risk management in Islamic banks should receive closer attention and a specific framework needs to be developed.
  - Lender of last resort arrangements for Islamic banking sector should be developed.

*Source: _cr05157 - 15.      The mission has the following general recommendations aimed at assisting the*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05157.pdf_