Financial Sector Reforms and the Efficiency of Banking Sector in Pakistan

8/10/2019 Financial Sector Reforms and the Efficiency of Banking Sector in Pakistan

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LAHORE SCHOOL OF ECONOMICS

Financial Sector reforms and the

efficiency of Banking sector in Pakistan

Quaid Ahmed Khan

09U068

BSc !"

Section #

Su$mitted to %iss Summaira Sa&&ad

Contents

Chapter 1: Introduction.................................................................2


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Financial Sector Refor! and the e"cienc# of $an%in& Sector in 'a%i!tan

1.1: $an%in& in 'a%i!tan:............................................................2

1.2: Rele(ance of the topic:........................................................2

1.): $ac%&round inforation......................................................)

1.*: Mana&erial and Acadeic concern!:....................................+

1., -e# ord!:..........................................................................1/

1.+: Stud# O0ecti(e!:...............................................................11

Chapter 2 Literature re(ie.........................................................12

2.1: he 0an%in& !ector of 'a%i!tan3 pre refor period:..............12

2.2: Initiation of li0erali4ation and pri(ati4ation refor!:..........1,

2.): E"cienc# anal#!i!5 odel! u!ed:.......................................16

2.*: Findin&! and !hort coin&!:..............................................21

Chapter ): Methodolo..............................................................2)

).1: $an%in& !ector refored:.....................................................2)

).2.1: 7ata En(elopent Anal#!i!:.........................................2*

).2.2: #pe! of Return! to !cale:.............................................2,

).2.): #pe! of e"ciencie!:....................................................2+

).): Model Orientation:.............................................................28

).*: Fraeor%:........................................................................)/

).,: 7ata Collection:.................................................................),

Reference!:...............................................................................)+

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Chapter 1: Introduction

1.1: Banking in Pakistan:

For any thriving economy, one of the pillars it has to stand on is the Banking sector. The major

role of the banks, that is, to channelize credit towards the industry and production units and to

encourage domestic saving by providing various types of deposits, is indeed what makes the

economy grow and sustain. In order to make this possible, it is important that banks are regulated

and efficient, so that the economics process is not hampered by the improper functioning of the

banking sector.

1.2: Relevance of the topic:

ince the beginning, the economy of !akistan has not been a very stable one. "ne reason for that

is the instable financial sector of !akistan, especially the banking sector. The role that the

banking sector plays is a very crucial one, which needs to be understood first. In order to

understand that we should know how a typical bank primarily operates. The bank generates

revenue through taking in deposits. The purpose of deposits is twofold. Firstly it provides an

opportunity to the public and private savers to earn income on their savings. The interest that is

given on the deposits is the revenue for the savers, which happens to be the incentive for saving

too. "n the other hand, the core deposits provide the bank with funds that they can lend out.

#gain, there are two direct benefits of this. Firstly the bank gets an opportunity to loan out funds

which have to be paid back with an interest charge. The spread, which is the difference between

the interest the bank gets on loaning out funds and the interest that the bank has to pay to the

depositors helps in generation of revenue. econdly, there are these private and public parties

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who get an opportunity to take credit, set up a production house or an industry altogether which

is ultimately beneficial for the economy.

#s we can see that the role of the banking sector is $uite an important one, it is essential that the

banks operate in such a manner which is of in the better interest of the consumers, the financial

sector, the economy and ultimately the bank itself. For this, banks must operate in an efficient

manner. "nly when efficiency is brought in, it would be possible for the banks to earn reasonable

revenue that is vital for its operations and growth and that consumers of financial services

provided by the bank are such that they are not left worse off.

1.3: Background information

Before independence, the %uslim and &indu community had the 'eserve Bank of India as the

central bank of India. #s there was a central bank already e(isting in India, the financial sector

was functioning very smoothly as the central bank was playing its regulatory role. &owever, with

the creation of !akistan in )*+, there was an unfair distribution of assets between the newly

created India and !akistan. !rior to the partition, the dominant &indu majority of India owned

most of the banks of India. #fter the partition, the banking community immigrated to the new

India and in !akistan, there were a very few number of skilled members. o, apart from the many

other problems !akistan faced, this was one. That is, there was an acute shortage of skilled

bankers who could run banks in an efficient and viable manner that could assist in the

functioning of the !akistani economy. In addition to this, there was another problem. The unfair

division of assets had just left one bank in !akistan, namely the &abib Bank -imited &B-/.

ince &abib bank was just a bank owned by the government and not a central bank, the financial

sector was not a regulated one. %oreover, this bank was not in a situation to cater for the needs

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of the populous country of !akistan. 0ith limited assets base and lack of skilled bankers, the

banking sector of !akistan was not in good health, not in a condition which could support the

economy in the most befitting manner. The importance of a central bank was strongly felt as the

economy had already taken in huge losses during the transitional independence period and it

continued to do so as the banking sector of !akistan was not a regulated one. %uhammad #li

1innah issued directives for the creation of a central bank and planning for it started on priority

basis. The )st day of 1uly, )*+2, marked the inception of The tate Bank of !akistan. The

constitution of the bank remained unchanged during the initial years. &owever, at the very start

of )*+, like many other institutions, the tate Bank of !akistan was nationalized under the

nationalization policy. Initially the purpose of this bank was to be the issuer of !akistani currency

notes and to keep with them reserves which would help !akistan in maintaining a monetary

system that shall be in advantage for the economy of !akistan. &owever, with the change in its

constitution, the role of this bank in !akistan3s economy increased. 4ow the role of this bank

increased, in addition to the previous role, it had to regulate all the banks operating in !akistan,

to maintain the e(change rate system and to formulate a credit and monetary policy as such that

it is in the better interest of !akistan. The biggest role of this bank is to issue notes and to

regulate the banking sector of !akistan so that it continues to function in harmony. It basically

provides the banks of !akistan a set of rules and a framework which they have to adhere to.

!rudential regulations are the ones that are of prime importance. They provide the basic

re$uirements that all the banks in !akistan will and have to follow. To name a few, these

regulations deal with the li$uidity, capital and deposit re$uirements of the banks. . Till today, the

tate Bank continues to play its role as a central bank and over the years, it has enjoyed greater

and greater autonomy.

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#nother important role the tate Bank of !akistan has played is the encouragement of the

private and public sector banks to open up its branches in urban and far flung rural areas so that

banking services are available to whole of !akistan and not just to the people who dwell in city

centers. The tate Bank was to some e(tent successful in this target of theirs. In )*+*, the

number of bank branches was )+ but in )*+, this figure had gone up to 5,+)2. This is a

testimony to the fact that the banking services was being made available to the commoners as

well as that banking system was becoming an inherent part of the economy. Total number of

accounts held by these banks amounted to ,67,)*. &owever, a serious blow to the banking

sector was the separation of 0est !akistan from its 8ast wing. The number of branches fell from

5,+)2 to 6,9::. It was a potent threat to the survival of the banking sector as the industrial loan

demand showed a considerable decline. 4onetheless, !akistan managed to successfully come out

of this threat and the banking sector flourished. &owever, the efficiency of these banks was still

an unanswered $uestion. ;nfortunately, this was not the only problem !akistan was facing. In

)*:3s, along with the Bhutto era came the nationalization policy. #long with ten major

industries, considerable nationalization was done in the banking sector too.

The nationalization of the banking sector indeed made the financial system to look like the most

regulated one, which should have brought in efficiency. %any of the nationalized banks were

merged to form the five big nationalized commercial banks, namelyovernment of !akistan

and foreign financial institutions. These reforms were aimed at deregulating the banking sector,

providing relief to the banking sector by the privatization of numerous national banks.

1.4: anagerial and !cademic concerns:

0ithout any doubt, we can see the banking sector is very important to the economy of !akistan

as it ensures its survival and growth. For that it is important that the banks operate under

circumstances which ensure ma(imum efficiency.

;nfortunately, the economic and financial policy of !akistan has not been the one which is very

stable. 0ith every change in the government regimes, be it a different political party or the

transfer of power from the civil to military regime and vice versa, every regime has brought its

own set of policies that they think shall be in the better interest of the country. ame goes for the

banking sector. Though the constitution has not changed much but the changes it brings about in

its functioning, especially the regulations it sets for the banks to follow are detrimental in the

outcome, whether it is efficient or not. "ne major concern that shall be highlighted in my

research is that whether or not the privatization of banks in !akistan has been successful in

bringing in more profitability in this sector or were the banks doing much better when they were

in the hands of the government.

The nationalization of banks in the )*:3s had its own advantages. Firstly, prior to the

nationalization process, wealth was concentrated in the hands of a few. This meant that few

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families had control over the financial streams. o, basically the policies came from them and the

credit that was to be given to various industries was to be decided by them. In simpler terms, the

establishment and survival of industries were dependent on these private banks which had

majority of the loan able funds. If they found out that returns from any particular industry would

be greater, they would make loans to production units in those industries instead of making loans

to other industries. This did increase the returns of the bank but the problem was that this

practice was not beneficial from the national point of view.

?uring the early years, !akistan was in a process of building up its economy. There were infant

industries that need to be supported and many were to be built from scratch. For that credit had

to be diverted to these priority sectors. From the national point of view, the returns from

financing them would not be much profitable for the banking sector in the short run but the

returns from the industry would be very higher as compared to the costs incurred in the long run.

&ence, these projects would be very much viable. o, the private banks would never be taking

these e(ternal benefits into account and would never give credit to these institutions but if these

banks were nationalized, only then credit could be diverted towards priority sectors.

In addition to this, another direct advantage of the nationalizing policy was that without any

second thoughts, a number of bank branches were opened up all over !akistan, especially the far

flung rural areas. This had two direct advantages. Firstly, the banks now had an opportunity of

increasing its asset base and to increase the number of accounts so that more and more funds can

be loaned out. The second advantage was that the banking services were now being made

available to a greater number of consumers. =onsumers previously who had no access to the

banks now had an opportunity of opening up bank accounts or use other services provided by the

banks.

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&owever, these major advantages coupled with other minor ones like better regulated financial

sector were over shadowed by the disadvantages brought by the process of nationalization.

Firstly, though the government was successful in targeting credit towards priority sectors, the

element of bias was never removed. In fact it grew even stronger. !rior to the nationalization

process, credit was directed to those sectors which they thought would provide the banks with

greater returns. This time around, a political bias was involved. -oans at times were made to

sectors that could not generate returns good enough or those projects were not profitable from

the national point of view but were given credit only because they had political support. 8ither

the industry itself was to be established by political leaders or people at the helm of affairs or the

creditors were people who had strong political connections. # lot of times it was witnessed that

the loans were made without taking appropriate guarantees, the loans were pledged against weak

collateral assets. This meant that the risk of non@performing loans faced by the banks increased

e(ponentially. The loans were not being made on merit and hence this caused the number of

non@performing loans to increase. These 4!-3s were not at all in favor for the smooth

functioning of the financial sector of !akistan.

In addition to this, though the number of branches increased and the banking services were made

available to a larger population but this did not help with the efficiency cause. In fact, this

backfired. The banks did increase a lot of jobs and helped with the unemployment but most of

the times the banks were over staffed and made its operations counterproductive. %oreover, the

banks operating costs witnessed an e(ponential increase in its administrative costs.

%oreover, there was no competition amongst the banks since all banks were government banks.

It did not matter which bank had the largest market share hence inefficiency was on the rise in

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the banking sector. 8ven the top, most important positions were given to employees on political

basis instead of making the appointments on merit. The inefficiency ultimately resulted in lower

domestic savings and hence a low economic growth rate. Inefficiency in the banking sector

deteriorated tremendously.

#ll of these disadvantages associated with having state owned banks gave rise to the thought the

banks should be privatized. This thought culminated into an actual process when the

privatization reforms were introduced. 0ith the privatization reforms in place, many of the state

owned banks were privatized. In addition to the privatization of the banks, one other important

point of these reforms was that investment in the banking sector was encouraged. !ublic parties

were encouraged to open up banks as many regulations were rela(ed and the licenses to open up

new banks were given away. The banks now can be classified into the following types?! of the Banking sectors assets grew from +.6D to 77.9D. The

growth in the banking sector had outpaced the nominal >?!. This result was a sharp disparity

with the >?! asset ratio in )**:. Thus the transformation that we see in the financial sector i.e.

from nationalization to privatization and the role played by tate Bank of !akistan is e(ceptional.

#s not only the >?! and profitability of banking was improved the capital ade$uacy ratio also

increased. #long with this the loan infection ratio decreased significantly. The Banks were

operating at the capacity considerably higher than it was in the *:3s. #ll these positive results

made it e(plicit that the financial reforms introduced played a significant role in the banking

sector of !akistan. Thus these reforms have made the financial sector of !akistan competent and

efficient. 'ehman E 'aoof, 6:):, p. ))6/

8mphasizing on the role of the privately owned banks if we look at the theoretical rationale

behind the workings of the state owned enterprises and privately owned enterprises we can

clearly see the difference in the twos workings. In tate owned enterprises "8s/ decisions are

politically motivated and biased. It is characterized by tardiness, lethargy and inefficient use of

resources. #lso it is commonly though that the workings of a state are corrupt. ;nlike the tate

owned enterprises, the private enterprises are profit orientatedG ensure the efficient usage of

resources, improvement in the technical efficiency, human resource development, which includes

training of staff and the physical e(tension of banks. They work rationally and without any

pressure from the state. For them time is money and it is utilized as efficiently as possible.

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&ence, private owned banks and other enterprises play a much stronger role in enhancing the

growth of !akistan3s economy altogether. &ussian, ;llah, aeed, E 'afi$, 6:)6, p. +)/

Today, the Banking sector is playing a fundamental role in the growth of the country3s economy.

In accordance with the state bank of !akistan, the banking system of !akistan is a two@tier

system including the tate Bank of !akistan B!/, commercial banks, pecialized banks,

?evelopment Finance Institutions ?FIs/, %icrofinance banks and Islamic Banks. 4awab, p.

)+/ By 1une 6:): the banking sector of !akistan comprised of 59 commercial banks including +

public sector commercial banks foreign banks and 67 local private banks/ and + specialized

banks with a total number of *,:2 branches throughout the country. 4awab, p. )+/

The current formation of the financial sector in !akistan is the result of numerous policy shifts

and developments. -ike many other developing countries, !akistan also undertook the procedure

of financial restructuring through reforms in early )**:s to establish a more market@based

system of financial intermediation and >overnment financing, conduct the monetary policy more

efficiently through greater reliance on indirect instruments and increase the contribution to the

rapid development of the stock markets. 4awab, p. )+/

2.3: /0cienc$ anal$sis models used:

In order to find efficiency of banks, various researchers use various techni$ues. ome have used

simple financial ratios, some have used various regression techni$ues but most have them have

used the frontier analysis. The frontier analysis can be further sub divided into two major

categories, stochastic and deterministic. Berger, )**2/ The stochastic frontier analysis can then

be further subdivided into the parametric approach and the non parametric approach. The

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parametric techni$ue enjoys preference over the non parametric one as the latter one has certain

deficiencies when it comes to measure efficiency. 'eason being, in calculating the efficiency, this

techni$ue does not take into account the random effects. By not doing so, the results which one

might get could be the inflated ones, rendering the results as dubious >rabowski et al., )**+/.

The parametric approach, the researchers usually have a choice amongst three approaches, the

first being the stochastic frontier approach, second being the distribution free approach and third

being the thick frontier approach. The most popular amongst these three are the stochastic

frontier approach which is then again divided into parametric and non parametric techni$ue. o,

to arrive at results that are reliable and certain, the parametric approach to frontier analysis is

used by many. In instances where it seems as if the inefficiencies will follow an asymmetric

distribution and the random errors follow a symmetric distribution, a composed error term is

used and hence the results come out to be more accurate Berger, )**2/.

The deterministic frontiers are the least popular. "ne barely finds any studies which show that

deterministic frontiers have been used in order to find efficiency scores. It basically because only

a small portion of the data actually supports the frontier, which ultimately leads to problems like

sampling, outlier and statistical noise. This results in the undermining of efficiency scores

Caparakis et al., )**+/.

#nother techni$ue that has been used is model built using a translog cost function together with

a composite fi(ed error term %ahmood, -oan, 6::9/. The composite error term helps in finding

out that if a firm lies above or below the cost frontier, is it due to internal shocks or does it results

from the internal inefficiency. It should be noted here that in such a type of a model one basically

is looking at cost efficiency. The efficiency is dependent on optimal costs.

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"ther techni$ues used, especially in the case of !akistan is the use of =#%8- and =#8-

ratios. Both of these are basically measures which help in the calculation of a given set of ratios,

using the balance sheet and income statement components. =#%8- ratio includes the capital

ade$uacy ratio, asset $uality ratio, management $uality ratio, earnings and profitability ratio,

li$uidity ratio and sensitivity to market ratio Chalid, 6::9/. In case of =#8-, the management

ratio is left out. Both of these measures have been adopted by the tate Bank of !akistan

ayyum, 6::9/. The major reasons for the use of these ratios are the simplicity of calculations

involved and the easy interpretation of results. &owever, the disadvantage is that it is just too

simple. =#%8- as an efficiency measure would not result in concrete findings, as it is possible

by ?ata 8nvelopment #nalysis ?8#/. In ?8#, an efficient decision making unit ?%;/ is

there and rest are compared with it whereas in the case of these ratios. In =#%8-, no such

comparisons can be made. =omparisons that are possible can be of comparing ratios with those

of the best firm in the market.

?ata 8nvelopment #nalysis is the most common model, whose results are accurate. It happens to

be a non parametric techni$ue, linear programming techni$ue #vikiran, 6::7/. %ajority of

researches, especially foreign ones have used this. It is specifically targeted towards the

measurement of efficiency when it comes to the ?ecision %aking ;nits ?%;3s/, banks in this

case. The ?8# basically compares each ?%; with the role model in the given set of ?%;3s. #

frontier is basically made using observed measures and a frontier is made. The firms lying on the

frontier get a value of ) and are considered efficient whereas the firms who are not that efficient

get a score of less than ) #khtar, 6::6/. This way, comparison within firms can be made easily.

2.4: indings and short comings:

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The studies that are related to the case of !akistan are very limited in number, especially when it

comes to the usage of ?8# model. #nalyses using =#%8- and =#8- ratio have been very

common. Chalid, 6::9/ The =#%8- ratios showed that the banks have been slow in showing

improvement in the initial years, right after the major reforms of early )**:3s. There was an

improvement but it was slow in the initial years. %assive improvement was seen in the later

years. The foreign banks were the ones who showed most improvement. This is mainly due to

the fact that they were new into the market and the way they operated was in a really

professional manner. The national banks were the ones who showed the least amount of

improvement. If there was any improvement, it was too small or there was an actual deterioration

in the ratios. 8ven the ?8# analysis show that there have been considerable improvements after

the initiation and implementation of the privatization and liberalization reforms ayyum, 6::9/.

8ven when the translog function was used, the results were somewhat similar %ahmood, -oan,

6::9/. It showed that the reforms had resulted in the improvement of efficiency but there were

still a lot of room for improvement. It is just not that the reforms completely lead to improvement

of efficiency of all the banks to an e(tent that most of them managed to get a place e(actly on the

frontier. >humro et al., 6:)6/ even tries looking up into finding an answer to the fact that how

successful privatization has been. In this study, the individual case of #llied Bank is taken up and

it shows that there has been an immense improvement in #B-3s state of affairs.

&owever, the other important thing is the consistency of inputs and outputs taken and the

approach used. Irrespective of the approach used. The ?8# analyses do show that the banks have

turned out to be efficient when financial liberalization reforms are undertaken #vkiran, 6::7/.

Transition countries, when subjected to such reforms do in fact give promising results Bonin et

al., 6::7/.

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"ur neighbor, India, also has been a country which had national banks in its early years. ?own

the road, they also introduced various financial reforms ?as, >osh, 6::7/. It should be noted

that it is important to follow the global trends, in order to profit from rapidly changing economic

conditions. &ence, India too implemented similar reforms and these reforms bore fruit aha,

'avisankar, )***/. ince there are a lot of similarities between the two nations, India and

!akistan, chances are that the effects of the reforms could be similar too.

>iven that these reforms lead to efficiency, it is not a rule of the thumb that such reforms alone

lead to improvement. Factors like banks size, the number of branches and the geographical

location of a bank too play an important role in the determination of efficiency -uo, 6::)/. The

banking structure too plays an important part #ltunbas, =hakravarty, )***/. ome studies

e(hibit contradicary findings, hence regressions need to be carried out with bigger samples hence

accurate correlations are found when it comes to different variables and efficiency.

Chapter 3: ethodolog$

3.1: Banking sector reformed:

The banking sector of !akistan has been subjected to many reforms, the most crucial of them

being the introduction of privatization and liberalization reforms in the banking industry of

!akistan. In the privatization phase, the banks that were previously under government ownership

were now being put under private ownership. 8ither the banks were fully privatized, to an e(tent

that all the shares were held by the public or private parties or there was a combined ownership.

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deregulation and lesser barriers in entry. Then the privatized banks are those banks which were

previously nationalized or from scratch belonged to the government but now their ownership got

transferred to private individuals or to the public.

3.2.1: ata /nvelopment !nal$sis:

The aim of this research as stated earlier is to determine how efficient banks are, after going

through many reforms. ?ifferent researchers and theorists used different models to determine

how efficient banks have been. The most popular amongst those models has been the ?ata

environment analysis ?8#/ which uses data on the input and output $uantities of a group of

countries or business units to construct a piece wise linear surface over data points.

Basically, the banks are considered to be the decision making units ?%;/. This is because

banks are our point of concern, whose efficiency scores we need to find, as this is the place

where all the decisions regarding its operations are made. Thus, the decisions took in the ?%;s

then have a strong effect on the efficiency scores. ?%;s are where the population process takes

place, using multiple inputs and outputs. It is not necessary that the number of inputs and outputs

are to be e$ualG this means that one to one relationship is not necessary. For e(ample, there can

be two inputs and three outputs or vice a versa. But what is of importance here is that all the

outputs and inputs taken into consideration should e(hibit some kind of relationship. For

instance, if deposits are taken as an input, these deposits are converted into loans and then given

out to bank3s customers. It is $uite evident from the above mentioned e(ample that a relationship

e(ists amongst the two variables. &ence efficiency analysis can be carried out using the ?8#

analysis.

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3.2.2: ,$pes of Returns to scale:

Initially, the original ?8# model was limited to firms that e(hibited constant returns to scale

phenomenon. It meant that if inputs in the ?8# model are doubled, the outputs should be

doubled up too. &owever, due to this constant return to scale condition, the ?8# model had

limited applicability.

-ater, the Hariable 'eturns to cale B== model/ was introduced. This meant that now, with the

doubling of inputs, it is not necessary that the output doubles too.

The =='s model e$uation =harnes et al., )*2/lobal

privatization trends and associated policies for state@owned enterprises and banking

institutions in !akistan.Pakistan Economic an! Social Re"ie#, $7)/, 9)@26.

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&ussian, . 0., ;llah, #., aeed, %., E 'afi$, %. 6:)6/. Banking Industry @ !ost

!rivatization !erformance in !akistan.Bankin% &n!ustr' ( Post Pri"ati)ation

Performance in Pakistan, +). 4awab. n.d./. *The Ra+i! ,ro#th of Bankin% Sector in Pakistan an! its &m+acts on

Re"enue ,eneration-, )6.

4awab. n.d./. *The Ra+i! ,ro#th of Bankin% Sector in Pakistan an! its &m+acts on

Re"enue ,eneration-, )+.

'ehman. 6:):/. 8fficiencies of !akistani Banking ector< # =omparative tudy.

Efficiencies of Pakistani Bankin% Sector. A /om+arati"e Stu!', ))6.

'ehman, E 'aoof. 6:):/.Efficiencies of Pakistani Bankin% Sector. A /om+arati"e

Stu!', ))).

'ehman, E 'aoof, #. 6:):/.Efficiencies of Pakistani Bankin% Sector. A /om+arati"e

Stu!', ))).

Documents

Financial Sector Reforms and the Efficiency of Banking Sector in Pakistan