Pakistan’s banking sector, largely dominated by public sector banks, suffers from the high intermediation costs, resulting from overstaffing, large number of loss-incurring branches, and a large non-performing loan portfolio. These factors make public sector banks unattractive for privatization.

Pakistan’s financial system comprises the State Bank of Pakistan, four nationalized commercial banks, two partially privatized banks, 3 specialized banks, 21 foreign commercial banks, 12 private domestic banks, 3 provincial commercial banks, 12 development finance institutions (DFIs), 15 investment banks, 33 leasing companies, 51 modarabas, 42 mutual funds, 3 stock exchanges, and 68 insurance companies.

The country undertook financial reforms in early 1990s to establish a more market-based system of monetary management. The reforms were designed primarily to correct the distortion implicit in the administered structure of rates of return on various financial instruments, to do away with the directed credit programmes, to enhance competition and efficiency in the financial system, and to strengthen the State Bank of Pakistan (SBP) supervision.

The government partially privatized two nationalized commercial banks (NCBs), and introduced an auction system for government securities as steps towards interest rate liberalization and open market operations. The SBP was granted greater autonomy in February 1994.

However, since interest rate liberalization preceded fiscal reforms, interest rates shot up, contributing to a further increase in debt servicing costs and the budgetary imbalance. Another important development was the deregulation of resident foreign currency accounts in February 1991.

Further financial liberalization was constrained by a marked deterioration in the financial position of the NCBs, which continued to dominate the banking sector.

This sector as a whole experienced declining profitability, increasing inefficiencies, a weakening of capital base, and a buildup of non-performing assets (NPAs). The stock of non-performing loans (NPLs) grew from Rs25 billion in 1989 to Rs128 billion in June 1998, or 4 per cent of gross domestic product (GDP), while total deposits grew only a little faster than inflation.

An increasing dollarization of the economy, growing direct borrowing by the government, low return on bank deposits due to high reserve requirements and the inefficiency of banks, especially the NCBs, and the lack of savers’ confidence in the NCBs also added to the grim banking scenario in Pakistan.

The foreign currency deposits grew rapidly to $11 billion by July 1997, accounting for half of the country’s total bank deposits, compared to less than $3 billion in the early 1990s. Their rapid increase reflected erosion of confidence in the rupee and strong attraction of tax incentives and the anonymity regarding the origin of the foreign exchange.

Despite liberalization in the early 1990s, financial markets continued to be segmented into the private and public sectors owing to continuing controls on interest rates paid on government debt and to special credit programmes.

The financial sector reforms in 1997/98 were under-taken mainly to promote financial saving, improve the process of financial intermediation, enhance competition, and assure efficient allocation of financial resources. Efforts to achieve these ends, however, have been hampered by political interference,aside from the lack of financial support to carry out banking reforms.

The Musharraf government has also launched banking reforms — Pakistan Banking Sector Restructuring and Privatization Project— in a bid to revitalize the banking sector. These reforms are focussing on privatization.

The World Bank has recently approved a $300 million credit to assist Pakistan with its banking reform programme. The World Bank officials believe the loan will ultimately help reduce poverty in the country. According to the WB research, a sound and efficient financial system contributes greatly to poverty reduction by leading to higher economic growth. The loan carries a low service charge of 0.75 per cent, maturing over 35 years with a 10-year grace period.

It was the government’s policy to restrict itself to soft borrowings on favourable terms. Central to the reforms is the restructuring of the nationalised banks, which would help stimulate competitiveness within the banking system.

Ten years ago, Pakistan allowed the privatization of banks, but the impact was limited, because five large banks dominated the marketplace. Under the latest project, the government would privatise nationalized banks to make the sector more competitive.

The Pakistan Banking Sector Restructuring and Privatization Project is expected to enable the country to develop a competitive private banking system, more effective banking courts, and a regulatory framework.

The entire sector was being re-profiled, with new taxation and recovery laws being introduced. The nationalized banks were also to be restructured and freed from vested interests. The 49 per cent stake in the Allied Bank would be offloaded in the process.

The World Bank is also encouraged by Pakistan’s commitment to reforming the institutional workings that underpin a healthy economy. The government has demonstrated that a safe and sound banking system is fundamental to Pakistan’s ability to create the conditions needed to bring about sustainable growth and a better life for its 138 million people.