Commercial banks have dominated the financial sector, and non-bank finance companies (NBFCs) have yet to fully exploit their potential. At the end of June 2006, total assets of NBFCs stood at Rs388 billion or just seven per cent of assets of the entire financial sector.

Mutual funds which are the largest constituent of non-bank financial sector are growing fast but their deposit base of Rs180 billion is equal to just five per cent of banks’ deposits of Rs3.2 trillion. However, since mutual funds provide a much higher tax-free return than the banks do, they have the potential to emerge as real competitors of commercial banks.

Whereas these funds offer up to 15 per cent return on fixed income assets, the average return on three to five-year term deposits of banks is a little over seven per cent. Besides, the return on mutual funds is tax-free.

However, the increase in the rates of return on national saving schemes, (NSS), tightening of monetary policy and the recent incentive given to banks to raise fixed deposits pose challenge to the mutual funds.

In the last two fiscal years, the government increased the return on popular National Saving Shemes by 1.5-2-percentage points and it re-allowed institutional investment in NSS. And the monetary tightening has pushed up the average deposit rates of banks by two percentage points.

And to top it all, the State Bank has now ruled that banks that mobilise fixed term deposits of one-year and longer maturity would enjoy exemption from keeping a seven per cent cash reserves.

Much of future growth of NBFCs depends upon the outcome of the second-generation capital market reforms. A recent report by the Board of Directors of the Asian Development Bank questions the institutional independence of and regulatory capacity of SECP, which it says are undermined by the direct intervention of the ministry of finance.

The bank has also linked the release of the promised $400 million for these reforms to convert SECP into Financial Services Commission of Pakistan (FSCP) for making its role more effective. The ADB wants that FSCP should be in charge of regulation and supervision of all non-bank financial institutions.

One of the most important conditions attached with the release of the $400 million reforms package is that FSCP would have to adopt reporting requirements of holding companies that own or control NBFIs.

DFIs: Development finance institutions (DFIs) are the second largest segment of non-bank financial sector. But their performance has somewhat declined recently. In the last calendar year, the ratio of non-performing loans of DFIs to their total loans jumped to 21.1 from 15.4 per cent a year earlier. And their after-tax profits also fell to Rs2.9 billion from Rs5.5 billion.

This happened due to over-reliance on capital gains, high equity exposures and costly borrowings. As interest rates rise, it will be difficult for DFIs to expand lending operations..

The return from capital gains hinge upon the stock market behaviour, which is quite volatile and cannot be relied upon for regular streams of income.

“Hence, the DFIs need to look out for more economical sources of funds, while broad-basing deposit mobilisation efforts so as to ease out their cost structure,” recommends a State Bank report.

It was the weak management of the locally-sponsored and public sector DFIs that led to their liquidation (Bankers Equity Ltd.) or take-over (NDFC) in 1990s.

For first few years, this situation created problems for those securing finances for long-term projects. But then those venture capital projects or DFIs that were set up in collaboration with other nations, tried to fill up the gap. Banks also participated in such syndicated financing in which these DFIs being lead arrangers evaluated the viability of the projects and determined the modes and scope of the financing.

Pakistan Kuwait Investment Company, for example, arranged long-term financing facility, syndicated or otherwise for Wapda, KESC, Pak-Arab Refinery and National Refinery both in local and foreign currencies.

The recent take-over of PICIC by Singapore-based Tamasek Holding has brightened the chances for creating depth in the DFIs operations.

IFCs: In FY2003, status of investment banks was changed into that of investment finance companies which opened up many new avenues of business for them. So, IFCs now have the opportunity to grow faster than before. In addition to doing their conventional job of investment financing, IFCs are also involved in underwriting securities, private placements, and financial advisory services for acquisitions, restructuring, etc.

Besides, they have increased brokerage activity either through obtaining brokerage licenses or through acquiring independent brokerage houses. One or two offer housing finance also. Though the number of investment banks has fallen over the years because of the consolidation phase they underwent before becoming IFCs, they have become stronger.

HFCs: As for housing finance companies, the House Building Finance Corporation (HBFC) continues to dominate the market. Having been in this business for well over five decades, HBFC is well positioned to cater to a very large number of borrowers.

Currently it is operating in more than 80 cities and plans to expand its outreach to 100-110 cities at the turn of this year. There are a few other institutions offering housing finance but they are very selective and cater to only a very small percentage.

Banks too offer housing loans on a limited scale. Besides, unlike HBFC, others offering housing finance charge a much higher interest rate thus closing down the doors on small and lower middle income borrowers.

Lately, banks have accelerated disbursement of housing loans and offered more than Rs27 billion in fiscal years 2005 and 2006 showing a 100 per cent increase in the volume of lending in two years.

Leasing Cos: Leasing companies, the third largest constituents of non-bank financial sector, have maintained a reasonable growth rate in the recent past. However, due to growing competition with banks since fiscal year 2003 and the increase in minimum capital requirement, smaller leasing companies have opted for merger with stronger institutions or voluntary liquidations. The number of leasing companies has dropped from 33 in FY2000 to 23 in FY2006.

“Now, to maintain a decent growth rate, leasing companies need to broaden branch network and increase their outreach particularly in smaller cities,” says a SBP report. “They also need to venture into newer areas of leasing in addition to automobile, machinery and equipment.” A few large leasing companies have already experimented with leasing in agriculture products and others say they may follow suit. In FY07 the net profit of the leasing sector fell from Rs2.2 billion to Rs1.6 billion but their cumulative cash dividends jumped from Rs366 million to Rs627 million.

Modarabas: Mergers, acquisitions and takeover of modarabas within and across other sectors were witnessed during the last six years. As a result, the number of modarabas fell from 45 in FY00 to just 25 in FY06.

The SECP had allowed modarabas in FY2003 to issue Musharaka based term finance certificates (TFCs). But the move did not raise enough resources at low cost.

The reconstitution of the Religious Board for Modarabas in FY2005 also could not make any significant impact by paving the way for modarabas to introduce more innovative financing products.

However, in their strive for survival amidst stiff competition from banks, modarabas have started focusing on diversifying their assets base. They are making their debut in the real estate and housing, financing and setting up of CNG filling stations and radio cab services. Modarabas are also making efforts to set foot in the areas of agricultural leasing, SME financing and Takaful/Islamic insurance.

In the last fiscal year, 18 out of 25 modarabas performed well enough to declare cash dividends and their cumulative payout increased 27 per cent compared with FY06.