KARACHI, Sept 4: Despite reforms spanning over a decade, a diversified and sophisticated capital market, though growing, remains "narrow and shallow" by regional standards and the financial system is "dominated" by commercial banks.

"Trading is highly concentrated, with just over half in the top 10 shares and 95 per cent in the top 30" of the 693 listed scrips, says an IMF financial sector assessment made for the end of the year 2003.

With assets controlled by commercial banks at 54 per cent of the Gross Domestic Product as compared to 57 per cent of the GDP for all financial institutions, the banks dominate the financial system. Over 75 per cent of the total banking assets are in the private sector. Relatively, the capital market, insurance and other non-bank intermediaries and instruments are small.

"A more developed and efficient securities markets, including both equity and debt, can help reduce a bank-dominated financial system," recommends the IMF report.

Stock market capitalization at $16.5 billion, is equivalent to 24 per cent of the GDP as compared to $280 billion or more than 50 per cent of India's GDP (end-2003) and $127 billion or 130 per cent of Malaysia's GDP as of end-2002. While increasing, the total investor base is less than 0.5 per cent of the population.

Somehow, the environment for listing of shares is not conducive. The government has attempted to broaden the base of ownership by off-loading shares of profitable state enterprises at the stock exchanges. But for a handful, the 40,000 strong private companies are hesitant to go for listing.

The low interest rates and narrowing difference in corporate tax on listed and private limited companies has combined with corporate law hassles to discourage private firms from listing shares at the stock exchanges. Those who do not want to share profits with minority shareholders also prefer private companies or partnerships, more so, when no long-term investment is intended, which in the past was also primarily foreign debt-driven.

The domestic investment pattern is also undergoing a change. The Investment Climate Survey by the World Bank in March 2003 indicated that by far the greatest source of finance for both small and large firms was retained earnings. Short-term investments aimed at strengthening of businesses are more self-financed than before. World Bank surveys of SMES indicated that they received seven per cent of their working capital and 7.3 per cent of their investment finance requirements from banks and other financial institutions as compared to 13.3 per cent and 23.6, respectively, for large firms.

Large segments of the population continue to operate with informal credit because business costs in the formal sector are prohibitive.

While the outstanding stock of credit to the corporate sector has been generally stable, says the IMF report, bank lending to small and medium enterprises and households has been increasing rapidly.

The share of personal loans, primarily auto loans, mortgage and credit cards, which was negligible in the mid-1990s, had risen to 12 per cent of the total bank credit as of September 2003.

Commercial banks have now overtaken the public sector specialized banks (under financial distress/restructuring) in providing agriculture, SME and housing finance. There is a surge in mortgage loans, but these remain low at under one per cent of GDP and are handicapped by significant obstacles. In 2003, it was estimated that bank credit reached 15 per cent of all farms.

The strength of the capital market and the financial system lies in a much wider dispersal of financial assets among an increasing range of institutions offering a variety of products and specialized services to the underserved segments of the market. And the good news is that IMF stress tests suggest that "the banking system could withstand shocks consistent in severity with historical experience."