Banking Sector Supervision in Pakistan

State Bank of Pakistan (SBP) which is the Central Bank of the country has been interalia entrusted with the responsibility for an ongoing effective supervision of the banking sector. The relevant provisions of law which vest powers in State Bank of Pakistan (SBP) to carry out inspection of banks are contained in the Banking Companies Ordinance, 1962. Besides, State Bank of Pakistan Act, 1956 and the Bank’s Nationalization Act, 1974, The Financial Institutions (Recovery of finances) Ordinance, 2001, Companies Ordinance, 1984 and Statutory Regulatory Orders (SROs) are the relevant legislations, which cover the activities concerning the banking sector.

The financial sector in Pakistan comprises of Commercial Banks, Development Finance Institutions (DFIs), Microfinance Banks (MFBs), Non-banking Finance Companies (NBFCs) (leasing companies, Investment Banks, Discount Houses, Housing Finance Companies, Venture Capital Companies, Mutual Funds), Modarabas, Stock Exchange and Insurance Companies. Under the prevalent legislative structure the supervisory responsibilities in case of Banks, Development Finance Institutions (DFIs), and Microfinance Banks (MFBs) falls within legal ambit of State Bank of Pakistan while the rest of the financial institutions are monitored by other authorities such as Securities and Exchange Commission and Controller of Insurance.

Under the WTO commitments the operational status of branch network of foreign banks operating in Pakistan as on 31-12-1997 has been protected and frozen. However, existing foreign banks having less than 3 branches can have branches to the extent of maximum number of 3 only. New foreign banks desirous of entering banking business in Pakistan will now be required to incorporate as domestic bank under the local laws. The branches of foreign banks operating in Pakistan can also be converted into a local commercial bank by incorporating under the local laws and subject to a minimum paid up capital of Rs.1 billion provided foreign share holding is restricted to a maximum of 49%.

At present there are 41 scheduled banks, 6 DFIs, and 2 MFBs operating in Pakistan whose activities are regulated and supervised by State Bank of Pakistan. The commercial banks comprise of 3 nationalized banks, 3 privatized banks, 15 private sector banks, 14 foreign banks, 2 provincial scheduled banks, and 4 specialized banks.

Under the Banking Companies Ordinance, 1962 the State Bank of Pakistan is fully authorized to regulate and supervise banks and development finance institutions. During the year 1997 some major amendments were made in the banking laws, which gave autonomy to the State Bank in the area of banking supervision. Under Section 40(A) of the said Ordinance it is the responsibility of State Bank to systematically monitor the performance of every banking company to ensure its compliance with the statutory criteria, and banking rules & regulations. In every case in which the management of a bank is failing to discharge its responsibility in accordance with the applicable statutory criteria or banking rules & regulations or is failing to protect the interests of the depositors or for advancing loans and finance without due regard for the best interests of the bank or for reasons other than merit, the State Bank is empowered to take necessary remedial steps. The State Bank of Pakistan can, interalia, exercise the following powers vested upon it under the Banking Companies Ordinance:-

Prohibiting the bank from giving loans, advances & credits. Prohibiting the bank from accepting deposits. Cancel license of a bank. Give directions to the bank as it deem fit. Remove chairman, directors, chief executive or other managerial persons from the office and appoint a person as chairman, director or chief executive.

Supersede the Board of Directors. Direct prosecution of directors, chief executive or other officer. Caution or prohibit bank against entering into any particular transaction(s). Require bank to make changes in management. Appoint its officers to observe the manner in which affairs of bank/its branches/office are conducted. Winding up the bank through high court. Apply to Federal Government for an order of moratorium in respect of a bank and to prepare scheme of reconstruction or amalgamation. Impose penalties including civil money penalties.

The State Bank has framed Prudential Regulations for banks and Rules of Business for DFIs that present a prudent operating framework within which banks and DFIs are expected to conduct their business in a safe and sound manner taking into account the risks associated with their activities. These regulations incorporate the spirit and essence of BIS regulations and are constantly watched for possible improvement so that their enforcement yields the best results to promote the objectives of supervision.

The State Bank is empowered to determine Statutory Liquidity and Cash Reserve Requirements for banks/DFIs. Presently the Cash Reserve Requirement is 5% on weekly average basis subject to daily minimum of 4% of Time & Demand Liabilities. In addition to that banks are required to maintain Statutory Liquidity Requirement (SLR) @ 15% of their Time & Demand Liabilities. Similarly, DFIs are required to maintain SLR of 14% and Cash Reserve of 1% of their specified liabilities. Additionally, The Banking Companies Ordinance had been amended in 1997 which empowers the State Bank to prescribe capital requirements for banks. In exercise of these powers the State Bank has laid down Minimum Capital Requirements for banks based on Basle capital structure. The banks have to maintain a Capital Adequacy Ratio in a way that their capital and unencumbered general reserves are, at the minimum, 8% of their risk weighted assets, and effective from 1st January, 2003 banks are required to maintain a minimum paid up capital level of Rs.1 Billion.

While the off-site monitoring aspect is looked after by the State Bank of Pakistan’s Banking Supervision Department the responsibility for the on-site examination of the banking system in Pakistan lies on the shoulders of the Banking Inspection Department. This has been designed to ensure that institutions operate in a safe and sound manner. The focus of the supervisory efforts by the State Bank of Pakistan is on the health and stability of the banking system in Pakistan.

Off-Site Monitoring at BSD

The objectives of off-site surveillance over the banking system are:-
to monitor the condition of individual banks, as well as condition within the banking system; to provide early identification of problems so that corrective action can be effected; and to target scarce on-site supervisory resources to areas or activities of greater risk.

Off-site surveillance system revolves around receipt, review and analysis of periodic financial statements and returns submitted to the State Bank. The off-site analysis facilitate monitoring of each bank’s performance and its observance of supervisory requirements over time, so that problems may be identified as soon as these emerge. The process thus assists in making the most effective use of scarce on-site inspection resources. The system also works as an early warning to identify those areas which reflect high probability of financial difficulties so that policies and corrective actions can be designed and implemented accordingly.

In consonance with the responsibilities envisaged under the Core Principles recommended by the Basle Committee, the On-Site examination capabilities at the State Bank of Pakistan have been substantially augmented to bring them at par with the expected international standards. While regulations have existed for some time aimed at convergence of the essential industry indicators to the globally accepted criteria, a risk-based approach to evaluations has been adopted by the bank in all its assessments. Periodic On-Site examinations of the financial condition of institutions, falling within SBP’s jurisdictions, remains the most effective supervisory tool, which support Banking Supervision Departments in maintaining a proactive approach in discharge of the statutory responsibilities.

The State Bank of Pakistan’s policy for frequency of inspection of banks and DFIs is designed to provide flexibility in scheduling inspections consistent with the need to maintain safety and soundness. The policy provides a framework within which supervisory ratings, surveillance and financial monitoring results, and other appropriate indicators of banks soundness, are to be considered in carrying out the State Bank of Pakistan’s fundamental policy of subjecting each bank and non-bank financial institution under its supervision to a periodic on-site inspection.

With a view to streamline the approach and the underlying procedures for effective and efficient banking supervision State Bank of Pakistan has embarked upon a major overhauling of its own capabilities so as to bring them at par with international practices. This entailed hiring of services of consultants of world repute (M/s. Arthur Andersen) under the FSID Project of the World Bank. These Consultants have compiled extensive on-site and off-site manuals. Besides qualified and professional trained human resource have been recruited and rigorous theoretical and hands-on training has been provided to them. With the shift in supervisory focus from ‘compliance oriented’ to ‘Risk Assessment Approach’ State Bank of Pakistan has developed a uniform bank rating system in conformity with international standards/benchmarks. Now each bank is appraised under the CAMELSS/CAELS Rating System.

In order to portray a legitimate and true financial condition of a bank the off-site surveillance system and the on-site inspection functions of banking supervision work extremely close together. As a result of these close coordination bank ratings reflects as accurately as possible, the true financial condition of a bank and the banking system as a whole.