3 Ensuring Soundness of Financial Sector

3.1 Overview
State Bank of Pakistan derives its goal of financial stability from its legal mandate, as specified in the
State Bank of Pakistan Act, 1956, responsible for securing monetary stability and soundness of the
financial system. Financial stability is defined in terms of the need to ensure and promote, in a
lasting way, and without major disruptions, an efficient allocation of savings to investment
opportunities1. Generally, maintaining financial stability depends on effective financial regulations
which aim to provide the right set of incentives for the prudential conduct of, and risk behavior by
financial institutions. The primary objective of financial stability policies and assessment is to
provide early warning signals for crisis prevention as distinct from crisis mitigation. Stability of the
financial system promotes: (i) a smooth and efficient financial intermediation processes that allocate
savings to profitable investment opportunities, (ii) balanced development of different segments of the
financial system, and (iii) proper transmission of monetary policy, whose effective conduct and
implementation in turn facilitates price stability.

State Bank of Pakistan (SBP), the central bank and primary regulator of the financial sector, given its
dual mandate of monetary policy and financial regulation and supervision, is in a unique position to
conduct financial stability. SBP has a finger on the pulse of the economy and as such is able to
decipher the monetary transmission mechanism and its impact on the economy and the financial
sector. At the same time, vigilance on banking sector helps SBP to understand the financial
transmission mechanism which helps in the formulation of the overall policy stance.

SBP has now been conducting financial stability analysis for the last 5 years or so. However, the
framework for financial stability is still evolving. Starting in 2002, SBP conducted annual Financial
Sector Assessment Program dovetailed with quarterly and annual Banking Surveillance Report.
Integrating these reports, in 2007, SBP launched its first comprehensive Financial Stability Review
(FSR) that offers a rich assessment of risks and vulnerabilities of financial sector and macroeconomic
challenges.

With the objective of institutionalizing financial stability analysis, there was a need to have a
designated department which can spearhead independent analysis and research, make policy
recommendations, and monitor financial stability issues on an ongoing basis, as done in other central
banks around the globe. Hence in February 2008, a separate Financial Stability Department was
established in the Monetary Policy and Research Cluster, tasked with providing independent, policy-
induced research on the financial sector to enable State Bank of Pakistan to achieve its objective of
financial stability. The Financial Stability Department works in close coordination with both Banking
Policy and Regulations Department (BPRD) and Banking Surveillance Department (BSD), in order to
achieve its objectives.

With this overview in mind, the rest of the chapter is dedicated to discussing the various regulatory
measures taken by the SBP during FY08 to ensure the stability of the financial sector.

3.2 Ensuring Stability of the Banking System

3.2.1 Capacity Building and Basel-II

Basel-II is a process rather than a destination therefore its implementation is an ongoing exercise.
Skilled human resources, authentic data, and efficient IT systems are the prerequisites for smooth
1
Mishkin, F. (1991): Anatomy of financial crisis, NBER Working Paper, No. 3934
37
State Bank of Pakistan Annual Report 2007-2008

implementation of Basel -II. State Bank has always encouraged banks to adopt international best
practices, develop systems and human resource skills. It has adopted a two-pronged approach for
capacity building of the banking sector. SBP arranged a seminar on Basel II with the help of Standard
Chartered Bank, UK to enhance the knowledge base of local bankers especially those related to the
execution of Basel II. In addition, a SAARCFINANCE Seminar on Basel-II was held in Islamabad
from June 26-28, June 2008.The purpose of the seminar was to share country experiences of Basel II
implementation. State Bank has also arranged several trainings / presentations / seminars on different
topics under Basel II for internal stakeholders. These programs helped SBP human resources to learn
different techniques adopted under Basel II and grasp the intricacies involved in its implementation.
Six cross functional teams have been deployed to address the issues pertaining to various areas i.e. (i)
Credit Risk Standardized Approach (ii) Credit Risk Advanced Approaches (iii) Operational Risk
(iv) Market Risk (v) Pillar II (Supervisory Review Process) and (vi) Pillar III (Disclosure
Requirements). Members of these teams have diversified experience. Banking Inspection staff share
their practical knowledge and industry practices to assist the back office functions of the Banking
Surveillance Department.

3.2.2 Implementation of Basel II

Implementation of the Standardized Approaches of Basel II commenced from January 01, 2008. Basel
II requires more rigorous measures for calculation of Capital Adequacy Ratio (CAR) in contrast to
Basel I. Basel II is not only more risk sensitive but also extends to such risk areas which are not
covered under Basel I. Supervisors / Regulators would have to act proactively to assess the risks of
the banks at individual and industry level. As stipulated by the State Bank, the banks / DFIs furnished
their 1st MCR statements under Basel II framework on 31-12-2006 while parallel run will continue
till 31-12-2008. SBP had provided detailed reporting formats under the new framework. Minimum
Capital Requirement (MCR) Reports as of 31-12-2007 of the banks / DFIs have revealed that they are
maintaining Capital Adequacy Ratio (CAR) of 13.86 percent under Basel II. However, this ratio is
lower than the CAR of 14.74 percent under Basel I. The consolidated data of all banks / DFIs at 31-
12-2007 shows the total eligible capital under Basel II is Rs. 542.23 billion as compared to Rs. 553.08
billion under Basel I. The reduction in the banking sector capital is due to more deductions applicable
under the new framework. Total Risk Weighted Assets (TRWA) under Basel II remained at Rs.
3,912.89 billion on 31-12-2007 while these constitute Credit Risk Weighted Assets (83 percent of
TRWA), Market Risk Weighted Assets (5 percent of TRWA), and Operational Risk Weighted Assets
(12 percent of TRWA). Under Basel II, Operational Risk is a new category whereas investments
Available for Sale (AFS) along with Held for Trading (HTM) have also been included to calculate
market risk.

3.2.3 Changes in CRR/SLR and Changes in CRR/SLR on F.E. 25

Cash Reserve Requirement (CRR) and Statutory Liquidity Requirement (SLR) are used as tools of
monetary policy. State Bank of Pakistan revised the definition of Time and Demand Liabilities in
August 2007, to exclude deposits with tenor of less than one year from time liabilities and included
the same in demand liabilities. This step was taken considering the overall liquidity situation of the
banks and DFIs and to promote monetary stability by providing incentive of zero CRR to banks on
deposits / liabilities which were long term in nature and hence less volatile.

To facilitate Islamic banking, the Islamic banks and branches were allowed to include their cash in
hand and balance with National Bank of Pakistan held in current account towards SLR. To further
encourage the Islamic Financial Products, GoP announced the Sukuks issued by Karachi Shipyard and
Engineering Works (KSEW) and WAPDA as SLR eligible. Presently the required level of CRR is
same for Islamic banks / branches and conventional banks, these are:-
Weekly average of 9% (subject to daily minimum of 8%) of total Demand Liabilities
(including Time Deposits with tenor of less than 1 year).
Time Liabilities with tenor of 1 year and above does not require any cash reserve.
38
 Ensuring Soundness of Financial Sector

Whereas SLR for commercial banks is 19% (excluding CRR) of total time and demand liabilities and
Islamic banks/Branches are required to maintain SLR at 9% of their time and demand liabilities.

Moreover, Special Cash Reserve Requirements (SCRA) against FE-25 deposits, maintainable against
US dollar equivalent amount, was lowered for from 15% to 5% for commercial banks and for Islamic
banks/branches the same was dropped from 6% to 2%. In June 2008, however, with overall
improvement in foreign exchange market liquidity, threshold for SCRR against FE-25 deposits was
raised to its original position. In addition to SCRA, all banks are required to maintain cash reserve
against their FE-25 deposits in US dollar equivalent amount at the rate of 5%.

3.3 Strengthening Legal Framework

A strong and robust financial system has its footings in an effective legal and regulatory framework.
With a mandate to ensuring the soundness and stability of the financial sector, SBP played a key role
in formulating an enabling legal environment. The Anti-money Laundering Ordinance was
enforced in September, 2007 through Presidential Ordinance. SBP has major contribution in drafting
and finalization of the law. The Ordinance criminalizes money laundering and requires financial
institutions to report Suspicious Transaction Reports (STRs) and extend mutual legal assistance on
bilateral basis. The thrust of the law is to meet FATF recommendations. The Ordinance would go a
long way in protecting financial sector from being used for money laundering and other financial
crimes.

3.3.1 Enhanced Focus on Corporate Governance

To cope with the changing pace of banking business and recent corporate governance scams
throughout the world, SBP has been striving hard to strengthen its corporate governance regime by
broadening the scope of its Fit and Proper Test (FPT). Sponsor shareholders/directors have been
clearly defined. They are now required to transfer their shares in a Blocked Account with CDC by
July 31, 2008 to ensure continued stake/ownership in banks and to avoid use of sponsor shares as
collaterals for financing

3.3.2 Restructuring/Privatization of Banks/DFIs

To turn around the financially distressed and inadequately capitalized financial institutions, SBP has
been working on restructuring/ recapitalization of number of banks. SBP is actively coordinating with
the Privatization Commission (PC) to finalize the privatization transaction of SME Bank. After
completing the due process and related legalities by the financial advisors, PC called for Expression
of Interest (EOI) from interested strategic investors. Short listing of the interested parties is under
process.

SBP is also working on the recapitalization of First Women Bank Limited (FWBL). SBP, in
consultation with the Ministry of Finance (MoF), engaged IFC to conduct a study on FWBL, and
formulate a roadmap, containing various options and main steps to be taken by the Board and
Management of the bank, to attract potential investment in FWBL. After thorough deliberations MoF
delegated SBP to take necessary steps to restructure and privatize FWBL. SBP initiated the process of
recapitalization of FWBL and transfer of management to a Strategic Investor in the light of IFCs
recommendation and engaged Financial Advisors for the transaction through a transparent and
competitive process. The process is at final stages and transaction structure will be finalized shortly.

The restructuring process of IDBP is also on the anvil. SBP has forwarded a complete financial
restructuring plan for IDBP to the federal government. An independent valuation of the bank has been
carried out and SBP is coordinating with the federal government for the best option. Once a decision
is made by the government, SBP will process the transaction on fast track basis. Khushhali Bank

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State Bank of Pakistan Annual Report 2007-2008

Limited has been successfully restructured by changing its legal structure and the process of its
strategic sale to a strategic investor with appropriate interest and capacity to develop microfinance.

3.3.3 Enhancing the Outreach of Banking Services through Branchless Banking

Branchless banking guidelines were issued after exhaustive deliberations with all stake holders.
Branchless Banking is a recent innovation and is expected to shift and change the mindsets of masses
from traditional branch banking to the new way of doing business. Branchless Banking is a
significantly cheaper alternative to conventional branch-based banking and it allows the banks to offer
financial services outside traditional bank premises. The delivery channels like retail agents, mobile
phone are to be used in branchless banking. One inherent feature of Branchless banking is that it can
be used to substantially increase the financial services outreach to the un-banked communities and at
the same time it helps in the promotion of financial inclusion in the country.

3.3.4 Mergers and Acquisitions in the Banking Sector

The financial system of Pakistan has embarked upon a guided consolidation process since early 2000.
The aim is to foster financial stability by encouraging merger and acquisition within the financial
sector having fewer but stronger banks capable of utilizing the economies of scale and withstanding
economic downturns. The scope of consolidation through merger and acquisition has not been
confined to the banking sector only rather the scope has been much broader, incorporating the entire
financial sector, including leasing companies, investment banks and modarabas. The initiatives of
merger among banks and NBFCs were further accelerated by the raising of regulatory minimum
capital requirements9MCR) for banks and certain tax incentives offered in this regard

During the last 7 years, SBP has processed 10 acquisitions and 40merger transactions. Most of the
transactions were merger of investment banks with commercial banks and banks with other banks
while other transaction involved merger of DFIs/leasing companies with commercial banks. The
exercise so far, has had a mixed color with both local and foreign stakeholders taking ownership of
the banks. The recent transactions have witnessed higher foreign participation wherein ownership and
management have been entrusted to the new acquirers after regulatory clearance granted.
To streamline consolidations, SBP took many important policy measures. A number of amendments
were made in the legal framework to facilitate the process. Section 48 was amended to allow merger
of NBFCs with banks under provisions of BCO, 1962. Foreign banks operating in branch mode has
been defined as foreign banking companies in BCO 1962. To facilitate merger of foreign banking
companies with other banks, Section 48 of BCO 1962 has been amended, wherein such scheme
approved by the foreign banking companys head office can be sanctioned by SBP. SBP also
proposed amendment in Income Tax Ordinance like section 57-A which was incorporated to carry
forward of tax losses both amalgamated (target) and amalgamating (surviving) institutions.

These initiatives adopted by SBP resulted in reducing the number of banks from 46 in 1997 to 39 in
the 2008, despite the fact that SBP issued new licenses to four Islamic banks and one foreign bank.
The consolidation process has also contributed in strengthening the capital position of most of the
merged entities. Moreover, consolidation also added to the development of a healthy competitive
environment among bigger and stronger financial institutions. The number of foreign banking
companies operating in branch mode decreased from 20 in 2000 to 7 in June 2008 due to change in
their business strategies, resulting in selling of their business to locally incorporated banks and/or
conversion of branch status to locally incorporated subsidiary. Going forward, if the process of
consolidation continues, more stable banking system can be expected in the country.

3.3.5 Issuance of Global Depository Receipts

After gaining internal strength and stability, Pakistani banks started exploring opportunities for equity
rising from capital markets abroad. To facilitate the banks in their efforts, SBP issued guidelines on
issuance of Global Depository Receipts (GDRs). So far GDRs of MCB and UBL have been issued.
40
 Ensuring Soundness of Financial Sector

NBP GDRs are in process and will be completed shortly. To facilitate the issuance of NBP GDR, the
Bank Nationalization Act was amended on the recommendations of SBP. A financial adviser has
been hired however; the transaction could not be started due to liquidity crisis in the international
markets and some other reasons. The transaction is expected to be completed this year.

3.3.6 Enhancing the Outreach of Bank Branches

State Bank of Pakistan Act 1956 and the Banking Companies Ordinance 1962 provides legal frame
work for licensing of bank branches. Under Section 28 of the Banking Companies Ordinance 1962,
State Bank of Pakistan has introduced a comprehensive branch licensing policy (BLP) for allowing
the banks to independently make their branch housing decision within broad parameters. One of the
most important mainstays of SBP Branch Licensing Policy (BLP) is to increase the level of outreach
of the branches by making it mandatory for banks with a network of more than 100 branches to open
at least 20 percent of their planned branches in the rural or underserved areas, outside the jurisdictions
of big cities where no branch of any bank exist. However if banks are interested to open more than 20
percent branches in rural areas they may approach SBP anytime for permission. Furthermore, the
revised BLP provides new options for enhancing the outreach of financial services which include
opening of sub-branches, where bank can perform limited functions controlled by any nearby big
branch allowing the bank to perform functions like cash receipt, payments, issuance of DD, PO, TT,
MT and TCs, etc. Account opening, issuance of account number, KYC and CDD, however, will be
performed by the controlling branch.

3.3.7 Protection of Borrowers and Depositors - Instructions on Lending and Deposit Rates
Depositors and bank borrowers are the two arms of flow of funds in the financial sector. To protect
the interest of the depositors SBP advised all banks to pay a minimum of 5 percent profit to all
depositors regardless of their account balances. On the other hand, to protect the interests of the
borrowers, SBP advised the banks to ensure transparency and adequacy in re-pricing of loans, loan
frequencies and loan documentation by linking the loan re-pricing to the relevant KIBOR rates. Banks
were also advised to make complete disclosure of the lending and deposit rates of all consumer
products offered by them and to clarify the pricing structure of the loan in the loan agreement.

3.3.8 Guidelines on Outsourcing Arrangements

Banks are increasingly using third party services to carry out activities, functions and processes as
outsourcing arrangements to meet new and complex challenges like innovation in technology,
increasing competition, economies of scale and improvement in quality of service to clients (i.e.,
customers, depositors or investors). The practice, however, can increase their dependence on third
parties and consequently their risk profile. Especially, the outsourcing of I.T related processing
activities outside Pakistan, which sometime involves divulgence of sensitive customer data to third
parties, can have serious repercussions for the concerned financial institution and its customers in
particular and the financial system in general. To mitigate such risks and to allow Banks/DFIs to
effectively manage the outsourcing arrangements, SBP issued guidelines on outsourcing
arrangements.

3.3.9 Entry of New Players in the Banking Sector

The soundness and stability of any financial sector can be gauged from the interest/entry of reputable
international financial institutions/groups in the sector. Pakistans banking sector is performing well
attracting foreign investors. Barclays Bank Plc, a subsidiary company of Barclays Plc, was also issued
a license to start banking business in branch mode as a foreign banking company. Barclays Plc is
listed in London, New York and Tokyo. Barclays Plc is the 18th largest company in the world
according to Forbes Global 2000 rankings (2007 list). The bank has brought US$ 90 million, SBPs
minimum capital requirements. In the first year the bank plans to operate 10 branches. Pakistani
operations will benefit significantly from the synergies and knowledge that Barclays, as one of the
largest financial services providers, can offer. Its presence in the market will translate into superior
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State Bank of Pakistan Annual Report 2007-2008

customer service and will also contribute to financial inclusion and modernization. In the recent past,
number of reputable international financial institutions like Temasek Holding Singapore, ABN
AMRO Bank, Standard Chartered Bank, SAMBA Financial Group of Saudi Arabia, DEG Germany,
Nomura European Investment, International Finance Corporation, etc have acquired strategic stake in
various banking institutions. Entry of such strong foreign banks is a harbinger of the confidence of
international business community in Pakistans economy generally and banking sector particularly.

During 2007-08, three Development Financial Institutions (DFIs) viz Pak Iran Joint Investment
Company Limited, Pak China Investment Company and Pak Brunei Investment Company were
allowed to start their operation in the country. The permission was granted mainly to strengthen DFI
sector and to enhance regional cooperation among the countries having their stake in these
institutions. Through entry of these new players the number of DFIs operating in the country
increased from 5 to 8.

3.4 Status of Islamic Banking in Pakistan

Islamic finance has developed more rapidly than conventional banking in the past 10 years, and is
poised to expand even more vigorously in the foreseeable future, making it one of the most vibrant
industries in global finance. According to some estimates the industry is said to have grown by
approximately 15 percent in each of the past three years, partially as a consequence of the increased
wealth in Islamic countries, which in turn was driven by high oil prices.

State Bank of Pakistan is also playing a leading role towards promotion and development of Islamic
banking in the country. Establishing a full-fledged Islamic Banking Department at SBP to focus on all
Islamic Banking issues provided the industry with the necessary impetus to grow and emerge as a
preferred choice of the public. SBPs drive to promote Islamic banking as a parallel system, operating
on a level playing field with commercial
banking, is aimed at building a broad based Table 3.1: Trends in Islamic Banking in Pakistan
financial system in the country to enable all billion rupees
segments of the population to access financial Financing & Total
Deposits
services and play their due role in the overall invest. assets
economic development. Up till June 2008, six Jun-04 13.2 13.1 18.8
full fledge Islamic banks were operating in the
Jun-05 37.8 37.2 54.0
country. Due to merger of Prime Commercial
Bank Limited and ABN Amro Bank N.V the Growth (%) 188 184 187
total number of conventional banks having Jun-06 59.7 57.9 87.6
dedicated Islamic banking branches now stands
at 12. The total assets of the Islamic banking Growth (%) 58 56 62

industry are around Rs. 230 billions which Jun-07 107.4 89.2 157.9
accounts for a market share of about 4.5
Growth (%) 80 54 80
percent (see Table 3.1). Total branch network
2
of the industry comprises of 359 branches with Jun-08 163.1 163.4 229.6
presence in over 50 cities and towns and Growth (%) 52 83 45
covering all the four provinces of the country
and AJK (see Table 3.2).

3.4.1 Initiatives Taken by SBP to Promote Islamic Banking

During the year under review SBP took major initiatives for promotion and development of the
Islamic banking industry including:

2
These numbers are as on September 1st 2008.
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 Ensuring Soundness of Financial Sector

Table 3.2: Islamic Banking Players (End-June)

(in number)
2003 2004 2005 2006 2007 2008
Islamic banks (operating) 1 1 2 4 6 6
a) Branches of Islamic banks 8 10 32 48 122 223
Conventional banks operating Islamic banking branches 0 5 9 11 13 12

b) Total standalone Islamic banking branches of conventional banks 0 10 30 39 61 103

Total Islamic banking branches (a+b) 8 20 62 87 183 326

a) Strengthening the Shariah Compliance Mechanism

SBP has put in place a comprehensive Shariah compliance framework for Islamic banking
institutions, for further strengthening of which the following initiatives have been taken:
Issuance of Instructions and Guidelines for Shariah Compliance in Islamic Banking
Institutions
Revision of Fit and Proper Criteria for Shariah Advisors of Islamic Banking Institutions
Adaptation / Adoption of Shariah Standards developed by Accounting and Auditing
Organization for the Islamic Financial Institutions (AAOIFI).
Finalization of Shariah Compliance Inspection Manual & Training to BID officials
Incorporation of Questionnaire on Shariah Compliance in the Institutional Risk
Assessment Framework

b) Islamic Financial Services Board Standards

The Islamic Financial Services Board (IFSB) serves as an international-standard setting body of
regulatory and supervisory agencies working to ensure the soundness and stability of the Islamic
financial services industry. It promotes the development of a prudent and transparent Islamic
financial services industry by introducing new, or adapting existing international standards in
consonance with Islamic Shariah principles, with recommendations for their adoption. Being the
full member of IFSB, SBP is responsible to support and adopt / adapt different standards
approved by it.

To introduce world class regulations and be part of the global Islamic banking industry, a process
has been put in place to introduce these standards in Pakistan. This process includes exposure of
the stakeholders of this industry and public to the draft guidelines / regulations. After necessary
adjustments, based on the feedback, laws and other regulatory considerations these standards are
being rolled out. In this regard, Risk Management (RM) guidelines for Islamic Banking
Institutions (IBIs) have been formulated with a view to further strengthens the regulatory
framework in the area of risk management for IBIs. Similarly, SBP is in the process of
implementing capital adequacy standard issued by IFSB in Pakistan and is carrying out an impact
study for the said purpose. The implementation of IFSB capital adequacy standard in Pakistan
will be another milestone in ensuring proper risk management in IBIs in line with international
standards recognizing the peculiar risk profile of Islamic banking products and services.

c) Liquidity Management and SLR Eligibility of WAPDA and KSEW Sukuk

State Bank of Pakistan has formed a Task Force to map out a plan for introducing short term and
medium term liquidity management products based on innovative Islamic Structures. It has
already prepared a structure for short term Shariah compliant government instrument which has
been sent for Government approval. It is worthwhile to mention that WAPDA Sukuk (1st and 2nd
Issue) and Karachi Shipyard & Engineering Works Limited (KSEW) (1st and 2nd Issue) Sukuk
have been notified as approved securities for the purposes of meeting Statutory Liquidity
Requirement (SLR) for Islamic banking institutions.

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State Bank of Pakistan Annual Report 2007-2008

d) Accounting and Taxation Issues

For development of Accounting Standards for Islamic Modes of Financing, a Committee was
constituted at Institute of Chartered Accountants Pakistan (ICAP), in which SBP is also
represented. The committee is reviewing the accounting standards prepared by Accounting and
Auditing Organization for Islamic Financial Institutions, Bahrain (AAOIFI) with a view to adapt
them to Pakistani circumstances. The committee has prepared the standards on Murabaha and
Ijara and is now working on Diminishing Musharaka Standard.

Also there have been some major taxation issues in Islamic banking industry due to its very nature
of asset backed / trade based modes of financing. SBP, along with other relevant bodies took up
relevant issues with Central Board of Revenue for resolution of tax problems being faced by the
industry. Lately in the Finance Bill 2007 it has now been ensured that taxation of Shariah
compliant Islamic banking would be treated at par with conventional banking.

e) Capacity Building Initiatives

During period under review some noteworthy initiatives taken by Islamic banking department
which include organizing:
Workshop jointly with IFSB on Capital Adequacy Standard" and "Transparency and
Market Discipline"
Awareness programs for officers of various departments of SBP and
Seminar on Islamic Financial Accounting Standards on Murabaha and Ijarah..

3.5 Vigilant Supervisory System

3.5.1 Revisiting Institutional Risk Assessment Framework (IRAF)

Institutional Risk Assessment Framework (IRAF) is used as a tool, in addition to CAELS, to assess
performance of individual institutions on continuous basis. IRAF not only provides an opportunity to
the financial institutions to carry out their assessment through IRAF self-assessment questionnaires
but also indicates the gap regarding compliance with SBP regulations. Moreover, to assign composite
IRAF rating to a financial institution, the system also considers onsite inspection findings, offsite
supervision assessment, various financial performance indicators and market information and
intelligence. The process, on the whole, provides continuous and updated system of offsite
supervision and, therefore, augments SBPs capacity to spot vulnerability of the financial institutions
to various risks at an early stage. IRAF depicts complete picture of a financial institution at certain
point of time to check the financial health of a bank/DFI.

During 2007-08, some major enhancements have been made in the existing IRAF mechanism to
reflect more precise risk rating of the financial institutions. Self assessment questionnaires were
restructured in the new system and instead of only two options available to financial institutions either
Yes or No they can now respond to every question on a scale of 1 (fully compliant) to
5(noncompliant). This allows a certain degree of flexibility to the financial institutions to evaluate and
reflect their actual degree of compliance. Similarly, different standards have been set for more
objective evaluation of market information and intelligence component. Likewise, weightages
assigned to different components and subcomponents have been revisited according to their
importance. Moreover, IRAF has also been upgraded to encompass emerging fields of development
finance like Islamic banking and agriculture finance.

3.5.2 Online Submission of Returns

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 Ensuring Soundness of Financial Sector

State Bank of Pakistan continued to bring improvement in its various supervisory processes in place
for financial institutions under its purview. Arrangements have been made to enable reporting
institutions upload online, through Data Acquisition Gateway (DAG) portal, their Weekly Statement
of Position under the Reporting Chart of Accounts (RCOA). As a further development, the reporting
institutions may now be able to upload online Quarterly Report of Conditions (QRC) in addition to
the Weekly Statement of Position (WSP) as mentioned above. This will significantly reduce paper
work and the time involved in the transmission of returns in hard copies. Besides, this will relieve the
burden of reporting institutions in meeting overlapping requirements of various departments of State
Bank of Pakistan and also minimize the time involved in processing and analyzing the submitted
information for decision making.

3.5.3 Consolidated Supervision: Needs and SBP Efforts

In Pakistan, financial markets and institutions have witnessed significant changes during the last few
years in terms of consolidation as well as diversification. Since 2000, about 40 transactions of mergers
and acquisitions have been executed within banks and between banks and non-bank finance
companies. On the other hand a number of banks/ DFIs as well as their holding groups have expanded
their activities into the areas where the banks hitherto were either not allowed or not interested. These
include insurance, asset management, brokerage, leasing and other non-banking finance services
essentially through separate entities. Along with financial services, various groups that control
different banks have also stakes in non-financial / real sector of economy. These stakes in financial
and non-financial sectors also cross over to and from foreign jurisdictions. This gives quite a
diversified spectrum of activities that a bank is involved in and has related relationship with, which
raises various supervisory concerns for the State Bank of Pakistan, including following:

Any trouble in another group entity could affect the stability of the bank/DFI. Such other
group entity could be a subsidiary of the bank (i.e. downstream of risk) or parent of the bank
or affiliate under the control of parent (i.e. upstream risk).
Bank/DFI together with other group entities under its control could take exposures on single
borrower, borrowing group, or sector that are beyond prudential limits.
Increasing complexities in the ownership and managerial structure of a group can make the
supervision of financial institutions in the group difficult.
Possibilities of regulatory arbitrage and non-arm length dealings in intra group transactions.

Cognizant of its responsibilities as a supervisor of the banking sector, which is facing a complex and
dynamic environment and in order to ensure compliance with the core principle (No. 24) for effective
banking supervision, the State Bank initiated a project in 2006 to formulate a framework for
consolidated supervision of the financial sector. This framework will enable State Bank to supervise
the banks / deposit taking institutions on consolidated basis. The framework envisages extending the
SBPs supervisory ambit to banking group level. Initially a framework was internally drafted by SBP
in 2007 and extensively discussed at different forums within the bank. In order to ensure that the
framework fulfills the intended objectives in line with the established standards and core principles,
the services of a renowned consultant have also been acquired by SBP. Further, legal amendments in
the Banking Companies Ordinance, 1962, required to enable SBP to carry out effective consolidated
supervision, are being deliberated upon amongst various internal and external stakeholders. Besides,
consultation process with external stakeholders is also underway to disseminate the supervisors
thought process as well as to gather their feedback. Once the recommendations from the consultant
are received and the required legal changes are enacted SBP would be able to implement the
consolidated supervision framework in line with the principles of effective banking supervision.

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State Bank of Pakistan Annual Report 2007-2008

3.5.4 Forum for Banking Departments

A committee, namely, Banking Policy Committee (BPC) was reconstituted, comprising executive
directors and directors of the departments in the Banking Cluster, as a forum for discussions and
collective decision making on banking issues relating to policy, regulations, supervision, enforcement
and development. The committee is to be chaired jointly by the Executive Director Policy and
Executive Director Supervision. The forum called Banking Team, functioning prior to restructuring of
SBP, has been replaced with BPC.

3.6 Proactive Inspection

Banking Inspection (on-site) Department (BID) is striving to secure stability of the financial system
and safeguard the interests of stakeholders through proactive inspections. BID conducts on-site
inspections of financial institutions i.e. Banks, Development Finance Institutions (DFIs),
Microfinance Institutions (MFIs) and Exchange Companies under the jurisdiction of SBP. BID also
prepares special reports on write-off cases of loans, advances and other special investigations based
on requests from internal and external stakeholders. Another important role of the department is to
provide policy input to policy-making departments regarding issues encountered during the on-site
inspections. As a result the existing policies are modified or replaced or new policies framed.

During 2007-08, the department has conducted full scope inspections of 35 banks/DFIs, 38 exchange
companies (both A and B categories). In addition to the full scope inspection, department has under
taken 3 IS inspection, 20 special inspections of banks/DFIs/exchange companies and handled more
than 500 complaints. To improve and strengthen its capabilities, and to meet the emerging supervisory
challenges, BID undertook some major initiatives as detailed below:

3.6.1 Restructuring the Department

BID has restructured to meet its objectives: to perform effectively under the given mandate, to better
utilize the human resources and to effectively oversee the levels of emerging risks. The redefined
structure of BID entailed identifying and developing a resource pool in specialized areas to meet the
future challenges like Basel-II implementation, Sharia Compliance Reviews, Information System
inspection, consumer banking, Treasury and Forex inspections and Anti-money Laundering. The
Department also provides assistance to the newly established Consumer Protection Department by
investigating complaints through a special division.

3.6.2 Inspection of Information System

Increasing use of technology and systems in the regulated institutions has added a new dimension to
the banking business. Consequently, new risks have emerged that need to be evaluated. To ensure
accuracy, integrity and adequacy of the systems used in the banks and DFIs, BID conducts IS
inspection of selected financial institutions under its purview.

3.6.3 Basel-II Implementation

The Basel-II Capital Accord provides a comprehensive and more risk sensitive capital allocation
methodology. Its implementation poses tremendous challenges not only in Pakistan but also
throughout the world. To ensure the implementation of Basel-II, a special group of officers was
constituted, who conducted on-site inspection to ensure Basel-II implementation. Banks operating in
Pakistan except three public sector institutions, shifted to standardized approach.

3.6.4 Devising Tools for Anti Money Laundering (AML)

BID has undertaken a developmental project with the objective to devise tools that would facilitate in
assessing preparedness of banks regarding AML. The importance of effective controls safeguarding
the banking sector from the risk of money laundering cannot be over emphasized. While
comprehensive regulations for anti money laundering have been issued by State Bank of Pakistan, the
newly promulgated Anti-Money Laundering Ordinance, 2007, makes non-reporting of suspicious
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 Ensuring Soundness of Financial Sector

transactions an offence punishable with imprisonment and fine. The tools and methodology developed
will help in assessing the adequacy and effectiveness of policies, procedures and controls relating to
anti-money laundering and identify the weaknesses and deficiencies that should be worked upon to
effectively tackle anti-money laundering risk.

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