Financial Stability Review 2007-08 Presented By Shyam Kumar ID # 6137

1. Financial Stability Review 2007-08 Presented By Shyam Kumar ID # 6137

2. Global and Domestic Developments : Financial Stability Implications for Pakistan

3. Global And Domestic Developments… • The benign global macroeconomic environment which prevailed for an extended period until 2007, and was termed as ‘great moderation’, gave way to financial crisis with global reverberations in Aug 2007 • The crisis originated in the sub-prime mortgage loan portfolio and entered a chaotic new phase in Sep ’08 and badly shook the confidence in global institutions and markets • The estimated loses from crisis currently stand at US$ 1.4 trillion • Contrary to previous episodes of Financial Crisis, developed economies were direct target marginally influencing emerging economies of Asia & other regions

4. Global And Domestic Developments… • Rising Inflation in the world • Rising Inflationary pressures for emerging economies due to rising food & oil prices • Pakistan, which remained unhurt from direct impact of crisis, has been more concerned with issues relating to monetary stability due to rising inflation since before advent of the crisis

5. Economic Growth Outlook • Growth in advanced economies expected to decline to 1.4 percent in 2008 and -0.3 in 2009 • Global growth expected to moderate to 3.75 % in 2008, & 2.2 % in 2009 • IMF forecasted Emerging Asia’s Growth in 2008 at 6.6%, about 1.4 % lower than 2007 • Avg economic growth rate in Pak was 7.1% for FY04-08 & moderated to 5.8 % in FY08

6. Macroeconomic Stability • Macroeconomic stability in Pak has been under stress on account of both domestic and external vulnerabilities • After record borrowing of Rs 689 Billion form central bank in FY08, Govt borrowing continued to rise in FY09 as IMF approved $ 7.6 billion loan • External current account deficit remained at an unsustainable level of 8.4 % of GDP in FY08 • Net Foreign Assets (NFA) of the banking system have depleted by Rs 317.4 billion in FY08 and 346.4 billion in first few months of FY09

7. Trade Prospects • The drop in external demand from US & Western Europe has affected the Asian region foremost through trade channel, because of traditional dependence of its exports on US & Euro Area • Pakistan’s primary dependence is still on the US (at 20% of total Exports for FY08, average of 23.6 % from FY03-FY08), despite gradual diversification of export destinations over the years • On the positive side, Pakistan’s level of trade integration within and across Asia shows an encouraging and growing share of around 40.0 % • While the exports figure for the first four months of FY09 has shown an increase of 16.3 percent YoY, continued downside risks to the growth of the exports base can be mitigated by focusing on high growth destinations, and striving to diversify the productbase.

8. Dimensions of Monetary & Financial Stability

9. Framework for Financial Stability • The framework for maintaining financial stability is still evolving, largely because of the lack of consensus on the varying institutional structures for banking supervision and central banking functions around the world • Another point of divergence from the prevalent monetary stability regimes is that the objective of safeguarding financial stability does not have a single purpose which can be attained with a specific set of instruments • The primary objective of financial stability policies and assessment is to provide early warning signals in order to help in crisis prevention as distinct from crisis mitigation • Stability of the financial system benefits and promotes: (i) smooth and efficient financial intermediation processes that allocate savings to profitable investment opportunities, (ii) a relatively balanced development of different segments of the financial system, and (iii) proper transmission of monetary policy signals

10. SBP’s Existing Framework for Financial Stability Assessment • SBP’s existing framework for financial stability assessment is primarily focused on the stability of the banking system along with independent review of the Non-Bank Financial Companies, the Insurance sector, Pension Funds, and Capital Markets • The assessment is undertaken as a shared responsibility within the central bank: • The Banking Policy and Regulation (BPR) group undertakes policy formulation on the basis of the off-site examination of the banking sector in monitoring developments and keeping an active dialogue with banks • The Banking Supervision group, on the other hand, undertakes both off-site enforcement and on-site inspection

11. Stability of Banking System

12. Profitability of the Banking System • Despite the challenging domestic and international economic environment, the banking sector in Pakistan has remained remarkably strong & resilient, on the back of a robust capital base and healthy profitability • The net profit of the banking sector for CY07 was Rs 73.3 billions, and decreased to Rs 63.2 billions for CY08 • The return on assets (ROA), declined during CY07 to more sustainable levels compared to the exceptionally high level in the previous years • The return on equity (ROE) has experienced a decline from 23.8 % in CY06 to 15.5% in CY07

13. Assets and Funding Structure of the Banking System • The assets of the banking system, grew by 18.8 % to reach Rs 5.2 trillion by the end of the year • A key characteristic of this growth was the huge expansion in the investment portfolio, which surged to Rs 1.3 trillion, with an annual growth of 53.0 % • Loan expansion during CY07 was only 10.8% compared to annual average increase of 27.7% for CY03-CY06 • The share of the investment portfolio in the overall assets, which had increased to 24.7 % in CY07, declined to 20.4% in H1-CY08 • Asset growth during CY07 and H1-CY08 was funded by substantial growth in the deposits (Rs 4.2 trillion by H1-CY08, showing an increase of 28.7 percent during the 18 months of CY07 and the first half of CY08), well-supplemented by the strong growth in capital

14. Risk Assessment:Credit Risk • Non Performing Loans (NPLs) of the banking system increased by Rs 30.6 billion to reach Rs 206.1 billion during CY07, and reached to Rs 241.9 billion in H1-CY08 after having seen a consistent decline during CY01-CY06 • The NPLs to loans ratio (Gross) of the banking system saw an increase of 30 bps during CY07 to reach 7.2 % by end CY07, which increased by 50 bps to 7.7% in H1-CY08 • Fortunately, this increase is not shared across the industry, as banks with NPLs to loan ratio of less than 5.0 % own 97.7 % share of assets • Although indicators of asset quality do not pose an immediate threat to the stability of the banking sector, increasing NPLs give rise to concern about asset quality

15. Risk Assessment:Liquidity Risk • SBP continued with its tight monetary policy stance during CY07 and H1-CY08 by increasing the discount rate and reserve requirements • Considerable decline in excess reserves especially from May CY08 onwards, indicating a more constrained liquidity position • The liquidity position of the banking system went through a temporary phase of deterioration in October, CY08, due to decline in deposits and the surge in global commodity prices, with consequent impact on the external current account and the fiscal deficit, and finally on the foreign exchange reserves with the central bank • Liquidity risk also emerged given the increase in the profit rates on National Savings Schemes

16. Perspective on Consumer Finance in Pakistan

17. Consumer Finance in Pakistan • Banks’ consumer finance portfolio has grown at a rapid pace over the last few years , and its share in overall credit of the banking system had risen to 13.8 % by end CY07, declining to 12.0 % by June CY08 • It constitutes 3.6 percent of the GDP • While all categories of consumer finance have grown substantially since the inception of this product, the most significant increase has been observed in personal loans

18. Consumer Finance–Myths and Facts • Phenomenal growth in consumer finance has also raised a debate regarding its downside risks and implications. • It is generally perceived that this particular asset product has: • given rise to consumerism in Pakistan, which has contributed to the low level of national savings; • fueled inflation; and • led to the rise in speculative activities in asset markets • An analysis of actual facts and figures, however, dispels these notions: • Rather than promoting consumerism, this product has contributed in enhancing the standard of living of the middle class. Trends in savings of the household sector also do not support the perception of consumerism, as the average saving rate of the household sector is higher in the post-2000 period as compared with the ’90s.

19. Consumer Finance–Myths and Facts ..... • An analysis of inflation dynamics does not support the claim that consumer finance is the reason for fueled inflation. Core inflation which is more sensitive to the level of credit and associated increase in demand, has shown quite contained growth over the last few years. The recent rise in overall inflation is attributable to factors such as international price shocks • Personal loan‘s potential for spurring speculative activities is limited because of the fact that: • this loan is priced competitively and is not an attractive funding option for speculators; • its main target market is mainly the fixed income / salaried segment of individual customers who are generally risk averse and are not known to indulge in speculative activities; • such loans are relatively smaller in amount (average loan size Rs. 200000) than other categories of consumer finance, whereas speculative transactions in asset markets generally require larger sums of money

20. Major Issues and Challenges • The rising inflation rate, and certain degree of slowdown in economic activities, has constrained the consumer’s debt-servicing capacity • This weakness is further intensified by rising interest rates • The infection ratio has gradually risen to 5.5 percent of the total outstanding credit in H1-CY08, and the overall infection ratio of the credit portfolio at 7.7 %

21. Stability Assessment Of Financial Markets

22. Foreign Exchange Market • The foreign exchange market in Pakistan faced a challenging environment in FY08. While FY07 was characterized by record foreign inflows in the form of FDI, foreign portfolio flows, privatization proceeds, workers’ remittances etc., which helped finance the current account deficit • FY08, in particular from November onwards, saw a slowdown, and even reversal, of some of these inflows • These developments were driven by a host of factors in the global and domestic markets, such as rising commodity prices which added pressure to the import bill, an unstable political environment which carried with it a certain degree of uncertainty • As a result, the trade deficit widened, foreign equity flows dried up, the privatization process was deferred and access to international markets was severely impacted, both due to the ongoing financial crisis, as well as the downgrading of Pakistan’s sovereign rating by Moody’s(from B1 to B3) and S&P ( B+ to CCC) due to the weakening macroeconomic environment

23. Foreign Exchange Market • These developments exerted great pressure on the external current account deficit and the rupee-dollar parity • After a period of 4 years of relative stability in the exchange rate, FY08 saw considerable volatility and depreciation in the value of the Pak Rupee against major currencies • In particular, the PKR depreciated by 11.5 percent against the US$ in FY08, and 13.3 percent in the first few months of FY09

24. Derivatives Market • In Pak three types of derivative transactions are permitted: a) Foreign Currency Options (FX Options), (b) Forward Rate Agreements (FRAs) and (c) Interest Rate Swaps (IRSs) • Cross-currency swaps on the other hand are approved on a case to case basis by SBP • Total volume of the derivatives market has reached Rs. 393.23 billion as of end-June FY08, from Rs. 212.61 billion as at end-June FY07, a growth of almost 85.0 percent in one year • Cross-Currency Swaps continue to have a dominant share (89.68 bn) in the volume of total outstanding derivatives, while FX options (42.56 bn) and Interest rate swaps (80.61bn) also have large shares • FRAs, however, continue to have a negligible share in total outstanding derivatives (300 mn)

25. Equity Markets • FY08 and the first two months of FY09 were particularly volatile for the stock market which touched its peak level of 15,676 points as well an all time low in trading volumes of 2.5 million shares • As against FY07, FY08 saw a net reversal of the substantial Foreign Portfolio Investment (FPI) flows • Issues related to macroeconomic stability and political noise impacted investor sentiments and exacerbated the situation • To halt the continuing decline in value, the KSE management placed a floor of 9,144 points on the KSE-100 Index from August 28, FY09 to Dec 15 2009 which served to prevent further decline and insulated the market from all kinds of global and domestic developments, while also reducing trading to negligible levels

26. Islamic Banking

27. International Developments • The appeal and acceptability of Islamic banking has increased tremendously in recent years, particularly in the Gulf and in predominantly Muslim countries • According to an estimate by S&P’s Ratings Services, as much as 20 % of banking customers would now spontaneously choose an Islamic financial product over a conventional one • Its presence in international financial hubs like London, Tokyo, Hong Kong and Singapore has increased significantly. • UK has shariah-compliant assets of US$ 10.4 billion, where London is now aspiring to be the emerging global hub for Islamic finance • Financial Services Authority (FSA) in UK has authorized 3 dedicated Islamic banks since 2004

28. Islamic Banking in Pakistan • Islamic banking has made swift progress in Pakistan since its re-launch in 2002 as evidenced by the commendable growth rate in excess of 60.0 percent per annum in both the assets and deposit base • At present there are six Islamic banks operating in Pakistan with a branch network of 228, and 103 stand-alone Islamic bank branches of 12 conventional banks, making a total of 331 branches by August, CY08 • ROA and ROE for Islamic banks at 0.6 and 3.3% for CY07 respectively are below the overall banking sector average • This decline is due to entry of four new banks in CY06 & CY07, as in CY05 ROA & ROE were higher at 2.6 & 16.3 % respectively

29. Risk Assessment Of The Insurance Sector

30. Overview Of Insurance Sector • CY07 was an eventful year for the insurance sector, in particular for the general insurance companies • However, the insurance sector of Pakistan, being small and with little correlation with the developments of the international insurance market, managed to perform reasonably well in CY07 • The insurance sector in Pakistan comprises of 1 general reinsurance company, 5 life insurance companies, 52 non-life or general insurance companies and 3 Takaful companies • The total assets of the insurance sector have increased by 32.1 % in CY07, as compared with growth of 18.8 % in the assets of commercial banks over the same period

31. Performance Review of the General Insurance Sector • The average paid up capital increased to Rs. 301 million during CY07, as compared to Rs. 252 million in CY06 • Six companies fall short of minimum paid-up capital requirements. The operations of these companies have been suspended by the SECP • The profitability of the general insurance sector increased to Rs 56 billion in CY07, which was considerably high compared to Rs.15 billion in CY06 • The premiums for motor insurance, which alone constitutes 50% of the total premiums, recorded a remarkable growth of 12% , against a 24% average growth in CY02-07 • The general sector witnessed a very high claim ratio in CY07 (64.4 %) as compared to 57.1 % CY06. Much of the increase in claims has been due to motor and fire insurance. The claim ratio for motor insurance stood at 76.6 percent in CY07, which is rather high and raises some concerns

32. Performance Review of the Life Insurance Companies • Currently, there are two domestic, two foreign and one state-owned companies operating in Pak • Although declining, the share of state-owned company still holds 91% of the total life insurance assets and 52.2% of total insurance assets • The claims ratio (net claims/net premium) for the life insurance companies was 48.5% during CY07, much lower than the 64.4% claims recorded by the general insurance companies during the same period • There is much rapid increase in premiums in comparison with claims

33. Performance of Non-Bank Financial Institutes

34. Non-Bank Financial Institutes • The group of Non-Bank Financial Institutions (NBFIs) includes the Non-Bank Finance Companies (NBFCs), Mutual Funds, Modarabas and Development Finance Institutions (DFIs) • The number of operative entities in FY07 was 209 which subsequently increased to 237 in FY08 • NBFCs, Mutual Funds and Modarabas are regulated by the SECP, DFIs are regulated by the SBP • A public limited company engaged in the business of asset management, investment finance, leasing, housing finance, venture capital investment, discounting and investment advisory, or a combination of these services, is categorized as an NBFC • For each financial service that an NBFC provides, it needs a separate license from the SECP

35. Ownership Structure & Performance Review • The asset share of the domestic private NBFIs (excluding foreign-owned companies) reached 61.6% by end FY07 compared to 50.5 % in the previous year On the other hand, the asset share of public sector NBFIs declined to 21.6 percent, compared to 32.4 percent in FY06 • Due to several mergers and acquisitions the number of operating institutions has declined in almost every category, except Mutual funds • The mutual funds sector, has grown more progressively than the other financial institutions among NBFCs

36. Performance Review (contd) • During FY07, total assets of the NBFIs sector registered a relatively higher growth of 22.7 % to reach Rs 567.0 billion, compared to the YoY growth of 17.4 % in FY06 • This growth in total assets largely came from Mutual Funds, which showed an exceptional growth of 77% compared with 30.1% in the previous year, whereas all other sub-sectors, except for modarabas, depicted negative growth during the period • The share of advances in the total assets of NBFIs (excluding mutual funds and venture capital) declined to 48.6% as compared to the relatively high share of 51% in FY06

37. Payment And Settlement Systems

38. Payment And Settlement Systems • Smoothly functioning Payment & Settlement System reduces the cost of both real and financial transactions, minimizes the occurrence of financial risks related to transactions, and strengthens the confidence of the general public in the financial system. • To modernize the payment infrastructure in the country SBP facilitated the establishment of the National Institutional Facilitation Technologies (Pvt) Limited (NIFT) for automated conventional clearing services (for instance, overnight clearing, same-day high value clearing, inter-city clearing etc.). • The NIFT network currently serves over 4,500 branches of 40 banks (including SBP) in 100 major cities of Pakistan. • Launched on July 1 2008, and operated by the SBP, the Real-Time Interbank Settlement System (PRISM) is a systemically important payment system and is designed to settle all large-value payments in the country.

39. Retail Payment System • The Retail payment system (RPS) in Pakistan is still dominated by traditional paper-based transactions, driven by cheques for cash withdrawals, and funds transfers through Cheque-clearing • High, but declining share of paper-based transactions in the total number of transactions is an indication of the increasing number of electronic transactions • The number of electronic transactions has increased from 11.5 million in Q1-CY05 to 33.9 million by Q2-CY08:

40. Impact on Risk Profile • Security Risk: • It is generally believed that e-banking increases the security risks as banks’ system are exposed to a more risky operating environment. The major types of security risks include: breaches with criminal intent; breaches by casual hackers; and loopholes in system design. • Strategic Risk: • Lack of a clear understanding of risks associated with e-banking activities among senior management may entail a strategic risk. Being relatively new, with a higher start-up cost, with different implications for early and late starters, e-banking activities can increase the institutions’ strategic risks. • Reputational Risk • The decision to offer e-banking services can potentially increase reputational risk, as issues such as the failure to deliver promised services, difficulty in using e-banking services, frequency of service disruptions, theft of confidential customer information; fraud etc. can affect the confidence of customers.

41. Thank You