Introduction to Financial Systems.pdf

(1)

Introduction to

Financial Systems &

Banking

Regulations

Stage 1

(2)

Pakistan

Written by: Muhammad Ali

，

MBA，DAIBP (United Bank Limited)

Reviewed by： Shan-ul-Haque, M.A Economics，DAIBP (IBP)

Editing by: Chartered Banker Institute and Keystone Business Associates, UK

The Institute of Bankers Pakistan has taken all reasonable measures to ensure the accuracy of the information contained in this book and cannot accept responsibility or liability for errors or omissions from any information given or for any consequences arising. This book should only be used as a reference book and other books and material must be referred to on this subject to complete understanding.

The Institute of Bankers Pakistan, August 2011

No part of this publication may be reproduced, stored in retrieval system or transmitted in any form or by any means - electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from The Institute of Bankers Pakistan.

Chartered Banker Institute is a trading name of The Chartered Insdtute of Bankers in Scotland: Charitable Body No SC013927

Financial system of any country consists of money, banking, financial institutions and the financial markets _ both money and stock. Thus study of tinancial systems is essentially the study of monetary issues affecting a country’s economy, along with how banks，financial institutions and financial markets operate and the role of the central bank in controlling financial institutions. A country’s financial system handles regular transactions such as payments in the retail or wholesale markets, payment of all types of bills, of wages and salaries, management of savings and investments, etc. The financial system also includes insurance companies and banks which in turn handle huge sums of money on behalf of individuals and business communities, both as depositors and borrowers. The IT systems facilitate payments between financial institutions, companies and individuals.

Components of the Financial System

A financial system has five components:

1. Money

2. Banks and Development Financial Institutions

3. Financial Instruments

4. Financial Markets

(7)

Overview of the Financial System 3

The Financial System in Pakistan

As in other parts of the world

，

Pakistan’s financial system consists of:

• Money (Pak Rupee)

• Banks and financial institutions

• Financial instruments

• Financial markets

• State Bank of Pakistan.

A. Money

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past, a standard of deferred payment. Any kind of object or secure verifiable record that fulfills these functions can serve as money. Further elaborating these functions:

• It must be accepted as a medium of exchange, i.e. widely accepted in for the and offered to in a given . One example of a of exchange is note/ coins.

• It must have a unit of account. The second very important function of money is that it must be accepted as a unit for measurement, by which value of goods and services can be accounted for or compared. The unit should be divisible into smaller units without loss of value.

• It can be used as a store of value. Money must be an object that is tradable and can be stored for future use. It is a fundamental component of the economic system because it allows trade to take place with items that have inherent value. An example of a store of value is currency, which can be exchanged for goods and services. If the value of currency becomes unpredictable, such as in times of hyperinflation, investors and consumers will shift to alternative stores of value, such as gold, silver, real estate. Nowadays, due to the recession, almost all major currencies, including the world’s reserve currency, the US Dollar, have failed to maintain their purchasing power and hence have failed as a reliable store of value. Governments of different countries are increasing supply of money by simply printing notes, and consequently the value of gold is increasing day by day.

(8)

Financial Systems and Regulation | Reference Book 2

"Money〃 is a broad term which includes all types of objects/

instruments that can fulfill the functions of money. All those instruments which can fulfill the function of money are collectively referred to as supply of money. The amount of money in any country/ economy can be calculated by adding together all financial instruments, such as currency in circulation, various types of bank deposits, issued negotiable instruments, short-term and medium-term financial instruments (Treasury bills, FIBs) prize bonds, etc. Supply of money must be according to the genuine needs of the economy. Excess supply results in inflation and a decrement in the value of money.

Velocity of money also plays a very important part in determining the health of an economy. The term "velocity" is used to describe the rate at which money is exchanged from one transaction to another. Velocity is important for measuring the rate at which money in circulation is used for purchasing of goods and services. This helps investors to determine how healthy the economy is. It can be measured as a ratio of GNP to a country's total supply of money.

The "Pak Rupee"

The Pakistani rupee came into circulation after the country became independent in 1947. For the first few months of independence, Pakistan used Indian notes with "Pakistan" stamped on them. Pakistani currency, including coins and banknotes, was issued in 1948. The currency was originally divided into 16 'Aanas'; and was decimalized on 1st January 1961 with one 'rupee, subdivided into 100 paisa.1 rupee coins were reintroduced in 1979, followed by 2 rupees in 1998 and 5 rupees in 2002.

(9)

Rs.1000

The Government of Pakistan started issuing bank notes in 1948 in denominations of 1

，

5，10 and 100 rupees, and continued to issue 1 rupee note till the 1980s. However, the issuing of 2,5,10 and 100 rupee notes was taken over by the State Bank in 1953. The 50 rupee note was introduced in 1957. In 1986 and 2002 respectively, 500 and 100 rupee notes were introduced. In 1998，2 and 5 rupee notes were replaced by coins. In 2005

，

20 rupee notes were added，followed by 5000 rupee notes in 2006.

Rs.100 139 x 65mm Red

Rs. 500 147 x 65mm

Rich Deep Green

155 x 65mm Dark blue

163 x 65mm Mustard

Since the time of its inception, the Pak rupee has been experiencing steep devaluation year on year. The current as well as the previous governments witnessed budget deficits in their reigns — that is,total expenditure always outweighed total revenue (excluding money from borrowings). In order to bridge this gap, the governments printed more notes, which always results in increased inflation and hence further devaluation of the currency. One of the reasons for increasing inflation is soaring fuel prices. In April 2011 fuel prices hit an all-time high, and since the Pak rupee was already very weak，it crashed further down，unable to withstand the pressure.

Value Dimensions

Rs. 5 115 x

65mm

Rs.10 115 x

65mm

Rs. 20 123 x

65mm

Rs. 50 131 x 65

mm

Greenish Grey

Orange Green Main Color

(10)

The State Bank, as the central bank of the country, plays a vital role in regulating the country’s currency. Being the initiator and implementer of monetary policy and controller of the major components of Pakistan’s financial system, The State Bank of Pakistan occupies a prime position. One of the aims of monetary policy is to bring about changes that help to curb inflation. In our country, however, the political agendas of the government dictate the currency supply and increasing budget deficits continue to translate into increased inflation. Since monetary policy cannot influence the behavior of the government, controlling inflation with the aim of currency devaluation seems like a farfetched reality.

Furthermore, the fact that Pakistan also faces a constant increase in foreign currency outflow, more than the inflow, need for adjustment in the exchange rate becomes inevitable. To maintain a balance in the inflow and outflow of foreign currency, interest rates must be increased. The SBP purchases foreign currency against domestic currency and generates local currency via open market operations. This results in increment of the interest rate in the domestic market, which further contributes to the increase in inflation.

The government must aim to minimize the budget deficit by spending no more than it generates. Once a budget deficit is created, the government borrows from The SBP and other commercial banks to close the gap between generated revenue and expenditure. This borrowing is not a healthy option

一

it results in increasing the country’s debt levels and has an associated interest cost.

Measures that the government can take to increase revenue are the introduction of new taxable avenues and/or by increasing the existing tax levels. The gap between revenue and expenditure can be further narrowed down by aiming to decrease expenses and/or by reducing government subsidies. If opting for a reduction in subsidies, care must be taken that suosidies must not be reduced on the goods and services which have a direct impact on cost of production. This may in turn result in a further increase in inflation levels.

It is pertinent to mention that Pakistan’s economy experienced inflation of 66% between June 2007 and October 2010. This is almost twice as much as the level of inflation during the period June 2003 and June 2007 wmch was around 36%. One of the reasons for this extraordinary rise is the transfer of government expenditure directly into power sector entities and an enormous increase in oil prices. Another reason for this high inflation is extremely high levels of government borrowing. From June 2003 to June 2007，currency in circulation grew by 70% and total deposits, excluding government deposits，grew by 104%. From June 2007 to June 2010, currency in circulation increased by 82% but bank deposits increased by only 40%.

(11)

Overview of the Financial System

RS.

US $ Rate

1990 1995 2000 2005 2010 2015

YEAR

Due to economic crises worldwide, the economy of Pakistan also experienced a balance of payments crisis.IMF bailed Pakistan out in November 2008 to prevent a balance of payments crisis by extending a loan of US $ 7.6 billion. To further assist Pakistan to overcome the economic crisis in July 2010，IMF increased this loan amount to US $

11. 3 billion.

Steps that can be undertaken by the government to curb inflation and stabilize the Pak

Year

US $

Rate

Year

US $

Rate

1961

4.76 1999

51.76 1970

4.76 2000

57.71 1972

9.91 2001

61.31 1980

7.887 2002

58.68 1990

21.32 2003

57.43 1991

24.74 2004

59.83 1992

25.46 2005

59.76 1993

30.12 2006

60.73 1994

30,76

2007

60.95 1995

33.59 2008

79.76 1996

39.53 2009

82.87 1997

43.64 2010

83.41

(12)

rupee include:

• Aim to increase the country’s exports，especially of finished products

• Aim to decrease imports of luxury goods

• Allow the import of those items which are essential for industrial and agriculture use

• Aim to minimize deficit financing

• Move towards being less reliant on other sources of funds such as foreign aid - especially while budgeting for the future

• Aim to minimize the gap between revenue and government expenditure in order to reduce the budget deficit

Aim to privatize loss-making government-owned organizations. Funds being used to finance such projects could then be diverted to other developmental projects.

Impact of Money on Local Trade

In 2005 one encouraging factor noted was an increase in retail and wholesale trade. According to the figures released by the Federal Bureau of Statistics, the size of this sector was 1,358,309 (m) in 2005，which represented a 96% increase in its size in 2000. Due to increased inflation in the country, wholesale prices and the Consumer Price Index are increasing at a very fast rate. The Consumer Price Index (CPI) is the main measure of price changes at the retail level. It measures changes in the cost of buying a representative fixed basket of goods and services and is generally accepted as a measure of inflation in the country. The Wholesale Price Index (WPI) measures the general price level in the wholesale market. Items are selected on the basis of the Family Budget Survey.

• Markets are selected through retail and wholesale trade surveys.

• Outlets are selected on a transaction value basis.

• Cities are selected on a population basis.

• Stratified sampling is used for the selection of cities.

(13)

Overview of the Financial System 9 350 300 250 200 150 100 50 ■

I Whole sale price index by commodities

_

ね

0

^ 歐セsale price index by commodities

i ■期）

Rs in Billion Food Raw material Fuel & Power Manufacturer Building Material •丨丨ニ：3£ 102.05 100.95 103.08 101.91 101.18 1厂— 105.62 115.51 115.95 103.67 102.9

112.99 135.12 119.23 111.83 126.46 •: ニ《14 125.03 110.69 138.01 113.05 143.79 -.3E55 133.78 121.93 174.57 116.35 144.18 •.孤17 145.67 138.85 184.1 119.92 151.9 丨

US 173.27 156.57 223.34 128.33 177.18

■しii,, 3T * 213.54 184.45 _{258.96 296 48} _{140.67 154 64} _{213 201 4} •一 _{•friolesaJe price ind}

l-TOO)

ex by commodities Rs in Billion

Bena^ Food Raw material Fuel & Power 細 •へ

13.4894444 234.5066667 213.5633333 300.7138889 151.3013889 221.3930556

‘‘ _{3S_6124444} _251.3866667 _227.3386667 _324.9962222 _157.3312222 _235.4052222

?!：：r- 25S.7354444 268.2666667 241.114 349.2785556 163.3610556 249.4173889 S6&3584444 285.1466667 254.8893333 373.5608889 169.3908889 263.4295556 Jfcis 22^9814444 302.0266667 268.6646667 397.8432222 175.4207222 277.4417222 |p!!P!% 295.1044444 318.9066667 282.44 422.1255556 181.4505556 291.4538889 :|fcrr 3142274444 335.7866667 296.2153333 446.4078889 187.4803889 305.4660556 pEiTli 3293504444 352.6666667 309.9906667 470.6902222 193.5102222 319.4782222 EE'rii 344.4734444 369.5466667 323.766 494.9725556 199.5400556 333.4903889

Wholesale price inc 1 2M^«1=100)

ex by commodities Rs in Billion

General Food Raw material Fuel & Power Manufacturer Building Material 'SC： 359.5964444 386.4266667 337.5413333 519.2548889 205.5698889 347.5025556

374.7194444 403.3066667 351.3166667 543.5372222 211.5997222 361.5147222 389.8424444 420.1866667 365.092 567.8195556 217.6295556 375.5268889 404.9654444 437.0666667 378.8673333 592.1018889 223.6593889 389.5390556 bE4 420.0884444 453.9466667 392.6426667 616.3842222 229.6892222 403.5512222 t?I3 435.2114444 470.8266667 406.418 640.6665556 235.7190556 417.5633889 450.3344444 487.7066667 420.1933333 664.9488889 241.7488889 431.5755556 ac7 465.4574444 504.5866667 433.9686667 689.2312222 247.7787222 445.5877222 ST'5

430.5804444 521.4666667 447744 713.5135556 253.8085556 459.5998889

iinmii

IWFBTIf I I I l i

mmw

H H I I

(14)

Consumer Price Index- Products Wise

Impact of Money on Foreign Trade

Foreign trade is indispensable for the full economic development of a country and includes framing commercial policies，conducting trade negotiations, and making bilateral, regional and international arrangements for promotion of trade. Foreign trade also includes all the merchandise coming from foreign countries into Pakistan through lawful channels under private and government accounts via sea, air, land routes and by parcel post, released by Customs either directly or in the form of bonds. Goods imported and deposited into bonds are not taken into account.

Consumer Price Index - Product Wise

Year General Food Textile House rent Fuel Transport Education Medicare

>002

104 103 fToT'

₁₀

^ 169

_M

165

₁₀

^

2003 107 105 107 164 118

₁₁₂

₁₁₀

106

2004

₁₁₂

₁₁

^

110

10

^

1^1

115 114

₁₀

ナ

2005

₁₂₂

126 113

₁₂₀

126 125 118 108

2006 132 134 118 132 137 146 125 111

2007 142 148 124 141 149 149 134

₁₂₁

2008 159 174 134 154 158 156 141 132

2009 192 216 153 181 199 193 165 147

(15)

Consumer Price Index- Products Wise

300

0 2002 2004 2006 2008 2010 Year

Impact of Money on Foreign Trade

Foreign trade is indispensable for the full economic development of a country and includes framing commercial policies, conducting trade negotiations, and making bilateral, regional and international arrangements for promotion of trade. Foreign trade also includes all the merchandise coming from foreign countries into Pakistan through lawful channels under private and government accounts via sea, air, land routes and by parcel post, released by Customs either directly or in the form of bonds. Goods imported and deposited into bonds are not taken into account.

Consumer Price Index - Product Wise

Year General Food Textile House rent Fuel Transport Education Medicare

20

W 164 103 165

他

₁₆

_^ 106 105

₁₀₂

2003 107 165

₁₆₇

164

₁₁

_§

₁₁₂

₁₁₆

106

2004

₁₁₂

₁₁₀

₁₀₂

_1^1

114 107

2005

₁₂₂

126 113

₁₂₀

126 1^5 118 108

2006 132 134 118 132 137 146 125

₁₁₁

2007 142 148 124 141 149 149 134

_1^1

2008 159 174 134 154 15§ 156 141 132

2009 192 216 153 181 199 195 165 14)

2010 214 243 162 206 227 204 186 157

(16)

(17)

In Pakistan，when calculating foreign trade statistics, the following transactions of imports and exports are excluded:

• Articles of baggage and personal effects of passengers

• Afghanistan trade in transit through Pakistan

• Imports into bonds

• Sale of imported goods in Duty Free Shops in Pakistan

• Defense Stores (if commercial value is declared on GD then the value will be included)

• Gold and Silver coins or Bullion and Currency Notes

• Relief goods of no commercial value

Balance of Payments

The balance of payments (BOP) is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world.

Balance of Trade

Balance of trade statistics compiled by the Federal Bureau of Statistics is based on physical movements of merchandise goods into and out of the custom territory of Pakistan recorded by the customs authorities. Foreign trade includes exports, re-exports, imports and re-imports carried through sea，land and air routes. The trade data of SBP，on the other hand, are based on realization of export proceeds and import payments made through banking channels for goods exported and imported. Trade - transactions such as land-borne trade, imports through foreign economic

assistance, exports and imports by Export Processing Zones and personal baggage etc. are not covered in the reporting by banks. Data on these transactions are collected from the relevant sources and included in the export receipts and import payments reported by the banks to arrive at the overall trade data. Pakistani balance of trade is negative.

Balance of Trade

(Million Dollars)

Year Exports Re-exports Imports Re-imports Balance of Trade 1

PtM

良5说奶奶 10,309.40 18.1 -1,691.80

mn ぬ.5 10,728.90 12,2 -1,476,00

fYdJ 76.1 10,339.50 11.1 -1,145.90

11,166.56 36.4 12,220.30 5.8 -1,015.50

FY04 1^15.36 4设う 15,591.80 143 -2,876.90

FYOS _14,3_う

_1.16

165.4 20,598.10 80.2 -6,183,80

FVde 1汝1 28,580.90 10.3 -12,010.90

FY 07 i^Ii 30,539.70 4,4 -13,405.80

FY 08 19,052.30 727.4 39,965.50 10.9 -20,196.70

FY09 17,688.00 263.3 34,822.10 20.4 -16,891,20

FY10 19,290.00 257 34,710.00 •

(18)

(19)

Balance of Trade 1

USD (Million)

50.0. 00

40.0. 00

30.0. 00 20

,

000.00 10

,

000.00

0.00

Year 19 5Q5 2010 2015

-10,000.00 -20,000.00

-30,000.00

B. Banks and Development

Financial Institutions (DFIs)

A growing and forceful banking sector is essential for economic development in Pakistan

一

as growth in the banking sector and the real economy mutually support each other. Pakistan already has a well developed banking system, which consists of a wide variety of institutions ranging from a central bank to commercial banks and to specialized agencies to cater for the special requirements of specific sectors. The banking sector constitutes the core of the financial sector in Pakistan. Private sector investment and consumption should be seen as the key drivers of the economy and must be supported by growing financial intermediation and services, including not only banks but also non-bank financial institutions, as well as debt securities and the stock market.

Judged by any indicator，the vitality and strength of the banking sector is impressive and stands out particularly relative to its state in the early 1990s when the financial system was dominated by public sector banks.

By the end of 2010，the banking system saw a rise in deposits to Rs 4.1 trillion and advances to Rs 3.3 trillion. Banks as profitable ventures have attracted close to over $4 billion of foreign direct investment during 2006- 2008. Almost half the assets of banks are now owned by foreign banks that are introducing innovative developments and technological improvements.

Prudent lending, supported by a strong regulatory and supervisory framework, has reduced net non-performing loans to historical lows. In line with international trends, SBP introduced Basel II and banks now have higher capital adequacy levels well above the minimum level for the sector as a whole. Despite economic shock and stress in the stock market, the banking system in years 2009 and 2010 has shown an increase in profitability.

(20)

(21)

Banks are the only financial institutions that can manage and control the imbalance between borrowers and lenders. Banks access and manage risk by processing information on potential borrowers and their creditworthiness. After credit has been extended, banks monitor borrowers’ performance and may extend additional credit as businesses develop; they are also closely involved in the payments and transactions of their customers. Banks, therefore, are the most appropriate and qualified intermediaries to deal with both smaller and start-up companies and with the household sector and need to move away from their excessive focus on financing large enterprises and the government.

C. Financial Instruments (covered in detail in Ch 4)

A financial instrument is a tradable asset of any kind, either: cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument.

This topic is discussed further in Chapter 4.

D. Financial Markets

A financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods)，and other tangible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Financial markets can be divided into the following:

a. Capital markets which consist of stock markets, which provide financing through the issuance of shares or common stock and enable the subsequent trading thereof.

b. Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

Deposits of Schedule Banks

As On Banks Deposits (Rs In 000s)

Dec 2002 1,315,168

Dec 2003 1,522,733

Dec 2004 1,808,264

Dec2005 2,174,050

Dec 2006 2,588,582

Dec2007 2,975,451

Dec2008 3,574,788

Dec 2009 3,652,605

Dec2010 4,400,569

(22)

(23)

c. Commodity markets, which facilitate the trading of commodities.

d. Money markets, which provide short-term debt financing and investment.

e. Derivatives markets, which provide instruments for the management of financial risk.

f. Futures markets, which provide standardized forward contracts for trading products at some future date.

g. Insurance markets, which facilitate the redistribution of various risks.

h. Foreign exchange markets，which facilitate the trading of foreign exchange.

Both money and capital markets are key components of financial markets. Both markets allow investors to buy debt securities which are financial products that a dealer purchases and the issuer promises to pay back

，

such as bonds. Capital markets also sell other types of securities and money markets specialize in short-term debt.

a. Capital Markets

Capital markets are any financial market or exchange that trades in financial products, such as stocks - the main equity security, bonds - the main debt security - as well as other products such as futures and options contracts.

b. Money Market

The money market focuses on short-term debt. Short-term debt means financial products - bonds

，

loans, promissory notes - that the issuer will pay back within 52 weeks. Much of the debt traded on capital markets has even shorter periods, like overnight bank loans or Treasury bills that mature in a matter of weeks.

Both types of markets move billions of dollars a day，making them extremely important in the global economy. Businesses and governments rely on both markets to raise money to pay for operations or expand activities. Furthermore, both markets are largely intangible. Most of the trading occurs through computerized trading platforms, not in physical market places or exchanges. While the floor of the New York Stock Exchange is the icon of the capital market, the number of traders on its floor decreases every year and the CEO of NASDAQ has called it a relic. Capital markets trade in both debt and equity, which is ownership investment such as stocks. While both capital markets and the money market restrict who can trade directly, the money market is the near exclusive dominion of very large institutions, banks and governments, while individuals can gain access to capital markets by opening a brokerage account.

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets.

Secondary markets allow investors to sell securities that they hold or use to buy other viable securities. The transactions in primary market are executed between companies and the public, while in the secondary market it is executed between investors.

Capital Market and Economic Growth

Economic growth in an economy hinges on an efficient financial sector that pools domestic savings and mobilizes foreign capital for productive investments. Without an effective set of financial institutions, productive projects may remain idle. An efficient stock exchange will attract savings kept at home, or lying idle in savings accounts. In Pakistan, often IPL are oversubscribed because investors want to invest their hard earned money in profitable ventures.

(24)

financial sector allows households to diversify risk and maintain liquid investments (e.g., bank deposits). Their second activity involves information gathering and selecting investment projects as well as monitoring industrial activities.

Without efficiently run capital markets, investors have limited means to diversify their portfolios. As a result, investors may avoid equity stakes because they are too risky. Hence，corporations may find it difficult to raise equity capital. With the creation of stock markets, individuals can diversify firm-specific risks，thus making investment in firms more attractive.

An efficient stock market can enhance growth by mitigating moral hazard and consequently increasing productivity. The significance of this effect depends on the magnitude of the moral hazard problem and on the proportion of the economy that is represented in the stock market. Another key growth contribution of an efficient stock market is its effect on the industrial sector. An entrepreneur considers not only the profits generated in a new venture but also the possibility of a lump-sum gain through selling the venture to the public. If the stock markets are not efficient, the public offering is less feasible as a result of high transaction costs or the uncertainty of getting a fair price in the stock market. Thus inefficient stock markets may reduce the incentive to enter new ventures, reducing overall long-term productivity of the economy.

An efficient stock market reduces the transaction costs of trading and plays a primary role in the development of the capital market. If the volume of the capital market is increased, production will be increased

，

and an increase in production will help in keeping general price levels in check and increasing exports.

Government Bond Market

After suspension of auctions of Federal Investment Bonds (FIBs) in June 1998, there was no long-term marketable government security that could meet the investment needs of banks, NBFIs, insurance companies, pension funds and corporate bodies. However, because of the attractive National Saving Scheme rates at that time and no bar on institutional investment, this vacuum was not even felt.

In order to develop the longer end of the government debt market by creating a yield curve and to boost the corporate debt market, the government decided to launch the Pakistan Investment Bond (PIB) in December 2000. It was hoped that there would be a sufficient demand for this instrument, given the institutional ban on investing in NSS and the fact that a new system of Primary Dealers (PDs) was established to develop a secondary market for these bonds.

As a pre-requisite for launching PIBs，primary dealers (PDs) were chosen on the basis of their treasury expertise and infrastructure, past performance as market players，and capital adequacy. These players were given explicit responsibility for developing an active secondary market by supplying non-PDs and institutional investors with PIBs.

E. The Central Bank - The State Bank Of Pakistan (SBP)

As the central bank of the country, the State Bank of Pakistan has a number of policies, regulatory and fiduciary responsibilities designed to strengthen the financial system of the country and provide a workable framework for the financial industry that will help in economic growth.

(25)

Role of SBP in regulating the activities of Pakistan's financial system

In addition to performing various functions mandated under relevant legislation, the State Bank performs a number of developmental roles as a responsible member of the economic management team of the country. These vary from undertaking ground-breaking research to introducing innovative products such as Islamic Export Refinance Schemes, Housing Finance Windows and promotion of microfinance, as well as provision of an enabling environment by facilitating and opening of Internet Merchant Accounts and developing a Real Time Gross Settlement System (RTGS) for the banking industry. The State Bank of Pakistan has been entrusted with the responsibility of formulating and conducting monetary and credit policy in a manner consistent with the Government’s targets for growth and inflation and the recommendations of the Monetary and Fiscal Policies. For that purpose SBP performs the following functions:

1. Regulation of Liquidity

(26)

(27)

in the financial sector of Pakistan in early 2005，which have been successfully completed, and now SBP has started a second phase of reforms to be implemented in the next five years. These reforms must be reviewed continuously to adjust them according to changing circumstances, both locally and internationally. The main objective of the second phase of reforms is to further strengthen the financial sector and to integrate it according to the needs of the global economy.

2. Ensuring Soundness of Financial System

One of the fundamental responsibilities of the State Bank is regulation and supervision of the financial system and to ensure its soundness and stability as well as to protect the interests of depositors. For this purpose SBP has established a Customer Protection Department. Banking activities are now being monitored through a system of ’off-site’ surveillance and f_on-sitef_{inspection and supervision.}

Off-site surveillance is conducted by the State Bank through rigorous checking of various returns regularly received from the different banks, while on-site inspection is undertaken by the State Bank, when required, in the premises of the banks concerned.

3. Inspection

As mentioned above，banking activities are monitored through a system of !off-sitef surveillance and ’on-site，inspection and supervision.

4. Prudential Regulations

In order to safeguard the interest of ultimate users of the financial services, and to ensure the viability of institutions providing these services, the State Bank has issued a comprehensive set of Prudential Regulations (for commercial banks) and Rules of Business (for NBFIs).

The "Prudential Regulations" for banks, besides providing for credit and risk exposure limits, prescribe guidelines relating to classification of short-term and long-term loan facilities, set criteria for management, and prohibit criminal use of banking channels for the purpose of money laundering and other unlawful activities.

5. Exchange rate management

(28)

(29)

6. Development Role

Besides discharging its traditional functions of regulating money and credit, the State Bank of Pakistan plays an active developmental role in promoting the realization of macroeconomic goals. Accordingly, conventional central banking functions are combined with a well- recognized developmental role. The Bank’s participation in the development process is in the form of rehabilitation of the banking system in Pakistan, development of new financial institutions and debt instruments in order to promote financial intermediation, establishment of Development Financial Institutions (DFIs), directing the use of credit according to selected development priorities, providing subsidized credit, and development of the capital market.

Reforms can be successfully implemented only if there is consultation, involvement and consensus among all the stakeholders throughout the process. Application of technology, thorough use of human resource competencies and managerial skills are the key tools for achieving results. In the first phase of the reforms, financial markets in Pakistan have been liberalized and have become competitive and relatively efficient, although they are still capable of farther development.

The range of financial instruments available for various types of transactions in the market has widened but the evolution of new instruments has to remain on track.

Financial infrastructure has been strengthened but the legal system is still too time consuming and costly for ordinary market participants. The regulatory environment has improved and the capacity of regulators to oversee and monitor is much better today, but the enforcement procedures and prompt corrective action capabilities need to be further enhanced.

Financial soundness indicators of the system show an upward moving trend in almost all dimensions but there are weaknesses that require to be addressed.

Corporate governance rules have been clarified and aligned with best international practices, but their consistent application and voluntary adoption by the industry as a whole remain uneven.

The financial sector is opening up to the middle and lower income groups, but the commitment and mindset of the providers still need to be improved in line with the new realities.

SBP's Banking Sector Reforms over the next decade have been formulated. The Banking Sector Strategy (BSS) is centered on reforms involving the SBP and the banking sector，which constitutes not only the core of the financial system in Pakistan but is also vital to the monetary and financial stability responsibilities of the SBP.

Since the BSS was first outlined on July 1

，

2008，the ongoing financial crises abroad and the deteriorating macroeconomic situation in Pakistan have led to a, review of the strategy. Despite the dynamics of the overall situation, there is no need for any change in the overall purpose of the

BSS but rather a reinforcement of the urgency of reform that will make the financial sector more stable and Pakistan a more attractive destination for domestic and foreign direct and portfolio investment.

The BSS includes the following ten main areas of reform:

1. Create a more diverse and inclusive banking sector

2. Improve consumer protection and financial education

3. Strengthen competition and efficiency

4. Consolidate and strengthen the banking sector

(30)

Overview of the Financial System

6. Introduce a framework for consolidated supervision

7. Develop a financial safety net

8. Strengthen SBP autonomy, accountability and governance

9. Develop a more balanced financial system

10. Develop the financial infrastructure.

Growth of the other financial subsectors has remained below their potential. Although stock market capitalization has shown impressive increases in recent years，this has not played a major mediator role, as there were few new listings and issues, and stock values declined sharply in 2008. The private debt securities market remains slow. The government

* debt market has grown in recent years to meet the government’s growing financing needs but the framework for issuing, pricing and trading government securities remains under-developed. The growth of nonbank financial intermediaries has lagged behind that of banks.

Traditional and Non-Traditional Functions off the State Bank of Pakistan

The State Bank of Pakistan is the Central Bank of the country. In order to achieve its objectives the State Bank performs all the traditional and non-traditional functions. Traditional functions are those which are performed by the central banks of all countries. Non-traditional functions are those which are not traditional or conventional but which SBP has assumed these functions taking into account the specific requirements of the country. In the Statute of the Bank for International Settlement, a central bank is defined as ’the bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in that country’ (Article 56 a).

Traditional functions

Traditional functions performed by Central Banks everywhere are divided into two groups, i.e. primary functions and secondary functions. Primary

functions are issuance of notes, regulation of the financial system, lender of last resort, and conduct of monetary

policy. Secondary

functions are management of public debt, management of foreign exchange, advising government on policy matters, securing the payment system and maintaining relationships with international institutions.

1. S o l e authority to issue Notes:

Under section 24 of the SBP Act 1956，this is the primary function of the bank - to issue notes in accordance with the requirements of business and the public as a whole. According to section 30 of the SBP Act, assets of the Issue Department (gold / silver reserve，approved foreign exchange and special drawing rights held with IMF) at no time should fall below its liabilities, i.e. total of notes issued. Out of total assets a minimum Rs.1.2 billion must be kept in the form of gold coins, gold bullion, and silver bullion or approved foreign exchange.

2. Conduct of Monetary and Credit policy:

(31)

bring economic stability to the country. The Bank uses direct and indirect instruments for credit control, such as discount rate for three days repo, T-bill auction rate, and open market operations. The Bank also controls credit by prescribing credit ceilings,

setting the

credit/

debit ratio, and fixing margin requirements. Since 1995, SBP has

been

controlling liquidity through open market operations.

3. Regulation and supervision of Financial System:

As the central bank, SBP is responsible for safeguarding the soundness of the financial system of the country. Under section 40 A of the Banking Companies Ordinance 1962，it is the responsibility of the SBP to monitor the performance of every banking company and DFIs, as well as Micro Finance banks.

Non-bank financial companies (NBFCs)，such as leasing companies, mutual funds, Modarba companies, the stock exchange and insurance companies

，

etc, all fall under the ambit of the Security and Exchange Commission of Pakistan (SECP) which is responsible for monitoring the affairs of these companies.

4. Off-site and on-site monitoring

(32)

(33)

5. Prudential Regulations

In order to safeguard the interest of depositors and to ensure the safety and soundness of the banks/DFIs，the State Bank has issued Prudential Regulations. The State Bank has devised separate Prudential Regulations for different areas

，

viz. Corporate and Commercial Banking, Small and Medium Enterprise Financing, Consumer Business, Micro Financing and Agriculture Financing.

The Prudential Regulations for Corporate and Commercial Banking govern operations of the financial institutions in respect of their dealing with corporate entities. The Regulations focus on Credit Risk Management, Corporate Governance, Anti Money Laundering and Operations. Regulations for Consumer Financing have been devised to encourage the banks to expand their loan portfolio through creation of new products and to ensure that banks undertake consumer financing in a sensible manner. Consumer financing covers any financing allowed to individuals for meeting their personal, family or household needs and includes credit cards，auto loans, housing finance and other methods of consumer financing.

The Prudential Regulations for Small and Medium Enterprises (SMEs) facilitate and encourage the flow of bank credit to the SME sector with the purpose of moving away from collateral-based lending to cash flow- based lending. The maximum limit of clean financing against personal guarantees has increased to Rs. 3 million for SMEs. This is greater than that for consumer financing as well as for corporate clean financing. The requirement for banks/DFIs to obtain a copy of accounts has been relaxed for exposures of up to Rs.10 million.

The State Bank has also issued Prudential Regulations for Microfinance Banks and institutions. Microfinance Banks/Institutions (MFBs/MFIs) shall not commence business unless there is a minimum paid-up capital as prescribed in MFIs Ordinance 2001.A MFB/MFI shall also maintain equity equivalent to at least 15% of its risk-weighted assets shall maintain a cash reserve equivalent to not less than 5% of its time and demand liabilities in a current account opened with the State Bank or its agent. In addition to a cash reserve it shall also maintain liquidity equivalent to at least 10% of its time and demand liabilities in the form of liquid assets, i.e. cash, gold and unencumbered approved securities. In particular:

• The MFB/MFI shall not extend loans exceeding Rs. 100,000/- to a single borrower.

• The outstanding principal of the loans and advances, payments against which are overdue for 30 days or more, shall be classified as Non-Performing Loans (NPLs).

6. The Bankers' Bank

(34)

(35)

requirements of a scheduled bank according to section 37(2) of the SBP Act 1956，such as capital and reserves are not less than the requirement prescribed by SBP.

The State Bank maintains an updated list of all scheduled banks at its various offices. These banks are entitled to certain facilities from the State Bank and in return they have some obligations to it. The State Bank provides the following three important services to the scheduled banks:

I. SBP keeps the deposits of commercial banks，which constitute the statutory reserves of scheduled banks. Scheduled banks are required to keep with the State Bank a certain percentage of their demand and time liabilities under Section 36 of SBP Act, 1956.

II. The State Bank also provides wide-ranging remittance facilities to banks at a concessional rate. The Bank provides this facility through the media of its own offices，the branches of National Bank of Pakistan acting as its agents，and treasuries and sub-treasuries holding permanent currency chests at places where the State Bank has no office.

III. In order to streamline payments through the financial system, the Bank also manages the operations of clearing houses. In the major cities, the functions of the SBP clearing house has been handed over to a private agency, namely National Institutional Facilitation Technologies Private Limited (NIFT), to the extent of sorting of payments instruments and preparing clearing schedules.

7. Lender of Last Resort

One of the most important functions of the State Bank is that it acts as the lender of last resort. Under section 17 of the SBP Act 1956，the State Bank provides loan and re-discount facilities to scheduled banks in times of dire need when they can find no other source of funds. These facilities are ordinarily provided by the Bank against government securities, trade bills, agriculture bills

，

etc. A 3-Day Repo facility was introduced by the State Bank of Pakistan with effect from IstFebruary, 1992，with the purpose of accommodating the short-term liquidity requirements of financial institutions.

8. Banker to the Government

The State Bank provides business banking facilities to Federal and Provincial Government and some government agencies. These functions performed by the Bank are similar to those ordinarily performed by commercial banks for their customers. The Bank provides the following services to government:

(36)

(37)

2. Federal and Provincial government keep their deposits with the State Bank free of interest. In turn, the State Bank does not charge any commission for the banking services rendered to them.

3. Federal and Provincial government can obtain advances from the SBP subject to mutual agreement in respect of the terms and conditions for such advances.

4. According to section 17，sub section (13) of the SBP Act, SBP, on behalf of Federal, Provincial or Local government, undertakes sale/purchase of gold, silver, approved foreign exchange, securities or shares in any company

，

and collection of returns on these shares/securities, transaction of SDR, etc.

Secondary Functions of SBP

1. Public Debt Management

The State Bank is responsible for the management of government debt under sub-sectionl7, sub- sec 13(e)，and section 21 of the SBP Act, 1956. The following actions are involved in this regard:

• Subscribing Federal and Provincial government securities at the time of their issue

• Sale/purchase of such securities in the Money Market

• Payments of interest to holders of public debt instruments

In order to efficiently manage the public debt, a department, namely Exchange & Debt Management Department (EDMD)，was created in February, 2000. For the auction of Treasury Bills and government bonds, a primary dealer system was developed. The securities are offered for sale on a fortnightly basis in the case of Market Treasury Bills (MTBs) and on a quarterly basis in the case of Pakistan Investment Bonds (PIBs) to primary dealers8. Primary dealers are then allowed to undertake the business of government securities in the secondary market which consists of SBP, primary dealers, banks other than primary dealers

，

non-bank financial institutions, financial brokerage houses, various financial funds, individuals, and others.

2. Management of Foreign Exchange

SBP is also responsible for maintaining the external value of the currency, and as such it manages and administers the exchange system of the country in line with the Foreign Exchange Regulation Act, 1947. Under sub-sections 3(a) and 13(a

，

f) of section 17，and section 23 of the SBP Act, 1956，SBP acts as an agent to the Government. The State Bank is authorized to purchase and sell gold，silver or foreign exchange and transactions of special drawing rights with the International Monetary Fund.

(38)

(39)

For the development of the Forex Market a number of reforms have been undertaken by the SBP, such as:

• Permission for residents to open foreign currency deposits.

• Granting licenses to Pakistani nationals and resident companies/firms to work as authorized money changers on payment of a prescribed fee.

•Permission to open a ’Special Convertible Rupee Account，by nonresidents for the purchase of shares quoted on the Stock Exchange.

• Permission for investment banks to raise foreign currency funds from abroad through issue of certificates of investment.

• Liberalization of rules relating to investment in government securities, including NIT Units, by non-resident Pakistanis on a reparable basis.

• Permission to authorized Dealers for the import and export of foreign currency notes and coins.

• Establishment of exchange companies.

• Relaxation in respect of trade-related remittances.

• Adoption of measures to deepen Forex markets/treasury operations

，

etc.

Exchange companies have been established to carry out sale/purchase, export/import and remittances of foreign currencies. They are allowed to make remittances on account of dividends, royalty and franchise fees etc” subject to an NOC from the designated authorized dealer. Formulation of exchange companies will help in the unification of exchange rates. Currently, this has provided a corporate culture for money changing / remittances businesses in the country. Home remittances are also being routed through these companies，which have been brought within the reporting ambit.

A new foreign currency accounts scheme has also been introduced under which banks retain the funds and pay out returns, while keeping in view their earnings and the costs of these funds. The funds under this scheme can be used to finance trade-related activities. Traders, particularly exporters, can now have access to foreign currency loans at cheaper rates.

3. Advisor to Government

(40)

(41)

Coordination Board" has been set up. As a member of this Board, the State Bank participates in economic policy making and coordinates information concerning fiscal, monetary, foreign trade and exchange rate policies.

SBP submits its review of the economy to the Parliament through its annual and quarterly reports on the state of the economy with special reference to economic growth, money supply, credit, balance of payments and price developments.

4. Relationships with International Financial Institutions

Pakistan is a member of the International Monetary Fund. The State Bank of Pakistan deals with the IMF on behalf of the Government of Pakistan as per power entrusted under section 17

，

sub-section 13(f) of the SBP Act 1956. The State Bank of Pakistan also deals with other international financial organizations including Bank for International Settlement, the World Bank，Central Banks of foreign countries, etc. Almost all the agreements of Provincial and Federal Government with International Financial Institutions (IFIs) are executed through the State Bank of Pakistan.

Non-Traditional functions

Responsibilities of the State Bank of Pakistan go well beyond the conventional functions that have been discussed above. The scope of the Bank’s operations has been considerably extended by including the economic growth objective in its statute under the State Bank of Pakistan Act, 1956. SBPs involvement in the development process has been in the form of:

• Rehabilitation of banking system in Pakistan

• Development of new financial institutions

• Development of debt instruments to promote financial intermediation

• stablishment of Development Finance Institutions (DFIs)

• Directing the use of credit according to development priorities

• Providing subsidized credit

• Development of capital market.

1. Development of the Banking System

The most significant contribution made by the State Bank of Pakistan towards facilitating and fostering economic development in Pakistan was the rehabilitation of the banking system.

(42)

(43)

2000 2002 2004 2006 2008 2010 2012 Year

broader outlook and a bold branch expansion program in 1949. At the time of independence the commercial banking system in Pakistan had virtually collapsed with the closure of a large number of bank offices which had been run and managed bynon-Muslims who migrated en- masse to India. A year later, it was decided to restrict internal banking to Pakistani banks and allow foreign banks to open new offices only in port towns or in other large cities where substantial trade was carried on with foreign countries. As of 31 December 2010，34 Pakistani and 12 foreign banks were operating in Pakistan with branch networks of 9281 and 58 respectively. In the last decade the banking industry has progressed significantly. The following figures speak for themselves.

•Deposits ■Advances

2. Micro Finance

In order to expand the banking services at grass roots level and to enable the financial sector to play its role in poverty alleviation, the State Bank of Pakistan is also promoting micro banking in the country. It has facilitated two micro finance banks, namely Khushhali Bank and the First Micro Finance Bank (FMFB) Limited. Khushhali Bank is in the public sector and FMFB is set up in the private sector.

3. Promotion of Islamic Banking

In order to meet demand for Shariah-compliant solutions for the various financial needs of the public, the State Bank of Pakistan is playing a leading role in the promotion of Islamic banking in Pakistan. Conferences, workshops, seminars and presentations are being conducted to create public awareness and develop better coordination among the various stakeholders of Islamic banking. The progress of Islamic banking in Pakistan is phenomenal ana is in geometrical progression.

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Deposits (In Mins)

1475 1678 1964 2393 2832 3255 3854 4218 4786 5128

Advances (In Mins)

910 921 1108 1574 1991 2428 2688 3173 3240 3494

(44)

(45)

4. Training Facilities for Bankers

As mentioned earlier, at the time of independence the commercial banking system in Pakistan had virtually collapsed with the closure of a large number of bank offices which had been run and managed by non-Muslims who migrated to India. In order to address the problem of an acute shortage of trained bankers at the time of independence, the State Bank introduced a "Bank Officers Training Scheme” within one month of its establishment, i.e. on July 1

，

1948. On September 17，1951 the Institute for Bankers Pakistan (IBP) was established in order to conduct examinations in prescribed banking courses. This action ensured that the country’s banking staff could become professionally qualified. The Institute is contributing significantly towards the improvement of the operational efficiency of the banking industry and in providing better facilities for training and education.

Recently the SBP has launched a unique training program for not only bankers involved in rural and agricultural credit but also farmers and other potential clients of rural financial service providers. Such training is held at the various offices of SBP (BSC). The objective of such training programs is creating awareness among the farming community.

5. Development of Specialized Financial Institutions

The State Bank has actively participated in setting up a number of specialized credit institutions designed to meet the long and medium- term financing needs of various sectors of the economy. These institutions include Agricultural Development Bank of Pakistanis (ADBP)，Federal Bank for Co-operatives (FBC) and House Building Finance Corporation (HBFC)

，

etc. These institutions were established to provide credit to the industrial, agricultural and other sectors.

6. Credit for Priority Sectors

The Bank has also introduced various credit schemes to channel resources towards priority sectors such as an export finance scheme, mandatory credit for agriculture, small businesses and small industries, etc.

7. Credit for Agriculture

The Agriculture Credit Scheme was introduced in 1972 by the SBP under the SBP Act 1956. The spirit of the scheme is to provide maximum credit availability through banking credit to small farmers having cultivable land up to Subsistence Level.

8. Export Finance Scheme 、

(46)

(47)

which financing facilities are provided on transaction bases and Part II which caters for financing requirements on a performance basis.

9. Islamization of the Banking System

The State Bank has also been involved in the process of Islamization of the economy in general and the banking system in particular. A unit was created in the Research Department of the Bank in the late 1950s that was subsequently developed into a fully-fledged Division，to undertake research work on the Islamic economic system. In 2001 an Islamic Banking Division was established in the Banking Policy Department to deal with regulatory and supervisory issues in Islamic banking.

Determinants of Financial Growth

The financial sector pools funds from dispersed households and allocates them efficiently to entrepreneurs who carry good credentials and reputation. Through the first activity, an efficient financial sector allows households to diversify risk and maintain liquid investments (e.g., bank deposits). The second activity involves information gathering and selecting investment projects together with monitoring industrial activities.

Government policies and strategies support the finance-led growth hypothesis, based on an observation first made almost a century ago by Joseph Schumpeter that financial markets significantly boost real economic growth and development. Schumpeter asserted that finance had a positive impact on economic growth as a result of its effects on productivity growth and technological change. As early as 1989 the World Bank also endorsed the view that financial deepening matters for economic growth nby improving the productivity of investment'1. A number of case studies on Asia and Southern African countries show the positive connection between development of financial intermediation and economic growth. Banks and DFI are the key players in Pakistan’s financial system. The progress of the different components of the financial system can be taken as a yardstick for determining financial growth.

Without efficiently run capital markets, investors have limited means to diversify their portfolios. As a result, investors may avoid equity stakes because they are too risky. Hence, corporations may find it difficult to raise equity capital. With the creation of stock markets, individuals can diversify firm-specific risks, thus making investment in firms more attractive. An efficient stock market can enhance growth by mitigating moral hazard and consequently increasing productivity. The significance of this effect depends on the magnitude of the moral hazard problem and on the proportion of the economy that is represented in the stock market. Performance of the bond and stock market can be treated as a base for determining capital market growth.

Factors affecting the growth and development of a financial market

(48)

Introduction to Financial Systems.pdf

Introduction to

Financial Systems &

Banking

Regulations

Stage 1

，

Contents

Contents

Part 1: Overview of the Financial System

Part 0ne

Overview of the Financial System

，

，

，

一

US $ Rate

Year

US $

Rate

Year

US $

Rate

1961

4.76

1999

51.76

1970

4.76

2000

57.71

1972

9.91

2001

61.31

1980

7.887

2002

58.68

1990

21.32

2003

57.43

1991

24.74

2004

59.83

1992

25.46

2005

59.76

1993

30.12

2006

60.73

1994

30,76

2007

60.95

1995

33.59

2008

79.76

1996

39.53

2009

82.87

1997

43.64

2010

83.41

ね

iinmii

IWFBTIf I I I l i

mmw

H H I I

>002

10

M

10

₁₀

_M

₁₀

₁₁₂

₁₁₀

₁₁₂

₁₁

₁₀

₁₂₂

₁₂₀

₁₂₁

₁₆

₁₀₂

₁₆₇

₁₁

₁₁₂

₁₁₆

₁₁₂

₁₁₂

₁₁₀

₁₀₂

_1^1

₁₂₂

₁₂₀

₁₁₁

_1^1

_1.16