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Serial Number
Table of Contents Page
No
Copyright Notice 1
Acknowledgement 2
Preface 3
Abstract 4-5
1 Introduction 6
1.1 Background 6-8
1.1.1 • Pakistan Banking Evolution System 8
1.1.2 • Dominance of Nationalized Commercial Banks (NCB) 8-9
1.1.3 • History of Non-Performing Loans (Snapshot) 9
1.2 Research Question 9
1.3 Purpose of the Research 9
1.4 Definitions 10
1.4.1 • What is privatization? Different Views 10
1.4.2 • Types of privatization 10-11
1.4.3 • Non-Performing Loans 11-12
1.4.4 • Definition of Banks 12
1.4.5 • Performance 12
1.5 Limitations 12
1.5.1 • Limitations of the Data 13
1.5.2 • Limitations of Research 13
1.6 Disposition 14
2 Theoretical Framework 15
2.1 Pakistan Economy and Lending Market 15
2.1.1 • Pakistan and the World (2008) 15
2.1.2 • Economy Overview 16
2.1.3 • History of Pakistani lending market and Non-Performing Loans
16-17
2.2 Privatization as an Economic Instrument 18
2.2.1 • Why Privatization 18
2.2.2 • Different views on effect of Privatization 19
2.2.3 • Efficiency of Privatization 19
2.2.4 • Views on the effect of Privatization on Customers 19 2.2.5 • Privatization Impact on NPLs and banks performance (IMF
Analysis)
20-21 2.3 Performance of the Banking Sector in Pakistan from (1980s to
now)
22
2.3.1 • The role of the Central Bank 22
Regulatory Authority 22
Reform Measures taken by State Bank of Pakistan 22
Recent trends in banking sector 22
2.3.2 • Introducing Major Reforms and Prudential Regulations in late 1980s
23
2.3.3 • Analysis of Financial Sector Reforms 24
Interest Rate 24
Performance and Efficiency of Financial Institutions 25
Privatization 25
2.3.4 • Conditions before privatization in Banking Sector performance
26 2.3.5 • Main problems before privatization took place in banking
sector
26
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2.3.6 • Financial sector reforms 1990 26-28
2.3.7 • Banking Law Reforms 28
2.3.8 • Post-privatization activities 28-29
2.3.9 • Banks privatized just after privatization 29-30
2.4 Non-Performing Loans and Classification 31
2.4.1 • Treatment of Non-Performing Loans 31
2.4.2 • Classification of Non-Performing Loans 31
2.4.3 • Facts regarding Non-Performing Loans 32-33
2.4.4 • Impact of NPLs on Banking sector 33-34
2.4.5 • Causes of Non-Performing Loans in different countries 34-35 2.4.6 • Different Views and Analysis on Non-Performing Loans 35-36 2.4.7 • Steps taken by State Bank of Pakistan to overcome NPLs in
future
36-37
• Conclusion on NPLs 38
2.4.8 • Short review of MCB and ABL 38
• MCB Privatization Impact Analysis 39
• ABL Privatization Impact Analysis 39
• MCB and ABL Comparison after Privatization 39
3 Research Methodology 40
3.1 Statement of the problem 40
3.2 Scope of the study 40
3.3 Research Philosophy 40
3.3.1 • Positivism 41
3.3.2 • Phenomenal 41
3.4 Research Approach 41
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3.4.1 • Inductive Approach 41
3.4.2 • Deductive Approach 41
3.5 Research Methods 42
3.6 Research Design 42
3.7 Research Criteria 42
3.8 Sample and Sample Size 43
3.8.1 • Population 43
3.8.2 • Sample 43
3.9 Hypothesis 43
Hypothesis Model 44
3.9.1 • Null Hypothesis Model 44
3.9.2 • Hypothesis Model 44
3.10 Dependent and Independent Variables 44
3.10.1 • Variable 1 44
3.10.2 • Variable 2 45
3.11 Analysis Format 45
3.11.1 • Percentages of Non-Performing Loans of Muslim Commercial Bank
45 3.11.1 • Percentages of Non-Performing Loans of Allied Bank
Limited
45-46
• Short review of NPL percentages 46
• Short Description of Chapter 4 47
4 Our Analysis and Outcome 48
• Levene’ s test for equality of variances 48
• Independent sample test 48
• T-test for equality of means 49
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• Confidence interval 49
Observations 49
• Observation No: 1 (Muslim Commercial Bank) 49-51
• Observation No: 2 (Allied Bank Limited) 51-53
5 Conclusions and Recommendations 53-54
Recommendation for further Research 54
6 Truth Criteria 55
• Reliability 55
• Validity 55-56
• Generalization 56
References 57-60
7 Glossary 61
8 Appendices 62-68
9 Index 69-72
Copyright Notice
Copyright @ Muhammad Tariq, Imran Karim Sirohi 2009
All Rights Reserved. No part of this thesis may be reproduced, stored in or introduced into a retrieval system or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise).
Students and academicians can take the advantage from this “Thesis Report”. If any individual wants to take reference from this report he/she can use it for the reference of his/her academic thesis.
Printed in Umea University, 2009
Acknowledgement
First of all we are grateful to Allah Almighty, the most beneficent and ever merciful who gave us courage to complete our Thesis Report.
It has been half year we have started our thesis entitled “Has privatization reduced the proportion of non-performing loans and increased bank performance in Pakistan” During this period, many people have contributed to the success of this thesis.
We wish to express our gratitude to the supervisor Miss. Catherine Lions for the advice that she provided us throughout the study period, in particular the discussions that we had during our stay at the University of Umea. Her maximum effort contributed to the success of this project. We want to acknowledge the help that we have received from Mr. Ghulam Abbas (Assistant Professor, University of Iqra, Pakistan). He helped us to acquire an in depth knowledge of the statistics part.
We are grateful for the support and co-operation that we have received from department of Business Administration of the University of the Umea, in particular the support of Miss. Gisela Taube Lyxzen.
The support of our family was also invaluable in completing this thesis. They all have been on our side through prayer, moral and support. Finally, we wish to express our gratitude to all our teachers in the university education that provided us with a good background for completing this thesis.
________________
Imran Karim Sirohi Student, Umea University
_____________________
Muhammad Tariq Student, Umea University
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Preface
The study of Finance has always been interesting and full of complexities. Think of today major economic sectors of Pakistan, Industrial, Textile, Agricultural, Banking, Telecom, Media and Government and Semi Government Sectors and many more, question is which sector has played an important role in making the economy of the country strong. Of course Banking Sector that has contributed a major part in the economy of the country after the privatization has taken place.
Other sectors like Telecom and Media have done a great job for the last seven to eight years but Banking has overcome other sectors because of the high stream of privatization process. So it is therefore necessary to study the measures of banking sectors and to find out the problems which have been affecting the economy of the country.
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Abstract
Privatization has become an important aspect all over the world especially in developing countries of the world. Pakistan has also embarked on privatization program for the state-owned financial sector. As this report is limited to banks so we have selected banks which were privatized in the decade of 1990-2002 and the topic on which we have emphasized is Non- Performing Loans.
This thesis is based on the two main things, firstly privatization of government owned banks and secondly Non-Performing Loans proportion with respect to the effect of privatization.
Privatization of government owned banks in Pakistan was the main reason behind the overcome of weak banking sector and as part of this policy, for the very first time in 1991, two government owned banks of Pakistan Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL) were converted into private entities.
In first step authors have tried to collect data regarding the history of Pakistan as an economic instrument, why privatization in banking sector was important, review of banking sector and its performance in Pakistan and Non-Performing Loans and its classification with respect to privatization in the banking sector.
Banking sector is considered as one of the most important sector of every country and there are so many measures to gauge the performance of the banking sector. There are many measures utilized to gauge the performance of the banking sector like measuring asset quality, capital adequacy, earning, profitability, liquidity. Out of these performance measures this study is targeted towards gauging the “operating performance” of banks keeping in view the global performance. We have taken one specific measure that is “Non-Performing Loans” of selective banks to find out the operating performance of the banking sector and impact of privatization has been kept in mind to find out the results. So the scope of the study is to find out the impact of privatization on performance of banking sector and the area of the study is Non-Performing Loans.
The nature of the topic puts on view that that it cannot be studied in artificial environment. The topic has been analyzed in natural environment without any involvement, so the research is more of exploratory research and as well as descriptive. The purpose of the study is “Exploratory” in nature, as it aimed to collect and create appropriate information related to the topic. The method of conducting this research is based on secondary data. We have adopted the secondary data collection method, for that we have gone through the newspapers, internet, books, magazines, annual reports, articles and different libraries have been investigated.
For the empirical studies, we have taken observations from two different banks: Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL) and we have done the comparison of means between their pre-privatization period and post-privatization period respectively to assess
the impact of privatization on Non-Performing Loans. To compare the means we have use SPSS software.
We looked at the Group Statistics in which we compared Levene’s Test for Equality of Variances to find out the variance result. Secondly we looked at the Independent Samples T-Test to compare means and finally to prove the hypothesis we looked at Confidence Interval of both the observations. We can conclude that Banks performance has improved on the basis of results of only one factor that is Non-Performing Loans and has a positive impact on NPLs overall and performance of banks have gone upward due to decrease in Non-Performing Loans percentages.
We can’t say that banking sector performance has improved overall, because there are so many factors from which we can have different results but as our research is limited to only one factor that is NPL, hence on the basis of that we conclude that privatization has a positive impact on Non-Performing Loans of two banks of Pakistan which we have studied.
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Chapter 1 (INTRODUCTION)
First chapter of our thesis is Introduction part which will cover the major aspects of this essay.
First one is Background of the report. Second thing is Research Question for what this research is happening and Purpose of the Research and some main Definitions related to our research topic. Finally we will present limitations and disposition of the thesis. Applied terms will be used throughout this part
(1.1) Background
Non-Performing Loans or we call it a bad loan has been a big problem for not only developing countries but also for developed countries. Many countries have adopted the formula of privatization in order to strengthen the banking performance and until now most of the developed countries have converted their state owned banks to private banks. According to the different studies privatization has played a major role in Banking Sector to develop it in a more efficient manner but issue of Non-Performing Loans is still debatable all over the world, especially in developing countries.
Researchers have found that most of the banks were merged or were closed in order to avoid the bankruptcy and main reason which was disclosed was high non performing loans and their high cost.
All countries in the world consider banking sector as a backbone of any developed country and to make the financial sector strong and stable, governments involve actively. Pakistani government has also worked actively in making the banking sector efficient and no doubt that after privatization Pakistani banking sector has performed very well in the global market, but the main problem in Pakistan which is still held there, is the problem of Non-Performing Loans.
The ongoing Non-Performing Loans has created a complex environment for banking sectors throughout the world but the most affecting one are developing countries whose banking sector has not really showed a vast improvement compare to developed countries. The main problem is the balance sheet which never figures out the true essence of Non-Performing loans. Pakistan Non-Performing Loans might be considered as a problem in the same way but there are so many reasons which compelled Pakistan to revive their banking sector and to expose the true picture of Non-Performing Loans.
Privatization impact has shown a vast improvement but still banking sectors never really come up with comprehensive reports on Non-Performing Loans. So there is a need of looking at the impact of privatization on banking sector and to see whether privatization was really the main solution to wipe out the Non-Performing Loans in different ways.
Before discussing the main Pakistan banking evolution system we need to know the main reasons of why financial institutions lost control on their money and how did they spread their loans without investigating in a true manner.
The main reasons which can be seen here are:
• Poor management with bad quality banking services
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• Large number loss incurring branches
• High percentage of non-performing loans
• High influence of political bodies in public financial institutions
• Inadequate market capitalization.
These are the problems which occurred before privatization and the main of them was Non- Performing Loans which affected the financial institutions very badly.
Non-Performing Loans as major problem in foreign key financial markets
Here we will discuss about some economies that are developed but still suffered from Non- Performing Loans. Just to provide the basic theoretical information in order to know how Non- Performing Loans have created problem in different foreign financial markets and then we will discuss about Pakistani banking system.US Market
US market has been fixed in the loan crisis from 1989 to 1994 and the main reason which author address here is real estate and consider it as a biggest banking crisis. The FDIC Corporation (Federal Deposit Insurance Corporation) has probably given the enhanced information about the saving and loans crisis and concerned about debt emergence problem.
Berger and DeYoung (1997) has analyzed the main link between cost efficiency and Non- Performing Loans in a complicated way. According to if Non-Performing Loans are higher in volume then the efficiency cost will be lower. Author further also explain that mismanagement of funds also one of the main reason of increasing Non-Performing Loans.
Some authors have different opinion from US financial market and they talk mainly about political connections which is why Non-Performing Loans proportion is going up. Remember, privatization is very old in US economy but still Non-Performing Loans are going up. We cannot compare Pakistani economy with American economy as both are in different ways.
China Market
Peiser and Wang (2000) have discussed the motion approach of concerned debts in China by the means of lay out of state-owned asset management companies for Chinese biggest state-owned banks. They compare their financial economy with US where (RTC) Resolution Trust Corporation was introduced to promote quick workout for Non-Performing Loans.
Another study was examined by Chen (2004). Chen’s main execution was to examine the legal and economical framework concerning securitization of Non-Performing Loans performance with respect to government involvement to check whether adjustments and debt restructuring plans are important for long term securitization.
Japan Market
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Herr and Miyazaki (1999) discuss about Non-Performing Loans problems and also favor securitization as a main proper solution in order to achieve a positive balance sheet for the financial markets. Authors further mention about the need of political involvement which can promote the idea of securitization especially for the private banks. Japanese market has mainly focused on privatization and it really worked for them but they also need a support of government to reduce Non-Performing Loans.
Barseghyan (2002/2004) has come up with the problem of Japanese lack of government interference in order to solve Non-Performing Loans and economic downturn. Barseghyan further says that government need to support and interfere more in privatization banks to create a suitable environment for financial markets and that will also increase the chances to overcome Non-Performing Loans.
Pakistani financial market is totally different from the above mentioned market and their nature of problems of Non-Performing Loans is totally different. High interference of so many sectors without privatization made it more complex. Privatization came late in Pakistan, so the main problem of Non-Performing Loans proportion need to be discussed.
(1.1.1) Pakistani Banking Evolution System
In Pakistan the activities involved in the financial sector are mostly in the hands of Government and the main reason behind control of government is to implement its own development strategy.1
In 1974 all domestic banks were nationalized and all banks were spitted into six main national banks. Other than the National Banks some credit institutions and House Hold Savings were also established. The main purpose behind the nationalization was to ensure bank credit towards government sectors and their funding, and this was one of the main reasons why Non-Performing Loans percentage in pre-privatization period was very high.High interference of the government enforced banks to hold 30% of their deposits as government securities and 5% as a cash reserve requirement which led to financial repression and banks could not hold their high returns on portfolios. This was yet another reason why Non-Performing Loans went up.2
(1.1.2) Dominance of Nationalized Commercial Banks (NCB)
From 1970s till 1991 Nationalized Commercial Banks had a strong influence on the banking sector due to highly strict restrictions imposed on opening of private banks; they worked as per the policies of government because State Bank of Pakistan was sharing a power with Pakistan Banking Council who did not allow the central bank to enjoy the freedom of decision making.
Hence politicians of Pakistan who had a strong influence over the main sectors of Pakistan especially financial sectors, kept on taking loans from the banks without realizing the outcome of financial repression which swelled the portfolio of Non-Performing Loans.3
The banking sector was in jeopardy when clear picture came in 1990, the banking sector was unable to provide a level of competition because of the higher ratio of National Commercial Banks. Till 1990 there were 8 state owned banks and there percentage was 92% in total banking assets, while other foreign banks which were 31 in number had only 8% of the total sector.4
Government never realized the importance of Non-Performing Loans till 1990s when most of the banks were in a pathetic position and they were unable to maintain the 30% of government securities .Politicians kept on taking loans without realizing of giving it back to the banks, while on the other side top management of banks enjoyed a healthy cash along with government people.
(1.1.3) History of Non-Performing Loans
First time Non-Performing Loans issue was raised in America when very serious financial crisis jolt American Stock Exchange in a very bad manner. (Morgan Stanley, 2004). In order to overcome these crisis American Government introduced the corporation known as Federal Saving and Loans Insurance Cooperation to work for the primary reasons of defaulted loans, but due to the high cost and cash problems this cooperation itself went into huge loss and it can clearly be seen that Non-Performing Loans are one of the major issues all over the world.5 Pakistani Financial Sector had also faced the same problem and still government and different financial companies trying to overcome this major problem. Banking Nationalization Act and Pakistan Banking Council should be stood as responsible for all this, but without having strong evidence one cannot blame them.
Non-performing loans have compelled many countries to establish Asset Management Companies that fix the problems of Non-Performing Loans.6
(1.2) Research Question
The Research question that we have formulated for our research is:
Has Privatization Reduced the Proportion of Non-Performing Loans and Increased Bank Performance in Pakistan?
(1.3) Purpose of the Research
The main aim of this research is to assess the impact of privatization on Non-Performing Loans, that how privatization helped Pakistani Banks to reduce the percentage of Non-Performing Loans and whether bank efficiency or performance has improved after privatization or not. The research will focus on the measurement of Non-Performing Loans and authors will find the problems or constraints which banks encountered at the time of privatization of state owned banks and what major post-privatization steps were taken by the authorities to reduce the proportion of Non-Performing Loans.
1
1Emilia Bonaccorsi Di Patti and Daniel C. Hardy, (2005) Effects of Banking System Reforms in Pakistan, The journal of banking and finance, IMF Monetary and Financial Systems Department, April 20, page 4-5.
2 Abid A. Burki and Ghulam Shabbir Khan Niazi, (2003) Effects of Privatization, Competition and Regulation on Banking Efficiency in Pakistan, 1991-2000, November 12, page 2-3
3 Ebit, 4 Ebit
(1.4) Definitions
(1.4.1)
What is privatization? Different viewsPrivatization (1)
Privatization is a pure conversion of productive items from public to private ownership and change in control of the firm. Privatization has also been considered as a major player to improve the economy of any country. Firstly privatization started in United Kingdom and then slowly and gradually started to take place in other parts of the world, especially industrial countries, but the motion of privatization started slowly in developing countries because of high influence and involvement of government authorities. Afterwards the pace went up and 1990s showed the major impact of privatizations all over the world.7
According to the author more than 15,000 state owned enterprises privatized. According to researchers, in next twenty years, $6 trillion of privatization assets will be sold of which 3 trillion has been sold in last ten years, majority coming from Eastern Europe and China.8
Privatization (2)
Different authors define privatization in different ways. According to Chowdhury F.L, privatization is a pure process of ownership transfer from public to private or in short words transfer of ownership of any government based company to private company.9
(1.4.2) Types of Privatization
There are three main different methods of privatization and they are:
Share Issue Privatization: In this method of privatization management of the company with the consent of their share holders sell shares to the stock market and this method is the most common method of privatization. This method is very useful in enhancing the liquidity and economic growth but it totally depends upon the strength of capital markets, if they are not sufficient enough then it is very difficult for the firm to find out the potential buyers and this could lead to higher transaction cost. Asset Sale Privatization: In this method of privatization one firm acquires other firm assets. Voucher Privatization: In this method of privatization shares of the owner are distributed among people at a very low price. This method is mostly used in Transition economies, like Central and Eastern Europe. Citizens can buy a voucher from the state owned institution which represents their shares in those institutions. 10
2
5 Jessica Peterson, Isac Wadman, (2004), Non-Performing Loans, The markets of Italy and Sweden, Bachelor Thesis Uppsala University Department of Business Studies, page 5
6 Ebit
%Robel Netserab Debassay, (2004) The Impact of Privatization on firm efficiency, labor and budget of government, University of the Western Cape, Bellville, page 1-2
8 Ebit
9 Chowdhury F. L (2006) Corrupt Bureaucracies and Privatization of Tax Enforcement, Article on Dhaka Studies
10 www.en.wikipedia.org/wiki/privatization
Privatization (3)
To convert publicly owned companies into privatization is to increase the efficiency of the firms;
because private owners tend to work more on profit maximization as compared to the government based owners who are not really interested in profits of the firm.11
Governments have implemented the method of privatization hoping that new private owners will increase the efficiency of the firms and reduce the demands of State Owned Enterprises. Further philosophers think that converting public enterprises to private enterprises would lead them to enhance their overall efficiency. (Richard and Mansoor, 1998).With privatization another thing like financial and technological resources will be planned more accurately in order to increase the chances of lucratively and reduction of government subsidies.12
(1.4.3) Non-Performing Loans:
When loan goes default for more than 3 months then that loan is considered to be as Non-Performing Loan. This can also be depending on the terms of loan contracts.13
Central Bank of Pakistan classifies Non-Performing Loans into following categories14
Other Assets Especially Mentioned: NPL type in which amount which has been recovered is less than 75% of the amount receivable and has been over due by more than 180 days.
(Provisioning)This is the type in which no provisioning is required.
Substandard: NPL type in which amount has been recovered is less than 60% of the amount receivable and has been overdue by more than 1 year. (Provisioning) of 20% of the difference resulting from the outstanding balance of principal less the realizable value of liquid assets.
Doubtful: NPL type in which amount has been recovered is less than 40% of the amount receivable and has been overdue by more than 2 years.(Provisioning) Provision of 50% of the difference resulting from the outstanding balance of principal less the realizable value of liquid assets.
Loss: NPL type in which amount has been recovered is less than 20% of the amount receivable and has been overdue by more than 3 years. (Provisioning) provision of 100% of the difference resulting from the outstanding balance of principal less the realizable value of liquid assets.
3
www.answers.com/topic/privatization
12 Robel Netserab Debassay, (2004) The Impact of Privatization on firm efficiency, labor and budget of government, University of the Western Cape, Bellville, page 1-2
13 www.en.wikipedia.org/wiki/non-performing
14 State Bank Report (2008), Guidelines for Infrastructure Projects Financing, page 21, State Bank of Pakistan
Banks definition of Non-Performing Loans consists of 2 different types:
• Loan which was executed and has been passed for more than 90 days and still accruing interest.
• Loans for which interest is not accrued.15 Impaired Loans:
Loans which are not expired but it is not sure whether debtor would be able to repay the debts.
Because of this uncertainty banks and other financial institutions don’t consider this loan as Non- Performing Loans. In other words this loan is a no loss provision for them.16
(1.4.4) Definition of Banks
BankBank is financial institution where people keep their extra money for saving and safe custody purposes. Institutions also deposit money in bank for interest earning purposes. Banks lend these deposits to other individuals and institutions in the form of a loan to earn profit and pay interest to their depositors.17
Commercial Bank
Commercial banks are those institutions where individual and institutions keep their money for saving and safe custody purposes. Commercial banks lend these deposits\savings to individuals, institutions in the form of loans for commercial business to earn profit and pay interest to their depositors.18
Private Bank
Private Banks are those financial institutions which are totally owned by private people. The percentage of shares in ownership in institution is more than 51%.For example: MCB Bank Ltd, Allied Bank Ltd, Bank Alfalah Ltd etc.
State Owned Bank
State owned banks are those financial institutions whose supervision is under the control of the government. The percentage of shares in ownership in institution is more than 51%... For example: National Bank Of Pakistan, State Bank of Pakistan.
(1.4.5) Performance
In terms of finance, performance of the firm refers to the profitability, stability, and validity of business. If firm profitability is increasing in both short and long term in constant way, means firm performance is improving. The firm with strong solvency position means ability to pay its long term obligations to the creditor’s, shows firm performing well. Performance of the firm also assessed through its liquidity position.19
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(1.5) Limitations
(1.5.1) Limitations of the Data
As this report is limited to banks so we will look at some banks which were privatized in the decade of 1990-2002. The banks which we have chosen for our Thesis Report are: Muslim Commercial Bank and Allied Bank Limited. Before privatization there were 6 banks which were nationalized their pre-privatize data was available but their post-privatize data was not that sufficient, and out of 6 nationalized banks 3 banks were privatized in 1997. Another problem was time constraint and access of banks which was difficult for us to cover all 6 banks that is why we limited our research to two banks. It was the hope that the banks might be restructured into more efficient, profitable, competent and value creating private enterprises. This thesis, therefore, assesses the impact of privatization on non-performing loans of banks.
(1.5.2) Limitations of Research
This research is to assess the performance of banks. There are so many factors from where we can assess the performance of banks, but as our research is limited to only one factor that is non- performing loans, so all the results of performance of banks is on the basis of percentages of non- performing loans of total loans to see whether from non-performing loans point of view banking performance has improved or not. If we combine other measures of assessing performance of banks along with the measure that we have taken, then the results are liable to change.
4
15 www.en.wikipedia.org/wiki/non-performingloans
16 Jessica Peterson, Isac Wadman, (2004) Non-performing Loans, The markets of Italy and Sweden, Bachelor Thesis Uppsala University Department of Business Studies, page 5
17 www.google.com.pk
18 www.investorwords.com/955/commercialbanks
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(1.6) DISPOSITION
This section will tell you the step by step chapters which will be covered at the later stage of the research, keeping in view the guidelines, which are necessary to follow.
(2) Theoretical Framework
A chapter which contains a deep study of the research papers, articles, newspapers, journals and academic source, solely related to the subject area. This chapter will guide reader to the proper reaching of research methodology and conclusion part. Topic related theories will be explained in this section with simple and appropriate explanations.
(3) Research Methodologies
This chapter will provide reader the methodological approach of the researcher as to how researchers have formulated the methodology of their subject and work order.
(4) Our Outcome and Analysis
This chapter will provide the depth description of the outcome of the topic. This chapter will also cover the results which will produce by applying some statistical tools and concepts.
(5) Conclusions and Recommendations
Finally on the basis of the results which will be given by the tools in the methodological chapter reader will get to know the conclusion of the topic and researcher will also come up with some recommendations.
(6) Truth Criteria
This chapter will show the reliability and validity of the report.
(7) Glossary (8) Appendices
This chapter will show the tables and graphs which have been used in this report.
(9) Index
19 www.answers.yahoo.com
Chapter 2 (Theoretical Framework)
This chapter is organized into following sections:• Section 2.1 will review history of Pakistan related to its economy and Non- Performing Loans
• Section 2.2 will review privatization and why privatization is important in Pakistan
• Section 2.3 will review banking sector and its performance in Pakistan
• Section 2.4 will review Non-Performing Loans and its classification
(Section 2.1)
The features and characteristics of non-performing loans all over the world can be varying from sector to sector. In Pakistan the financial sector and especially the banking sector is the highly affected sector from the Non-Performing Loans and therefore it is useful to find out whether after privatization Non-Performing Loans proportion has been reduced or not. This is the main theme of the research and keeping in the view it will be discussed in this chapter of literature review.
(2.1) Pakistan Economy and Lending Market
When Pakistan came into being in 1947 there was not a single industry in Pakistan and almost whole economy of Pakistan was based on Agriculture and 75% of Pakistan population was living in rural areas. Culture of Landlord, one can say a gift of God since independence but unfortunately high interference of landlords in the politics and good relationship with the government officials came out in the clear picture of Non-Performing Loans. Landlords took loans but they never paid back and this worsened situation of non-performing loans ran till 1990.
The country Pakistan is located in South Asia with total population is around 160 million. Gross Domestic Product of Pakistan grows by 5% to 6% every year.20
(2.1.1) Pakistan and the World (2008)
21Nominal GDP in $ 126.8M
GDP Rank 44/185
Per Capita (GNI) in $ 800
Per Capita GNI Rank 162/209
Population Rank 6/224
Geographical Area Rank 35/250
Global Competitiveness 92/131
Economic Freedom Index 93/157
Human Development Index Rank 136/177
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(2.1.2) Economy Overview
Initially after independence people from India and Pakistan displaced due to the Hindu-Muslim disputes and country economy was mainly based on Agriculture sector which could not produce large amount of employment in the country, however slowly and gradually growth rate was increasing as time was passing. Pakistan average growth was 6.8% in 1960s, 4.5% in 1970s, 6.5% in 1980s and 4.8% in 1990s.In 21 century growth picked up a speed and today after China and India, Pakistan growth rate is the third fastest. The country’s GDP in 2006 was 128.8 Billion.
Services had a major share of 52.9% contributing in a Pakistan’s economy; Industry contributed 26.7% and Agriculture contributed 20%. Growth rate from 2003-2007 was 7.5% which was record in Pakistan’s whole economy history, the main reason behind this impressive growth was increase in domestic demand. The major problem facing the economy of Pakistan is the inflation rate, which was 17.2% in April 2008. Quarter of the Gross domestic product is contributed by manufacturing sector and two large industries in Pakistan are manufacturing and cotton textile production. Other than these industries, revolve around construction, paper, food, fertilizer, sugar, electric goods, beverages and shipbuilding. The Government of Pakistan has taken steps to encourage privatization of these public sectors through the help of privatization committee which was established in 1990. Until now committee has privatized around 143 public sectors including seven banks, one major telecommunication company, 12 energy sector units, five newspapers, five hotels and around 100 industrial units. In recent years, services which are the main contributor to GDP are mainly consisting of construction, trade, transportation and communications. These sectors have increased the flow of foreign direct investments (FDI).Further, there is a wide improved change in the financial system and problem of supervisory and inadequate governance, due to which Non-performing Loans were touching the sky for a longer period of time, has been corrected through a series of government backed reforms.22
(2.1.3) History of Pakistani lending market and Non-Performing Loans
Pakistan’s history of Non-Performing Loans is based on the following characteristics, which has been discussed in one of the research reports written by Salman A. Shaikh. We would like to discuss those issues in this report.Concentrated in the large scale manufacturing sector: According to the author, sector which was affected more by the Non-Performing Loans was the large-scale manufacturing sector and the sectors which were affected are textiles, sugar, cement and public sector companies. He further mentioned that SME Non-Performing Loans do not have so much impact on (SMEs) Small and Medium Enterprises it was mainly due to the debt aversion/low leverage in the SME sector and high leverage in the manufacturing sector.23
Concentrated in the public sector banks and financial institutions: According to the author, most of the time Pakistan’s Non-Performing Loans were man-made and avoidable. 90% of the Non-Performing Loans were mostly situated in banks and financial institutions which play an
www.privatization.gov.pk/finance/finance.htm
21 www.thomaswhite.com/explore-the-world/pakistan.aspx
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important role in the economy of the country. Non-Performing Loans were mainly in public sector banks. In private sector and foreign banks, Non-Performing Loans were very low except in 1990s when economic and industrial growth was not up to the mark as it was working previously. The other main reasons behind low Non-Performing Loans % in private banking sector was due to the protection from overseas competition through tariffs on import-substitution industries and below market interest rates.24
Zero Equity Projects in 1980s and 1990s: Easy policies on finance projects, collusive lending, pathetic corporate governance and bureaucratic style were also one of the reasons of an increase in Non-Performing Loans of Pakistan. In this period so many projects which were set up, under capitalization and high gearing became of the norm of every project and paid up capitals went up.25
Amateur Entrepreneurs: According to the author, another main reason behind the increase in the Non-Performing Loans was business groups without knowing anything about the projects.
Groups like agriculturists, bureaucrats, military officers and judges who never understood the meaning of business took loans and their main motive was to continue the tradition of Non- Performing Loans that is to take loans and never give back. These influential defaulters taking the advantage of their reputable statuses blocked efforts at enlightened NPL reform. 26
Direct Lending: People in the upper top management of public sector banks and enterprises were solely selected by politicians and military officials without having professional competency and capability inside them. These individuals were also satisfying their well wishers by giving them loans and never took back from them. (Non-Performing Loans were at birth). Bankers did whatever instructions came from them and public money was deteriorated.27
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Salman A. Shaikh, (2003) Maximizing Value of Non-performing Assets, Pakistan Experience, 1999-2003, 10-11 November, Seoul, Korea
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(Section 2.2) Privatization as an Economic Instrument (2.2.1) Why Privatization?
Privatization, till 1978 there was no such thing to implement; it was first time in 1979 when British Thatcher Government introduced a word privatization with so many modern policies. For the first twenty years not so many countries believe in this thing but slowly and gradually countries understood the importance of Privatization and now all over the world Private Companies Ratio is more than State Owned Firms. [Megginson, Price and Netter, 1998]28
A strong favor in privatization can be proved when in early 1990s more than 15000 state-owned firms turned privatized. [Kikeri, Nellis and Shirley, 1994]. According to Drucker in 1960s, Government is a poor manager means companies which are owned by the government are good in making plans but poor at spitting them out.29
The main question arises from the privatization that whether privatization has improved firm performances or companies just following successful company trends. We will focus more on banking Non-Performing Loans.
In Pakistan when Banking Sector was state owned, banking sector was suffering from huge losses and banks were unable to meet the requirements. Main reasons which can be seen to adopt the policy of privatization by the state owned banks were competition, political intervention and corporate governance.
Competition
According to the analysts, a greater competition will take place when privatization will improve the operations and allocation of resources in the economy.30
Political Intervention
Another main advantage of privatization is that it could help in improving firm efficiency without changing the face of market monopolies if it stops interference of political bureaucrats who since independence of Pakistan took loans and never returned to banks.
Corporate Governance
Another main point which strengthens favor in privatization is weak corporate governance in
“State Owned Banks in Pakistan”. No doubt that Pakistani State Owned Banks had multiple aims and objectives and planned it in an accurate way but problem with them is that due to weak corporate governance they never executed it in a professional way. 31
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(2.2.2) Different views on effect of Privatization
According Clarke et al (2003), country and cross country studies, he found that privatization put the banks performance in positive node. He further analyzed that where the institutions setup is weak, the ownership transfer to strategic investors through direct sales has more positive effect on banks performance than ownership transfer through public offering.32
According to Otchere (2003), study of privatized banks of low and middle income countries. He found that after privatization the bad loans proportion increases and also banks were overstaffed which affects the banks performance in negative way. On the other hand he found that privatized banks were more responsible for their underperformance and more professional managers were there to manage the activities in effective manner.33
According to Boehmer et al. (2003) he examines those 101 countries from database that whether political and economic factors affect the government decisions regarding privatization. He took both developed and developing countries for the analysis. From his study, he found that banks privatization weakens the banking sector in developing countries where government is more accountable to its people.34
(2.2.3) Efficiency of Privatization Property Rights Theory
According to this theory, privatization is necessary for productive activities in the government sector because individual or group showing no interest in government enterprise. The reason of lack of interest of these groups is that they have no own stakes/property rights in the government enterprises which is the main reason of inefficiency of state enterprises in productive activities.35
(2.2.4) Views on the effect of privatization on Customers
From different research studies, we found that privatization of firms affects the customers positively as well as negatively. But commonly the negative impact of privatization on customers is increased prices of product and services etc. For Example: Bunn and Vlahos (1989), after detailed analysis of effect of privatization in electricity industry, argue those twenty five years ahead, the prices will increase in the range of 40 to 90%. 36
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Robel Netserab Debassay, (2004) The Impact of Privatization on firm efficiency, labor and budget of government, University of the Western Cape, Bellville, page 12
29 Ebit
30 Umer Khalid, (2006) The effect of privatization and liberalization on banking sector performance in Pakistan, SBP Research Bulletin, Volume 2, Number 2, page 406
31 Ebit
32 Umer Khalid, (2006) The effect of privatization and liberalization on banking sector performance in Pakistan, SBP Research Bulletin, Volume 2, Number 2, page 406-407
33 Ebit, 34 Ebit
35 George R.G Clarke, Robert Cull, Mary Shirley, Empirical studies of Bank Privatization, some lessons ,page 3
36 Ebit
Privatization vs. Competition
From study drawn by Shirley and Walsh 2003, According to their analysis privatization brings competition in the market which pushes the firm’s performance in positive trend. Due to privatization, operations and allocation of resources improve which makes the industry and economy competitive. From their study they found that state owned enterprises are less competitive because politicians use them for their self interest purposes i.e more higher of personal without any need or giving more different incentives to their known private institution which puts extra burden on firm budget to achieve their political goals, due to these reasons state owned enterprises not perform efficiently and effectively. State owned enterprises are less competitive because they don’t have enough problems in generating funds, incentives etc because in any worse situation government supports them by different incentives. On the other hand private firms are more competitive because they need profit and performance to remain in the market.37
Privatization vs. Political Intervention
From the studies of (Shleifer and Vishny 1994, Gaal 1991: Shirley and Nellis 1991, World Bank 1995), concludes that after privatization the firm performance normally improves because politicians are unable to use the firm resources for their own interest. The reason is that in private sector the management is more capable to handle any intervention.
For example, in private banks, the managers are more independent in decision making regarding their branch operations i.e decisions regarding loans and cost minimizing etc as compare to state own banks. So he makes the decisions according to their bank policies and goals etc.38
Privatization vs. Corporate Governance
According to studies of these researchers (Berglof and Roland 1998, Dewaripont and Maskin 1995, Schmidt 1996, Lopez-calva 1999, Vickers and Yarrow 1989, 1991), privatization improves the corporate governance structure in firm by giving more incentives to their employees in order to use their skills in efficient and effective manner which in result improves the firm performance. On the other hand, in state own enterprises is weak due to less incentives to employees, no worry of loss of job, lack of interest etc which results in bad performance of employees. Bad performance of employees affects the firm performance in negative way.39
According to Adam, Cavendish, and Mistry 1992, Caves 1990, Commander Killick 1988, Cook and Kirkpatrick 1988, 1997, Stiglitz 1999, that mostly in developing countries firm performance is not good even after privatization because of weak court system, weak policies for bankruptcy problem, weak capital markets and weak banking systems etc.40
(2.2.5) Privatization impact on NPLs and banks performance (IMF Analysis)
According to the IMF report privatization has helped commercial banks to maintain their NPL issues and records shows that NPL trend is going downward. Write off guidelines were issues inOctober 2002, which enabled banks to clean the stock of Non-Performing Loans more quickly.
Banks were expecting these guidelines for a long term period because they have kept NPL on their balance sheet for a longer period of time even after 100% provisioning.41
According to the IMF report, after privatization the ratio of Non-Performing Loans starts from 0.4% to 35% on average across all the banks. If you look at the overall position Asset Quality in five largest banks of Pakistan is generally poorer than other small banks especially foreign banks. Five largest banks gross loans to total NPL starts from 15 to 35%.Foreign banks ratio of provision of NPL is 79.5% and overall its 63%.42
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George R.G Clarke, Robert Cull, Mary Shirley, Empirical studies of Bank Privatization, Some lessons, page 5-8
38 Ebit
39Ebit, 40 Ebit
41 IMF report, (2005) Condition of the banking system, Pakistan Financial Sector Assessment Program, (Technical Note), IMF Report No 05/157, Publication services 700, 19th street, Washington DC, page 7-8
# Ebit
(Section 2.3) Performance of the Banking Sector in Pakistan (1980 to now) (2.3.1) The role of the Central Bank
Regulatory Authority
The Regulatory Authority in Banking Sector of Pakistan is the Central Bank which is known as the State Bank of Pakistan. According to the new prudential regulations in 1989 Central bank was able to increase the capacity of its supervisory because Pakistan Banking Council was no more in charge after the prudential regulations. Other than State Bank of Pakistan SECP also supervises the banks which are related to public shareholding matters 43
Main Responsibilities of State Bank is 1. Licensing
2. Directing 3. Supervising 4. Controlling 5. Inspecting Banks
6. Exercising Monetary Control Policy Measures.
Reform Measures Taken by State Bank of Pakistan
44• To make the Prudential Regulations more mature and powerful
• Liberalization in increase or decrease bank branches
• Exchange Rate with free-floating rate has been introduced and buying and selling of foreign currency from the bank has been lifted.
• Banking Companies Act 1997, introduced in order to look into the issues of Non- Performing Loans of different banks and financial institutions, which has been pending since years.
• Corporation with name Corporate Industrial Restructuring Corporation (CIRC) has been established by the government with certain terms and conditions. The main aim of this corporation is to takeover NPL portfolios of nationalized banks and instead of that issue them government guaranteed bonds in order to earn market rates of return.
• Minimum capital of banks has been enhanced to Rs 1Billion.
• Credit Rating has been made mandatory for all the banks
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• Requirement of good corporate governance in order to avoid non-performing loans in the future.
• Relaxation in Merger and Acquisition
Recent Trends in Banking Sector
45• Relaxation in Merger and Acquisitions has helped local private banks to connect with several domestic acquisitions.
• Expansion in banks branch network
• More committed to consumer finance and customer service
• Reduction in NPLs due to good corporate governance.
(2.3.2) Introducing Major Reforms and Prudential Regulations in Late 1980s
Major financial reforms were introduced at the end of 1980s, by introduction of these reforms the interest rates slope went from upward trend to downward trend and credit ceiling was also eliminated till 1992.In 1989 new prudential regulations came into the market and these regulations helped Central Bank of Pakistan to increase its capacity of supervisory. Pakistan Banking Council was no more in position of to disturb central bank leading authority. Another system for the government securities was established that this system of auctioning government securities and regular auctions for six months bills began in 1991 (Hardy 2000).46The breakthrough in the Pakistani Banking Sector came at that time when Privatization Commission took place in 1991 and liberalization of authorities gave chance to banks to get privatized. For the very first time in Pakistan two state-owned banks were privatized named as:
• Muslim Commercial Bank
• Allied Bank Limited
Other than this, 10 other new banks started their operations and this shows the major positive effect of reforms and regulations. Still there were 4 state owned banks in 1997 but great numbers of domestic banks gave them a very intense competition.
Branching policy, reduction in employees, departments to overcome the recovery of Non- Performing Loans and defaulters, and closing of unprofitable branches were one of the major advantages that industry had.47
The main step which State Bank of Pakistan took in order to clean the problem of Non- Performing Loans was that it made a plan for how to recover Non-Performing Loans and reformed the guidelines for loan classification. Because of these State-owned banks non- performing loans further went up.48
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(2.3.3) Analysis of Financial Sector Reforms
49As we above discussed the history of Pakistan economy and financial sector reforms specially banking sector in deep. Prior to 1990, Pakistan financial institutions were in jeopardy due to following major factors:
• Poor management with bad quality banking services.
• Large number loss incurring branches.
• High percentage of Non-Performing Loans (NPL).
• High influence of political bodies in public financial institutions.
• Inadequate market capitalization.
These factors very badly affected Pakistan economic growth in between 1970-1980. In order to improve and strengthen the economic system of country, Government of Pakistan undertook financial restructuring reforms in early 1990 as we discussed above.
Strong banking system is necessary for the economic development of any country. The objectives of these financial reforms are to strengthen the banking system in country. As Shamshad Akhtar (Governor State Bank of Pakistan) said that:
• We can improve and can make our financial institutions affective by high effective resource mobilization and transferring these resources to improve economic growth.
• More strengthen the financial institutions performance.
• Promote and extend the financial to every sector of society especially poor.
Here we discuss the impact of these financial reforms in different terms.
Interest Rate
Prior to reform interest rate were set administratively and on average it was negative in real terms. Due to negative trade investors or savers were encouraged to deposit money with financial institutions. This situation is not good for any economy where people not take interest to strengthen country financial institution which is very important for economic development.50 After these reforms the price of financial services was determined by banks on a competitive basis. In june2005, SBP reports show that lending rates decrease 8.81% from 15.6% as in 1998.
But real interest rate increase from 3.6% (1996) to 10.9% (2000). The decline trend in lending rate shows the profitability of banks but in actual it is ad hoc not due liberalization. On the other hand the deposit rate also reduced for 6.8 %( 1998) to 1.37% (2005) which further reduce the saving in the economy.
The interest rate spread play very important role for profitability, competitiveness and efficiency but after SBP reforms bring competition in economy but still there is high interest rate spread which reached 7,44% in 2005 which discourage investment and saving in the economy but SBP taking different measures to take down the interest rate spread.51
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Performance and Efficiency of Financial Institutions
We can analyze the performance and efficiency of financial institutions after reforms in two aspects i.e. Insolvency and sustainable profitability. We take Non-Performing Loans (NPL) to measure the performance of financial institution after reforms of 1990. As from history we know that NPL was big hurdle in economic development before 1990. Even after SBP reforms its percentage is on upward trend i.e. National commercial banks (NCBs) and DFIs in Pakistan are facing great problem of high NPL i.e. Rs.25 billion in 1989 which increased to Rs.128 billion in June 1998, 4% of GDP. Further it increased from Rs 230.7 billion (Dec.1999) to Rs.240, 1 billion in (DEC, 2000). But since 2001, NPL percentage was on declining trend which improves the performance of financial institution and this resulted of significant reforms and effort of SBP and Government of Pakistan policies. Due to the fact that effective measures NPL went down from 25% to 8.3% of the total advance of banks and DFIs at the end of 2005. The net NPLs ratio was 2.1%. These all indicators show that performance of banking sector improved because 1996 the banking system was near to default and 1/3 of its assets stuck in form NPLs but now it seems stable.52
Privatization
Before 1990 all banks in Pakistan were public owned in which the problem of overstaffing, no market competition, high NPLs ratio etc were big hurdles in the growth of banking sector. After 1990 financial reforms, Government adopted the policy of privatization. In start only two banks were privatized i.e. Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL) which brought little market competition but then process was delayed for several years. In 2002, Government privatized another largest bank of the country United Bank Limited (UBL). Then the asset share of domestic private banks was 47% and Public owned banks share was 41%.
Currently, only one bank is state owned bank. The privatization reform affects the economy and brings more competition in market which result good services to people etc. The government also more facilities to banks in restructuring process by recapitalization of bank through equity injection of Rs 46billion in some of public sectors banks and write offs to Rs.51 billion and also close of 2000 branches which were in loss. In overall, financial restructuring is a continuous process not an event for one time. Before 1990 financial sector reforms, Pakistan economy were faced different problem i.e. weak prudential regulation, weak banking system, lack of accounting standards etc. But due to financial sector restructuring (1990 to 2004), Pakistan financial sector improved then before 1990 era. Specially banking sector showed good performance but still improvement and measure are required to more stabilize the economic development.
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www.privatisation.gov.pk/finance/finance.htm, source State Bank of Pakistan (Report)
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#$Emilia Bonaccorsi Di Patti and Daniel C. Hardy, (2005) Effects of Banking System Reforms in Pakistan, The journal of Banking and Finance, April 20, page 4-5, IMF Monetary and Financial Systems Department.
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# Muhammad Arshad Khan and Sajawal Khan, (2007) Financial sector restructuring in Pakistan, The Lahore journal of economics, special edition, September 2007, page 107-131
50 Ebit, 51 Ebit
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Furthermore the capital market also needs more measures to contribute in economy of country in well mannered. However, due to reforms, financial sector of Pakistan improved enough in this short period of time.53
(2.3.4) Conditions before Privatization in Banking Sector Performance
Domination of the public sector or we call it a state owned sector and government made (NBFIs) Non Banking Financial Institutions, and Direct Monetary Control were all involved in making the banking sector inefficient from all corners. Percentage of public sector banks in early 1990s was 92% amazingly in total assets of banking sector. Not even a single percent was belonged to domestic private banks as there was not such bank exist at that time. Competition and growth was not there in banking sector as due to the 92% was in the hand of government.54
The main problem in banking sector was Pakistan Banking Council who played an important role in spreading its financial network all over Pakistan without realizing concern about financial repression in the country. State bank was in no power to stop these activities as policies regarding credits to political people were so lean that Non-performing Loans were swelling with the period of time.55
(2.3.5) Main Problems before Privatization took place in Banking Sector
• High Intermediation Costs
• Over-staffing and over-branching
• Huge portfolio of Non-Performing Loans
• Poor Customer Services
• Under-capitalization
• Poor Management / Narrow Product Range
• Averse to Lending to SMEs/housing & other segments
• Undue Interference in Lending, Loan Recovery & Personnel issue
To overcome these problems and to avoid the further swelling in Non-Performing Loans Pakistan produced there Financial Sector Reforms of 1990s with the hope that banking sector performance will go up and sector will work in an efficient way56
(2.3.6) Financial Sector Reforms 1990
It was quite clear that BNA and PBC Banking Nationalization Act and Pakistan Banking Council were not at all efficient and there were so many problems which they created for the Banking sector, it was a time to call up for something which can bring banking sector back on the track.
Institutional Reforms
In order to address issues like political intervention into credit allocation, loan recovery and other inefficiencies from financial institutions, steps of policy reforms were taken to increase the participation of private sector. Things like autonomous power to the Central Bank and NBFIs
