introduction to financial systems(1)

Introduction to Financial Systems &

Banking Regulations

Stage 1Published by The Institute of Bankers Pakistan M.T. Khan

Road Karachi - 74200, 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

ContentsPart 1:Overview of the Financial System

Chapter 1:Importance of a Branch 2

Part 2: Structure of the Financial System

Chapter 1:Money Markets 36

Chapter 2： Mutual funds 41

Chapter 3： Depositories 49

Chapter 4 ： Capital markets 52

Chapter S： Non-Banking Financial Instituitions 77

Part 3: Securities and Exchange Commission of Pakistan

Chapter 1：Securities and Exchange Commission of Pakistan

83

Part 4 ： Financial Instruments

Chapter 1：Money Market Instruments 96

Chapter 2: Capital Market Instruments 105

Part 5: Yields

Chapter 1:Yields 118 Part 6: Credit Rating and Risk Evaluation

Chapter 1:Concept, scope and significance 131

Chapter 2: Regulatory Framework 135

Chapter 3: Credit Rating Agencies in Pakistan 137

Chapter 4: Rating Methodologies for Various Instruments 141

Chapter 5: Evaluation of Risk and Benefits for Investors 143

147

150

152

157

15

9

16

5

16

9174

179

Contents

Part 7: Financial Systems and Policies

Chapter 1:Major Functions of Financial Policy in a Developing Country

Chapter 2: Financial Intermediation

Chapter 3: Financial Disintermediation,Deepening, Repression and Shallow Finance

Part 8: Financial Sector Reforms

Chapter 1: Importance, Scope and Impact

Chapter 2： Deregulation and Liberalization of the Financial Sector

Chapter 3: Globalization： Integration with Global Financial Sector

Chapter 4: Privatization of the Banking Sector

Chapter 5: Strengthening of Supervisory Controls: SBP^ role

191

Part 9: Current Trends in the financial .Industry in Pakistan

Chapter 1: Innovation Challenges, Interest-Free Banking and New Areas of Financing

Part 10: Laws relating to Financial Systems

Chapter 1: Banking Laws and Regulations

Part 1: Overview of the Financial System

Chapter 1: Overview of the

Financial System Introduction to

Financial Systems

Financial Systems in Pakistan

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

system Traditional and Non-Traditional Functions of the State

Bank of Pakistan Traditional Functions Secondary Functions of

SBP Determinants of Financial Growth

Factors affecting the growth and development of a financial

market Development of Pakistan Financial SystemFactors for positive change in the Pakistan Financial System

Learning Outcome

Introduction to Financial Systems

2 Financial Systems and Regulation | Reference Book 2

Part 0ne Overview of the Financial SystemChapter 1 Overview of the Financial System

By the end of this chapter you should be able to:■ Discuss the structure of Pakistan's financial system

« List the prominent players of Pakistan's financial system

親 List the traditional and non-traditional functions of the SBP■ Disqjss the changes and developments experienced by Pakistan's financial system

■ Discuss the factors of change that have modified the dynamics of Pakistan's financial system

■ List the components of a financial system

» List and discuss the functions of the key components of a financial system

■ List and discuss the factors affecting the growth and development of a financial market

■ Discuss the role and importance of the regulatory authorities governing the financial markets

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

5. The Central Bank

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.

It can be used as a standard for deferred payment. Since money is used as a standard object/unit for settlement of all types of transactions, it can also He used for settlement of deferred payments, such as settlement of debts/ loans. International debts are increased or decreased with the increase / decrease in the value of money. Every country maintains its books of accounts in local currency. With the increase or decrease in the value of currency, the volume of the loan increases or decreases.

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.

Depiction (Back) Value

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

Purple

Green


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%.

(DATA Source Governor SBP Speech at CCI13 Dec 2010)Currency Exchange Rates Vs US $

Year US $ Rate Year US $ Rate

1961 4.76 1999 51.76

1970 4.76 2000 57.71

1972 9.91 2001 61.31

Overview of the Financial System

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

1998 46.11 2011 85.95

RS. US $ Rate

1990 1995 2000 2005 2010 2015YEAR

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 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.

• Different income groups are compiled to judge the CPI.

350300250200

15010050

■


歐セ sale price index by commoditiesi ■期）

Rs in BillionFood Raw material Fuel & Power Manufacturer Building Material

•丨丨ニ：3£ 102.05 100.95 103.08 101.91 101.181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 151.3013

889221.3930556

‘‘ 3S_6124444 251.3866667 227.3386667 324.9962222 157.3312222

235.4052222?!：：r- 25S.7354444 268.2666667 241.114 349.2785556 163.3610

556249.4173889

S6&3584444 285.1466667 254.8893333 373.5608889 169.3908889

263.4295556Jfcis 22^9814444 302.0266667 268.6646667 397.8432222 175.4207

222277.4417222

|p!!P!% 295.1044444 318.9066667 282.44 422.1255556 181.4505556

291.4538889:|fcrr 3142274444 335.7866667 296.2153333 446.4078889 187.4803

889305.4660556

pEiTli 3293504444 352.6666667 309.9906667 470.6902222 193.5102222

319.4782222EE'rii 344.4734444 369.5466667 323.766 494.9725556 199.5400

556333.4903889

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 205.5698

889347.5025556

374.7194444 403.3066667 351.3166667 543.5372222 211.5997222

361.5147222389.8424444 420.1866667 365.092 567.8195556 217.6295

556375.5268889

404.9654444 437.0666667 378.8673333 592.1018889 223.6593889

389.5390556bE4 420.0884444 453.9466667 392.6426667 616.3842222 229.6892

222403.5512222

t?I3 435.2114444 470.8266667 406.418 640.6665556 235.7190556

417.5633889450.3344444 487.7066667 420.1933333 664.9488889 241.7488

889431.5755556

ac7 465.4574444 504.5866667 433.9686667 689.2312222 247.7787222

445.5877222ST'5 430.5804444 521.4666667 447744 713.5135556 253.8085

556459.5998889

iinmii

IWFBTIf IIIli

mmwHHII

iiiiii mu ■ iiiii iim

I Whole sale price index by commodities

_

ね 0^


Consumer Price Index - Product WiseYear General Food Textile House

rentFuel Transport Educatio

nMedicare

>002 104 103 fToT' 10^ 169 M 165 10^2003 107 105 107 164 118 112 110 1062004 112 11^ 110 10^ 1^1 115 114 10ナ

2005 122 126 113 120 126 125 118 1082006 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 1322009 192 216 153 181 199 193 165 1472010 214 243 162 206 227 204 186 157

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 WiseYear General Food Textile House

rentFuel Transport Educatio

nMedicare

20W 164 103 165 他 16^ 106 105 102

2003 107 165 167 164 11§ 112 116 1062004 112 112 110 102 1^1 114 1072005 122 126 113 120 126 1^5 118 1082006 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 1322009 192 216 153 181 199 195 165 14)

2010 214 243 162 206 227 204 186 157

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.

250


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 economicassistance, 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 -1,015.50FY04 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 -6,183,80FVde 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 • -15,163.00

Balance of Trade 1


USD (Million)

50.0. 00

40.0. 00

30.0. 00 20,000.00 10,000.00

0.00Year 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.

Pakistan’s banking industry and the broader financial sector has enormous potential to support faster economic growth and development. In recent years, a wide range of important structural reforms have already taken place，but further reforms are needed for the banking sector to grow to its full potential to support strong and sustained economic growth and development.


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

Dec 2011 5,024,480

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.


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.

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). 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.

These responsibilities include regulation of the domestic monetary and credit system through an efficient monetary policy, securing monetary and exchange rate stability and ensuring financial stability through effective regulation and supervision of the banking sector in particular and the financial industry in general.


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

As regulator of the financial system of Pakistan, SBP is continuously taking steps to improve the financial system. During the period of Mr Ishrat Hussain as governor of SBP, the SBP initiated five years of reforms


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 fon-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

One of the major responsibilities of the State Bank is the maintenance of the external value of the currency. In this regard, the State Bank is required, among other measures, to regulate the country’s foreign exchange reserves in line with the stipulations of the Foreign Exchange Act 1947. As an agent of the Government of Pakistan, the State Bank is authorized to purchase and sell gold, silver or approved foreign exchange and transactions of Special Drawing Rights with the International Monetary Fund under sub-sections 13(a) and 13(f) of Section 17 of the State Bank of Pakistan Act, 1956.


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

5. Strengthen prudential regulation and supervision


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 growingfinancing 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:

According to section 9A of the SBP Act, the State Bank of Pakistan is responsible for regulation of the monetary and credit policy of the country in such a manner that it should 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

The Bank monitors banking activities through a combination of off-site monitoring and on-site inspection. Off-site surveillance is conducted by the State Bank through various periodical returns received from banks and DFIs, while on-site inspection is undertaken on the premises of the banks concerned. The purpose of inspection is to check the assets and liabilities as they appear on the books, to evaluate the quality of the assets, to determine compliance with laws, regulations, directives and policy guidelines provided by the State Bank， to judge the soundness of operations and the prudence of lending and investment policies， to appraise the quality of the management and to attempt an estimate of the overall position of the bank.


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

The SBP also functions as the bankers’ bank. Banks are classified as scheduled and non-scheduled. A scheduled bank is that which fulfills the


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:

1. Accepts deposits of cash, cheques and drafts by the Government and undertakes the collection of cheques and drafts drawn on other banks. The Bank transfers government funds from one account to another or from one centre to another as advised by them.


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.

SBP is responsible for maintaining the exchange rate of the rupee at an appropriate level. As the custodian of the country’s external reserves, the State Bank is also responsible for the management of the foreign exchange reserves.


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

In accordance with section 9 A(d，e) of the SBP Act 195 6,the State Bank of Pakistan also acts as an advisor to the Government on financial and economic matters, particularly with reference to their monetary aspects. Advice is also given on matters such as agricultural credit, cooperative credit, industrial finance, exchange regulations, banking and credit control, mobilization of savings, financial aspects of planning and development and other similar economic issues. The State Bank of Pakistan also tenders advice to the Government on debt management issues. According to section 9B of the SBP Act 1956，a ”Monetary and Fiscal


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.

For promotion of the country、banking services overall，the State Bank initiated a scheme for setting up the National Bank of Pakistan with a

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

Deposits & Advances in last decade


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 、

For the purpose of export growth, the State Bank introduced the Export Finance Scheme (EFS) in 1973, enabling banks to seek reimbursement from the State Bank against financing facilities provided to exporters of non-traditional and newly emerging export items. In 1977 the scope of the scheme was enlarged and financing was made available for all manufacturing goods. Moreover, it was split into two parts, Part I in


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

The role of long-term capital in the economic development of a nation cannot be over emphasized. Most economic managers recognize that a well organized capital market is crucial for mobilizing both domestic and


international capital. In many developing countries, however，capital has been a major constraint in economic development.

Capital and money markets are affected by a multitude of factors. The capital market consists of primary and secondary markets. The primary market is one in which underwriters help companies raise capital in the form of initial public offerings or by issuing seasoned stocks and bonds to investors. The secondary market, however, is where shareholders can resell their shares to other interested buyers on the stock exchange or the over-the-counter market.

The money market is used by a wide array of participants, from a company raising money by selling commercial paper into the market to an investor purchasing CDs as a safe place to park money in the short term. The money market is typically seen as a safe place to put money due to the highly liquid nature of the securities and short maturities，but there are risks in the market that any investor needs to be aware of, including the risk of default on securities such as commercial paper. The following are the factors which affect the development of the Stock Exchange and money:

1. Political stability

Political stability allows businesses to plan for future investments. Local consumers and foreign countries feel more comfortable investing in capital markets, spending money and negotiating long- term trade agreements in a politically stable country.

Countries that lack political stability fail to instill the level of confidence necessary in encouraging cooperation with other nations. When foreign countries see coups every couple of years in a country, they tend not to invest due to the associated risks，as the next regime that takes power may not accept decisions taken by the predecessors.

2. Law and order situation

In order to attract investment in both capital and money markets, the rule of law should be established. The law and order situation must be satisfactory; otherwise, neither local nor foreign investment will flow in the markets. This is the basic requirement; all other factors follow subsequently.

3. The legal and regulatory frameworkIn order to ensure orderly and equitable dealings in securities, as well as the protection and security of investors, all capital markets, especially the emerging ones, operate within a framework of laws and regulations enacted by the country. The extent to which these laws are enforced will have a direct bearing on the development of the stock market.

4. Information disclosure requirements

Public disclosure of relevant information about securities is important for both pricing efficiency and market confidence. If investors are to make sound judgments about the value of securities, they must be fully informed about the relevant facts.


5. Transparency of transactions

Transparency of trading and other procedures allow efficient price setting and confidence, leading to fairness in the market. Fragmented or privately conducted trading with limited disclosure of quantity and price means that each new transaction in effect must be based on relatively expensive search costs, with a risk of the transaction going out of line with prevailing prices.

6. Accounting and auditing standards

Users of accounting information include the government, the regulatory agencies, chartered accountants, accounting firms， the investing public and the general public. Information of such sorts must be correct and represent the true affairs of the firms being audited. The Institute of Chartered Accountants must adopt the Statements of Accounting Standards of the International Federation of Accountants (IFAC). If accounts of listed companies are prepared by reputable firms, submitted accounts to the Stock Exchange can be expected to be internationally acceptable.

7. Barriers to entry and exit

Too many barriers, especially to foreign investors, hamper the development of any stock exchange. The purchase of shares on the Stock Exchange in Pakistan has been described as being without any significant restrictions. Generally, if all listed stocks are freely available to foreign investors, there will be free and full foreign exchange remit ability for dividends, interest and capital gains. Initial capital invested may also be remitted without any restrictions.

8. Taxation of investment income

Tax rates on income from different financial instruments can influence how individuals or corporate bodies make their financial and investment decisions. Differences in taxation may also determine if an individual should invest in securities，demand deposits or whether a corporate body should raise funds through equity or debt instruments.

9. Efficiency of the Stock Exchange

Market efficiency has generated more discussion among financial economists than any other topic. A market is said to be efficient if it incorporates correct information into prices with considerable speed. Market efficiency therefore depends on the ability of traders to devote time and resources to gather and publicize information. Markets that are more efficient attract more investors, which translate into increased market liquidity.

Development of Pakistan Financial System

Pakistan’s financial system has grown in recent years but continues to have an enormous growth potential. The system remains relatively small in relation to the economy, when compared with other emerging countries

31

Overview of the Fi的ncial System

in Asia and around the world. Given that a dynamic and growing financial system is central to a growing economy, the small size (lack of depth) of Pakistan’s financial sector implies that many financing needs cannot be met and that much of the country's economic potential remains unfulfilled. A wide range of important structural reforms have already taken place but many more remain to be defined and implemented, if the financial sector is to meet its full potential for supporting strong and sustained economic growth and development. Pakistan has been challenged by inflation over the last four decades and as it continues to persist over the last three and a half years, is still the most serious financial issue currently faced by the country. As the central bank of the country, the State Bank plays the role of referee, being the initiator and implementer of monetary policy and controller of the major components of Pakistan、financial system.

The growth of Pakistan’s financial system indicates that the economy is moving towards betterment to some extent. In terms of assets, these increased to Rs 9.2 trillion in June 2010，showing a healthy growth of 20 percent from the December 2008 level of Rs 7.71 trillion (State Bank’s Financial Stability Review).

The role of Government in the financial sector in the development of the country is encouraging. The stability of the financial system is due to the predominant position of the banking sector, as other components of the financial system continue to grow at a slow pace. "Domestic banking sector assets constitute 73.2 percent of total financial system assets/'Bank deposits, which have a key contribution in maintaining financial stability, grew by 13.5 percent in CY09，and 8.2 percent in H1-CY10, bringing total deposits in the banking system to Rs. 5.1 trillion by end-June CY10. The growth in deposits is largely due to the growth in home remittances sent by Pakistanis living abroad, and these are contributing to gradual economic recovery, as well as the substantial increase in government borrowing, a portion of which flows back into the banking system in the form of deposits.

The pace of deterioration in the quality of advances is disturbing. In 2009 Non Performing Loans (NPLs) increased by 24.2 percent to Rs 432 billion and further by 6.4 percent to Rs 460 billion by end-June 2010. Going forward, NPLs will remain a key cause of concern for the banking sector. The slow performance of Non-Bank Financial Institutions (NBFIs)，which emerged as a strong threat to their commercial viability in previous years, continues to be a source of risk，while the insurance sector continued to provide necessary support to the economy, despite its relatively small size in comparison to the other players. Financial markets, in contrast to the instability in global financial markets, have continued to strengthen, due to the low level of integration with global financial markets, and continue to provide necessary support to the financial system in the form of financial intermediation.

In order to build our financial system on a strong footing, we must continue to work towards removing the weaknesses and bridging the gaps and agree upon the speed, content and phasing of the changes required at all levels to bring about a much stronger system. The following are the priority factors which will produce promising results.


Factors for positive change in the Pakistan Financial System

1. Financing of Middle and Lower Income Groups:

Banks have learned that, by broadening their client base, adding new products to their portfolio and offering new types of services， they can not only diversify their risks but also earn higher returns. The aim should be to continue to along these lines and try to reach small farmers in the agriculture sector and small, medium and micro enterprises in the coming years. This approach should be successful, if bankers are enterprising but prudent, forward-planning but not risk averse, and flexible but not too lenient in reaching out to the small farmers，small firms or individuals with micro-finance or consumer financing needs.

2. New Liability Products:

The industry has paid adequate attention so far to developing new products on the asset side but neglected the liability side, i.e. depositors. It is a one-sided approach as it is the savers and depositors who provide sources of funds for the industry to perform its basic functions of financing and investment. This could be an opportune time for the banks and nonbank financial institutions to devise new remunerative liability products for the 30 million depositors and savers of Pakistan.

3. Infrastructure Financing：

In addition to public sector enterprises, banks and DFIs must sponsor ways of fostering private-public partnerships in the area of infrastructure development. Successful experiences in other countries should be examined and adapted to conditions in Pakistan.

4. Branchless Banking

Much progress has been made in establishing the platform for branchless banking. With an increase in the numbers of ATMs，and extended availability of internet and telephone banking, small and medium banks can now offer on-line services to their customers, beyond their branch networks. The large banks have to move more expeditiously. As such, transaction costs will become lower and customer service will improve.

5. Investment Banking:

Investment banking in Pakistan has not progressed so far at the required pace. The corporate sector should use investment banks to render services such as investment advice, corporate restructuring, distressed assets acquisition and disposal, mergers and acquisitions, equity and debt financing. The investment banks must build up their capabilities in these areas. This is a specialized field and commercial banks cannot compete with them either on cost or customer satisfaction, although they all claim that they can provide total banking solutions for their clients1

needs.


6. Improvement in the quality of Risk Management：

Risk management is the gray area for the domestic banks. Although some banks have developed risk management strategies within their own institutions, this capability must become more widespread. Banks have not yet become fully aware of the essential need to attract human resources of the right kind, and to set up internal rating systems with the supporting technology. SBP have initiated training courses to cater for the needs in this area with the help of IBP.

7. Promotion of Islamic Banking：

It is encouraging that the response to the setting up of Islamic banks and branches in the country is positive. Through the mechanism of Islamic banking, those who have until now remained outside the financial sector because of their faith and beliefe, can now be attracted into using financial services, if not in their millions, but hopefully in their thousands.


2: Structure of the Financial System

Chapter 1:Money Markets

Money Market

Difference between Money Market and Stock Market

Framework followed by the money market in Pakistan

international money market (IMM)

Chapter 2: Mutual funds

What is a Mutual Fund?

Types of Mutual Funds locally and internationally

Chapter 3： Depositories

Depository participant issuers and registrar

CDC performs the following functions/services to customers


Chapter 4: Capital markets

Primary MarketImportance of International Capital Market in the overall performance of the financial system

Types of Capital Markets

Financial Market Intermediaries

Secondary Market

35

Part 2: Structure of the Financial System

Significance of secondary market Functions of secondary market

Influence of secondary market on overall financial system

Role of Intermediaries in overall performance of financial system

SECP

Stock Market

How does trading in the stock exchange take place?Sector and Market Capitalization Rules K~

Chapter 5: Capital markets

Various Types of NBFIs

Types of market players

Money Markets

Learning Outcome

Money Market


PartTwo Structure of the Financial SystemChapter 1 Money Markets

By the end of this chapter you should be able to:

» Define money markets

_ Describe the primary role and significance of a money market

_ Describe the framework being followed by the money markets in Pakistan

■ Discuss the money markets in Pakistan

■ Describe the importance of Pakistan's money markets in the overall working of the country^ financial system

■ Discuss the functions and importance of international money markets in the overall performance of any financial system

The money market is a segment of a financial market in which financial instruments with high liquidity and very short maturities are traded. The users borrow or lend for a short term which varies from several days to maybe just under a year. Money market securities consist of negotiable certificates of deposit (CDs)， bankers’ acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements.

A bearish market is considered risky by investors for their savings. High returns always expose an investor to high risk. For many investors, the money market offers an alternative to these higher-risk investments.

Financial Market

Financial markets such as money markets， foreign exchanges and capital markets are an essential part of a financial system.

Following are the main functions of these financial markets.

The money markets： they provide financial intermediaries, i.e. banks, non-bank financial institutions, a way by which to borrow and lend in the short term and square their respective positions.

The foreign exchange markets： they provide a working environment for international trade.

Capital markets: they provide long-term finance, both equity and debt ， for government and the corporate sector.

37Money Markets

All these markets work in close collaboration with each other. The performance of one market affects that of any other, in one way or another. These markets play an important role in sending monetary policy signals to the national economy. In fact, monetary policy communications are initiated by the financial markets, particularly money and Forex markets, which then impose an impact on the other financial intermediaries (banks, non-bank financial institutions), firms and households and then finally affect inflation and economic growth.

Difference between Money Market and Stock Market

The main difference between the money market and the stock market is that most money market securities transactions take place on a very large scale, whereas stocks are dealt in small proportions. Due to the large size of the transactions, it becomes difficult for the individual investor to gain access to the money market，whereas it facilitates firms to buy and sell securities in their own accounts, at their own risk. In a stock market a broker receives commission to act as an agent, and the investor takes the risk of holding the stock. Another difference is that a money market lacks a central trading floor for transactions; deals are transacted over the phone or through electronic systems, while the stock market has a trading floor for transactions.

The money market is accessible for mutual funds or through a money market bank account. These accounts and funds collect the assets of thousands of investors in order to buy the money market securities on their behalf. It is possible to purchase some money market instruments, like treasury bills, directly; otherwise they can be obtained through large financial institutions with direct access to these markets. Primary role of Money Market

The primary role of the money market is to encourage trading of money in short-term financial instruments railed ’’paper." This makes it different from the capital market which allows investment for shorter as well as longer periods in the form of bonds and shares.

The main function of the money market is interbank lending, that is, banks borrowing and lending to each other using T-bills, commercial paper, repurchase agreements and similar instruments. The price of these instruments is determined according to the benchmark, i.e. fLondon Interbank Offered Rate (LIBOR).' In Pakistan also there are companies with strong credit ratings who issue commercial papers / bonds， debentures, etc to meet their financial needs.

The money market mainly caters for fixed income groups. People connect the term "fixed income" with "bonds”， implying that they are one and the same, but a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities that mature in less than one year.

Money market investments are also called cash investments because of their short maturity period. Money market securities are government


securities, and financial institution and large corporation securities. These instruments are easy to liquidate and so are considered safe to deal. The traditional money market securities offer lower returns than most other securities.

Framework followed by the money market in Pakistan

Banks operating in the money markets are required to ensure monetary and financial stability. Some of these operations are designed basically to implement the monetary policy decisions of the central bank and others are designed mainly to provide liquidity for the banking system. The SBPfs operating framework consists of a number of elements, including policies on access rights to central bank facilities; collateral policies; and an operating system.

The basic tools of this framework are:

The demand for reserves

The demand for reserves can change for a number of reasons. During pressurized/stressed times， the interbank market may not work effectively and a bank that is short of liquidity may find it more difficult than usual to borrow money. The central bank uses reserves as a tool to check the money market.

Monetary policy implementation by setting interest rate

Central banks communicate the stance of monetary policy by setting a short-term interest rate. Their operations in money markets are conducted with the objective that the interest rates at which banks transact for short periods of time are close to this policy rate.

Open Market Operation (OMO) is a multilateral transaction in which the central bank at its own initiative deals in the market and thus affects the banking system as a whole.

The interbank money market

The interbank money market is the market in which banks borrow and lend short-term funds to each other; the duration is usually no longer than a week. These transactions have to be settled via banks’ accounts with the central bank. If payment flows leave one bank with a surplus of reserves and another with a shortage of reserves, they have an incentive to trade with each other at a market-determined rate.

The interbank market forms the centre of a wider money market in which non-bank financial institutions often participate. Overnight liquidity and transparent pricing helps to maintain efficient working of the financial markets.

Performance of Money Market in Pakistan

An efficient money market provides a mechanism for meeting the shortterm liquidity needs of the lenders and borrowers and facilitates financial intermediation at efficient transactional costs without undue delays. The money market also provides an instant response to the central bank’s policy actions for influencing liquidity and short-term interest rates in the economy.

Due to inflationary pressures emanating from the surge in international commodity prices and a persistent rise in aggregate demand pressures, SBP, as the regulator of the financial system, continued with its monetary tightening stance during the first two quarters of FY09. However, with the subsequent decline in international commodity prices，inflationary pressures eased off in the latter part of the financial year，and further resulted in CPI inflation decline from March FY09 onwards. SBP lowered its discount rate by 100 bps in April FY09， which was the first rate cut since the start of monetary tightening in April 2005. Prior to reversing the stance in April FY09，the discount rate was raised twice; first by 100 bps and then by 200 bps to reach 15.0 percent in November FY09. Never-ending government borrowings and seasonal demand for private credit on the back of rising input prices helped banking assets grow by 7.7 percent during 2010. A major portion of growth in assets can be attributed to soaring investments in government securities. Total investment grew by Rs. 269 billion, posting growth of 14.3 percent during the quarter.

In 2010， investments registered strong growth of 22.2 percent with the major share in government papers， including T-bills and PIBs. Apart from traditional interest-bearing government securities, the quarter under review also witnessed 96 percent growth in investments by Islamic banking institutions, due to their investment of Rs 89 billion in two tranches of the last two years.

The growing government borrowings provided banks with a continuous stream of lucrative risk-free securities. Unsurprisingly, the amount of investments (net of provisions) doubled from Rs 1.08 trillion in FY08 to Rs 2.14 trillion in Q4-CY10. The share of net investments in total assets also increased from 19 percent in Dec-08 to 30 percent by Dec-10 (SBP Review).

International money market (IMM)

International trade, financing and investments, and related cash and credit transactions, developed at a very fast pace in the 1960s and 1970s. The international monetary system has continued to develop to accommodate the need for foreign-currency denominated transactions and in the process has been provided with opportunities for its continuing onward development.

The International Monetary Market (IMM) was introduced in December 1971 and started to function in May 1972. The very first future trading contracts were made against the U.S. dollar with other currencies such as the British pound, Swiss franc, German deutschmark，Canadian dollar, and Japanese yen. In 1992，the German deutschmark/Japanese yen pair was introduced as the first futures cross rate currency.There were two major challenges faced by IMM. The first and foremost challenge was to connect values of IMM foreign exchange contracts to the interbank market and the second was to allow the IMM to be the free-floating exchange image for the money markets. To solve these problems, clearing member firms were incorporated to act as a link between banks and the IMM to facilitate orderly markets between bids and ask spreads. The Continental Bank of Chicago was later hired as a delivery agent for contracts.

The international money market is playing a vital role in the development of international trade. The Asian money market is also linked up with the IMM because Asian governments, banks and businesses needed to facilitate


business and trade in a faster way rather than borrowing U.S. dollar deposits from European banks.

The IMM progressed further in the mid 1980s when options began trading on currency futures. By 2003， foreign exchange trading had hit an estimated value of $347.5 billion.

Learning Outcome

What is a Mutual Fund?

Mutual Funds 41

PartTwo Structure of the Financial SystemChapter 2 Mutual Funds


■ Define mutual funds

職 List the types of mutual funds internationally and locally

思 Discuss the risks involved in dealing with mutual funds and mitigation strategies available

_ State and discuss the SECP regulations concerning mutual funds and describe the impact of these regulations on their performance

A mutual fund is an investment company that uses members* capital to buy a diverse group of stocks from other companies. A mutual fund pools together

savings of various investors -individuals as well as institutions - and collectively invests these savings in stocks，bonds and / or money market instruments. It offers many advantages to investors, particularly retail investors, by linking directly with capital and money markets.

The pooled funds from many investors are used for investments in securities and similar assets. Mutual funds are operated by money managers, who invest the funds in capital and attempt to produce capital gains and income for the fund’s investors. A mutual fundTs collection is planned and maintained to match the investment objectives stated in its offer document. One of the main advantages of mutual fiinds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which are otherwise difficult to manage with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund and thus risk is spread out. Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share. Profit is paid by:” Dividend Payments: On an annual basis， the fiind’s management will declare dividends in either cash form or in the form of bonus units. ”

Appreciation in Price: When the price of a fund increases due to appreciation in the overall portfolio of the fund, it results in capital gains for investors who can now redeem their units at a higher price.

Management Company

A management company is responsible for the day-to-day running and marketing of the fund, attendance to client queries, financial reporting to the regulatory bodies, etc. The management company is supposed to analyze and choose the investments that will be most beneficial to the unit holders. It is also the management company’s job to make sure that unit holders' accounts are accurate and up to date, and that they are


regularly informed of how the fundfs investments are performing. The Trustee must hold under its control all the property of the fund in trust for the unit holders. Cash and other assets must be deposited or registered in the name of or to the order of the Trustee. The Trustee must carry out the instructions of the management company in all matters including investment and disposition of the fund property, unless they are in conflict with the Deed, the Rules and applicable laws.Following are the major advantages of investing in mutual funds:

• The fund management consists of investment specialists who manage B

the fund’s investment portfolio on a continuous basis. The fundmanager’s job is to analyze the financial markets for the purpose of selecting those securities which are in line with investment objectives.

•Mutual funds provide investors with exposure to a diversified portfolio of investment instruments, reducing the investors* overall portfolio risk.

• In contrast to a bank’s term deposit scheme, investors holding units of open-ended mutual funds can invest and disinvest at any time to match their particular liquidity needs with little or no transaction cost.

• Investors can transfer part or all of their investments from one fund to another so as to obtain the most benefit from their money.

• Under the current tax rules, capital gains on sale of units as well as bonus units are exempt from taxes.

Front-end Load

Entry/ front-end load are the sales and processing charges payable by an investor upon purchase of units. This charge is added to the Net Asset Value in determining the Offer Price. This is a one-time charge and is paid on investment.

Back-end Load

Exit/ back-end load are the sales and processing charges payable by an investor upon redemption of units. This charge is deducted from the Net Asset Value in determining the Redemption Price. This is a onetime charge and is paid at the time of redemption of units.

Open-ended fund

An open-ended fund is a collective investment scheme which can issue and redeem shares at any time. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders. It contrasts with a closed end fund，which typically issues all the shares at the outset and which are usually tradable between investors thereafter.

The first Government of Pakistan National Investment Trust Limited (NITL) was established in 1962. It launched the first Open End Equity Fund in Pakistan, called NIT units.

Mutual Funds 43

Closed-ended fund

A closed-end fund is a collective investment scheme with a limited number of shares. It rarely issues new shares once the fund has launched and the shares are not normally redeemable for cash or securities until the fund liquidates.

An investor can acquire shares in a closed-end fund by buying shares on a secondary market from a broker, market maker, or other investor, as opposed to an open-end fund where all transactions eventually involve the fund company. The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund, divided by the number of shares in the fund, is called the Net Asset Value (NAV) per share. The market price of a fund share is often higher or lower than per share Net Asset Value.

In 1966， the Government of Pakistan established ICP which launched a

series of Closed End Funds.

Until 1994，NIT and ICP were the only companies offering mutual funds. In

1995, SECP allowed the private sector to enter the mutual fund industry.

Since 2002 MFIs are flourishing, showing growth in both number and

volume, particularly since 2002. The growth in mutual funds in Pakistan is

attributed to:

(a) liberalization of the sector

(b) economic growth and macroeconomic stability that attracted

investors, including foreign investors, to the stock market

(c) increased liquidity with institutional investors, which was

channeled into the stock market and mutual funds

(d) high corporate earnings that increased the earnings potential for

mutual funds

(e) a floating stock market that provided mutual funds with good returns in the form of capital gains. Liberalization has helped to facilitate entry of the private sector into the mutual funds industry.

The mutual fund industry in Pakistan has witnessed a period of fast growth since 2002 with an average growth rate of about 50 percent. Net assets reached the highest ever level of about Rs. 425 billion in April FY08 when the stock market was at its peak. However, the rapid decline of the market in 2009 had an adverse impact on the assets of the mutual funds which were reduced to Rs. 211.9 billion by end 2009，as compared to Rs. 334.8 billion in 2008.


Developments in the regulatory and services environment indicate there is still strong potential for the mutual funds sector to continue its growth momentum, although the challenges faced by the sector need to be addressed as a priority. Some significant challenges which are being faced by the mutual funds industry are:

• Institutional investors, who generally have large funds for investment, such as provident and pension funds, are restricted from investing in mutual funds.

•Contrary to this, institutional investors have access to national savings schemes for their investments.

• Financial illiteracy is one of the reasons for inadequate mobilization of investments from retail investors.

•Lack of depth in the domestic securities market that constrains investment decisions.

•The need to introduce stringent fit and proper tests for fund managers and intermediaries, including their sales force.

•The need to implement international best practices across the sector and improve fund governance and transparency.

Types of Mutual Funds locally and internationally

Types of Mutual Funds

Before investing, every potential investor wants to know what returns can be expected on their investment, as well as the potential associated risks. In general, the higher the potential return, the higher the risk of loss. There are some funds that are less risky than others, but all mutual funds have some level of risk. This is a fact for all investments. Each fund has a predetermined investment objective that tailors the fund’s assets, areas of investments and investment strategies. There are basically three types of mutual funds and all mutual funds fall within these categories:

1) Equity funds (stocks)

2) Fixed income funds (bonds)

3)Money Market funds

Money Market Funds

The money market consists of short-term debt instruments, mostly Treasury bills (T-bills). Although the money market is a safe place to invest, the investor will not gain very high returns, but at the same time the original investment will remain intact.

Mutual Funds 45

Bond/Income Funds

Income funds are a comparatively safe investment. Their purpose is to provide continuous income on a regular basis. When referring to mutual funds, the terms "fixed-income ’ ，， ”bond”，and "income” are identical. These terms denote funds that invest primarily in government and corporate debt. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors. As such， the potential investors in these funds consist of conservative investors and retirees.

Balanced Funds

The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities. A typical balanced fund might have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class.

Equity Funds

Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class ot tunds is long-term capital growth with some income. There are different types of equity funds in the market to match various types of equities.

Global/International Funds

An international fund or foreign fund invests outside the home country of the investors. Global funds may invest anywhere around the world, including the home country of the investor.These funds cannot be considered nsMer or safer than domestic investments but they can be maintained as part of a well-balanced portfolio, wmch actually reduces risk by increasing diversification as the economic conditions of each country are different.

Specialty Funds

These funds are more comprehensive in nature compared to other funds. They invest in the securities of a particular industry, sector, security or geographic region. Specialized funds offer higher returns but higher risk due to lack of diversification.

• Sector funds target specific sectors of the economy such as finance ，technology, health, etc. These funds are extremely risky but at the same time can give excellent returns.

• Regional funds make it easier to focus on a specific area of the world such as south Asia, Middle East, etc, or an individual country, for example，India only. Like sector funds, the investor has to accept the high risk of loss, which occurs if a particular region goes into a bad recession.


• Socially-responsible funds, or ethical funds, invest only in companies/entities that meet certain criteria or conform with certain guidelines or beliefs. Mostly these funds are not invested in industries such as tobacco, alcoholic beverages, and armaments.

Index Funds

The last important funds are index funds. This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or KSE 100 index. An investor in an index fund knows that most fund managers can’t beat the market. An index fund merely replicates the market return and benefits investors in the form of low fees. How to mitigate risk

•The investor should focus on well-diversified mutual funds with a well- established performance track record of, ideally, at least 3 years.

• Sector funds should be avoided as they are a high risk, high return investment proposition, and they tend to lose sheen when the sector is out of favor，or during a down turn in the equity markets, thus resulting in erosion of wealth.

• Instead of investing a lump sum amount, it would be better to adopt the SIP (Systematic Investment Plan) route while investing, as this enables the investor to manage the volatility of the markets well, and provide him/her with the advantage of compounding and rupee-cost averaging.

• If investment in a particular class of shares is not giving the expected return, it would be better to exit from that investment and instead invest in a well-diversified equity fund.

•While investing in equity mutual funds, one must have a long-term investment period of say, 3 to 5 years. In this way the average return will be better than with a very quick change of investment.

• If the investor selects mutual funds in the right manner by taking into account the host of factors (past performance, return, risk， etc) attractive returns on the investments should result.

•The investor’s age and objectives are very important factors to be taken into account when investing funds. Persons of old age should not invest in equity (whether direct equity, i.e. in stocks, or indirect equities, i.e. through mutual funds). In this case, debt instruments would be a safer option.

Regulatory Control (SECP)

SECP regulates the mutual funds industry, all stock exchanges in Pakistan, all listed companies, the insurance industry, investment banking sector and the stock brokerage business. The SECP has established and continues to develop a stringent set of rules and requirements and an organization has to abide by them in order to operate as an Asset Management Company.

The management company also falls under the regulations of SECP and SBP, etc. The role of SECP in regulating the capital markets in Pakistan has had a positive impact and total funds in the industry have reached Rs. 3,027 billion (US$ 50.45 billion).


As the regulator of an emerging market, the SECP’s regulatory philosophy is based on the principle of continuous development in regulation. SECP, therefore, places considerable emphasis on market development while also administering and enforcing various corporate and securities laws.

The SECP wants to promote investment through mutual funds, and therefore it has allowed investment of 50 percent of provident funds in authorized unit trust schemes. SECP also allows exposure of up to 20 percent of their funds to a single scheme. The SECP has permitted formation of index funds, sector funds and other various kinds of funds, along with the conversion of a closed-end fund to an open-end fund in order to provide product diversification. It has been made obligatory for asset management companies to have the unit trust schemes that they manage, rated by a rating agency registered with the SECP.

Performance of Mutual Funds industry up to 2010

[Rupees in Billions)Year 2003 2004 2005 2006 2007 2008 2009 2010

Net Assets 51.6 93.7 125.8 159.9 289.1 334.8 219.3 211.9

Share by Ownership

Public Sector 78.50/0 52.80/o 48.50/0 40.2% 31.5% 25.4% 30.8% 20.5%

Private Sector 21.5% 47.20/0 51.5% 59.8% 68.5% 74.6% 69.2% 79.5%

Share by Type

Open-ended Funds 78.20/0 73.60/0 70.1% 72.70/0 82.40/0 86.1% 87.3% 84.10/0

Closed-ended Fund 21.8% 26.40/0 29.9% 27.3% 17.60/o 13.90/0 12.70/0 15.9%

Share by Category

Equity Funds 81.20/o 76.5% 72.80/0 63.0% 47.30/0 41.6% 44.5% 34.7^/o

Income Funds 6.6% 6.40/0 6.20/0 10.6% 24.40/0 24.9% 23.2% 32.80/0

Money Market Funds 4.6% 3.6% 3.9% 7.3% 15.0% 17.2% 13.7% II.70/0

Balanced Funds 5.8% 10.3% 9.0% 7.2% 4.6% 4.9% 4.10/0 3.6%

Islamic Funds 1.8% 3.2% 4.70/0 5.6% 4.90/0 6.2% 8.50/0 10.8%

Tracker Funds 0.0% 0.0% 0.0% 0.6% 0.5% 0.2% 0.1% 0.1%

Fund of Funds 0.0% 0.0% 0.40/0 0.5% 0.3% 0.6% 0.5% 0.6%

Others 0.0% O.OO/o 3.00/0 5.20/0 3.0% 4.4% 5.4% 5.7%


Part Two Structure of the Financidl SystemChapter 3 Depositories

Learning Outcome By the end of this chapter you should be able to:

» Define depositories

« Discuss the role and functions of a

depository

_ Discuss the concepts of depository

" - - - - _________________________み . を :^:::--.' - . V '. こ . ベ .. そ ... シ ;• ニニ - • - • " - - " r


participants, issuers and registrars理 Recall the Central Depositories Act, 1997 (Pakistan) and list its stakeholders

■Discuss the role and functions of the CDA, 1997

What is a Depository? A "Depository” is a facility for holding securities, which enables secunties

transactions to be processed by book entry. To achieve this purpose，the depository may stock the securities or dematerialize them. ”Dematerialization’’ is a process by which physical certificates are converted into electronic form. Pakistan has chosen the dematerialization route.

Central Depository Company (CDC) of Pakistan

Limited incorporated as a public limited company in 1993. This is the only depository in Pakistan. The Company started operations in September 1997. This is the sole entity handling the electronic settlement of transactions carried out at all three stock exchanges of the country.

CDC was mainly established to operate the Central Depository System (CDS) for equity, debt and other financial instruments that are traded in the Pakistani Capital Market. CDS is an electronic book entry system used to record and maintain securities and their transfer registration. The system changes the ownership of secunties without any physical movement or endorsement of certificates and execution of transfer instruments. All the members of stock exchanges, banks (both commercial and investment) and DFIs can open their account as a Participant, whereas corporate bodies and qualified private investors can open their account as an Account Holder.

CDC is regulated by the Securities and Exchange Commission of Pakistan (SECP). It has branches in Karachi, Lahore, Islamabad and Hyderabad.

Taking another step towards capital market development, CDC has diversified its operations in the following services:

.Launched in 1999， Investor Account Services (IAS) allows retail investors to open and maintain securities accounts directly with CDC.

• Trustee and Custodial Services (T&C) were


introduced in 2002 and includes Open-end and Closed end Mutual Funds and Voluntary Pension Schemes.

• Share Registrar Services (SRS) provides to issuing companies facilities for registrar and transfer agent services，including registration and verification of shares and records and customer dealing on behalf of issuer companies.

The system changes the ownership of securities without any physical movement or endorsement of certificates and execution of transfer instruments. CDS facilitates equity，debt and other financial instruments in the Pakistani capital market. It manages ordinary and preference shares, TFCs，WAPDA Bonds ， Sukuk, open-end and closed-end funds and Modarba Certificates.

Following are some of the advantages of electronic settlement of securities through CDS:

• Reduction of workload due to paperless settlement.

• Immediate transfer of ownership.

• Investors can have their securities, subscribed in IPOs, directly credited to their accounts in electronic form.

.Immediate credit of bonus, rights and new issues.

• Suitable place for keeping pledging of securities.

• No stamp duty on transfers in CDS.

•Risk of damaged, lost, forged or duplicate certificates has been eliminated.

• No traditional vaults due to the paperless environment.

• No hassle during book closure.

CDC performs the following functions/services to customers

As stated above, CDC diversified its operations by providing the following services:

•Launched in 1999, Investor Account Services (IAS) allows retail investors to open and maintain securities accounts directly with CDC.

• Trustee and Custodial Services (T&C) were introduced in 2002 and includes Open-end and Closed-end Mutual Funds and Voluntary Pension Schemes.

• Launched in 2008，Share Registrar Services (SRS) provides to issuing companies state-of-the-art facilities for registrar and transfer agent services, including registration and verification of shares and records and customer dealing on behalf of issuer companies.


CDC provides the following services to customers:

• Deposit of Securities

•Transfer of Securities

• Pledging of Securities

• Pledge Release

• Pledge Call

•Withdrawal of Securities

• Specialized services for corporate customers' requirements


The companies or Issuers of capital whose securities (both equity and debt) are converted from physical to electronic securities play a significant role in CDS. The physical securities are converted into electronic book entry securities only after proper verification and approval by these Issuers in CDS. This process eliminates the problem of fake certificates as securities are thoroughly checked by the Issuers before approval for CDS.

Rights of depositories and beneficial owner

•A depository shall be deemed to be the registered owner for the purposes of effecting transfer of ownership of security on behalf of a beneficial owner.

• The depository as a registered owner shall not have any voting rights or any other rights in respect of securities held by it.

•The beneficial owner shall be entitled to all the rights and benefits and be subjected to all the liabilities in respect of his securities held by a depository.

Register of beneficial owner - Pledge or hypothecation of securities held in a depository

•Subject to such regulations and bye-laws，as may be made in this behalf, a beneficial owner may, with the previous approval of the depository, create a pledge or hypothecation in respect of a security owned by him through a depository.

• Every beneficial owner shall give intimation of such pledge or hypothecation to the depository and such depository shall thereupon make entries in its records accordingly.

Learning Outcome


Part Two Structure of the Financial SystemChapter 4 Capital Markets


■ Define a capital market

■ Describe the primary role and significance of a capital market

■ List the functions of a capital market and how they affect the overall dynamics of a financial system

■ Discuss the capital markets of Pakistan

■ Describe the importance of Pakistan's capital markets in the overall operation of Pakistan's financial system

■ Define international capital markets

■ Discuss the functions and importance of international capital markets in the overall performance of any financial system

■ Discuss the types of capital markets present in a financial system setup

■ Differentiate between the various types of capital markets in terms of their operations and functions

■ Define international capital markets

■ Discuss the functions and importance of international capital markets in the overall performance of any financial system

® Define primary markets

■ Discuss the significance and scope of primary markets

■ List the various agencies and institutions involved in primary market operations

■ Discuss how a primary market develops, what factors are responsible for these developments and how these developments affect the overall operation of the financial system

■ Discuss the role and importance of the following primary market intermediaries in the overall functioning of a financial system: merchant bankers, registrars, underwriters, bankers to issue, portfolio managers, debenture-trustees

■ Define a secondary market

_ Discuss the significance of secondary markets

■ List and discuss the functions and scope of secondary

markets■ Discuss how secondary market functions influence the overall performance of a financial system in a country

53

■Discuss the role and importance of the following secondary market intermediaries in the overall functioning of a financial system: stockbrokers, sub-brokers, advisors, the rules, regulations and code of conduct framed by SECP

« Describe the regulatory framework and control available to monitor and regulate the proper functioning of stock exchanges

■Define and discuss the primary operations of stock exchanges and how these operations regulate the overall dynamics of a financial system

■Define and discuss the classification and listing of securities and the impact and significance of these listings on the activities of the financial system

_ Define the concept of over-the-counter markets

■List and discuss the functions and roles of the market players in a financial system

■Discuss the role of investors and companies in the performance of the financial system

_ Discuss the laws and regulations concerning securities and how they impact on trading/usage in order to influence the economic outcome

Primary Market Capital market

Stock is the capital raised by a corporation through the issuance and distribution of its shares. A person or organization holding these shares are called the corporation's shareholders or stockholders. ’Market capitalization1 is the term for aggregate value of all the shares 、 issued by a corporation. It is a measure of size of a business enterprise

(corporation) equal to the share price times the number of shares outstanding (shares that have been authorized, issued, and purchased by investors) of a publicly traded company. As owning stock represents ownership of the company, including all its equity， capitalization could represent the public opinion of a company’s net worth and is a determining factor in stock valuation.

The Government of Pakistan has been trying to improve market efficiency, enhance transparency and bring the Pakistani equity market up to international standards. Many reforms have been initiated. The most prominent of these is the formation of the Securities Exchange Commission of Pakistan (SECP), by virtue of which introduction of screen-based trading, shortening of the trading cycle ， demutualization of stock exchanges, establishment of depositories, disappearance of physical share certificates and better risk management systems in stock exchanges have been accomplished.

Capital markets of Pakistan

In the 1990s， Pakistan’s capital markets had a number of critical issues to confront, including, among others, a weak and outdated regulatory framework; an inefficient, non-transparent and stagnant stock market;

Capital Markets


a poorly regulated and publicly-owned mutual funds industry and a growing insurance industry that contributed little to capital market development. In those years, National Saving Schemes offered higher interest rates which were inappropriate, although they attracted personal and institutional savings incompatible with the risks. This situation slowed the development of the capital market, hampered the growth of the corporate debt market, and delayed financial intermediation. It effectively starved the private sector of much-needed capital.

After two decades, the aggregate market capitalization increased manifold and stood at Rs. 3,148 billion by the end-March 2011. The market registered a rise of more than 15.2 % the preceding year, which shows that Pakistan's equity market has been one of the best performing equity markets in the world for almost one decade.

During the period from July-March 2010-11, the capital markets demonstrated a wavering rising trend and posted modest gains. A total of 638 companies were listed at the Karachi Stock Exchange (KSE) in July-March 2010-11 with total listed capital of Rs. 920.1 billion. Pakistan’s stock markets have remained very progressive during the first two quarters of 2010-11 in terms of market index and market capitalization, which remained steady until January 2011.

The KSE witnessed a rise of 16 percent as compared to the corresponding period of 2009-10, and the main reason for this recovery is the absence of leverage products for the stock market in addition to soaring inflation levels and rising interest rates. However, volumes gathered pace and the average volume increased by 19 percent to touch 114.2 million shares per day during the third quarter of 2010-11. Investment in the capital market during the period July-March 2010-11 by foreign investors showed a net inflow of US$ 301.5 million, but a noteworthy contribution was made during the first two quarters of 2010-11.

Importance of capital market

The efficiency of a capital market contributes to the economic growth of a country. Economic growth mainly depends on the availability of capital and its efficient allocation to the productive sector of the economy. Efficient capital allocation means that funds are channeled towards investment projects. Therefore, there is a direct relationship between the capital market and economic development. Pakistan's capital market is playing a significant role in the economic development of the country. In the last decade the capital market has registered a significant growth and it was most favored for investment. A huge foreign exchange inflow was noted from 2003 to the first quarter of 2008. In 2010，the capital market started to build up momentum and at present, the KSE 100 index has exceeded 12300 points, which indicates that the capital market is on the right track.

Importance of capita 丨 market in overall financial system

The stock market is the most important part of the capital market. The best way for a business organization or a company to raise money for capital is through the stock market. Companies sell their shares of ownership in a public market and thus raise additional financial.A stock exchange provides investors with the facility to quickly and easily sell securities. This is called liquidity. This is an attractive feature of investing in stocks, compared to other,

less liquid investments.

The price of shares and other assets is important for economic growth. Growth in the capital market predicts a rising economy. In fact, the capital market is considered the primary indicator of a country’s economic strength and development. The financial system in Pakistan has undergone a remarkable transformation. Now more investment is flowing directly to the financial markets instead of being invested in traditional bank deposits. The general public is developing an interest in investing in the stock market, either directly or through mutual funds. The same pattern is being noted all over the world. In developed economic systems, the trend has been the same _ savings have moved away from traditional bank deposits to more risky securities of one sort or another.

International Capital Market

The international capital market is defined as the financial market where shares, bonds, debentures, currencies, mutual funds and other long-term securities are purchased and sold. A group of various countries’ capital markets constitutes the international capital market. The members connect with each other through the Internet. It is a place for the international companies and investors to deal in shares and bonds of different countries. The International Capital Market Association (ICMA) was formed in July 2005 by the merger of the International Primary Market Association and the International Securities Market Association. ICMA aims to promote high standards of market practice, appropriate regulation, trade support, education and communication. It produces standard documentation for transactions, such as equity and debt issuance and repos. It is a self- regulatory organization and a trade association for participants in the capital markets.

Importance of International Capital Market in the overall performance of the financial system

It is due to the international capital market that various countries and communities of the world have an opportunity to prosper at levels which were otherwise impossible to access. Since the advancement of IT, there has been a revolution in the global financial sector and all financial markets are covered by international capital markets, for example Hong Kong, Singapore and New York World Trade Centre. The international capital market started by dealing in foreign exchange. With globalization of the financial sector, companies have to take certificates for dealing in the international market. Suppose that a Pakistani company wants to sefl shares in Hong Kong: to do this, the Pakistani company needs to take a certificate named a Global Depository Receipt (GDR) and can them participate in the international market.

The international capital market、daily turnover now exceeds S5 The international capital market is very helpful in reducing thr

small companies because, in the international market, an investor can buy company shares from different countries, as well as debentures and mutual funds. Different countries have different business environments, so if a country is facing a loss due to a financial crisis, investors may suffer loss, but then can recuperate this loss by investing in other countries. Therefore, overall risk will be reduced by this technique.


A borrower pays for the use of other people’s savings. The cost of those savings is generally expressed in terms of an interest rate. The cost of the loan, i.e. interest, depends on the cost of funds available to the bank. If costs of funds in a country are high, the lending cost will also be high. This means that borrowers in countries with low interest rates pay lower interest rates on the loans.

One major advantage of globalization is that it gives access to borrowers to funds from countries with higher savings rates. The result for the lender is access to cheaper money in the form of lower interest rates.

Other advantages are:

•Financial globalization gives the borrower access to sophisticated products and services.

• Indirectly, globalization will increase the efficiency of domestic financial markets.

•Financial globalization gives investors access to investments with higher returns and thus greater profits.

• Financial globalization helps to reduce the risks of investment, such as country risk and currency risk.

• Financial globalization enables financial institutions to access new markets.

• Financial globalization facilitates increased foreign investment in underdeveloped countries such as Pakistan, Indonesia, Thailand, etc.

•Financial crises in weak countries can be easily controlled in a globalized economy.

Types of Capital Markets

A capital market consists of:

Stock markets： they provide financing through the issuance of shares or common stock, and enable subsequent trading through a secondary market.

Bond markets： they provide financing through the issuance of bonds, and enable subsequent trading through a secondary market.There are two types of capital markets:

A primary market is concerned with issuance of new securities by the following methods:

• Initial public offering (IPO)• Rights issue (for existing companies)•Preferential issue

A secondary market is a market where investors purchase securities or assets from other investors, rather than from issuing companies

Primary market

A primary market is a market for raising fresh capital in the form of shares. Public limited companies which want/need to raise capital funds through the issue of securities approach the primary market. Public limited and government companies are the issuers and individuals, institutions and mutual funds are the investors in this market.

The functions and scope of primary markets are:

• Securities are sold for the first time.

• Securities are issued by the company directly to investors.

• The company receives the money and issues new security certificates to the investors.

•The primary market lends money for setting up new businesses or for expansion or modernization of existing businesses.

• The primary market facilitates capital formation in the economy.

• The new issue market does not include other sources of long-term external finance, such as loans from financial institutions.

Financial Market Intermediaries

Merchant Banker:

Merchant bankers carry out the work of underwriting and portfolio management as well as new issue management. They are required to get separate registration with SECP as portfolio managers. Underwriting can be done without any additional registration. They have to carry out the work related to the new issue，such as determination of security, mix to be issued, drafting of prospectus, application forms, allotment letters, appointment of registrars for handling share applications and transfer, making arrangement for underwriting placement of shares, appointment of brokers and bankers to issue, making public notification of the issue. They are also known as lead managers to an issue. Merchant bankers can act as consultants, advisers, portfolio managers and co-managers, underwriters, advisors and consultants.Underwriters:

The company issuing shares has to appoint underwriters in consultation with the merchant bankers or lead managers. The underwriters play an important role in the development of the primary market. The underwriters are the institutions or agencies, which make a commitment to taking up the issue of shares in cases where the company fails to achieve full subscription from the public. They receive commission for their services. Underwriting services are provided by the brokers, investment companies, commercial banks，etc.

Bankers to the Issue：

Bankers play a very important part in the operations of the primary market. They collect applications for shares and debentures, along with application money from investors in respect of issue of shares. They also refund the application money to the applicants to whom shares could not be allotted on


behalf of the issuing company. A company is not authorized to collect the application money directly. Money on account of new rights issues of shares and debentures must be collected through the banks. Therefore, an issuing company has to appoint bankers to collect money on its behalf.

Registrar:

A registrar is an intermediary who carries out functions such as keeping a proper record of applications and money received from investors, assisting the companies in determining the basis of allotment of shares as per stock exchange guidelines and, in consultation with stock exchanges, assists in the finalization of allotment of shares and processing and dispatching of allotment letters, refund orders, share certificates and other documents related to capital issues. A registrar can also be called a Share Transfer Agent who maintains records of holders of shares of the company on behalf of the company and handles all matters related to transfer and redemption of securities of the company. They also function as Depository Participants.

Brokers:

Brokers are the middlemen who provide a very important link between the prospective investors and the issuing company. They assist in the subscription to issues by the public. The appointment of brokers is not mandatory. Brokers receive their commission from the issuing company according to the rules and regulations. There is an agreement between the brokers and the issuing company. A broker must have thorough knowledge, professional competence and integrity in order to carry out the overall functions required to deal with an issue. The names and addresses of the brokers to the issue are disclosed in the prospectus issued by the company to help investors make their choice of the company in which to invest.Secondary Market

A secondary market is also known as a stock market, and deals in securities that have been already issued by companies. For the efficient growth of the primary market, a sound and efficiently performing secondary market is an essential requirement. If investors get a good return in resale transactions (secondary market) they will invest more in the primary market. The secondary market offers an important facility of transfer of securities.

It is a market where investors purchase securities or assets from other investors, rather than from issuing companies. The national exchanges - such as the Karachi Stock Exchange and the Lahore Stock Exchange - are secondary markets.

Secondary markets exist for other securities as well， such as for funds, investment banks, or the bonds of entities such as WAPDA, Agro Chemicals， etc. In any secondary market trade, the cash proceeds go to an investor rather than to the underlying company/entity directly.

A newly issued IPO (Initial Public Offering) will be considered a primary market trade when the shares are first purchased by investors directly from the underwriting investment bank，after which any shares traded will be on the secondary market between investors themselves. In the primary market，prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security.

Rating

Independent rating is necessary of the riskiness of the safekeeping and transaction settlement processes in a market, based on an assessment of all post-trade risks to which investors are exposed in that market. The ratings, which use the familiar AAA to C rating scale，measure the extent to which the infrastructure and processes in a market minimize the exposure of investors. The six main risks which are monitored by the monitoring service are: asset commitment, liquidity, counterparty, financial, asset servicing and operational risks. The ratings enable users to compare total post-trade risk exposures across the markets.

Significance of secondary market:

For the general investor, the secondary market provides an efficient platform for trading of shares and securities. For the management of companies, secondary equity markets serve as a monitoring and contr ol medium for facilitating control activities, enabling implementation of incentive-based management contracts, and through market-based information guides company management to take better decisions. The main features of the secondary market are:

Ready market information:

Sometimes investors believe that they have the latest information about a particular share or security which other market participants do not have. This information leads them to believe that the security is not being correctly priced by the market. If the information is good, this suggests that the security is currently under-priced, and investors with access to such information will prefer to buy that share/security. Contrary to this, if the information about the share/security is bad, investors will prefer to sell their holdings to secure their investment.

Quick convertibility into cash：

Another important feature of a secondary market is its liquidity. Liquidity motivates investors to transact in the secondary market. If the investor is in a position of having either excess or adequate liquidity, he can invest surplus cash holdings in buying shares/securities, whereas if the investor is short of liquidity, he can immediately sell his holdings and improve his liquidity position.

Functions of secondary market:

Following are the key functions of the secondary market:

•To facilitate liquidity and marketability of outstanding equity and debt instruments

• To contribute to economic growth through allocation of funds to the most efficient channel through the process of disinvestments to reinvestment.

• To provide instant valuation of securities affected by changes in the internal environment.

• To facilitate valuation of the cost of capital and the rate of return of economic entities at the micro level by taking into account local as well as international factors.


•To protect investors' interests through readily available market information.

•To stimulate companies to improve performance since the market price at the stock exchanges reflects the performance of the company.

•To update investors about the market price of their investments.

Influence of secondary market on overall financial system

A secondary market is crucial for the development of an efficient financial system. The secondary market connects investors, need for liquidity with the capital users’ need to make use of their capital for a longer period. For example, in a partnership, one partner cannot access another partner’s investment and can use only his or her investment in that partnership, even on an emergency basis. However，he or she can break up the ownership of the equity into parts/shares and sell his or her respective proportion to another investor. This kind of trading is facilitated only by the secondary market.The international financial market has grown very fast in recent years. The private capital market has been consistently improving since 1997. In the overall development of the capital market, the secondary market has played a vital role. Dealers1 involvement in overseas markets has increased optimistic cross-border capital flows, and such positive impacts have increased the existing strength of the financial markets, domestically as well as internationally.

Secondary markets all over the world are greatly affected by the operation of hedge funds. The use of hedge funds has allowed trading activities for a large number of dealers. Traditionally, banks are involved in the activities of lending and receiving deposits, but now banks are also managing investment portfolios and thus playing a positive role in the overall development of financial markets.

The banking sector, as a secondary market intermediary, has played a major role in the development and financial stability of the public in general and of the middle classes in particular. Development of the financial sector has led to reduction of the transaction costs of investment. Most countries have now realized the true benefits of a fully-functioning financial market and accordingly are eager to develop such a market.

Intermediaries in the secondary market:

The term ”financial intermediary” may refer to an institution, firm or individual who performs intermediation between two or more parties in a financial situation. Usually the first party is a provider of a product or service and the second party is a consumer or customer. Financial intermediaries are banking and non-banking institutions which transfer funds from those who have surplus funds to those who would like to utilize those funds. Bank Financial Institutions or Bank Financial Intermediaries (BFIs) are central banks and commercial banks, while Non-Bank Financial Intermediaries (NBFIs) are insurance companies ， mutual funds, investment companies, pension’s funds, discount houses ， etc.

Financial Intermediaries are broadly classified into two major categories:

1) Fee-based or Advisory Financial Intermediaries

2)Asset-based Financial Intermediaries.

Fee-Based/Advisory Financial Intermediaries:

These offer advisory financial services and charge a fee accordingly for the services rendered. Their services include:

• New/rights issue management

• Underwriting of scrip issues

• Portfolio managementCorporate analysis

Arrangement of Syndicated Credit

•Arranging external/foreign alliance services

• Mergers and Acquisitions

• Debenture issuance

• Capital Restructuring Asset-based

Financial Intermediaries:

These finance the specific requirements of their customers. The required infrastructure, in the form of the required asset or finance, is provided on easy financial terms. Such companies earn their incomes from the interest spread, i.e. the difference between interest paid and interest earned. These financial institutions may be regulated by regulatory authorities, and must provide evidence to the regulators of the qualifications of the persons advising potential clients in order to protect the interests of the depositors or equity holders.

Secondary market intermediaries Stockbroker:A stockbroker plays a very important part in secondary market activities by helping both the broker and the client. A broker is an intermediary who arranges to buy and sell securities on behalf of clients. They receive commission for these services.A stockbroker means a member of a recognized stock exchange who holds a certificate of registration granted by SECP.

Sub-Broker:A sub-broker is a person who intermediates between investors and stockbrokers. He acts on behalf of a stockbroker as an agent or otherwise to assist investors in buying /selling securities through a stockbroker.

Security Dealers:Those who purchase and sell government securities on the stock exchange are known as Security Dealers. Each transaction has to be separately negotiated.


Depositories：A depository is an entity where the securities of an investor are held in electronic form. The person who holds a de-mat account is a beneficiary owner. In case of a joint account, the account holders will be beneficiary holders of that joint account. Depositories help in the settlement of the dematerialized securities.

Portfolio Manager:A Portfolio Manager is a professional with expertise in the field of capital as well as the money market. He studies the market and adjusts the investment mix for his client on a continuing basis to ensure safety of investment and reasonable returns on the investment for his client.

Role of Intermediaries in overall performance of financial system

Financing the deprived class

Mostly financial institutions do not serve lower income groups because of apparent high risks，high costs involved in small transactions, apparent low profitability, and most importantly, inability to provide the physical collateral generally required by such institutions. In order to address this issue, the regulators issue instructions/regulations about facilitating financing to this class.

Role in restructuring/liquidationFinancial intermediaries play a key role in the restructuring and liquidation of companies in distress. If a company requires further funding for reorganization/health improvement, banks/DFIs provide fresh funding. In other situations reorganization under bank supervision or management is required, where the bank prepares a liquidation program of asset sales with proceeds to be used to recover the bank’s liabilities.

Clearing and settling payments:Financial intermediaries provide a wide range of services to households as well as to the old aged segment of society. Banks also provide support in handling pension funds. Pension funds play an important role in boosting the efficiency of financial systems, by influencing the structure of securities markets.

Provision of a mechanism for pooling of funds and subdivision of shares: Financial intermediaries provide direct services to households and other investors, in acquiring information and knowledge needed to invest in a range of shares and securities.

SECP

SECP is required to protect the interests of investors in securities and to promote the development of the securities market, as well as regulating the securities market by such measures, as it thinks fit.

Conduct of SECP in regulating the secondary market

• Regulating the business in stock exchanges and any other securities markets.

•Registering and regulating the work of stockbrokers, sub-brokers， share

transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner.

•Registering and regulating the working of the depositories, participants, custodians of securities, foreign institutional investors, credit rating agencies or any other as SECP may, by notification, specify in this regard.

• Registering and regulating the working of the funds and collective investment schemes including mutual funds.

• Promoting and regulating self-regulatory organizations.

• Prohibiting fraudulent and unfair trade practices relating to securities markets.

• Promoting investors’ education and training of intermediaries of securities markets.

• Prohibiting insider trading in securities.

•Regulating substantial acquisition of shares and take-over of companies.

• Calling for information through undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds, other persons associated with the securities market, intermediaries and self-regulatory organizations in the securities market.

• Calling for information and records from any bank or any other authority or board or corporation established or constituted by or under any central or provincial Act in respect of any transaction in securities which is under investigation or inquiry.

• Levying fees or other charges for carrying out its affairs.

• Conducting research for the above purposes.

• Calling from or furnishing to any such agencies, as may be specified by SECP, such information as may be considered necessary by it for the efficient discharge of its functions.

•Performing such other functions as may be prescribed by the government.

Regulatory body to monitor Stock Exchange

SECP is the regulatory body which is responsible for monitoring and regulating proper functioning of the Stock Exchange. Its mission is to develop a fair，efficient and transparent regulatory framework, based on international legal standards and best practices, for the protection of investors and mitigation of systemic risk aimed at fostering growth of a robust corporate sector and broad-based capital market in Pakistan.

Following are the departments which are responsible for monitoring the operation of the Stock Exchange.


Market Monitoring & Surveillance and Beneficial Ownership Wing (MSW)The Wing is responsible for monitoring trading activities at the stock exchanges on a real-time basis. The MSW keeps a close watch on price movements of scripts [scrip issues???], monitors abnormal prices and turnover, detects cases of market manipulation and insider trading and conducts detailed investigations in such cases. The Beneficial Ownership section of this wing is responsible for monitoring the trading activities of beneficial owners of listed companies and detects cases where beneficial owners of companies have managed to make gains on account of transactions made within a period of six months. Such amount of gain is recoverable as an arrear of land revenue.

Stock Exchanges, Depository and Clearing, Policy and Regulation Wing (SEW)

The SEW is responsible for the development and review of policies and regulations governing key capital market institutions, including stock and commodity exchanges, central depository company, national clearing company and other market participants. This Wing is also responsible for improving the regulatory and operational efficiency of the capital market by providing a regulatory regime that conforms to international best standards and ensures compliance with the IOSCO principles. SEW endeavors to base its regulatory philosophy on the principle of developmental regulation and places great emphasis on investor protection, improved risk management, market development and creating market conditions which boost investor confidence and transparency and foster growth of the Pakistani Capital Market.

Capital Issues Wing

The Capital Issues Wing (CIW) deals with cases regarding approval of prospectuses for public issue/offer of securities. The prospectus of any company inviting public subscription for its securities is required to be approved by the SECP under the Companies Ordinance, 1984 prior to its issue, circulation and publication. The CIW also processes cases regarding issue of securities outside Pakistan under Section 62-A of the Companies Ordinance, 1984，registration of Special Purpose Vehicles (SPV) under the Companies (Asset-Backed Securitization) Rules, 1999， cases requiring enforcement actions under the Listed Companies (Substantial Acquisition of Voting Shares and Takeovers) Ordinance ， 2002 ， relaxation of the requirements of the Companies (Issue of Capital) Rules, 1996 pertaining to Initial Public Offerings and cases reported under Section 18-A of the Securities and Exchange Ordinance, 1969 which prohibits submission of more than one application by a single applicant for subscription of shares.

Stock Market

Stock Exchange

A stock exchange is an institution that provides services for stockbrokers and traders to trade stocks, bonds, and other securities. It also provides facilities for the issue and redemption of securities and other financial instruments. Securities traded on a stock exchange include shares issued by companies, unit trusts, and bonds^-etc.

Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order.

Karachi Stock Exchange (KSE) began with a 50 shares index. As the market grew, a representative index was introduced. On November 1，1991 tiae KSE-100 was introduced and is now accepted as a standard measamc urif the Exchange. Karachi Stock Exchange 100 Index (KSE-100 Index) is a benchmark used to compare prices， and companies with the highest market capitalization.

In 1995 the need was felt for an all share index to reconfirm the KSE-100 and also to provide the basis of index trading in future. On August the 29th, 1995 the KSE All Share Index was constructed and introduced on September 18，1995. Karachi Stock Exchange is the biggest and most liquid exchange in Pakistan. It was declared the ’’Best Performing Stock Market of the World for the year 2002n by "Business Week". As of Dec 8， 2009，654 companies were listed with a market capitalization of Rs. 8.561 trillion (US$ 120.5 billion) having listed capital of Rs. 2805.873 billion (US$ 40.615 billion). The KSE 100TM Index closed at 11,967 on May 16， 2011. By 30 July total market capitalization is expected to reach Rs2.95 trillion, approximately 350 billion dollars. As of December 8， 2009, 652 companies were listed with a market capitalization of Rs. 2.561 trillion (US$ 30.5 billion) having listed capital of Rs. 717.3 billion (US$ 12 billion). On December 26， 2007，the KSE 100 Index reached its highest value ever and closed at 14,814.85 points.

Foreign buying had been very active in 2006 and continued in 2007. According to estimates from the SBP site, foreign investment in capital markets totals about US$523 million. According to a research analyst in Pakistan, around 20 % of the total free float in the KSE-30 Index is held by foreign participants. KSE has seen some fluctuations since the start of 2008.

Karachi Stock Exchange Board of Directors announced plans in 2007 to construct a 40 storey high-rise KSE building, as a new direction for future investment. Disputes between investors and members of the Exchange are resolved through discussion by the Arbitration Committee of the Exchange.

Trading procedure：

Karachi Stock Exchange was the first Stock Exchange to provide a nation-wide, confidential, order-driven ， screen-based trading system. Members input to the system details of their orders, such as the quantities and prices of securities they want to transact. A transaction is executed as soon as a matching sale is found or an order bought from a counter party. All the orders are electronically matched on a price/time priority basis. This has resulted in a considerable reduction in time spent, cost and risk of error, as well as fraud, resulting in improved operational efficiency. Information on prevailing prices is provided, so that market participants can see the whole market on a real time basis.

How does trading in the stock exchange take place?

The following are the steps involved in the trading of securities at a stock exchange:

Placing orders:

An order is placed by an investor with the broker either to buy or sell a certain


number of shares/securities at a certain specified price. An order can be placed by telephone, telex/ fax, letter or in person.An order can be processed in the following ways:

• When the client places a limit on the price of the share/security, it is called a ’Limit Order’.

.Where the order is to be executed by the broker at the best price, such an order is called ’Best Rate Order'

• When the client does not fix any price limit or time limit on the execution of the order and relies on the judgment of the broker, it is called an ’Open Order，.

Trade execution：

The broker has to execute the order placed by his client during trading hours. The order is executed as per the client’s requirements. The broker is required to negotiate with other parties in order to execute the orders.

Contract note:

When the order is executed, the broker prepares a contract note which is the basis of the transaction. Particulars such as price, quantity of securities, date of transaction, names of the parties， brokerage, etc. are entered in the contract note.

Delivery and clearing:

Delivery of shares takes place through the transfer deed. Requirements are:

• The transfer deed must be signed by the transferor or the seller and it must be witnessed.

• It should contain the details of the transferee, stamp of the selling broker, etc.

• Delivery and payment should be completed after 14 days as specified at the time of negotiation.

.Delivery and clearing of security takes place through a clearance house.

Settlement:

On the date of settlement, cheques and securities are exchanged as per the delivery order. The clearing house makes the payment and delivers the security certificates to the members on the payout day. Each broker settles the account with every client by taking delivery or giving delivery of securities certificates and receipts or payment of cheques. Karachi Stock Exchange Crisis 2008

•April 20: Karachi Stock Exchange achieved a major milestone when the KSE-100 Index exceeded the psychological level of 15,000 for the first time in its history and peaked at 15,737.32 on 20 April 2008. Moreover, the increase of 7.4 per cent in 2008 made it the best performer among major stock exchanges.

•May 23: Record high inflation in the month of May，2008 resulted in the unexpected increase in the interest rates by State Bank of Pakistan, which eventually resulted in a sharp fall in the Karachi Stock Exchange. Investors suffered heavy losses and the market was crippled.

•July 16: KSE-100 Index dropped one-third from an all-time high hit in April, 2008 as pressure increased on the shaky Pakistani coalition government to tackle militants.

• August 28: Karachi Stock Exchange set a floor for stock prices to halt a sink that had wiped out $36.9 billion of market value since April..

• December 15: Trading resumes after the removal of floor on stock prices that was set on August 28 to halt sharp falls.

• Since then market has shown mixed tendencies. Investors’ confidence is still shaky.

Sector and Market Capitalization Rules

Sector Rules

Sector rules govern the selection (or deletion) of companies on the basis of being the top capitalization stock in each of the 34 KSE sectors (excluding Open-end Mutual Fund sector). Two rales are recommended to undertake selection in this area: one is a time-based rule and the other is a value-based rule. Application can be triggered by compliance with either rule.

Value-based rule:A company (not in the index) which becomes the largest in its sector by a minimum of 10% greater in capitalization value than the present largest in the sector (in the index) will enter the index after one re-composition period.

Time-based rule:A company (not in the index) which becomes the largest in its sector (by any amount of value) will enter the index after maintaining its position as largest in the sector for two consecutive re-composition periods.

Capitalization RuleCapitalization rules govern the selection (or deletion) of companies on the basis of being among the largest capitalization companies in the stock market. Only one rule applies here - the time-based rule.

Rules for new issueA newly listed company or a privatized company will qualify to be included in the existing index (after one re-composition period) if the market capitalization of the new or privatized company is at least 2% of the total market capitalization.

Capital Markets 69

Listing of securities and impact on financial growth

The listing of companies in the capital market means the admission of the shares of a company to dealings on a recognized stock exchange. The securities or shares may be of any public limited company, Central government ， Provincial government and other financial institutions/corporations, municipalities, etc. All stock exchanges have a listing department to grant approval for listing of shares of companies in accordance with the various provisions of the law. The role of longterm capital in the economic development of a nation cannot be overemphasized. Most economic managers recognize that a well organized capital market is crucial for mobilizing both domestic and international capital. In many developing countries, however， capital has been a major constraint on economic development. Many factors affect the development of the capital and money markets. The capital market consists of primary and secondary markets. The primary market is the one in which underwriters help companies raise capital in the form of initial public offerings or by issuing stocks and bonds to investors. As such, the listing of new companies， financial activities will be increased, which will result in an increase in production, creation of new job opportunities and rollection of more revenue to the government.

A company intending to have its shares listed has to comply with the listing requirements prescribed by the Stock Exchange. Companies that have been classified as large cap companies have slightly different rules from those classified as small cap.The objectives of listing are to:

• Provide liquidity to shares

• Mobilize savings for economic development

• Protect interest of investors by ersuring full disclosures.

Stock exchanges follow a set procedure for companies that wish to offer their scrips through public issues. The companies are required to obtain the exchange's prior permission to use its name in the prospectus or offer for sale documents before filing the same with the relevant office of the Registrar of Companies.

Submission of ApplicationAs per Companies Acts requirements, a company looking for listing of its scrips on an exchange is required to submit a letter of application to all the stock exchanges where it proposes to have its shares listed before filing the prospectus with the Registrar of Companies.

Allotment of SecuritiesMost exchanges stipulate that a company complete allotment of scripts offered to the public within 30 days of the date of closure of the subscription list and approach the regional stock exchange, that is, the stock exchange nearest its registered office, for approval of the basis of allotment. In the case of a book building issue, allotments are normally insisted upon not later than 15 days from the closure of the issue.


Trading PermissionAs per Securities and Exchange Guidelines, the issuer company should complete the formalities for trading at all the stock exchanges where the securities are to be listed within 7 working days of finalization of basis of allotment.

Payment of Listing FeesMost exchanges require that all listed companies pay an annual listing fee.

Types of listing:

Initial listing: If the shares or securities are to be listed for the first time by a company on a stock exchange this is called an initial listing.

Listing for public issue： When a company whose shares are listed on a stock exchange comes out with a public issue of securities, it has to list such issue with the stock exchange.

Listing for right issue: When companies whose securities are listed on the stock exchange issue securities to existing shareholders on a rights basis，it has to list such rights issues on the relevant stock exchange.

Listing for bonus shares： Shares issued as a result of capitalization of profit through bonus issue should list such issues also on the relevant stock exchange.

Listing for merger or amalgamation： When an amalgamated company issues new shares to the shareholders of the amalgamating company, such shares are also required to be listed on the relevant stock exchange.

Over-the-counter (OTC) marketAnother name for this is off-exchange trading. In OTC, trading of financial instruments such as stocks, bonds, commodities or derivatives takes place directly between two parties. This is different from exchange trading in the sense that transactions take place via facilities constructed for the purpose of trading, i.e. stock exchanges. An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. Forwards and swaps are prime examples of such contracts. OTC trading is mostly done via computer or telephone. The OTC market is sometime referred to as the "Fourth Market."

Market players in financial system

In the financial markets, there is a transfer of funds from one group, that is, of investors to another group who require funds. Generally these groups do not have a direct link between them. The link is provided by market intermediaries such as brokers，mutual funds, leasing and finance companies, etc.In fact, there is a very large number of participants in the financial market; some of them are discussed below:

Individual party:These are net savers who purchase the securities issued by corporate authorities. Individuals provide funds by'subscribing to these securities or by making other investments.

Companies or corporations:Corporate bodies are generally borrowers. They require funds for different projects from time to time. Sometimes the corporate bodies also invest excess funds. The funds raised by issue of securities are invested in assets like plant and machinery. The income generated by these assets is distributed as interest or dividends to the investors who own the securities.

Government:Government sometimes borrows funds to take care of the budget deficit or to avoid liquidity, etc. Government may require funds for the long term or for the short terms in the money market. In Pakistan, the National Saving Scheme is a good example of government securities. Regulators: The financial system is regulated by different government agencies. The relationships among participants, the trading mechanism and the overall flow of funds are managed, supervised and controlled by these statutory agencies. In Pakistan, two basic agencies regulating the financial market are the State Bank of Pakistan and the Securities and Exchange Commission of Pakistan (SECP).

Market Intermediaries ： A number of market intermediaries, known as financial intermediaries or merchant bankers, operate in the financial system. Some of the market intermediaries are:

• Lead Managers

• Bankers to the Issue

• Registrar

• Depositories

• Share brokers

• Credit Rating Agencies

•Underwriters

• Custodians

• Portfolio ManagersMutual Funds

Share index comparison

Up to Up to Up to up to Up to

29-12-2007 31-12-2008 31-12-2009 31-12-2010 19-05-2011

Total No. of Listed Companies

654 653 651 644 638

Total Listed Capital - Rs.

671,255.82 750,477.55 814,478.74 919,161.26 930,556.69


Total Market Capitalization - Rs.

4,329,909.79 1,858,698,90 2,705,879.83 3,268,948.59 3,154,胤

67

KSE-100™ Index

14075.83 5865.01 9386.92 12022.46 11878.81

KSE-30™ Index 16717.1 5485.33 9849.92 11588.24 11540.74

KSE All Share Index

9956.76 4400.76 6665.55 8359.31 8263

Share

Index

What is

a share

Index?

A share market index is a graph which tracks the value of a number of prominent shares on the exchange to present the performance of that exchange as a whole. These are combined shares that are considered representative shares. The group of shares tend to experience some of the same market-specific circumstances and so when the index goes up or down, one can say that the market is going up / down in general. KSE began with a 50 shares index. As the market grew, a representative index was needed. On November 1，1991 the KSE-100 was introduced

and remains to this day the most generally accepted measure of the Exchange. Karachi Stock Exchange 100 Index (KSE-100 Index) is a benchmark used to compare prices over time, and companies with the highest market capitalization are selected. To ensure full market representation, the company with the highest market capitalization from each sector is also included.

As mentioned earlier, in 1995 the need was felt for an all share index to reconfirm the KSE-100 and also to provide the basis of index trading in future. On August the 29th，1995 the KSE All Share Index was constructed and introduced on September 18，1995.

How KSE 100 Index is calculated

This is an index of market prices of a particular group of stocks such as the KSE shares. It was introduced in November 1999 with a base value of 1000 points. The index is comprised of 100 companies selected on the basis of sector representation and highest market capitalization, which represent around 80 % of the total market capitalization of the companies listed on the Stock Exchange. A list of 34 sectors has been selected by the KSE, i.e. one company from each sector (excluding open-ended funds as such total sectors are 35) on the basis of largest market capitalization. The remaining 66 companies are selected on the basis of largest market capitalization in descending order.

Now we shall discuss the formula for calculating the KSE 100 share index- To make the computation simple, the total market value of the base period has been adjusted to 1000 points. Thus, the total market value of the base period has been assigned a value of 1000 points.

The KSE100 Index calculation at any time involves the same multiplkation of share price and shares outstanding for each of the KSE 100 Index component stocks. The aggregate market values are divided by the base value and multiplied by 1000 to arrive at the current index number.

Thus， the KSE 100 is similar to other indicators that track various sectcws of the Pakistan economic activity such as the gross national product, consumer price index, etc.

Example of calculating KSE 100 Index (Day 2)Stock Shares price Rs Numbers of Shares Market vale

A 12 50,000,000 600,000,000

B 23 100,000,000 2,300,000,000

C 34 150,000,000 5,100,000,000

Market value capitalization 8,000,000,000

Day 2 index 8000,000,000 1.143X1000 = 1143 7,000,000,000

From the above example formulas for calculating share price index are given below:

Example of calculating KSE 100 Index (Day 1)Stock Shares price Rs Numbers of Shares Market vale

A 10 50,000,000 500,000,000

B 20 100,000,000 2,000,000,000

C 30 150,000,000 4,500,000,000

7,000,000,000

Base period value / base divisor = Rs. 7,000,000.000 =1000


Sum of shares outstanding X Current price XI000 Base Period Value

Or

Market capitalization X1000 Base divisor

KSE 30 Shares Index

The primary objective of the KSE-30 Index is to have a benchmark by which the stock price perfofmance can be compared over a period of time. In particular, the KSE-30 Index is designed to provide investors with a sense of how large companies scripts [or scrip issues???] of Pakistan’s equity market are performing. Thus, the KSE-30 Index will be similar to other indicators that track various sectors of the country、economic activity, such as the gross national product, consumer price index, etc.

The KSE-30 Index is calculated using the MFree-Float Market Capitalization” method. In accordance with this method, the level of index at any point in time reflects the free-float market value of 30 companies in relation to the base period.

Free-float means the proportion of the total shares issued by a company that are readily available for trading at the Stock Exchange. It generally excludes the shares held by controlling directors / sponsors / promoters, government and other locked-in shares not available for trading in the normal course.

Requirements to qualify for inclusion in the KSE-30 Share Index are:

• The Company which is on the Defaulters’ Segment / Non-Compliant Segment and /or its trading is suspended，declared Non-Tradable (i.e. NT) in preceding 6 months from the date of re-composition shall not be considered for inclusion in KSE-30 Index.

• The Company will be eligible for the KSE-30 Index if its securities are available in the Central Depository System.

•The Company should have a formal listing history of at least two months on KSE.

• The Company must have an operational track record of at least one financial year and it should not be in default(s) of the Listing Regulations.

• The Company should have minimum free-float shares of 5% of total outstanding shares.

• The Company will be eligible for the KSE-30 Index if its securities are traded for 75% of the total trading days.

Open-End and Closed-End Mutual Funds are not eligible for inclusion in the KSE-30 Index.

Online Computation of the share index

During market hours, prices of the Index scripts at which trades are executed, are automatically used by the trading computer to calculate the KSE-30 Index and constantly make updates on all trading workstations connected to the KSE trading computers on a real time basis.

Final Rank

The script should include the top 30 companies on the basis of final ranking. The final rank is achieved by assigning 50% weightage on the basis of free-float market capitalization and 50% weightage to the liquidity based on Impact Cost of the securities. The security having

the highest free-float market capitalization and the lowest impact cost is assigned full marks and the marks for the rest of the securities are calculated proportionately.

Selection of 30 companies for inclusion in the KSE-30 Index

Selection of companies for inclusion in the KSE-30 Index is determined on the basis of nFree-Float Market Capitalization” methodology. As per this methodology, the level of Index at any point in time reflects the free- float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of free-float shares determined for the purpose.

Stock Market in the First Quarter 2011

In the first three months of 2011，the equity returns at the Karachi Stock Exchange were the lowest in the last 10 years.

The January-March return stood at minus 1.8 per cent. The average returns on equities in the 10 years stood at 3.9 per cent. Most analysts termed the local market performance as impressive in March in spite of massive foreign outflow of $16.2 million during the month. That was in sharp contrast to the inflow of $5.5 million in the month earlier. Local investors had done well in the unfavorable atmosphere of political disorder in the Middle East and North Africa region, followed by the March 11 earthquake and tsunami disasters in Japan. But over the quarter, there was net inflow of $52m into the Pakistani market, compared with the outflow of the staggering sum of $4.2 billion from the Asia Pacific (e.g. Japan) region. The reason for this inflow was that Pakistani equities produced a return of 6 per cent (in US dollar terms), which was above the rest of the Regional Markets.

The KSE had posted a negative return in IQ for the first time in last 10 years，largely on the back of intensified political disturbance; growing tensions in the Middle East and North Africa region; concerns about the effects of the dreadful earthquake in Japan, and the announcement of new taxes. Due to the measures taken by the government, political turmoil in the Middle East and North Africa, Pakistani trade will be adversely affected and profits of companies may well be down by an average of 2 percent.

Learning Outcome

Non-BankingFinancialinstitutions(NBFIs)

Non-Banking Financial Institutions 77

PartTW0 Structure of the Financial SystemChapter 5 Non-Banking Financial Institutions


* List and discuss the various type of NBFIs 睡 Discuss the operating mechanism, growth potential and the role of NBFIs in the financial sector

■ List the types of financial industry players in Pakistan, their formation, regulation and discuss the role they play as part of the system

Various Types of NBFIs

Non-Banking Finance Companies (NBFCs) were introduced in 2002. The main objective or introducing these companies was to enable the existing single-product institutions serving specific markets to offer a whole range of

financial products through a one-window operation according to the prescribed regulatory requirements followed by international banking. The various financial services which used to be handled by small companies are now managed by NBFCs. The following investment financial services are offered by NBFCs: leasing, housing finance, venture capital investment, discounting, investment advice and asset management.

Operating mechanism

There are laws related to the operating structure for each category of NBFIs. NBFCs operate as public limited companies to carry out the business or investment finance, leasing, housing finance, venture capital investment, discounting, investment advice and asset management. For every unique financial service that an NBFC provides it is required to have a separate license from SECP.

Investment advisory and asset management license holders can offer mutual funds for public subscription. Mutual funds are constituted through trust deeds, although a closed-end mutual fund may be set up as a company.

Modarbas were introduced in 2002 and since then have operated within the robust legal framework of SECP. Modarbas follow Shariah law to manage finance investments and operate in a two-tier fund structure to conduct business. There is a Registrar of Modarbas who works under SECP and Modarbas can be floated only with his permission by the Modarba management company. The Federal Government has constituted a Religious Board, from who certification is required, so that the business of the Modarba is not in opposition to the injunctions of Islam. The low

Fi的ncial Systems and Regulation | Reference Book

capital base of NBFCs and Modarba management companies are loi capital bases of investment and they have to compete against banks fc mobilization of their funds.

In Pakistan, the non-bank financial institutions in the private sector ai the dominant owners of NBFIs. In past years the majority of institution except one, were owned and managed by the private sector. The on] public sector institution is the National Investment Trust Limited，whic manages the largest open-end mutual fund, National Investment (Unii Trust (NIT), in the country.

Types of market players

Development Finance Institution

(DFI)

DFI comprises a range of financial institutions including microfinanc institutions, community development financial institution and revolvin loan funds. These institutions provide credit in the form of higher ris loans, equity positions and risk guarantee instruments to private sectc investments in developing countries. DFIs are backed by states wit developed economies.

DFIs have a mandate to provide finance to the private sector for projed that promote development. The purpose of DFIs is to ensure investmei in areas where otherwise the market fails to invest sufficiently. DFI specialize in loans with longer maturities and other financial product

Investment advisory services

The services are established under the Companies Ordinance, 1984 ad licensed by the Securities and Exchange Commission of Pakistan (SEQj to undertake asset management and investment advisory services undi the Non-Banking Finance Companies (Establishment and Regulatio^ Rules 2003. All investment carries some risk and thus needs carefi analysis and expert advice. The key to being a successful investor is achieve appropriate risk/return trade off by identification of risks thi exist and managing them proactively. Investment advisory servij professionals specialize in identifying risks arising from regulatioi competition and macroeconomic forces and designing strategies to manag them to the investor’s advantage.

Leasing

Leasing is a legal agreement between two parties that specifies the tern and conditions for the rental of property. For example, leasing a machiij is based on an agreement. This agreement does not take place betwee the customer and the machine dealer; rather it is between the customi and a leasing company selected by the dealer. In other words, the machiD is actually sold to the leasing company who, in turn, rents the machiij to the actual customer (the lessee). The dealer simply acts as an agent fc the leasing company and negotiates the terms under which the customc will rent the machine from the leasing company.

Non-Banking Financial Institutions 79

There are two categories of leasing:

•Direct lease： You identify the asset (and negotiate the price) and arrange for the leasing company to buy it from the manufacturer (if new) or the previous owner (if used) to lease it to you.

•Sale-and-leaseback (also called purchase leaseback): You sell an asset you already own to the leasing company for the fair market value or book written down value (whichever is less) and then lease it back.

There are three major types of leasing:

• Finance leasing

• Operating leasing

• Contract hire.

Finance leasing (full payout lease) ■ A customer obtains all the financial benefits (and risks) without actually acquiring a legal title. The leasing rate is decided after calculations to collect the full value of the asset (plus finance charges) during the contract period. At the end of the lease, the asset is sold to a third party and the customer can receive a share of the sale proceeds. Generally, the customer will not be able to become the owner of the asset at any time - unless a private arrangement is made with the third party.

Operating lease - Operating leasing is more like a regular rental. The leaser is allowed to either sell the asset in the second-hand market or to lease it again and therefore it is not expected to recover the total asset value through lease payments. This lease may be extended at the end of the leasing period (this negotiation can only take place at the end of the initial rental period). This option does not allow the leaser to become the owner of the asset at any time nor to have his share of the sale proceedings.

Contract hire ■ This is also a form of operating lease and is most commonly used with cars and other vehicles that include a number of additional services such as maintenance, management or replacement if the asset needs repairs.

Hire purchase - This is an agreement for the hiring of an asset with an option to purchase. The legal title will pass to you when all payments have been made. The term of a hire purchase must be significantly shorter than the working life of the asset. You can claim capital allowances as if you had purchased the asset outright, gaining immediate use of it. Hire purchase agreements are typically written for domestic users, not for business users.


End of lease optionsAt the end of the lease term, the lessee has various options. Lease contracts can stipulate that the lessee:

• returns the asset

•has the right to act as an agent to sell the asset to an independent third party

•can renew the contract or enter into secondary periods. Pakistan leasing sector

Pakistan’s leasing sector is a major component of the Non-Banking Financial Institution (NBFI) sector and it plays a vital role in economic growth and containing poverty in the country. The leasing industry helps to channel resources to small and medium size enterprises to fund their business needs.

The first leasing company was established in 1984 and has been performing well since then. However, the economic downturn, adverse business conditions and liquidity crisis affected the sector negatively during the fiscal year 2009

Housing Finance Services

Housing finance services available in Pakistan are still at an evolutionary stage due to both demand and supply factors. The total value of outstanding finance is less than 1 percent of GDP, which is declining steadily from its peak value of 0.98 percent in CY06.

Mortgage finance in the domestic financial system is being offered by the Housing Building Finance Corporation Limited (HBFC)，banks and NBFCs. They are licensed to offer housing finance facilities. Although banks are relatively new in this area， they have emerged as a major provider of housing finance due to access to low-cost funds and better outreach.

Mortgage finance is generally extended for three purposes, i.e. construction, outright purchases and renovation. During 2009 ， due to a slump in economic activities, mortgage loans for construction and outright purchases grew by only 3.4 percent and 6 percent respectively, as compared to 12.5 percent and 29 percent respectively in 2008，whereas loans for renovation experienced negative growth of 19 percent, as against significant growth of 57 percent in 2008.

Venture Capital Investment

Venture Capital (VC) investment refers to funds provided for start-up businesses with potential for high growth. This is a risk investment; therefore venture capital companies require a matching rate of return, along with some measure of control over the management and strategic orientation of the investee company. Venture capitalists usually exit from the project after a certain period of time, i.e. 3 to 7 years, when the equity is either sold back to the client company or offered on the stock exchange.VC business in Pakistan has essentially remained limited in scope despite the enabling regulatory framework provided by the SECP which has set out the rules and requirements for VC investments in the NBFCs

Non-Banking Financial Institutions

Rules.

Some of the impediments to the growth of the VC industry in Pakistan are:

(1) Complexlegal framework

(2) Lack of appropriate tax incentives

(3) Limited exit options

(4) Restrictions on institutional investors participating in venture capital funds

(5) Unavailability of data on foreign funds5 participation in local firms

(6) Inadequate institutional support.

Keeping in view the potential for economic growth in Pakistan, SECP issued “The Private Equity and Venture Capital Fund Regulations, 2008” (PE & VCF Regulations) in August 2008. However, despite the regulatory framework provided by the SECP, the Venture Capital (VC) industry is developing rather slowly. At the end-FY09， there were 3 operative VC companies which accounted for a mere 0.4 percent of aggregate assets of the non-bank financial sector. During FY09, the asset base of the sector grew by 67 percent to Rs. 2.6 billion, against a decline of 57 percent in FY08， and therefore FY09 recorded net profit (after tax) for the first time. It is expected that SECP5s support will promote the growth of this sector in coming years.

Part 3： Securities and Exchange Commission of Pakistan

Chapter 1:Securities and

Exchange Commission

of Pakistan Main

functions of SECP

Risk Management

Enhancing Corporate Governance

SECP Guidelines for disclosure and investors

protection

Responsibilities, Powers, and Functions of

Board of Directors

Part Three

Chapter 1

Learning Outcome

The Securities and Exchange Commission of Pakistan (SECP)

Securities and Exchange Commission of Pakistan 87

Securities and Exchange Commission of PakistanSecurities and Exchange Commission of Pakistan


■Describe the role of SECP in regulating the financial market operations of Pakistan

盤 Discuss corporate governance

麗 Discuss the SECP guidelines for disclosure and investor protection

The Securities and Exchange Commission of Pakistan (SECP) started to function in 1999 by way of the Securities and Exchange Commission of Pakistan Act, 1997. SECP functions as the sole administrative authority and financially independent body in carrying out its regulatory and statutory tasks.

The purpose of establishing the SECP was to control and regulate the development of a modern and efficient corporate sector and capital market, based on sound regulatory principles, that results in high economic growth and better promotion of social harmony in the country. SECP’s mission is to protect investors by reducing systemic risk and thus encourage growth of the corporate sector and an extensive capital market in Pakistan. In the beginning SECP’s function was to regulate the corporate sector and capital market but since then its scope of work has expanded over time, so that it now also supervises and regulates the operations of insurance companies, non-banking finance companies and private pensions.

The SECP also oversees various external service providers to the corporate and financial sectors, including chartered accountants, credit rating agencies, corporate secretaries, brokers, surveyors, etc. The Commission is responsible for regulating the securities of any businesses in the stock exchange or in other security markets.

The main functions of SECP are listed below:

•Supervising and monitoring the activities of any central depository and stock exchange clearing house

• Registering and regulating the work of stockbrokers, share transfer agents, portfolio managers, investment advisors or anyone associated with security markets

•Registering and regulating investment schemes; regulation of securities industry and related organizations such as leasing


companies and financial institutions


• Protecting the market from unfair practices; promoting education of investors and training of intermediaries

•Auditing of Stock Exchanges and other intermediary organizations

• Encouraging the development of the capital market and the corporate sector in Pakistan

• Regulating the acquisition of shares and mergers and takeovers of companies

• Suggesting reforms in the rules and regulation of companies.

Since organizations/institutions in the public and private sectors also often sell securities on the capital markets in order to raise funds, thus the capital market mobilizes domestic resources and channels them efficiently for better productivity. The level of activity in the capital market is an important determinant of a country’s level of savings, efficiency of investment and economic growth rate.

For effective supervision and growth of the capital market, SECP has enacted various laws, rules, and guidelines to improve the regulatory framework of the markets in general and of the stock exchanges in particular. Several improvements have been made in the trading and settlement system of the stock exchanges and Central Depository Company (CDC). In addition, federal government has taken several steps to reduce policy and regulatory constraints faced by market participants. After the stock market crisis in May 2000， the SECP implemented some corrective measures to restore investor confidence and to achieve a fair，transparent and efficient stock market. The steps taken include:

• implementation of the T+ 3 settlement system

• substantial increase in net capital requirements

• stipulation of capital adequacy requirements for brokers

•strengthening of margin requirements

•appointment of 40 percent independent directors on the boards of the stock exchanges

• ensure independence of the Commission’s Chief Executive Officer (CEO) of each exchange.

The commission has also implemented various regulatory reforms including the issuance of registration rules for brokers and agents and the Insider Trading guidelines.

In order to protect small investors against excessive price instability due to the misuse of confidential information, the SEC implemented the ”Listed Companies (Prohibition of Insiders Trading) Guidelines" on March 27， 2001. These guidelines increased the degree of transparency


in the market and gave protection to small investors from possible losses. In order to implement these new rules, SECP was authorized to investigate and inspect the accounts and records of individuals deemed to be insiders and associated members of the stock exchanges.

Risk Management

In order to improve risk management and governance at stock exchanges，

various rules were amended in the Securities and Exchange Rules, 1971. The rules were applicable to the net capital of stock exchanges in line with internationally accepted best practice.

A measure of capital adequacy for stockbrokers has been specified. The exposure of a broker must not exceed 25 times the net capital employed. In the stock exchanges, circuit breakers were introduced to reduce excessive volatility in the prices of scrips. They protect a clearing house from large defaults caused by extreme market movements. In addition, they also protect brokers and investors from defaults due to price fluctuations, even when these individual defaults do not endanger the clearing house. Currently, the following design is being used in all three local exchanges:

•For downward circuit breakers, during a day，the price of a scrip cannot fall below 5% or Rs 1，whichever is higher, from the closing price of the previous day.

• For upward circuit breakers, during a day，the price of a scrip cannot rise more than 7.5% or Rs 1.5, whichever is higher, from the closing price of the previous day.

In addition, stock exchanges have established investor protection funds and clearing house protection funds under the instruction of the SECP.

Enhancing Corporate Governance

A notification ’Code of Governance1 was issued by the Securities and Exchange Commission of Pakistan dated March 4， 2002. The purpose of the document was to establish a framework of good corporate governance so as to encourage the management of a listed company to act in compliance with best practices and in exercising the powers conferred by sub-section (4) of section 34 of the Securities and Exchange Ordinance, 1969 (XVII of 1969). All the stock exchanges were directed to insert the clauses appropriately in their respective listing regulations immediately.

This comprehensive law aims to enhance investor confidence by increasing transparency in the business practices of listed companies. It covers diverse areas of corporate governance such as issuing guidelines on the constitution of the Board of Directors of the company, a framework of internal control, rules on the financial and accounting responsibilities of directors, directors1 report, disclosure regarding pattern of shareholding and scope of internal audit, etc.

A major objective was to improve the corporate governance of the stock exchanges and enable them to improve their management and operational


efficiency. This process of reviewing the codes was initiated by SECP in 2000 and completed by September 2002.

The following reforms have been implemented with a view to improving governance.

• Nomination of 40 percent independent directors by the SECP on the Board of each stock exchange. In 2001，seven non-broker directors were nominated on the Boards of the KSE and the LSE and five directors on the Board of the ISE.

• SECP approves the appointment and removal of the Managing Directors/ CEO of each stock exchange and thus ensures the presence of independent professional management. Independent CEOs have already been appointed at the KSE and the LSE, with the prior approval of SECP.

•The directors of each exchange have been directed not to delegate their operational powers to any person other than the Managing Director.

•The number of broker-directors in the CDC has been reduced from five to three (out of a total of nine).

•The Chairman of the CDC is to be a non-broker.

•The Board of Directors of the CDC is required not to delegate their operational authority to anyone except the CEO.

•The SECP has nominated a director on the Board of the CDC.

Exemption has twice been granted to sole proprietorship and partnership members of stock exchanges from capital gains arising out of the conversion to encourage corporatization of the stock exchanges.

SECP Guidelines for disclosure and investors protection

Disclosure of interest by Commissioners and Members (http://www.secp.gov.pk/secpact/conflict.asp)

1. A person shall be deemed to have an interest in a matter if he has any interest, pecuniary or otherwise, in such matter which could reasonably be regarded as giving rise to a conflict between his duty to honestly perform his functions under this Act and such interest, so that his ability to consider and decide any question impartially or to give any advice without bias ， may reasonably be regarded as impaired.

2. A Commissioner or a Member having any interest in any matter to be discussed or decided by the Commission or the Board or a committee shall, prior to any discussion of the matter, disclose in writing, respectively, to the Commission, the Board or a committee, as the case may be, the fact or his interest and the nature thereof.

http://www.secp.gov.pk/secpact/conflict.asp


3. A disclosure of interest shall be recorded in the minutes of the Commission，the Board，or a committee, as the case may be，prior to any discussion of, or decision on, the matter and, after the disclosure, the Commissioner or, as the case may be, the Member:

(a) Shall not, save, in the case of Commissioners, take part nor be present in any deliberation or decision of the Commission, the Board or a committee, as the case may be, and

(b) Shall be disregarded for the purpose of constitution of a quorum of the Board, the Commission or a committee, as the case may be.

4.Any Commissioner, Member or the member of a committee who fails to disclose his interest as required by this section shall be guilty of an offence and shall on conviction be liable to imprisonment for a term which may extend to one year, or a fine not exceeding one million rupees, or both.

5. It shall be a valid defense for a person charged with an offence under sub-section (4)， if he proves that he was not aware of the facts constituting the offence and that he exercised due care and diligence in discovering those facts which he ought reasonably to have known in the circumstances.

V

6.Each Commissioner shall give written notice to the Federal Government of all direct or indirect pecuniary interests that he has or acquires in a body corporate carrying on a business in Pakistan. The nature of such interests and the particulars thereof shall be disclosed in the annual report of the Commission made under section 25.

7. If a Commissioner is not the Chairman and the Chairman becomes aware that a Commissioner has the interest, the Chairman shall:

(a) If the Chairman considers that the Commissioner should not take part, or continue to take part, as the case may require, in determining the matter, direct the Commissioner accordingly ， or

(b) In any other case, cause the Commissioner^ interest to be disclosed to the persons concerned in the matter (including any person whose application is pending decision or adjudication by the Commission).

8. The Commissioner in respect of whom a direction has been given shall comply with the direction.

9. If the Commissioner is the Chairman, he shall disclose his interest to the persons concerned in the matter (including any person whose application is pending decision or adjudication by the Commission).

10.The Chairman or the Commissioner who has any interest in any matter referred to in this section shall not take part，or continue to take part, as the case may require, in determining the matter unless everyone concerned in it consents to the Chairman or, as the case may be，the Commissioner so taking part.


Notification of interest by others

1. Where a person who，in the course of:

(a) Performing a function, or exercising a power, as a delegate of the Commission,

(b) Performing functions or service as an employee, or

(c) Performing a function or services in any capacity by way of assisting or advising the Commission, the Board, any committee or any delegate of the Commission, is required to consider a matter in which he has an interest, such person shall forthwith give to the Commission a written notice stating that he is required to consider the matter and has an interest in it and setting out particulars of the interest.

2. The person referred shall also declare his interest whenever it is necessary to avoid the conflict of interest.

Improvements and Modernization of Security Market Infrastructure

There was a need to improve the infrastructure at the stock exchanges. The outdated system at the stock exchanges had to be replaced by adopting a harmonized, automated trading system by all the stock exchanges; a Central Depository and a National Clearing and Settlement System needed to be developed. Accordingly, the open system has been abolished and all three stock exchanges are now fully automated. In order to establish efficient delivery, settlement and transfer of securities through a computerized book entry system, the Central Depository Company of Pakistan Limited (CDC) was established.

Other divisions of SECP

In addition to the Securities Market Division, the SECP has:

• Specialized Companies Division, responsible for the regulation and monitoring of leasing companies, Modarba, mutual funds and other specialized companies

• The Enforcement and Monitoring Division (EMD) responsible for the enforcement of corporate laws in respect of listed companies (other than insurance companies and specialized companies). The EMD has taken initiatives to protect the interests of minority shareholders, creditors and other stakeholders.

Code of Corporate Governance

On March 4， 2002， the Securities and Exchange Commission of Pakistan issued directives concerning good corporate governance whereby a listed company must be managed in compliance with best practices. The salient features of the Code of Corporate Governance are given below.


Board of Directors

All listed companies should encourage effective representation of independent non-executive directors, including those representing minority interests, on their Boards of Directors so that the Board as a group includes core competencies considered relevant in the context of each listed company. For this purpose, listed companies may take necessary steps such as:

Minority shareholders as a class are facilitated to contest election of directors by proxy solicitation, for which purpose the listed companies may:

• Annex to the notice of general meeting at which directors are to be elected, a statement by a candidate(s) from among the minority shareholders who seeks to contest election to the Board of Directors, which statement may include a profile of the candidate(s).

•Provide information regarding shareholding structure and copies of register of members to the candidate(s) representing minority shareholders.

.On the request by the candidate(s) representing minority shareholders and at the cost of the company, annex to the notice of general meeting at which directors are to be elected an additional copy of proxy form duly filled in by such candidate(s) and transmit the same to all shareholders in terms of section 178 (4) of the Companies Ordinance, 1984.

• The Board of Directors of each listed company includes at least one independent director representing institutional equity interest of a banking company, Development Financial Institution, Non-Banking Financial Institution (including a Modarba, leasing company *or investment bank), mutual fund or insurance company.

• The expression ”independent director” means a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties. The test of independence principally emanates from the fact whether such person can be reasonably perceived as being able to exercise independent business judgment without being subservient to any apparent form of interference.

• Any person nominated as a director under sections 182 and 183 of the Companies Ordinance, 1984 shall not be taken to be an "independent director” for the above-mentioned purposes.

* The independent director representing an institutional investor shall be selected by such investor through a resolution of its Board of Directors and the policy with regard to selection of such person for election on the Board of Directors of the investee company shall be disclosed in the Directors1 Report of the investor company.


• Executive directors, i.e. working or whole time directors, are not more than 75% of the elected directors including the Chief Executive:

• Provided that in special circumstances, this condition may be relaxed by the Securities and Exchange Commission of Pakistan.

_ Provided further that nothing contained in this clause shall apply to banking companies, which are required by Prudential Regulation No. 9 for Banks to have not more than 25% of the directors as paid executives of the banks.

• The directors of listed companies shall, at the time of filing their consent to act as such, give a declaration in such consent that they are aware of their duties and powers under the relevant law(s) and the listed companies，Memorandum and Articles of Association and the listing regulations of stock exchanges in Pakistan.

Qualification/ eligibility to act as Director

• No listed company shall have as a director, a person who is serving as a director of ten other listed companies.

• No person shall be elected or nominated as a director of a listed company if:

(a) his name is not borne on the register of National Tax Payers except where such person is a non-resident; and

(b) he has been convicted by a court of competent jurisdiction as a defaulter in payment of any loan to a banking company, a Development Financial Institution or a Non-Banking Financial Institution or he， being a member of a stock exchange, has been declared as a defaulter by such stock exchange;

• A listed company shall endeavor that no person is elected or nominated as a director if he or his spouse is engaged in the business of stock brokerage (unless specifically exempted by the Securities and Exchange Commission of Pakistan).

Tenure of office

The tenure of office of Directors shall be three years. Any casual vacancy in the Board of Directors of a listed company shall be filled up by the directors within 30 days thereof.

Responsibilities, Powers, and Functions of Board of Directors

The directors of listed companies shall exercise their powers and carry out their fiduciary duties with a sense of objective judgment and independence in the best interests of the listed company.

Every listed company shall ensure that a ‘Statement of Ethics and Business Practices5 is prepared and circulated annually by its Board of Directors to establish a standard of conduct for directors and employees, whichStatement shall be signed by each director and employee in acknowledgement of his understanding and acceptance of the standard of conduct.

The Board of Directors shall adopt a vision/ mission statement and overall corporate strategy for the listed company and also formulate significant

Securities and Exchange Commission of Pakistan

policies，having regard to the level of materiality, as may be determined by it. Significant policies for this purpose may include:

• risk management;

• human resource management including preparation of a succession plan;

• procurement of goods and services;

• marketing and determination of terms of credit and discount to customers;

• write-off of bad/ doubtful debts;

• advances and receivables;

• acquisition/ disposal of fixed assets;

• investments and borrowing of moneys and the amount in excess of which borrowings shall be sanctioned/ ratified by a general meeting of shareholders;

• donations, charities, contributions and other payments of a similar nature;

• determination and delegation of financial powers;

• transactions or contracts with associated companies and related 、 parties; and health, safety and environment.

A complete record of particulars of the significant policies, as may be determined, along with the dates on which they were approved or amended by the Board of Directors shall be maintained.

The Board of Directors shall define the level of materiality, keeping in view the specific circumstances of the listed company and the recommendations of any technical or executive sub-committee of the Board that may be set up for the purpose.

The Board of Directors establishes a system of sound internal control, which is effectively implemented at all levels within the listed company.

The following powers can be exercised by the Board of Directors on behalf of the listed company and decisions on material transactions or significant matters are documented by a resolution passed at a meeting of the Board:

• determination of the nature of loans and advances made by the listed company and fixing a monetary limit thereof

• write-off of bad debts，advances and receivables and determination of a reasonable provision for doubtful debts

• write-off of inventories and other assets

• determination of the terms of and the circumstances in which a law suit may be compromised and a claim/ right in favor of the listed company may be waived, released, extinguished or relinquished

• appointment, remuneration and terms and conditions of employment of the Chief Executive Officer (CEO) and other executive directors of the listed company are determined and approved by the Board of Directors; and


• in the case of a Modarba or a Non-Banking Financial Institution, whose main business is investment in listed securities, the Board of Directors approve and adopt an investment policy, which is stated in each annual report of the Modarba/ Non-Banking Financial Institution.

The investment policy shall, inter alia, state, that the Modarba/ Non- Banking Financial Institution shall not invest in a connected person, as defined in the Asset Management Companies Rules, 1995，and shall provide a list of all such connected persons; that the Modarba/ Non- Banking Financial Institution shall not invest in shares of unlisted companies; and the criteria for investment in listed securities. The Net Asset Value of each Modarba/ Non-Banking Financial Institution shall be provided for publication on a monthly basis to the stock exchange on which its shares/ certificates are listed.

The Chairman of a listed company shall preferably be elected from among the non-executive directors of the listed company. The Board of Directors shall clearly define the respective roles and responsibilities of the Chairman and Chief Executive, whether or not these offices are held by separate individuals or the same individual.

Meetings of the board

• The Chairman of a listed company, if present, shall preside over meetings of the Board of Directors.

• The Board of Directors of a listed company shall meet at least once in every quarter of the financial year. Written notices (including agenda) of meetings shall be circulated not less than seven days before the meetings, except in the case of emergency meetings, where the notice period may be reduced or waived.


days thereof, unless a shorter period is provided in the listed company’s Articles of Association.

In the event that a director of a listed company is of the view that his dissenting note has not been satisfactorily recorded in the minutes of a meeting of the Board of Directors, he may refer the matter to the Company Secretary. The director may require the note to be appended to the minutes, failing which he may file an objection with the Securities and Exchange Commission of Pakistan in the form of a statement to that effect.

In order to strengthen and formalize the corporate decisionmaking process, significant issues shall be placed for the information, consideration and decision of the Boards of Directors of listed companies.

Appointment of CFO and company secretary

The appointment, remuneration and terms and conditions of employment of the Chief Financial Officer (CFO), the Company Secretary and the head of internal audit of listed companies shall be determined by the CEO with the approval of the Board of Directors. The CFO or the Company Secretary of listed companies shall not be removed except by the CEO with the approval of the Board of Directors.

Directors' reports to the shareholders

The directors of listed companies shall include statements to the following effect in the Directors ， Report, prepared under section 236 of the Companies Ordinance, 1984:

(a) The financial statements, prepared by the management of the listed company, present fairly its state of affairs, the result of its operations, cash flows and changes in equity.

(b) Proper books of account of the listed company have been maintained.

(c) Where any statutory payment on account of taxes, duties, levies and charges is outstanding, the amount together with a brief description and reasons for the same shall be disclosed.

(d) Significant plans and decisions, such as corporate restructuring, business expansion and discontinuance of operations, shall be outlined along with future prospects，risks and uncertainties surrounding the listed company.

(e) A statement as to the value of investments of provident, gratuity and pension funds, based on their respective audited accounts, shall be included.

(f) The number of Board meetings held during the year and attendance by each director shall be disclosed.


(g) The pattern of shareholding shall be reported to disclose the aggregate number of shares (along with name wise details where stated below) held by:

• Associated companies, undertakings and related parties (name wise details); NIT and ICP (name wise details);

• Directors, CEO and their spouse and minor children (name wise details); executives;

• Public sector companies and corporations;

• Banks, Development Finance Institutions, Non-Banking Financial Institutions, insurance companies，Modarba and mutual funds;

• Shareholders holding ten percent or more voting interest in the listed company (name wise details).

Explanation ： the expression “executive” means an employee of a listed company other than the CEO and directors whose basic salary exceeds five hundred thousand rupees in a financial year.

‘Securities And Exchange Commission Of Pakistan，No.2 (10) SE/SMD/2002- March 28，2002

http://www.secp.gov.pk/news/code_corporate(revised).htm

http://www.secp.gov.pk/Guides/AmendedGuidelinesForAppointme nt.pdf

http://www.secp.gov.pk/Guides/Promhttp://www.secp.gov.pk/corporatelaws/pdf/CodeofCorporateGovernance.pdfotersGuideEnglish-new.pdf

http://www.secp.gov.pk/corporatelaws/pdf/CodeofCorporateGovernance

http://www.secp.gov.pk/Guides/Promhttp

http://www.secp.gov.pk/Guides/AmendedGuidelinesForAppointme

http://www.secp.gov.pk/news/code_corporate(revised).htm

■


Part 4: Financial Instruments

Chapter 1:Money Market Instruments

Define and discuss the workings of the following money market instruments:

a.Treasury Billsb. PIBsc.Certificates of Depositsd.Bankers' Acceptancese.Eurodollarsf.Repos and Reverse Reposg.Call Money Market

Chapter 2: Capital Market Instruments

Discuss the operations of the following fixed income instruments:

1. Bonds/Sukuk2.Municipal Bonds3.Corporate Bonds4.Term Finance Certificates5. Asset-Backed Securities6.Treasury Notes

Discuss the operations of the following equity securities:

1. Preferred stock2.Common stock

Chapter 1

Learning Outcome

Money Market Instruments in Pakistan


Part Four Financial Instruments

Money Market Instruments

By the end of this chapter you should be able to: _ Define and discuss the workings of the following money market instruments:

a. Treasury Billsb.PIBsc.Certificates of Depositsd.Bankers7 Acceptancese.Eurodollarsf.Repos and Reverse Reposg.Call Money Market

The following are the Money Market instruments in Pakistan: I.Pakistan Investment Bonds (PIBs)

Pakistan investment bonds are issued by SBP on behalf of the Federal Government. These are the only long-term debt securities and a benchmark for

long-term debt. These are risk free and transferable between interbank and NBFI. Tenure starts from 3 up to thirty years.They carry a fixed coupon rate of 9.1%, 9.3%, 9.6%, 10.0%, 10.5% andII. 0% respectively. Due to the phasing out of FIBs and the curb on institutional investment in the National Saving Scheme, PIBs were introduced in December 2000 as the only attractive avenue available for long-term investment. In December 2006 the Government launched 30 year bonds. Commercial banks and corporate customers can purchase these bonds from any of the primary dealers. The importance of these bonds has also increased since institutions, as well as provident and pension funds, has been restricted by SBP from investing in the National Saving Scheme. SBP acts as an agent on behalf of the government for raising short-term and long-term funds from the market. Primary Dealers maintain a Subsidiary General Ledger Account (SGLA) with SBP for settlement purposes. The PIBs are sold by SBP to ten approved Primary Dealers through multiple price sealed bids auction. The PIBs represent 63% of total permanent debt and 13.23% of the total domestic debt.

Some key features of PIBs are:

• PIBs are issued at par and/or premium or discount (depending on the investor’s outlook on long-term interest rates) under the aegis of SBP at publicly announced auctions. They are sold by SBP through auctions conducted every month by calling bids from the Primary Dealers. PIBs are issued in multiples of PKR 100,000 and are traded in the secondary market on the basis of price on current yield and yield to maturity basis.


• These bonds are issued in the form of un-certificated bonds and are maintained in SGLA only.

• Coupon payments are made semi-annually.

• Interest receivable on these bonds is subject to withholding tax @ 10% at source.

• Zakat is not applicable on these bonds.

Current Yield of PIBs

This relates the annual coupon to the market price of the bonds. The current yield considers only the coupon income and no other source of return. The current yield can be worked out by using the formula below:

Current Yield = Annual Coupon / Price

For example:

A 15% 10 year PIB at Rs.100.60 would have a current yield of: CY =15/100.60 =

14.91%

Yield to maturity (YTM)

The current yield does not take into account any gain or loss associated with a bond. The current yield cannot be used for comparing different securities, as it does not take into account the effect a difference in maturities has on the yield of bonds. The investor must use the bond price, maturity date and coupon payments to arrive at the return offered by a bond over its life. The YTM is a measure of the average rate of return that will be earned on a bond if it is bought and held to maturity. A bond's YTM is the internal rate of return on an investment in that bond. The YTM can be interpreted as the compound rate of return over the life of a bond, under the assumption that all bond coupons be reinvested at an interest rate equal to the bond’s YTM.

2. Federal Investment Bonds (FIBs)

FIBs are an approved Federal Government Security that qualifies for the liquidity / investment of a bank. They were offered with maturities of 3 ， 5 and 10 years. FIB auctions have been discontinued since July 1998，and have since been replaced by PIBs.

3. Market Treasury Bills (T-Bills)

T-Bills are the most marketable money market security. Their popularity is mainly due to their ease in purchasing and discounting. Basically， T- Bills are a source for the government to raise money from the market (both individuals and institutions). These are short-term securities that mature in one year or less from their issue date. They are issued withEthree- month, six-month and one-year maturities. These are short-term zero- coupon bond debt obligations of the Government of Pakistan.


They do not carry an explicit interest rate and are traded on a discount basis，with the difference between purchase price and maturity value being the investor’s return. T-Bills are characterized by high liquidity, shorter maturity and almost non-existent risk other than re-investment risk. They can be purchased for a price that is less than their (face) value; when they mature, the government pays the holder the full par value. For example, if an investor bought a 90-day T-Bill at Rs.9，8000 and held it until maturity, he would earn Rs.2000 on his investment. The only negative point to T-Bills is that the investor does not receive a high return because T-Bills are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest but carry higher risk.

Treasury Bills have the following features:

• Zero Coupon bonds sold at a discount of their face values.

• Issued in three tenors of 3-month, 6-month and 12-months maturity.

•Can be purchased by individuals, institutions and corporate bodies including banks, irrespective of their residential status.

• Can be traded freely in the country’s secondary market. Settlement is normally through a book entry system through Subsidiary General Ledger Accounts (SGLA) maintained by banks with State Bank of Pakistan(SBP). Physical delivery could be effected if required.

• Profit is taxable.

• State Bank sells the MTBs and PIBs to the 10 Primary Dealers through price sealed bids auction. The 10 Primary Dealers are:

• Faysal Bank Ltd 參

• Citibank

• Habib Bank Ltd

•JS Bank Ltd

• MCB Bank Ltd

• National Bank of Pakistan

• Pak Oman Investment Co.

• NIB

• Standard Chartered Bank (Pakistan) Ltd

•United Bank Ltd

The auction of TBs is done on a fixed schedule on a fortnightly basis ， while the auction of PIBs is done under a Jumbo issuance mechanism


under which the previous issues are reopened in order to enhance their liquidity in the secondary market.

T-Bills are generally considered the most liquid of a bank’s assets. That is why many banks hold T-Bills to meet their reserve requirements and as collateral to be used in REPO agreements or for their short-term trading portfolio. The following are some key features of T-Bills:

• T-Bills are issued in the form of tender in the primary market and generally are traded via the SBP-nominated Primary Dealers, amongst which are the ‘big five，. A cut-off point determines the last accepted bid fat discount1 by the SBP as per bank needs. The bills are then allocated to the successful bidders. Trading in the secondary market is conducted on maturity value depending on remaining days and the redemption value would be fixed at Rs.100 (PAR). Thus, there is never any difficulty in calculating the exact value of the security at any stage during its life span.

• T-Bills can either be purchased from the primary market, that is, at the SBP auctions and open market operations, or from the secondary market.

• The bills can be traded freely and are transferable by endorsement and delivery.

• The Government of Pakistan guarantees payment of the principal and profit.

• Face value of the bills， i.e. principal and profit, are payable on maturity.

• Zakat will be deducted at source，where applicable.

• Withholding tax @ 20% is deducted at source on the interest receivable.

Calculation of the Yield of T-Bills

T-Bills do not offer coupon payments but are sold at a discount price from par value. Their yield is influenced by the difference between the selling price and purchase price. If an investor purchases a newly issued T-Bill and holds it until maturity, the return is based on the difference between the par value and the purchase price. If the T-Bill is sold prior to maturity, the return is based on the difference between the price for which the bill was sold in the secondary market and the purchase price.The annualized yield from investing in a T-Bill(Y) can be determined as:

Y = (S-P)/P times 365/N

Where, S = selling price

P = Purchase price

N = Number of days of the investment

Assume that an investor purchases a T-Bill with a six-month (182 day) maturity and Rs 10,000 par value for Rs 9,600. If this T-Bill is held to maturity, the yield is:


Y =(10,000 - 9600) / 9600) * (365/182) = 8.36%

If the T-Bill is sold prior to maturity, the selling price and therefore the yield are dependent on market conditions at the time of the sale. Suppose the investor plans to sell the T-Bill after 120 days and forecasts a selling price of Rs 9,820 at that time. The expected annualized yield based on this forecast is:

Y = (9,820 一 9,600 / 9,600) * (365 /120) = 6.97 %

Price of a Treasury Bill

Assume a 6-month T-Bill with a par value of Rs 100 and a yield of 7.23% is to be sold in an auction. Its price would be calculated in the following manner:

=100 /1 + (T-Bill yield x tenor/365)

= 100/1 + 0.073x180/365 =Rs

96.5251

4.Term Finance Certificates (TFCs)

A TFC is a corporate debt instrument issued by companies to generate short and medium-term funds. Corporate TFCs offer institutional investors, in particular retirement funds and insurance companies，a viable high- yield alternative to the National Saving Schemes (NSS) and bank deposits. TFCs are also an essential complement to risk-free， lower-yielding government bonds such as PIBs. TFCs can be issued both as a fixed or floating rate instrument and may have a call qj put option.

A TFC must be rated before issuance. The rating reflects the credit risk of the TFC, i.e. the issuer’s ability and commitment to reoav scheduled TFC payments. Currently two rating agencies, PACRA and JCR-VIS, are operating in Pakistan.

Like bonds, TFCs are structured to provide regular income in the form of coupons. A TFC，s principal may gradually be redeemed over the tenor of the instrument. These are exempt from capital gains tax. However, coupons payments are subject to income tax.

5.Certificate of Investments (COIs)

A Certificate of Investment can be issued as either a short-term or a longterm investment product and it is denominated in Pak Rupees. Its main features are lower-risk，attractive returns and exceptional credibility. Examples are Orix Leasing Certificate of Investment, Meezan Bank Limited Certificate of Investment, etc.6.Certificate of Deposits (CDs)

A Certificate of Deposit (CD) is an interest-bearing debt instrument offered by financial institutions with maturities ranging from short-term to long-term. CDs offer comparable rates of return on investment with low risk. Premature

* While underwriting the issue, banks/DFIs shall ensure that their total exposure, including underwriting, does not exceed their per party exposure limits prescribed in these guidelines and under Prudential Regulations.


withdrawal is usually subject to a substantial early withdrawal penalty. Banks and financial institutions generally grant higher interest rates on CDs than on other similar deposits. At most institutions, the depositor can arrange to have the interest periodically mailed as a check or transferred into another account. One example is the UBL Certificate of Deposit.

A CD is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), have a specified interest rate， and can be issued in any denomination. Like all time deposits, the funds cannot be withdrawn on demand like those in a checking account, except on payment of a penalty. CDs offer a slightly higher yield than T-Bills because of the slightly higher risk for a bank.

7.Commercial Papers (CPs)

Commercial Paper means an unsecured Promissory Note with maturity of not less than 30 days and not more than 9 months. It is sometimes difficult for companies to borrowing short-term money from banks due to the long approval and documentation process. This can be avoided by using Commercial Paper.

This is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivable and inventories. It is generally issued at a discount, reflecting current market interest rates. Maturities on commercial paper are generally short, e.g. one and two months but no longer than nine months. Commercial paper can be treated as a safe investment because the financial situation of a company can easily be checked over a few months dealing. Generally only jose companies which carry high credit ratings and credit worthiness issue commercial paper.

General conditions

• Banks/DFIs shall not deal in any manner and in any capacity in commercial

papers (CPs) of denomination below Rs 1 million.

• There is no bar in dealing CPs if script less or dealing with CP in script form.

• All the endorsements made by the banks/DFIs to the subsequent purchasers of their holding of CPs shall be strictly on “without recourse basis”.


Banks/DFIs shall not provide any fund based or non-fund based facility against the security of Commercial Paper.

Banks and DFIs are eligible to perform the role of issuing and payment agent (IPA) provided that they meet the minimum capital requirement of SBP and have a minimum credit rating of A- (medium to long term) and A2 (short term) from the credit rating agencies approved by SBP or from Standard & Poor, Moody’s or Fitch. All the regulatory requirements as prescribed by SECP and SBP must be duly met by the issuer.

8.Bankers' Acceptances

A Banker’s Acceptance (BA) is a short-term credit investment created by a non-financial firm and guaranteed by a bank to make payment. Acceptances are traded at discounts from face - value in the secondary market. This is particularly useful when the creditworthiness of a foreign party is unknown.

Acceptances sell at a discount from the face value:

Face Value of Banker’s Acceptance Rs.1000,000

Minus 2% Per Annum Commission Rs. » 20，000for One Year

Amount Received by Rs. 980,000Exporter in One Year

A banker’s acceptance can be sold off in the secondary markets where investors and institutions constantly trade BAs.

9.Eurodollars

Eurodollars are U.S. dollar-denominated deposits at banks outside of the United States. The Eurodollar market is relatively free of regulation; therefore，banks can operate on les$er margins than thdV counterparts in the United States.

The average amount of a Eurodollar deposit is generally in the millions and has a maturity of less than 食 six months. A variation on the Eurodollar time deposit is the Eurodollar Certificate of Deposit. A Eurodollar CD is basically the same as a domestic CD, except that it is the liability of a non-U.S. bank. The Eurodollar market is obviously out of reach for all but the large institutions. The only way for individuals to invest in this market is indirectly through a money market fund.

Money Market Operations 10.

REPO

Repurchase agreements (repos) are a form of overnight borrowing backed by government securities. Those who deal in government securities use repos in this way. A dealer or other holder of government securities generally sells T-Bills etc to a lender and agrees to repurchase them at an agreed future date at an agreed price. In other words, REPOs are basically a means of raising funds by selling government-approved securities (T-Bills, PIBs, FIBs) at a fixed rate with the inttention of repurchasing them at a specified future date.

Securities and Exchange Commission of Pakistan «B

For the party selling the security (borrower of funds) the transaction is referred to as a REPO, whereas for the purchaser (lender of funds), the transaction is referred to as a reverse REPO. Funds transacted through REPOs do not fall under the category of demand and time liabilities and therefore the 5% cash reserve is not applicable. Currently, this type of transaction is the most common among financial institutions because of its flexibility, simplicity and security of principal. REPOs are an important tool in managing funds in the Money Market. These transactions are carried out through money market brokers or via the Reuters Dealing System.

The following are some key features of REPO transactions:

•The REPO is priced at the market price including accrued interest on the underlying collateral security. The REPO，s principal will be based on the value assigned to the collateral security, which is usually at a discount from the current market price of the security.

• REPO is a high quality and flexible short-term investment

alternative.

• REPO agreements are hybrids，having elements of both buy- sell transactions and collateralized loans.

• Money market participants enter into REPO transactions when they want short-term investment or have surplus securities and want to borrow short-term funds against such securities to meet the reserve requirements. ^

11. Reverse Repurchase Agreements - (Reverse-REPOs)

The reverese repo is the complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price. It is a mirror image of a REPO transaction. The difference between the purchase price and the sale price represents the lending yield of funds involved against the said transactions.

Term Repo - exactly the same as a repo except the term of the borrowing is

more than 30 days.

12. Discount Window Facility

As a lender of last resort, The State Bank of Pakistan provides discounting facility to commercial banks to obtain funds to meet their CRR. Banks can borrow for a maximum period of 3 days and are charged a fixed rate of interest known as the discount rate. Under the discounting banks enter into a REPO transaction with the SBP.


13. Call Money (Clean Borrowing / Lending of Funds)

Call Money is a non-collateralized clean lending / borrowing of rupee funds on an overnight basis. However, on some structured deals, Call funds are also exchanged for a fixed period. All call transactions are made on the basis of lines approved by the credit committee of a bank. The MM dealer borrows or lends funds in Call directly over the telephone, through approved brokers or via the Reuters Dealing System. Upon mutual agreement of the prevailing interest rate of the market, he/she will enter into a call transaction, which is generally assumed to be for an overnight period, unless specified otherwise. Brokerage is charged for transactions of PKR 50 million and above.

The brokerage for call business is calculated as follows:

Brokerage = No. of Days x Principal x *0.0325

365

*This brokerage rate can be changed from time to time by FMA.

The principal plus interest payments on call borrowing / lending are settled at maturity.

Chapter 2

Learning Outcome

105Capital Market Instruments

part— Financial Instruments

Capital Market Instruments


■ Discuss the operations of the following fixed income instruments:

1. Bonds/Sukuk2.Municipal Bonds3.Corporate Bonds4.Term Finance Certificates5. Asset-Backed Securities6. Treasury Notes Discuss the operations of the

following equity securities: 1.Preferred stock2.Common stock

1.Sukuk

A Sukuk is an Islamic financial certificate, similar to a bond in Western finance that complies with Shariah, the Islamic religious law. Because the traditional Western interest-paying bond structure is not permissible, the issuer of a sukuk sells an investor group the certificate, who then rents it back to the issuer for a prearranged rental fee. The issuer also makes a contractual promise to buy back the bonds at a future date at par value. It must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated from an asset purchased. This is because trading in debt is prohibited under Shariah \s such, financing must only be raised for identifiable assets.

Generally these are used to finance capital projects. They are considered permitted since the returns are not interest based on the money lent but rather a portion of the profits or rent generated from the project that was financed. Most sukuk are offered by Islamic investment firms or some governments such as Pakistan, Malaysia, and UAE etc. However, they are not as widely available to regular investors as conventional bonds. The issuance of Government of Pakistan Ijara Sukuk which had been a longstanding need of the Islamic banking industry has also served as a new source of funds for the Government. A total of four tranches of Govt of Pakistan Ijara Sukuk have been issued since its introduction in 2008 ， amounting to Rs 42.24 billion.

Sukuk are among the best ways of financing large enterprises that are beyond the ability of a single party to finance, an ideal means for investors seeking to deploy streams of capital, an excellent way of managing liquidity for banks and Islamic financial institutions and a means for the equitable


distribution of wealth as they allow all investors to benefit from the true profits resulting from the enterprise in equal shares.

Pakistan has very ambitious infrastructure projects in the pipeline and is developing fast with over 6 per cent gross domestic product growth in the last decade, but Islamic banking and Islamic structured finance initiatives have never taken off in the state. In spite of Pakistan being 97 per cent Muslim and having a population of more than 165 million people, Islamic banks do not have more than 2.1 per cent of market share of banking assets. Dubai Islamic Bank has already opened up branches in all of Pakistan’s four provinces， and the recent Affin Sukuk illustrated the growing interest in the area from East Asian-based Islamic finance houses.

Malaysian Sukuk issuers Affin Investment Bank issued its first Islamic bond. The Malaysian-based bank was appointed lead adviser and coplacement agent for a $250 million mixed residential and commercial property development project near Lahore, Pakistan, and the money is being raised through a Musharika Sukuk. Sukuk issuance for development projects in Pakistan must be given due importance. There have been only five Sukuk brought to market, and out of these two have closed. International Sukuk was brought to market in January 2005 by an association of arrangers that included Citigroup, HSBC, National Bank of Pakistan, Dubai Islamic Bank，Arab Bank，and ABC Islamic Bank. The other closed issue was a $133 million Water and Power Development Authority (VvAPDA) First Sukuk, which was brought to market by City Group, the Muslim Commercial Bank and Jahangir Siddiqui and Company, a Pakistani investment bank. It is the first Musharika issue; the other issues have been Ijara.

Sukuk the major component of the Islamic financial system

The Islamic bond market - the Sukuk market - represents a key component of the Islamic financial system. This recent decade has seenitiie accelerated development of this market and its significant role in strengthening the evolution of Islamic finance. The global development of this market is particularly important in this more challenging financial and economic environment. It has contributed to enhancing the effectiveness and efficiency of the mobilization and allocation of funds within national financial systems and in the international financial system. This development is also evidenced by the level of innovation and sophistication of the products and services being offered by the Islamic financial institutions. The encouraging development of the Islamic bonds market has also had an important role in enhancing the linkages between financial markets as it facilitates cross-border flows in the international financial system.

The Sukuk market as an important source of financing for large scale investment projects has a key role in facilitating the economic development process. For investors, it provides high returns and greater potential for diversification into new asset classes.

107Capital Market Instruments

Role of Sukuk in economic development

The financing requirements for economic development are enormous. The bond market is key to meeting funding needs for both the public and private sectors. This is particularly important for emerging market economies. In the Middle East and in Asia ， including Pakistan, which is regions of growth in the global economy, implementation of infrastructure projects is taking place，following privatization. The challenge is to put in place an intermediation system that will channel the surplus savings in these regions into productive investments. It is in this context that the Sukuk market will serve as an important avenue to efficiently mobilize longer term funds to meet these funding requirements.

Global experience has shown that the lack of well developed bond markets brings with it over-reliance on financing from the banking sector. This has often resulted in funding mismatches with adverse implications for financial stability. Development of the bond market allows access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows diversification of risks by issuers and investors.

The main merit of the Sukuk structure is that it is based on real underlying assets. The Ijarah Sukuk, for example, is an Islamic bond which applies a sales and leaseback arrangement, and thus it is an asset-backed instrument providing continuous security for the investor.

In addition, Islamic finance requires that the financing must be channeled into productive purposes, such as for project financing, rather than for speculative activities.

In the current environment, the demand for Sukuk significantly exceeds the supply. Today, the global Sukuk market, denominated in international currencies, is estimated to be USD18 billion. If domestic Sukuk issuance is included, it has now exceeded USD50 billion. Although the size of the market may seem modest by global standards, the Sukuk market has been registering an impressive average growth of 40 percent per annum. This phenomenal demand has been spurred by the high levels of surplus savings and reserves in Asia and Gulf regions.

The Sukuk market brings with it many benefits to both issuers and investors:

• Issuers can benefit from the huge increase in liquidity in the Islamic world, and can tap into these new sources of funds.

• Raising funding from the Islamic bond market in the current environment has been 10 to 20 basis points lower than mainstream bonds.

• An increased number of multiparty agencies are issuing Sukuk to finance development projects.


• From the investor’s perspective, there are the benefits of dive •辦

• In a Sukuk issue 48 per cent of the issuance was subscribed by com investors.

Malaysia's achievements in developing the Sukuk market

Malaysia is one of the key intermediary destinations along this N Road that offers a platform for the origination, distribution and of Islamic capital market and treasury instruments, including Malaysia is positioning itself as an Islamic investment gateway to with a place in Islamic fund and wealth management. Malays' 』 developed a comprehensive Islamic financial system that ope: parallel with the conventional financial system. Of significance is inter-connectivity within the system that includes the banking and industries, and the Islamic money and capital markets - a matrix mutually reinforces the integrity and stability of the Islamic fi system. This is supported by the financial infrastructure, the legal regulatory framework and the expertise to contribute to the grow* Islamic finance.

The Malaysian Islamic bond market has made significant progress ぐ . the first Sukuk issue in 1990 by a multinational corporation opera " in Malaysia. For the development of its market, the requirements ars:

• initiatives to facilitate an efficient issuance process• a price deciding process• widening of the investor base• the establishment of a benchmark yield•liquidity in the secondary market and strengthening of the regula

framework.

These initiatives have been reinforced by the legal and Shariah ftamework and the supporting financial inftastructure, including the settlement and bond informatkm system.

In 2002 ， Malaysia achieved a further significant milestone when the Malaysian government issued the first global sovereign Sukuk, raising USD 600 million. With this issuance, it became an international benchmaik for the issuance of global Sukuk. The Sukuk issue was listed on the Luxembourg Stock Exchange ， Labuan International Financial Stock Exchange and Bahrain Stock Exchange. There have since been further sovereign issues in the global capital market.

In 2006， the Malaysian market saw the launch of a Sukuk using concepts such as Mudharabah, Musharika and Ijara. The issuers included Malaysia’s government-linked companies. A landmark example was the USD750 million exchangeable Sukuk Musharika by Khazanah, the government’s investment corporation for the purpose of selling a stake in Telekom Malaysia. It marked the world’s first issue of its kind, incorporating full convertibility features common to conventional equity-linked transactionsBy January 2007，Malaysia accounted for 67 per cent, about two-thirds of

* Both government agencies and the corporate sector have considered the Sukuk market as an attractive source of financing.

the global Sukuk outstanding, amounting to about USD47 billion. Another important aspect of the development of the Sukuk market is the development of the other key components of the Islamic financial system， the money market， banking, and takaful sectors. The various components are able to meet the different requirements of the economy including the differentiated tenor for which the funds are required. This includes providing stable long-term funds for large investments and development projects.

The development of the Islamic Sukuk market involved initiatives to facilitate an efficient issuance process, the price discovery process, the broadening of the investor base，the establishment of a benchmark yield, the liquidity^ in the secondary market and the strengthening of the regulatory framework. These initiatives have been reinforced by the legal and Shariah framework and the supporting financial infrastructure including the settlement and bond information system.

2.Modarba

In Pakistan the process of Islamization of the economy was initiated in 1980 when the Government introduced the concept of Modarba for Islamization of the economy in the banking and corporate sector by promulgating the Modarba Companies & Modarba (Floatation & Control) Ordinance 1980 and Modarba Companies and Modarbas Rules 1981.

Modarba is a kind of partnership, wherein one party provides finance to another party for the purpose of carrying on business. The party who provides the finance is called the nRabb-ul-Maln, whereas the other party who contributes management skills for the Modarba is called the n Modarib”. The benefit of this form of business is that one party has money but does not have the expertise and the other party has the expertise but does not have money. Modarba provides opportunities for both parties, i.e. Modarib and Rabb-ul-Mal, to jointly cooperate for the good of the business under the Shariah. Rabb-ul-Mal can liquidate his or her investment anytime by selling his/her Modarba Certificate through stock markets to other Rabb-ul-Mal. In other words it is a business in which a subscriber participates with his money and the manager participates with his knowledge and skill, and profits made on investment of the Modarba funds are distributed among the subscribers. Thus, it is a concept of Islamic finance through which one partner or more participate with the funds and another with his skill and efforts in some trade, business and industry permitted by Islam. The one who contributes their efforts assumes the role of manager，while the provider of funds becomes the beneficial owner.

In modern terminology, a ”Modarba’ is similar to the concept of mutual funds minus the un-Islamic features. Among other activities, the law provides that a Modarba can undertake Ijara, Morabaha, Musharika financing activities, trading of Halal commodities，project financing activities, investment in the stock market and can act as a special purpose vehicle and a venture capital company.

SECP the Regulator (covered in detail in Chapter 3)The Modarba Wing of SECP is responsible for the registrati authorization, regulation and enforcement of regulatory provisi pertaining to Modarba Management Companies and Modarba. All products and business activities of the Modarba are approved by Religious Board with the facilitation of the Modarba Wi

Financial Systems and Regulation I Reference Book 2

A Modarba company is registered under the Modarba Companies Modarba Floatation and Control Ordinance, 1980. The interested p applies to the Registrar of Modarba，on ’’Form l?l and with the requi documents as may be prescribed，for permission to float Modarba An application for floatation of Modarba must be accompanied by q prospectus which should contain the following information:

• Name and type of the Modarba;

• The terms and conditions and amounts of the Modarba to be floated and the division thereof into Modarba Certificates of fixed amount;

• The nature of business scheme, prospectus and mode of distribution of profit;

•The amount to be subscribed by the Modarba company to the Modarba in its own name supported by evidence of its ability to meet the commitment;

•The form of the Modarba Certificate;

•Any other matters as may be required by SECP.

The application, prospectus and other documents filed must be authenticated by all the directors of the company before submission.

Business of Modarba

Modarba can conduct business which is according to the injunctions of Islam and the Registrar shall not permit the floatation of a Modarba unless the Religious Board has certified in writing that the Modarba is not a business opposed to the principles of Islam.

The Registrar, after obtaining from the Religious Board a certificate to the effect that the proposed Modarba business is not opposed to the principles of Islam, and on being satisfied that it is in the public interest so to do，grant a certificate in the prescribed form authorizing the floatation of Modarba on such conditions as he may deem fit，including conditions as to the business to be undertaken, expenses relating to the management of the Modarba Fund, preservation of assets and other matters relating to the mode of management and distribution of profits. Before issuing the certificate of authorization, the Registrar may require the Modarba Company to make such modifications, additions or omissions in the prospectus as the Religious Board may have indicated or as he may deem fit.

Capital Market Instruments 111

Sources of Funds of Modarba Companies

Major funding sources of Modarba companies include floatation of Modarba in the form of equity, and financing facilities from banks and other financial institutions in the form of various Islamic financing arrangements. These funds are largely utilized in the three financing agreements, namely Musharika, Murayama and Ijara, which were approved by the Religious Board in the early 1990s. In addition, these funds are also utilized for investing in shares of Shariah-compliant listed companies. In order to promote the Modarba sector ， SECP has introduced various policy initiatives. Earlier， in 2008， in order to provide diversification, SECP approved 11 new financing modes which were approved by the Religious Board. Additionally, a conceptual framework for the issuance of Sukuk by Modarba companies，with a tenor of 90 to 365 days, was also approved. Both these initiatives were mainly meant to provide an environment for Modarba companies to improve their outreach, promote product diversification and ensure sustainable growth. Performance of Modarba companies

The Modarba industry has successfully completed 30 years of business operations. The thirty years in the life of an industry may not be a long time, but it is certainly an important milestone. Modarba is a leading Islamic mode of financing. The Modarba and Non-Banking Islamic Financial sector play a very vital role in the promotion of Islamic Finance in Pakistan’s financial markets.

Since the inception of Modarba companies, which constitute the second- largest NBFI sub-group in terms of the number of entities, various policy initiatives have been introduced for the promotion and growth of the sector. Whatever the size of the Modarba sector, in terms of its share in total NBFI assets it is relatively small. Up to 2006 Modarba sector operations were based on three financing agreements, namely Musharika, Murayama and Ijara, which were approved by the Religious Board in the early 1990s. In FY08， SECP extended the list of approved financing modes to 11 by including 8 more Model Financing Agreements which were approved by the Religious Board.

From 2004 up to 2007 the aggregate asset base of the Modarba companies was increasing at an average rate of 20 percent per annum, but in 2008，

due to political change, it grew by only 12.4 percent. The relative size of each Modarba company in terms of shares in total assets and total equity clearly indicates that the Modarba sector has suffered from widespread breakup in the form of a large number of small and weak entities, with limited market share. Due to the excellent performance of some major market players, key performance indicators have shown some sign of improvement from 2009 onward.

3.Municipal Bond

A municipal bond is a debt security issued by a municipality to finance its capital expenditure. Generally, municipal bonds are exempt from federal taxes. For example in America, in most states, they are exempt from state taxes and local taxes, and this applies especially if the bond is issued in the state in which the bond holder lives.


Municipal bonds are generally used for funding capital expenditure as the construction of highways, bridges or schools. Municipal securities that are issued for the purpose of financing the infr needs of the issuing municipality. These needs vary greatly but can • schools，streets and highways, bridges, hospitals, public housing, and water systems, power utilities, and various public projects, types of bonds are not common in Pakistan. These are generally America and Western Europe.

Characteristic of Municipal Bonds

•Municipal bonds are considered different from other types of bonds their special ability to provide tax-exempt income.

•The risk of a municipal bond is measured by the capacity / credenf of the issuer to make all payments, on time and in full, as promised the agreement between the issuer and bond holder.

• Different types of bonds are secured by various types of repa sources, based on the promises made in the bond documents, such income generated by a water utility from payments by custo

•Repayment as promised in the bond agreement is often determined an independent reviewer, or ”rating agency".

• New issues of municipal bonds must indicate in an official stateme among other things, the security pledged for repayment of the bor the terms of payment of interest and principal of the bonds, the exempt status of the bonds, and material about financial and operating status of the bonds.

4.Corporate Bond

Bonds are loans to companies, local authorities or the government. They usually pay a fixed rate of interest each year and aim to pay back the capital at the end of a stated period. Corporate and government bonds are traded on the stock market, so their value can go up or down due to various reasons.

A corporate bond is issued by a corporation and that is why it is called a corporate bond. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer- term debt instruments, generally with a maturity date falling at least a year after their issue date. Corporate bonds are generally listed on major exchanges. The coupon of interest payment is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets.

If we compare corporate bonds with government bonds, generally corporate bonds have a higher risk of default. This risk depends upon the nature of business, financial stability of the corporation issuing the bond, the current market conditions, and the rating of the company. When bonds are first issued, investors buy directly from the corporation that is looking to raise capital by selling bonds. Once the bond is first issued，the bond can be sold and resold on the bond market until the date it matures.

If a bond is purchased at face value, it is called purchased at par. The face value refers to the amount the bond was issued for，which is written on the

certificate. This is the amount the bond holder will receive when the corporation pays back the debt or the bond matures or the corporation calls the bond. Bonds can sometimes be purchased at a discount, meaning the investor pays less for the bond than what is written on the face. If the bond buyer pays more than the face value, this is called at a premium.

S.Term Finance Certificate (TFC)

A term finance certificate (TFC) is a corporate debt instrument issued by companies to generate short and medium-term funds. TFCs normally offer higher rates of return than bank deposits and government bonds. Unlike bonds, some TFCs offer investors the option to redeem a portion of the principal during the term of the instrument.

A Public Limited Company is eligible to offer TFCs to the general public under section 57 [read with] section 120 of the Companies Ordinance 1984. The entity as well as the instrument should have a minimum credit rating grade of Triple B Minus (BBB-) assigned by a credit rating agency registered with the SECP.

The application for subscription of TFCs is categorized as for Rs. 5,000/- ， Rs. 25,000/-, Rs. 50,000/-， Rs. 100,000/- and in multiples of the highest category. The TFCs offered to the general public should be allocated among different categories of applications in the following manner: In the case of Public Offer up to Rs. 50 Million

Category of Application Reserve Allocation of TFCsFor and in multiple of Rs. 5,000/- 100% of the public offer

Reserve Allocation of TFCs

For Rs. 5,000/-

For Rs. 50,000/-


In case of Public Offer above Rs. 50 Million and up to Rs.100 Million

Category of Application

25% of the public offer, Minimum Rs. 50 million.

For Rs. 25,000/-The balance should be equally allocated to each category.

For and in multiple of Rs. 100,000

Characteristics of TFCs

• Corporate TFCs offer institutional investors, in particular retirement funds and insurance companies, a viable high yield alternative to bank deposits.

• TFCs are also an essential complement to risk-free ， lower-yielding government bonds such as PIBs.

•TFCs can be issued both as a fixed or floating rate instrument and may have a call or put option. A TFC must be rated before issuance.

• The rating reflects the credit risk of the TFC, i.e. the issuer’s ability and commitment to repay scheduled TFC payments.

• Currently two rating agencies，PACRA and JCR-VIS，are operating in Pakistan.

•Like bonds, TFCs are structured to provide regular income in the form of coupons.

• Unlike a generic bond, a TFC’s principal may gradually be redeemed over the tenor of the instrument.

• TFCs are exempt from Capital gains tax. However, coupon payments are subject to income tax.

• Redeemable capital.

• Monitored by a team of Trustees.

• Return on investment can be fixed or floating.

6. Asset-backed securities (ABS)

Asset-backed securities are debt instruments secured against specific

assetsor against specific cash flows. Asset-backed securities may be used toremove assets from the issuer’s balance sheet or to manage risk by limiting

Capital Market Instruments 115

lenders’ recourse other than to the specific assets concerned. The creation of an asset-backed security requires the securitisation of a pool of assets or a series of future cash flows. In some cases the assets may themselves be backed by other assets belonging to the issuer's borrowers. For example, a bank might finance a large portion of its mortgage lending with an asset-backed security. A financial security must be backed by a loan, lease or receivables against assets other than real estate and mortgage- backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.

An ABS is basically the same thing as a mortgage-backed security, except that the securities backing it are assets such as loans， leases，credit and debit cards, a company’s receivables， royalties and so on， and not mortgage- based securities.

In our everyday business, consumer loans are a good example of ABS which is presently the largest asset class within the asset-backed securities market in America and Europe and constitute a major part of consumer loans in Pakistan. In America and Europe, student loans, credit cards, equity and auto loans, etc. are all obtained through asset-backed securities. Students can finish their studies, and clear the loans with the salary they earn.

What are stocks/ shares?

When a limited company is formed, its ownership interest is divided into small units called shares. There are different classes of shares. Each class must have something that makes it different from the other classes，and all the shares within one class must have the same rights. If there is only one class of shares issued, they may be called "ordinary shares' or just "shares” or,’stock”. When a person owns a share of stock, he/she can vote for the directors of the company.

Common Stock

Common stock consists of ordinary shares which generally have voting rights. Holders of common stock can influence the company through votes on establishing company objectives and policies, and electing the company’s board of directors. Holders of commorfstocks do not have any right of fixed dividend hence their returns on shares are uncertain, and dependent on the profitability of the company.

Preferred Stock

This kind of stock can also be called preference shares, because these shares possess special rights both in profit and equity. Preferred stock does not carry voting rights, but carry priority for payment of dividend and upon liquidation over common stock, i.e. ordinary shares. These shares have some rights that are preferential to common shares, but their position on other matters is also limited.

•Preferred shareholders may have the right to a certain amount of money before the common shareholders get any money, but at the same time these shares are non-voting.

Parts

Chapt

1U Financial Systems and Regulation | Reference Book 2 Yields

These shares can have cumulative dividend rights, which basically means that if they cannot get dividends for any reason, they have the right to ask for back payments of dividends before any dividend payments are made to common shareholders.

Preferred shares can be made redeemable by the company. This means that the company can buy back the shares at a fixed price and the shareholder will have to accept it.

Preferred shares can sometimes be made convertible into common/ordinary shares at the option of the shareholder. The conversion ratio is set such that itfs not worthwhile to convert the preferred shares unless the common shares appreciate in value quite substantially.

Part 5： Yields

Chapter 1:Yields

Discuss the importance of interest rates in the financial system of a country

Describe the properties (functions/features) and pricing methodologies of financial assets

Discuss the level and structure of interest rates and their impact on the overall economy

List and discuss the forces determining rates in an economy and how these forces can be controlled in order to achieve the desired outcomes

Define Term structure - the yield curve - and discuss its significance in the functioning of an economy

Define what is meant by spot rates and forward rates, and how these impact on the actions of financial system players

Discuss the concept, impact and significance of local benchmark rates such as KIBOR, t-bill rates on the local financial system

Discuss the concept, impact and significance of international benchmark rates such as LIBOR rates on the local financial system

Importance of Interest Rate in the financial system of a country


PartFive Yields

Chapter 1 Yields

Learning Outcome By the end of this chapter you should be able to：

■ Discuss the importance of interest rates in the financial system of a country

■ Describe the properties (functions/features) and pricing methodologies of financial assets

■ Discuss the level and structure of interest rates and their impact on the overall economy

m List and discuss the forces determining rates in an economy and how these forces can be controlled in order to achieve the desired outcomes

■ Define Term structure - the yield curve - and discuss its significance in the functioning of an economy

■ Define what is meant by spot rates and forward rates, and how these impact on the actions of financial system players

■ Discuss the concept, impact and significance of local benchmark rates such as KIBOR, t-bill rates on the local financial system

謹 Discuss the concept, impact and significance of international benchmark rates such as LIBOR rates on the local financial system

Interest is defined as the fee paid as compensation by the borrower to the

lender for the use of funds. Interest is the profit that is paid to customers by

the financial services over due time on financial instruments. All banks and

m

any customers are involved in the act of borrowing and lending money. The lender wants to get the

highest return for his lending, whereas the borrower makes an effort to obtain funds at the lowest

possible cost.

Interest rate is the amount of predetermined cost of borrowing or lending that is known to the parties. The interest rate is the amount of money charged per unit which is normally expressed as a percentage rate over a period of one year.

In past years short-term interest rates have generally shown mixed trends. In both US and UK the rate has been in decline since December 2007. On the other hand, the rate in the Euro zone and some advanced economies was increasing at a faster pace. Among the emerging market economies, the rate witnessed a mixed trend, while in Pakistan the interest rate showed a rising trend.

119

Impact of interest on financial system and economic growth

Interest has a vital role in the financial system. Financial systems are the link

between borrowers and lenders. The functions of financial systems directly

affect the economic growth of a country. Financing cost (interest) is a crucial

factor in companies，decisions to undertake an investment project. If the

financing cost is high, i.e. the real interest rate is high, then it will reduce the

profitability of an investment project and therefore reduce the chances of the

project being undertaken. There will be a standstill on new projects, resulting

in a decline in production, fewer market activities and fewer job opportunities,

and lower revenue collection by the tax authorities.

Interest rates directly affect spending and saving. A high interest rate

environment discourages borrowing of money. A customer may decide to

hold off the purchasing of a new home until interest rates go down. Higher

interest rates encourage saving, and customers are more inclined to invest

when they receive good profits if higher rates are being offered on term

deposits.

The difference between what the bank pays to depositors in the form of profit

and the amount it charges as a fee on loans/ advances is the "spread”. The

State Bank of Pakistan, which， as the central bank of Pakistan, sets

monetary policy, has a direct influence on interest rates across the country.

Interest rates are adjusted through the T-bills rate, on the basis of which

banks charge interest (KIBOR) to one another in the overnight market. When

the SBP signals the increase of the T-bill rate, it raises the interest rates in the

lcerb[what is this?] market, which gradually filters down through the entire

banking system. Banks and other lending institutions increase interest rates

following the directions of the new policy. This phenomenon is known as

tightening of the economy. When the SBP lowers the T-bills rate, thereby

reducing interest rates, then KIBOR reduces, and financial institutions also

reduce their interest rates on loans/ lending. When the central bank eases its

monetary policy，it motivates the economy.

Risks

The change in interest rate affects all financial obligations and agreements. It

puts investors at risk since an investments value will change due to a change

in the absolute level of interest rates.

Higher interest rates make borrowing money more expensive. From an

investment bank’s viewpoint, higher interest rates result in lower stock prices.

When companies find it more expensive to borrow they have to limit their

expansion, which results in lower stock prices. On the contrary, a lower

interest rate environment results in increased borrowing which encourages

investors to switch from bonds to stocks. Also， lower rates encourage

companies to borrow to fund their development projects.


Interest rate fluctuations affect prices of asset classes. The three main asset classes are equities (stocks), flxed-income (bonds) and cash equivalents (money market instruments).

An increase in interest rates also causes an increase in items of daily use. When borrowing is more expensive, a goods manufacturer will pass on the higher cost of doing business to customers, which creates a negative effect.

The most significant theme of classical economics is that supply will equal demand if the market is allowed to operate freely. Supply and demand are kept in balance by adjusting the price of the good being traded. Well known classical economists include Adam Smith, David Ricardo and John Stuart Mill. In the classical theory, interest rates are determined by the interaction between savings and investment.

The classical theory argues that the rate of interest is determined by two forces:

•The supply of savings，derived mainly from households

•The demand for investment capital, coming mainly from the business sector

The Liquidity Preference theory of Interest

This theory was proposed by Keynes in 1936. The theory is also known as Cash Balances Theory. He stated that the rate of interest is really a payment for the use of a scarce resource, i.e. money. Interest rates are the price that must be paid to persuade money holders to surrender a perfectly liquid asset (cash and bank balance) and hold other assets that carry more risk.

Nominal Interest Rate

Nominal interest rate is laid down in contracts between involved parties. The nominal interest rate is simply the interest rate stated on the loan or investment agreement.

The Real Interest Rate

Real interest rates adjust the nominal rates to take inflation into account. For instance if inflation is 10% and the nominal interest rate is 15%， then the real interest rate will be 15% -10% = 5%.

Impact on other variables

An increase in interest rates affects other variables in the following ways:

• Stock exchange index will fall as investors will prefer to earn better profit.•The rise in the cost of running a business will cause a decline in a firm?s profits.

• Private investment will decline.

• Consumer value declines due to high costs.

• Foreign capital inflows for buying bonds.

• Exchange rate is pushed up.

• Huge public expenditure reserves are used to pay for public projects already underway, which might result in reduction in other areas of public expenditure.

•Lower disposable income for households with large debt commitments taken on at variable rates.

• Larger disposable income for households that have lent to others at variable rates.

Forces determining the interest rate

Changes in interest rates occur for both internal and external reasons. Different types of interest rates are linked， therefore they influence each other. Economic development and business activities, credit potential as well as money supply play an important role in changes in interest rate.

Furthermore, interest rates are determined in negotiations between borrower and lender, dependent on publicly available benchmark rates (in Pakistan T-bills rate). In other words, we can say that interest rates are determined mostly within institutional agreements.

The main factors that determine interest rates are given below:

• Central Bank Monetary Policy： This is one of the most powerful factors impacting on these agreements, for example through the instrument of direct determination of the official discount rate such as T-bills, or the rate for refinancing.

• Interbank Rate： An increase in money offered in the interbank market by the central bank is favorable to a fall in the interbank rate，upon which many contracts are based.

• Treasury Operation： This influences the interest rates and provides an important reference point for the determination of call money market rate.

• Demand of loans： Demand of loans by market forces is an alternative to Treasury bills. There are situations in which the interest rate policy is entirely in the hands of the Treasury.

The main factors that cause an increase in interest rat


• An anti-inflationary policy of the central bank, based on restricti to the growth of the money supply and on a rising discount inte rate.

• A policy by the central bank aimed at revaluating the currency or defending it from devaluation.

• The central bank policy for covering government deficit by issuing more bonds in a tight money market.

• An attempt by banks to widen their margins, possibly as a reaction to losses.

• Any increase in other interest rates, and also foreign rates rising for whatever reason.

Some probable reasons for a decrease in interest rates:

•A pre-determined policy of the central bank.

• Industrialists and business community requests for cheaper money to deal with crisis situations.

•A loose monetary policy to increase income through increased exports.

•As a measure to end an inflationary phase.

•To defend exchange rates.

Role of Inflation in Determining Interest Rate

Inflation is defined as a constant increase in the average price of all goods and services produced in an economy.

There is an inverse relationship between interest rates and inflation; high interest rates cause low inflation whereas low interest rates result in high inflation.

Money loses purchasing power during inflationary periods since each unit of currency buys progressively fewer goods. For example, the overall price level increased by 3% during the past 12 months. Elf a family spent Rs.30，000.00 during the first month for all household expenses，then they must budget Rs.30900.00 for the last month for exactly the same quantity of goods and services.

Long-term inflation occurs when the money supply grows at a faster rate than the output of goods and services. This is often described as fftoo much money chasing too few goods." Government intervention is required to control the high level of unpredictable inflation since this can severely disturb the economy.The tools which are available to control inflation include:

Monetary policy

Monetary policy affects inflation in two ways. First, an indirect effect: if

monetary policy is able to achieve a multiplier effect, it boosts economic activity. Inciting labor and capital markets to raise outputs beyond their capacity and creating an upward pressure on wages causes inflation to rise (cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short run which further accelerates inflation. As wages and prices start to rise they are harder to bring back down, stressing the need for early policy measures to be taken.

Secondly ， monetary policy can directly affect inflation via future expectations. If people expect prices to rise in future， they push for an increase in wages, which in turn affects prices, resulting in higher inflation.

Fiscal policy

Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation,s economy.

Such policies affect tax rates, interest rates and government spending, in an effort to control the economy.

The government must take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies governments are able to control economic phenomena.

Factors that Influence Exchange Rates

Exchange rates are the basic factor that affects the nation’s trading relationships with other nations. A high-value currency makes a countryfsEexports more expensive and imports cheaper in foreign markets, while a low-value currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country’s balance of trade, while a lower exchange rate would increase it.

Determinants of Exchange Rates

There are numerous factors that determine exchange rates in relation to trading between two countries. These rates are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.

Differentials in Inflation Rates

A country with a consistently lower rate of inflation will have a high- value currency and its purchasing power will be greater as compared to other currencies.Interest rates， inflation and exchange rates are all interrelated. The bank changes interest rates and puts pressure on inflation and exc rates, and the change in interest rates impacts on inflation and cu values. Higher interest rates attract foreign capital and cause the exc rate to rise, whereas the opposite relationship exists for decreasing in rates - that is, lower interest rates tend to decrease exchange

Differentials in Interest Rates


Current Account Deficits

The current account of a country is the balance of trade between trading partners. A deficit in the current account shows the conntiy spending more on foreign trade than it is earning, and that it is bo] capital from foreign sources to make up the deficit. In other words, country requires more foreign currency than it receives through sales goods and services. The excess demand for foreign currency lowers country’s exchange rate.

Public Debt

Countries use large-scale deficit financing to pay for public sector prof and government funding to stimulate the domestic economy， but nation] with large public deficits and debts are less attractive to foreign investonL A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real money in thr future. A government may print money to pay part of a large debt, bm increasing the money supply inevitably causes inflation* If a government is not able to service its deficit by selling domestic bonds then it must lower the price of securities for sale to foreigners.

Terms of Trade

The ‘terms of trade’ is the ratio of a nation’s export prices to its import prices. It is used to measure the country’s trading position related to current accounts and the balance of payments. If the price of a countr/s exports rises by a greater rate than that of its imports, its terms of trade have a favorable trend and vice versa. Increased ‘terms of trade’ shows greater demand for the country’s exports. This, in turn, results in rising revenues from exports， increased demand for the country、currency and an increase in the currency’s value. If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.

Political Stability and Economic Performance

Foreign investors want to make investments in countries with strong economic performance. Political instability causes a loss of confidence in a currency and a movement of capital to countries with stable economies.

Types of Rates

Banks are the classic lending institutions and they finance their credit activity in various ways.

125

Collection of public money (small savers) with payment of interest on deposits.

• Issuance of bonds on fixed annual interest rate.

•Issuance of bonds by taking short-term loans from other banks at the inter-banking interest rate.

•Borrowing money from the central bank，at an interest rate for refinancing operations.

At international level the interest rate for the public is determined with reference to LIBOR, e.g. n1.5% more than LIBOR11. In Pakistan, local currency financing is set at 3% above KIBOR, or a fixed interest rate with periodical review. The interest rate for companies is decided in keeping with a company’s financial status. A financially sound company with strong credentials might be charged a lower interest rate compared to the rate the same bank will charge new and less established customers in order to reduce the high risk. Depositors receive interest on their bank accounts; usually higher if they block money for a certain period such as for a fixed term, and lower if it is a savings account.

Exchange rates are determined by a number of factors already discussed above.

The real return on an institution’s portfolio is established by the exchange rate of the currency of major investments. A declining exchange rate obviously decreases the purchasing power and capital gains derived from any returns. In addition, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities.

Term structure and yield curve

The term structure of interest rates is the change in interest rates with time; usually the interest rates increase with time. For example, a government bond which has the maturity time of 10 years will have a different YTM (yield to maturity) from the one which has only one year from maturity. The ’term structure，when explained as a graph, is called the ’yield curve，.

It is normal for interest rates to increase with the length of the period; if a zero coupon bond has a longer period till maturity, then it will have a higher rate of return on it. When the ’term structure’ shows this behaviour, the yield curve shows an upward slope. A downward sloping yield curve is called an inverted yield curve. The yield curve shows the relation between the interest rate, i.e. cost of borrowing, and the maturity of the debt for a given borrower in a given currency.

The yield curve slopes upward for several reasons. The most important factor is liquidity preference, that is, investors need a return for the potentially lower liquidity of long-term bonds. The other factor is greater exposure to interest rate risk and inflation risk for a longer duration investment. Inflation and interest rates move together, so the risks are linked.


The yields on long-term bonds are arithmetical averages of p expected future rates. An upward sloping curve shows that future short rates will be higher than the current rate. A d sloping yield curve shows that expected future rates will be 1 the current rate.

Liquidity preference theory

This theory states that yields on long-term period bonds are gr the expected return from rollover of short-term bonds in or compensate investors in long-term bonds for bearing interest The theory is explained in the following table and yield

Rate

Spot and Forward

contracts Spot RateSpot rate is the price that is quoted for immediate settlement on a commodity, or a security or a currency. Spot rates settlement is completed within one or two business days from trade date. It reflects market expectations of future price movements for a currency, security or commodity such as gold, silver. These rates are used for ready transactions whose settlement has to be made within a couple of days.Forward Rate

PIB RatesYear Rate

5 13.77

7 14.09

10 14.18

15 14.57

20 14.94

Yield Curve of PIB

5 8

6 4

2 4

8 6

1444413

31

11

1 1

r H

Forward rate represents the amount that is required to deliver a currency, commodity, or some other asset at a future date. It is the price used to determine the price of a future contract. It accounts for holding costs ，

appreciation and demand for the currency, security or precious metal, etc (other than perishable goods).

Forward Rate Agreement

This is an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. It will determine the rates to be used along with the termination date and notional value. In this type of agreement, it is only the differential that is paid on the notional amount of the contract.

Significance of local benchmark like T-bill rates rate and KIBOR for the local financial system

State Bank of Pakistan is responsible for general monetary and credit conditions in Pakistan. It is an independent agency within the Pakistan government. Among several functions of the SBP, the most important is the formation and implementation of the nation’s monetary policy in pursuit of macroeconomic goals of achieving investment boost and better employment conditions and price stability.

The SBP attempts to achieve its macroeconomic goals by using mainly three tools, called monetary instruments:

•The discount rate•The reserve requirement• Open market operations.

The discount rate is an interest rate charged on a loan made by SBP to a depository institution. This is the only interest rate officially set by the SBP, but some economists consider it a signal of a monetary policy to come.

The reserve requirement represents the obligation of depository institutions such as commercial banks and DFIs to maintain a certain percentage of their deposit liabilities in reserves. A change in the reserve requirement is used by the SBP to change the supply of money in the economy.

Open market operations, the most frequently used and most effective tool among the three, are buying and selling of government securities, mainly Treasury bills and Pakistan investment bonds (PIBs) in an open market to change the amount of excess reserves held by depository institutions. The excess reserves are the actual reserves over the legally required amount. Financial institutions change their loan behavior depending on the excess reserves held: increasing loan activities when more excess reserves become available and reducing loans when excess reserves become exhausted. Financial institutions have an incentive toloan out as much excess reserves as possible to maximize their • for money left idle in their vault does not generate income. When with a threat of recession as a result of a faltering demand in the eco the SBP attempts to reinvigorate the economy by prescribing what economists call an "easy money" policy. An easy money policy is an by the SBP to


make more money and credit available so that the cort using money, the interest rate, becomes lower.

Lowering of short-term real interest rates (T-Bills rate), and even long-term rates (PIB rate) can have a broad and deep impact throu; the economy. Lower real interest rates in say, T-bills, affects KIBOR stimulates business investment by making more investment prof profitable, allowing for an expansion of capacity and efficiency. Witia reduced cost of investment, more machines and equipment will be new factories and warehouses built, and additional stores and ap buildings opened. Businesses may also increase production because oC lower cost of financing inventories. A fall in interest rates thus investment and production.

Lower interest rates may also affect business investment in another w Because fixed-rate investments such as Certificates of Deposits (CO) Term Deposit Receipts (TDR) and other saving accounts now earn a 1 return, the holders of wealth would switch their portfolios to incli more variable-rate investments such as stocks. This increased demand fad stocks may cause a stock market to unite for more aggressive business An increase in the value of stocks, in turn, makes it easier for businesses to issue more stocks or to borrow funds to finance additional investmenL

Declining real interest rates also induce consumers to increase their purchase of goods by making it cheaper to buy the goods on credit Consumers typically buy automobiles, appliances, and home furnishings on credit. The impact of a lower interest rate on the economy can be substantial, considering the fact that consumer spending accounts for about two-thirds of the nation's total expenditure.

Impact of international benchmark rate such as LIBOR rates on the local financial system

A benchmark: A standard by which something can be measured or judged

LIBOR: This is an abbreviation of London Interbank Offered Rate. Overnight rates and LIBOR rates on forward contracts are quoted in 17 different currencies and for various durations. The LIBOR is among the most commonly used benchmark interest rate indexes to make adjustments to adjustable currency rates and interest rates. Other Interbank lending rates are: EURIBOR, SIBOR，HIBOR and rates for other European countries.

Different types of interest rate are linked and influence each other, so that the functioning of financial markets and international relationships account for a good deal of interest rate fluctuations. International tendencies exert an important influence on domestic conditions as well, since financial markets are now global in scope and there is a growing co-operation among central banks. The increase in benchmark interest rates did significantly impact deposit growth, especially foreign currency deposits. If banks offer a higher interest rate, then LIBOR-rated fresh deposits can be taken. On the other hand, an interest rate change could also become a burden on our foreign exchange reserve.

List some of the credit rating methodologies available for assessing various


Part 6: Credit Rating and Risk Evaluatio

Chapter 1:Concepts, scope and significance

Define the concept of credit rating and risk evaluation

Discuss the scope and significance of credit rating and risk evaluation and credit rating agencies

Chapter 2: Regulatory Framework

Discuss the role of the regulatory framework with respect to the operations of credit rating firms

Describe sovereign (country) ratings and explain how they impact on investment decisions

Chapter 3: Rating

Methodologies for Various Instruments

fie of the credit rating different instrument

Chapter 4： Credit Rating Agencies in Pakistan

List the generic process of credit rating adopted by the credit rating agencies operating in Pakistan

Chapter 5 : Evaluation of Risk and Benefits for Investors

Describe why risk evaluation is necessary

List the beneficiaries of risk evaluation reports

Describe the various benefits investors derive from credit ratings and risk evaluation reports

Chapter 1

Learning Outcome

Concept of credit rating and risk evaluation

Concepts, scope and significance 131

partsix Credit Rating andRisk Evaluation

Concepts, scope and significance


■ Define the concept of credit rating and risk evaluation

■ Discuss the scope and significance of credit rating and risk evaluation and credit rating agencies


Large companies• Bond/ debenture issuers• Government regulating agencies

Scope and significance of credit rating and risk evaluation and rating agencies

Banks’ DFIs and other financial institutions issue debt securities, \v are traded on the secondary market. They do this for various fun •• purposes, for example:

• With the help of a credit rating, the credit worthiness of a fin institution can be measured.

• If the credit rating of a financial institution or bond issuer is high, the amount of interest paid to the investors will be low because consider the investment to be less risky. On the other hand, if the rating of a financial services provider or bond issuer is low, then amount of interest paid to the investors will be high because the imr consider the investment to be more risky and the issuer tries to compe~ the degree of risk by paying a high rate of interest.

Credit ratings of financial institutions are useful for the following entities:

• Banks and DFIs• Bond issuers• Investment banks• Broker-dealers.Government regulatory agencies• Any company involved in the issuence of financial instruments

The leading credit rating agencies which carry out credit ratings on financial institutions include the following:

•A.M. Best (United States)• Moody’s (United States)•Fitch Ratings (United States)•Japan Credit Rating Agency• Standard & Poor’s Ratings (United States)• Dominion Bond Rating Service (DBRS-Canada)• Bay Corp Advantage (Australia)•PACRA (Pakistan credit rating agency)•JCR-VIS Credit Rating Co. Ltd Pakistan• China Lianhe Credit Rating Co. Ltd•Credit Rating Agency of (Bangladesh), Ltd.•CRISL is an S&P company, (India)• European Rating Agency (ERA)

Credit rating agencies play a major role in the assessment of credit risk. Their management of important data helps investors to make fast and informed decisions.

Concepts, scope and significance 133

The SBP defines credit raters in these words:’’Credit rating is an independent opinion expressed by the professional bodies, i.e. credit rating agencies. Their statement about capacity of an entity to meet its obligations is based on various quantitative and qualitative factors.”

The ratings represent the opinions of respective rating agencies and do not represent investment advice. Furthermore, these rating do not reflect the views of the State Bank of Pakistan.

There are two types of credit rating: short-term credit rating and longterm credit rating, the details of which are given below:

Short-term Credit Rating

A1 +: Obligations supported by the highest capacity for timely repayment.

A-1-: Obligations supported by a strong capacity for timely repayment.

A-2: Obligations supported by a satisfactory capacity for timely repayment, although such capacity may be susceptible to adverse changes in business, economic, or financial conditions.

A-3: Obligations supported by an adequate capacity for timely repayment. Such capacity is more susceptible to adverse changes in business, economic, or financial condition than for obligations in higher categories.

B: Obligations for which the capacity for timely repayment is susceptible to adverse changes in business, economic, or financial conditions.

C: Obligations for which there is an inadequate capacity to ensure timely repayment.

D: Obligations which have a high risk of default or which are currently in

.............?????

Long-term Credit Rating

AAA Highest credit rating

These ratings indicate the lowest anticipation of credit risk. They are assigned only in cases of very strong capacity for timely payment of financial commitments. This capacity is highly unlikely to be adversely affected by probable events.

AA +, AA, AA_ Very high credit rating

These ratings indicate a very low anticipation of credit risk. The capacity of the company being assessed is considered very strong for timely payment of financial commitments. This capacity is not very vulnerable to likely events.


A +, A, A- High credit rating

These ratings indicate a low expectation of credit risk. The capadf) timely payment of financial commitments is considered strong. I capacity, nevertheless, may be more vulnerable to changes in circumsia( or in economic conditions than is the case for higher ratij

BBB +, BBB, BBB- Good credit rating

These ratings show that there is currently a low expectation of crediB The capacity for timely payment of financial commitments is conr adequate, but adverse changes in circumstances and in economic co • are more likely to damage this capacity. This is the lowest inv ご grade category.

BB +, BB, BB- Speculative

These ratings indicate that there is a possibility of credit risk devel particularly as a result of adverse economic change over time; how business or financial alternatives may be available to allow fin commitments to be met. Securities rated in this category are not inv grade.

B +, B, B- Highly Speculative

These ratings indicate that significant credit risk is present, but a linv margin of safety remains. Financial commitments are currently br met; however, capacity for continued payment is dependent upon continued, favorable business and economic environmec

CCC, CC, C High Default Risk

Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon continuous, favorable business or economic developments. A fCC? rating indicates that default of some kind appeals probable. ’C’ ratings signal imminent default.

Part Six

Chapter 2

Learning Outcome

Regulatory framework

Regulatory Framework 135

Credit Rating and Risk EvaluationRegulatory Framework


■ Discuss the role of the regulatory framework with respect to the operations of credit rating firms

■ Describe sovereign (country) ratings and explain how they impact on investment decisions

The reputation of credit rating agencies was badly affected after the financial crisis faced by America and some European countries. These agencies were considered to have failed to, firstly, judge early enough in their credit ratings the decline in market conditions, and secondly, adjust credit ratings before the market crisis deteriorated. The rating agencies had given good ratings to lower categories of financial products, and many investors complained that they had lost billions of dollars by relying on these ratings. These agencies are still operating and are popular in America and other parts of the world.

Now banks and DFIs have started their own evaluation of the risks of financial products. A former head of compliance at Moody's has said that banks' fears about taking on more responsibility are not baseless since conducting due diligence on securities requires specialized knowledge. If banks take on these responsibilities internally or contract with a third party, it will be costlier than relying on the judgments of a credit rater.

Regulatory framework for the operations of credit rating firms The reliance on credit rating agencies by global securities and banking is ever increasing. Their ratings are used by investors, borrowers, and issuers of bonds and securities. Some government agencies consult them in the process of making investment and financing decisions. Credit ratings have a considerable impact on the operation of the primary and secondary markets by building trust and confidence among investors and consumers.

Regulatory Framework 136

As such there should be some regulatory framework with regard to the operation of these companies, such that:

• Credit rating activities must be conducted in accordance with the principles of integrity, transparency, responsibility and good governance.


• In order to avoid possible conflicts of interest, credit rating must focus their professional activity on the issuance of credit only.

•Credit rating agencies should use independently audited statements and public disclosures, as well as random sampling of the information received.

•These agencies must consider contractual obligations and coi clearly stipulating liability for the rated entity or its related third

•Rating agencies should not carry out consultancy or advisory _ and their board should consist of independent directors.

•Performance of credit rating agencies must be monitored by the banks and other regulatory agencies.

In Europe，a regulatory framework for credit rating agencies has been designed and implemented. Even those rating agencies whose office is not situated in Europe have been advised to open an o any member country of the European community in order to c direct evaluation of money and capital market instrum

Sovereign rating (country rating and its impact on invest decisions)

The ratings issued by the main international credit rating agencies as Fitch, Moody’s，and Standard and Poor’s are the key factor afii an independent country’s or a company’s access to capital markets, assessments of rating agencies affect not only investment decisions in international securities and loan markets, but also directly affect for ニ： investment and portfolio equity flows. Generally, small and medi sized investors do not have the expertise to evaluate a country risk as as a company risk. As such，they prefer to rely on the assessments prov" by rating agencies. Having no rating, however，may have wo consequences than having a low rating. Unrated countries are oft believed by creditors to be more of a risk than countries which are I rated, on the grounds that at least facts about a low-rated country aic available.

A sovereign rating provides a benchmark for capital market activities in the private sector. "The rating process, as well as the rating itself, can operate as a powerful force for good governance, sound market-oriented growth, and the enforcement of the rule of law. From a business perspective sovereign credit ratings serve as a baseline for evaluating the economic environment surrounding investment possibilities and as a benchmark for investors to distinguish among markets, which provides valuable information and a basis for evaluating risk’，(US Department of State, 2006).Investors normally use sovereign ratings to obtain a comprehensive view of the risk of investing in a particular country. For a developing country, the sovereign rating can provide a benchmark for the cost and size of potential debt issuance. Even aid allocations from international agencies and bilateral donors are affected by sovereign creditworthiness criteria.

Chapter 3

Learning Outcome

Process of credit rating adopted by the credit rating agencies operating in Pakistan.

Credit Rating Agencies in Pakistan 137

partsix Credit Rating andRisk Evaluation

Credit Rating Agencies in Pakistan


_ List the generic process of credit rating adopted by the credit rating agencies operating in Pakistan


component of eligibility criteria, it must demonstrate that it minimum standards as stated below:

• It has established rating definition, criteria and methodology.

•The methodology, systems and procedures for assigning risk be consistent across the board.

•The ECAI should have a robust procedure for rating assignment on published information, market data, interviews with the ma and any other means that provide reasonable assurance for the risk ratings.

•While assigning risk rating, the ECAI should take into account all features of credit quality and ensure that the ratings are assigned into account all risk factors of the rated entity.

•The ECAI should demonstrate that the rating methodologies are to quantitative back testing. For this purpose, the ECAI should and publish default studies, recovery studies and transition ma For this purpose, the ECAI should have a definition of default equivalent to the international standard and is relevant to the do market.

•The assessment methodology for each market segment incluiS rigorous back testing must have been established for at least one j

•All rating decisions should be made by the rating committee, by u "• the ECAI’s established criteria and methodology.

•The ECAI should have a mechanism in place to review its proced- and methodologies in order to adapt them to the changing enviro

•The ECAI should maintain adequate system/internal records to support its assigned ratings.

The ECAI should be independent， free from economic or any extemjl pressures that may influence its credit assessment. The independence of an ECAI shall be assessed on the basis of the following four parameters:

Ownership: The ownership structure should not be such that could jeopardize the objectivity of the rating process; for instance, if the owners have other businesses or are members of businesses or associations that are rated by the ECAI.

Organizational Structure and Corporate Governance: The ECAI should

demonstrate that their organizational structure minimizes the scope of external influence that can negatively impact the rating process. The ECAI should have in place high standards of corporate governance that safeguard the independence of its risk assessment and promote integrity.

Financial Resources： Since the core earning of an ECAI is the issuer fee ， this commercial pressure may give rise to conflicts of interest. The ECAI must demonstrate that their business is financially viable and is able to

Credit Rating Agencies in Pakistan 139

sustain any commercial pressure exerted by rated entities. The ECAI must demonstrate that their financial viability is not dependent on a few clients. Similarly， the ECAI should not be providing any other services to the rated entities.

External Conflict of Interest: The risk assessment process of the ECAI should have the ability to withstand external pressure. The ECAI should demonstrate that it is free from all sorts of external conflicts of interest.

International Access and Transparency ： The risk assessment of the ECAI should be available to both domestic and foreign institutions on equivalent terms. The ECAI may charge a fee for the provision of rating/ risk assessment; however， the fee structure should be the same for both.

In order to promote transparency and enable its stakeholders to make decisions about the appropriateness of its risk assessment methodology, the ECAI should disclose sufficient information. The information, at a minimum, should include the rating definition, general methodology for arriving at the rating, the rating process, time horizon of rating and the surveillance and review procedure.

Disclosure:The ECAI should demonstrate that it allows access to information that enables its stakeholders to decide about the appropriateness of risk assessments. The purpose of this disclosure requirement is to promote transparency and introduce market discipline.

The ECAI is therefore expected to make public the following information:

• Code of conduct•Definition of default•Use of time horizons• Rating definitions•Assessment methodologies (any material changes in methodologies should be disclosed as and when made)• Actual default rates experienced in each assessment category•Transition matrices•Whether rating was solicited or unsolicited•The date of last review and updating

Resources:The ECAI should possess sufficient human and technical resources to carry out high quality credit assessment.Human resources: The assessment of human resources adequacy shall be made on the basis of the technical expertise of the people carrying out risk assessment and to the extent the ECAI can extend ongoing contact with the management of entities that are rated.

Technical resources:The ECAI is expected to have in place quantitative techniques and models that can process and analyze large quantities of data.


Credibility:The ECAI must demonstrate that it enjoys credibility in the it operates. The credibility of an ECAI is indicated by the extent it meets the criteria mentioned above.

Withdrawal of Recognized Status：In cases where any recognized ECAI is subsequently found to compliant with any of the prescribed eligibility conditions or is be non-compliant with any other instructions issued by the from time to time, the State Bank may withdraw its status of ECAI and prohibit banks using the credit ratings of that ECAI calculation of their capital requirement.

Chapter 4

Learning Outcome

Credit rating methodologies available for assessing various different instruments

141

Rating Methodologies for Various Instruments

partsix credit Rating andRisk Evaluation

Rating Methodologies for Various Instruments


_ List some of the credit rating methodologies available for assessing various different instruments

The rating methodologies of any money market or capital market instrument consist of analyzing the operational and financial standing of the issuer. Whenever we take any social or financial decision we consider the reputation, proven credentials, and financial standing of the other party. Exactly the same applies when assessing any financial instrument and considering factors such as

management capabilities, financial risk involvement, purpose, proven credentials of the issuer and political / market conditions. For example, in a country like Pakistan，if we are assessing any short- term instrument, then a favorable business and financial risk profile, as well as political stability will make it much easier for the issuer to fulfill its short-term commitments.

The same principles are also applicable to long-term instruments but with some additional factors. These include:

(1) Traditional credit scrutiny that focuses on the possibility of timely payment, i.e. risk of default.

(2) An assessment of the variety of protection factors such as collateral security, and the capabilities/ expertise of the lender to exit quickly from a deteriorating credit before default occurs.

(3)Anticipated recovery in the event of default.

From the foregoing discussion it can be concluded that, for an instrument rating, we have to consider two main elements: default risk and anticipated recovery in the event of default.

When evaluating different instruments, the intensity of scrutiny may differ considerably because of the nature of the risks each entity faces as part of day-to-day business. All credits should be monitored on an ongoing basis. The capabilities of the instrument issuer in managing negative circumstances also play a very important part in determining instrument rating.

An issuer default rating focuses solely on the likelihood of the rated entity meeting its commitments on time according to the terms of the instrument A recovery rating highlights the final recovery that the holder of a specific instrument is expected to receive in the event that the instrument faces a payment default.


An instrument rating which is actually related to the specific ’ determines the two features of credit: (a) default risk and (b) recovery in the event of default.

Default ratings evaluate the likelihood of a borrower meeting pa: on time. Recovery ratings presume that default will occur, regardless df how likely or unlikely that is to happen, and evaluate the outcome dM that default for various debt instruments or classes of debt in terms dl the cost incurred in recovering the principal.

These two elements of credit - the likelihood of default and the natmd of that default if it happens - are both essential features of the ndd management system of any financial institution or investcjt

Part Six

Chapter 5Learning Outcome

Importance of Risk Evaluation

Evaluation of Risk and Benefits for Investors 143

Credit Rating and Risk EvaluationEvaluation of Risk and Benefits for Investors

By the end of this chapter you should be able to：

* Describe why risk evaluation is necessary

■ List the beneficiaries of risk evaluation reports

玀 Describe the various benefits investors derive from credit ratings and risk evaluation reports

Risk assessment is very necessary before taking any decision, either social or financial. The basic purpose of any investment is to get the best possible return over the time of

the investment. Risk assessment is the determination of the quantitative or qualitative value of risk related to the investment. Quantitative risk assessment requires calculation of two components or risk, i.e. the magnitude of the potential loss and the probability that the loss will occur. Our decision should be based on an honest assessment of the risks and rewards of the investment and also of the market and its stability, rather than our own hopes and emotions. This is relevant when deciding both what and how much to invest. This assessment is made in both the cases from investment point of view and credit point of view.

If the investment is large, it is advisable to first conduct a feasibility study which is a part of risk evaluation . The purpose of studying feasibility is to objectively and rationally determine the strengths and weaknesses of the existing business / investment by considering all relevant factors. A well-designed feasibility study should provide a historical background of the business or project, description of the product or service, accounting statements, details of the operations and management, marketing research and policies, financial data, legal requirements and tax obligations. Nobody can predict the future with 100% accuracy. We take decisions on the basis of the facts and figures available, historical background of the situation and the rest depends on God. This feasibility is used by the project initiator as well as by the banks/financial institutions when evaluating credit requirement. The purpose of the risk study is to provide the investor with the information needed to determine if the proposed investment or businesses venture is viable. While such a study will probably not provide a magical, ,fquick-fixn answer, the investor will need to carefully assess the conclusions of the risk study and decide if the proposed investment has sufficient merit to move forward.


The beneficiaries of risk evaluation reports

Risk can be evaluated through the process of completing a h study. It is a complete assessment of business problems / oppo the alternative solutions available and the recommended sol implementation. It is beneficial for an investor, a business i fund raiser or a project manager who can use the feasibility/ risk study as a sample to assess any type of solution, within any type of environment.

The outcome of the feasibility study is a risk evaluation report provides the user with guidance, and ensures that all of the ir elements of risk assessment are adequately covered. It can also be as an exercise that involves documenting each of the potential to a particular business problem or opportunity. Such studies cam undertaken by any type of business, project or team.The various benefits investors derive from credit ratings and risk ev reports

Risk/ Credit evaluation

(Note: Risk evaluation is used by the investor as well as by banks other financial institutions because both parties are basically inv Credit evaluation on the other hand is done by the credit rating ar and the bank's own risk department for assessing their risk in case future eventualities. In essence, both credit evaluation and risftj evaluation are more or less the same thing, therefore the followiag text applies to both of these terms.)

Credit evaluation is the process by which a business or an individual m assessed for eligibility for a loan or ability to pay for goods and services over a longer period. It also refers to the process which banks/DFb undertake when evaluating a request for credit. Credit approval depends on the readiness of the lender to lend money and assessment of the ability and willingness of the borrower to return the money or pay for the goods purchased, plus profit within the terms of credit. Generally, small businesses must seek credit approval to obtain funds from bankers and vendors, as well as allowing credit to their customers.

In general, credit facilities depend on the confidence of the lender in the borrower's credit worthiness. Creditors and bankers utilize a number of financial tools to assess the credit worthiness of a potential borrower. When assessing a credit proposal, much of the evaluation relies on analyzing the borrower's balance sheet, cash flow statements, inventory, turnover rates, debt structure, management performance, and market conditions. Bankers generally favor borrowers who generate net earnings in excess of debt obligations. Following are some of the factors lenders consider when evaluating an individual or business that is seeking credit

Proven credentials. A history of reliability, moral character, and expectations of continued performance demonstrate a debtor’s ability to pay. Bankers give more favorable terms to those with high credit ratings via lower point structures and interest costs.

Evaluation of Risk and Benefits for Investors 145

Ratio of debt to equity. Bankers prefer those borrowers .、ニ ost t三フニ^

power exceeds the demands of the payment schedule. The size or borrowing and its repayment should be well within the available resources. Bankers prefer to maintain a safe ratio of debt to capital.

Size of loan. Bankers prefer large loans because the administrative costs decrease proportionately to the size of the loan. Lenders must have adequate resources to entertain large loan applications. In addition, the borrower must have the capacity to consume a large sum of money.

Regular borrowing. Those who are regular borrowers build up a reputation which directly affects their ability to secure debt on beneficial terms.

Period of loan. Bankers take additional risk as the time period increases. To cover the risk, lenders charge higher interest rates for longer term loans.

Obtaining a favourable credit rating is a good option for business enterprises considering the problems they face in seeking finance. Rating agencies assess a firm’s financial viability and capability of honouring business obligations, providing an insight into its sales，operational and financial composition, and thereby assessing the risk element, all of which highlights the overall health of the enterprise. Some of the benefits that companies can derive are:

Faster avasiability of loans: Banks prefer an independent analysis of the facts and figures. Although some large bank have their own risk assessment departments, a third party’s assessment is also considered a favourable option and should be given due consideration.

increased credibility： Companies rated by rating agencies can achieve more credibility in domestic and international markets by providing the bank, customers and business associates with credible information about the company. This increases their confidence in the company and helps in increasing business and building better relationships.

Detailed assessment; The rated company receives a rating report from the rating agency that includes comprehensive details about the companyfs performance, as well as its strengths and weaknesses. This rating report can also be used by the company for other beneficial purposes. In addition, the rating report also serves as a guide to focus on areas of improvement and enables the enterprise to benchmark against competition.

Publicity： Names of the companies rated are listed on the websites of the rating agencies and in their brochures. This serves as a good source of publicity for the rated institutions and farther enhances their credibility. Banks, financial institutions and foreign counterparties can use the websites of rating agencies to identify and research companies in greater detail.

Part 7: Financial Systems and Policies


Chapter 1:Major Functions of Financial Policy in a Developing Country

Discuss the major functions of financial policy in a developing country

Discuss how the role of financial policy differs in a developing and a developed country

Chapter 2: Financial Intermediation

Define the concept of financial intermediation

Discuss the factors hampering financial intermediation and discuss its impact on the operation of a financial system

Chapter 3: Financial Disintermediation, Deepening, Repression and .Shallow Finance

Discuss the concept of financial

disintermediation Define the concept of shallow

finance Define the concept of financial

repression Define the concept of financial

deepening

Chapter 1

Learning Outcome

Major Functions of Financial Policy

Major Functions of Financial Policy in a Developing Country 147

PartSeven Financia! Systems and Policies

Major Functions of Financial Policy in a Developing Country

By the end of this chapter you should be able to: ■ Discuss the major functions of financiai policy in a developing country

■Discuss how the role of financial policy differs in a developing and a developed country

Successful development is not just the growth of productivity and per capita GDP, but also ensuring that the pattern of growth is inclusive, delivers broad-based improvement in the quality of life, and contributes to human development. This becomes even more important for a developing country. Financial policies that apply to and take account of the specific features and role of individual sectors,

must tailor those policies to achieve the objectives of both growth and human development.

Financial policies include both monetary policy in the conventional sense and other policies affecting banks and other financial intermediaries. Acquiring information and making transactions create incentives for the emergence of financial markets and insti tutions. Financial sy stems therefore serve one primary function: they facilitate the allocation of resources, across space and time, in an uncertain environment, and thereby can control transaction and information costs.

The financial sector can serve as a significant catalyst to growth by accumulating and investing the savings of different agents of varying economic strength and allocating the profits of these investments to different competing demands for funds. Given the incremental output that can be obtained from a unit of investment, growth in any period depends on the share of national income devoted to investment. Many factors influence the incentives to invest and, therefore, the level and structure of intended investments. However, some, or a substantial share, of those intentions may remain unrealized, even when potentially viable, because of lack of access to the capital needed to finance such investments or the insurance needed to guard against unforeseen risk. This has obvious implicationsfor growth.

Functions of Financial Policy in Developing Countries

In developing countries, financial policy should focus on the transformation of financial agents and markets into instruments of inclusive growth, while ensuring that their presence and/or operations do not render the system fragile and crisis-prone in the long run.

Financial policies are needed because financial markets are not like those for other goods and services. A loan or an insurance contract is not a


concurrent trade, but a payment made by one part in lieu of m or contingent return in the future.

Policies in developing countries must focus on the availability ofi to borrowers (of all types and sizes). Similarly, the system must availability of information which is central to the effective of financial markets. What kind of information needs to be av which groups of society? Savers need information on the via practices of financial intermediaries; intermediaries need info on the health and motivations of entities they lend to; and bo need information on the options they have when seeking

Over the last two to three decades, many developing countries, in attracting foreign capital flows, have liberalized policies govemm? presence and activities of foreign financial firms in their domestic sectors. One likely consequence that has received considerable att is an increase in financial fragility and the likelihood of currency financial crises. The impact on fiscal and monetary policy has r less attention.

Types and Impacts of Financial Policy

The implementation of financial policies can be divided into three

1. Definition and formulation of the main objectives and specifics^ of potential and immediate tasks that must be addressed to ac V goals for a certain section of society;

2. Identification of key areas of financial resources, and development methods, tools and concrete forms of organizational relationshf through which these objectives can be achieved in the shortest possM time, and so that immediate and long-term problems can be solved optimally;

3. Setting up of an organizational structure to implement the policy and instigation of the practical actions required to achieve the set goals. Naturally, the direct impact of financial policy on the economy begins only at the third stage/but the essential content of the policy is determined at the two previous stages.

Based on the tasks assigned to the financial policy (e.g.，maintenance of high employment, economic growth, equalizing the balance of payments, etc.) leading economists divide financial policy into three categories policy and economic growth (enabling), stabilization policies and the policy of restricting business activity (restrictive/contraction). Under the first, i.e. the policy of economic growth, a system of financial measures aimed at increasing the actual volume of gross domestic product and increased employment must be devised and implemented. Such financial incentive policies include:

Major Functions of Financial Policy in a Developing Country 149

If the government tries to maintain the volume of production at the level that is typical for the country, as well as maintaining price stability, it is considered that the state is pursuing a policy of stabilization. It would be wrong to assume that a stabilization policy automatically replaces a moderate financial policy in order solely to balance the economic situation in the country, as there are major differences between these two concepts.,

For example, a policy of economic growth may be appropriate at a time when， typically, a country has already exceeded the volume of production and production is approaching its full potential, while a stabilization policy would not be helpful in such a situation and might even restrict growth of production capacity.

A contractive or restrictive policy involves:Reducing government spending• Increasing taxes

SUGGEST GIVE EXAMPLES OF EFFECTS OF REDUCING GOVT SPENDING AND INCREASING TAXES ON ECONOMY OF A (DEVELOPING) COUNTRY

Fiscal consolidation or retrenchment, i.e. reduction in government spending and increase in taxes，has the following impact and effects:

• It typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand-consumption and investment-falls by about 1 percent.

• Reductions in interest rates usually support output during episodes of fiscal consolidation. For each 1 percent of GDP of fiscal consolidation, interest rates usually fall by about 20 basis points after two years.

• A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation. For each 1 percent of GDP of fiscal consolidation, the value of the currency usually falls by about 1.1 percent. The contribution of net exports to GDP rises by about 0.5 percentage point. However, developing countries may not be able to increase net exports at the same time.

• Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.

Chapter 2Learning Outcome

PartSeven Financial Systems and Polici

150 Financial Systems and Regulation I Reference Book 2

Financial Intermediation


■ Define the concept of financial intermediation

■ Discuss the factors hampering financial intermediation and its impact on the operation of a financial system

2. Market faflure protection: The conflicting needs of lenders and borrowers are reconciled, preventing market failure

The cost advantages of using financial intermediaries include:

1. Reconciling conflicting preferences of lenders and

borrowers

2. Risk aversion: Intermediaries help spread and decrease the risks

3. Economies of scale: Using financial intermediaries reduces the costs of lending and borrowing

4. Economies of scope: Intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)

Financial intermediaries provide important real services to the economy. The provision of these services has substantive implications for macroeconomic behavior. The basic premise is that, in the absence of intermediary institutions, financial markets are incomplete. This incompleteness arises primarily because of certain informational problems. By specializing in gathering information about loan projects, financial intermediaries help to reduce market imperfections and thus facilitate lending and borrowing. Accordingly, changes in the level of financial intermediation due to monetary policy, legal restrictions, or other factors, may have significant real effects on the economy. It is often argued that the severity of the Great Depression was due in part to the loss of intermediary services suffered when the banking system collapsed in 1930-33.

Chapter 3

Learning Outcome

Financial Deepening


partseven Financial Systems and Policies

Financial Disintermediation, Deepening, Repression and Shallow Finance "

By the end of this chapter you should be able to: a Discuss

the concept of financial disintermediation

■ Define the concept of shallow finance

■ Define the concept of financial repression

■ Define the concept of financial deepening

Financial deepening refers to the increased provision of financial senr with a wider choice of services geared to all levels

of society. The t also refers to the macro effects of financial deepening on the 1 economy. Financial deepening generally means an increased ratio money supply to GDP or some price index. It can also refer to liqrf money. The more liquid money is available in an economy, the morr opportunities exist for continued growth.

It can also play an important role in reducing risk and vulnerability for disadvantaged groups, and increasing the ability of individuals anc households to access basic services like health and education, thus having a more direct impact on poverty reduction.

Financial deepening and increased financial intermediation have their uses when economies develop and become more complex, but they are not virtues in themselves. In all economies, the value of financial proliferation depends on its ability to ease transactions, facilitate investment: and direct financial resources to the projects that yield the best social returns. This implies that there are financial systems and policies that shape these characteristics in the ways most appropriate for each country at specific stages of development. Autonomously evolved financial systems may not be the most appropriate, since they can reflect the imperfections and inequities of the economic base from which they emerge.

In practice, there are a number of reasons why autonomously evolved and unregulatedfinancial sectors can be inappropriate from a developmental point of view. For example， informal financial structures in backward and predominantly agrarian economies reflect the unequal distribution of assets and economic power and, because of the inter-linking of land, labor and credit markets, operate in ways that result in usurious money lending inimical to productive investment Similarly, autonomously evolved financial structures that reflect a high degree of interconnectedness between an oligopolistic industrial sector and a numerically small set of financial intermediaries are known to result in an excessive concentration of credit and in investment choices influenced by considerations that put at risk the savings of uninformed depositors. According to Diaz-Alejandro (1986:13-14)，"between 1975 and 1982，Chile went from a

Financial Intermediation 153

financially shallow economy, where inflation had wiped out the real value of debt，to an excessively financially deep economy where creditors owned a very large share of real wealth，a clear case of ,too much debt and too little equityf.,f This was because linkages "between banks andfirms, which were hardly arms' length, were responsible for the high use of debt by private firms. In Chile by late 1982 private firms were more indebted than state enterprises; within the private sector, extreme indebtedness was found among those that controlled banks. ” By late 1982， the two largest business groups in Chile controlled the principal insurance companies, mutual funds, brokerage houses, the largest private company pension fiinds and the two largest private commercial banks. Many banks had lent one quarter or more of their resources to affiliates. Such concentration of credit in related enterprises not only results in exclusion of other potential borrowers, but also in lending driven by criteria other than economic or even social returns and in overexposure that can lead to default [Reference: UNDESA - Financial Policies，Notes - 2007 by C.P. Chandrasekhar]

Financial Disintermediation

Disintermediation is the removal of intermediaries from a process, supply chain or market. The emergence of disintermediation is the natural course of free markets seeking the lowest cost overall and the most efficient use of resources. Financial disintermediation means withdrawal of funds from intermediary financial institutions. This situation exists when depositors withdraw their savings from financial institutions and invest the money directly in the market place. This is done usually because they can obtain a higher yield even though also running a higher risk of losing their money.

Shallow Finance

Lack of or stagnant growth of output of any country is often caused by "shallow finance". A shallow financial depth (FD) means that the range of financial assets for that country is narrow. It is a scenario that goes far in explaining why some developing countries have low or negative per capita growth rates. Under shallow finance, the real interest rate can be low or negative which discourages investment; governments have inadvertently adopted shallow finance by capping interest rates to encourage investment; however, capping the nominal interest rate will discourage saving (especially if there is inflation, which reduces the real interest rate); as a result, there is a both a shortage of investment funds and a misallocation of available investment funds.

In comparison， under deep finance, the real interest rate is positive, more funds are channeled through intermediaries, the signs of improvement are more positive, resources are better allocated and choice of technique is more efficient.

Financial Repression

Financial repression is a term used to describe several measures which governments employ to channel funds to themselves which, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt.


The term "financial repression” was first introduced in 1973 by S economists Edward S. Shaw and Ronald I. McKinnon. The term is to describe emerging market financial systems. However, the techniques were also used extensively in developed economies, partic after World War II and until the 1980s，when such direct govei intervention in markets fell out of favor.

Financial repression may consist of the following key eleme

1. Explicit or indirect capping or control over interest rates, such as government debt and deposit rates.

2. Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.

3. Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or by removing any incentives of alternative options that institutions might otherwise prefer.

4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

These measures allow governments to issue debt at lower interest rates than would otherwise be possible. A low nominal interest rate can help governments reduce debt servicing costs, while a high incidence of negative real interest rates liquidates or erodes the real value of government debt Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.

Giovannini and de Melo (1993) calculated the size of the financial repression tax for a 24 emerging market country sample from 1974-1987. Their results showed that financial repression exceeded 2% of GDP for seven countries, and greater than 3% for five countries. For five countries (India, Mexico, Pakistan, Sri Lanka, and Zimbabwe) it represented approximately 20% of tax revenue. In the case of Mexico, financial repression was 6% of GDP, or 40% of tax revenue.


Chapter 1:Importance, Scope and Impact

Discuss the importance and scope of financial sector reforms

Describe how these reforms impact the overall workings of a financial system

Chapter 2: Deregulation and Liberalization of the Financial Sector

Define what is meant by deregulation and liberalization of the financial sector

Discuss the concept of and rationale behind deregulation and liberalization of the financial sector


Chapter 3: Globalization: Integration with Global Financial Sector

Define the concept of integrating a country's financial system with the global financial sector

Discuss the pros and cons of such integration

Chapter 4： Privatization of the Banking Sector

Define the concept behind privatization of the banking sector

Discuss the changes this action brought about in the overall dynamics of Pakistan's financial and economic arena

Discuss which banks are privatized


Chapter 5: Strengthening of Supervisory Controls: SBP's role

Discuss SBP's role in overall strengthening of supervisory controls with respect to the performance of the financial system

Chapter 1

Learning Outcome

Reform of the Financial Sector in Pakistan

157Importance, Scope and Impact

part Eight Financial Sector Reforms

Importance, Scope and Impact

By the end of this chapter you should be able to：

■ Discuss the importance and scope of financial sector reforms

■ Describe how these reforms impact the overall workings of a financial system

Banking in Pakistan has largely been dominated by government-owned institutions and has accommodated the financial needs of the government, public enterprises and the private sector. Public sector dominancy，among others, led to inefficiency in the banking sector. The economic efficiency of the

banks remained low so that a low level of savings and investment in the private sector resulted in low growth. These problems include concentrated ownership of financial assets， high taxes, and a narrow range of products.

The reform of the financial sector in Pakistan should be examined in a macroeconomic context, against the backdrop of the overall strategy of reforms implemented during the last decade and the strengthening of the Central Bank’s capacity to regulate and supervise the financial sector. It was only when the macroeconomic situation took a turn for the better that structural reforms were vigorously pursued and the State Bank of Pakistan achieved autonomy and competence that the financial sector began to show some demonstrable results. Without these pre-requisites in place， it is hard to imagine whether any meaningful progress could have been possible. Banking sector reforms cannot be successfully implemented and sustained in the absence of a favorable and stable macroeconomic environment. Pakistan’s track record in macroeconomic management and governance during the 1990s was dismal.

A strong regulatory and supervisory system is extremely vital to cope with financial crises and promotes the efficient functioning of financial markets. Therefore the challenge is to formulate an appropriate regulatory framework that enables the banking system to be more resilient to insolvency. In addition, timing, sequencing and speed of restructuring measures are very important.

Financial sector reform usually refers to two distinct but complementary types of change that are needed in order to establish a modern financial system capable of acting as the ’’brain of the economy” and allocating the economy’s savings in the most productive way among different potential investments. First is the liberalization of the sector: putting the private sector rather than the government in charge of determining who gets credit and at what price. Second, establishing a system of prudential supervision designed to restrain the private actors so that we can be


reasonably sure that their decisions will also be broadly in the social interest. Liberalization without supportive arrangements for • supervision can easily lead to anti-social behavior by bankers, of the referred to as "looting and gambling". This provides a parac% example of the more general proposition that establishment of a economy requires a change in the role of government rather tzm elimination of all government action, with the new role being one focuses on providing an environment within which the private can act effectively.

Chapter 2

Learning Outcome

flight Financial Sector Reforms

Deregulation and Liberalization of the Financial Sector 159

Deregulation and Liberalization of the Financial Sector


鐵 Define what is meant by deregulation and liberalization of the financial sector 級 Discuss the concept of and rationale behind deregulation and liberalization of the financial sector


The other half of the intermediation function is to select those borrowers who will receive credit. In a repressed financial decision is largely made by the government, while in the market it is made by bankers. It is important to understand that one docs want banks to lend to those who promise the highest returns, for will almost always be the most risky borrowers. Nor should they lend to the least risky, for the most rewarding investment prospects inevitably involve some element of risk. The ideal is to lend to those offer the prospect of a good return, given the risk involved. One a bank to be free to charge an interest rate that reflects the riskiness each particular loan, and then make a prudent portfolio choice that bring it a good overall return for a modest level of risk, after limi' risk by choosing a diversified portfolio.

Consider next the rationale for free entry into the banking sector, is very similar to the rationale for free entry into any other sector- threat of actual or potential competition keeps the interest spread and disciplines banks into operating efficiently, and eliminates any that are not capable of keeping up with current standards of effici The entry of foreign banks can bring modem techniques into the in&Free entry avoids political favoritism being used to award rents to fri However, there is also a serious intellectual case against free entry, W " stems from the notion that a substantial positive franchise value ind self-discipline in lending. The argument is that a bank that does not a stake in being able to continue to lend in the future will have incentive to make risky loans, taking gambles that will yield it big if things turn out right but impose big losses on others (the govern or depositors, depending on whether bank deposits are effectively guaranteed or not) if things go wrong. But if it knows that it can expect to earn a stream of quasi-rents from its reputational capital in the future it will not risk its reputation. Prudence may thus suggest maintaining a balance between the benefits and the costs of early action to permit free entry.

This seems an appropriate place to acknowledge that one other restrainl on financial liberalization has sometimes been advocated in the interest of maintaining a positive franchise value of the banks. This is to place a ceiling on the interest rate that banks are allowed to pay on deposits. An interest rate modestly below the competitive level will increase the profitability of banking, and thus the franchise value of the banks, without having much effect on saving (though it will make savers somewhat worse off). If the ceiling is set equal to the treasury bill rate, such a regulation will also prevent banks bidding for deposits by offering more than the risk-free interest rate, an offer that can only be justified on deposits if they are recognized to be risky or else if effective deposit insurance provides a subsidy to the bank.

Bank Autonomy

The case for bank autonomy is straightforward. One cannot expect bankers who are not allowed to manage their own banks by deciding whom to appoint, and how much it is necessary to pay to motivate and retain good staff，to take responsibility for the outcome of their operations. One wants


bankers to make their own decisions, guided perhaps by general rules, but making inherently discretionary decisions like these for themselves so that the responsibility for bad outcomes is unambiguous.

Privately-owned banks will necessarily have autonomy, which is a part of the case for privatizing banks. Another consideration is that a publicly- owned bank may be subject to pressure to allocate loans according to the political interests of governing politicians rather than in accordance with commercial considerations. But perhaps the most important consideration stems from a different role of banks. Allocating lending between alternative prospective borrowers is only part of their job: they also need to monitor the use made of their loans to maximize the probability that they will be repaid on time.

In some countries, this monitoring is done in an arms’ length way. A bank is able to observe the cash flow of its borrowers, and can threaten not to renew loans falling due if they see a borrower’s financial position weakening. This pressures the borrower into cutting back its activities. In Germany and Japan, in contrast, banks play an active role in the corporate governance of their major borrowers, with bankers often sitting on company boards，thus permitting them to play a direct role in steering the policies of their borrowers in a way that will ensure they can maintain debt service. The relative virtues of these two approaches remains an unresolved issue, but some economists who believe that the Anglo-Saxon model is the most suitable one for advanced countries also believe that the German-Japanese model is preferable for countries where financial talent is spread thinly and hence most effectively deployed by placing qualified bankers on a number of company boards.

These measures are meant to maintain stability of the financial system so that the overall economy of the country can be stabilized. One of the fears voiced by early critics of financial liberalization was that, in the absence of the right to decree credit ceilings, the central bank would have no effective policy tool with which to limit bank lending, resulting in a loss of monetary control and hence macroeconomic instability. These fears have not been realized in most countries that have liberalized their financial system. On the contrary, most countries have found that after a rather short space of time they were able to utilize indirect methods of monetary control (i.e. open-market operations, management of an official discount rate， and perhaps variations in reserve requirements) to maintain more sensitive monetary control than had proved possible with the old direct methods，in which bankers so often had an interest in circumventing their orders.

Prudent Supervision

Banks cannot be allowed a free hand in maximizing profits. One reason stems from the unusual balance sheet of banks, coupled with the problem of asymmetric information. Because banks have a high debt/equity ratio, a relatively small loss of debt service can push a bank into a position of possible insolvency (negative net worth). Unless the bank has a high franchise value stemming from an expectation of being able to make a stream of profitable loans in the future, this creates an incentive for a


The other half of the intermediation function is to selea borrowers who will receive credit. In a repressed decision is largely made by the government, while in the it is made by bankers. It is important to understand that want banks to lend to those who promise the highest r ニ will almost always be the most risky borrowers. Nor should lend to the least risky, for the most rewarding investment pi

： inevitably involve some element of risk. The ideal is to lend offer the prospect of a good return, given the risk involved. a bank to be free to charge an interest rate that reflects the each particular loan, and then make a prudent portfolio bring it a good overall return for a modest level of risk, after risk by choosing a diversified portfolio.

Consider next the rationale for free entry into the banking is very similar to the rationale for free entry into any other threat of actual or potential competition keeps the interest ベ and disciplines banks into operating efficiently, and eliminates that are not capable of keeping up with current standards of The entry of foreign banks can bring modem techniques into the'Free entry avoids political favoritism being used to award rents to However, there is also a serious intellectual case against free entrj; stems from the notion that a substantial positive franchise value 雄 self-discipline in lending. The argument is that a bank that does a stake in being able to continue to lend in the future will incentive to make risky loans, taking gambles that will yield it big if things turn out right but impose bigjosses on others (the gov< or depositors, depending on whether bank deposits are effc guaranteed or not) if things go wrong. But if it knows that it can to earn a stream of quasi-rents from its reputational capital in the fi it will not risk its reputation. Prudence may thus suggest mainta—ip ， balance between the benefits and the costs of early action to permit す」 entry.

This seems an appropriate place to acknowledge that one other r on financial liberalization has sometimes been advocated in the int of maintaining a positive franchise value of the banks. This is to placse a ceiling on the interest rate that banks are allowed to pay on deposits. Am interest rate modestly below the competitive level will increase the profitability of banking, and thus the franchise value of the banks, without having much effect on saving (though it will make savers somewhat worse off). If the ceiling is set equal to the treasury bill rate, such a regulation will also prevent banks bidding for deposits by offering more than the risk-free interest rate, an offer that can only be justified on deposits if they are recognized to be risky or else if effective deposit insurance provides a subsidy to the bank.

Bank Autonomy

The case for bank autonomy is straightforward. One cannot expect bankers who are not allowed to manage their own banks by deciding whom to appoint, and how much it is necessary to pay to motivate and retain good staff，to take responsibility for the outcome of their operations. One wants


banker to engage in what is known as "gambling for redemption，，. As a private banker sees it, his only hope of remaining a banker is to make high-risk， high-return loans. If the loans pay off， his bank will be solvent again ("will be redeemed”). If the loans go bad, he will be no worse off ， since his bank will still go bust. Thus all the potential gains accrue to the banker and all the losses fall on someone else (the government if bank deposits are guaranteed either explicitly or because the bank is judged ’’too big to fail ’，，or the depositors otherwise). A banker faced with these incentives would be irrational if he did not gamble with his depositors’ money. Moreover, it is usually not obvious to outsiders when this first occurs (this is the asymmetric information), so that in the absence of prudential supervision there is no one to stop him gambling for redemption. Even a supervisor may have difficulty in judging whether new loans are being extended defensively rather than in support of promising new investment opportunities.

A second reason why supervision is needed is that private bankers would often be tempted to lend to themselves or their friends in the absence of any restraint, and again usually nobody would be any the wiser until it was too late, because of asymmetric information. Such "looting” (lending to oneself or onefs friends without a reasonable expectation of repayment) can arise for several reasons. At the crudest, it may reflect an inability on the part of the banker to distinguish between funds entrusted to him as deposits and his own personal property, but it need not be that crude. It may happen because other enterprises in which the banker happens to have an equity stake are running into hard times，and the only hope he can see of saving them is to extend credit from his bank (this was an important factor in Argentina during their first liberalization attempt in 1978-82). Or it may result from a very human tendency to be over- optimistic about the probability that one’s own investment projects, or those of onefs friends, will turn out well. Whatever the reason, experience has shown that banks are all too likely to be subject to looting in the absence of supervision.

A supervisor can help avoid such situations arising in several ways. First, he may know more about the bank's situation than outsiders can normally be expected to know，which may enable him either to restrain the bank from making additional risky loans, or restrain it from paying dividends ， or even to force it into making only specially safe loans (e.g. lending only to the government), when its net worth deteriorates. (This is known as requiring ’’prompt corrective action”.） Second，he can require the bank to maintain a prescribed level of capital relative to its loans (such as the Basel minimum 8% capital adequacy standard), which means that there is an equity cushion before gambling for redemption becomes a rational policy choice，and again require prompt corrective action if capital falls below that level. In order to police whether a bank is maintaining adequate capital,a supervisor will want to satisfy itself that the bank is using appropriate accounting standards. Third, the supervisor may require the publication of certain information in order to increase transparency and diminish the information asymmetry. Fourth, he will limit the amount of insider lending that is permitted, and will conduct spot checks on the books of the banks in an attempt to ensure that those rules are observed. A bank with a positive franchise value will find it in its own interest to


act in the ways that are being prescribed by the supervisor. The is that it will avoid the threat that supervisory action can continuation of the profitable lending. Conversely, however, a is on the edge may seek to mislead the supervisor, so as to be engage in gambling for redemption (risky lending) in the hope will be able to recover. This illustrates the importance of having 丨 strong banking system in which the franchise value of most of the is distinctly positive, as well as a strong supervisor who is in a jr to identify the occasions when a bank is close to the margin and may be tempted to gamble or loot.

Most often the task of supervision is assigned to the central bank, would seem to have some advantage in this role，akin to that commercial banks have in monitoring borrowers. That is, the bank has daily knowledge of the credits and debits of each bank, hence may be in a position to get some early warning when thi starting to go wrong. But several countries have in recent years the task of bank supervision to a distinct specialized agency, which that there is no overwhelming reason why this function needs to with the central bank if there is some important institutional pointing in the opposite direction.

The central bank also has a key role in forestalling one other pro that can arise in a private banking system. Because the liabilities of are much more liquid than most of their assets, especially loans to private sector, a bank can experience a run if lenders come to doubt ability of the bank to continue honoring its obligation to pay de on demand. If those suspicions arise because the bank，s solvency is y then the central bank has a difficult decision as to whether it should out the bank or not. But if the run reflects simply liquidity pressure then the classic response is for the central bank to act as lender of last resort, lending freely (though at a penal interest rate). It is important to have a central bank able to play this role if the banks are to feel secure in their role of maturity transformation.

[Source-1: Financial Sector Reforms and the Efficiency of Banking in Pakistan by Abdul Qayyum, PIDE. Year: Presented at the 8th Conference of SANEI，2007}

[Source-2: FINANCIAL SECTOR REFORMS IN PAKISTAN by Dr. Ishrat Hussain, ex-Governor SBP. Year: Paper read at Italy-Pakistan Trade and Investment Conference, Rome on September 28，2004]

[Source-3: The rationale for financial sector reform by John Williamson, Peterson Institute for International Economic, a speech given at the "Workshop on Financial Sector Reform" dated September 1999 sponsored by the US-Nepal Chamber of Commerce,http://www.iie.com/publications/papers/paper.cfm?ResearchID=355]

http://www.iie.com/publications/papers/paper.cfm?ResearchID=355

Chapter 3

Learning Outcome


Globalization: Integration with Global Financial Sector 165

Globalization： Integration with Global Financial Sector


_ Define the concept of integrating a country's financial system with the global financial sector

« Discuss the pros and cons of such integration

The concept of integrating a country's financial system with the global financial sector

The world has become a global ”village” and no country can progress independently without becoming involved in and affected by the international "community”• Economies of countries are now so interdependent that a good or bad market situation in one country affects the financial sector of others. Financial globalization means that the domestic financial system of one country is very much linked into global financial markets and institutions. The degree of connectedness of financial markets around the world has increased considerably during the past three decades. A key factor underlying this process has been the increased globalization of investments seeking higher rates of return, although this also means an increased exposure to risk globally. Therefore, from one perspective gloDaiization is advantageous but from another it can be seen as having some negative impacts. The impact of the failure of Lehman Brothers in America ， for example, had a significant disastrous effect on a number or large banks in Europe and Asia. It is said that Lehman Brothers’ bankruptcy played a major role in the escalation of the global financial crisis in 2008.

Financial globalization has caused dramatic changes in the structure of national ana international capital markets. The most important change was in the banking system, which went through a process of disintermediation. This was a market change of a fundamental nature. As financial globalization progressed, the presence of international financial intermediaries has expanded considerably. This applies more to international commercial banks than to investment banks, insurance companies and mutual funds. The increase in the degree of integration of world capital markets has been accompanied by a significant rise in private capital flows to developing countries.

Pakistan

The Pakistan financial sector, i.e. equity and related exchange-traded derivatives markets, are close to international standards. Global financial market conditions are favorable for Pakistan if we control our law and


order situation. The basic elements of any competitive market, equally relevant for an efficient Pakistani financial se

•There should be a sufficient number of buyers and sellers, that * numbers of market participants should be price-#5

• The primary market (for all issuance) should have a large n participants;

•Valuations in the secondary market should be clear and liquid to allow easy exit by both domestic and foreign partici

• The bid-ask spreads in the secondary markets should be

On the other hand, compared to some other countries, Pakistan’s fi sector is relatively small. Intermediation costs in banking are high the productivity of investments needs to be improved. Corporate markets are underdeveloped and well behind international comp: Government should take confidence-building measures to bring investors into the market.

Pros and cons of integration of country's financial system the global financial sector

Advantages

The arguments for supporting financial openness are summarised in following four main points:

•The advantage of worldwide risk diversification.

• Inflow of capital which results in domestic investment and grow

• Enhanced competition which increases efficiency，as well as enfordi stability.

* Enhanced opportunities for local financial systems to have access in foreign banks and financial institutions.

Risk diversification

With access to world capital markets, risk can be shared, allowing the country to borrow during a recession or crises and lend surplus funds in fgoodT times. Through financial integration, goods of basic needs can be shipped to the places where these are required, and thus contribute to domestic households' consumption, and increase welfare.

Inflow of capital

Inflow of capital allows access of foreign investment to the domestic market which results in a rise in domestic investment and economic growth. In many underdeveloped countries, the capacity to save is low due to the low level of income.

Globalization: Integration with Global Financial Sector 167

The benefits of large capital inflows, or foreign direct investment (FDI) ， are an increase in production and the creation of new job opportunities. In addition to this direct effect on growth, FDI may also have major indirect long-term effects. The liberalization of international portfolio capital flows may lead to higher rates of economic growth because they have the capacity to accelerate the development of domestic equity markets and that, in turn, may lead to increased productivity.

Increase efficiency, as well as stability

Countries which follow more closely controlled macroeconomic policies have the means to increase efficiency and economic stability which can also lead to higher rates of economic growth. An open economy where there is less restriction on capital inflow and outflow may also encourage macroeconomic and financial stability, ensuring a more efficient allocation of resources and higher rates of economic growth.

Enhanced opportunities for domestic institutions to have access to foreign banks and financial institutions

Financial openness usually results in an expansion of domestic financial markets. Foreign bank access to the domestic market may improve the quality and availability of financial services, by increasing the degree of competition and enabling the application of more refined banking techniques arid technology. In addition, foreign banks may also contribute to an improvement in the overall quality of the loan portfolios of domestic banks.

Disadvantages

In addition to the potential benefits just discussed, open financial markets can also have significant negative impacts.

Uneven policies of capital flow by developed countries It is true that periods of ’surge’ in cross-border capital flows tend to be highly concentrated in a small number of beneficiary countries. The dramatic increase in capital inflows in the last two decades was directed to only a few middle-income countries. Thus, a number of developing countries, particularly the small ones, were ’left out，of world capital markets, despite the fact that their policies were very friendly toward foreign investment.

Threat to local investors and industryThere is a well-known saying that the shadow of big trees affects the growth of the small trees and plants. Foreign Tgiantsf sometimes do not allow local industries to grow, and the local industries neither have the resources nor the technology to compete with them.

Furthermore, in countries where the financial system is weak, i.e. banks with low net worth and a low ratio of capital to risk-adjusted assets, direct or indirect intermediation of large amounts of funds by the banking system may aggravate the moral problems associated with the business.


Loss of economic stabilitySometimes large capital inflows result in undesirable ma effects, including rapid monetary expansion, inflationary pn exchange rate appreciation, and increasing current account defkm. a flexible exchange rate, growing external deficits are likely to bring currency depreciation, which may eventually lead to unacceptabk rises and inflation.

On the other hand, under a fixed exchange rate regime, a F competitiveness and growing external imbalances can result in a confidence in the local currency which in turn results in inr financial instability.

Instability of capital flowsA high degree of financial openness may favor a high degree of ¥ in capital movements. A higher level of short-term debt is related to borrowing country’s foreign exchange reserves. An outflow of ■ investment will result in draining the foreign exchange reserves, and also create risks of bank runs and general financial crises. Short * capital flows tend to be more unstable than longer-term flows, and more conducive to financial crises occurring.

Negative aspect of the presence of foreign banksThere is no doubt that foreign bank access can yield several types benefits, but it can also have some potentially negative effects. For g foreign banks may allow credit to small firms to a lesser extent domestic banks, and concentrate instead on larger corporate firms stronger companies. If foreign banks follow a strategy of concentn their lending operations only on the most creditworthy corpo borrowers, their presence will be less productive and will not contrf significantly to an overall increase in efficiency and development in thr financial sector.

Learning Outcome

Privatization

Financial Sector Reforms

Privatization of the Banking Sector 169

Chapter 4 Privatization of the Banking Sector


« Define the concept behind privatization of the banking sector

« Discuss the changes this action brought about in the overall dynamics of Pakistani financial and economic arena

麗 Discuss which banks are privatized

Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector (the state or government) to the private sector (businesses that operate for a private profit) or to private non-profit organizations. In a broader sense, privatization refers to transfer of any government function to the private sector - including governmental functions like revenue collection and law enforcement.

Privatization of the Banking Sector

The privatization of the banking sector means the end of government ownership and control in the banks and how they are managed. The case for bank autonomy is straightforward. Bankers who are not allowed to manage their own banks cannot be expected to decide whom to appoint ， or how much it is necessary to pay to motivate and retain good staff， or to take responsibility for the outcomes of their operations. Bankers want to take responsibility for making their own decisions, guided perhaps by general rules， but making inherently discretionary decisions like these for themselves, along with the resultant consequences of their actions. Privately-owned banks will necessarily have autonomy, which is part of the case for privatizing banks. Another consideration is that a publicly- owned bank may be subject to pressure to allocate loans according to the political interests of governing politicians rather than in accordance with commercial considerations.

Privatization of the Banking Sector in Pakistan

Privatization of government-owned banks and other liberalization measures were the cornerstone of the financial sector reforms initiated in the early nineties in order to revitalize the entire financial system of the country. As part of this policy， in 1991 two of the publicly-owned banks，the Muslim Commercial Bank (MCB) and Allied Bank (ABL)，

were privatized. At the same time, permission was granted for the


setting up of new banks in the private sector, with 10 new banks being granted licenses to commence their operations in 1991. Consequently, towards the end of 2002， the structure of the banking sector in Pakistan had

Privatization of the Banking Sector 171

changed considerably (see Table 1)as a result of the liberalization policies pursued as part of the broader pi sector reforms. The share of public sector banks in the assets i system was reduced to just 41 percent by 2002 compared to i in 1990，while that of private banks had reached over 45 ] from nil in 1990. Similarly, the share of public sector banks i base of the banking system was reduced to 43.5 percent j in 1990.

Generally, the case for privatization of state-owned enterprises I can be grouped around three main themes, i.e., competition, intervention and corporate governance. The competition ar that privatization will improve the operation of the firm and the i of resources in the economy，if it results in greater competition. Pm^dflol can improve efficiency even without changing market structuir ? hinders interventions by politicians and bureaucrats who wouW 1 use the SOEs to further their political or personal gains. It is also. that corporate governance is weaker in state-owned enterprises i private firms because of agency problems, and also because of the i incentive structure for managers to perform efficiently. They do noil a market for their skills or the threat of losing their jobs for performance.

Different authors have researched the present comprehensive analysis the pre- and the post-privatization performance of privatized banks; their rival banks in low- and middle-income countries. No signi evidence of improvements in the privatized banks，post-privatizat performance could be found. In fact, the privatized banks have a his proportion of bad loans and appear to be overstaffed relative to tl rivals, in the post-privatization period. The continued government; ownership of privatized banks is found to be responsible for their underperformance, as it hinders managers，ability to restructure them effectively.

Privatization has to be seen in the overall context of the respective roles of the state and markets. The state has to be strong to combat the excesses of the market and cope with market failures. It is not that the state should

Table 1.Dynamics of the Banking SectorNumber Amount (Rs. Billion)

1990 2002 1卿 2002 1990

Assets

Public

7 5 392J 877.6 922

Private - \6 * 968.3 -

Foreign 17 17 33.4 280.9 7ぶ

Total 24 38 425.6 2126.8 100Deposits

Public

7 5 329.7 721.9 93

Private • 16 * 754.2 .

Foreign 17 17 24.9 184.1 7

Total 24 3S 354.6 mo.2 100Source: State Bank of Pakistan (2000) and (2(K)2)


play a lesser or reduced role but a different role in so far as it provides an enabling environment for equitable development and creates the necessary conditions for growth through investment in human development and infrastructure.

The govemmenfs effective role in regulating and monitoring the market has to be strengthened to promote healthy competition and avoid the rigging of the market by a few. Markets are the best known vehicle for efficient allocation and utilization of resources and thus the decisions as to which goods and services to produce, and how much to produce. Distribution and trade can be handled much better by the private sector and not left in the hands of the bureaucrats. This division and redefinition is also essential to reduce corruption and generate sustained and equitable growth in the country. Market-based competition, privatization of public banks and a strong regulator have successfully reformed the banking sector in Pakistan during the last few years and this model should be replicated elsewhere in the economy.

After the reforms in the banking sector，most of the indicators of bank performance have showed significant improvements, evident in enhanced competition, mainly influenced by liberalization, deregulation, and institutional strengthening measures. In particular, the deregulation of controls on banking operations has instilled the zeal for competition in the banking sector.

Table 2: Impact of Liberalization, Deregulation, and institutional strengthening measures on Bank's Performance

Do non Not Skghdy H^ity ____Know Signifies* Sipoificant Simificant Significant

[Source： PIDE Working Paper on Impact of Financial LiberalisationandDeregulation on Banking Sectorin Pakistan"]

1 Lowered admimstrativeejqjeiises

3 hoptoved bad dd>t portfolio4 Increased profitability5 Icgjroved iiitem^diatiooinefficienci^6 Increased recovery of loans7 Adc^>ted mtematioQal

U7.70.07.70.00.0777715

15.430.87.7 0.0

7.77.70.00.0

0.0

0.0

00

0.0

7.70.00.0

0 0

0.0

0.0

46.230.815.4 0.0

7.715.47.77.7

7.77.715.47.7 15 4

15.430.830.8

7.7

11

5 8

8 2

2 2

99

38.见订

46

.007

6.76

0.07.7 30853.823115.415.415.411

30

.8

15

.4

23

.123.130.8

7.

7

7.

7

?.?

practices

9 Became more regulationcotaphaoX10 Adopted soimd bahldiigpractices11 Became moi^ accountableand trax 钱

parent12 Updated technology in

2 2 5 2 2 级矽 6

146

46

13 Io^roved professional skills14 Adopted good govemaoceI^actices15 Nopolitiad iofiuexice16 No desual of access to bankcredit17 Cr^lit decisioas based on

4 I

15.4

15.4

7

.7

18 Operate under competimt ravircmment

9


Those banks which adopted best practices became more credit disbursements, implemented SBPfs prudential rq faced less political interference in lending decisions. Similarty. bankers who now believe that a significant improvement has place in key areas of banking operations, including recovery accountability and transparency in policies, up-grading of IT sy reduction in intermediation inefficiencies of banks. In par* measures taken in 1997 and onward have impacted significanllf soundness and ’’health ’ ， of banks. The freedom given to banks to their own HR policies has also helped in strengthening staff skills hiring of professionals and capacity building of officials at indu •

The banks are now operating in a relatively more competitive env' as a consequence of financial liberalization, removal of qu controls/restrictions on bank operations, as well as other compl measures. If compared with the pre-reform period, denial of bank credit has also reduced significantly. However, this does not to equitable distribution of bank credit, which is still more skewed manufacturing sectors, despite its relatively small share (16 per real GDP.

With regards to a reduction in the number of "bad” portfolios banks, it is noted that the quality of portfolios has improved signi particularly after implementation of the BASEL framework and relevant measures. The corporate governance of banks has also imr significantly, largely due to the issuance of a code of conduct and guidelines concerning good governance. Profitability of NCBs has noticeably improved following privatization with the promulgation encouragement of a more competitive environment in the banking s.The privatization of banks has also resulted in less political interfe which has induced improved performance in a competitive envirom This aspect is important as too much intervention by the govern prior to the implementation of reforms, caused deterioration in efficiency of nationalized banks. Reduction in administrative costs banking spread are the two areas where banking sector reforms have impacted significantly.

The ownership structure of state-owned banks has changed significandy with amendments in the Banks (Nationalization) Act, 1974 in 1991- Before privatization, the government held 100 percent asset shares of NCBs. As a corollary to this factor，the government was accustomed to interfering in NCBs’ banking affairs in the pre-reform period. According to respondents, most of the financial problems of NCBs were due to the state-controlled structure of banks. With the implementation of the decision regarding the dilution of government equity in NCBs, the government’s asset share in nationalized banks decreased from 100 percent in 1990 to less than 50 percent in 2006.

Changes in the ownership structure of privatized banks impacted positively on their role and areas of business and this in turn resulted in a positive effect on their performance overall. Besides privatization, financial liberalization, institutional strengthening, and other complementary measures also played a significant role in improving overall efficacy.

There was too much governmental interference in the operational affairs of nationalized banks in the pre-reform period. The purpose of such intervention was to divert the financial resources of nationalized banks towards the achievement of the government's economic targets. Additionally, with the change in the mechanisms of monetary and credit management, the privatization of NCBs, the abolition of the Pakistan Banking Council, grant of autonomy to the SBP in its operational decisions ， and the implementation of the BASEL framework, banks' discretionary power to make lending decisions has been substantially enhanced.

0.07.7 30853.823115.415.415.411

30

.8

15

.4

23

.123.130.8

7.

7

7.

7

?.?


Privatization of Commercial Banks in Pakistan

The privatization of commercial banks in Pakistan started to happen in the 1990’s when two major Pakistani banks were privatized - MCB and ABL in 1999，and the process for HBL and UBL was completed in 2002.

Name of Bank Year of

Privatization

Transfer of Ownership

r 妒て ■■ • i** S - X ' ASK .五へ .ふ * «V..

Allied Bank Limited (ABL) 1991 Employees of ABL

Habib Bank Limited (HBL) 2004 Aga Khan Fund for Economic

Development

United Bank Limited (UBL) 2002 Abu Dhabi Group/Best way Group

[Source-1: The rationale for financial sector reform by John Williamson, Peterson Institute for International Economics, a speech given at the ’’Workshop on Financial Sector Reform" dated September 1999 sponsored by the US-Nepal Chamber of Commerce,

http://www.iie.com/publications/papers/paper.cfm?ResearchID=355]

[Source-2: SBP Research Bulletin 一 Volume 2，Number 2, 2006 一

The Effect of Privatization and Liberalization on Banking Sector Performance in Pakistan by Umer Khalid [Research Dept, SBP],

http://www.sbp.org.pk/research/bulletin/2006/vol2num2/Privatization_ Liberalization_of_Banking_Sector_in_Pakistan.pdf]

[Source-3: Address by Mrlshrat Husain, Governor of the State Bank of Pakistan, at the 11th Get Together of the Overseas Universities Alumni Club and the 21st Century Business & Economics Club, Karachi,12 August 2005

http://www.bis.org/review/r050829c.pdf]

[Source-4: PIDE Working Paper on “Impact of Financial Liberalization and Deregulation on Banking Sector in Pakistan，，，2010，

www.pide.org.pk/pdf/Working%20Paper/WorkingPaper-64.pdf]

http://www.pide.org.pk/pdf/Working%20Paper/WorkingPaper-64.pdf

http://www.bis.org/review/r050829c.pdf

http://www.sbp.org.pk/research/bulletin/2006/vol2num2/Privatization_

http://www.iie.com/publications/papers/paper.cfm?ResearchID=355

Chapter 5

Learning Outcome

SBP's role in strengthening of supervisory controls



Strengthening of Supervisory Controls： SBP's role


_ Discuss SBP's role in overall strengthening of supervisory c with respect to the performance of the financial system

The State Bank of Pakistan (SBP), as per its legal mandate, is en with the responsibility of securing monetary stability and soun ， the financial system. The monetary policy objective of price し includes financial stability as a secondary objective, which in turn the soundness of the financial system. Thus, SBP maintains fin stability in its dual role of being a central bank and also regulator of banking sector.

Ensuring the Stability of the Banking System Strengthening of Capital Adequacy Regime

The State Bank of Pakistan follows a policy of maintaining large adequately capitalized banks. In view of the global slowdown in gr and capital accumulation by financial institutions, the minimum up capital (free of losses) requirements for banks were revised downw in April 2009. Local/domestic incorporated banks were required to maintain a minimum paid-up capital (free of losses) of Rs. 6 billion by December 31，2009 and increase it gradually to Rs.10 billion by December 31，2013. Banks and DFIs were asked to maintain a Capital Adequacy Ratio (CAR) of at least 10 percent. Growing regulatory capital requirements are primarily aimed at promoting sound， prudent, and solvent financial institutions. The risky nature of banking business，especially in the contemporary context of global financial crisis, demands a more vigilant approach to regulating and monitoring financial business. The higher capital requirements are helping to keep in check the burgeoning growth of small and less viable financial institutions.

Despite the slowdown in economic growth and bearish capital market conditions, the industry witnessed improved solvency during FY10. Some banks, which were short of MCR, have managed to survive by way of injections of capital from their sponsors while more such investments were waiting in the pipeline. Merger and acquisition transactions are also in progress, which, when complete, should result in stronger, solvent banks. The solvency ratio of the entire banking industry remained in a comfortable zone at 14 percent in CY09. The CAR of the majority of banks remained much higher than the required level of 10 percent, which shows their capability of meeting future



challenges and achieve sustainable growth. A few banks, falling short of the required CAR, are under the prudent and continuous vigilance of SBP.

175

Strengthening of Supervisory Controls： SBP's role

Developments in the implementation of Basel ll/lll

The capital adequacy regime in Pakistan moved towards Basel II in June 2006. Starting with a parallel run of one and a half years, the capital requirement on the basis of Basel IIfs simplest approaches was made mandatory for all banks and DFIs operating in Pakistan from January 2008. However, the transition to more advanced approaches was made discretionary in June 2008, and those institutions planning to adopt these advanced approaches within the next five years were advised to submit their action plans to SBP. Further, to establish a mechanism of risk-based capital assessment in the institutions, guidelines on the Internal Capital Adequacy Assessment Process (ICAAP) were issued in August 2008. Banks were given flexibi 時 to adopt any available capital assessment methodology based on their size， nature, and complexity of their operations. While the adoption of advanced approaches is still optional, SBP has been following a policy to improve internal risk management within banks. In this regard， banks/DFIs were advised to put in place Internal Credit Risk Rating Systems and report the ratings of all corporate borrowers in eCIB. Similarly，in respect of consumer loans, banks were advised to start scoring all applicants. The reporting of consumer scoring is now mandatory. Operational risk is another area of importance for SBP. SBP is currently considering various options to help banks adopt sophisticated measures to assess and manage their operational risk.

The recent global financial meltdown has revealed a number of grey areas relating to regulation and supervision of financial institutions. The Bank for International Settlements (BIS) and supervisory authorities across the world are in the process of introducing a number of reforms to ensure overall financial stability. BIS has introduced minimum global standards for liquidity risk and strengthening the resilience of the banking sector. The fully calibrated set of standards is targeted to be implemented by end 2012.

Stress Testing

To assess the resilience of banks to exceptional but plausible shocks, SBP has been conducting sensitivity-based stress testing using individual banks’ portfolios since 2004. In 2005， it was made mandatory for all banks to conduct sensitivity-based stress testing of their financial operations. While sensitivity analysis provides a quick, but crude, assessment of the impact of shocks to financial systems, it ignores the inter-relationships of tmanciai and macro-economic variables through which financial institutions operate. Scenario analysis is a technique that accounts more accurately for the impact of these inter-relationships, and thus more realistically demonstrates actual business cycle movement. Although it is a complex and time-consuming process，scenario analysis produces more reliable results. Recognizing the importance of scenario analysis, in June 2008 SBP started macro-stress testing of credit risk to assess the resilience of the banking system to credit shocks. The models used for analysis forecast default rates for the quarter ahead.


Risk Management

To establish a robust and comprehensive risk management £ in the banking industry, State Bank of Pakistan has taken the policy measures:

•New Disclosure Requirements and Internal Controls over fi Reporting (ICFR)

• Strengthening the Loan Classification Provisioning Reqn

• Deposit Protection Scheme

Strengthening the Legal

FrameworkAnti-Money Laundering/ Countering the Financing of Te The Anti-Money Laundering Ordinance was promulgated in 2007. later enacted as AML Act 2010 after approval from the Par”The Asia Pacific Group on Money Laundering (APG) conducted a Evaluation of Pakistan in 2009 to assess the overall efficacy of the law enforcement, and financial regulatory regime to counter a laundering and terrorist financing in the country. The evaluation was adopted after extensive deliberations in the annual meeting ofl body in July 2009.

State Bank has issued instructions to banks, including the supply of ' records to law enforcement agencies and taking action against a holders who fail to furnish identity documents for establishing maintaining business relationships with banks. New CNIC were dei and acquired from all account holders and only three percent of accounts remained without new CNIC as of February 2010. The ba industry was asked to resolve such issues through mutual sugg< and consultations. To this end, Compliance Forum meetings were oigan* to streamline the process of actions under UNSC Resolutions, repoit: of STRs, installation and development of monitoring software, and of bank staff.

Enhanced Focus on Corporate Governance

SBP has always strived to strengthen the corporate governance regime t0 cope with the changing pace of banking business. The recent corporate governance nscams” throughout the world in the wake of global financial crisis has reinforced this need. The Prudential Regulations on Corporate Governance are being reviewed in line with international principles and best practices， including the broader scope of the Fit and Proper Test (FPT) requirement which now, inter alia, requires Pakistani banks to seek prior clearance from SBP under the FPT Criteria for appointment of key executives for their overseas operations. The due diligence procedure for directors， sponsors， and chief executives of the banks/DFIs has been further strengthened. Moreover, banks/DFIs have been given flexibility regarding payment of remuneration to their non-executive directors for attending board/committee meetings, thus enabling banks/DFIs to appoint high caliber professionals for the best strategic input in corporate affairs of the bank with optimal time commitment.

177

Privatization and Restructuring of Banks

The Government of Pakistan and SBP are actively pursuing privatization of public sector institutions to enhance their competitiveness and operational efficiency, enlarge the ownership base，restrict government participation in business activities, ease the drain on budgetary resources, enhance their revenues and utilize the sale proceeds for elimination of national debt and for poverty alleviation.

[Source-1: SBP Annual Report 2010，http://www.sbp.org.pk/reports/annual/arFY10/Vol2/Chapter3.pdf]

Strengthening of Supervisory Controls: SBP's role

http://www.sbp.org.pk/reports/annual/arFY10/Vol2/Chapter3.pdf


Part 9: Current Trends in the Financial Industry in Pakistan

Chapter 1：Innovation Challenges, Interest-Free Banking and New Areas of Financing

Discuss the expected benefits and challenges posed by innovations such as branchless banking, mobile banking； risk mitigation and BASEL II, BASEL III

Define interest-free banking

Discuss the need to introduce interest-free banking in Pakistan and what are the expected benefits from this initiative

Discuss Islamic Banking

Discuss the new areas of financing that have become a part of Pakistan's financial system

Explain Microfinance

Part Nine

Chapter 1

Learning Outcome

Innovations in Banking and Finance

Innovation Challenges, Interest-Free Banking and New Areas of Financing 179

Current Trends in the Financial Industry in PakistanInnovation Challenges, Interest-Free Banking and New Areas of Financing


_ Discuss the expected benefits and challenges posed by innovations such as branchless banking, mobile banking, risk mitigation and BASEL II, BASEL III

_ Define interest-free banking

■ Discuss the need to introduce interest-free banking in Pakistan and what are the expected benefits from this initiative

^ Discuss Islamic Banking

a Discuss the new areas of financing that have become a part of Pakistan's financial system

_ Explain Microfinance

Banking systems have been continually evolving over the past two centuries, and what have come to be regarded as traditional banking activities and channels have been gradually overtaken by new and innovative developments, largely dictated by rapidly changing information and communications technology and the globalization of financial markets. The global perspective of banking and finance has changed enormously, and the technological innovations have completely remodeled the "face” of banking.

The changing global needs of banking and finance have led to the introduction of new, alternative channels by which banking services can be delivered, such as branchless banking, mobile banking and internet banking. Inter-bank fund transfers and related services are becoming the norm for transactions in developed as well as developing countries. Pakistan has also been at the forefront and has slowly accepted and implemented all such channels.

These new channels create many benefits as well as some challenges for the financial system of any country.

Branchless Banking

Branchless banking is a type of banking where the banking customer does not need to visit a branch or central location of the bank. Rather, banking business may be completed through technological services, such as online, over the phone, or through an ATM; alternatively, banks may offer services in third-party locations such as post offices or grocery stores. Branchless banking is very common, and many people are able to complete


all their banking online without ever having to visit the There are many benefits to branchless banking. There is no nea3 time out of the day to visit the bank in order to withdraw oc money; account balances can be checked and verified at any ti day; there is instant access to see if checks have cleared, or if bill payments have been made. Many people are able to log on bank’s website through a smartphone and so it is no longer even to have access to a computer.

In addition, branchless banking can often help to save the bank This could potentially lead to the bank offering better interest loans or charging less fees on certain accounts, for example. AK this is of course not always the case，many banks do find that appreciate the convenience of being able to complete their business from any location. Small banks located in grocery stores offices also have all the services of a branch bank, with the exce " safe deposit boxes.

There are some downsides to branchless banking, however. First, af one’s account through the computer or a smartphone may not secure; there is always the potential for viruses or spyware to be p on the computer. In addition, sometimes it is necessary to visit the such as to open an account, or to place something in a safe deposit If the bank does not have any nearby locations because it is focused branchless banking, this could be inconvenient, and might enco customers to switch to a different bank.

The best idea might be to do one’s banking business with a local that also offers online banking services and convenient ATM locati This way, one can visit the bank if necessary. Otherwise, one can still all of onefs banking business as needed completely over the phone online.

Customers primarily make payments and send transfers through branchless banking channels, even when most of these channels offer a broader range of services, including account opening，cash deposits, and cash withdrawals. Most customers either time their deposits to coincide with bill payments or cash withdrawals, leaving a near-zero balance in their accounts, or they do not open a savings account at all. Consider the following experiences:


• In Russia, more than 100,000 automated payment terminals have sprung up in the larger cities in recent years. One provider ，

CyberPlat, claims to have processed 1.2 billion transactions worth US$4.7 billion through the first three quarters of 2007 via its 70,000 "cash acceptance， 1 points, mostly for prepaid air time, television, Internet, and other utilities.

• The average mobile banking customer of WIZZIT (a mobile phone banking provider in South Africa) bought air time with WIZZIT twice as often (2.6 times) as they withdrew funds from a branch or ATM (1.3 times), and five times as often as they made a money transfer (0.5 times).

The predominance of payments services over savings also reflects the perceived relative value that each service brings to the economic lives of the poor. Using banking agents and electronic payments to pay utility bills takes less time than traveling to and queuing in a range of utility offices, thereby bringing very tangible benefits. Similarly，collecting a pension， remittance receipt, and welfare or salary payment is a strong driver for opening accounts.

Innovations such as branchless banking, mobile and internet banking have led to a need for further tightening the security aspects of banking. Risk mitigation is an important sector for banks and bankers today.

Risk Mitigation

Risk mitigation has emerged as one of the biggest challenges for bankers worldwide. With the advent of modern technology and the globalization of financial markets, it has become very difficult to manage the risks attached to the size and range of portfolios that banks currently undertake. This has led to the high amount of leverage that banks have taken on ， which ultimately results in bank meltdowns. The recent financial crisis of 2007-2009 is a clear example of how banks were unable to handle or were simply ignorant about their risk management needs.

Global initiatives, such as the Basel II Accord, were instigated, in part, to raise awareness of the‘ need for better risk management. Basel II is the second of the Basel Accords， which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II，which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the serious financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

In theory, Basel II attempted to accomplish tms by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.


One of the most difficult aspects of implementing an internatio agreement is the need to accommodate differing cultures, varying structi models, and the complexities of public policy and existing regulati Banks’ senior management will determine corporate strategy, as well the country in which to base a particular type of business, based in p< on how Basel II is ultimately interpreted by various countries’ legislatures! and regulators.

Basel III

Basel III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. Basel III proposes many newer capital, leverage and liquidity standards to strengthen the regulation, supervision and risk management of the banking sector. The capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than under current Basel II rules. The new leverage and liquidity ratios introduce a non-risk based measure to supplement the risk-based minimum capital requirements and measures to ensure that adequate funding is maintained in case of crisis.

It is estimated that the medium-term impact of Basel III implementation on GDP growth is in the range of ?0.05 to ?0.15 percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass on a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy.

Risk mitigation initiatives such as Basel II and Basel III are extremely important for developing economies such as Pakistan. However, the banks and financial institutions in Pakistan have not been able to meet these standards as of mid-2011. The State Bank of Pakistan has set milestones and deadlines for the implementation.

ニ - -201

12012 2013 2Q1

42015 2016 2017 2018 As of 1

January 2019

Leverage Ratio Supervisorymonitoring

Parallel run 1 Jan 2013 -1 Jan 2017 Disclosure starts

1 Jan 2015

Migration to Pillar 1

Minimum Common Equity Capital Ratio

3,5% 4.0% 4,5%

45% 4.5% 4-5% 4.5%

Capital Conservation Buffer 0.625%

1.25%

1.875% 2.50%

Minimum common equity plus capita! conservation buffer

3.5% 4.0% 45% 5.125%

5.75%

6375% 7.0%

Phase-in of deductions from CET1 (including amounts exceeding the fimit for DTAs, MSRsand financials)

2ft% 40% 60% 80% 100% 100%

Minimum Tier 1 Capital 4.5% 5,5% 6.0%

6.0% 6.0% 6.0% 6.0%


Minimum Total Capital 8.0% 8,0% 8.0%

8.0% 8.0% 8.0% 8.0%

Minimum Total Capita! plus conservation buffer

8.0% 8*0%

8.0%

8.625%

9.25%

9*875% 10.5%

Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital

Phased out over 10 year horizon begmning 2013

Liquidity coverage ratio ニニintroduce minimum

standard

Net stable funding ratio period begird

；siencsar(i

Interest-Free Banking / Non-interest based banking

An important element of the financial systems of developing countries is the availability of interest-free banking. Interest-free banking is a fundamental concept derived from the Islamic form of banking. It operates with the primitive professional and ethical standards that exclude ”Muslims” from paying or receiving any kind of interest. This certainly does not mean that revenue-generating activities or money-raising businesses are not encouraged. All of these business forms are greatly appreciated as far as they do not involve interest of any kind. Many financial tools have been introduced by Islamic financial bodies to fulfill these business or profit-making requirements, in that they deal with equity financing rather than debt financing. In addition，as a replacement for fixed interest rates on savings accounts, these interest-free banks give a small percentage of return on deposits on an annual basis.

Interest-free financial institutions have been in existence for quite some time now. By and large, nearly all interest-free banks concur on the indispensable values of Islamic banking. Nonetheless, individually, all the banks differ in the services and benefits they offer. These differences occur due to individual country rules, needs of the inhabitants and the customized bank’s experiences and objectives.

In spite of being successfully implemented, the interest-free banking model has some problems when it comes to some areas ot rmancing. However, there are alternatives to such problems，such as putting up loans with a service charge and introducing the participatory financial model. It can still be concluded that interest-free banking does


have acompetitive advantage in co-existence with the other business inthe financial industry. Such a concept is also becoming widely in some non-Islamic countries.

The most outstanding feature of this kind of bank is the basic of helping a person to become debt-free at the earliest oppoi Interest-free banks operate by the rule that the lender must takr of the profits or the losses incurred by the borrower or the be: enterprise. Thus it is mandatory to share the profits as well as the The lender and the borrower are more like partners and this plays a major role in characterizing the social order. In turn it remove the discrimination between the modern-day ’’rich""poor，，. The traditional banking system，on the other hand，collecrs amounts of interest from the borrower regardless of success or and imposes a huge amount of risk on any entity that is bo money.

Islamic Banking

Islamic banking is banking or banking activity that is consistent with principles of Islamic law (Sharia) and its practical application thr ニ the development of Islamic economics. Sharia prohibits the payment acceptance of specific interest or fees (known as Riba or usury) for of money. Investing in businesses that provide goods or services const1

contrary to Islamic principles is also Haram (forbidden). While principles were used as the basis for a flourishing economy in e times, it was only in the late 20th century that a number of Islamic were formed to apply these principles to private or semi-private co — 「 institutions within the Muslim community.

An Islamic banking and finance system without usury or interest w* started around the latter part of the nineteenth century when Muslims were doing well, both politically and economically. Islamic banks started to establish centers in the large and renowned cities of Islamic countries, as well as non-Islamic countries, to supply their comprehensive business needs.

Generally, all Islamic banks harmonize on the essential values of Islamic banking. Nonetheless, individually, all banks differ in the services and benefits they offer. As with interest-free banking, these differences occur due to individual country rules, needs of the inhabitants and the customized bank’s experiences and objectives.

The concept of Islamic banking is also becoming widely popular in some non-Islamic countries. The fundamental law that helps a person become debt-free at the earliest opportunity can be called the most wonderful feature of Islamic banks. Islamic banks operate by the rule that the lender must have a share of the profits or the losses incurred by the borrower or the borrowing enterprise. Thus the sharing of profits as well as losses is mandatory in an Islamic banking system. The basic justification for this is that ’’Allah has permitted trade and prohibited Riba，，，therefore the principles of Islamic finance are based on prohibition of Riba and Gharar. While gain by the principal is not prohibited, the deciding factors


are the nature of the transaction, entitlement to profit and liability for risk of loss of the capital itself. Profit is to be earned by sharing the risk and reward of ownership through provision of goods，services or benefits. The lender and the borrower are like partners and this concept plays a major role in characterizing the social order. In turn it helps to remove discrimination and prejudice between the Mrich?f and the ”poor' As already observed above, the traditional banking system collects huge amounts of interest from the borrower, regardless of success or failure, and imposes great risk on anyone that is borrowing money. Such a method of operation is deemed is to be cruel/without mercy in an Islamic banking and finance system.

Islamic banking was introduced in July, 1979 in the banking and financial system of Pakistan. The government of Pakistan decided that only an Islamic economic system could ensure a better standard of living. To ease the introduction of interest-free banking, some necessary amendments were made to the Banking laws in June, 1980 in Pakistan. Various companies were then allowed to start business on the basis of an interest- free system.

An Islamic banking system without the use of interest (Riba) is very popular in Pakistan, but there are still many people in business and among the general public who do not yet know about the benefits of this interest-free banking system.

Islamic banks and banking institutions that offer Islamic banking products and services (IBS banks) were required to establish a Shariah Supervisory Board (SSB) to advise them and to ensure that the operations and activities of the banking institutions comply with Shariah principles. This has already been established for the banks that currently work in Pakistan. On the other hand, there are also those who believe that no form of banking that involves interest payments can ever comply with the Shariah.

Prohibitions in Financial Activities

- Avoidance of Riba (risk-free or guaranteed rate of return on loaned money or investment)

- Avoidance of Gharar (exercise uncertainty in contracts)- Avoidance of Exploitation- Avoidance of Gambling (and Chance)- Avoidance of Haram TransactionsIslamic Financial Transaction Terminology Bai1 al 'inah (sale and buy-back agreement)

Bai，al inah is a financing facility with the underlying transactions between the financier and the customer. The an asset from the customer on a spot basis. The price paid by constitutes the disbursement under the facility. Subsequ: is sold to the customer on a deferred-payment basis and payable in installments. The second sale serves to create tiari on the part of the customer under the facility. There are opinion amongst the scholars on the permissibility of however this is practised in Malaysia (a set of strict con •• complied with) and similar jurisdictions.


Bai' bithamanajil (deferred payment sale)

This concept refers to the sale of goods on a deferred payment price which includes a profit margin agreed to by both parties, al ?

inah, this concept is also used under an Islamic financing:Interest payment can be avoided as the customer is paying the which is not the same as interest charged on a loan. The pro' is that this includes linking two transactions in one which is € in Islam. The common perception is that this is simply strai charging of interest disguised as a sale.

Bai1 muajjal (credit sale)

Literally bai’ muajjal means a credit sale. Technically, it is a technique adopted by Islamic banks that takes the form of m muajjal. It is a contract in which the bank earns a profit margin on purchase price and allows the buyer to pay the price of the co: at a future date in a lump sum or in installments. It has to ex mention cost of the commodity and the margin of profit is mu agreed. The price fixed for the commodity in such a transaction car. the same as the spot price or higher or lower than the spot price* muajjal is also called a deferred-payment sale. However, one of the ( descriptions of riba is an unjustified delay in payment or either ini or decreasing the price if the payment is immediate or delayed-

Musharakah

Musharakah (joint venture) is an agreement between two or more partners, whereby each partner provides funds to be used in a venture. Profits made are shared between the partners according to the invested capital. In case of loss， each partner loses capital in the same ratio. If the bank provides capital， the same conditions apply. It is this financial risk, according to the Shariah，that justifies the bank’s claim to part of the profit. Each partner may or may not participate in carrying out the business. A working partner gets a greater profit share compared to a sleeping (non-working) partner. The difference between Musharaka and Madharaba is that, in Musharaka, each partner contributes some capital, whereas in Madharaba, one partner, e.g. a financial institution, provides all the capital and the other partner, the entrepreneur, provides no capital. Note that Musharaka and Madharaba commonly overlap.


Mudarabah

f,MudarabahT? is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called ?,rabb-ul-malM, while the management and work is an exclusive responsibility of the other, who is called Mmudaribn

The Mudarabah (Profit Sharing) is a contract, with one party providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. Compared to Musharaka, in a Mudaraba only the lender of the money has to take losses.

Murabahah

This concept refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled. This type of transaction is similar to rent-to-own arrangements for furniture or appliances that are common in North American stores.

Musawamah

Musawamah is the negotiation of a selling price between two parties without reference by the seller to either costs or asking price. While the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key distinction between Murabahah and Musawamah with all other rules as described in Murabahah remaining the same. Musawamah is the most common type of trading negotiation seen in Islamic commerce.

Baisalam

Baisalam means a contract in which advance payment is made for goods to be delivered later. The seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified, leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver ， or currencies based on these metals. Barring this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.Microfinance is the provision of financial services to low ’ or solidarity lending groups including consumers and the. who traditionally lack access to banking and rel *More broadly, it is a movement whose object is na wood many poor and near-poor households as possible have peF~ to an


appropriate range of high quality financial services, just credit but also savings, insurance, and fund transfers.™ promote microfinance generally believe that such access people out of poverty.

Microfinance is a broad category of services, which includes Microcredit is the extension of very small loans (microloam i 他 poverty，designed to spur entrepreneurship. These indi ニ collateral, steady employment and a verifiable credit history and cannot meet even the most minimal qualifications to gain traditional credit. Microcredit is a part of microfinance, w こ provision of a wider range of financial services to the Microcredit is a financial innovation that is generally considered originated with the Grameen Bank in Bangladesh. In that cd ニニsuccessfully enabled extremely impoverished people to engage employment projects that allow them to generate an income many cases，begin to build wealth and exit poverty.

Due to the success of microcredit, many in the traditional banking • have begun to realize that these microcredit borrowers should correctly be categorized as pre-bankable; thus, microcredit is incrr: gaining credibility in the mainstream finance industry, and traditional large finance organizations are contemplating mic~ projects as a source of future growth, even though almost eve: larger development organizations discounted the likelihood of microcredit when it was begun.

In Pakistan, microfinance banks and institutions have been pi support by the government and the State Bank of Pakistan to launch fledge operations. These banks and institutions have gathered tog to create the Pakistan Microfinance Network (PMN).

The Pakistan Microfinance Network (PMN) is a network of organiza engaged in microfinance and dedicated to improving the outreach sustainability of microfinance services in Pakistan.

Compared to some other countries, the microfinance sector in Pakistan is still in its initial stages of development. Estimates suggest that as many as 27.7 million people in Pakistan need microfinance services. However, such services reach less than seven percent of this figure. Practitioners must improve their programs if microfinance is to achieve its potential and serve a larger share of the population. The Network has become increasingly active since 1999，establishing its membership, activities，and credibility in an effort to address these issues. It has fostered greater awareness among policymakers, launched comprehensive capacity-building initiatives, established standards and benchmarks for transparency in microfinance institutions, and serves as an information hub for the local microfinance industry.• Khushhali Bank (KB)• Network MicroFinance Bank Ltd. (NMFB)•Pak-Oman Microfinance Bank Ltd. (POMFB)• Rozgar Microfinance Bank Ltd. (RMFB)•Tameer Microfinance Bank Ltd. (TMFB)•The First MicroFinanceBank Ltd. (FMFB)• KashfMicroFinance (KMFB)


Microfinance Institutions

•Akhuwat•Asasah•Kashf Foundation• Orangi Pilot Project (OPP)• Sindh Agricultural and Forestry Workers Cooperative Organization (SAFWCO)• Community Support Concern (CSC )• Development Action for Mobilization and Emancipation(DAMEN) Rural Support Programs• Lachi Poverty Reduction Project (LPRP)• National Rural Support Programme (NRSP)• Punjab Rural Support Programme (PRSP)• Sarhad Rural Support Programme (SRSP)•Thardeep Rural Development Programme (TRDP)

Part 10: Laws relating to Financial Syste

Chapter 1：Banking Laws and Regulations

Recall the salient features of the Banking

Company Ordinance Recall the salient

features of the Negotiable Instruments

Acts Recall the salient features of the

State Bank of Pakistan Act 1956 Recall

the salient features of the Foreign

Exchange Manual Recall Financial

Institution Ordinance 2001 Recall the

scope and salient features of the

Prudential Regulations

Part Ten

Chapter 1

Learning Outcome

Privatization


Laws relating to Financial SystemsBanking Laws and Regulations


■ Recall the salient features of the Banking Company

Ordinance

■ Recall the salient features of the Negotiable

Instruments Acts

■ Recall the salient features of the State Bank of

Pakistan Act 1956 _Recall the salient features of the

Foreign Exchange Manual _ Recall Financial

Institution Ordinance 2001 ■ Recall the scope and

salient features of the Prudential Regulations

Law is the principles and regulations established in a country by some authority and applicable to its people, whether in the form of legislation or of custom and policies recognized and enforced by judicial decision. It is the implementation of social order and justice created by adherence to such a system. The system of judicial administration puts the laws of a community into effect, e.g. all citizens are equal before the law.

Banking laws: an overview

Banks and bank accounts are regulated by Federal statutory law. Banks are established under the Banking Companies Ordinance 1962 ， regulated by SBP through Prudential Regulations, and Exchange Control Manual. Bank accounts may be established by private and state-owned banks (National Bank of Pakistan) and National Savings centers. All are regulated by the Federal laws. Cheques and related matters (bearer order，crossing protection to the bankers, etc) are governed under the Negotiable Instruments Act 1881.

For smooth running of the banking system it is vital that the public should have confidence in it and be assured that their interest is protected by the government through regulators. One of the most important functions of the State Bank of Pakistan is protection of customers， rights. Following are the major laws which regulate banking business in Pakistan:

1. BCO 19622. SBP Act 19563. FI (Recovery of Finance Ordinance) 2001

Banking Laws and Regulations 191

4. Exchange Control Manual5. Banking Tribunals Ordinance 19846. Banking Companies Tribunals (Validation of Orders) Act 19947. SBP Banking Service Corporation Ordinance 2001


8. Khushhali Bank Ordinance 2000

9. Microfinance Institutions Ordinance 2001

10. Payment Systems and Electronic Funds Transfer Act

11. Prudential Regulations

Banking Companies Ordinance 1962

•This ordinance was issued on 7th June 1962 and is the which the functioning of the banking system in Pakistan is

•Section 5 of this ordinance defines banking，banking com] creditors, debtors, demand liability, loans， advances，credits other related terms used in banking business.

•Under Section 7，different forms of the business in which a bank engage are described in detail.

•Section 9 deals with prohibition of trading. A banking company involve itself in any kind of trading except actionable claims.

•Section 13 deals with the requirement of minimum paid-up capital reserve (which is determined by State Bank of Pakistan). After implementation of Basel II，SBP is strictly adhering to the capital adequacy aspect across the banking industry.

• Section 15， 15A, 15B， 15C，deals with corporate governance and of directors.

• Section 21 deals with reserve funds, and Section 22 cash reserve.

• Section 25 deals with the powers of State Bank of Pakistan to control advances made by banking companies such as maintenance of a credit ceiling by banking companies in general or a company in particular.

•Section 25-A authorizes SBP to collect credit information from banking companies and disclosing this to other players in the industries.

• Under Section 25-AA, SBP prepare and submit to the Federal Government, details of loans written off and rescheduling and restricting of loans.

• Section 26 deals with the prohibition of accepting deposits unless otherwise after obtaining a licence from SBP.

• Section 26A deals with acceptance of deposits and the basis on which these deposits can be accepted; for example on participation in Profit and Loss (PLS) free of interest or return on any form (now SBP has issued instructions to the banks to pay minimum 5 % return on Saving Deposits).says that no officer or member of a trade union in a banking company shall use any banking facilities including a car or telephone to promote trade union activities or carry weapons into banking premises, unless so authorized by the management during office hours, or subject bank officials to physical harassment or abuse, and nor shall he be a person who is not an employee of the banking company in question. Any person guilty of an

offence is punishable with imprisonment of either description which may extend to three years or with a fine or both.

•Section 29 deals with maintenance of liquid assets.

•Section 31 deals with unclaimed deposits. Throughout this section all banks are directed to surrender to SBP all deposits and bills payable which have been outstanding in the books of the banks for ten years and more and where no contact has been established with the customers. Before surrender, banks are required to give three months notice in writing by registered post acknowledgement due to the creditor, beneficiary of cheque, draft, or bill of exchange or the person in whose name the article stands in the books of the bank. The above provisions shall not be applicable to minors1 account, government deposits, and court of law cases.

•Section 33-A deals with the secrecy to be maintained relating to customers except when law and practice permits.

•Section 34 deals with the requirement for the preparation of a Balance Sheet in the format laid down under the second schedule of BCO.

•Section 38 relates to the display of the Balance Sheet and Profit and Loss Account in branches and principal offices.

.Section 40 deals with the inspection of banking companies. It is obligatory for banking companies to produce all such books and documents to the inspecting officers as desired by him. Based on the inspection report, SBP is authorized to impose penalties including winding up of the banking company (Section 49).

•Under Section 41，41-A，41-B, SBP can direct banking companies in Pakistan to merge themselves, remove the chairman，member(s) of board of directors, Chief Executive and appoint its own nominee to manage the affairs of the banking company. Under Section 41-C, if a banking company is aggrieved with the order of SBP under Section 41 ， 41-A, 41-B, they can make an appeal to the central Board of Directors of SBP whose decision shall be final.

• Section 82-A was added to BCO and deals with the b

•Appointment of banking Mohtasib by the President of consultation with the Governor of SBP.

• Deals with qualification of banking Mohtasib.

• Deals with the jurisdiction of banking Mohtasib.

• Deals with the tenure of banking Mohtasib.

•Banking Mohtasib shall not hold or occupy any other positioo the right to remuneration for rendering service.

• Section 82-B deals with the terms and conditions of the post and responsibilities of banking Mohtasib.

• 82-C deals with reference to the court of banking Mohtasib.

Banking Mohtasib


• 82-D deals with the procedure for making complaints.

• 82-E deals with recommendation for implementation.

• 82-F deals with power to call for information.

• 82-G deals with report of banking Mohtasib to SBP.

• Section 88 deals with the change of the name of a banking com i.e. only State Bank of Pakistan can authorize a change of name ofn banking company.

• Section 89 deals with amendments to the memorandum of a b; company. Any change in the memorandum of a banking company be made only after certification from SBP.

Negotiable Instrument Act 1881

The Negotiable Instruments Act 1881 deals with different instruments used in the banking system for different transactions. This law is applicable to the whole of Pakistan and contains definitions of a negotiable instrument, promissory note, bill of exchange and cheques.

A promissory note is a written unconditional promise to pay a certain sum of money at a fixed or determinable future time, to or to the order of a certain person or to the bearer of the instrument. A bill of exchange is a written unconditional order for the payment of certain money. The person who makes this order is called the drawer, the person to whom it is addressed and who accepts it is called the acceptor/ drawee, and the person in whose name this bill is drawn is called the payee.says that no officer or member of a trade union in a banking company shall use any banking facilities including a car or telephone to promote trade union activities or carry weapons into banking premises, unless so authorized by the management during office hours, or subject bank officials to physical harassment or abuse, and nor shall he be a person who is not an employee of the banking company in question. Any person guilty of an offence is punishable with imprisonment of either description which may extend to three years or with a fine or both.

•Section 29 deals with maintenance of liquid assets.

•Section 31 deals with unclaimed deposits. Throughout this section all banks are directed to surrender to SBP all deposits and bills payable which have been outstanding in the books of the banks for ten years and more and where no contact has been established with the customers. Before surrender, banks are required to give three months notice in writing by registered post acknowledgement due to the creditor, beneficiary of cheque, draft, or bill of exchange or the person in whose name the article stands in the books of the bank. The above provisions shall not be applicable to minors* account, government deposits，and court of law

* Section 48 deals with amalgamation and winding-up of the banking company.

•Section 59 deals with voluntary winding-up of the banking company.

cases.

•Section 33-A deals with the secrecy to be maintained relating to customers except when law and practice permits.

•Section 34 deals with the requirement for the preparation of a Balance Sheet in the format laid down under the second schedule of BCO.

•Section 38 relates to the display of the Balance Sheet and Profit and Loss Account in branches and principal offices.

•Section 40 deals with the inspection of banking companies. It is obligatory for banking companies to produce all such books and documents to the inspecting officers as desired by him. Based on the inspection report, SBP is authorized to impose penalties including winding up of the banking company (Section 49).

•Under Section 41，41-A, 41-B, SBP can direct banking companies in Pakistan to merge themselves, remove the chairman，member(s) of board of directors, Chief Executive and appoint its own nominee to manage the affairs of the banking company. Under Section 41-C, if a banking company is aggrieved with the order of SBP under Section 41 ， 41-A, 41-B, they can make an appeal to the central Board of Directors of SBP whose decision shall be final.

• Section 82-A was added to BCO and deals with the banking M

•Appointment of banking Mohtasib by the President of Pakistan ’ consultation with the Governor of SBP.

• Deals with qualification of banking Mohtasib.

• Deals with the jurisdiction of banking Mohtasib.

• Deals with the tenure of banking Mohtasib.

•Banking Mohtasib shall not hold or occupy any other position the right to remuneration for rendering service.

• Section 82-B deals with the terms and conditions of the post, and responsibilities of banking Mohtasib.

• 82-C deals with reference to the court of banking Mohtasib.

• 82-D deals with the procedure for making complaints.

• 82-E deals with recommendation for implementation.

• 82-F deals with power to call for information.

• 82-G deals with report of banking Mohtasib to SBP.

• Section 88 deals with the change of the name of a banking company,i. e. only State Bank of Pakistan can authorize a change of name of a banking company.

• Sections 60 to 82 deal with the procedural framework to be followed in winding up of the banking company.

Banking Mohtasib


• Section 89 deals with amendments to the memorandum of a banking company. Any change in the memorandum of a banking company can be made only after certification from SBP.

Negotiable Instrument Act 1881

The Negotiable Instruments Act 1881 deals with different instruments used in the banking system for different transactions. This law is applicable to the whole of Pakistan and contains definitions of a negotiable instrument, promissory note, bill of exchange and cheques.

A promissory note is a written unconditional promise to pay a certain sum of money at a fixed or determinable future time, to or to the order of a certain person or to the bearer of the instrument. A bill of exchange is a written unconditional order for the payment of certain money. The person who makes this order is called the drawer, the person to whom it is addressed and who accepts it is called the acceptor/ drawee, and the person in whose name this bill is drawn is called the payee.


A promissory note is a promise，while a bill of exchange is an order. In,a promissory note there are only two parties, while in a bill of exchangethere are three parties, i.e. drawer, drawee and payee.

Characteristics of Negotiable Instruments

• Every negotiable instrument must be in writing.

• If it is a promissory note it must indicate promise for payment of money.

• If it is a bill of exchange it must indicate order to pay.

• If it is a cheque it can be an order or a bearer instrument.

•All these instruments must be written as unconditional.

•The order / promise must be for money only.

•The sum payable must be certain.

• Date in a promissory note and bill of exchange is not generally an essential requirement, ilf the date is omitted for any reason, the instrument date shall be treated as the date on which it was made. The date is an essential part of those instruments where the amount is payable at a certain time after the date, or where an element of interest is involved. Correction of the date or insertion of a date on an undated instrument is permitted.

•A cheque must contain a date; if a cheque is postdated, undated or stale, banks refuse payment.

•A negotiable instrument can be drawn on a holiday.

• It is customary/ standard practice that the amount is expressed both in words and figures. If there is difference between the amount in words and in figures, the amount stated in words shall be taken to be the correct amount.


•At sight or on presentation means on demand. If no time i in an instrument, then the instrument will also be trea i payable on demand.

•A cheque must always be payable on demand to the

• If a cheque or a banker's cheque is not presented up to 6 the date of issue, it becomes stale and requires revalidation -

• In a promissory note or bill of exchange, generally the place is not specified, but if place is specified, it must be paid in place.

• In the case of a bill of exchange, presentment for acceptance is when it is made payable at a specified place other than the drawer.

•A cheque is also required to be presented where it is made obstacle has been removed because of the introduction of online payment systems.

Parties to a Negotiable Instrument

The parties involved in a negotiable instrument depend on the of the instrument. In the case of a promissory note, there can be parties: drawer/maker and payee. There must be at least three part- the case of a bill of exchange/ cheque: drawer, drawee and payee- same party can enjoy any two positions.

Drawee in case of need

If in a bill, or in any endorsement, the name of any person is given to resorted to in case of need, such person is called n drawee in case of He may accept or pay the bill even if it is not presented to the o ' drawee.

If in a bill the name of a drawee in case of need is mentioned, the bill is not treated as dishonored unless it is dishonored by the drawee in case of need.

Important points- definitions

"Negotiable instrument" means a promissory note, bill of exchange or cheque payable either to order or to bearer.

A "promissory note，， is an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking signed by the maker, to pay on demand or at a fixed or determinable future time, a certain sum of money only to， or to the order of a certain person, or to the bearer of the instrument.

’， Bill of exchange” means an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to

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.±ametmM

truments

Characteristics of Negotiable

Instnir•Every negotiable instrument must be in

writing.•If it is a promissory note it must indicate promise for payment of

money.• If it is a bill of exchange it must indicate order to

pay.

A muHaiirf'! i Mils Hear a


• • If it is a

cheque it can be an order or a bearer instrument.

•All these instruments must be written as unconditional.

•The order / promise must be for money only.

•The sum payable must be certain.

• Date in a promissory note and bill of exchange is not generally an essential requirement, ilf the date is omitted for any reason, the instrument date shall be treated as the date on which it was made. The date is an essential part of those instruments where the amount is payable at a certain time after the date, or where an element of interest is involved. Correction of the date or insertion of a date on an undated instrument is permitted.

•A cheque must contain a date; if a cheque is postdated, undated or stale, banks refuse payment.

•A negotiable instrument can be drawn on a holiday.

• It is customary/ standard practice that the amount is expressed both in words and figures. If there is difference between the amount in words and in figures, the amount stated in words shall be taken to be the correct amount.


•At sight or on presentation means on demand. If no time is in an instrument, then the instrument will also be treated as payable on demand.

•A cheque must always be payable on demand to the bearer or

• If a cheque or a banker!s cheque is not presented up to 6 months the date of issue, it becomes stale and requires revalidation by the ’

• In a promissory note or bill of exchange, generally the place of pay is not specified, but if place is specified, it must be paid in that s; place.

• In the case of a bill of exchange, presentment for acceptance is n when it is made payable at a specified place other than the place ofi drawer.

•A cheque is also required to be presented where it is made payable, obstacle has been removed because of the introduction of online cheqnr payment systems.

Parties to a Negotiable Instrument

The parties involved in a negotiable instrument depend on the nature of the instrument. In the case of a promissory note, there can be two parties: drawer/maker and payee. There must be at least three parties in the case of a bill of exchange/ cheque: drawer, drawee and payee. The same party can enjoy any two positions.

Drawee in case of need

If in a bill， or in any endorsement, the name of any person is given to be resorted to in case of need, such person is called "drawee in case of need". He may accept or pay the hill even if it is not presented to the original drawee.

If in a bill the name of a drawee in case of need is mentioned, the bill is not treated as dishonored unless it is dishonored by the drawee in case of need.

Important points- definitions

"Negotiable instrument” means a promissory note, bill of exchange or cheque payable either to order or to bearer.

A ’’promissory note” is an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking signed by the maker, to pay on demand or at a fixed or determinable future time, a certain sum of money only to, or to the order of a certain person， or to the bearer of the instrument.

”Bill of exchange” means an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to


pay on demand or at a fixed or determinable future time, a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument.

A "cheque” is a bill of exchange drawn on a specified banker and not expressed payable otherwise than on demand.The "drawer” is the person thereby directed to pay the "drawee' When in the bill or in any endorsement thereon the name of any person is given in addition to the drawee to be resorted to in case of need, such person is called a Mdrawee in case of need.”

n Acceptor": After the drawee of a bill has signed his assent upon the bill，

or， if there are more parts thereof than one, upon one of such parts, and delivered the same，or given notice of such signing to the holder or to some person on his behalf, he is called the "acceptor.”

’， Acceptor for honour": When a bill of exchange has been noted or protested for non-acceptance or for better security, and any person accepts is supra protest for honour of the drawer or of any one of the endorsers, such person is called an "acceptor for honour."

"Payee”： The person named in the instrument, to whom or to whose order the money is by the instrument directed to be paid is called the "payee.”

’’Holder”: The "holder" of a promissory note, bill of exchange or cheque means the payee or endorsee that is in possession of it or the bearer thereof but does not include a beneficial owner dealing through a benamidar.

”Holder in due course” means any person who for consideration becomes the possessor of a promissory note, bill of exchange or cheque if payable to bearer, or the payee or endorsee thereof, if payable to order, before it became overdue, without notice that the title of the person from whom he derived his own title was defective.

"Payment in due course’’ means payment in accordance with the apparent tenor of the instrument in good faith and without negligence to any person in possession thereof under circumstances which do not afford a reasonable ground for believing that he is not entitled to receive payment of the amount therein mentioned.

Negotiation: When a promissory note, bill of exchange or cheque is transferred to any person, so as to constitute that person the holder thereof, the instrument is said to be negotiable.

Endorsement: When the maker or holder of a negotiable instrument signs the same, otherwise than as such maker, for the purpose of negotiable, on the back or face thereof or on a slip of paper annexed thereto, or so signs for the same purpose a stamped paper intended to be completed as a negotiable instrument, he is said to endorse the same, and is called the "endorser".Endorsement ’’in blank” and ’’in full":(1)If the endorser dgn only，the endorsement is said to be ’， in blank”. (2) If he adds a to pay the amount mentioned in the instrument to, or to tx a specified person，the endorsement is said to be fin fall"，and so specified is called the "endorsee” of the in "At sight ’’ ， T’On presentment”，"After sight": The expressions 1 and "on presentment ’ ， mean on demand. The expression means, in a promissory note, after presentment for sight,


and, * of exchange, after acceptance, or noting for non- acceptance, or; for non-acceptance.

Maturity: The maturity of a promissory note or bill of exchange date at which it falls due.Defective title: When a promissory note, bill of exchange or c been lost or has been obtained from any maker，drawer, a— holder thereof by means of an offence or fraud, or for an consideration, neither the person who finds or so obtains the ir nor any possessor or endorsee who claims through such person is to receive the amount due thereon from such maker, drawer, ac ニ holder, unless such possessor or endorsee is，or some person t whom he claims was, a holder thereof in due course.

Cheque payable to order

(1) Where a cheque payable to order purports to be endorsed by or behalf of the payee, the drawee is discharged by payment in course.

(2) Where a cheque is originally expressed to be payable to bearer, drawee is discharged by payment due to the bearer thereof, motj withstanding any endorsement whether in full or in blank appearing thereon, and notwithstanding that any such endorsement purport to restrict or exclude further negotiation.

Drafts drawn by one branch of a bank on another payable to order: Wherr any draft, that is， an order to pay money, drawn by one office of a bank upon another office of the same bank for a sum of money payable to order on demand, purports to be endorsed by or on behalf of the payee, the bank is discharged by payment in due course.

"Effect of material alteration": Any material alteration of a negotiable instrument renders the same void as against anyone who is a party thereto at the time of making such alteration and does not consent thereto, unless it was made in order to carry out the common intention of the original parties. Alteration by endorsee and any such alteration, if made by an endorsee, discharges his endorser from all liability to him in respect of the consideration thereof.

Revocation of banker’s authority: The duty and authority of a banker to pay a cheque drawn on him by his customer are determined by:

(1) Countermand of payment;


(2) Notice of the customer’s death;

(3) Notice of adjudication of the customer as insolvent.

Cheque crossed generally: Where a cheque bears across its face an addition of the words "and company” or any abbreviation thereof, between two parallel transverse lines, or of two parallel transverse lines simply, either with or without the words ’’not negotiable' that addition shall be deemed a crossing and the cheque shall be deemed to be crossed generally.

Cheque crossed "account payee":(a) Where a cheque crossed generally bears across its face an addition of the

word "account payee" between the two parallel transverse lines constituting the general crossing，the cheque, besides being crossed generally, is said to be crossed "account payee".

Where a cheque is crossed "account payee” it shall cease to be negotiable; and

(b) It shall be the duty of the banker collecting payment of the cheque to credit the proceeds thereof only to the account of the payee named in the cheque.

Cheque crossed specially: Where a cheque bears across its face an addition of the name of a banker either，with or without the words ’， not negotiable", that addition shall be deemed a crossing，and the cheque shall be deemed to be crossed specially，and to be crossed to that banker.

"Crossing after issue": Where a cheque is uncrossed, the holder may cross it generally or especially. Where a cheque is crossed generally， the holder may cross specially. Where a cheque is crossed generally or specially, the holder may add the words "not negotiable".

Where a cheque is crossed specially, the banker to whom it is crossed may again cross it specially to another banker, his agent, for collection. When an uncrossed cheque, or a cheque crossed generally, is sent to a banker for collection he may cross it specially to himself.

Crossing a material part of a cheque: A crossing authorized by this Act is a material part of the cheque; it shall not be lawful for any person to obliterate, or, except as authorized by this Act, to add to or alter, the crossing.

Payment of cheque crossed generally: Where a cheque is crossed generally, the banker on whom it is drawn shall pay it otherwise than to a banker. Payment of cheque crossed specially: Where a cheque is crossed specially, the banker on whom it is drawn shall not pay it otherwise than to the banker to whom it is crossed, or his agent for collection.

Payment of cheque crossed specially more than once: Where a cheque is crossed specially to more than one banker, except when crossed to an agent for the purpose of collection, the banker on whom it is drawn shall refuse payment thereof.


Payment in the course of crossed cheque: Where the banker a crossed cheque is drawn in good faith and without negligencr if crossed generally, to a banker，and if crossed specially, to the t ニ whom it is crossed or his agent for collection, being a banker, thr paying the cheque, and (in case such cheque has come to the the payee) the drawer thereof, shall respectively be entitled to rights, and be placed in the same position in all respects, as thcv respectively be entitled to and placed in if the amount of the c! been paid to and received by the true owner thereof.

Payment of crossed cheque out of due course: Any banker paying a crossed generally otherwise than to a banker, or a cheque crossed otherwise than to the banker to whom the same is crossed, or his for collection, being a banker, shall be liable to the true owner cheque for any loss he may sustain owing to the cheque having paid.

Provided that where a cheque is presented for payment which docs at the time of presentment appear to be crossed, or to have had a crz^ which has been obliterated, added to or altered otherwise thaal authorized by this Act, the banker paying the cheque in good faith without negligence shall not be responsible or incur any liability shall the payment be questioned, by reason of the cheque having — crossed, or of the crossing having been obliterated or having been to or altered otherwise than as authorized by this Act, and of pay having been made otherwise than, to a banker or to the banker to w the cheque is or was crossed，or to his agent for collection, being a as the case may be.

Cheque bearing "not negotiable” ： A person taking a cheque cr‘ generally or specially, bearing in either case the words Mnot negotiable, shall not have，and shall not be capable of giving, a better title to tbe] cheque than that which the person from whom he took it had. Subject to the provisions of this Act relating to cheque crossed "account payee”，where a banker in good faith and without negligence receives payment for a customer of a cheque crossed generally or specially to himself, and the customer has no title or a defective title thereto, the banker shall not incur any liability to the true owner of the cheque by reason only of having received such payment.

Explanation: A banker receives payment of a crossed cheque for a customer within the meaning of this section notwithstanding that he credits his customer’s account with the amount of the cheque before receiving payment thereof.

Application to drafts: The provision of this Chapter shall apply to any draft, as defined in section 85A， as if the draft were a cheque. Protection to banker crediting cheque crossed ’'account payee” ： Where a cheque is delivered for collection to a banker does not at the time of such delivery appear to be crossed "account payee ’ ， or to have had a crossing "account payee” which has been obliterated or altered, the banker, in good faith and without negligence, collecting payment of the


cheque and crediting the proceeds thereof to a customer shall not incur any liability by reason of the cheque having been crossed "account payee", or of such crossing having been or and of the proceeds of the cheque having been obliterated or altered and of the proceeds of the cheque having been credited to a person who is not the payee thereof. Cheque not operating as assignment of funds: A cheque of itself does not operate as an assignment of any part of the funds to the credit of the drawer with the banker.

State Bank of Pakistan Act 1956

State Bank of Pakistan came into existence on 1st July 1948 through an order issued by the father of the nation, Quaid-e-Azam Mohammad Ali Jinnah. Gradually it was realized that this order was not sufficient to cover the fast growing national institution, and as such, the State Bank of Pakistan Act 1956 was enacted and promulgated on 18th April 1956.

This Act consists of five chapters, a brief summary of which is given below:

Chapter■I

This chapter consists of the short title, extent and commencement of the SBP Act 1956 and definitions of the different terms used in the Act.

Chapter - II

This chapter consists of matters related to the establishment, incorporation and share capital of the State Bank of Pakistan.

Chapter - III

This chapter deals with the management of the State Bank. The head office of the bank is in Karachi and the bank may establish branches, offices, agencies in Pakistan, or，with the prior approval of the Federal Government, anywhere outside Pakistan.

The Bank can establish and maintain subsidiaries or trusts for:

(a) Catering for the training needs of bank employees，the financial sector, organizations or institutions pertaining to the banking and financial sector.

(b) Handling the functions of receipt, supply and exchange of bank notes and coins which are legal tender.


(c) Issuing supply, sale and purchase of prize bonds, thereof and other National Savings instruments, and

d) Generally carrying out any other business or discharging incidental to, or connected with, the affairs of the bank.

Central Board of Directors

The affairs and business of the bank shall be entrusted to board of directors which shall consist of:

(a) the Governor

(b) Secretary Finance Government of Pakistan and

(c) Seven Directors including one director from each p nominated by the Federal Government, ensuring repr the banking and industrial sectors.

The Governor will be the chairman of the central board. All the of the central board shall be taken by the majority of the members and voting, and, in the event of equality of votes，the Gover^ exercise the casting vote. The service terms of the directors are for 2 of three years. Out of the first directors appointed, through drawal two directors shall retire after one year, the other two shall retire two years, and the remaining three shall retire on completion of term of three years.

Functions and responsibilities of the Central Board

The main function of the central board is to secure monetary sta and soundness of the financial system of the country

(a) Formulating and monitoring monetary and credit policy, and determining the expansion of liquidity, by taking into account Government targets for growth and curbing inflation;

(b) Determine and enforce, in addition to the overall expansion of liquidity, the limit of credit to be extended by the bank to the Federal Government, Provincial Government, and other agencies of Federal and Provincial Government for all purposes;

(c) Approve credit requirement of the private sector and intimate the same to the Monetary and Fiscal Policies Coordination Board;

(d) Tender advice to the Federal Government on the interaction of monetary policy with fiscal and exchange rate policy;

(e) Analyse and advise Federal Government on the impact of various policies on the state of the economy;

(f) Submit a quarterly report to the Majlis-e-Shoora (Parliament) on the state of the economy with special reference to economic growth, money supply credit, balance of payments, and price development;


igj Discharge such other functions that may be necessary to formulate monetary policy and regulate the monetary system, or as may be assigned by the Federal Government, from time to time.

Governor and Deputy Governor

The Governor of the bank shall be the Chief Executive Officer and shall on behalf of the central board, direct and control the whole affairs of the bank. The Governor is appointed by the President of Pakistan for a term of three years, and is eligible for reappointment for another term of three years. The maximum age for holding office of the governor is sixty-five years.One or more deputy governor(s) may be appointed by the Federal Government (not exceeding five years). The Deputy Governor shall perform such duties as may be assigned to him by the central board, shall attend meetings of the board，but shall have no right to vote.

Executive committee

There shall be an Executive committee consisting of the Governor, Deputy Governor, and three directors elected by the central board, to represent respectively the areas specified in the schedule and an officer, (appointed by the Federal Government) to act as a member of the executive Committee.Except when the central board is in session, the executive committee shall deal with and decide on any matter within the competence of the board.

Local board

A local board shall be constituted for each of the three areas specified in the schedule and shall consist of:

(a) Two members elected in the manner prescribed by the regulations made under this Act from amongst themselves by the shareholders registered on the register for that area and;

(b) Not more than three members nominated by the Federal Government.

A local board shall advise the central board on such matters as may be generally or specifically referred to it and shall perform such duties as the central board may, by regulation, delegate to it.

Chapter IV

This chapter deals with Business and Functions of State Bank of Pakistan The bank is authorized to carry on and transact the several kinds of business; some of them are summarized below:

1)Accepting of money on deposits from and collection of money for Federal Government, Provincial Government, local authorities banks and other persons (no interest will be paid on deposits).

(2) The purchase, sale and rediscount of bills of exchange, promissory notes drawn on and payable in Pakistan and arising out of bona fide or commercial trade transactions.The purchase, sale and rediscount of bills of exchange，pror notes drawn on and payable in Pakistan and bearing two or i good signatures, one of which shall be that of a schedule ba drawn on or issued for the purpose of financing seasonal ag operations or marketing of crops.

(3) The purchase and sale of approved Foreign Exch^


(4) The granting to local authorities, schedule banks, or coopei banks of advances and loans repayable on demand and on i of a fixed period (not exceeding one hundred and eighty i against security of stocks, funds and securities, other than i property, in which a trustee is authorized to invest trust monc any law for the time being in force in Pakistan. Gold or si documents of title of the same.

Such bills of exchange and promissory notes that are digit purchase or rediscount by the bank.

Making loans and advances out of rural credit funds established i the specific purpose.

Banking of loans and advances out of the Industrial Credit Fi_ established for the specific purpose, but are payable on dems

(5) Making advances to the Federal Government, Provincial Gover repayable within three months from the date of advance.

(6) The granting of advances and loans to institutions or banks specia_ established for the purpose of promoting agriculture or industria development in the country, and as and when directed by theFeder_ Government, purchase, holding and sale of shares and debentures of any banking company, providing finance to the schedule banks or financing institutions on the basis of participation in profit, and on other terms and conditions as the central board decide from time to time.

(7) The issue and purchase of telegraphic transfer, demand draft and other kind of remittances, made payable at its own branches, offices or agencies.

(8) The drawing and accepting, making and issue on its own account or on account of Federal Government, as the case may be, of any bills of exchange of Pakistan, promissory notes or engagement for the payment within or outside Pakistan, or foreign currency payable to bearer or to a banker on demand, with the prior approval of the Federal Government.

(9) Purchase and sale of the securities of Federal Government or Provincial Government or such securities of local authorities as may be specified in this behalf by Federal Government by notification in the Official Gazette on recommendation of the central board.

(10) Custody of monies, securities, and other articles of value, and collection of proceeds whether principal or interest, profit, dividend, or other returns of any such securities.

(11) Sale and realization of allproperty, whether moveable or immoveable, which may in any way come into the possession of the bank in satisfaction or part satisfaction of any of its claims.

(12) Acting as agent of the Federal Government, any Provincial Government, or any local authority in the transaction of, purchase, sale of gold or silver or approved foreign exchange, purchase, sale ， transfer of bill of exchange, securities or shares，in any company, collection of proceeds whether principal or interest, profit or dividend or other returns of any securities. Remittance of such proceeds.

(13) Management of public debts.


(14) The transacting of special drawing rights with the IMF.

(15) Opening of an account with, or making an agency arrangement with, and acting as agent or correspondent of a bank incorporated in any country outside Pakistan or the principal currency authority of any country under the law for the time being in force in that country or any international or regional bank for such principal currency authority.

(16) The making and issue of bank notes.

(17) Entering into clearing and payment arrangements with any country or group of countries.

(18) Establish credits and give guarantees.

(19) Establish fund for any specified purpose as the Federal Government may notify.

(20) Establish and maintain rural credit fund, industrial credit fund ， export credit fund, loans guarantee fund, housing credit funds within the rules prescribed under this Act.

(21) If, in the opinion of the central board, or the governor, or circumstances so warrant, the bank may purchase, sell or discount any bill of exchange，promissory note, though such bill of exchange or promissory note does not bear signature of a schedule bank.

(22) The bank shall sell or buy from authorized dealers in Pakistan, approved foreign exchange at such rate of exchange, at such places and on such conditions as the Federal Government may determine.

(23) The bank has sole right to issue bank notes made payable to bearer on demand in Pakistan.


Business which the bank may not transact

1. Engagein trade or otherwise have a direct interest in industrial or other undertaking except it may in any course of satisfaction of any of its claims and the same disposed of in earliest possible time.

2. Purchase its own shares, or the shares of any other company, or grant advance or loan on the security of

3. Advance money on the mortgage, or otherwise on the immoveable property or document of title relating where such advance is made to any of its officers or building a house for his personal use, against security or

4. Become owner of any immoveable property except whert is necessary for the use of such property by the bank, or i residence, recreation, welfare of its officers or servants,

5. Make unsecured advances and loans.

6. Draw or accept bills payable otherwise than on demand.

Exchange Control Manual

The current (eighth) edition of SBP FE Manual was published in Volume -1 consists of a summary of instructions issued to Am Dealers, the Foreign Exchange Regulation Act, 1947，the Notil issued there under by the Federal Government and State Bank of and the list of Authorised Dealers (BANKS). Volume - II consists specimens of the prescribed forms, a list of Chambers of Commerce Industry and Trade Associations authorised to recommend bus ニtravel cases and scales of daily allowances.

The amendments in the Manual are made in consultation with tiir persons involved in the foreign exchange area, i.e. traders, importers and exporters, etc， and taking into consideration the views of Authorised Dealers (Banks). Changes in the Manual, made from time to time, art conveyed to the Authorised Dealers through F.E. Circulars/Circular Letters. The Manual is very comprehensive and consists of XXII chapters, but only a few chapters need to be discussed - those which deal with day-today branch banking operations.

Chapter I deals with Foreign Exchange Policy and its operation in Pakistan. The policy is formulated and regulated in accordance with the provisions of the Foreign Exchange Regulation Act, 1947, The object of this Act is to regulate, in the economic and financial interests of Pakistan, certain payments, dealings in foreign exchange, securities, import/export of currency and bullion. Under the Act, the basic regulations are issued by the Government of Pakistan.

Chapter n deals with:


1. Authorization to deal in Foreign Exchange.

II. Application for Authorized Dealer’s License.

Applications for an Authorized Dealer’s License should be made by the Head Office of the bank/NBFI or the Principal Office in Pakistan in the case of a foreign bank， to the Director, Exchange Policy Department, stating the nature of transactions that are desired to be dealt with and it should be confirmed that trained staff and the required systems and equipment to handle foreign currency transactions are available.

III. Authorized Dealers should satisfy the condition that no Contravention or Evasion of the Provisions of the Act is contemplated.

IV. Authorized Money Changers (AMCs).

Applications for a license to act as an AMC should be made to the area office of the Exchange Policy Department where the applicant’s business is located. The application should contain full particulars as regards business conducted by the applicant, location of business premises, names and addresses of the proprietor(s)/partners/directors of the applicant and the same may be routed through an Authorized Dealer/applicantfs banker who should enclose a confidential report on the financial standing and creditworthiness of the applicant and its suitability for grant of AMC’s license. The applicant will be required to pay an application-processing fee (non-refundable) through pay order in favor of the State Bank for granting of a new license and for renewal up to 30th June of each year. Fee for this purpose will be as follows: New license Rs.100，000/ Renewal of license Rs.12，000.

V. Code of Conduct for Authorized Money Changers.

VI. Inspection of Authorized Money Changers.

Chapter III deals with authorized rates of Foreign Exchange. Section 4(2)of the Act lays down that, except with the general or special permission of the State Bank，all transactions in foreign exchange shall be carried out at rates authorized by the State Bank. A general permission has been given to Authorized Dealers to determine their own rates of exchange, both for ready and forward transactions for the public，subject to the condition that the margin between the buying and selling rates should not exceed fifty paisa per US dollar or its equivalent in other currencies. This condition does not apply to inter-bank transactions.

2. In the case of an import bill against which no forward cover has been taken by the importer, the exchange rate prevailing on the date of lodgment of the bill would apply.


Chapter IV deals with Forward Exchange Facilities.

Authorized Dealers (Banks and DFIs) may enter for forward purchase or sale of foreign currencies regulations set out in this chapter. Before entering ’ exchange contract with the public, Authorized Dc satisfied about the applicants being bona fide and forward cover is required for genuine and firm approved nature.

Authorized Dealers may provide forward cover for and foreign private loans.

Authorized Dealers may freely enter into forward with each other, provided their ’Exchange Exposure' at of the day remains within the prescribed limits.

Chapter V deals with Foreign Currency Accounts of Authorized and sale of Foreign Currencies.

Chapter VI deals with private Foreign Currency Ar

Accounts other than Pak Rupees are Foreign Currency Foreign currency accounts can be opened only in those h that have been permitted by SBP to deal in Foreign Ex Rules relating to foreign currencies are given in SBP’s Exchange Manual chapter VI. Prudential Regulation M-l to 5 and all CDD/KYC and AML rules and regulations applicabk Pak rupee accounts are also applicable to Foreign Cu accounts. Further procedures for opening the account documentation required for different types of accounts are Jx same as for Pak rupee accounts.

For accounts opened against special permission, in addition to normal documentation, SBP approval shall also be made part of the documentation.According to the SBP Foreign Exchange Manual, (chapter VI) the following private Foreign Currency accounts can be opened without prior approval from SBP:

1. Pakistani national resident in or outside Pakistan, including those having dual nationality.

2.All foreign nationals residing abroad or in Pakistan.

3.Joint account with resident and non-resident.

4.All diplomatic missions and their diplomatic officers.

5.All international organizations in Pakistan.

6.Companies established in Pakistan, including foreign share holdings.


7.Charity trusts, foundations, etc which are exempt from Income Tax.

8.Branches of foreign firms and companies in Pakistan.

9.Non-resident Exchange Companies even if owned by a bank or financial institution.

10. All foreign firms, corporations, other than the banks and financial institutions owned by the banks, incorporated and operating abroad, provided these are owned by persons who are otherwise eligible to open foreign currency accounts.

Foreign Currency accounts whose general permission is given in the above cases should not be used for:

1. Foreign Exchange borrowed under any general or specific permission given by SBP, unless permitted.

2. Any payment for goods exported from Pakistan.

3. Proceeds of securities issued or sold to non residents.

4. Any payment received for service rendered in or from Pakistan.

5. Earning of profit of the overseas offices or branches of Pakistani firms and companies including banks.

6. Investment of resident Pakistani abroad.

7. Any foreign exchange purchased from an authorized dealer in Pakistan for any purpose.

Corporate or legal bodies cannot generate funds from the kerb market for deposit in their foreign currency accounts. Foreign currency accounts can be used for:

A. Remittances from abroad.

B. Traveler’s cheques issued outside Pakistan (whether in the name of foreign currency account holder or any other person).

C. Foreign currency notes.

D. Foreign exchange generated by encashment of securities issued by the Government of Pakistan

The above accounts are free of all foreign exchange restrictions except a foreign currency account existing as on 28 May 1998 and restrictions were issued vide FE Circular No 12 of 1998. Accounts covered under FE 12 are transferable from one bank to other.


The main points of FE Circular No 12 of 1998 were:

I. Withdrawals in foreign currencies from the then existing currency accounts - whether maintained by the resident or non-residents were temporarily suspended.

II. Withdrawals were allowed in Pakistan rupees if so desired by the account holders. Payments in such cases could be made M the rate of Rs. 46 per dollar and for other currencies, at the rate crossed with New York、closing mid-rate for the previous working day.

The facility of a foreign currency account is NOT available to the following

1. Airlines and shipping companies operating in/through Pakistan or collecting passage, freight in Pakistan.

2. Investment banks.

3. Leasing companies/ Modarba companies including those whkh have been granted permission to deal in foreign exchange-

4. Financing facilities can be given against marking lien on Foreign Currency Accounts.

Surrender of Foreign Exchange

All citizens of Pakistan and other persons residing in Pakistan continuously for six months or more and in possession of foreign exchange, whether in Pakistan or abroad，are required to sell such foreign exchange to Authorized Banks within three months from the date of its acquisition except:

I. Foreign exchange held abroad by foreign diplomats, foreign nationals employed by embassies, missions of foreign countries.

II. Foreign exchange held by foreign nationals and foreign business houses except that foreign exchange which represents business conducted in Pakistan or services rendered while in Pakistan.

III. Foreign exchange held by residents of Pakistan in countries other than India， Bangladesh, Afghanistan and Israel provided amount in these accounts does not exceed US dollar 1000 or equivalent in that currency.

IV. Afghan currency whether held in Pakistan or outside Pakistan.

V. Foreign nationals are not allowed to make payment on behalf of Pakistani or foreign nationals residing in Pakistan against Pak rupees. This includes foreign currency accounts maintained by foreign nationals in Pakistan.


Other important points

•Pakistani nationals resident in Pakistan are allowed to open and maintain a F C account outside Pakistan ， except in Afghanistan, India，Bangladesh and Israel, provided the balance maintained in these accounts should not exceed US $ 1000 or equivalent.

•Interest paid by the banks to the foreign currency account holders shall be reported as sale on the monthly exchange return.

Chapter VII deals with Non-resident Rupee Accounts of foreign bank branches and correspondents.

Chapter VIII deals with private non-resident Rupee Accounts. Chapter IX deals

with Block accounts.

Chapter X deals with inward and outward remittances. The salient features of this chapter are given below:

1 . I n w a r d Remittances.

The term "inward remittance” means purchase of foreign currencies in whatever form and includes not only remittances by M.T” T.T., draft etc. ， but also purchase of traveler's cheques, drafts under traveler’s letters of credit, bills of exchange, currency notes and coins, etc. Debit to banks1 non-resident Rupee accounts also constitutes an inward remittance.

2. No Restrictions.

There is no restriction on receipt of remittances from abroad either in foreign currency or by debit to non-resident Rupee accounts of banks’ overseas branches or correspondents. Authorized Banks may freely purchase T.Ts, M.Ts，drafts, bills etc.，expressed and payable in foreign currencies or drawn in Rupees on banks’ non-resident Rupee accounts. There is also no objection to their obtaining reimbursement in foreign currency from their overseas branches and correspondents in respect of Rupee bills and drafts which are purchased by them under letters of credit opened by non-resident banks or under other arrangements.

3. Outward Remittances.

The term "outward remittance” means sale of foreign exchange in any form and includes not only remittances by T.Ts, M.Ts, drafts etc” but also sale of traveler’s cheques, traveler’s letters of credit, foreign currency notes and coins, etc. Outward remittance can be made either by sale of foreign exchange or by credit to non-resident Rupee account of banks1 overseas branches or correspondents.

4. Mode of Remittances.

Authorized banks should avoid issuing drafts in cover of outward remittances whenever remittance can be made by T.Ts, or M.Ts, etc.


Where, however, the normal means of transfer is likely to result unnecessary hardship or inconvenience to the remitter, drafts may issued in the name of the beneficiaries of the remittance but such should be crossed by the issuing bank as ’’Account Payee o ,

5. Prescribed Application Forms.

(i) There are three types of application forms for outward remi

(a) Form fIT is to cover remittance against imports.(b) Form fT-l? is to cover sale of exchange for travdL

(c) Form fM' is to cover all other remittances

(ii) Any person who wishes to purchase foreign exchange must lodjr an application with an Authorized Bank in the appropriate prescribed form， duly supported by the requisite documents. On receipt, the application should be examined and if the bank is satisfied that the application is covered by the regulations and it is empowered to approic the remittance on behalf of the State Bank, it may effect the sale of foreign exchange. If the transaction requires prior approval of the State Bank, the application should be forwarded by the bank to the State Bank for consideration, with comments, under its stamp and signature.

6. In some cases， where application is made by letter, it should be accompanied by Form ?T-1? or 'M’ as the case may be，duly filled in. If the remittance is permissible, the State Bank will return the form duly approved. In cases where remittance is required to be made in installments at periodical intervals (student permits, etc), the State Bank may issue special permits authorizing remittances in the desired manner.

1 . P e r m i t s for Recurring Remittances.(i) Permits issued by the State Bank are of three types. In the first type of permit, the State Bank authorizes remittances up to a stated amount within a stated period which an Authorized Bank may make on behalf of the permit holder. Remittances under such permit may be made during the period of validity of the permit in amounts as required by the applicant provided that the total of such remittances under the permit does not exceed the overall limit laid down in the permit.

(ii) The second type of permits covers remittances on a periodical (monthly) basis but the periodical (monthly) limits are not cumulative and all remittances during any one period (month) must not exceed the prescribed rate laid down in the permit. If remittances are not made up to the full extent of the limit in any period (month), it is not permissible to carry forward unutilized balance in order to make larger remittances in subsequent periods.

(iii) The third type of permits allows remittances on a periodical (monthly) basis but the periodical (monthly) amount is sanctioned on a cumulative basis so that unutilized amounts for earlier periods (months) can be remitted in subsequent periods (months). Unutilized amounts may， however， be accumulated only within the validity of the permit and the entire unutilized balance of such permits will lapse after the last day of the validity of the permit. In such cases it is not permissible to make remittances in advance of the entitlements of the subsequent periods (months).

(iv) Requests for utilization of lapsed quotas should be forwarded by Authorized Banks to the State Bank giving full reasons for non-utilization on due dates supported by suitable documentary evidence, wherever available.

Effecting Remittances against Permits

In all cases where permits are issued by the State Bank, it will be in order for the Authorized Banks to effect remittances against the permits subject to reporting on form fMf. Authorized Banks must state on form ’M’ the number of the permit against which the remittance has been made and also certify that the remittance has been endorsed on the permit. The remittance must be endorsed on the reverse of the permit giving the amount and date of remittance under their stamp and signature. When the permit is exhausted, it should be returned to the State Bank by the Authorized Banks along with the form ’M’ on which the last remittance is reported.

In all cases where the purpose for which the permit was granted ceases to exist, the unutilized permit should be returned to the State Bank with an advice that the permit should be cancelled. And no further Regulations as laid down by the Government from time to time, including the necessity of obtaining an export license wherever necessary. The Government of Pakistan has under the Export Trade Control Regulations banned exports to Israel.

Chapter XIII deals with Imports. Import Trade Control

Import of goods into Pakistan is regulated by the Ministry of Commerce, Government of Pakistan, under the Imports and Exports (Control) Act, 1950 and the notifications issued there under. No import is permissible from Israel or from any other country which may be notified by the Ministry of Commerce. Import of goods originating from any of these countries/ sources is also prohibited. Imports from India are regulated as notified by the Ministry of Commerce, Government of Pakistan from time to time.

Period of validity of approval by the State Bank

All Authorizations given by the State Bank are valid for a period not exceeding 30 days from the date of approval unless they are expressly approved as valid for a specified longer period or unless they have been revalidated for a further period. Similarly，permits issued by the State Bank are also valid for specified periods as stated on the permit. Authorized Banks should not effect any remittance against approved forms, permits etc., which have been lapsed unless they have been duly revalidated.Release of Foreign Exchange for Travel Abroad

Foreign exchange is issued to travelers against specific or general given by the State Bank. It may be drawn in any foreign currency to the sanctioned amount.

In cases where a traveler desires to draw foreign exchange partly in currency instruments and partly in foreign currency notes, Aut]Banks will prepare two separate fT-lf forms. In the portion meant their certificate, the Authorized Banks will give on both the fT-l'f a suitable indication as to the amounts of foreign exchange released r foreign currency instruments and notes.

Authorized Banks will give a suitable indication to this effect, both on ： the original sanction as well as its photocopy which will be attached witli the relative fT-lT forms and surrendered to the State Bank along withtkd monthly returns of foreign exchange transactions.

Chapter XI deals with dealing in Foreign Currency notes and coins, etc.

Chapter XII deals with Exports.


Exchange policies regarding exports cover all goods exported from Pakistan irrespective of whether they are subject to license under the Export Trade Control Regulations or not. Similarly, nothing in the Exchange policies relieves the exporters from the necessity of complying with the Export Trade Control.

Chapter XIV

1. Freightand Passage Collections.

2. Reporting of Passage and Freight Earnings.

3. Remittance of Surplus Passage and Freight Collections.

4. General Average Payments.

5. Operating Expenses of Pakistani Shipping Companies/Airlines.

6. Charter of Foreign Ships and Aircrafts.

7. Export Claims.

8. Guarantees for Payment of Claims.

9. Employment of Overseas Agents etc.

10. Remittance of Royalty/Franchise and Technical Fees.

11. Technical Services and Consultancy Agreements and

Engagement of Foreign Technicians.

12. Remittances by Information Technology Sector.

13. Remittance of Profits by Foreign Banks/Companies.

14. Payment of Dividend to Non-Resident Shareholders.

15. Export of Dividend Warrants.

16. Foreign Articles in Pakistani Newspapers and Magazines.

17. Remittances on account of News Feature, News Picture, Syndication

Services, Gambles, Comics, Puzzles, Book Reviews etc.


18.Remittances of salary/remunLeration as well as Telex/ Tele fax/

Telegram/ Telephone Charges to the Overseas Correspondents of

Pakistani Newspapers.

19.Advertisements in Newspapers and Magazines abroad.

20.Bank Charges and Sundries.

21.Purchase of Tender Forms from abroad.

22.Registration of Patents and Trade Marks in Foreign Countries.

23.Registration of Exporters of Pharmaceutical products in Foreign

Countries.

SBP Banking Service Corporation Ordinance 2001

Under this ordinance, the establishment of the SBP Banking Service Corporation was promulgated by the President of Pakistan as a subsidiary of the State Bank of Pakistan under its management and control. As in other ordinances and Acts, Section One contains details relating to the title and in Section Two the terms used in the ordinance are defined. The Head Office of the Corporation shall be in Karachi and it may establish branches, offices and agencies in Pakistan and anywhere outside Pakistan with the prior approval of SBP.

Board of Directors

The management and business of the bank and overall policy making in respect of the operation shall vest in the Board of Directors, which may exercise all such powers and perform all such acts, deeds and things that may be exercised or conducted by the SBP (BSC). The Board consists of members of the Central Board of SBP, and the Managing Director of BSC. The Governor is the chairman of the BSC. The Managing Director shall be appointed by the State Bank and he will be the Chief Executive Officer of the Corporation.

Business and functions of SBP BSC

Under the supervision and overall control of SBP, the BSC may transact and carry on all or any of the following functions:

(a) To carry on the statutory and administrative functions and activities of State Bank of Pakistan transferred or delegated.

(b) The handling of the receipt, supply and exchange of bank notes and coins which are legal tender.

(c) The issue, supply, sale, encashment and handling of prize bonds, draws and other saving instruments of Federal Government or of Provincial Government.

(d) Performance of any other activity or business which the State Bank may by order in writing specify.


(e) The State Bank shall not delegate any matter relating to:

• Monetary or credit policy• Regulation and supervision of the financial sector• Foreign exchange regime and exchange rate policy• Payment and settlement system.

Financial Institution Ordinance (Recovery of Finance) 2001

This ordinance further reinforces the rules for the recovery of finance. The Government of Pakistan has modified the rules for loan recovery by modifying the Banking Companies Recovery of Loans, Advances，Credit and Finance Act 1997 and promulgating the Financial Institution Recovery of Finance Ordinance 2001.

Sections 1 and 2 define the title and set out the definitions used in the ordinance.

ection 3 defines the duties of the customer. It shall be the duty of a customer to fulfill his obligation to the financial institution. Where the customer defaults in the discharge of his obligation, he shall be liable to pay，for the period from the date of his default, till the realization of the cost of the funds of the financial institution as certified by the State Bank of Pakistan from time to time apart from such other civil and criminal liabilities that he may incur under the contractor rules or any other law of the time tで ing in force. The provisions of this ordinance shall override anything inconsistent contained in any other law of the time being in force.

Establishment of Banking Courts

Under this ordinance the Federal Government may establish as many banking courts as it considers necessary, and appoint a judge for each such court. In the case of more than one banking court, it shall specify territorial limits within which the banking court shall exercise its jurisdiction.

The high court may, if it considers necessary in the interest of justice or for the convenience of the parties or of the witnesses, transfer any case from one banking court to another.

The judge of the banking court shall be appointed by the Federal Government after consultation with the Chief Justice of the High Court of the Province.

Powers of the Banking Courts

The banking courts, in exercise of their Civil jurisdiction, shall exercise the powers of a civil court and, in the case of criminal jurisdiction, power as vested to the Court of Session，under the relevant law. No court other than a banking court shall have or exercise any jurisdiction with respect to any matter to which the jurisdiction of a banking court extends under the ordinance.


Suit for recovery of written off finance

A financial institution may, within three years from the date of coming into force of this ordinance, file a suit for recovery of any amount written off, released, or adjusted under any agreement, contract, consent, including a compromise or withdrawal of any suit or legal proceeding or adjustment of a decree between a financial institution and a customer, on any day on or after the first day of January 1990.

Procedure of Banking Court

Where a customer or a financial institution commits a default in fulfillment of any obligation, with regard to any finance the financial institution or, as the case may be, the customer, may institute a suit in the banking court by presenting a plaint, which shall be verified on oath by the Branch Manager or officer of the financial institution, duly authorized in this behalf by power of attorney or otherwise.

The plaint shall be supported by a statement of accounts of the customer and other relevant documents in sufficient numbers so that there is one set of copies for each defendant and one extra copy. The»plaint, if filed by a financial institution, shall specifically state:

(a) The amount of finance availed by the defendant from the financial institution.

(b) Amount paid by the defendant with the date of payment.

(c) The amount of finance and other amount relating to finance payable by the defendant to the financial institution up to the date of the institution of the suit.

(d) The amount, if any, which the defendant disputes as payable to the financial institution and facts in support of the plea.

The application for leave to defend shall be accompanied by the documents which, m the opinion of the defendant, support the substantial question of law or facts raised by him. Banking documents must be properly filled in and signed by the customer such as date, amount, the property, details of securities, etc.

Where application for leave is accepted, the court shall treat the application as a written statement.Where application to leave for defends is rejected, or where the defendant fails to fulfill the conditions attached for grant of leave, the banking court shall proceed to pass judgment and decree in favor of the plaintiff against the defendant.

Interim decree

If the banking court is of the opinion that the dispute between the parties does not extend to the whole of the claim or part of the claim is either


undisputed or is clearly due, it shall, while granting leave and ^ issues with respect to the disputed amount, pass an interim respect of the part of the claim which relates to the principal and which appears to be payable by the defendant to the (claimant). The amount of interim decree shall be deducted " amount of final decree as and when awarded.

Final decree

The final decree passed by the banking court shall provide for from the date of the default of the amount of the funds to be pay account of default in payment of obligation, and cost.

What is Prudential Regulation (PR)?

Prudential regulation is regulation of deposit-taking institutions supervision of the conduct of these institutions and which sets requirements that limit their risk-taking. The aim is to ensure the of depositors’ funds and maintain the stability of the financial sy The absence can lead to bank failures and complete instability, establishing sound, clear and easily monitored rules for financial acu both encourages managers to run their institutions better and fa 、 the work of supervisors.

The State Bank of Pakistan, as Central Bank of the country, has Prudential Regulations for agriculture financing, consumer fin commercial and corporate financing, SME financing and micro banks.

PR Agriculture

The importance of agriculture cannot be overemphasized for the economf of Pakistan. It is also a fact that the state of development of Pakistani* agriculture sector lags behind many developing countries, including oar neighboring country, India. While there is a number of steps which can be taken to bring our agriculture sector on a par with other countries one critical factor is the sufficient availability of credit for agriculture^ The Prudential Regulations for Agriculture Financing may be considered only as the minimum standards and the banks/DFIs should take adequate measures to ensure that agricultural financing is undertaken in a prudent manner.

Definitions

Agricultural Financing means the following:

(i) Farm Credit, which includes:

•Production Loans for inputs like seeds, fertilizers, pesticides, etc Production Loans also include working capital finance to meet various associated with farming.


•Farm Development Finance (including finance for improvement of agricultural land, orchards, etc.) and construction of Godowns ， etc. for storage of seed, raw agriculture/farm produce.

• Finance for the purchase of agricultural machinery and equipment like tractors， threshers, etc.

• Credit Card (including Kissan Card) holders are eligible to use their cards for the purposes of Agricultural Financing.

• Non-fund based facility (letter of Guarantee/SBLC and Letter of Credit etc.) for procurement/import of agricultural supplies, etc by corporate and non-corporate farmers.

(ii) Non-farm Credit includes financing for Livestock viz, Dairy, Poultry and Fisheries. Agriculture Financing shall also cover those items eligible under "Methodology Report for Estimation of Agriculture Credit” or any other item approved by SBP/ACAC (Agriculture Credit Advisory Committee) from time to time.

1. A g r i c u l t u r e Financing shall not include loans to traders and intermediaries engaged in trading/processing of agriculture commodities. Such lending would be covered under Prudential Regulations for Corporate/ Commercial Banking or SME Financing. However, agricultural financing can be extended to entities (including corporate farms, partnerships and individuals) engaged in farming activity as well as processing, packaging and marketing of mainly their own agricultural produce, provided 75% of the agricultural produce being processed, packaged and marketed should be produced by the above-mentioned entities themselves.

2. Agriculture Pass Book means a document which confirms land ownership of the farmers and it is issued by the relevant official from Revenue Records of the Provincial Governments/District/City Governments. It contains all revenue records and gives details of Ownership of Land with address，exact location of the land, Khewat，Khatooni and Khasra Number, Produce Index Units (PIU) Value and Market Value of the land, mutation / transferred, loan obtained/repaid, the name of mortgagee, etc. All entries in the said Pass Book are made and authenticated as per provisions contained in M Agriculture, Commercial and Industrial Purposes Act 1973” by the competent authority of the Revenue Department.

3. Bank means a banking company as defined in the Banking Companies Ordinance, 1962 and includes Punjab Provincial Cooperatives Bank Ltd.

4. Borrower means a person, including a corporate farm, to whom any agricultural financing has been extended by a bank/DFI.

5. Corporate Farm means a legal entity separate from its owner(s) and which is carrying out farming activity on a large scale. An entity which is exclusively engaged in processing，packaging and marketing ofagricultural produce shall not fall under this category. Entities eng in farming activity as well as processing, packaging and marketing mainly their own agricultural produce, provided that more than 75% the agricultural produce being processed，packaged and marketed shot have been produced by the farm itself, would be categorized as a Corporaic Farm (i.e. only where the farming constitutes a major portion of its operations).

6. DFI means Development Financial Institution and includes tbe Pakistan


Industrial Credit and Investment Corporation (PICIC)， the Saudi Pak Industrial and Agricultural Investment Company Limited, the Pak Kuwait Investment Company Limited, the Pak Libya Holding Company Limited, the Pak Oman Investment Company (Pvt.) Limited，Investment Corporation of Pakistan, House Building Finance Corporation and any other financial institution mentioned under Section 3-A of the Banking Companies Ordinance, 1962.

7. Equity of the Bank/DFI means Tier-I Capital or Core Capital and includes paid-up capital, general reserves, balance in share premium account, reserve for issue of bonus shares and retained earnings / accumulated losses as disclosed in latest annual audited financial statements. In case of branches of foreign banks operating in Pakistan, equity will mean capital maintained, free of losses and provisions, under Section 13 of the Banking Companies Ordinance, 1962.

8. Equity of the Borrower includes paid-up capital, general reserves, balance in share premium account, reserve for issue of bonus shares and retained earnings / accumulated losses，revaluation reserves on account of fixed assets and subordinated loans. Preference Shares，only with the following features, will now also be included in the equity of the borrower:

• There should not be any provision for redemption or the redemption should be at the option of the issuer.

• In cases where the issuer is given an option to redeem the preference shares, as per agreed terms and conditions, the issuer will redeem the shares only through a sinking fund created out of the profits of the company. Further, the sinking fund created for this purpose would not be included in the calculation of the equity of the issuer.

• The terms and conditions should not give rise to a contractual obligation on the part of the issuer to deliver another financial asset or exchange another financial instrument under conditions that are or can be potentially unfavorable to the issuer. However ， an option to convert preference shares into common shares may be included in the features of the preference shares.

• The terms and conditions of the preference shares should not be such as to compel the issuer economically, financially or otherwise to redeem the shares.

•Payment and distribution of dividend to the holders of preferred shares, whether cumulative or non-cumulative, should be at the discretion of the issuer.

Revaluation reserves will remain part of the equity for the first three years only, from the date of asset revaluation, during which time the borrower will strengthen its equity base to enable it to avail facilities without the benefit of revaluation reserves. However, if a borrower gets revaluation during the three years period， the borrower will be allowed the benefit from fresh revaluation, to the extent of increase in revaluation reserves, but restricting the benefit of such incremental value to 3 years only. Similarly, if，after 3 years，the borrower again gets revaluation of the assets with resultant addition in their value, the benefit of such revaluation may also be allowed for the next 3 years，again to the extent of increase in revaluation reserves.

The revaluation reserves to be eligible for benefit should be calculated by the valuers on the approved panel of the PBA. If the bank/DFI obtains a copy of accounts as per the requirement in Prudential Regulation R- 27， then such revaluation reserves should appear in the said accounts, and in such case，no parallel calculation by the banks / DFIs for amortization purposes will be required. In case of no requirement of copy of accounts, the borrower may still be given the benefit of revaluation reserves in the way mentioned above, but the bank / DFI will calculate the amortization of the same independently.

9. Exposure means financing facilities whether fund based and / or non-fund based and includes:

i) Any form of financing facility extended or bills purchased/ discounted except ones drawn against the L/Cs of banks / DFIs rated at least ?A! by Standard & Poors，Moodyfs，and Fitch-Ibca or credit rating agency on the approved panel of State Bank of Pakistan and duly accepted by such L/C issuing banks/ DFIs.

ii) Any financing facility extended or bills purchased/discounted on the guarantee of the person.

iii) Subscription to or investment in shares, Participation Term Certificates, Term Finance Certificates or any other Commercial Paper by whatever name called (at book value) issued or guaranteed by the persons.

iv) Credit facilities extended through credit cards or kissan cards or other such cards, etc.

v) Any financing obligation undertaken on behalf of the person under a letter of credit including a stand-by letter of credit, or similar instrument.

vi) Loan repayment financial guarantees issued on behalf of the person.

vii) Any obligations undertaken on behalf of the person under any other guarantees including underwriting commitments.

viii) Acceptance/endorsements made on account.

ix) Any other liability assumed on behalf of the client to advance funds pursuant to a contractual commitment.

10. Financial Institution mean banks, Development Financial Institutions (DFIs) and NBFCs.11. F o r c e d Sale Value means the value which fully reflccrs ipossibility of price fluctuations and can currently be obtained by *• the mortgaged/pledged assets in forced/distressed sale conc

12. Government Securities shall include such types of Pat obligations of the Federal Government or a


Provincial Gover of a Corporation wholly owned or controlled, directly or ind the Federal Government or a Provincial Government and gua the Federal Government as the Federal Government may, by nc in the Official Gazette, declare, to the extent determined from time，to be Government Securities.

13. Group means persons，whether natural or juridical, if one ofl or his dependent family members or its subsidiary have control or 1 substantial ownership interest over the other. For the purpose of 1

(a) Subsidiary will have the same meaning as defined in 3 section 3(2) of the Companies Ordinance, 1984，i.e. a companfl a body corporate shall deemed to be a subsidiary of; company if that other company or body corporate directly < indirectly controls, beneficially owns or holds more than 50%4 its voting securities or otherwise has power to elect and; more than 50% of its directors.

(b) Control refers to an ownership，directly or indirectlf] through subsidiaries, of more than one half of voting power ci an enterprise.

(c) Substantial ownership / affiliation means beneficial share holding of more than 25% by a person and / or by his dependent family members, which will include his/her spouse, dependat | lineal ascendants and descendants and dependent brothers mi sisters. However, shareholding in or by Government-owi entities and financial institutions will not constitute substantial ownership/affiliation, for the purpose of these Prudentijl Regulations.

14. Liquid Assets are the assets which are readily convertible into cash without recourse to a court of law and mean encashment/realizabfe value of government securities, bank deposits, certificates of depoal, gold/silver ornaments, certificates of National Saving Schemes, shares of listed companies which are actively traded on the stock exchange, NIT Units, certificates of mutual funds, Certificates of Investment (COIs) issued by DFIs/NBFCs rated at least ’A’ by a credit rating agency on tbe approved panel of State Bank of Pakistan, listed TFCs rated at least fA" by a credit rating agency on the approved panel of State Bank of Pakistan and certificates of asset management companies for which there is a book maker quoting daily offer and bid rates and there is active secondary market trading. These assets with appropriate margins should be in possession of the banks/DFIs with perfect lien.

Guarantees issued by domestic banks/DFIs, when received as collateral by banks/DFIs, will be treated at par with liquid assets, whereas, for guarantees issued by foreign banks，the issuing banks’ rating，assignedeither by Standard & Poors，Mood/s or Fitch-Ibca, should be !Af and above or equivalent.

The Inter-branch Indemnity/Guarantee issued by the bank’s overseas branch in favor of its sister branch in Pakistan, would also be treated at par with Liquid Assets, provided the bank is rated ?AT and above or equivalent either by Standard & Poors, Moody’s or Fitch-Ibca. The indemnity for this purpose should be similar to a guarantee, i.e. unconditional and demand in nature.

15. Market Value means value assigned by the revenue authorities on the basis of three years average market sale price per acre of the area, OR valuation carried out by PBA approved evaluator.

Banking Laws and Regulations

223

16. NBFC means Non Bank Finance Company as defined in NBFC Rules 2003，issued by Securities and Exchange Commission of Pakistan (SECP).

17. Other Form of Security means hypothecation of movable agricultural machinery, pledge/ hypothecation of agriculture produce on the farm or in godown，and charge on livestock on the farm. In case of pledge/ hypothecation of agriculture produce lying in godown, the title/ownership of the produce in the name of the borrower shall be determined on the basis of appropriate documents.

18. PIU Value means value of the agricultural land determined by the Federal Government on the basis of produce index units.

19. Secured means exposure backed by tangible security and any other form of security with appropriate margins (in cases where margin has been prescribed by the State Bank, appropriate margin shall at least be equal to the prescribed margin). Exposure without any security or collateral or backed solely by personal guarantees would be considered as clean.

Banks/DFIs may also take exposure against Trust Receipt. They are, however, free to take collateral/securities, to secure their risks/exposure, in addition to the Trust Receipt.

Banks/DFIs will be free to decide about obtaining security/collateral against the L/C facilities for the interim period, i.e. from the date of opening of L/C till the receipt of title documents to the goods.

20. Subordinated Loan means an unsecured loan extended to the borrower

by its sponsors, subordinate to the claim of the bank / DFI taking exposure on the borrower and documented by a formal subordination agreement between provider of the loan and the bank / DFI. The loan shall be disclosed in the annual audited financial statements of the borrower as a subordinated loan.

21. Tangible Security means liquid assets (as defined in these Prudential Regulations) and mortgage of land, both urban and rural property (equitable as well as registered), building and any other fixed asset.


Mortgage of land created by way of bank’s charge on passbook registration of charge in the books of the revenue authority wcmM be considered valid tangible security.

Regulations

Regulation R-l Repayment capacity of the borrower.

Regulation R-2 Comprehensive agriculture financing poiicjJ

Regulation R-3 Standardized documents.

Regulation R-4 Expeditious processing and communicatioml of decision to borrower.

Regulation R-5 Maximum per party limit.

Regulation R-6 Maximum unsecured financing.

Regulation R-7 Repayment schedule and relaxation to agricultural meet indicative targets.

Regulation R-8 Proper utilization of loan.

Regulation R-9 Credit report.

Regulation R-10 Borrower basic fact sheet and KYC requirements.

Regulation R-ll Cash recovery outside the bank’s authorized place of Business.

Regulation R-l 2 Bar on adjustment lending to avoid classification or meet indicative targets.

Regulation R-l 3 Guarantees. *

Regulation R-14 Classification of agriculture loans.

Regulation R-l5 Regularization of the non-performing loans.

Regulation R-l 6 Tenure.

Regulation R-l7 Classification and provisioning.

Regulation R-18 Classification and provisioning.

C. Loans for the Purchase of Machinery / Equipment:

Regulation R-l 9 Security.

Regulation R-20 insurance.

Regulation R-21 Classification and provisioning.

Regulation R-22 Security.

Regulation R-23 Periodic inspection and verification.

Regulation R-24 Tenure.

Regulation R-25 Classification and provisioning.Regulation R-26 Linkage between financial indicators of the

borrower and total exposure from financial institution.

Regulation R-27 Copy of audited accounts where exposure exceed Rs 10 million.

Prudential Regulations for Corporate and Commercial Banking

D e f i n i t i o n s

For the purpose of these regulations:

1. Account Holder means a person who has opened any account with a bank or is a holder of deposit/deposit certificate or any instrument representing deposit/placing of money with a bank/DFI or has borrowed money from the bank/ DFI.

2. Alternate Director means a person who has been designated by a director during his absence, as per provisions of sub-section (2) of section 192 of Companies Ordinance, 1984.

3.Bank means a banking company as defined in the Banking Companies Ordinance, 1962.

4.Borrower means a person on whom a bank/DFI has taken any exposure during the course of business.

5. Chief Executive Officer (CEO), in relation to bank/DFI, means an individual who, subject to the control and directions of the directors, is entrusted with the whole, or substantially the whole, of the powers of management of the affairs of the bank/DFI, occupying the position of Chief Executive Officer and including President, acting President, Managing Director, Country Head of Foreign bank, Executive assuming charge of the bank for interim period or by whatever name called, and whether under a contract of service or otherwise.

6.Contingent Liability means:

a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or

b) a present obligation that arises from past events but is not recognized because:

i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation;

or

ii) the amount of the obligation cannot be measured with 、sufficient reliability;

and includes letters of credit, letters of guarantee, bid bonds/performance bonds, advance payment guarantees and underwriting commitments.

7.Corporate Card means credit card issued to the employees of an entity where the repayment is to be made by the said entity.8.DFI means Development Financial Institution and includes ±ie Industrial Credit and Investment Corporation (PICIC)，the Industrial and Agricultural Investment Company Limited, the Investment Company Limited, the Pak Libya Holding Compauf the Pak Oman Investment Company (Pvt.) Limited，In Corporation of Pakistan, House

Building Finance Corporation, Pak Brunei Investment Company Pak-Iran Joint Investment Company Limited2, Pak-China I 广Company Limited3, and any other


financial institution notified Section 3-A of the Banking Companies Ordinance，

9. Documents include vouchers, cheques, bills, pay-orders, p notes, securities for leases/advances and claims by or against the or other papers supporting entries in the books of a b

10.Director includes any person occupying the position of a diiedor the Board of a bank/DFI and includes sponsor，nominee and alt director or by whatever name called.

11. Executive Director means a paid employee or executive in the bank/DFI or employee or executive in a company/group where spoonrj shareholders of the bank/DFI have substantial interest.

12. Equity of the Bank/DFI means Tier-I Capital or Core Capital and includes paid-up capital, general reserves, balance in share premhmi account, reserve for issue of bonus shares and retainec earnings/accumulated losses as disclosed in latest annual audited financiai statements. In case of branches of foreign banks operating in Pakistan, equity will mean capital maintained, free of losses and provisions, under Section 13 of the Banking Companies Ordinance, 1962.

For the purpose of Regulation R-l, reserve shall also include revaluation reserves on account of fixed assets to the extent of 50% of their value. However, for this purpose assets must be prudently valued by valuators on the panel of Pakistan Bank Association (PBA) ， fully taking into account the possibility of price fluctuations and forced sale value. Revaluation reserves reflecting the difference between the book value and the market value will be eligible up to 50%.

13. Equity of the Borrower includes paid-up capital, general reserves, balance in share premium account, reserve for issue of bonus shares and retained earnings/accumulated losses, revaluation reserves on account of fixed assets and subordinated loans.

Preference Shares, only with the following features, will also be included in the equity of the borrower:

• There should not be any provision for redemption or the redemption should be at the option of the issuer.


share only through a sinking fund created out of the profits of the company. Further, the sinking fund created for this purpose would not be calculated towards the equity of the issuer.

•The terms and conditions should not give rise to a contractual obligation on the part of the issuer to deliver another financial asset or exchange another financial instrument under conditions that are or can be potentially unfavorable to the issuer. However, an option to convert preference shares into common shares may be included in the features of the preference shares.

• The terms and conditions of the preference shares should not be such as to compel the issuer economically, financially or otherwise to redeem the shares.

•Payment and distribution of dividend to the holders of preferred shares, whether cumulative or non-cumulative, should be at the discretion of the issuer.

Revaluation reserves will remain part of the equity for the first three years only, from the date of asset revaluation, during which time the borrower will strengthen its equity base to enable it to avail facilities without the benefit of revaluation reserves. However，if a borrower gets revaluation during the three years period, the borrower will be allowed the benefit from fresh revaluation, to the extent of increase in revaluation reserves, but restricting the benefit of such incremental value to 3 years only. Similarly, if after 3 years, the borrower again gets revaluation of the assets with resultant addition in their value, the benefit of such revaluation may also be allowed for the next 3 years, again to the extent of increase in revaluation reserves.

The revaluation reserves to be eligible for benefit should be calculated by the valuers on the approved panel of the PBA. If the bank/DFI obtains copy of accounts as per requirement in Prudential Regulation R-3, then such revaluation reserves should appear in the said accounts, and in such case, no parallel calculation by the banks/DFIs for amortization purposes will be required. In case of no requirement of copy of accounts, the borrower may still be given the benefit of revaluation reserves in the way mentioned above, but the bank/DFI will calculate the amortization of the same independently.

14. Exposure means financing facilities whether fund based and/or nonfund based and includes:

i) Any form of financing facility extended or bills purchased/discounted except ones drawn against the L/Cs of banks/DFIs rated at least fA? by Standard & Poors, Moodyfs, Fitch- Ibca, Japan Credit Rating Agency (JCRA) or credit rating agency on the approved panel of State Bank of Pakistan and duly accepted by such L/C issuing banks/DFIs:

ii) Any financing facility extended or bills purchased/discounted on the guarantee of the person.


iii) Subscription to or investment in shares, Particij Term Certificates, Term Finance Certificates or any Commercial Paper by whatever name called (at book value) issuoij or guaranteed by the persons.

iv) Credit facilities extended through corporate card&

v) Any financing obligation undertaken on behalf of dar person under a letter of credit including a stand-by letter of credit or similar instrument.

vi) Loan repayment financial guarantees issued on behalf of the person.

vii) Any obligations undertaken on behalf of the person under any other guarantees including underwriting commitments.

viii) Acceptance/endorsements made on account-

ix) Any other liability assumed on behalf of the client to advance funds pursuant to a contractual commitment.

15. Family Member as defined in sub-section (fF) of section 5 of Banking Companies Ordinance 1962.1

16.Financial Institutions mean banks, Development Financial Institutions (DFIs) and NBFCs.

17. Forced Sale Value (FSV) means the value which fully reflects the possibility of price fluctuations and can currently be obtained by selling the mortgaged/pledged assets in a forced/distressed sale conditions

18. Government Securities shall include such types of Pak. Rupee obligations of the Federal Government or a Provincial Government or of a Corporation wholly owned or controlled, directly or indirectly, by the Federal Government or a Provincial Government and guaranteed by the Federal Government as the Federal Government may, by notification in the Official Gazette，declare，to the extent determined from time to time, to be Government Securities.

19. Group means persons, whether natural or juridical, if one of them or his dependent family members or its subsidiary, have control or hold substantial ownership interest over the other. For the purpose of this:

a) Subsidiary will have the same meaning as defined in subsection 3(2) of the Companies Ordinance, 1984, i.e. a company or a body corporate shall deemed to be a subsidiary of another company if that other company or body corporate directly or indirectly controls, beneficially owns or holds more than 50% of its voting securities or otherwise has power to elect and appoint more than 50% of its directors.

b) Control refers to an ownership directly or indirectly through subsidiaries, of more than one half of voting power of an enterprise.


c) Substantial ownership/affiliation means beneficial shareholding of more than 25%2 by a person and/or by his dependent family members, which will include his/her spouse, dependent lineal ascendants and descendants and dependent brothers and sisters. However, shareholding in or by Government- owned entities and financial institutions will not constitute substantial ownership/affiliation, for the purpose of these regulations.

20. Independent Director means such a person who is not linked directly or indirectly with bank/DFI or its sponsor or strategic shareholders. For the purpose of such determination, an ’’independent director” is a director who:

Has not been employed by Bank /DFI within the last five years;

Has not been an employee or affiliate of any present or former external auditor/consultant/legal advisor of Bank/DFI within the last three years; has not been an executive officer or employee of a subsidiary or associated company of the bank/DFI or where Directors of the bank/DFI has substantial beneficial interest (20% or more shareholding of director’s own or combined with family members) has not been employed by a company of which an executive officer of Bank/DFI has been a director within the last three years; is not affiliated with a not-for-profit entity that received contributions from Bank/DFI exceeding the greater of 10 million or 2 percent of such charitable organization、consolidated gross revenues during the current fiscal year or any of the last three completed fiscal years.

(Note ： An independent director shall submit a declaration for his/her independence to SBP at the time of his/her appointment.)

21. Key Executive' means key executives of banks/DFIs and includes the following functional responsibilities for the present:

a) Any executive, acting as second to CEO including Chief Operating Officer，Deputy Managing Director or by whatever name called

b) Chief Financial Officer/Head of Finance/Head of Accounts

c) Head of Internal Audit

d) Country Treasurer

e) Head of Credit/Risk Management

f) Head of Operations

g) Head of Compliance

h) Head of Human Resource

i) Head of Information Technologyk) Head of overseas operations of a bank at head office levd

1)Country Head/Regional Head (where a region consists of nxar than one foreign countryi)

m) CEO/Head of subsidiary banking company outside Pakistsm

n) CEO of Joint Venture (where majority stake is with the bank


incorporated in Pakistan and authority to appoint CEO)2

The above list will be reviewed from time to time by SBF.

22. Liquid Assets are the assets which are readily convertible into casii without recourse to a court of law and mean encashment/realizable value of government securities, bank deposits, certificates of deposit, shares of listed companies which are actively traded on the stock exchange, NIT Units, certificates of mutual funds, Certificates of Investment (COIs issued by DFIs/NBFCs rated at least 'Af by a credit rating agency on the approved panel of State Bank of Pakistan, listed TFCs rated at leastby a credit rating agency on the approved panel of State Bank of Pakistan and certificates of asset management companies for which there is a book maker quoting daily offer and bid rates and there is active secondary market trading. These assets with appropriate margins should be in possession of the banks/DFIs with perfected lien.

Guarantees issued by domestic banks/DFIs when received as collateral by banks/ DFIs will be treated at par with liquid assets whereas, for guarantees issued by foreign banks，the issuing banks，rating, assigned either by Standard & Poors, Moody’s or Fitch-Ibca, should be ?A? and above or equivalent.

The inter-branch indemnity/guarantee issued by the bank’s overseas branch in favor of its sister branch in Pakistan, would also be treated at par with liquid assets, provided the bank is rated fA* and above or equivalent either by Standard & Poors ，Moody?s, Fitch-Ibca or Japan Credit Rating Agency (JCRA). The indemnity for this purpose should be similar to a guarantee i.e. unconditional and demand in nature.

23. Major Shareholder of a bank/DFI means any person holding 5% or more of the share capital of a bank/DFI either individually or in concert with family members. Family members have the same meaning as defined in the Banking Companies Ordinance，1962.

24. Medium and Long Term Facilities mean facilities with maturities of more than one year and Short Term Facilities mean facilities with maturities up to one year.

25.NBFC means Non-Banking Finance Company and includes a Modaraba，

Leasing Company, Housing Finance Company, Investment Bank, Discount House, Asset Management Company and a Venture Capital Company.


26.. Nominee Director means a person nominated on the board of a bank/DFI by sponsor(s), persons, company, institution etc. by virtue of his/their shareholding in a bank/DFI.

27. Other Form of Security means hypothecation of stock (inventory), assignment of receivables, lease rentals, contract receivables，etc.

28. PBA means Pakistan Banks Association.

29. Person means and includes an individual,a Hindu undivided family, a firm, an association or body of individuals whether incorporated or not, a company and every other juridical person.

30. Readily Realizable Assets mean and include liquid assets and stocks pledged to the banks/DFIs in possession, with 'perfected lien’ duly supported with complete documentation.

31.Secured means exposure backed by tangible security and any other form of security with appropriate margins (in cases where margin has been prescribed by State Bank, appropriate margin shall at least be equal to the prescribed margin). Exposure without any security or collateral is defined as clean.

The banks/DFIs may also take exposure against Trust Receipt. They are, however, free to take collateral/securities, to secure their risks/exposure, in addition to the Trust Receipt.

Banks/DFIs will be free to decide about obtaining security/collateral against the L/C facilities for the interim period, i.e. from the date of opening of L/C till the receipt of title documents to the goods.

32.Sponsor Shares 1 mean 5% or more paid-up shares of a bank, acquired by a person(s) individually or in concert with his family members (including his spouse, lineal ascendants and descendents and dependent brothers and sisters), group companies, subsidiaries, and affiliates/associates.

Such acquisition of shareholding will include all the shares acquired by aforesaid person(s) including, inter alia, through (a) as original subscriber/promoter of the bank; (b) subsequent right/bonus issues; (c) market based acquisition deal;(d) reconstruction/restructuring of a bank carried out by SBP; (e) strategic sale through privatization (f) amalgamation of banking companies; or (g) any other mode of acquisition. All shares acquired by common shareholders, who are also sponsor shareholders, of amalgamating banking companies in amalgamation transaction shall be considered Sponsor Shares.

33. Sponsor Shareholdersl means all those shareholders of a bank holding sponsor shares.

34. Sponsor Director 1 means the member of the Board of Directors of a bank holding sponsor shares.

35. Strategic Investment is an investment which a bank/DFI makes with the intention of holding it for a minimum period of 5 years.The following must be noted further in respect of strategic investment:


a. The bank should mark strategic investment as such at the time of investment.

b. If there are a series of purchases of stocks of a company, the minimum retention period of 5 years shall be counted from the date of the last purchase.

c. The banks/DFIs will report their investment in strategic portfolio to the Banking Policy Department, within 2 working days from the date of such investment.

36. Subordinated Loan means an unsecured loan, extended to the borrower for a minimum original maturity period of 5 years, subordinate to the claim of the bank/DFI taking exposure on the borrower, and documented by a formal sub-ordination agreement between provider of the loan and the bank/DFI. The loan shall be disclosed in the annual audited financial statements of the borrower as subordinated loan.

37. Substantial ownership/affiliation2 means beneficial shareholding of more than 20% by a person and/or by his dependent family members, which will include his/her spouse, dependent lineal ascendants and descendants and dependent brothers and sisters. However, shareholding in or by the Government owned entities and financial institutions will not constitute substantial ownership/affiliation, for the purpose of these regulations.

38. Tangible Security means readily realizable assets (as defined in these Prudential Regulations), mortgage of land， plant, building, machinery and any other fixed assets.

39.Underwriting Commitments mean commitments given by commercial banks/DFIs to the limited companies at the time of new issue of equity/debt instrument, that in case the proposed issue of equity/debt instrument is not fully subscribed, the un-subscribed required.

REGULATION R-1LIMIT ON EXPOSURE TO A SINGLE PERSON/GROUP

1. The total outstanding exposure (fund based and non-fund based) by a bank/DFI to any single person shall not at any point in time exceed 30% of the bank’s/DFI’s equity as disclosed in the latest audited financial statements, subject to the condition that the maximum outstanding against fund based exposure does not exceed 20% of the bank’s/DFI’s equity.

2.The total outstanding exposure (fund based and non-fund based) by a bank/DFI to any group shall not exceed 50% of the bankfs/DFIfs equity as disclosed in the latest audited financial statements, subject to the condition that the maximum outstanding against fund based exposure does not exceed 35% of the bank’s/DFI’s equity.

3.Limit on exposure to a single person/Group effective from 31-12-2009 and onward would be as under:


Effective date Exposure limit as a % of bank /DFFs equity (as disclosed in the latest audited financial statements)

For single person For group

Total outstanding(fund

and non-fund based) exposure

limit

Fund based outstanding

limit

Total outstanding (fund and nonfund based) exposure limit

Fund based outstanding

limit

31-12-2009 30 20 45 3531-12-2010 30 20 40 35

31-12-2011 30 20 35 3031-12-2012 30 20 30 25

31-12-2013 25 25 25 25

4. The group will cover both corporate entities as well as SMEs, in cases where such entities are owned by the same group.

5. For the purpose of this regulation banks/DFIs are required to follow the guidelines given at Annexure-I.

REGULATION R-2LIMIT ON EXPOSURE AGAINST CONTINGENT LIABILITIES

1. Contingent liabilities of a bank/DFI shall not exceed at any point in time 10 times of its equity. Following shall not constitute contingent liabilities for the purpose of this regulation:

a) Bills for collection.

b) Obligations under Letters of Credit and Letters of Guarantee to the extent of cash margin retained by the bank/DFI.


c) Letters of credit/guarantee where the payment is gu by the State Bank of Pakistan/Federal Government or ba rated at least ’A’ by a credit rating agency on the approved of State Bank of Pakistan or Standard & Poors? Moody's. Fi Ibca or Japan Credit Rating Agency (JCRA).

d) Non-fund based exposure to the extent covered by liquid

e) Claims other than those related to provision of facilities ( 參 based or non-fund based) to the banks，/DFIs，constituents, wheir the probability of conversion of these claims into liabilities jut remote.

2.For the purpose of this regulation, weightage of 50% shall be given ^ bid/mobilization advance/performance bonds and 10% to forward fordgB exchange contracts.

REGULATION R-3MINIMUM CONDITIONS FOR TAKING EXPOSURE

1. Whileconsidering proposals for any exposure (including renewal enhancement and rescheduling/restructuring) exceeding such limit as may be prescribed by State Bank of Pakistan from time to time (presently at Rs 500,000), banks/DFIs should give due weightage to the credit report relating to the borrower and his group obtained from Credit Information Bureau (CIB) of State Bank of Pakistan. However, banks/DFIs may take exposure on defaulters keeping in view their risk management policies and criteria, provided they properly record reasons and justifications in the approval form. The condition of obtaining CIB report will apply to exposure exceeding Rs 500,000/- after netting-off the liquid assets held as security.

renewal, enhancement and rescheduling/restructuring) until and unless the Loan Application Form (LAF) prescribed by the banks/DFIs is accompanied by a fBorrowerfs Basic Fact Sheet1 under the seal and signature of the borrower as per approved format of the State Bank of Pakistan (Annexure II-A for corporate borrowers and Annexure II-B for individual borrowers).

REGULATION R-4LIMIT ON EXPOSURE AGAINST NSECURED FINANCING FACILITIES

1. Banks/DFIs shall not provide unsecured/clean financing facility in any form of a sum exceeding Rs 500,000/- (Rupees five hundred thousand only) to any one person. Financing facilities granted without securities including those granted against personal guarantees shall be deemed as fcleanf for the purpose of this regulation. Further, at the time of granting a clean facility, banks/DFIs shall obtain a written declaration to the effect that the borrower in his own name or in the name of his family members, has not availed of such facilities from other banks/DFIs so as to exceed the prescribed limit of Rs 500,000/- in aggregate.

2. For the purpose of this regulation, following shall be excluded/exempted from the per party limit of Rs 500,000/- on the clean facilities:

a) Facilities provided to finance the export of commodities eligible


under Export Finance Scheme.

b) Financing covered by the guarantee of Pakistan Export Finance Guarantee Agency.

c) Loans/advances given to the employees of the banks/DFIs in accordance with their entitlement/staff loan policy.

d) Investment in COIs/inter bank placements with NBFCs, provided the investee NBFC is rated ,A+' fA? or fAJ for long-term rating and at least fA2? for short-term rating or equivalent by a credit rating agency on the approved panel of the State Bank of Pakistan or Standard & Poors, Moody’s，Fitch-Ibca or Japan Credit Rating Agency (JCRA).n instructions, will be exempted from the aggregate exposure limit.


REGULATION R-5LINKAGE BETWEEN FINANCIAL INDICATORS OF THE BORROWER AND TOTAL EXPOSURE FROM FINANCIAL INSTITUTIONS

1. While taking any exposure, banks/DFIs shall ensure that the total exposure (fund-based and/or non-fund based) availed by any borrower from financial institutions does not exceed 10 times of borrower's equity as disclosed in its financial statements (obtained in accordance with Para 2 of Regulation R-3), subject to the condition that the fund based exposure does not exceed 4 times of its equity as disclosed in its financial statements. However, where the equity of a borrower is negative and the borrower has injected fresh equity during its current accounting year， it will be eligible to obtain finance up to 4 times of the fresh injected equity (instead of the existing 3 times) provided the borrower shall plough back at least 80% of the net profit each year until such time that it is able to borrow without this relaxation. After 30th June 2009, the borrower will be eligible only up to 3 times of his fresh injected equity.

In exceptional cases, banks/DPIs may allow seasonal financing to borrowers, for a maximum period of six months, not meeting the criteria of 4 times of fund based exposure and 10 times total exposure, subject to the condition that fund based exposure does not exceed 8 times and total exposure does not exceed 12 times of borrower equity. In case of NBFCs, the total exposure (i.e. fund based and/or non-fund based) availed by any NBFC from financial institutions shall not exceed 10 times of its equity, without the restriction of fund based exposure to be 4 times as in case of other types of borrowers.

2. At the time of allowing fresh exposure/enhancement/renewal, the banks/DFIs should ensure that the current assets to current liabilities ratio of the borrower is not lower than such ratio as may be required under the Credit Policy of the bank/DFI. Banks/DFIs shall prescribe the minimum current ratio under their Credit Policy keeping in view the quality of the current assets, nature of the current liabilities, nature of industry to which borrower belongs to, average size of current ratio of that industry, appropriateness of risk mitigants available to the bank/DFI etc. It is expected that bank/DFFs Credit Policy, duly approved by the Board of Directors, shall emphasize higher credit standards and provide full guidance to the management about the current ratio requirement for various categories of clients and corresponding risk mitigants etc. acceptable to the bank/DFI.1

3. For the purpose of this regulation, subordinated loans shall be counted as equity of the borrower. Banks/DFIs should specifically include the condition of subordinated loan in their Offer Letter. The subordination agreement to be signed by the provider of the subordinated loan, should confirm that the subordinated loan will be repaid after that bankfs/DFITs prior approval.


Industrial Restructuring Corporation (CIRC) and the State Bank of Pakistan BPD Circular No. 29 dated October 15 ， 2002， for a period of five years from the date of such settlement. Export finance and finance provided to ginning and rice husking factories shall also be excluded from the borrowings (exposure) for the purpose of this regulation.

5. Where the banks/DFIs have taken exposure on exceptional basis as provided in para 1 above， they shall record in writing the reasons and justifications for doing so in the approval form and maintain a file in their central credit office containing all such approvals. The Exceptions Approval file shall be made available to the inspection team of State Bank during the inspection.

REGULATION R-6

EXPOSURE AGAINST SHARES/TFCs AND ACQUISITION OF SHARES

1. A) EXPOSURE AGAINST SHARES/TFCs:

Banks/DFIs shall not:

a) Take exposure against the security of shares/TFCs issued by them.

b) Provide unsecured credit to finance subscription towards floatation of share capital and issue of TFCs.

c) Take exposure against the non-listed TFCs or the shares of companies not listed on the Stock Exchange(s). However，banks/DFIs may make direct investment in non-listed TFCs.

d) Take exposure on any person against the shares/TFCs issued by that person or sits subsidiary companies. For the purpose of this clause, person shall not include individual.

e) Take exposure against 'sponsor director’s shares’ (issued in their own name or in the name of their family members) of banks/DFIs.

f) Take exposure on any one person (whether singly or together with other family members or companies owned and controlled by him or his family members) against shares of any commercial bank/DFI in excess of 5% of paid-up capital of the share issuing bank/DFI.

g) Take exposure against the shares/TFCs of listed companies that are not members of the Central Depository System.

h) Take exposure against unsecured TFCs or non-rated TFCs or TFCs rated below ， BBB’ or equivalent. Exposure may, however, be taken against unsecured/subordinated TFCs, which are issued by the banks/DFIs for meeting their minimum capital requirements, as per terms and conditions stipulated in BSD Circular No.12 of August 25，2004.

i) Take exposure against shares unless the beneficiary of the facility is absolute owner of the shares so pledged or has the necessary mandate to pledge the shares of third party as security for availing financing facility from the bank/ DFI.a) Banks/DFIs shall not own shares of any company/scrips in excess of 5% of their own equity. Further, the total investments of banks in shares should not exceed 20% of their own equity. DFIs which are not mobilizing funds as deposits/COIs from general public/individuals will be exempt from the requirement of capping their total investment in equities. However, DFIs which are mobilizing funds as deposits/COIs from general public/individuals will be required to contain their investment in shares upto 35% of their equity. The shares will be valued at cost of acquisition for the purpose of calculating bankfs/DFIfs exposure under this regulation. The investments of the bank/DFI in its subsidiary companies (listed as well as non-listed) and strategic investments of the bank/DFI, shall not be included in these limits. The shares acquired in excess of 5% limit due to the underwriting commitments will be sold


off/off loaded within a period of three months.

The condition of capping aggregate exposure shall also be applicable on Islamic banks to the extent of 35% of their equity. For the purpose of this regulation, shares will also include units of all forms of Mutual Funds excluding NIT units till its privatization.

b) Banks/DFIs may also take exposure in future contracts to the extent of 10% of their equity on aggregate basis. In this connection, the 10% exposure limit for future contracts will include both positions taken in futures buying and selling.

c) Banks/DFIs may combine the limits for ready market and future contracts and have the aggregate exposure in shares to the extent of 30% of their equity (in case of Islamic Banks/DFIs upto 45% of their equity) provided that investment in future contracts shall not exceed 10% of their equity. In order to facilitate development of Real Estate Investment Trusts (REIT) in Pakistan, banks/DFIs’ investment in units of REIT shall not be counted towards the aggregate investment limits of 30% and 45% of equity of the banks and Islamic banks/DFIs respectively.1

d) Banks/DFIs will obtain prior approval from the State Bank while purchasing shares of a company in excess of 5% of their paid-up capital or 10% of the capital of investee company, whichever is lower. These limits will be calculated as under:

x In the case of investee company,10% limit will be calculated by taking 10% of the number of its paid-up shares.

x In the case of investing bank, 5% limit will be calculated by taking 5% of paid-up shares of the bank and then multiplying with their face value.

The bank’s/DFI’s request will be considered in the light of the nature of relationship of the investing bank and the investee company. Further, other factors, such as financial standing of the investing bank, its aggregate investment portfolio, experience in managing the same, efficacy of internal controls etc. will also be taken into account.


In case, shares in excess of above limit are acquired by the bank/DFI through settlement of a facility or by any other means, the information to this effect will be conveyed to the State Bank of Pakistan within three days of the acquisition of such shares. Furthermore, the shares so acquired should be disposed off within one year to comply with the limits given above.2

e) Regarding strategic investment, the banks/DFIs will exercise proper diligence， as their decision to make strategic investment carries great significance, keeping in view the implications of such investment in terms of liquidity management and long term outlook of the investee companies. In this regard, the banks/DFIs should take into account all relevant factors. Accordingly, the following should be ensured:

x A committee, clearly designated/empowered by the bank, should take the decision for strategic investment.

x All Record of transactions/decisions, taken by the committee, regarding strategic investment should be properly maintained and kept in a separate file，for provision of the same to the SBP Inspection Team during their visit to the bank.

x The banks/DFIs will report their investment in strategic portfolio to the Banking Policy Department, within 2 working days from the date of such investment.

f) While calculating the maximum limit for investment in shares, the amount of provisions created against permanent diminution by debiting the Profit and Loss account, as instructed vide BSf) Circular No.10 dated July 13，2004，may be deducted from the cost of acquisition of such investments and the maximum limit. Further, investment in preference shares, which fulfill the criteria of equity instrument as laid down in Part- A of these regulations, shall be considered as part of investment in equities. Correspondingly, any investment in preference shares that do not conform to these conditions shall not be included in the limits prescribed under this regulation. However, such investment portfolio will be considered as part of the maximum exposure limit as prescribed under R-1 of these regulations.

2. Banks/DFIs shall not hold shares in any company whether as pledge, mortgagee，or absolute owner, of an amount exceeding 30% of the paid-up share capital of that company or 30% of their own paid-up share capital and reserves, whichever is less.4. Exposure against TFCs rated ’A’ (or equivalent) and above by a credit rating agency on the approved panel of State Bank of Pakistan shall be subject to a minimum margin of 10% while the exposure against TFCs rated fA-! and ’BBB’ shall be subject to a minimum margin of 20%.

REGULATION R-7 GUARANTEES

1. All guarantees issued by the banks/DFIs shall be fully secured, except in the cases mentioned at Annexure-III where it may be waived up to 50% by the banks/DFIs at their own discretion, provided that banks/DFIs hold at least 20% of the guaranteed amount in the form of liquid assets as


security.

2. The requirement of security can also be waived by the banks/DFIs in cases of guarantees issued to Pakistani firms and companies functioning in Pakistan against the back to back/counter guarantees of branches of guarantee issuing bank/DFI or banks/DFIs rated at least fAf or equivalent by a credit rating agency on the approved panel of State Bank of Pakistan or Standard & Poors ， Moody's, Fitch-Ibca or Japan Credit Rating Agency (JCRA). Besides， in cases where the counter-guarantee issuing bank is situated in a foreign country, the rating of at least TAf or equivalent by a local credit rating agency of the respective country shall also be acceptable, provided the guarantee issuing bank in Pakistan is comfortable with and accepts the counter-guarantee of such foreign bank.

However, the prescribed rating requirement for banks situated in foreign countries may be relaxed for transaction amounts up to US$250,000, subject to internal credit controls and approval of the relevant bank/DFI in Pakistan. For transaction amounts greater than US$250,000, banks/ DFIs may approach the State Bank of Pakistan for specific approvals/exemption, on a case-by-case basis, where the prescribed minimum rating requirement cannot be complied with. Banks/DFIs are encouraged to set limits for acceptance of guarantees issued by other banks/DFIs.

3. In case of back-to-back letters of credit issued by the banks/DFIs for export-oriented goods and services, banks/DFIs are free to decide the security arrangements at their own discretion subject to the condition that the original L/C has been established by branches of the guarantee issuing bank or a bank rated at least ’A’ by Standard & Poors, Moody's ， Fitch-Ibca or Japan Credit Rating Agency (JCRA).


REGULATION R-8CLASSIFICATION AND PROVISIONING FOR ASSETS LOANS/ADVANCES:

1. Banks/DFIs shall observe the prudential guidelines given at Annexure- IV in the matter of classification of their asset portfolio and provisioning there-against.

2. In addition to the time-based criteria prescribed in Annexure-IV, subjective evaluation of performing and non-performing credit portfolios shall be made for risk assessment and, where considered necessary, any account including the performing account will be classified, and the category of classification determined on the basis of time-based criteria shall be further downgraded. Such evaluation shall be carried out on the basis of credit worthiness of the borrower, its cash flow, operation in the account, adequacy of the security, inclusive of its realizable value and documentation covering the advances.

3. The rescheduling/restructuring of non-performing loans shall not change the status of classification of a loan/advance etc. unless the terms and conditions of rescheduling/restructuring are fully met for a period of at least one year (excluding grace period, if any) from the date of such rescheduling/restructuring and at least 10% of the outstanding amount is recovered in cash. However, the condition of the one year retention period, prescribed for restructured/rescheduled loan account to remain in the classified category, will not apply in cases where the borrower has repaid or adjusted in cash at least 50% of the total restructured loan amount (principal + mark-up), either at the time of restructuring agreement or later during the grace period, if any.

The unrealized mark-up on loans (declassified after rescheduling/restructuring) shall not be taken to the income account unless at least 50% of the amount is realized in cash. However, any short recovery in this respect will not impact the de-classification of this account if all other criteria (meeting the terms and conditions for at least one year and payment of at least 10% of outstanding amount by the borrower) are met. Banks/DFIs are further directed to ensure that status of classification, as well as provisioning, is not changed in relevant reports to the State Bank of Pakistan merely because a loan has been rescheduled or restructured. However, while reporting to the Credit Information Bureau (CIB) of State Bank of Pakistan, such loans/advances may be shown as ’rescheduled/restructured1 instead of ’default’.

Where a borrower subsequently defaults (either principal or mark-up) after the rescheduled/restructured loan has been declassified by the bank/DFI as per above guidelines, the loan will again be classified in the same category it was in at the time of rescheduling/restructuring and the unrealized markup on such loans taken to income account shall also be reversed. However, banks/DFIs at their discretion may further downgrade the classification, taking into account the subjective criteria. At the time of rescheduling/restructuring, banks/DFIs shall consider and examine the requests for working capital strictly on merit，keeping in view the viability of the project/business and appropriately securing their interest etc.


All fresh loans granted by the banks/DFIs to a party after rescheduling/ restructuring of its existing facilities may be monitored separately, and will be subject to classification under this Regulation on the strength of their own specific terms and conditions.

4. Banks/DFIs shall classify their loans/advances portfolio and make provisions in accordance with the criteria prescribed above, keeping in view the following: a) Banks are allowed to take the benefit of 40% of Forced Sale value (FSV) of the pledged stocks and mortgaged residential, commercial and industrial properties (where building is constructed) held as collateral against NPLs for three years from the date of classification for calculating provisioning requirement. However, the banks/DFIs can avail the benefit of 40% of FSV of mortgaged residential, commercial and industrial land (open plot and where building is constructed separate valuation of land must be available) held as collateral against NPLs for four years from the date of classification for calculating provisioning requirement. This benefit would be available in such cases where FSV valuation of land is not more than four years old. For the purpose of determination ofFSV, revised Annexure-V of PR for Corporate/Commercial Banking shall be followed.1

b) Banks/DFIs may avail the above benefit of FSV subject to compliance with the following conditions:

i) The additional impact on profitability arising from availing the benefit ofFSV against pledged stocks and mortgaged residential, commercial and industrial properties (land and building only)1 shall not be available for payment of cash or stock dividend.

ii) Heads of Credit of respective banks/DFIs shall ensure that FSV used for taking benefit of provisioning is determined accurately as per guidelines contained in PRs and is reflective of market conditions under forced sale situations.

iii) Party-wise details of all such cases where banks/DFIs have availed the benefit ofFSV shall be maintained for verification by State Bank’s inspection teams during regular /special inspection.

c)Any misuse ofFSV benefit detected during regular/special inspection of SBP shall attract strict punitive action under the relevant provisions of the Banking Companies Ordinance, 1962. Furthermore, SBP may also withdraw the benefit of FSV from banks/DFIs found involved in its misuse.

INVESTMENTS AND OTHER ASSETS:5.The banks shall classify their investments into three categories viz. ’Held for Trading’， 'Available for Sale1 and ’Held to Maturity1. However, investments in subsidiaries and associates shall be reported separately in accordance with International Accounting Standards as applicable in Pakistan and shall not be subject to mark to market.

Investment portfolio in ’Held for Trading’ and ’Available for Sale， and other assets will be subject to detailed evaluation for the purpose of their


classification keeping in view various subjective and objective factors given as under

a) Quoted Securities:Government Securities will be valued at PKRV (Reuter Page). TFCs, PTCs and shares will be valued at their market value. The difference between the market value and book value will be treated as surplus/deficit.

b) Un-quoted Securities:PTCs and TFCs will be classified on the evaluation/inspection date on the basis of default in their repayment in line with the criteria prescribed for classification of medium and long-term facilities. Shares will be carried at the cost. However, in cases where the breakup value of such shares is less than the cost， the difference of the cost and breakup value will be classified as loss and provided for accordingly by charging to the Profit and Loss account of the bank/DFI.

c) Treatment of Surplus/deficit:The measurement of surplus/deficit shall be done on portfolio basis. The surplus/deficit arising as a result of revaluation of ’Held for Trading, securities shall be taken into the Profit and Loss Account. The surplus/deficit on revaluation of ’Available for Sale1 category shall be taken to "Surplus/Deficit on Revaluation of Securities”. Impairment in the value of ’Available for SaleT or fHeld to Maturity* securities will be provided for by charging it to the Profit and Loss Account.

d) Other Assets:Classification of Other Assets and provision required there-against shall be determined, keeping in view the risk involved and the requirements of the International Accounting Standards.

TIMING OF CREATING PROVISIONS:6. Banks/DFIs shall review, at least on a quarterly basis, the collectibility of their loans/advances portfolio and shall properly document the evaluations so made. Shortfall in provisioning, if any, determined as a result of quarterly assessment, shall be provided for immediately in their books of accounts by the banks/DFIs on a quarterly basis.

REVERSAL OF PROVISION:7. In cases of cash recovery, other than rescheduling/restructuring, banks/DFIs may reverse specific provision held against classified assets, subject to the following:

(a) In the case of Loss account, reversal may be made to the extent that the remaining outstanding amount of the classified asset is covered by minimum 100% provision.

(b) In the case of a doubtful account, reversal may be made to the extent that the remaining outstanding amount of the classified asset is covered by minimum 50% provision.

(c) In the case of a substandard account, reversal may be made to the extent that the remaining outstanding amount of the classified asset is covered by minimum 25% provision.


While calculating the remaining provision required to be held after cash recovery and reversal of provision there-against, the banks/DFIs will enjoy the benefit of netting-off the amount of liquid assets from the outstanding amount, in the light of guidelines given in this regulation. However, the provision made on the advice of State Bank of Pakistan will not be reversed without prior approval of State Bank of Pakistan.

VERIFICATION BY THE AUDITORS:8. The external auditors, as a part of their annual audits of banks/DFIs, shall verify that all requirements of Regulation R-8 for classification and provisioning for assets have been complied with. The State Bank of Pakistan shall also check the adequacy of provisioning during on-site inspection.

REGULATION R-9 ASSUMING OBLIGATIONS ON BEHALF OF NBFCs

Banks/DFIs shall not issue any guarantee or letter of comfort nor assume any obligation whatsoever in respect of deposits, sale of investment certificates, issue of commercial papers, or borrowings of any non-banking finance company.

Banks/DFIs may, however, underwrite TFCs, commercial papers and other debt instruments issued by NBFCs, and issue guarantees in favor of multilateral agencies for providing credit to NBFCs, provided the banks’/DFIsf such exposure remains within the per party exposure limit as prescribed in Regulation R-l. Banks/DFIs may also allow exposure to any of their client against the guarantee of an NBFC which is rated at least fAT or equivalent by a credit rating agency on the approved panel of State Bank of Pakistan. The total amount of guarantees issued by an NBFC, and accepted by the banks，on the strength of which the exposure will be allowed by the commercial bank/DFI, will not exceed per party limit of the bank/DFI as mentioned in Regulation R-l. Before taking exposure against the guarantee of NBFC, banks/DFIs shall ensure that total guarantees issued by an NBFC in favour of banks/DFIs do not exceed2.5 times of capital of the NBFC as evidenced by the latest available audited financial statements of the NBFC and such other means as the banks/DFIs may deem appropriate.

REGULATION R-10 FACILITIES TO PRIVATE LIMITED COMPANY

Banks/DFIs shall formulate a policy, duly approved by their Board of Directors,about obtaining personal guarantees of directors of private limited companies. Banks/DFIs may， at their discretion, link this requirement to the credit rating of the borrower, their past experience with it or its financial strength and operating performance.

REGULATION R-11 PAYMENT OF DIVIDEND

Banks/DFIs shall not pay any dividend on their shares unless and until:

a) they meet the minimum capital requirements as laid down by the State Bank of Pakistan from time to time;


While calculating the remaining provision required to be held after cash recovery and reversal of provision there-against, the banks/DFIs will enjoy the benefit of netting-off the amount of liquid assets from the outstanding amount, in the light of guidelines given in this regulation. However, the provision made on the advice of State Bank of Pakistan will not be reversed without prior approval of State Bank of Pakistan.

VERIFICATION BY THE AUDITORS:8. The external auditors, as a part of their annual audits of banks/DFIs, shall verify that all requirements of Regulation R-8 for classification and provisioning for assets have been complied with. The State Bank of Pakistan shall also check the adequacy of provisioning during on-site inspection.

REGULATION R-9 ASSUMING OBLIGATIONS ON BEHALF OF NBFCs

Banks/DFIs shall not issue any guarantee or letter of comfort nor assume any obligation whatsoever in respect of deposits， sale of investment certificates, issue of commercial papers, or borrowings of any non-banking finance company.

Banks/DFIs may, however, underwrite TFCs, commercial papers and other debt instruments issued by NBFCs, and issue guarantees in favor of multilateral agencies for providing credit to NBFCs, provided the banksf/DFIsf such exposure remains within the per party exposure limit as prescribed in Regulation R-1. Banks/DFIs may also allow exposure to any of their client against the guarantee of an NBFC which is rated at least fAf or equivalent by a credit rating agency on the approved panel of State Bank of Pakistan. The total amount of guarantees issued by an NBFC, and accepted by the banks, on the strength of which the exposure will be allowed by the commercial bank/DFI, will not exceed per party limit of the bank/DFI as mentioned in Regulation R-1. Before taking exposure against the guarantee of NBFC, banks/DFIs shall ensure that total guarantees issued by an NBFC in favour of banks/DFIs do not exceed2.5 times of capital of the NBFC as evidenced by the latest available audited financial statements of the NBFC and such other means as the banks/DFIs may deem appropriate.

REGULATION R-10 FACILITIES TO PRIVATE LIMITED COMPANY

Banks/DFIs shall formulate a policy，duly approved by their Board of Directors，瀵 bout obtaining personal guarantees of directors of private limited companies. Banks/DFIs may, at their discretion, link this requirement to the credit rating of the borrower, their past experience with it or its financial strength and operating performance.

REGULATION R-11 PAYMENT OF DIVIDEND

Banks/DFIs shall not pay any dividend on their shares unless and until:

a) they meet the minimum capital requirements as laid down by the State Bank of Pakistan from time to time;b) all their classified assets have been fully and duly provided for in accordance with the Prudential Regulations and to the satisfaction of the State Bank of Pakistan; and

c) all the requirements laid down in Banking Companies Ordinance, 1962 relating to payment of dividend are fully complied.

REGULATION R-12 MONITORING

While extending fiind-based facilities to borrowers against hypothecation of stock and/or receivables on pari-passu basis, banks/DFIs shall obtain monthly statements from borrowers that contain a bank-wise break-up of outstanding amounts with the total value of stocks and receivables there-against.

REGULATION R-13 MARGIN REQUIREMENTS

1. Banks/DFIs are free to determine the margin requirements on facilities provided by them to their clients taking into account the risk profile of the borrower(s) in order to secure their interests. However, this relaxation shall not apply in case of items, import of which is banned by the Government. Banks/DFIs are advised not to open import letter of credit for these items in any case till such time the lifting of ban on any such item is notified by the State Bank of Pakistan.

2. Banks/DFIs will continue to observe margin restrictions on shares/TFCs as per existing instructions under Prudential Regulations for Corporate/Commercial Banking (R-6). Further, the cash margin requirement of 100% on Caustic Soda (PCT heading 2815.1200) for opening Import Letter of Credit as advised by the Federal Government and notified in terms of BPD Circular Letter No. 5 dated 4th May，2002 ，will also continue to remain applicable.

3. State Bank of Pakistan shall continue to exercise its powers for fixation/reinstatement of margin requirements on financing facilities being provided by banks/DFIs for various purposes including Import Letter of Credit on a particular item(s)，as and when required.

REGULATION G-1CORPORATE GOVERNANCE/BOARD OF DIRECTORS AND MANAGEMENTThe following guidelines are required to be followed by banks/DFIs incorporated in Pakistan. They will also follow fCode of Corporate Governance，issued by the Securities and Exchange Commission of Pakistan (SECP) so long as any provision thereof does not conflict with any provision of the Banking Companies Ordinance, 1962，Prudential Regulations and the instructions/guidelines issued by the State Bank of Pakistan. Foreign banks are required to adhere to these guidelines wherever feasible and applicable.


However, they need not necessarily seek approval of their Board of Directors, as stipulated below in the case of local banks/DFIs:

A.FIT AND PROPER TEST

1. The "Fit and Proper Test” (FPT) is applicable to the sponsors (both individual and companies) who apply for a commercial banking license, the investors acquiring strategic/controlling stake in the banks/DFIs ， major shareholders of the banking companies and to the appointment of Directors, CEO, and Key Executives of the banks/DFIs. The fitness and propriety will be assessed on the following broad elements (Annexure VII-B):

a) Integrity, Honesty and Reputationb) Track Recordc) Solvency and Integrityd) Qualifications and Experiencee) Conflict of Interestf) Others

2. The first three elements are applicable to all categories of individuals, whereas the last three elements will be considered while assessing the FPT of Directors, CEO and Key Executives of banks/DFIs. In addition to the above requirements, sponsors and strategic investors are evaluated respectively in terms of "Guidelines and Criteria for setting up of a Commercial Bank” and ”Criteria for Establishment of Islamic Commercial Banks” issued by SBP and Code of Corporate Governance issued by SECP.

3. The sponsors, the strategic investors, and appointment of the Directors and CEO require prior clearance in writing from SBP. The CEO and Key Executives shall be full time employees of the bank/DFI. The Directors and CEO will not assume the charge of their respective offices until their appointments are approved in writing by SBP. All the requests for seeking approval of SBP for appointment of Directors and CEO of the banks/DFIs should be routed through respective banks/DFIs along with information on Annexure-VI-A and VI-B.

4. The appointment of Key Executives will not require prior clearance of SBP. However ， the banks/DFIs must themselves ensure while appointing Key Executives that they qualify FPT in letter and spirit. The information on appointment of Key Executive is required to be forwarded to SBP on prescribed format at Annexure-VIIA within seven days of assumption of the charge of the post by the incumbent. The information submitted may be checked on post fact basis by Banking Inspection Department of SBP during inspection.

5. The sponsors are required to seek prior approval of SBP along with the information at Annexure- VI-B and other information as required in the "Guidelines and Criteria for Setting up a Commercial Bank” and” Criteria for Establishment of Islamic Commercial Banks”• The strategic investors contemplating to acquire strategic/controlling stake are required to seek prior approval from SBP either directly or through the relevant department/Ministry of Government executing strategic sale transaction of the bank as required and provided in the transaction structure. The


bank should also ensure to give prior intimation to SBP before dealing with any investors/bank/institutions/person for sale/purchase of sponsors/ strategic shares and seek approval of SBP for conducting due diligence of bank/DFI in terms of BPD Circular No. 8 of 2003.

6. The major shareholders are required to seek prior approval in writing from SBP for acquiring 5% or more shares along-with information on Annexure- VI-B, with proper justification for holding more than 5% shares of the paid up capital. All the banks/DFIs are required to ensure that major shareholders have sought such an approval from SBP and place it on record.

7. Deposit of sponsor shares in blocked account with Central Depository Company of Pakistan (CDC).

a) All sponsor shares and subsequent right and bonus shares shall be deposited in a blocked account with CDC. The procedure for deposit of sponsor shares in the CDC blocked account is provided at Annexure-XI.

b) No withdrawal of the sponsor shares from the blocked account would be allowed without prior written permission of SBP.

c) Blocked account should be opened by the sponsor shareholders of banks exclusively for deposit of the sponsor shares and subsequent right and bonus shares issued thereon，:

d) Charges for opening and operating of the blocked account with CDC will be borne by the sponsor shareholders.

e) These instructions shall not be applicable to the shareholding of Federal and provincial governments in banks.

8. Fit and Proper Test prescribed in the guideline is continuous in nature. All persons subject to FPT should immediately submit any change in the information already submitted (at the time of clearance) either through Company Secretary or Human Resources Department to Banking Policy and Regulations Department. Violation of the instructions, circumvention, concealment, misreporting and delay in submission of information to SBP may result in withdrawal of SBP approval, besides penal action under the provisions of BCO.

B. RESPONSIBILITIES OF THE BOARD OF DIRECTORS:

1. The Board of Directors shall assume its role independent of the influence of the Management and should know its responsibilities and powers in clear terms. It should be ensured that the Board of Directors focus on policy making and general direction, oversight and supervision of the affairs and business of the bank/DFI and does not play any role in the day-to-day operations, as that is the role of the Management.


of the institution are carried out prudently within the framework of existing laws and regulations and high business ethics.

3. All the members of the Board should undertake and fulfill their duties and responsibilities keeping in view their legal obligations under all the applicable laws and regulations. All Board members should preferably attend at least 1-2 weeks training program(s) which will enable them to play effective role as a director of bank/DFI, at an institution like Pakistan Institute of Corporate Governance or other similar institution within first year of their directorship on the Board of bank/DFI.

4. The Board shall clearly define the authorities and key responsibilities of both the Directors and the Senior Management without delegating its policy-making powers to the Management and shall ensure that the Management is in the hands of qualified personnel.

5. The Board shall approve and ensure implementation of policies, including but not limited to, in areas of Risk Management, Credit, Treasury and Investment, Internal Control System and Audit, IT Security, Human Resource, Expenditure, Accounting and Disclosure, and any other operational area which the Board and/or the Management may deem appropriate from time to time. The Board shall also be responsible to review and update existing policies periodically and whenever circumstances justify.

6. As regards Internal Audit or Internal Control,a separate department shall be created which shall be manned preferably by professionals responsible to conduct audit of the bank’s/DFI’s various Divisions, Offices ，Units, Branches etc. in accordance with the guidelines of the Audit Manual duly approved by the Broad of Directors. The Head of this department will report directly to the Board of Directors or Board Committee on Internal Audit.

7. The business conditions and markets are ever changing and so are their requirements. The Board, therefore, is required to ensure existence of an effective 'Management Information System, to remain fully informed of the activities, operating performance and financial condition of the institution, the environment in which it operates, the various risks it is exposed to and to evaluate performance of the Management at regular intervals.


9. The Board should carry out its responsibilities in such a way that the external auditors and supervisors can see and form judgment on the quality of Board’s work and its contributions through proper and detailed minutes of the deliberations held and decisions taken during the Board meetings.

10. To share the load of activities, the Board may form specialized committees with well-defined objectives, authorities and tenure. These committees, preferably comprising of 'Non-Executive* Board members, shall oversee areas like audit, risk management, credit, recruitment, compensation etc. These committees of the Board should neither indulge in day-to-day affairs/operations of the bank nor enjoy any credit approval authority for transaction/limits. These committees should apprise the Board of their activities and achievements on regular basis.

11. The Board should ensure that it receives management letter from the external auditors without delay. It should also be ensured that appropriate action is taken in consultation with the Audit Committee of the Board to deal with control or other weaknesses identified in the management letter. A copy of that letter should be submitted to the State Bank of Pakistan so that it can monitor follow-up actions.

12. Whenever the Board of Directors/relevant appointing/removing authority of a bank/DFI considers to remove its President/Chief Executive Officer/Country Head/Country Manager before the expiration of his/her term of office through the defined statutory process, State Bank of Pakistan (SBP) must invariably be informed at least two months ahead of the implementation of such decision along-with the reasons for the same.

The President/CEO/Country Head/Country Manager, wherever, decides to tender resignation before completion of his/her term of office, he/she must inform SBP at least two months before tendering resignation. The Chairman of the Board of Directors/relevant removing authority of bank/DFI would be responsible for submission of the requisite information to SBP.

C. MANAGEMENT:

1. No member of the Board of Directors of a bank/DFI holding 5% or more of the paid-up capital of the bank/DFI either individually or in concert with family members or concerns /companies in which he/she has the controlling interest, shall be appointed in the bank /Dpi in any capacity except as Chief Executive of the bank/DFI. Further, maximum two members of Board of Directors of a bank/DFI including its CEO can be the Executive Directors.

*remuneration to be paid to the non-executive directors and chairman for attending the Board and/or committee meetings shall be approved by tKe shareholders on a pre. or post facto basis in the Annual General Meeting (AGM). However, no such remuneration shall be paid to the


executive directors except usual TA/DA as per bank，s/DFI，s standard rules and regulations. No consultancy or allied work will be awarded to the non-Executive directors or to the firms/institutions/companies etc. in which they hold substantial interest.

3. Chairman of the Board of Directors may，if deemed necessary, appoint one advisor to advise and facilitate him in discharge of his duties/responsibilities. The appointment of such an advisor will be subject to the following conditions:

a) The advisor must possess the required technical experience relating to banking and finance at a senior level to enable him /her to render a professional advice to the Board.

b) The terms of reference of the advisor shall be approved by the Board.

c) A reasonable remuneration may be paid to the advisor with the approval of the Board of Directors.

d) The advisor may attend the meetings of Board of Directors and Board Committees in which his/her participation is required but h /she will not be a member of the Board and/or its committees. The advisor shall be required to sign an appropriate confidentiality agreement to ensure confidentiality of documents/information that may come to his/her knowledge, before assuming any such role.2

D.COMPLIANCE OFFICER:

Banks/DFIs shall put in place a Compliance Program to ensure that all relevant laws are complied with, in letter and spirit ， and, thus, minimize legal and regulatory risks. For this purpose, the Board of Directors, or Country Manager in case of foreign banks, shall appoint/designate a suitably qualified and experienced person as Compliance Officer on a countrywide basis，who may be assisted by other Compliance Officers down the line. The Head of Compliance will report directly to the President/Chief Executive Officer of the bank/DFI. The Compliance Officers will primarily be responsible for bankfs/DFrs effective compliance relating to:

(a) SBP Prudential Regulations.

(b) Relevant provisions of existing laws and regulations.

(c) Guidelines for KYC.

(d) Anti money laundering laws and regulations.

(e) Timely submission of accurate data/retums to regulator and other agencies.

(f) Monitor and report suspicious transactions to President/Chief Executive Officer of the bank/DFI and


2. Banks/DFIs are, however, free to add other areas of compliance under the responsibilities of Compliance Officer and consider setting up a compliance committee under him, as they deem fit to protect the interest of the institution.

3. The Compliance Officers will(i) serve as a contact point between President/Chief Executive Officer and senior management, with regard to functioning of the compliance program (ii) provide assistance in this area to branches and other departments of the bank/DFI, and (iii) act as liaison with State Bank of Pakistan concerning the issues related to compliance.1

4. Banks/DFIs are, therefore, advised to put in place, in writing, a complete program of compliance down the line under the supervision of a Compliance Officer.

E. FITNESS AND PROPRIETY OF KEY EXECUTIVES:

1. Banks/DFIs shall strictly follow the guidelines contained in the ’Fit and Proper Testf (FPT) during the course of appointment of key executives.l

2. The banks/DFIs should also develop and implement appropriate screening procedures to ensure high standards and integrity at the time of hiring all employees, whether contractual or permanent.

3. In case it is found at subsequent stage/during the course of inspection that guidelines of FPT have not been followed or the incumbent is not a fit and proper person, strict punitive action will be taken under the relevant provisions of Banking Companies Ordinance 1962，in addition to directing the bank§/DFIs to dispense with the services of the officer concerned if recruited afresh; and in case of existing employee, the same to be transferred from the post immediately.

REGULATION G-2DEALING WITH DIRECTORS, MAJOR SHARE-HOLDERS AND EMPLOYEES OF THE BANKS/DFIs

1. Banks/DFIs shall not enter into leasing, renting and sale/purchase of any kind with their directors, officers, employees or such persons who either individually or in concert with family members beneficially own 5% or more of the equity of the bank/DFI. This restriction does not apply in case of purchase of vehicles by the paid directors, officers or employees of the banks/DFIs which remained in their own use，provided such sale is covered under the employees service rules duly approved by the Board of Directors of the banks/DFIs and is effected by the banks/DFIs at least at book value at the date of such transaction.

2. Banks/DFIs shall not:

a) take unsecured exposure on, or take exposure against the guarantee of:i) any of their directors;

ii) any of the family members of any of their directors;


iii) any firm or private company in which the bank/DFI or any of the persons referred to in (i) or (ii) are interested as director, proprietor or partner; or

iv) any public limited company in which the bank/DFI or any of the persons as a foresaid are substantially interested; and

v) their Chief Executive and shareholders holding 5% or more of the share capital of the bank/DFI, including their spouses, parents, and children or to firms and companies in which they are interested as partners, directors or shareholders holding 5% or more of the share capital of that concern.

b) take any exposure on any of their directors or to individuals, firms or companies in which they or any of their directors, either directly in the borrowing entity or in any of its group companies, hold key management positions, or are interested as partner, director or guarantor, as the case may be， their Chief Executives and

shareholders holding 5% or more of the share capital of the bank/DFI, including their spouses, parents, and children or to firms and companies in which they are interested as partners, directors or shareholders holding 5% or more of the share capital of that concern, without the approval of the majority of the directors of that bank/DFI excluding the director concerned. The facilities to the persons mentioned above shall be extended at market terms and conditions and be dealt with at arm length basis.

REGULATION G-3CONTRIBUTIONS AND DONATIONS FOR CHARITABLE, SOCIAL, EDUCATIONAL AND PUBLIC WELFARE PURPOSES

Banks/DFIs shall strictly observe the following rules in the matter of making any donation/contribution for charitable, social, educational or public welfare purposes:

i) The total donations/contributions made by the bank/DFI during the year shall not exceed such amount as approved by their Board of Directors. It is expected that banks/DFIs making these donations/contributions would have already met provisioning and capital adequacy requirements.

ii) The banks/DFIs shall develop policy/guidelines duly approved by the Board of Directors for making donations/contributions.

2. All donations or contributions to be made during the year must be specifically approved by the Board of Directors on pre or post facto basis as convenient.

3. Banks/DFIs are further directed to expressly disclose in their annual audited financial statements the total donation/contribution made during the year along with names of donees, to whom total donations/ contributions during the year were made in excess of Rs 100,000/. In the case of donations where any director or his family members have interest in the donee, the names of such directors， their interest in the donee and the names and addresses of all donees，


REGULATION G-4 CREDIT RATING

1. With a view to safeguarding the interest of prospective investors, depositors and creditors, it shall be mandatory for all banks/DFIs to have themselves credit rated by a credit rating agency on the approved panel of the State Bank of Pakistan.

2. Foreign banks which are credit rated by M/s. Standard & Poors, Moody’s Fitch-Ibca and Japan Credit Rating Agency (JCRA) and are given a minimum rating of A3/A- and above shall be exempt from the application of this requirement. All other foreign banks have to go through a credit rating process in Pakistan.

3. The credit rating will be an ongoing process, i.e. credit rating should be updated on a continuous basis from year to year，within six months from the date of close of each financial year and the rating report complete in all respects be submitted to the State Bank of Pakistan and made public within a period of seven days of the notification of rating by the credit rating agency. Further, the banks/DFIs will disclose their credit rating prominently in their published annual and quarterly financial statements.

REGULATION M-1 CUSTOMER DUE DILIGENCE (CDD)1

1. With a view to preserving the integrity and safety of the financial system, it is expedient to prevent the possible use of the banking sector for money laundering and terrorist financing. To this end, Customer Due Diligence/Know Your Customer (CDD/KYC) procedures require special attention and concrete implementation. Accordingly, the following minimum guidelines are required to be followed by banks/DFIs to avert the risks posed by money laundering and terrorist financing activities. However, banks/DFIs are free to take additional measures in line with Financial Action Task Force Recommendations.

2.Banks/DFIs shall formulate and put in place, a comprehensive CDD/KYC policy duly approved by their Board of Directors and in the case of branches of foreign banks，approved by their head office, and cascade the same down the line to each and every business location/officers concerned, for strict compliance.

3.CDD/KYC policy of the banks/DFIs shall inter alia include a description of the types of customers that are likely to pose a higher than average risk to the bank/DFI and guidelines for conducting Enhanced Customer Due Diligence depending upon the customers’ background, country of origin, public or high profile position, nature of business, etc.

4. Banks/DFIs should undertake customer due diligence measures when:

a) establishing business relationship;

b) conducting occasional transactions above rupees one million whether carried out in a single operation or in multiple operations that appear to be linked;c) carrying out occasional wire transfers (domestic/cross border) regardless of any threshold;

d) there is suspicion of money laundering/terrorist financing; and


e) there is a doubt about the veracity or adequacy of available identification data on the customer.

5. Banks/DFIs shall undertake at least the following Customer due diligence measures:

a) Banks/DFIs should not open and maintain anonymous accounts or accounts in the name of fictitious persons.

b) All reasonable efforts shall be made to determine the identity of every prospective customer. For this purpose, a minimum set of documents is to be obtained by the banks/DFIs from various types of customers/account holder(s)， at the time of opening the account, as prescribed in Annexure-VIII of the Prudential Regulations for Corporate/Commercial Banking. While opening the bank account of’’proprietorships’' the requirements laid down for individuals at Serial No.(1)of Annexure-VIII shall apply except the requirement mentioned at No. (3) of the Annexure. Banks/DFIs shouid exercise extra care in view of the fact that constituent documents are not available in such cases to confirm existence or otherwise of proprietorship.

c) Banks/DFIs shall identify the beneficial ownership of accounts/ transactions by taking all reasonable measures.

d) For all customers, banks/DFIs should determine whether the customer is acting on behalf of another person, and should then take reasonable steps to obtain sufficient identification data to verify the identity of that other person.

e) For customers that are legal persons or for legal arrangements, banks/DFIs are required to take reasonable measures to (i) understand the ownership and control structure of the customer (ii) determine who are the natural persons who ultimately own or control the customer. This includes those persons who exercise ultimate effective control over a legal person or arrangement.

f) Government accounts should not be opened in the personal names of the government official(s). Any such account, which is to be operated by an officer of the Federal/Provincial/Local Government in his/her official capacity, shall be opened only on production of a special resolution/authority from the relevant administrative department duly endorsed by the Ministry of Finance or Finance Department of the relevant Government.

6. Verification is an integral part of CDD/KYC measures for which banks/DFIs shall ensure that:

a) copies of CNIC wherever required in Annexure-VIII are invariably verified, before opening the account, from NADRA through utilizing on-line facility or, where the banks/DFIs or their branches do not have such facility, from the regional office(s) of NADRA.

b) the identity of the beneficial owner is verified using reliable


information/ satisfactory sources.

c) the cost of verification of CNIC from NADRA should not be passed on to their account holder(s) (either existing or prospective).

7. Banks/DFIs shall note that:

a) For customers/clients whose accounts are either dormant as per bankfs own policy or an attested copy of account holder’s Computerized National Identity Card (CNIC) is not available in bank’s /DFI’s record ， bank/DFIs may allow credit entries in such accounts. Debit transactions/ withdrawals shall not be allowed until the account holder produces an attested copy of his/her CNIC and fulfills all other formalities for activation of the account. However, transactions e.g. debits under the recovery of loans and markup etc. any permissible bank charges, government duties or levies and instruction issued under any law or from the court will not be subject to debit or withdrawal restriction.

b) For all other customers/clients including depositors and borrowers, banks/DFIs shall obtain the attested copies of CNICs. Banks/DFIs shall block accounts without CNIC (after serving one month’s prior notice) for all debit transactions/withdrawals, irrespective of mode of payment, until subject to the regulatory requirement being fulfilled. However， debit block from the accounts shall be removed upon submission of copy of CNIC.

8. Banks/DFIs are also advised that CDD/KYC is not a onetime exercise to be conducted at the time of entering into a formal relationship with customer/account holder. This is an on-going process for prudent banking practices. To this end, banks/DFIs are required to:

a) set up a compliance unit with a full time Head.

b) put in place a system to monitor the accounts and transactions on a regular basis.

c) update customer information and records, if any, at reasonable intervals.

d) install an effective MIS to monitor the activity of the customers1

accounts.e) chalk out plan of imparting suitable training to the staff of bank/DFI periodically.

f) maintain proper records of customer identification and clearly indicate, ia writing, if any exception is made in fulfilling the CDD/KYC measures.

9. Banks/DFIs shall conduct enhanced due diligence when:

a) dealing with high-risk customers, business relationship or transaction including the following:

i) non-resident customers;

ii) private banking customers;


iii) legal persons or arrangements including non-governmental organizations (NGOs)/not-for-profit organizations (NPOs) and trusts/charities;

iv) customers belonging to countries where CDD/KYC and antimoney laundering regulations are lax;

v) customers with links to offshore tax havens;

vi) customers in cash-based businesses;

vii) high net worth customers with no clearly identifiable source of income; and

viii) customers in high-value items etc.

b) there is reason to believe that the customer has been refused banking facilities by another bank/DFI.

c) opening correspondent banks' accounts.

d) dealing with non-face-to-face/on-line customers. Adequate measures in this regard regard should be put in place, e.g. independent verification by a reliable third party, client report from the previous bank/DFI of the customer，etc.

e) establishing business relationship or transactions with counterparts from or in countries not sufficiently applying FATF recommendations.

f) dealing with politically exposed persons or customers holding public office or high profile positions.

10. For politically exposed persons or holders of public office or high profile positions, enhanced due diligence should include the following:

a) Relationship should be established and /or maintained with the approval of senior management including when an existing customer becomes a holder of public office or a high profile position.b) Appropriate risk management systems to determine whether a potential customer, a customer or the beneficial owner is a politically exposed person/ holder of public office or high profile position and sources of wealth / funds of customers, beneficial owners for ongoing monitoring on regular basis.

11. Where there are low risks and information on the identity of the customer and the beneficial owner of a customer is publicly available, or where adequate checks and controls exist, banks/DFIs may apply simplified or reduced CDD/KYC measures. The following cases may be considered for application of simplified or reduced CDD/KYC:

a) Financial institutions provided they are subject to requirements to combat money laundering and terrorist financing consistent with the FATF recommendations and are supervised for compliance with those requirements.

b) Public companies that are subject to regulatory disclosure requirements and such companies are listed on a stock exchange or similar situations.


c) Government administrations or entities.

12. Reduced CDD/KYC measures shall not be applied where there is risk of money laundering or terrorist financing or when a customer resides in a country which does not comply with FATF recommendations.

13. In case where banks/DFIs are not able to satisfactorily complete required CDD/KYC measures including identity, beneficial ownership or information on purpose and intended nature of business relationship, an account should not be opened or any service provided and instead reporting of suspicious transactions be considered. Similarly, the relationship with existing customers should be terminated and reporting of suspicious transactions be considered if CDD/KYC is found unsatisfactCHy

14. State Bank of Pakistan, during the course of inspection, will particularly check the efficacy of the CDD/KYC policies and system of the banks/DFIs and its compliance by all the branches and the staff members. Appropriate action shall be taken against the bank/DFI and the staff members concerned for non-compliance and negligence in this area ， under the provisions of Banking Companies Ordinance, 1962.

REGULATION M-2ANTI-MONEY LAUNDERING MEASURES

Banks/DFIs are advised to follow the following guidelines to safeguard themselves against their involvement in money-laundering activities, and other unlawful trades. These will add to or reinforce the precautions banks/DFIs may have been taking on their own in this regard:

a)Banks/DFIs shall ensure that their business is conducted in conformity with high ethical standards and that banking laws and regulations are adhered to. It is accepted that banks/DFIs normally do not have effective means of knowing whether a transaction stems from or forms part of wrongful activity. Similarly, in an international context, it may be difficult to ensure that cross-border transactions on behalf of customers are in compliance with the regulations of another country. Nevertheless, banks/DFIs should not set out to offer services or provide active assistance in transactions which, in their opinion，are associated with money derived from illegal activities.

b) Specific procedures to be established for ascertaining the customer’s status and his source of earnings, for monitoring of accounts on a regular basis, for checking identities and bona fides of remitters and beneficiaries, for retaining internal record of transactions for future reference. Those transactions which are out of character/inconsistent with the history, pattern, or normal operation of the account, involving heavy deposits/withdrawals/transfers, should be viewed with suspicion and properly investigated.

c) Banks/ DFIs are required to include accurate and meaningful originator information (name, address and account number) on funds transfers including wire transfers and related messages that are sent, and the information should remain with the transfer or related message throughout the payment chain. However, banks/ DFIs may, if satisfied, substitute the requirement of mentioning address with CNIC, Passport，Driving license or similar identification number for this purpose.


d) Beneficiary financial institutions shall adopt effective risk-based procedures for identifying and handling wire transfers that are not accompanied by complete originator information. Wire transfers with incomplete originator information may be seen with suspicion which may require reporting to FMU or termination of the transaction. Banks/ DFIs should remain wary of financial institutions which do not comply with aforesaid requirements by limiting or terminating the business relationship.

e) Banks た )FIs shall not allow personal accounts to be used for business purposes except proprietorships, small businesses and professions where constituent documents are not available and the banks/DFIs are satisfied with the KYC profile of the account holder ， purpose of relationship and expected turnover of the account, keeping in view the financial status and nature of business of that customer.1

f) For an effective implementation of banks’/DFIs1 policy and procedures relating to anti money laundering/other unlawful trades, suitable training to be imparted to members of staff and they be informed of their responsibility in this regard.Keeping in view the above principles, banks/DFIs shall issue necessary instructions for guidance and implementation by all concerned.

REGULATION M-3 RECORD RETENTION

1. The records ot transactions and identification data etc. maintained by banks/DFIs are of critical importance as far as legal proceedings are


coocemed. Prudence demands that such records be maintained in a systematic manner with a precise period of preservation to avoid any setback on legal and reputational aspects. Banks/DFIs shall, therefore, maintain, for a minimum period of five years, all necessary records on transactions, both domestic and international. The records so maintained must be sufficient to permit reconstruction of individual transactions (including the amounts and types of currency involved, if any) so as to provide，if necessary, to SBP or law enforcement agencies for investigation or as evidence in legal proceedings. Banks/DFIs shall, however, retain those records for a longer period where there are transactions relating to litigation or are required by the Court of law or by any other competent authority.

2. Banks/DFIs shall keep records on the identification data obtained through the customer due diligence process (e.g. copies or records of official identification documents like passports, identity cards, driving licenses or similar documents), account files and business correspondence for at least five years after the business relationship is ended.

3.Records relating to the suspicious transactions reported by the bank/DFI will be retained by the bank/DFI, even after the lapse of the period prescribed above, till such time the bank/DFI gets permission from State Bank of Pakistan to destroy such records.

4. Banks/ DFIs should provide timely information relating to suspicious transactions to domestic law enforcement agencies (LEAs)，sought in terms of legal powers available to them under the respective laws in order to support investigations/ prosecutions«l

REGULATION M-4 CORRESPONDENT BANKING

1. Banks/DFIs shall gather sufficient infbrmatkMi about tfieir oonopHiaA banks to understand fully the nature of their busii^ss. Factors to considerinclude:

x Know your customer policy (KYC)x Information about the correspondent bank’s management and ownershipx Major business activities x Their locationx Money laundering prevention and detection measures x The purpose of the accountx The identity of any third party that will use the correspondent banking services (i.e. in case of payable through accounts) x Condition of the bank regulation and supervision in the correspondent’s country

2. Banks/DFIs should establish correspondent relationships with only those foreign banks that have effective customer acceptance and KYC policies and are effectively supervised by the relevant authorities.

3. Banks/DFIs should refuse to enter into or continue a correspondent banking relationship with a bank incorporated in a jurisdiction in which it (the correspondent bank) has no physical presence and which is unaffiliated with a regulated financial group (i.e., shell banks). Banks/DFIs should also guard against establishing relations with correspondent foreign financial institutions that permit


their accounts to be used by shell banks.

4. Banks/DFIs should pay particular attention when continuing relationships with correspondent banks located in jurisdictions that have poor KYC standards or have been identified by the Financial Action Task Force as being "non-cooperative” in the fight against money laundering.

5. Banks/DFIs should be particularly alert to the risk that correspondent accounts might be used directly by third parties to transact business on their own behalf (e.g., payable-through-accounts). In such circumstances, banks/DFIs must be satisfied that the correspondent bank has verified the identity of and performed on-going due diligence on the customers having direct access to accounts of the correspondent bank/DFI and that it is able to provide relevant customer identification data upon request to the correspondent bank/DFI.

6. Approval should be obtained from senior management, preferably at the level of Executive Vice President or equivalent, before establishing new correspondent banking relationships.

REGULATION M-5 SUSPICIOUS TRANSACTIONS

1. Banks/DFIs should pay special attention to all complex, unusually large transactions, and all unusual patterns of transactions, which have no apparent economic or visible lawful purpose. Examples of such suspicious transactions are listed at Annexure-IX. However, these are not intended to be exhaustive and only provide examples of the most basic ways in which money may be laundered. The background and purpose of such transactions should，as far as possible, be examined, the findings established in writing, and be available to help the relevant authorities in inspection and investigation.

2. If the bank/DFI suspects, or has reasonable grounds to suspect, that funds are the proceeds of criminal activity or terrorist financing, it should report promptly, its suspicions, through Compliance Officer of the bank/DFI to Director General, Financial Monitoring Unit, Karachi. The report should contain, at a minimum, the following information:

a) Title, type and number of the accounts.b) Amounts involved.c) Details of the transactions.d) Reasons for suspicion.

The State Bank has been encouraging banks/DFIs to make use of technology and upgrade their systems and procedures in accordance with the changing profile of various risks. Accordingly, all banks/DFIs are advised to implement systems which could flag up unusual patterns of transactions so that suspicious transactions can be reported. The existing list of examples of suspicious transactions at Annexure-IX is supplemented with the3. The employees of banks/DFIs are strictly prohibited to disclose the fact to the customer or any irrelevant quarter that a suspicious transaction or related information is being reported for investigation.

4. In cases of foreign branches of banks/DFIs and subsidiaries of banks/DFIs in foreign countries undertaking banking business, banks/DFIs should ensure

enclosed list of characteristics of financial transactions that may be acause for increased scrutiny as Annexure-X.


compliance with the regulations (relating to Anti Money Laundering and KYC) of State Bank of Pakistan or the relevant regulations of the host country, whichever are more exhaustive.

REGULATION 0-1UNDERTAKING OF CASH PAYMENTS OUTSIDE THE BANK'S AUTHORIZED PLACE OF BUSINESS

1. Banks shall not undertake any business of cash payments, other than the authorized place of business, except through the installation of Automated Teller Machines (ATM). Banks desirous of providing the facility of withdrawal through Authorized Merchant Establishments at various Points of Sale (POS) may do so up to a maximum cash limit of Rs 10,000/- For this purpose, adequate and suitable security measures should be put in place for cash feeding and safety of the machines.

2.Banks may do collection and payment of cash for their prime customers through cash carrying companies registered with the relevant Government department. This facility should, however, be provided through designated branches of the banks and after the banks have devised procedures including necessary security measures.

REGULATION 0-2 WINDOW DRESSING

Banks/DFIs shall refrain from adopting any measures or practices whereby they would either artificially or temporarily show an ostensibly different position of banks， /DFIs, accounts as given in their financial statements. Particular care shall be taken in showing their deposits, MCR, nonperforming loans/assets, provisioning, profit, inter-branch and inter-bank accounts, etc.

REGULATION 0-3RECONCILIATION OF INTER-BRANCH ACCOUNTS AND SETTLEMENT OF SUSPENSE ACCOUNT ENTRIES

1. All entries outstanding in the Inter-Branch Accounts (by whatever name called) and/or Suspense Account must be reconciled/cleared and taken to the proper head of account within a maximum period of 30 days from the date the entry is made in the above-named accounts.

2.Entries made in Suspense Account on account of tax at source, advance tax paid, tax recoverable, advance expense on new branches, advance rent paid, legal expenses, mark-up/service charge recoverable, Qarze Hasna for


marriage, and forward cover fee, may be classified as "Other Assets，，and the above instructions shall not be applicable to the foregoing items. Besides，entries relating to frauds and forgeries，cash theft and looting, payments against equity, scrips/debt instruments and contributory payments of capital nature to be capitalized at a later stage shall also be excluded from the purview of the said regulation. The exclusion of entries relating to frauds and forgeries ， cash theft and looting will, however, be subject to the condition that the same are cleared immediately on receipt of insurance claims. Further, outstanding amounts of the premium on Crop Loan Insurance Scheme (CLIS) receivable from Government of Pakistan (GoP) shall also be classified in other assets. The outstanding amount shall, however，be reconciled/cleared immediately on reimbursement of premium amount from the GoP.

3.Banks/DFIs shall institute an effective internal control system for the operations of Inter-Branch and Suspense Accounts, which ensures reconciliation/clearing of the entries in the shortest possible time and also clearly places responsibility on the official(s) for neglecting the timely reconciliation and clearance.

REGULATION 0-4MAINTENANCE OF ASSETS IN PAKISTAN

Every bank/DFI shall maintain in Pakistan not less than 80% of the assets created by it against such time and demand liabilities as specified in Part- A of Form X (prescribed under Rule 17 of the Banking Companies Rules, 1963). Accordingly，assets held abroad by any bank/DFI shall not, at any point in time， exceed 20% of its time and demand liabilities specified in the said Form X. All other assets financed from sources other than time and demand liabilities specified in the said Form X shall be held within Pakistan.

REGULATION 0-5FOREIGN CURRENCY DEPOSITS UNDER FE 25-1998

1. Banks shall not invest FE 25 deposits in foreign currency/local currency denominated instruments below investment grade. Neither shall they invest/place such deposits in fund management schemes of other banks/DFIs/NBFCs, whether in Pakistan or abroad.

2. Banks shall be required to maintain the prescribed ratio of Cash Reserve/Special Cash Reserve against FE 25 deposits in US Dollars.

3. Placement of funds of FE-25 deposits with any one bank/financial institution, whether in Pakistan or abroad, shall be subject to the following conditions:

a) The investing bank shall comply with Regulation R-l (Annexure- 1 Para F)，which mentions different weightages according to credit ratings of financial institutions.

b) The investing bank will not place in a single institution an amount exceeding 25% of the total investable funds, available with

3. The employees of banks/DFIs are strictly prohibited to disclose the fact to the customer or any irrelevant quarter that a suspicious transaction or related information is being reported for investigation.


4. In cases of foreign branches of banks/DFIs and subsidiaries of banks/DFIs in foreign countries undertaking banking business, banks/DFIs should ensure compliance with the regulations (relating to Anti Money Laundering and KYC) of State Bank of Pakistan or the relevant regulations of the host country, whichever are more exhaustive.

REGULATION 0-1UNDERTAKING OF CASH PAYMENTS OUTSIDE THE BANK'S AUTHORIZED PLACE OF BUSINESS

1. Banks shall not undertake any business of cash payments, other than the authorized place of business, except through the installation of Automated Teller Machines (ATM). Banks desirous of providing the facility of withdrawal through Authorized Merchant Establishments at various Points of Sale (POS) may do so up to a maximum cash limit of Rs 10,000/- For this purpose, adequate and suitable security measures should be put in place for cash feeding and safety of the machines.

2.Banks may do collection and payment of cash for their prime customers through cash carrying companies registered with the relevant Government department. This facility should, however, be provided through designated branches of the banks and after the banks have devised procedures including necessary security measures.

REGULATION 0-2 WINDOW DRESSING

Banks/DFIs shall refrain from adopting any measures or practices whereby they would either artificially or temporarily show an ostensibly different position of banks VDFIs’ accounts as given in their financial statements. Particular care shall be taken in showing their deposits, MCR, nonperforming loans/assets, provisioning, profit, inter-branch and inter-bank accounts, etc.

REGULATION 0-3RECONCILIATION OF INTER-BRANCH ACCOUNTS AND SETTLEMENT OF SUSPENSE ACCOUNT ENTRIES

1. All entries outstanding in the Inter-Branch Accounts (by whatever name called) and/or Suspense Account must be reconciled/cleared and taken to the proper head of account within a maximum period of 30 days from the date the entry is made in the above-named accounts.

2.Entries made in Suspense Account on account of tax at source, advance tax paid, tax recoverable, advance expense on new branches, advance rent paid, legal expenses, mark-up/service charge recoverable, Qarze Hasna for marriage, and forward cover fee，may be classified as "Other Assets” and the above instructions shall not be applicable to the foregoing items. Besides, entries relating to frauds and forgeries, cash theft and looting, payments against equity, scrips/debt instruments and contributory payments of capital nature to be capitalized at a later stage shall also be excluded from the purview of the said regulation. The exclusion of entries relating to frauds and forgeries, cash theft and looting will, however, be subject to the condition that the same are cleared immediately on receipt of insurance claims. Further, outstanding amounts of the premium on Crop Loan Insurance Scheme


(CLIS) receivable from Government of Pakistan (GoP) shall also be classified in other assets. The outstanding amount shall, however, be reconciled/cleared immediately on reimbursement of premium amount from the GoP.

3.Banks/DFIs shall institute an effective internal control system for the operations of Inter-Branch and Suspense Accounts, which ensures reconciliation/clearing of the entries in the shortest possible time and also clearly places responsibility on the official(s) for neglecting the timely reconciliation and clearance.

REGULATION 0-4MAINTENANCE OF ASSETS IN PAKISTAN

Every bank/DFI shall maintain in Pakistan not less than 80% of the assets created by it against such time and demand liabilities as specified in Part- A of Form X (prescribed under Rule 17 of the Banking Companies Rules, 1963). Accordingly, assets held abroad by any bank/DFI shall not，at any point in time, exceed 20% of its time and demand liabilities specified in the said Form X. All other assets financed from sources other than time and demand liabilities specified in the said Form X shall be held within Pakistan.

REGULATION 0-5FOREIGN CURRENCY DEPOSITS UNDER FE 25-1998

1. Banks shall not invest FE 25 deposits in foreign currency/local currency denominated instruments below investment grade. Neither shall they invest/place such deposits in fund management schemes of other banks/DFIs/NBFCs, whether in Pakistan or abroad.

2. Banks shall be required to maintain the prescribed ratio of Cash Reserve/Special Cash Reserve against FE 25 deposits in US Dollars.

3. Placement of funds of FE-25 deposits with any one bank/financial institution, whether in Pakistan or abroad, shall be subject to the following conditions:

a) The investing bank shall comply with Regulation R-l (Annexure- 1 Para F), which mentions different weightages according to credit ratings of financial institutions.

b) The investing bank will not place in a single institution an amount exceeding 25% of the total investable funds, available with the investing bank, under the FE-25 Deposit Scheme. The conditions above shall，however, not be applicable on placement of funds by the bank with its own branches overseas. Furthermore, compliance with all other relevant Prudential Regulations shall also be ensured.

4. Banks shall be free to decide the rate of return on deposits mobilized under FE-25.

5. Banks shall be free to use such deposits for their trade-related activities provided the exchange risks are adequately covered and a square position is maintained.


6. Foreign currency deposits mobilized under FE 25 scheme, after netting- off the deposits utilized to finance trade related activities such as financing against Import and Export documents, should not at any point exceed twenty percent of the local currency deposits of the banks at the close of business on the last working day of the preceding quarter. Banks/DFIs may also exclude FE-25 Deposits in the form of Foreign Direct Investment and funds received for social and economic uplift through international donor agencies/welfare organizations from the calculation of limit on FE-25 Deposits prescribed in Para 6 of Regulation 0-5. This will, however, be subject to the condition that the banks/DFIs will obtain an undertaking from the Account Holder that such funds are remitted from abroad and would be used for poverty alleviation and socio-economic uplift. The genuineness of all such exclusions will be verified by the SBP Inspectors during the subsequent inspections.

7. Banks will report the equivalent Pak Rupee amount (with a foot note on $ equivalent) of FE 25 deposits utilized for trade related activities under newly created code No.80-05 of their Weekly Statement of Position submitted to the Banking Supervision Department.

Khushhali Bank (KB) Ordinance 2000

Founded in 2000，Khushhali Bank Limited is a part of the Government of Pakistan’s Poverty Reduction Strategy and its Microfinance Sector Development Program (MSDP). MSDP was developed with the facilitation of Asian Development Bank (ADB). With its headquarters based in Islamabad，Khushhali Bank Limited operates under the supervision of the State Bank of Pakistan (SBP) and many commercial banks are its shareholders. The mandate remains to retail microfinance services and to act as a medium in stabilizing the country、newly formed microfinance sector. This bank is established to provide services to poor persons, particularly to poor women.

Section lv and 2 relate to the title and definition. The Head Office of the bank shall be in Islamabad and it can open regional and other offices with the approval of SBP. It is not a banking company for the purpose of Banking Companies Ordinance 1962 or any other law for the time being in force relating to banking companies. Major functions of KB are to help poor people and improve their financial conditions. No information or data provided by a person applying to the KB in connection with any application for financial assistance or any other service shall be disclosed or used by any member, auditor or staff member of KB for any purpose other than the purpose for which it was intended.

Objective, functions and power of KB：

• To provide credit with or without collateral security under such terms and conditions to the poor for all types of economic activities.

•To accept deposits.

• To accept pledges，mortgages, hypothecations and assignment to it of any kind of moveable or immoveable properties provided as security by the borrower.

• To undertake the management and control of any organization, enterprise


or trust, for the benefit of poor persons.

• To buy, sell and supply on credit to poor persons industrial and agriculture inputs, livestock machinery, equipment and industrial raw material; to act as an agent for any organization for the sale of such goods and livestock.

• To take on lease, sell, exchange, surrender, mortgage, or deal, in any moveable or immoveable property on behalf of the customers in order to promote development opportunities, building of assets ， promotion of markets for economic growth and development.

•To establish subsidiaries, wholly or partly owned.

•To pay, receive and remit money and securities within the country.

•To open an account or make any agency arrangement with or to act as agent or correspondent of any bank or financial institution.

•To invest funds in government and market securities.

•To impose and receive fees, profit charges, on its services.

• To mobilize and provide financial and technical assistance and training to customers.

•To undertake mobile banking.

•To receive grant of investment share of any body corporate, the objective of which is to provide Khushhali services to poor persons.

•To provide storage and safe custody facility.

•To carry out surveys and research, and to issue publications and maintain statistics relating to the improvement of economic condition for poor persons.

.To encourage investment in such cottage industries and income- generating projects for poor persons as may be prescribed.

• To provide services and facilities to customers to hedge various risks relating to the business activities.

• To render managerial, marketing， technical, and administrative advice to the customers.

•To borrow and raise money and open bank accounts.

•To purchase from government or any other source permitted by SBP.

•To establish trust and endowment funds.

•To generally perform all such acts that may be necessary to the fulfillment of its functions and achievement of its objectives.

Microfinance Institutions Ordinance 2001

Microfinance may be defined as the provision of financial services, including credit, savings， insurance and payment transfers etc, required by poor households and their micro enterprises. Microfinance Institutions are specialized financial institutions, which cater for the financial services needs of the poor. Commercial banks and other traditional financial institutions are neither mandated nor have the capacities to serve the microfinance market. They perceive the poor as a high risk, high cost and difficult to serve market and keep away from them. NGO-MFIs and the specialized poor focused programs, therefore, are the major providers of microfinance, both domestically and internationally. NGOs alone, however, given their resource constraints - financial and managerial-are not likely to substantially increase the outreach of MF services to the poor in the foreseeable future. The concept of formal microfinance banks, with the capacity to provide a range of financial services to the poor on a self sustainable and commercial basis, first emerged in the mid 1990s and is gaining increased acceptance in most parts of the world, including Pakistan.

Microfinance Ordinance was promulgated by the President of Pakistan to regulate the establishment, and operation of microfinance institutions, with the aim of providing organizational, financial and industrial support to poor persons, particularly poor women， to mitigate poverty and promote social welfare and economic justice, through community building, and social mobilization for the deprived classes of society, as well as safeguarding microfinance institutions against political and other outside interferences.

As with other Ordinances and Acts, the first and second sections deal with the title and definitions of the terms used in the ordinance. Microfinance institutions means a company that accepts deposits from the public for the purpose of providing microfinance services. Microfinance services means the financial and other related services specified in the ordinance, the value of which should not exceed such amount as the SBP may determine from time to time.Poor person means persons who have meager means of survival ami whose total income or receipts during a year is less than a minim—i taxable limit set out in the law relating to income tai


The Licensing, Regulatory and Supervisory Agency

The licensing, regulation and supervision of MFBs established/to be established under MFIs Ordinance 2001 has been entrusted to State Bank of Pakistan under MFIs legal framework. No institution/person can commence operations as a microfinance bank unless granted a liceme by the State Bank under section 13 of the MFIs Ordinance*

Who Can Apply for a License for Establishing Microfinance Banks?

Any person or group of persons, Pakistan or foreign national, having the requisite financial and managerial capacity and exposure to and understanding of dynamics of the MF sector, as well as the established integrity levels, may apply for a license under the MFIs Ordinance.

Functions

•To provide financial facilities with or without collateral security, in cash or kind under such terms and conditions as may be prescribed to poor persons for all types of economic activities. Excluded is business in foreign exchange transactions (except to receive remittances from abroad payable in Pakistani rupees.

•To accept deposits.

•To accept pledges, mortgages, hypothecations or assignment to it of any kind of moveable or immoveable properties provided as security by the borrower.

• To undertake the management and control of any organization, enterprise or trust, for the benefit of poor persons.

• To buy, sell and supply on credit to poor persons industrial and agriculture inputs, livestock，machinery, equipment and industrial raw material and to act as an agent for any organization for the sale of such goods and livestock.

* To invest shares of any corporate body，the objective of which is to provide microfinance services to poor persons.

•To provide storage and safe custody services.

•To carry out surveys and research and to issue publications and maintain statistics relating to the improvement of economic conditions of poor persons.

•To establish subsidiaries, wholly or partly owned.

• To pay, receive and remit money and securities within the country.


• To open accounts or make any agency arrangement with or to act as an agent or correspondent of any bank or financial institution.

• To invest funds in government and market securities.

• To impose and receive fees, profit charges on its services.

•To mobilize and provide financial and technical assistance and training to customers.

•To undertake mobile banking.

•To receive grants of invested shares of any body corporate, the objective of which is to provide microfinance services to poor persons.

• To provide professional advice to poor persons, regarding investment in small business，and such cottage industries as may be prescribed.

• To encourage investment in such cottage industries and income- generating projects for poor persons as may be prescribed.

• To provide services and facilities to customers to hedge various risks relating to the microfinancing activities.

•To purchase, take on lease or otherwise acquire, sell, exchange, surrender, lease，mortgage, dispose of and deal in any moveable and immoveable property and rights of all kind for and on behalf of its customers for the purpose of promoting development opportunities for building of assets resource, allocation promotion of market and adoption of better technology for economic growth and development.


Setting rules and standards

•Arbitration under the rules of the ICC International Court of Arbitration is on the increase. Since 1999， the Court has received new cases at a rate of more than 500 a year.

• ICCfs Uniform Customs and Practice for Documentary Credits (UCP 600) are the rules that banks apply to finance billions of dollars worth of world trade every year.

• ICC Banking Commission designed Uniform Rules for collection which were last revised in May 1995 and are detailed in ICC publication 522 (URC 522).

• ICC Inco terms are standard international trade definitions used every day in thousands of contracts. ICC model contracts make life easier for small companies that cannot afford big legal departments.

• ICC is a pioneer in business self-regulation of e-commerce. History of the

ICC

The International Chamber of Commerce came into existence in 1919 with an aim that remains unchanged: to serve world business by promoting trade and investment, open markets for goods and services, and the free flow of capital. The organization^ international secretariat was established in Paris and subsequently the ICC International Court of Arbitration in 1923. One year after the creation of the United Nations in 1945，ICC was granted the highest level consultative status with the UN and its specialized agencies.

Practical services to business

The first Uniform Customs and Practice for Documentary Credits came out in 1933 and the latest version, UCP 600，came into effect in July 1st 2007. These rules are used by banks throughout the world. A supplement to UCP 600，called the eUCP, was added in 2002 to deal with the presentation of all electronic or part electronic documents. Another ICC service, the Institute for World Business Law, was created in 1979 to study legal issues relating to international business.

How ICC works Council

The ICC World Council is the equivalent of the general assembly of a major intergovernmental organization. The difference is that in ICC the delegates are business executives and not government officials. There is a federal structure, based on the Council as ICC’s supreme governing body. The National Committees name delegates to the Council, which normally meets twice a year.National committees and groups

They represent the ICC in their respective countries. The national committees and groups make sure that ICC takes account of their national business concerns in its policy recommendations to governments and international organizations.

The Chairmanship and Executive Board

The Council elects the Chairman and Vice-Chairman for two-year terms. The Chairman, his immediate predecessor and the Vice-Chairman form the Chairmanship. The Council also elects the Executive Board, responsible for implementing ICC policy, on the Chairman、recommendation. The Executive Board has between 15 and 30 members, who serve for three years, with one third retiring at the end of each year.

Secretary General

The Secretary General heads the International Secretariat and works closely with the national committees to carry out ICC， s work programme. The Secretary General is appointed by the Council at the initiative of the Presidency and on the recommendation of the Executive Board.

ICC commissions

Member companies and business associations can shape the ICC stance on any given business issue by participating in the work of ICC commissions. These consist of a total of more than 500 business experts who give their time to formulate ICC policy and elaborate its rules. Commissions scrutinize proposed international and national government initiatives affecting their subject areas and prepare business positions for submission to international organizations and governments. Since 1946 ， ICC has engaged in a broad range of activities with the United Nations and its specialized agencies.

Dispute Boards

Dispute Boards (DBs) are normally set up at the start of a contract and remain in place and are remunerated throughout its duration. Comprising one or three members thoroughly acquainted with the contract and its performance, the DB informally assists the parties, if they so desire, in resolving disagreements arising in the course of the contract and it makes recommendations or decisions regarding disputes referred to it by any of the parties. DBs have become a standard dispute resolution mechanism for contractual disputes arising in the course of mid- or long-term contracts. ICC Dispute Board Centre International Chamber of Commerce 38 court Albert ler75008 Paris，France

International Court of Arbitration

The Court organizes and supervises arbitration and helps in overcoming obstacles. It does not itself resolve disputes, but this task is carried out by independent arbitrators. The Court makes every effort to ensure that the


award is enforceable in national courts of the related countries. A final and enforceable decision can generally be obtained only by the courts or by arbitration. Arbitral awards are not subject to appeal， they are much more likely to be final in comparison to the judgments of courts where appeals can be filed in higher courts.

More than 140 countries (including Pakistan) have signed the 1958 United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards，known as the "New York Convention11. The Convention facilitates enforcement of awards in all contracting states. Judicial systems do not allow the parties to a dispute to choose their own judges. In contrast, arbitration offers the parties the unique opportunity to designate persons of their choice as arbitrators, provided they are independent. This enables the parties to have their disputes resolved by people who have specialized competence in the relevant field.

Procedure

• The Claimant submits a Request for Arbitration to the Secretariat of the International Court of Arbitration in Paris.

•The Secretariat then transmits the Request to the other party or parties (the Respondent), which must send the Answer to the Request, together with any counterclaim, within 30 days. '

• After receipt of the Request, the Secretary General normally requests the Claimant to pay a provisional advance intended to cover the costs of arbitration until the Terms of Reference have been drawn up. Depending on circumstances, the Arbitral Tribunal proceeds within the shortest possible time to establish the facts of the case by all appropriate means.

•When it is satisfied that the parties have had a reasonable opportunity to present their cases, the Arbitral Tribunal declares the proceedings closed and prepares a draft Award.

• The Court scrutinizes the draft Award. While not interfering with the arbitrators1 liberty of decision，the Court may，if necessary, draw the Arbitral Tribunars attention to points of substance and lay down modifications as to the form of the Award.

• Once approved, the Award is signed by the arbitrator(s) and notified to the parties.

Rules of Arbitration

It is recommended that all parties wishing to make reference to ICC arbitration in their contract use the following Standard clause:

"Any party to this contract shall have the right to have recourse to and shall be bound by the pre-arbitral reference procedure of the Internation al Chamber of Commerce in accordance with its rules or a pre-arbitral reference procedure."All disputes arising out of or in connection with the present contract shall be finally settled under the rules of Arbitration of the InternationalChamber of Commerce by one or more arbitrators appointed in accordance with the said rules of arbitration.?f


Following is the gist of different articles related to the arbitration proceeding:

Article 1International Court of ArbitrationThe Court of Arbitration is a body attached to the ICC. Its members are appointed by the World Council of the ICC. The function of the court is to provide settlement by arbitration of business disputes of an international character in accordance with the rales of arbitration of the ICC. If so empowered by an agreement, the court shall also provide for settlement by arbitration in accordance with these rules of business disputes not of an international character.

Article 2

This is a section of definitions such as ”arbitral” ”claimant” ’’Award’1. Article 3

This article deals with notification or communication, and time line. Article 4

This article deals with requests for arbitration. If a party is willing to have recourse to arbitration, advice is given as to how to proceed and contact ICC Secretariat. Date of receipt of request shall be treated as the date of commencement of "arbitral proceeding”. Request should contain name and address of each party，nature arid circumstances of dispute, statement of the relief sought and indication of amount claimed, relevant agreement and arbitration agreement, details regarding numbers of arbitrators or any choice of an arbitrator, place of arbitration.

Articles 5This Article relates to the answer to the request / counterclaims. Within 30 days of receipt of the request at ICC Secretariat, the respondent shall file an answer which should contain name and address of each party, nature and circumstances of dispute, statement of the relief sought and indication of amount claimed， relevant agreement and arbitration agreement, details regarding numbers of arbitrators or any choice of an arbitrator, place of arbitration. The Secretariat can grant the respondent an extension of time for filing the answer.

Article 6This Article relates to the effects of the arbitration agreement. Generally the date of commencement is taken as the date of arbitration proceeding, unless the parties set rules for the date of their arbitration agreement. If the respondent does not file an answer or any party raises one or more plea(s) regarding existence, validity or scope of the arbitration agreement, the court may decide without prejudice to the admissibility or merit of the plea or pleas that the arbitration shall precede if it is satisfied that an arbitration under the rules may exist. If the court is not satisfied, the parties shall be notified that arbitration cannot proceed. If any of the parties refuses or fails to take part in the arbitration or any


stage thereof, the arbitration shall proceed despite refusal or failure, arbitral tribunal shall determine respective rights of the parties aod give a ruling even though the contract itself may be non-existent or and void.

Article 7This Article relates to the general provisions related to the arbitral tribunal such as:

Arbitrator must remain independent. Before appointment or confirmation, the arbitrator shall sign a statement of independence and disclose in writing to the Secretariat any fact or circumstances which might be of such a nature as to call into question the arbitrator’s independence in the eyes of the parties. The decision of the court as to the appointment, confirmation, challenge or replacement of an arbitrator shall be final.

Article 8 deals with numbers of arbitrators.

Article 9 deals with appointment and confirmation of arbitrators.

Article 10 deals with the multiple parties, whether as complainant or as respondent and constitution of arbitral tribunal.

Article 11 deals with the challenge of arbitrators. The court shall decide on the admissibility, and if necessary on the merits of a challenge，take point of view of arbitrator concerned, and other party or parties and any other member of the tribunal, and such comments shall be communicated to the parties and the arbitrators.

Article 12 deals with the replacement of arbitrators.

Article 13 deals with transmission of file to the tribunal.

Article 14 deals with the place of arbitration.

Article 15 deals with rules governing the proceeding.

Article 16 deals with language of the arbitration.

Article 17 deals with applicable rules of law. This means parties will be free to agree upon the rules of law to be applied by the arbitral tribunal to the merits of the dispute.

Article 18 deals with terms of reference and procedural timetable. Article 19

deals with new claims.

Article 20 deals with establishment of the facts of the case.

Article 21 deals with hearing, appearance of the parties and failure to appear.

Article 22 deals with closing of the proceeding.

Article 23 deals with conservatory and interim measures. Article 24 deals with

time limit of the award.

Article 25 deals with making of award and the reasons on which award is

based.

Article 26 deals with award by consent, that is, if parties reach a settlement after start of proceeding, it shall be recorded in the form of an award.

Article 27 deals with the scrutiny of the award by the court. Article 28 deals with notification, deposit, and enforceability of the award.

Article 29 deals with correction and interpretation of the award. This means on its own initiative the arbitral tribunal may correct a clerical, computational, typographical error contained in the award. Such correction must be submitted to the court within 30 days of the date of such award.

Articles 30 and 31 deal with the cost of arbitration.

Articles 32 to 35 deal with other miscellaneous items such as modified time limit，waivers, exclusion of liability and general rules.

• investment and disinvestment of funds where the maturity period of such investments is six months or more, except in the case of banking companies, Non-Banking Financial Institutions, trusts and insurance companies

• The Chairman of a listed company shall ensure that minutes of meetings of the Board of Directors are appropriately recorded. The minutes of meetings shall be circulated to directors and officers entitled to attend Board meetings not later than 30

Credit risk is the major risk in the banking system and exists in almost all income-generating activities. The way a bank selects and manages its credit risk is vitally important to its performance over time. Many institutions fail because of reduction in capital due to loan losses. It is therefore essential to identify possible risks and adopt measures to minimise the risk. All banks and DFIs should have credit risk management systems in place that ensure accurate and timely risk assessment. Such systems highlight the problems in lending activities and the overall level of risk involved in order to enable lending managers make correct decisions based on the merits of each lending proposition.

Risk appraisal or assessment is the combined process of first identifying the risks to which companies or individuals may be exposed and then evaluating those risks. Quantitative or qualitative measures may be used in the evaluation process. For this, lending institutions can refer to credit rating agencies. At present, there are more than 100 credit rating agencies all over the world.

It is beneficial for financial institutions to obtain credit ratings from the leading credit rating agencies due to the following reasons:

•To be able to utilize the interbank deposits market in order to widen funding sources. Financial institutions that lack a


credit rating cannot utilize the interbank deposits market. The upper limit of the level of interbank deposits depends on the credit rating of financial institutions. A higher ceiling is assigned to progressively higher credit ratings, and vice versa.• To be able to issue instruments in the capital markets (notes, bonds and sukuks), since the investors buying these instruments require a credit rating as a prior condition of their participation.

•The strength of a particular financial institution is judged according to its credit rating. The financial institutions for which the credit rating is done usually include the following:

•Banks and DFIs• Investment banks

• In order to ensure a high level of investor confidence，credit rating agencies should be subject to registration. For this purpose, uniform rules, regulations, terms and conditions for the granting，registration, suspension and withdrawal of such registration must be established.

SBP has made it mandatory for all the banks/NBFIs to have themselves credit rated by a Credit Rating Agency on the approved panel of the State Bank of Pakistan. Keeping in view the significance of credit rating it is advised that:

•Credit rating will be mandatory for all Banks/NBFIs w.e.f. June

30，2001.

• The credit rating will be an ongoing process, i.e. credit rating should be updated on a continuous basis from year to year and the rating report be submitted to the State Bank of Pakistan within a period of one month of the last notification of rating.

•All Banks/NBFIs listed on the Stock Exchange(s) will make a disclosure of their credit rating to the public within one month of the last notification of rating.

• All other Banks/NBFIs not listed on the Stock Exchange(s) will get themselves credit rated; however, it shall be mandatory upon them to make their credit rating public within a period of two years from the date of their first rating and thereafter annually within one month of the last notification of rating.

Non-compliance with these instructions shall render the Financial Institutions and Official(s) concerned liable to penal action under the relevant provisions of the Banking Companies Ordinance, 1962.

SBP criteria for External Credit Assessment Institutions (ECAI) SBP has prescribed criteria for External Credit Assessment Institutions (ECAI) for the calculation of their credit risk. The criteria provide a basis for the evaluation and

recognition of the rating agencies that apply to SBP for eligibility for the purpose of Basel II. The Securities and Exchange Commission of Pakistan will continue to remain the supervisory / licensing authority for credit rating companies in Pakistan and only those credit rating companies that are duly licensed by SECP under the Credit Rating Companies Rules, 1995，will be eligible to apply to the State Bank for Basel II recognition. The credit rating companies incorporated in Pakistan will also be required to follow the Code of Conduct for Credit Rating Companies issued by SECP. ECAIs should have in place a methodology of assigning credit rating that is rigorous, systematic, continuous and subject to validation. To establish that an ECAI fulfils this primary• Growth of public expenditure•Reducing the tax burden• Fiscal retrenchment in countries that face a higher perceived

sovereign default risk (which is true for some developing countries) tends to be less contractionary. However, even among such high-risk countries, expansionary effects are unusual.

Financial intermediation consists of "channeling funds between and deficit agents' A financial intermediary is a financial irt • that connects surplus and deficit agents. The classic example of a intermediary is a bank that transforms bank deposits into bank

Often the agents doing the saving in the economy are not the samr those doing the investing (for example, households save，but firms in Banks are the main intermediaries in poor countries between savers investors. If financial intermediation is poor (the real interest rate negative, people do not trust banks, etc.) then people will keep savings at home or in non-financial assets, which prevents the sav* going toward investment. As such, financial intermediaries channel 一 from people who have extra money (savers) to those who do not enough money to carry out a desired activity (borrowe

The degree of financial intermediation is the share of financial assets financial


institutions in the value of all financial assets. Finane* intermediaries also play a stabilizing role in the econom

Financial intermediaries perform 3 major functions:

1. Maturitytransformation Converting short-term liabilities to long-term assets (banks deal w* large numbers of lenders and borrowers, and reconcile their confli • needs).

2. Risk transformation Conversion of risky investments into

relatively risk-free ones (e 各lending to multiple borrowers to spread the risk).

3. Convenience denominationMatching small deposits with large loans and large deposits with small loans.

There are two essential

advantages of using financial

intermediaries:

1. Cost advantage over direct

lending/borrowingDeregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces. Deregulation does not mean elimination of laws against fraud or property rights but eliminating or reducing government control or how business is done, thereby moving toward a more laissez-faire, free

market.

Financial Liberalization

The six different dimensions of financial liberalization are considered to be:-The elimination of credit controls• The deregulation of interest rates-Free entry into the

banking sector (or, more generally, the financial services industry)

-Bank autonomy (allowing bankers rather than bureaucrats to decide whom to employ, at what wage rate, where to open branches, etc.) -Privatization of banks -Liberalization of international capital flows

Elimination of credit controls and deregulation of interest rates means allowing the market to handle the process of intermediation between savers and investors. There is no intervention from the government or its agencies. There are two distinguishable effects. First, the liberalization of interest rates has typically resulted in their increasing above the low levels that are usually found in repressed financial systems. Advocates of financial liberalization argue that this will increase the level of saving ，


and therefore investment, and so promote growth. There has been much empirical work examining this thesis in recent years. The evidence suggests that the level of saving has little elasticity with respect to the rate of interest. However, while the overall level of saving does not systematically increase when the interest rate rises, more of the saving that does occur is placed in the financial system, so that financial depth does rise, and hence more of a given level of saving is intermediated through the formal financial system. That will bring a benefit if the formal financial system is better at allocating savings than alternative mechanisms (such as the informal financial system or buying gold). The higher interest rates will also benefit savers, which should be counted a social benefit to the extent that savers tend to be less wealthy than investors.

• In Brazil, bill payments and the payment of government benefits to individuals comprised 78 percent of the 1.53 billion transactions conducted at the country’s more than 95,000 agents in 2006. CGAP research in Brazil found that, of the 750 people who responded to a survey in Pernambuco State, 90 percent reported using banking agents to pay utility and other bills, only 5 percent reported opening a bank account at the agent, and less than 5 percent said they had made a cash deposit into their bank account at an agent. Indeed, 87 percent of those who had opened an account stated that they had

done so just to receive welfare or salary payments.• Section 27 deals with licensing of banking companies. Section 27B was added on 2 June 1997 and deals with disruptive union activities, which• Section 48 deals with amalgamation and winding-up of the banking company.

• Section 59 deals with voluntary winding-up of the banking company.

Sections 60 to 82 deal with the procedural framework to be followed in winding up of the banking company.

• Instruments executed in Pakistan are required to be stamped under the Stamp Act before or at the time when they are signed. Cheques are exempted from the application of stamp duty.

•Time for payment can be expressed in the following ways:

• On demand or

•At sight or on presentation.

•Certain time after date.

•A certain time after a certain event has happened.

• Instruments executed in Pakistan are required to be stamped under the Stamp Act before or at the time when they are signed. Cheques are exempted from the application of stamp duty.

•Time for payment can be expressed in the following ways:

•On demand or

•At sight or on presentation.

• Certain time after date.

•A certain time after a certain event has happened.

• In cases where the issuer is given an option to redeem the preference shares，as per agreed terms and conditions, the issuer will redeem the2. Banks/DFIs shall, as a matter of rule, obtain a copy of financial statements duly audited by a practicing Chartered Accountant, relating to the business of every borrower who is a limited company or where the exposure of a bank/DFI exceeds Rs 10 million, for analysis and record. The banks/DFIs may also accept a copy of financial statements duly audited by a practicing Cost and Management Accountant in case of a borrower other than a public company or a private company which is a subsidiary of a public company. However effective from December 31 ，2009，if the borrower is a public limited company and exposure exceeds Rs. 500 million, banks/DFIs should obtain the financial statements duly audited by a firm of Chartered Accountants which has received satisfactory rating


under the Quality Control Review (QCR) Program of the Institute of Chartered Accountants of Pakistan. Subsequently, if the firm’s rating is downgraded in QCR program, then the financial statements of such borrowers are audited in the subsequent year by a firm having satisfactory rating under QCR.l Banks/DFIs may waive the requirement of obtaining copy of financial statements when the exposure net of liquid assets does not exceed the limit of Rs 10 million. Further, financial statements signed by the borrower will suffice where the exposure is fully secured by liquid assets.3. Banks/DFIs shall ensure that the aggregate exposure against all their clean facilities shall not, at any point in time，exceed the amount of their equity. However, investment of banks/DFIs in subordinated and unsecured TFCs, issued by other banks/DFIs to raise Tier-II Capital as per State Bank of Pakistan's instructions, will be exempted from the aggregate exposure limit.4. This regulation shall not apply in case of exposure fully secured against liquid assets held as collateral, as well as in cases where the exposure is taken on Units/Projects revived as a consequence of settlement under Committee for Revival of Sick Industrial Units (CRSIU)，Corporate &3. Exposure against the shares of listed companies shall be subject to minimum margin of 30% of their current market value，though the banks/DFIs may，if they wish, set higher margin requirements keeping in view other factors. However, banks/DFIs should not give a margin call until the margin reaches to the level of 25%. Banks/DFIs will monitor the margin on at least weekly basis and will take appropriate action for top-up and sell-out on the basis of their Board of Directors，approved credit policy and pre-f act written authorization from the borrower enabling the bank/DFI to do this.4. The guarantees shall be for a specific amount and expiry date and shall contain a claim lodgment date. However, banks/DFIs are allowed to issue open-ended guarantees without clearance from State Bank of Pakistan provided banks/DFIs have secured their interest by adequate collateral or other arrangements acceptable to the bank/DFI for issuance of such guarantees in favour of Government departments ，

corporations/autonomous bodies owned/controlled by the Government and guarantees required by the courts.2. The Board shall approve and monitor the objectives, strategies andoverall business plans of the institution and shall oversee that the affairs8. The Board should meet frequently (preferably on monthly basis, but in any event, not less than once every quarter) and the individual directors of an institution should attend at least half of the meetings held in a financial year. The Board should ensure that it receives sufficient information from Management on the agenda items well in advance of each meeting to enable

it to effectively participate in and contribute to each meeting. Any advisor, if appointed by the Board member, shall neither attend the Board meeting(s) on behalf of the Board member nor shall regularly sit in the Board meeting(s) as an observer or any other capacity.2. The banks/DFIs during a calendar year may pay a reasonable andappropriate remuneration for attending the Board or its committee (ies)meeting (s)，to their non-executive directors and chairman. The scale of• Provide professional advice to poor persons，regarding investment in small business and such cottage industries as may be prescribed.• To render managerial, marketing, technical, and administrative advice to the customers.

•To borrow and raise money and open bank accounts.

•To purchase from government or any other source permitted

by SBP.

•To establish trust and endowment funds.

•To generally perform all such acts that may be necessary to the fulfillment of its functions and achievement of its objectives.

ICC International Chamber of Commerce

ICC (International Chamber of Commerce) is the voice of world business communities. It is the only truly global business organization which is forceful in expressing business views. Its activities covers a broad range, from arbitration and dispute resolution to making the case for open trade and the market economy system, business self-regulation, fighting corruption or combating commercial crime. This is an organization which is functioning freely, without any political or regional influence, and runs its operation on democratically sound principles.