FOROFFICIAL USEONLY FINANCIAL SECTOR ASSESSMENT PAKISTAN MARCH 2005 SOUTHASIAREGIONVICEPRESIDENCY FINANCIALSECTOR VICEPRESIDENCY BASED THEJOINTIMF-WORLDBANKFINANCIAL SECTORASSESSMENT ON PROGRAM I.INTRODUCTION 1. This Financial Sector Assessment (FSA) i s based on the work o f thejoint IMF-World Bank missions1that visitedPakistan from February 16-27,2004 andApril 7-15,2004 inthe context o f the Financial Sector Assessment Program (FSAP). The principal objectives o fthe missions were to identifythe strengths and systemic vulnerabilities o f the financial sector, and to assist the Pakistaniauthorities indesigningappropriate policy measures for improving the operation and oversight of the systemand its contributionto economic growth and development. 2. The FSAPfindingswere discussedwith senior officials ofthe StateBank of Pakistan,the Ministry ofFinance, andthe Securities and ExchangeCommissionof Pakistanat a wrap-up meetingchairedby the Governor ofthe StateBankof Pakistan. The authorities expressedbroad agreement with the conclusions o f the assessment, andhave taken a numberofmeasuresto implement some ofthe.keyrecommendations. The final FSAPReport was deliveredto the authorities inJanuary, 2005. This report summarizes the main findings and policy recommendations o f the missions. 11. MACROECONOMIC AND BACKGROUND CONTEXT 3, Considerableprogresshasbeen made in macroeconomicstabilization.Real GDP growth has progressively strengthened(5.1% in2003/04), inflationhas been subdued (3.1%), and the overall fiscal deficit and public debt have beenbrought down markedly from earlier The FSAP missions were ledbyMs.Ann Rennie (Head, World Bank), and Mr.Syed K.Wajid(DeputyHead, IMFMFD),and included Messrs. Jorge I. Kriljenko, Vassili Prokopenko,and Axel Schimmelpfennig Canales (IMFMCD); Ms.Elena Loukoianova, Ms.Emma Warrack, and Ms.Nirmaleen Jayawardane (all IMFMFD); Ms. Nagavalli Annamalai, Ms.Asli Demirguc-Kunt, and Messrs. Joselito Gallardo, Mudassir Khan, Richard Him, and Rodney Lester (all World Bank); Messrs. KeithBell (formerly Canadian Office o f the Superintendent o f Financial Institutions), JohnFarrell (formerly N e w Zealand Securities Commission), MillardLong (retired World Bank) and Ms.F.Haishim(Bank NegaraMalaysia). Messrs. SyedHashemi (CGAP), and Olivier Hassler (World Bank) also contributed to the mission's findings. - 2 - levels. The current account position i s comfortably insurplus, leadingto a large accumulation o f external reserves. Internationalcapital markets have shown a renewedappetite for Pakistan's sovereign debt. Risks related to dollarization have also diminished substantially. 4. While macroeconomicstabilizationhas helpedto limitvulnerabilities andimprove performanceinthe financialsector, the outlook remainssubject to a number of risks. Credit to the private sector has beenexpanding very rapidly (28.5 percent in2003). While this reflects the buoyant economy, ifsustained, it could portendfuture credit quality problems. In addition, awidely anticipated rise ininterest rates andtighter liquidity conditions could adversely impact banks' balance sheets. Finally, a change inthe domestic or international political environment could leadto a dryingup o f remittances, which have been unusually high inrecent years. 111. OVERALL ASSESSMENT 5. Pakistanhas undertakenmajor reformsinrecentyears inthe financialsector that have resultedin a sounder and moreefficientfinancialsystem. The reforms have been implementedinthe context o f abroader macroeconomic stabilizationand structural agenda, providing an essential foundation to financial sector recovery. A major achievement o fthe reformprocess has beenthe transformationo f a predominantly state-owned and weak banking sector into a healthier, market-based system, ownedprimarily by the private sector. This has beenfacilitated by the restructuringo f major banks, ongoing consolidationo f the sector, strengtheningo fregulatorycapacity, and improvements intransparency, corporate governance, andcredit culture. 6. The reformefforts are reflectedinimprovingfinancialsoundnessindicators, greater resiliencyto credit, market and liquidityrisks,and good compliancewith internationalsupervisory standards. However, the improvements inkeyperformance indicators are recent andhave beenachieved against a backdrop o f favorable macroeconomic andpolitical developments. The key challenges going forward will be to consolidate, complete andinstitutionalizethe reforms, andto further deepenanddiversify the sector to support equitable economic growth. 7. Increasedliquidityhas ledto a rapidincreasein creditto the privatesector,bothin aggregateterms andto a wider rangeof borrowers.While increased lendingand intermediationi s a normal complement to higher real economic growth and wider access to credit i s awelcome development, financial institutions and their supervisors need nonetheless to ensure that this growth does not compromise credit quality and underminebanks' balance sheets. 8. Credit to previouslyunderservedmarketshas expandedmarkedly.Consumer, housing, small- and medium-sized enterprises (SME) and agricultural finance have all shown strong gains inthe past two years. Credit to these market segments, once the domain o fpublic development finance institutions (DFIs) and specialized banks, i s now beingprovidedby a broad rangeo f financial institutions. Largesegments ofthe economy, however, continue to operate with little formal credit. The authorities and industrywill needto continue their efforts to promotenew business models and technologies, and to broaden outreach ina sustainable and cost-efficient manner. - 3 - 9. To consolidate recent structural reforms and protect the system from future policy reversals, the process of privatization and legal reforms needs to be continued. The government should divest its remaining stake inbanks, and existing plans to privatize the Small andMediumEnterprise Bank (SMEB), IndustrialDevelopment BankofPakistan (IDBP), House BuildingFinance Corporation(HBFC), andNational Investment Trust (NIT) should be expedited. The government should reconsider its continued ownership ofthe National Bank of Pakistan (NBP) and the three public insurance companies. The progress achieved thus far can be solidified byrevising key financial sector legislation, most notably the SBP Act and Banking Companies Act inaccordance with sound practice to avoid relapsing into past practices and unwarrantedgovernment interference. 10. The reform process is not equally advanced across all segments of the financial sector. Insurance penetration i s very low relativeto other countries at Pakistan's income level, reflecting a number o f factors, including a history o f nationalizationandinstability, and weak consumer protectionand awareness. And, while the securities markets have benefitedfrom recent reforms, a tradition o fhighlyleveraged and speculative trading through the COT or "badla" system, coupledwith weak supervision o fmarket intermediaries pose potential systemic risks.2 Finally, issues regarding the sustainability and oversight o fpension systems need to be addressed . Iv.FINANCIAL INSTITUTIONS AND MARKETS 11, Pakistan's financial system i s sophisticated and diversified relative to other low income developing countries. While the system remains dominated by commercial banks, it also includes an active stock market and a variety o f institutionalinvestors and other nonbank financial institutions: DFIs, investment banks, life insurers, leasing companies, mutual funds, housing finance companies, and Islamic finance companies (Table 1). As o f end- September 2003, total assets o fcommercialbanks amounted to PKRs 2,380 billion(about US$42 billion), equivalent to around 55 percent o f GDP, while M 2 stood at 42 percent o f GDP. 12. Significant financial sector reforms have been implementedduring the last decade. These have included a return to market-based monetary and exchange ratepolicies, a diminished role o f the state inthe financial sector throughprivatizationof nationalizedcommercialbanks, improvements incorporate governance, disclosure, andtransparency, and the adoptiono f a modernregulatory approach inthe oversight o fthe financial sector. A. The Regulatory and Supervisory Framework 13. The Banking Companies Ordinance establishes the State Bank o f Pakistan(SBP) as the authority responsible for the supervision, regulation, and licensing o f commercial banks, microfinance banks, andDFIs, while most other financial institutions are regulated by the Securities and Exchange Commissiono fPakistan (SECP). The two regulators have instituted - 4 - procedures for cooperation and exchange o f inf~rmation,~ butthese may needto bereinforcedin light o f ongoingmergersbetweenbanks andNBFCs, and the needto ensure effective consolidated supervision of the new entities and to avoid opportunities for regulatory arbitrage. The legal framework for microfinancebanks (MFB) i s comprehensive and providedby the Microfinance Ordinance o f 2001. 14. The SBP has mademajor stridesin enhancingitssupervisory capacityinrecent years, bringingit broadlyinlinewith internationalstandards. There i s ahighdegree o f compliance with Base1Core Principles for EffectiveBanking Supervision. The SBP has an array o fpowers to control the risks assumedbybanks, has issued appropriate prudentialregulations, has adopted sound methods for on- and off-site supervision, and has the power to require a wide range o f remedial measures. Inaddition, it has adequate resources, and the quality o f its staffhas beensignificantly upgraded inrecent years. However, the upgradingo fthe supervisory structure i s relatively recent and remains to be tested over a longer period. There also are areas o f less than full compliance with supervisory standardsthat relate to legalprovisionsregarding the independence o f the regulator, arrangements for consolidated supervision, andprovisions for country risk. The pendingreview o fthe Banking Companies Ordinance should be usedto address these legal deficiencies. 15. Sinceitsinceptionin 1999, the SECP has adoptedfar-reachingreforms,but needsto reinforceitssupervisorycapacity.Reformshave enhancedriskmanagement, govemance, disclosure, transparency, and investor protections; andthe SECP i s continuing a robust program o f review o frelevant laws andpractices. These measures have contributedto improved investor confidence and created a more conducive environment for the development o f the securities market. The SECP has a broadmandate, which has recentlybeen expanded with the assumption o f regulatory responsibility for all NBFCs. While the Commissioni s empowered to conduct on- site inspections o fregulated entities, it has generally not done so unless it has reason to believe there has beenmalpractice. The mission is o fthe view that the Commission needs to commence a regular program o f on-site supervision o fregulated firms.4 It suggeststhat the SECP undertake a formal review to determine where it needs additional resources andcapacity to adequately perform its functions and exercise its powers. The authorities also need to address the lack o f regulation or oversight o fprivate pensions and clarify the respective roles o f the Ministry o f Commerce and the SECP inregulatingthe insurance industry. B. Vulnerabilities,Soundness andDevelopmentofthe FinancialSystem Banking Sector 16. The divestitureofstate ownership of nationalizedcommercialbankshas ledto a sounder, more efficient, and more competitivebankingsector. Privatebanks,which controlledjust 8 percent o f the market in 1990, now have a market share o f approximately 80 An MOUbetweenthe SBP and the SECP is inplace. The two regulators meet quarterly on a formal basis, and interact and share information as required. Subsequent to the mission, the SECP has commenced on-site inspections o f members o f the stock exchanges. - 5 - percent. Privatizationhas been accompanied by the liberalizationo f the financial system and greater domestic and foreign competition. Financial soundnessindicators o f commercial banks have all improved markedly inrecent years, and earlier govemment interference inbank operations hasbeen sharply curtailed. While capital to risk-weightedassets has improved (standing at 13.1 percent as o f September2003), it varies considerably acrossbanks. Profitability and liquidityindicators have also shown amarkedimprovement, despite a narrowinginthe net interest margin, due to higher business volumes, a substantial retrenchment o fpersonnel, closure o fnumerous unprofitable branches, and higher non-interest income. Liquidityinthe bankingsector has also increased significantly, fueled by a substantial increase inworkers' remittances inrecent years. 17. While portfolioquality has improved,non-performingloans(NPLs) remainhigh and concentratedinthe largestbanks.5Inthepast, highNPLsconstrained banks' earning potential and threatened bank solvency. The recent decline inthe ratio has been helpedby various recoverydrives, promulgationo f a foreclosure law, restructuringo f loans, issuance o f write-off settlement guidelines andthe takeover o f some large NPLs by the Corporate and Industrial RestructuringCorporation (CIRC). The flow o fnew NPLs has declined significantly. A substantial share o fNPLs were bookedprior to 19976, andreflect the legacy ofpast political interference inthe nationalizedpublic banks.Finally, provisioning against NPLs i s improving. 18. Notwithstandingthe banks' improvedperformance,the recentvery rapidgrowthin credit to the privatesector warrants close monitoring.While the outstanding stock ofcredit to the corporate sector has beengenerally stable, bank lendingto small- and medium-sized enterprises and the consumer sector has beenincreasing rapidly. The share o fpersonal loans, which was negligible inthe mid-l990s, has risento 12percent o ftotal bank credit (as o f September 2003). While this represents a welcome broadening and diversificationo fbanks' portfolios, it requires close monitoring to ensure it does not leadto a deteriorationincredit quality. Concerns are underscored bythe challenges that the former nationalizedbanks still face, including developing a credit evaluation culture for lendingto new sectors, timely recovery o f defaulted loans, and maintenance o f some loss-making branches inthe "unbanked" areas. 19. Results of stress tests suggest that the bankingsystemcouldwithstandshocks consistentinseverity with historicalexperience, but is vulnerable to relativelysevere combinedshocks. While most bankshave enough capital to withstand sizeable increasesin NpLs, weaker banks experience capital adequacy problems inthe face o f a relatively modest deterioration inportfolio quality. This suggests that banks on the lower end o fthe capital adequacy and asset quality spectrum warrant close attention by supervisors. ~ The aggregate ratio o fNPLs to total loans masks differences across individual banks, with the ratio ranging from 0.4 percent to 35.1 percent. Asset quality o f the five largest banks i s weak, with the ratio o fNPLsto total loans ranging from 15 percent to 35 percent. A large stock ofoldNPLsreflects banks' reluctance to write offthese loans evenafter 100percentprovisioning because they fear that this may compromise their legal position inthe loan recovery process. - 6 - Financial and Capital Markets The improvedmacroeconomicsituation, low interestrate environment, and excess liquidityhavefueled a rapidrise inPakistan'sstock markets.The Securities andExchange Commission o f Pakistan (SECP) and SelfRegulatory Organizations (SROs) have taken a number of steps to increase the transparency, efficiency and integrityo fthe markets and to buildinvestor confidence. Ongoing policy reforms, including further privatizations and the creation ofpersonal pensionplans, should serve to broaden and deepenthe market. However, speculative trading through the COT system andweak oversight o f market intermediaries have left the market vulnerable to systemic risks. The authorities have announced a time-bound phase-out o fthe COT system, and have initiated on-site supervision ofmembersofthe stock exchanges. Bothare welcome developments, which should mitigatethese risks going forward. Insurance 20. The insurancesector is underdeveloped,butrecenthealthygrowthrateshave demonstratedthat there is scope for substantialdevelopmentwithin an appropriate regulatoryframework.Among other things, this is likelyto entail ongoing liberalizationofthe sector, combined with further moves towards a more marketholvency regulatory and supervisory regime. Immediate challenges include the continuing rationalization o f an overpopulated nonlife sector7and adjustingto new international accounting and solvency norms. The future of the three public sector insurers also needs to be considered. Eachneeds to be subjected to normalmarket forces and to have highlyprofessional management inplace ifit i s to have a legitimate long-term role. 21. The InsuranceOrdinance 2000 has introduceda numberoflaudablereforms,but has omitteda numberofelementsthat are keyto a modernrisk-basedsupervisory regime. Problems, which notably include limitedprompt corrective actionpower, are exacerbated by a lack o f on-site supervision capacity and in-house specialist skills. Inaddition, the division o f responsibilities betweenthe Ministryo f Commerce (MOC) and SECP needs to be be clarified. There appears to be a general consensus that all regulatory and supervisory responsibility for insurance should lie with SECP (and possibly MOF for associated legalreform), and responsibilities relatingto ownership and govemance o f the public sector insurers should rest with MOC. Pensions 22. Pakistanhasthe basicelements of a diversifiedmuiti-pillar pensionscheme that can provideold-ageincomesupport and contributeto long-termsocial and economic development,Thereis sufficient scope for capital accumulationwithin the current and anticipated framework for the pension systemto have positive effects instimulating new savings and supporting capitalmarket development. To achieve this, however, the Pakistani authorities will needto address significant issues regardingthe financial sustainability and regulation and oversight of the present schemes. Boththe civil service scheme and Employees Old Age Benefits 'Empirical research shows a negative correlation between overall insurance capacity ina country and the degree o f fragmentation o f its insurance sector - 7 - Institution (EOBI) are fiscally unsustainable and needto bebrought into balance, and a comprehensive legal andregulatory framework needs to be established for private occupational and personal pensions inorder to protect pension savings. It will also be important to establish strong governance and independentoversight o f the investmentprocess. A comprehensiveapproachto the regulationof occupationalandpersonalpension schemes shouldbe established.Althoughthe SECP is assignedgeneral authority for personal andprivate occupational pensions, there i s currently no direct oversight or supervision, andthe scope o f such pensions i s not known as there i s no reporting requirement. This represents a potential vulnerability to the savings and old age security o f fundmembers, and offers scope for tax abuse due to the tax preference affordedthese plans. An appropriate regulatoryframework would provide, inter-alia, custodial requirements, funding and investmentstandards, reporting and valuation standards, and prohibitions on self dealing andtransactions with related parties, and should bebuttressedwith a regular programo f oversight to ensure compliance with the standards. IV. ImprovingAccess to FinancialServices 23. Untilthe late 1990's' the Governmentof Pakistan's approachto providingcredit to underservedmarketswas to channelsubsidized resourcesthrough publicDevelopment FinanceInstitutionsor through directed credit.These policieswere largelyunsuccessful in achievingtheir objectives. The removal o f restrictions and the development o f an enabling regulatory environment, coupledwith increased liquidity and competition inthe market, are producingmore encouraging results. Lendingto previouslyunderservedmarkets has risen substantially since 2001, and commercialbanks have now overtaken the public specialized banks inproviding agricultural, SMEandhousingfinance. There is, however, aneedto Wher expand outreach. In2003, it is estimated that bank credit reached 15 percent o f the country's 6.5 million farms, and SMEs obtained ust over 7 percent o f their financial requirementsfrom banks and other financial institutions. Inorder to scale-up lendingina cost-effective manner,the banking i community andNBFCs will need to adopt newproducts and technology, including modern programmedlending tools and credit scoring models, particularly inthe SME sector. Credit bureaus and registries can play a keyrole inthis expansion. A. Developmentfinance and specializedinstitutions(DFIs) 24. Sincethe late 199Os,the government has accelerated reformsofthe DFIsto complementthe reformstakingplaceinthe commercialbankingsystem. Prior to 2000 Pakistan had an extensive network o f government-owned and managed specialized banks and development finance institutions. All were infectedby corruption, mismanagement and inefficiency. A number o f DFIshave been closed or merged, and others are beingrestructured. The remaininggovernment-owned development finance institutions have a mandate to provide fimding to areas o fthe economy considered to be underservedbythe private banks, but they are Investment Climate Survey, World Bank, March 2003. Surveys o f SMEs indicatedthey received 7 percent o f their working capital and 7.3 percent o f investment finance requirements from banks and other financial institutions (versus 13.3 percent and 23.6 percent respectively for larger firms).By far the greatest source of finance for both small and large firms was retained earnings. - 8 - to operate on a commercial basis with no new finding from government, and are scheduled to be privatizedinfull or inpart after restructuring. The remainingDFIs are weak institutions, and face considerable challenges inrestructuring and introducing financial discipline. While, these institutions are small and do not pose a threat to the overall stability o f the financial system, the fiscal costs o frestructuringthe DFIs have beensubstantial, and it i s recommended that the government implement its plans for these institutions rapidly to avoid further losses. B. Microfinance 25. The provisionoffinancialservices to the poor is an importantcomponentofthe government's poverty alleviationstrategy.The last few years have seen positive developments inthemicrofinance sector inthe form ofincreased commitmentto financial sustainability, greater transparency, the emergence o f a few strong MFIs, a well endowed apex organization with highquality staff (Pakistan Poverty Alleviation Fund, or PPAF), and a supportive regulatory framework. However, the outreach o fNGOMFIs andmicrofinance banks currently represents only a few hundredthousand clients. Increasing access on a sound, sustainable basis going forward will require a concerted effort at buildingretail capacity, performance-based fundingthat providesthe rightincentives for sustainability, support for capacity buildingofthe top players to commercializeand achieve significant scale, and a drive for greater transparency inreporting. Donorswill needto work withthe government andeachother inamore coordinated fashion. There i s currently an ambivalence between a financial systems approach and a poverty alleviation approach that sometimes leads to contradictoryinitiatives. 26. The legaland regulatoryframework for microfinance(theMicrofinanceOrdinance 2001) is generallysound.M F I s are free from the problems o f interest rate caps that plague the industryinso many countries, andprudentialrules are generally inline with goodpractice. However the minimumcapital requirements for microfinance banks (MFBs) are very highby intemational standard^,^ and current limits on total MFIexposure to a single client and ban on lendingto individualswhose income exceeds the minimumtax threshold may be overly restrictive and prove difficult to monitor and enforce. C.Housingfinance 27. The governmenthas taken a number of measuresto create a more conducive environment for housingfinance. These include the new, simplified foreclosure procedures established by the 2001 LoanRecovery Ordinance, the liftingor relaxing o fa number o f regulations that severely restricted bank lendingto the sector, and increased tax incentives. These measures, combinedwith highliquidityand lower interest rates, have triggered a surge in mortgage lendingsince early 2003. Nevertheless, the volume o f total lendinginthis arearemains low, andfurther rapidgrowth inhousingfinance will berequiredto address the acute housing shortage inthe years ahead. This intum will require addressing fundamental weaknesses in provincialproperty and security rights administration systems and introducing new long-term finding instruments. Minimumcapital requirements are PKRs 500million, or US$8.8 million for a nationallicense, PKRs 250 million for a provincial license, and PKRs100 million for a district license. - 9 - D.FinancialSector Infrastructure Legal Issues 28. As in many developingcountries,problemswith debt recovery and contract enforcementhaveunderminedcreditor rightsand contributedto the very highlevel of non-performingloansinthe bankingsystem. The introductiono fthe DebtRecovery Ordinance in2002 has improved the debt recovery environment, but further reforms are required.The creationo fBankingCourts was avery positive development, but they are limited innumberandjurisdiction. Other problems includethe lack ofcapacity ofthe courts to execute judgment andthe lack o f commercialknowledgeinjudges. Improvingthe standard of legal education and training for judges andjudicial and administrative staffwould improve thejudicial environment. 29. Though effortshavebeenundertakenby the government to updateand improvethe legislativeframeworkfor the financialsector, a numberof laws lagbehindcurrent practice.There is therefore aneedto repeal, amend andupdate old laws to avoidpolicy reversals and legal challenges. The State Bank o f Pakistan Act o f 1956 (amended 2003) i s antiquated, with provisions that, inter-alia, authorize the government to supersedethe central board and allow the federal government to liquidate the bank. Inpractice, SPB functions as a modern independent central bank, and there i s a clear need to revamp the law to better reflect current practice. The legal provisions governinginsolvency anddebt restructuring, and the BankingCompanies Ordinance 1962 (amended 2001) (BCA) also requiremodernizationto ensure that the legal framework i s inline with best internationalpractice. Payment Systems 30. Major efforts to modernizethe paymentsinfrastructureare ongoing,which should helpto curtailsystemic risks.An automatedcheck clearing system (NIFT), established in collaboration with the private sector, has beenoperational since 1997 and the SBP i s now inthe process o f establishing a Real Time Gross Settlement System (RTGS) to replace the current manualbook-entry system. The planned introductiono fthe Real-Time Gross Settlement System should reduce systemic risks and improve the reliability and efficiency o f the payments system. Thereremain, however, some deficiencies inthe legal framework for payment system oversight which needto be addressedensure the safety and soundness o fthe payment system. Corporate Governance and Accounting and Auditing 31. Regulationsin the area of corporate governance are extensiveand comprehensive. Inadditionto the detailed corporate governanceprovisions inthe CompanyOrdinance, the Securities Commissiono f Pakistan issued inMarch 2002 for all listed companies a detailed Code o f Corporate Governance that i s broadly inline with OECD Principles, and inMarch 2003 issued a code for insurance companies. PrudentialRegulations for Commercial Banking issuedby the State Bank prescribe detailed standards o f corporate govemance for board o f directors, management and shareholders o fbanks and DFIs.These reforms are all relatively recent, but with effectiveimplementation and enforcement, Pakistan would have one o fthe best corporate govemance environments inthe region. - 10- 32. Accounting and auditingstandards are generally of a high andinternationally acceptable quality, at leastfor larger corporationsandfinancialinstitutions.Pakistanhas adopted 39 o f the 41 InternationalAccounting Standards.All registeredcompanies are required to have their accounts audited and submit the statutory returns promptly. The Instituteo f Chartered Accountants o fPakistani s a SRO that plays an active role inensuringquality and discipliningmembers. The SECP has also beenproactive instrengtheningthe financial reporting framework and the reliability o f audits, and sanctions have beenimposed on prominent auditing firms for breaches o fmandated standards. Anti-Money Launderingand Countering the Financing of Terrorism (AML/CFT). 33. A detailed AMLKFT assessmentwas conductedbythe Asia Pacific Group (APG) on Money LaunderinginDecember, 2004. The report has not yet beencompleted or submitted to the APG Plenary for adoption. V. LiquidityManagementandMarkets 34. The framework for systemic liquidity managementis transparent,andthe instrumentsfor managingdomesticliquidityare market-based,flexible and relativelywell developed.The SBP seeks to "secure monetary stability andthe soundnesso fthe financial system.yy1opubliclydisclosed monetaryprogrami s designedto achieve low inflation, currently A definedas 4 to 5 percent average annual CPIinflation. The SBP i s considering the implications for its monetary operations o f the growing, but still small, Islamic banking sector. 35. The SBP haseffectivelymanagedthe sizeableinflows of foreign exchangein recent years. Inflationhas remained low althoughthe partially sterilizedinterventionhas accelerated the money growth rate. The inflows have ledto substantial accumulation o f foreign exchange reserves at the SBP. The authorities might consider developinga strategic plan for an orderly liberalizationo fremaining capital controls. 36. The authoritieshavebeeneffective in undertakinglender oflastresortfunctions and dealingwith distressedbanks.While past episodes ofbank distress suggest that the constructive ambiguity inlender o f last resort policies has beeneffective, the SBP might consider settingout formal internal procedures for providing emergency liquidity support to banks, specifying the terms and conditions for such loans and limitingthe acceptable collateral to marketable government securities. The SBP has prepared a ProblemBank Manual that sets out progressive actions that should be taken inthe case o f a problembank, ranging from the signing o f an MOUwith the bank on remedial actions to liquidation. Three banks have beensuccessfully resolved inrecent years. VI. RECOMMENDATIONS loSee SBP Act, section 9A. - 11- 37. The following are the principalFSAPpolicy recommendations. More detailed suggestions were included inthe full FSAPreport. It i s noteworthy that the authorities' ongoing reform initiatives include a number o f these proposals: an asterisk (*) denotes measuresthat are currently underwayby the authorities. Priority Recommendations The SECP should expedite the adoption o fprudent margin financing rules to replace the carry over transactions (COT),* and obtain an independent assessment on the adequacy o fprotection funds. A formal review to determine whether SECP has adequateresources and capacity to fulfill its mandate should beundertaken. Staffingshould beadequateto conduct regular on-site inspections o f regulated entities. The authorities should addressthe issues identified inthe Base1Core Principles (BCP) assessment, includingrevisiono fthe SBP Act to strengthenthe autonomy o f the SBP and provide legal authority to conduct consolidated supervision. * The government andthe SBP should develop a strategy to privatize theNBP and continue divestiture from the capital o f other banks.The IDBP should be resolved (privatized, merged or closed) inthe least cost manner as a priority to stem mounting operational losses." A comprehensive legal andregulatory framework for private occupational andpersonal pensions needs to be established, and compliance overseen by the SECP. Reliable data needto be collectedand accurate projections made for civil service and EOBIschemes to formulate appropriate reforms to ensure fiscal sustainability and long-termbalance." Other Key Recommendations e The roles and future strategies for the state-owned insurers shouldbereviewed. The State L i f e Insurance Corporation (SLIC) should beput on a paripassu basis with the rest o f the life insurance sector, and its top management drawn from professionalinsurance ranks. The current legal confusion over the respective roles ofthe Ministryo f Commerce (MOC) and SECP inthe insurance sector shouldbe resolved, and the SECP needs to be providedwith adequate on-site inspection capacity andpowers to requireprompt corrective action. 0 A more comprehensive debtpolicy andrelated riskmanagement system needto be developed, with a view to minimizing interest costs while avoiding maturity-bunching and potentialroll-over problems, and the Debt Policy Coordination Office (DPCO) should bemade fully functional.* National Savings Schemes (NSS) rates should be alignedmore closely with marketrates and market-based alternatives to the present schemes should be considered.* There i s also a need to computerize andmodernize operations of the NSS.* - 12- e A single law to providea coherent and comprehensive legal framework for Anti-Money Laundering and Countering the Financing o f Terrorism (AMLKFT) inline with FATF recommendations should bepromulgated. * e A clear legalmandate for SBP to overseethe payments systemandproviderules on nettingandzero hour rule' should also be established. Consideration also should be * givento tighteningprovisioningrequirements, andadopting market risk-relatedcapital charges. * e The legalprovisions governinginsidertrading and substantial security disclosure law shouldbe reviewed.* e To facilitate housing finance, there i s aneedto launchtitle regularizationprograms, reformregistration services, and lower property andmortgage registrationduties. * Appropriate long-term capitalmarketsinstruments to fund housingloans needto be developed. e The legal framework for microfinance shouldbereviewedinconsultation with industry representatives, with a view to removing legal hurdlesto the growth o fthe sector.* The review should include an assessmento f the appropriateness o f the current minimum capital requirements for microfinancebanks and ceilings on income and loans. e There is a needto establish a clear legal framework for private creditbureaus to enable them to provide more comprehensive credit informationinsupport o f consumer and SME lending. " "zero hourrule" makesalltransactions bythebankruptparticipantnullfromthestart("zero hour") oftheday The o fthe bankruptcy (or similar event). Ina real-time gross settlement system, the effect could be to reverse payments that have apparently already been settled and were thought to be final. Ina system with deferred net settlement, such a rule could cause the netting o f all transactions to be unwound. This would entail a recalculation o f all net positions and could cause significant changes to participants' balances, with possible systemic consequences. The law on the payments system therefore should expresslyprovide that the "zero hour rule" will not apply to ensure finality o f payment,