Introduction To Financial Management

Introduction to
Financial Systems &

Banking
Regulations
Stage 1
Published 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
Contents
Part 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
Contents
Part 7: Financial Systems and Policies
Chapter 1:Major Functions of Financial Policy in a Developing 14

Country 7
Chapter 2: Financial Intermediation
15
Chapter 3: Financial Disintermediation, 0
Deepening, Repression and Shallow Finance
15
2
Part 8: Financial Sector Reforms
Chapter 1: Importance, Scope and Impact

Chapter 2： Deregulation and Liberalization of the Financial Sector
15
Chapter 3: Globalization： Integration with Global Financial Sector 7
Chapter 4: Privatization of the Banking Sector
Chapter 5: Strengthening of Supervisory Controls: SBP^ role 15
Part 9: Current Trends in the financial .Industry in Pakistan

16
Chapter 1: Innovation Challenges, Interest-Free Banking and New Areas
of Financing
5
Part 10: Laws relating to Financial Systems

16
Chapter 1: Banking Laws and Regulations 19
19
17
4
17
9
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 System

Factors for positive change in the Pakistan Financial System
Part 0ne
Overview of the Financial System
Chapter 1 Overview of the Financial System
Learning Outcome
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
Introduction to
Financial Financial system of any country consists of money, banking, financial institutions and
Systems
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.
A system that works at the global, regional or firm-specific
The financial system covers Components of the Financial System level and enables them to exchange funds.
Money, Banks, Financial institutions, The firm's financial system is the set of implemented
insurance companies and is basically the A financial system has five components: procedures that track the financial activities of the company.
study of how these institutions work, how On a regional scale, the financial system is the system that
they are controlled by central bank and the
monetary issues they are facing. 1. Money enables lenders and borrowers to exchange funds. The
global financial system is basically a broader regional
A financial system is a system that allows system that encompasses all financial institutions,
the exchange of funds between lenders, 2. Banks and Development Financial Institutions borrowers and lenders within the global economy.
investors, and borrowers. Financial systems
operate at national and global levels.
They enable individuals and companies to
3. Financial Instruments
share the associated risks
4. Financial Markets
Financial institution is also termed as financial
intermediaries because they act as middlemen 5. The Central Bank
between the savers and borrowers.
2 Financial Systems and Regulation | Reference Book 2

The Financial System in Pakistan
，Pakistan’s financial system consists of:

As in other parts of the world
• Money (Pak Rupee)
• Banks and financial institutions
• Financial instruments
• Financial markets
• State Bank of Pakistan.
A. Money legal tender or a medium of exchange
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.
Money is a legal tender which can be used: • It must have a unit of account. The second very important
For payment of goods and services.
For making deferred payments i.e for the repayment of debts
function of money is that it must be accepted as a unit for
As a medium of exchange. measurement, by which value of goods and services can be
As a store of value which means that it is tradable and
can be stored for future use. accounted for or compared. The unit should be divisible into
Unit for measurement to compare the value of goods and services 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.
Overview of the Financial System 3

Simply put, it's the rate at which people spend money. The velocity of money is usually measured as a ratio of gross national product (GNP) to a country's total supply of money.
Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services, as this helps investors gauge how robust the economy is, and is a key input
in the determination of an economy's inflation calculation. Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle and should have a
higher rate of inflation — all things held constant.
Issue" means the first delivery of an instrument by the maker or drawer, whether to a holder or nonholder, for the purpose of giving rights on the
instrument to any person
"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 BUDGET DEFICIT
money in any country/ economy can be calculated by adding GOVT. BORROWINGS
EXCESS SUPPLY
together all financial instruments, such as currency in INFLATION
circulation, various types of bank deposits, issued negotiable DEVALUATION
instruments, short-term and medium-term financial instruments FOREIGN DEBT INCREASES
(Treasury bills, FIBs) prize bonds, etc. Supply of money must be

according to the genuine needs of the economy. Excess supply
tHE RATE AT results in inflation and a decrement in the value of money. TOO MUCH MONEY CHASING LIMITED RESOURCES
WHICH THE
MONEY CHANGES
more negative gap in expenditure and revenues leads to more borrowings and increased supply of money
HANDS Velocity of money also plays a very important part in The term "velocity of money" refers to how fast
determining the health of an economy. The term "velocity" is money passes from one holder to the next.
used to describe the rate at which money is exchanged from one Economies that exhibit a higher velocity of
money relative to others tend to be further
transaction to another. Velocity is important for measuring the along in the business cycle and should have a
rate at which money in circulation is used for purchasing of higher rate of inflation — all things held
constant.
goods and services. This helps investors to determine how
The Pakistani rupee was put into circulation in
healthy the economy is. It can be measured as a ratio of GNP to Pakistan after the dissolution of the British Raj
a country's total supply of money. in 1947. Initially, Pakistan used British Indian
coins and notes simply over-stamped with "
The "Pak Rupee" Pakistan". New coins and banknotes were
issued in 1948. Like the Indian rupee, it was
The Pakistani rupee came into circulation after the country originally divided into 16 annas, each of 4 pice
or 12 pie. The currency was decimalised on 1
became independent in 1947. For the first few months of January 1961, with the rupee subdivided into
independence, Pakistan used Indian notes with "Pakistan" 100 pice, renamed (in English) paise (singular
paisa) later the same year. However, coins
stamped on them. Pakistani currency, including coins and denominated in paise have not been issued
banknotes, was issued in 1948. The currency was originally since 1994
divided into 16 'Aanas'; and was decimalized on 1st January 1961 ! anna- 4 paisa
16 anna-64 paisa
with one 'rupee, subdivided into 100 paisa.1 rupee coins were The one and two rupee coins were changed to
reintroduced in 1979, followed by 2 rupees in 1998 and 5 rupees aluminium in 2007.
in 2002. On 1 April 1948, provisional notes were issued
by the Reserve Bank of India and the
Government of India on behalf of the
Government of Pakistan, for use exclusively
within Pakistan, without the possibility of
Depiction (Back) Value
redemption in India.
Until 1971, Pakistani banknotes were bilingual, featuring Bengali translation of
the Urdu text (where the currency was called taka instead of rupee), since
Bengali was the state language of East Pakistan (now Bangladesh).[11]
The word Rupee is from the Sanskrit word rup or rupa, which means silver in
most Indo-Aryan dialects.
The Pakistani Rupee was put into circulation in 1947, after the nation became
independent from British Rule.
For some time after independence, Pakistan used Indian cash and banknotes
with Pakistan stamped on them.
The current cash and banknotes were issued beginning in 1948. (Seems to
contradict the second bullet.)
Similar to the Indian Rupee, the Pakistan Rupee was originally divided into
sixteen annas, each composed of four pice or 12 pie.
The Pakistan Rupee was decimalized on January 1, 1961 and partitioned into
a hundred pice; the name was changed to pais later the same year.
When Pakistan was carved out of the British India on 14 August 1947, it had
no currency notes or coins of its own, nor a central bank or mint to print paper
currency or mint coins. In order to cope up with the requirement of the new
country, the Governor General of undivided India issued the â€˜Pakistan
(Monetary System and Reserve Bank) Order, 1947â€™ on 14 August 1947,
the day before partition. Under this order, the Reserve Bank of India was to act
as the common currency authority for India and Pakistan until 30 September
1948, allowing a cushion period of almost a year for the newly born state to
issue its own currency. As an interim arrangement, the currency notes and
coins issued by the Reserve Bank of India and the Government of India were
to be the legal tender in Pakistan.
Financial Systems and Regulation | Reference Book 2
Till 1960, when Pakistan adopted the metric system, one Pakistani rupee had 16 ana and each ana having 4 paisa, i.e. one rupee having 64 paisas. And
as for the coins, there were coins of one, two paisa, one ana, two ana, 4 ana, 8 ana and one rupia (rupee). Thus, one ana was the basic coin (below left
two sides of one ana, 2 ana and 8 ana). Then in 1960, the country switched to metric system and now one Pakistani rupee had 100 paisa
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.
Value Dimensions Main Color
Rs. 5 115 x Greenish

65mm Grey
Rs.10 115 x Green

65mm
Rs. 20 123 x Orange Green

65mm
Rs. 50 131 x 65 Purple

mm
Rs.100 139 x 65mm Red
Rs. 500 147 x 65mm

Rich Deep Green
Rs.1000
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.

The State Bank, as the central bank of the country, plays a vital role in By monetary policy we mean any conscious
regulating the country’s currency. Being the initiator and implementer of action undertaken by the monetary authorities
to change the quantity, availability or cost (rate
monetary policy and controller of the major components of Pakistan’s of interest) of money.
financial system, The State Bank of Pakistan occupies a prime position. One
SBP introduces monetary policy and its aim is to bring down
of the aims of monetary policy is to bring about changes that help to curb inflation.
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 EXPORTS < IMPORTS
LOCAL CURRENCY VALUE < FOREIGN CURRENCY VALUE
currency outflow, more than the inflow, need for adjustment in the exchange INCREASING INTEREST RATES to
rate becomes inevitable. To maintain a balance in the inflow and outflow of INCREASE the LOCAL CURRENCY
foreign currency, interest rates must be increased. The SBP purchases RESERVES through the open market operations
to balance the outflow and inflow of the foreign
foreign currency against domestic currency and generates local currency via currency
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 SOLUTION TO PROBLEMS
introduction of new taxable avenues and/or by increasing the existing tax introducing new taxes
levels. The gap between revenue and expenditure can be further narrowed increasing existing taxes
increasing govt. revenues
down by aiming to decrease expenses and/or by reducing government reducing the expenditure/spending
subsidies. If opting for a reduction in subsidies, care must be taken that reducing the subsidies
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 Pakistan which is mainly an oil importing nation,
66% between June 2007 and October 2010. This is almost twice as much as spends large chunk of its precious foreign
exchange reserves, almost $14 billion yearly on
the level of inflation during the period June 2003 and June 2007 wmch was oil imports.
around 36%. One of the reasons for this extraordinary rise is the transfer of The government official urged that during
government expenditure directly into power sector entities and an enormous Jul-Feb 2017-18, Pakistan imported 60.4 million
barrels of crude oil, while it locally extracted
increase in oil prices. Another reason for this high inflation is extremely high 21.8 million barrels oil. It is also urged that the
levels of government borrowing. From June 2003 to June 2007，currency in yearly consumption of petroleum products in
Pakistan was around 26 million tons during the
circulation grew by 70% and total deposits, excluding government last fiscal year. The economists also see that
deposits，grew by 104%. From June 2007 to June 2010, currency in the indigenous crude oil met only 15 percent of
circulation increased by 82% but bank deposits increased by only 40%. the country’s total requirements, while 85
percent requirements were met through imports
in the shape of crude oil and refined petroleum
(DATA Source Governor SBP Speech at CCI13 Dec 2010) products.
Currency Exchange Rates Vs US $ Pakistan is much sensitive to oil prices. A series
Pakistan needs almost 15,000 to 20000 MW power for each day, nonetheless, at present, it can
of changes followed in its macroeconomic
create approximately 11,500 MW daily consequently there is a shortage of almost 4000 to
condition since the declining trend recorded in
9000 MW daily.
the global oil market.
Due to devaluation of money in comparison to dollar, there is an increase in oil prices. The government puts taxes on petrol and
petroleum related products to bring
A balance of payments crisis occurs when so much money is flowing outside a country that it has improvement in existing refineries also
difficulty borrowing to make up the difference. attracting foreign investment in this sector of
Pakistan.
the record of all economic transactions between the residents of the country and the rest of world in a
particular period of time (ov In case, the government borrows from the central bank, which takes the form of printing of money, the excess money supply
causes inflation, which makes imports cheaper and exports expensive.er a quarter of a year or more commonly over a year). The balance of payments is
a summary of all monetary transactions between a country and rest of the world. These transactions are made by individuals, firms and government
bodies. Thus the balance of payments includes all external visible and non-visible transactions of a country. The difference between capital inflows and
outflows is met by foreign borrowing, which results in debt accumulation. External debt servicing is a drag on national resources and leads to widening of
the fiscal deficit.
Year US $ Year US $
Rate Rate
1961 4.76 1999 51.76
1970 4.76 2000 57.71
1972 9.91 2001 61.31
1980 7.887 2002 58.68
1990 21.32 2003 57.43
1991 24.74 2004 59.83
1992 25.46 2005 59.76
1993 30.12 2006 60.73
1994 30,76 2007 60.95
1995 33.59 2008 79.76
1996 39.53 2009 82.87
1997 43.64 2010 83.41
1998 46.11 2011 85.95
RS. US $ Rate
1990 1995 2000 2005 2010 2015

YEAR
Pakistan collects 48% of its total Due to economic crises worldwide, the economy of Pakistan also experienced a
revenue by levying customs duties balance of payments crisis.IMF bailed Pakistan out in November 2008 to prevent a
and other taxes on imports.
Pakistan is under the International balance of payments crisis by extending a loan of US $ 7.6 billion. To further assist
Monetary Fund’s (IMF) programme, Pakistan to overcome the economic crisis in July 2010，IMF increased this loan
where it has to achieve stringent
revenue collection targets.
amount to US $
11. 3 billion.
It has shrunk the policy space for the
government, which sees taxes on
international trade as an easy and
less costly means to achieve the
Steps that can be undertaken by the government to curb inflation and stabilize the Pak
revenue targets.
There is no close alternate of oil in Pakistan and Pakistan is also facing energy crises. Oil prices are very important for the health of the economy, if the
Oil price rises; it also raises cost of production, individual and national expenses. Literature shows that Oil prices affect the economy through a variety of
ways; shift in income from Oil importer’s to Oil exporter’s countries, decrease in GDP and increase in inflation, lower investment, deterioration in trade
balance, decrease in business and consumer confidence, rise in cost of production of goods and services, direct and indirect impact on financial markets,
increase in unemployment. As Pakistan is Oil importing country increase in Oil price affects many macro economic variables which are discussed
above. There are certain policy recommendations about the control in inflation with respect to Oil price and Exchange rate on the basis of literature
review and analysis. Overview of the Financial System There should be alternate energy sources which can by utilized as oil alternate. As when oil
prices increases, alternate sources of energy can be utilized to control the Inflation. Government should use the price ceiling system to control the
Inflation. Government should control the depreciation in the money
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. CPI is widely used as an economic
indicator. It is the most widely used
According to the figures released by the Federal Bureau of Statistics, the size of this measure of inflation and, by proxy, of
sector was 1,358,309 (m) in 2005，which represented a 96% increase in its size in the effectiveness of the government’s
economic policy. The CPI gives the
2000. Due to increased inflation in the country, wholesale prices and the Consumer government, businesses and citizens
Price Index are increasing at a very fast rate. The Consumer Price Index (CPI) is the an idea about prices changes in the
economy, and can act as a guide in
main measure of price changes at the retail level. It measures changes in the cost of order to make informed decisions
about the economy.
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 CPI and the components that
make it up can also be used as a
the general price level in the wholesale market. Items are selected on the basis of the deflator for other economic factors,
Family Budget Survey. including retail sales, hourly/weekly
earnings and the value of a
consumer’s dollar to find its
• Markets are selected through retail and wholesale trade surveys. purchasing power.
A measure of changes in the

purchasing-power of a currency and
• Outlets are selected on a transaction value basis. the rate of inflation. The consumer
price index expresses the current
prices of a basket of goods and
• Cities are selected on a population basis. services in terms of the prices during
the same period in a previous year, to
show effect of inflation on purchasing
• Stratified sampling is used for the selection of cities. power. It is one of the best known
lagging indicators.
• Different income groups are compiled to judge the CPI. The CPI measures price inflation for
consumers and is used by Congress,
the President, and the Federal
Wholesale Price Index (WPI), amounts to the average change in prices of commodities at wholesale level i.e Reserve to develop fiscal policy.
at the initial stage of the transaction, when the goods are bought by one corporation from another for reselling it. Each month, data collectors from the
WPI is concerned with the prices paid on the trade of goods between two business houses for the purpose of resale Bureau of Labor Statistics (BLS), call
or visit thousands of retail stores,
Conversely, the price paid at the last / final stage of the transaction is used to measure inflation in consumer price index. doctor's offices, colleges, and
Consumer Price Index (CPI), indicates the average change in the prices of commodities, at retail level. apartments, collecting price
information for over 80,000 items for
consumers living in urban areas.

歐セsale price index by commodities
i ■期）
Rs in Billion
Food Raw material Fuel & Power Manufacturer Building Material
•丨丨ニ：3£ 102.05 100.95 103.08 101.91 101.18
1厂— 105.62 115.51 115.95 103.67 102.9
112.99 135.12 119.23 111.83 126.46
•: ニ《14 125.03 110.69 138.01 113.05 143.79
-.3E55 133.78 121.93 174.57 116.35 144.18
•.孤17 145.67 138.85 184.1 119.92 151.9 丨
US 173.27 156.57 223.34 128.33 177.18
■しii,, 3T * 213.54 184.45 258.96 296 48 140.67 154 64 213 201 4
•一 •friolesaJe price ind ex by commodities Rs in Billion
l-TOO)
Bena^ Food Raw material Fuel & Power 細 •へ

13.4894444 234.5066667 213.5633333 300.7138889 151.3013889 221.3930556
‘
3S_6124444 251.3866667 227.3386667 324.9962222 157.3312222 235.4052222
?!：：r- 25S.7354444 268.2666667 241.114 349.2785556 163.3610556 249.4173889
S6&3584444 285.1466667 254.8893333 373.5608889 169.3908889 263.4295556
Jfcis 22^9814444 302.0266667 268.6646667 397.8432222 175.4207222 277.4417222
|p!!P!% 295.1044444 318.9066667 282.44 422.1255556 181.4505556 291.4538889
:|fcrr 3142274444 335.7866667 296.2153333 446.4078889 187.4803889 305.4660556
pEiTli 3293504444 352.6666667 309.9906667 470.6902222 193.5102222 319.4782222
EE'rii 344.4734444 369.5466667 323.766 494.9725556 199.5400556 333.4903889
Wholesale price inc ex by commodities Rs in Billion
1 2M^«1=100)
General Food Raw material Fuel & Power Manufacturer Building Material
'SC： 359.5964444 386.4266667 337.5413333 519.2548889 205.5698889 347.5025556
374.7194444 403.3066667 351.3166667 543.5372222 211.5997222 361.5147222
389.8424444 420.1866667 365.092 567.8195556 217.6295556 375.5268889
404.9654444 437.0666667 378.8673333 592.1018889 223.6593889 389.5390556
bE4 420.0884444 453.9466667 392.6426667 616.3842222 229.6892222 403.5512222
t?I3 435.2114444 470.8266667 406.418 640.6665556 235.7190556 417.5633889
450.3344444 487.7066667 420.1933333 664.9488889 241.7488889 431.5755556
ac7 465.4574444 504.5866667 433.9686667 689.2312222 247.7787222 445.5877222
ST'5 430.5804444 521.4666667 447744 713.5135556 253.8085556 459.5998889
350 I Whole sale price index

300 by commodities
250 iinmii
200 IWFBTIf I I I l i
150
mmw IIIIII mu ■ _
100 IIIII iim
50 HHII
ね0^
■

Consumer Price Index - Product Wise
Year General Food Textile House rent Fuel Transport Education Medicare
>002 104 103 fToT' 10^ 169 M 165 10^

2003 107 105 107 164 118 112 110 106
2004 112 11^ 110 10^ 1^1 115 114 10ナ
2005 122 126 113 120 126 125 118 108
2006 132 134 118 132 137 146 125 111
2007 142 148 124 141 149 149 134 121

2008 159 174 134 154 158 156 141 132
2009 192 216 153 181 199 193 165 147
2010 214 243 162 206 227 204 186 157
Consumer Price Index- Products Wise
A unilateral transfer is a one-way transfer of money, goods, or services from one country to another. The prefix "uni" means one. In a unilateral transfer,
one party is making a transfer to the other party. They are not receiving anything back from the other party. Unilateral transfers often involve gifts to
governments, foreign aid or any transaction where one party is promising to deliver and then delivering payments or items to another country, population
or government without receiving anything in return. This can be contrasted with a bilateral transfer. The prefix "bi" means two. A bilateral transfer involves
two parties exchanging goods, money or services. Unilateral transfers are included in the current account of a nation's balance of payments.
They are distinct from international trade, which would be Impact of Money on Foreign Trade
a bilateral transfer since two parties are involved in a trade.
Unilateral transfers encompass things such as humanitarian
aid and payments made by immigrants to their former Foreign trade is indispensable for the full economic development of a country
country of residence. 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.
requires

Consumer Price Index - Product Wise
Year General Food Textile House rent Fuel Transport Education Medicare
20W 164 103 165 他 16^ 106 105 102

2003 107 165 167 164 11§ 112 116 106
2004 112 112 110 102 1^1 114 107
2005 122 126 113 120 126 1^5 118 108
2006 132 134 118 132 137 146 125 111
2007 142 148 124 141 149 149 134 1^1
2008 159 174 134 154 15§ 156 141 132
2009 192 216 153 181 199 195 165 14)
2010 214 243 162 206 227 204 186 157
Consumer Price Index- Products Wise
300
250
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.

Foreign trade, also referred to as International Trade, is the exchange of capital, goods, and services between two or more countries.
Foreign trade arises from the fact that no country is self-sufficient in term of producing all the goods and services that it requires. Countries have to buy
from other countries what they cannot produce or can produce less than the requirements or is in deficit. Similarly, a country sells to other countries the
goods and services which it has in surplus.
International trade consists of ‘export trade’ and ‘import trade’. Export trade involves sale of goods and services to other countries. Import trade involves
purchasing of goods and services from other countries.
Types of Foreign Trade – The two types of Foreign Trade are:

Bilateral trade: This is a trade agreement in which two countries exchange goods and services.
Multilateral trade: This is the type of international trade where a country trade with two or more countries.
Division of Foreign Trade

Import Trade: Import trade refers to purchase of goods by one country from another country or inflow of goods and services from foreign country to
home country.
Export Trade: Export trade refers to the sale of goods by one country to another country or outflow of goods from home country to foreign country.
Entrepot Trade: Entrepot trade is also known as Re-export. It refers to purchase of goods from one country and then selling them to another country
after some processing operations.
Reasons for International Trade/Foreign Trade

Uneven distribution of natural resources:
Expansion of market for products: Foreign trade is necessary as it helps to widen the market for goods produced.
Difference in taste
Difference in technology
Difference in skills
Difference in climatic condition
Desire to improve the standard of living
Difference in efficient use of natural resources
Barriers to International Trade/Foreign Trade

Difference in currency
Difference in culture and beliefs
Difference in language
Distance
Political instability
Problem of documentation
Transportation and communication
Government policy
Difference in legal system/ emigration laws
difference in weights and measurement
The balance of payment keeps a track of transaction in goods, services, and assets between the country’s residents, with the rest of the world.The balance of payments is a summary of all
monetary transactions between a country and rest of the world. These transactions are made by individuals, firms and government bodies. These transactions include payments for the country's
exports and imports of goods, services, financial capital, and financial transfers. The scope of BOP is greater than BOT, or you can also say that Balance of Trade is a major section of Balance of
Payment.
The balance of payments data can be used to evaluate the performance of the country in international economic competition Suppose a country is experiencing trade deficits year after year.
This trade data may then signal that the country's domestic industries lack international competitiveness. A balance of payments deficit means the country imports more goods, services and capital
than it exports. It must borrow from other countries to pay for its imports. In the short-term, that fuels the country's economic growth.
A balance of payments surplus means the country exports more In Pakistan，when calculating foreign trade statistics, the following
than it imports. Its government and residents are savers. They
provide enough capital to pay for all domestic production. transactions of imports and exports are excluded:
They might even lend outside the country.
Sources of funds for a nation, such as exports or the receipts of
loans and investments, are recorded as positive or surplus items. • Articles of baggage and personal effects of passengers
Uses of funds, such as for imports or to invest in foreign countries,
are recorded as negative or deficit items.
It combines all the public-private investments to know the inflow and outflow
of money in the economy over a period. If the BOP is equal to zero, then it
• Afghanistan trade in transit through Pakistan
means that both the debits and credits are equal, but if the debit is more than
credit, then it is a sign of deficit while if the credit exceeds debit, then it shows
a surplus. The Balance of Payment has been divided into the following sets of • Imports into bonds
accounts:
Current Account: The account that keeps the record of both tangible and
intangible items. Tangible items include goods while the intangible items are • Sale of imported goods in Duty Free Shops in Pakistan
services and income.
Capital Account: The account keeps a record of all the capital expenditure • Defense Stores (if commercial value is declared on GD then the value will
made and income generated collectively by the public and private sector.
Foreign Direct Investment, External Commercial Borrowing, Government loan be included)
to Foreign Government, etc. are included in Capital Account.
Errors and Omissions: If in case the receipts and payments do not match with
each other then balance amount will be shown as errors and omissions. • Gold and Silver coins or Bullion and Currency Notes
• Relief goods of no commercial value

Balance of Trade is a statement that captures the country's export and import
of goods with the remaining world. The Transactions are related to goods only.
Capital Transfers are not included in the Balance of Trade.
Which is better?It gives a partial view or a half picture of the country's Balance of Payments
economic status.
The balance of payments (BOP) is a statistical statement that systematically
summarizes, for a specific time period, the economic transactions of an
Key Differences Between Balance of Trade and Balance of Payments economy with the rest of the world.
The following are the major differences between the balance of trade and balance of payments:
A statement recording the imports and exports done in goods by/from the Balance of Trade
country with the other countries, during a particular period is known as the
Balance of Trade. The Balance of Payment captures all the monetary
transaction performed internationally by the country during a course of time. Balance of trade statistics compiled by the Federal Bureau of Statistics is
The Balance of Trade accounts for, only physical items, whereas Balance of
Payment keeps track of physical as well as non-physical items. based on physical movements of merchandise goods into and out of the
The Balance of Payments records capital receipts or payments, but Balance custom territory of Pakistan recorded by the customs authorities. Foreign
of Trade does not include it.
The Balance of Trade can show a surplus, deficit or it can be balanced too. trade includes exports, re-exports, imports and re-imports carried through
On the other hand, Balance of Payments is always balanced.
The Balance of Trade is a major segment of Balance of Payment. sea，land and air routes. The trade data of SBP，on the other hand, are
The Balance of Trade provides the only half picture of the country’s based on realization of export proceeds and import payments made through
economic position. Conversely, Balance of Payment gives a complete
view of the country’s economic position. banking channels for goods exported and imported. Trade - transactions
such as land-borne trade, imports through foreign economic
assistance, exports and imports by Export Processing Zones and personal
baggage etc. are not covered in the reporting by banks. Data on these
transactions are collected from the relevant sources and included in the
export receipts and import payments reported by the banks to arrive at the
overall trade data. Pakistani balance of trade is negative.
Balance of Trade
(Million Dollars)
Year Exports Re-exports Imports Re-imports Balance of Trade 1
PtM 良5说奶奶 10,309.40 18.1 -1,691.80

mn ぬ.5 10,728.90 12,2 -1,476,00
fYdJ 76.1 10,339.50 11.1 -1,145.90
11,166.56 36.4 12,220.30 5.8 -1,015.50
FY04 1^15.36 4设う 15,591.80 143 -2,876.90
FYOS 14,3 う1.16 165.4 20,598.10 80.2 -6,183,80
FVde 1汝1 28,580.90 10.3 -12,010.90
FY 07 iÎi 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

First, the balance of payments provides detailed information concerning the demand and supply of a country's currency. For example, if Sudan imports
more than it exports, then this means that the quantity supplied of Sudanese pounds by the domestic market is likely to exceed the quantity demanded in
the foreign exchanging market, ceteris paribus. One can thus infer that the Sudanese pound would be under pressure to depreciate against other
currencies. On the other hand, if Sudan exports more than it imports, then the Sudanese pound would be likely to appreciate.
Second, a country's balance of payments data may signal its potential as a business partner for the rest of the world. If a country is grappling with a
major balance of payments difficulty, it may not be able to expand imports from the outside world. Instead, the country may be tempted to impose
measures to restrict imports and discourage capital outflows in order to improve the balance of payments situation. On the other hand, a country with a
significant balance-of payment surplus would be more likely to expand imports, offering marketing opportunities for foreign enterprises, and less likely to
impose foreign exchange restrictions.
To interpret balance of payments data properly, it is necessary to understand how the balance of payments account is constructed.[1][2] These
transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. It is prepared in a single
currency, typically the domestic currency for the country concerned. Balance of Payment account keeps the systematic records of all the economic
transactions (visible and non-visible) both of a country with all other countries in the given or specific periods. In BoP account, all the receipts from
abroad are recorded as credit and all the payments to abroad are debit. Since, the account is maintained by double entry book keeping system, it shows
the balance of payment account is always balanced. Sources of funds for a nation, such as exports or the receipts of loans and investments, are
recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.
a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a specific amount if sources of funds (such
as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that
amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. A BoP
surplus (or deficit) is accompanied by an accumulation (or decumulation) of foreign exchange reserves by the central bank.
Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing
foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the
exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is
sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float where some changes
of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float
the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign
exchange reserves do not change, and the balance of payments is always zero.
USD (Million)
50.0. 00
40.0. 00
30.0. , ,
00 20 000.00 10 000.00
0.00
Year 19 5Q5 2010 2015
Balance of Trade 1
-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 The private sector is the part of a
country's economic system that is
growth in the banking sector and the real economy mutually support each other. Pakistan already run by individuals and companies,
has a well developed banking system, which consists of a wide variety of institutions ranging from a rather than the government. Most
private sector organizations are
central bank to commercial banks and to specialized agencies to cater for the special requirements run with the intention of making
of specific sectors. The banking sector constitutes the core of the financial sector in Pakistan. profit.
The segment of the economy
Private sector investment and consumption should be seen as the key drivers of the economy and under control of the government is
must be supported by growing financial intermediation and services, including not only banks but known as the public sector.
Charities and non-profit
also non-bank financial institutions, as well as debt securities and the stock market. organizations are sometimes
considered to make up a third
Judged by any indicator，the vitality and strength of the banking sector is impressive and stands segment, known as the volunteer
sector
out particularly relative to its state in the early 1990s when the financial system was dominated by An industry or business may start
public sector banks. out in one sector and move to the
other. The act of turning a
publicly-run enterprise over to
By the end of 2010，the banking system saw a rise in deposits to Rs 4.1 trillion and advances to Rs private citizens is known as
3.3 trillion. Banks as profitable ventures have attracted close to over $4 billion of foreign direct privatization. The opposite
movement, from private to public,
investment during 2006- 2008. Almost half the assets of banks are now owned by foreign banks is known by various names,
that are introducing innovative developments and technological improvements. including nationalization or
municipalization, depending on the
Prudent lending, supported by a strong regulatory and supervisory framework, has reduced net level of government involved.
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
Trading of financial instruments
take place.
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:
Trading of equity securities. 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.
Trading of debt securities. b. Bond markets, which provide financing through the issuance of bonds, and enable the subsequent
trading thereof.
A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold.
A capital market can be either a primary market or a secondary market.
In primary market, new stock or bond issues are sold to investors, directly from the company, often via a mechanism known as underwriting. The main
entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business
enterprises (companies). When a company goes public it issues new stocks and bonds in the form of IPO. Governments issue only bonds, whereas
companies often issue both equity and bonds.
In the secondary market, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere
between the investors. The existence of secondary markets increases the willingness of investors in primary markets, as they know they are likely to be
able to swiftly cash out their investments if the need arises. e.g NASDAQ, NYSE, LSE PSX
In the stock markets (for equity securities, also known as shares, the investors become the owners of companies) and the bond markets (where investors
become creditors)

The money markets are used for the raising of short-term finance, sometimes for loans that are expected to be paid back as early as overnight. In
contrast, the "capital markets" are used for the raising of long-term finance, such as the purchase of shares/equities, or for loans that are not expected to
be fully paid back for at least a year. Funds borrowed from money markets are typically used for general operating expenses, to provide liquid assets for
brief periods. For example, a company may have inbound payments from customers that have not yet cleared, but need immediate cash to pay its
employees. Together, money markets and capital markets form the financial markets,
Regular bank lending is not usually classed as a capital market transaction, even when loans are extended for a period longer than a year. First,
regular bank loans are not securitized (i.e. they do not take the form of a resaleable security like a share or bond that can be traded on the markets).
Second, lending from banks is more heavily regulated than capital market lending. Third, bank depositors tend to be more risk-averse than capital
market investors. These three differences all act to limit institutional lending as a source of finance. When a government wants to raise long-term
finance it will often sell bonds in the capital markets.
When a company wants to raise money for long-term investment, one of its first decisions is whether to do so by issuing bonds or shares. If it chooses
shares, it avoids increasing its debt, and in some cases the new shareholders may also provide non-monetary help, such as expertise or useful
contacts. On the other hand, a new issue of shares will dilute the ownership rights of the existing shareholders, and if they gain a controlling interest,
the new shareholders may even replace senior managers. From an investor's point of view, shares offer the potential for higher returns and capital
gains if the company does well. Conversely, bonds are safer if the company does poorly, as they are less prone to severe falls in price, and in the event
of bankruptcy, bond owners may be paid something, while shareholders will receive nothing.
Most capital market transactions take place on the secondary market. On the primary market, each security can be sold only once, and the process to
create batches of new shares or bonds is often lengthy due to regulatory requirements. On the secondary markets, there is no limit to the number of
times a security can be traded, and the process is usually very quick. With the rise of strategies such as high-frequency trading, a single security could
in theory be traded thousands of times within a single hour.[f] Transactions on the secondary market do not directly raise finance, but they do make it
easier for companies and governments to raise finance on the primary market, as investors know that if they want to get their money back quickly, they
will usually be easily able to re-sell their securities
There are several ways to invest in the secondary market without directly buying shares or bonds. A common method is to invest in mutual funds[g] or
exchange-traded funds. It is also possible to buy and sell derivatives that are based on the secondary market; one of the most common type of these is
contracts for difference – these can provide rapid profits, but can also cause buyers to lose more money than they originally invested.[13]
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
marketable instruments which are payable in one year.
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 stock market utilizes the savings
lying idle at homes, for a better
and mobilizes foreign capital for productive investments. Without an effective set of financial purpose
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

Diversification of risk through the stock market
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.
A price level is the average of Without efficiently run capital markets, investors have limited means to diversify their portfolios. As a
current prices across the entire
spectrum of goods and services result, investors may avoid equity stakes because they are too risky. Hence，corporations may find it
produced in the economy. In a
more general sense, price level difficult to raise equity capital. With the creation of stock markets, individuals can diversify firm-specific
refers to any static picture of the risks，thus making investment in firms more attractive.
price of a given good, service,
or tradable security.
Price levels provide a snapshot of An efficient stock market can enhance growth by mitigating moral hazard and consequently increasing
prices at a given time, making it productivity. The significance of this effect depends on the magnitude of the moral hazard problem and
possible to review changes in the
broad price level over time. As on the proportion of the economy that is represented in the stock market. Another key growth
prices rise (inflation) or fall
(deflation), consumer demand for contribution of an efficient stock market is its effect on the industrial sector. An entrepreneur considers
goods is also affected, which leads not only the profits generated in a new venture but also the possibility of a lump-sum gain through
broad production measures, such
as gross domestic product (GDP), selling the venture to the public. If the stock markets are not efficient, the public offering is less feasible
higher or lower. Price levels are
one of the most watched economic
as a result of high transaction costs or the uncertainty of getting a fair price in the stock market. Thus
indicators in the world. It is widely inefficient stock markets may reduce the incentive to enter new ventures, reducing overall long-term
believed that prices should stay
relatively stable from year to year productivity of the economy.
so as not to cause undue inflation
(rising prices). If price levels begin An efficient stock market reduces the transaction costs of trading and plays a primary role in the
to rise too quickly, central bankers
development of the capital market. If the volume of the capital market is increased, production will be
，
or governments look for ways to
decrease the money supply or the
aggregate demand for goods and
increased and an increase in production will help in keeping general price levels in check and
services. increasing exports.
Government Bond Market

Government issued debt instrument
that is used to raise capital. Federal After suspension of auctions of Federal Investment Bonds (FIBs) in June 1998, there was no long-
bonds are often used to finance term marketable government security that could meet the investment needs of banks, NBFIs,
federal projects and activities with
investors receiving special tax insurance companies, pension funds and corporate bodies. However, because of the attractive
incentives. The investor receives National Saving Scheme rates at that time and no bar on institutional investment, this vacuum was not
a promise from the federal
government to repay the principal even felt.
as well as any interest that has
accrued by the maturity date of the bond.
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

Policy making: SBP formulates the monetary and fiscal policy of the country to bring economic stability in the country either directly or indirectly using instruments of
discount, open market operations, credit ceilings, fixing margin requirements, reserve requirement etc. The State Bank participates in economic policy making and provides
information to the government concerning fiscal, monetary, foreign trade and exchange rate policies. In accordance with section 9 A of the SBP Act 1956,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. 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.
Issuing regulations: The State Bank has issued Prudential Regulations to provide general guidelines to bankers, to safeguard the interest of ultimate users of the financial
services, to ensure the viability of institutions, to ensure the safety and soundness of the banks/DFI, to prohibit criminal use of banking channels for the purpose of money
laundering and other unlawful activities, 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 Regulations focus on Credit Risk Management, Corporate
Governance, Anti Money Laundering and Operations
Issuing 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.
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, introducing new products 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
Strengthening and supervising the financial system in general & banking sector in particular: To protect the interests of depositors SBP has established a Customer
Protection Department.
Stabilizing money and exchange rates: Maintenance of the external value of the currency as an agent of the Government of Pakistan, SBP is also responsible for
maintaining the external value of the currency (the exchange rate of the rupee), the management of the foreign exchange reserves, trading of gold silver or foreign
exchange and transactions of special drawing rights with the International Monetary Fund.
Fiduciary responsibilities; Protecting the rights of consumers
Off-site’ and On-site inspection and supervision. Offsite is conducted through checking of various returns received from different banks, while on-site inspection is
undertaken, in 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
Lender of Last Resort: Under section 17 of the SBP Act 1956， the State Bank provides loan and rediscount facilities to scheduled banks in times of dire need when they
can find no other source of funds with the purpose of accommodating the short-term liquidity requirements of financial institutions.
Banker to the Government: The State Bank provides business banking facilities to Federal and Provincial Government and some government agencies. Accepts deposits of
cash, cheques and drafts by the Government
Public Debt Management: The State Bank is responsible for the management of government debt under 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 (trading) of such securities in the Money Market
• Payments of interest to holders of public debt instruments
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
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 growing
financing needs but the framework for issuing, pricing and trading
government securities remains under-developed. The growth of nonbank
financial intermediaries has lagged behind that of banks.
Traditional and Non-Traditional Functions off the State Bank of

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

two groups, i.e. primary functions and secondary functions. Primary
functions are issuance of notes, regulation of the financial system, lender of last resort, and
conduct of monetary policy. Secondary functions are management of public debt,
management of foreign exchange, advising government on policy matters, securing the
payment system and maintaining relationships with international institutions.
1. S o l e authority to issue Notes:
Under section 24 of the SBP Act 1956，this is the primary function of the bank - to issue
notes in accordance with the requirements of business and the public as a whole. According
to section 30 of the SBP Act, assets of the Issue Department (gold / silver
reserve，approved foreign exchange and special drawing rights held with IMF) at no time
should fall below its liabilities, i.e. total of notes issued. Out of total assets a minimum Rs.1.2
billion must be kept in the form of gold coins, gold bullion, and silver bullion or approved
foreign exchange.
2. Conduct of Monetary and Credit policy:
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

Open market operations (OMO)
refer to the buying and selling of
government securities in the open
market in order to expand or
contract the amount of money in
the banking system. Securities'
purchases inject money into the
banking system and stimulate
growth, while sales of securities do
bring economic stability to the country. The Bank uses direct and indirect instruments for the opposite and contract the
credit control, such as discount rate for three days repo, T-bill auction rate, and open market economy.
Depending upon the context,
operations. The Bank also controls credit by prescribing credit ceilings, setting the discount rate has two different
credit/ debit ratio, and fixing margin requirements. Since 1995, SBP has been controlling definitions and usages. First, the
discount rate refers to the interest
liquidity through open market operations. rate charged to the commercial
banks and other financial
institutions for the loans they take
3. Regulation and supervision of Financial System: from the Federal Reserve Bank
through the discount window loan
As the central bank, SBP is responsible for safeguarding the soundness of the financial process, and second, the discount
rate refers to the interest rate used
system of the country. Under section 40 A of the Banking Companies Ordinance 1962，it is in discounted cash flow (DCF)
the responsibility of the SBP to monitor the performance of every banking company and analysis to determine the present
value of future cash flows.
DFIs, as well as Micro Finance banks. Reserve requirements are the
amount of cash that banks must
have, in their vaults or at the
Non-bank financial companies (NBFCs)，such as leasing companies, mutual funds,
，
Modarba companies, the stock exchange and insurance companies etc, all fall under the
closest Federal Reserve bank, in
line with deposits made by their
customers. Set by the Fed's board
ambit of the Security and Exchange Commission of Pakistan (SECP) which is responsible of governors, reserve requirements
for monitoring the affairs of these companies. are one of the three main tools of
monetary policy — the other two
tools are open market operations
4. Off-site and on-site monitoring and the discount rate.
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.

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

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.
Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Deposits 1475 1678 1964 2393 2832 3255 3854 4218 4786 5128
(In Mins)
Advances 910 921 1108 1574 1991 2428 2688 3173 3240 3494
(In Mins)
Deposits & Advances in last decade
•Deposits
■Advances
2000 2002 2004 2006 2008 2010 2012 Year

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.

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. FOR WOMEN ENTREPRENEURS
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 framework

In 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
A strong legal and a
regulatory framework 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

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.
Overview of the Fi的ncial System 3

1
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 Market
Importance of International Capital Market
in the overall performance of the financial
system
Types of Capital Markets
Financial Market Intermediaries
Secondary Market

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
35
Money Markets
PartTwo
Structure of the Financial System
Chapter 1 Money Markets
Learning Outcome 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
Money Market
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.

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
Money Markets 37
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.

PartTwo
Chapter 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
What is a A mutual fund is an investment company that uses members* capital to buy a
Mutual Fund? 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
Mutual Funds 41
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 fund
manager’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.

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.
Mutual Funds 43
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.

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.
Mutual Funds 45
• 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%
Mutual Funds 48
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Part Two
Structure of the Financidl System
Chapter 3 Depositories
» Define depositories
« Discuss the role and functions of a depository
_ Discuss the concepts of depository 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

Depositories 49
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.

Part Two
Chapter 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

■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 53
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 management
Corporate 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/liquidation
Financial 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 Rule
Capitalization 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 issue

A 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.
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 Application
As 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 Securities
Most 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.
Capital Markets 69
Trading Permission
As 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 Fees

Most 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) market

Another 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 Managers
Mutual 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 654 653 651 644 638

Companies
Total Listed Capital - 671,255.82 750,477.55 814,478.74 919,161.26 930,556.69

Rs.
Total Market 4,329,909.7 1,858,698,9 2,705,879.83 3,268,948.5 3,154,胤 67

Capitalization - 9 0 9
Rs.
KSE-100™ 14075.83 5865.01 9386.92 12022.46 11878.81

Index
KSE-30™ Index 16717.1 5485.33 9849.92 11588.24 11540.74
KSE All Share 9956.76 4400.76 6665.55 8359.31 8263

Index
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 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
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:
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
n
Free-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.
PartTW0
Chapter 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
Non-Banking Various Types of NBFIs

Financial
institutions
Non-Banking Finance Companies (NBFCs) were introduced in 2002. The
(NBFIs)
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
Non-Banking Financial Institutions 77

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.
Fi的ncial Systems and Regulation | Reference Book

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.
Non-Banking Financial Institutions 79

End of lease options
At 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

Rules.
Some of the impediments to the growth of the VC industry in Pakistan are:
(1) Complex legal 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
Non-Banking Financial Institutions

Securities and
Part Three
Exchange Commission
of Pakistan
Securities and Exchange Commission of Pakistan
Chapter 1
■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 The Securities and Exchange Commission of Pakistan (SECP) started to
and Exchange function in 1999 by way of the Securities and Exchange Commission of
Commission of Pakistan Act, 1997. SECP functions as the sole administrative authority and
Pakistan (SECP) 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
Securities and Exchange Commission of Pakistan 83

• 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.

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 1or
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.
1 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, which
Statement 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

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
Securities and Exchange Commission of Pakistan

• 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

Part 4: Financial Instruments
Chapter 1:Money Market Instruments
Define and discuss the workings of the following money

market instruments:
a. Treasury Bills
b. PIBs
c. Certificates of Deposits
d. Bankers' Acceptances
e. Eurodollars
f. Repos and Reverse Repos
g. Call Money Market
Chapter 2: Capital Market Instruments
Discuss the operations of the following fixed income

instruments:
1. Bonds/Sukuk
2. Municipal Bonds
3. Corporate Bonds
4. Term Finance Certificates
5. Asset-Backed Securities
6. Treasury Notes
Discuss the operations of the following equity securities:
1. Preferred stock
2. Common stock

Part Four
Financial Instruments
Chapter 1 Money Market Instruments
Learning Outcome By the end of this chapter you should be able to: _ Define and
discuss the workings of the following money market
instruments: a. Treasury Bills
b. PIBs
c. Certificates of Deposits
d. Bankers7 Acceptances
e. Eurodollars
f. Repos and Reverse Repos
g. Call Money Market
Money The following are the Money Market instruments in Pakistan:

Market I.Pakistan Investment Bonds (PIBs)
Instruments
in Pakistan 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% and
II. 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) 2 (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
2 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.

offer comparable rates of return on investment with low risk. Premature
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. » 20，000

for One Year
Amount Received by Rs. 980,000

Exporter 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

食
has a maturity of less than 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.

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.
Securities and Exchange Commission of Pakistan «B

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.

part— Financial Instruments
Chapter 2 Capital Market Instruments
■ Discuss the operations of the following fixed income
instruments:
1. Bonds/Sukuk
2. Municipal Bonds
3. Corporate Bonds
4. Term Finance Certificates
5. Asset-Backed Securities
6. Treasury Notes Discuss the operations of
the following equity securities: 1.Preferred stock
2. 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
Capital Market Instruments 105

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.

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 grow3 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 transactions
By January 2007，Malaysia accounted for 67 per cent, about two-thirds of
3 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
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.
Financial Systems and Regulation I Reference Book 2

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 TFCs

For and in multiple of Rs. 5,000/- 100% of the public offer
In case of Public Offer above Rs.
50 Million and up to Rs.100
Million Reserve Allocation of TFCs
Category of Application
For Rs. 5,000/- 25% of the public offer, Minimum Rs. 50
million.
For Rs. 25,000/-
For Rs. 50,000/- 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 assets

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

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.

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

Parts
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

Chapt
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.
1U Financial Systems and Regulation | Reference Book 2 Yields

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
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
Importance of
Interest Rate in Interest is defined as the fee paid as compensation by the borrower to the
the financial lender for the use of funds. Interest is the profit that is paid to customers by
system of a the financial services over due time on financial instruments. All banks and
country many 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.

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.
119
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.
• Anmain
The factors thatpolicy
anti-inflationary causeofanthe
increase
central inbank,
interest raton restricti to the
based
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
Current in Interest
Account Rates
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.

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.
125
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
PIB Rates
Year Rate
5 13.77
7 14.09
10 14.18
15 14.57
20 14.94
Yield Curve of PIB
Rate
5
6
8
1
46
4
44
4
12
3
4
3
8
1 1
rH
1 1 1
Spot and Forward

contracts Spot Rate
Spot 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
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 to
loan 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.

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
List some of the credit rating methodologies available for

assessing various
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

partsix Credit Rating and
Risk Evaluation
Chapter 1 Concepts, scope and significance

■ Define the concept of credit rating and risk evaluation
Learning Outcome
■ Discuss the scope and significance of credit rating and risk
evaluation and credit rating agencies
Concept of
credit rating
and risk
evaluation
Concepts, scope and significance 131

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.

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.
Concepts, scope and significance 133

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 grade ご
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
Credit Rating and
Risk Evaluation
Regulatory Framework
Chapter 2
■ 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
Regulatory The reputation of credit rating agencies was badly affected after the financial
framework 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.
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.
Regulatory Framework 135

• 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.

partsix Credit Rating and
Risk Evaluation
Chapter 3 Credit Rating Agencies in Pakistan
Learning Outcome By the end of this chapter you should be

able to:
_ List the generic process of credit rating
adopted by the credit rating agencies
operating in Pakistan
Process of credit
rating adopted by
the credit rating
agencies operating
in Pakistan.
Credit Rating Agencies in Pakistan 137

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

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.
Credit Rating Agencies in Pakistan 139

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.

partsix credit Rating and
Risk Evaluation
Rating Methodologies for Various Instruments
Chapter 4
_ List some of the credit rating methodologies available for
assessing various different instruments
Credit rating The rating methodologies of any money market or capital market instrument
methodologies consist of analyzing the operational and financial standing of the issuer.
available for Whenever we take any social or financial decision we consider the
assessing various reputation, proven credentials, and financial standing of the other party.
different instruments 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.
Rating Methodologies for Various Instruments 14
1
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
Credit Rating and
Risk Evaluation
Evaluation of Risk and Benefits for Investors
Chapter 5
* 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
Importance of Risk Risk assessment is very necessary before taking any decision, either social or
Evaluation 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.
Evaluation of Risk and Benefits for Investors 143

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.

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
Evaluation of Risk and Benefits for Investors 145

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

PartSeven
Financia! Systems and Policies
Major Functions of Financial Policy in a Developing Country
Chapter 1
Learning Outcome 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
Major Functions Successful development is not just the growth of productivity and per capita
of Financial GDP, but also ensuring that the pattern of growth is inclusive, delivers broad-
Policy 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
Major Functions of Financial Policy in a Developing Country 147

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:

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.
Major Functions of Financial Policy in a Developing Country 149

PartSeven
Financial Systems and
Financial Intermediation
Polici
Chapter 2 Outcome
Learning By the end of this chapter you should be able to:
■ Define the concept of financial intermediation
■ Discuss the factors hampering financial intermediation and
its impact on the operation of a financial system
150 Financial Systems and Regulation I Reference Book 2

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.
partseven Financial Systems and
Policies
Chapter 3
Financial Disintermediation, Deepening, Repression and Shallow
Finance "
Learning Outcome
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
Financial Deepening
■ 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.
Financial Intermediation 154

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

part Eight Financial Sector Reforms
Importance, Scope and Impact
Chapter 1
■ Discuss the importance and scope of financial sector reforms

■ Describe how these reforms impact the overall workings of a financial
system
Reform of the Banking in Pakistan has largely been dominated by government-owned

Financial Sector institutions and has accommodated the financial needs of the government,
in Pakistan 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
Importance, Scope and Impact 157

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.

flight Financial Sector Reforms
Chapter 2 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
Deregulation and Liberalization of the Financial Sector 159

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
ニ
highest r 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 staf，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
丨
importance of having 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]

Globalization： Integration with Global Financial Sector
part Eight Financial Sector

Reforms
Chapter 3
_ 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
Globalization: Integration with Global Financial Sector 165

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 4

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.
4 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.

)，
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 industry

There 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.
Globalization: Integration with Global Financial Sector 167

Loss of economic stability
Sometimes 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 flows

A 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 banks

There 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.

Financial Sector Reforms
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 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 169

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.
Table 1.Dynamics of the Banking Sector
Number Amount (Rs. Billion)
1990 2002 1卿 2002 1990
Assets 7 5 392J 877.6 922
Public
Private - \6 * 968.3 -
Foreign 17 17 33.4 280.9 7ぶ
Total 24 38 425.6 2126.8 100

Deposits 7 5 329.7 721.9 93
Public
•
Private 16 * 754.2 .
Foreign 17 17 24.9 184.1 7
Total 24 3S 354.6 mo.2 100

Source: State Bank of Pakistan (2000) and (2(K)2)
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

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 Hîty
Know Signifies*
Sipoificant Simificant Significant
1 Lowered admimstrative
15.4 46.2 0.0
.4777.70.0
0.0777715.415
U7.70.07.70.0
38
5
ejqjeiises 7.7
30.8 30.8
8
7.7 15.4 . 308
见
3 hoptoved bad dd>t 订
8
portfolio 0. 0.0
46 0076 76
53.8
4 Increased profitability
2
0
.
5 Icgjroved iiitem^diatioo 7.7 231

2
inefficienci^ 7.7 15.4 15.4

.
2
6 Increased recovery of 7.7 15.4

practices 7.7
99
loans 0.0 7.7 15.4

97 Became
Adc^>tedmore
mtematioQal 0.0
regulation 7.7 11
0.0
cotaphaoX
10 Adopted soimd 7.7 30.8
0.0
bahldiig 15.4
practices 级
15.4
2
00
11 Became moi^ 7.7 矽
614646
accountable 15 4 23.1
13
and trax
Io^roved
parent 0.0
5
钱
12 Updatedskills
professional technology in 7.7 15.4
23.1
2
14 Adopted good 30.8

I
4
30.8
govemaoce 0.0
2
0.0
Iâctices 30.8 7.7
15 Nopolitiad 15.4 00
iofiuexice 7.7 7.7
16 No desual of 15.4 0.0 9
18 Operate
access under
to bank 11 ?.?
competimt
credit 7.7 0.0
17 Cr^litPIDE
ravircmment
[Source：
decisioas
Working Paper on Impact of Financial LiberalisationandDeregulation on Banking Sectorin Pakistan"]
38.5
based on
Privatization of the Banking Sector 171

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.
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.
part Eight FinancialPrivatization

Sector Reforms
Name of Bank Year of 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 The 一
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]

part Eight Financial Sector
Reforms
Chapter 5 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
SBP's role in
financial stability as a secondary objective, which in turn the
strengthening
soundness of the financial system. Thus, SBP maintains fin stability in
of supervisory
its dual role of being a central bank and also regulator of banking
controls
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.

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
時
given flexibi 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.
Strengthening of Supervisory Controls： SBP's role 175

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
Framework
Anti-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.

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 177

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 Current Trends in the
Financial Industry in Pakistan
Innovation Challenges, Interest-Free Banking and New Areas of
Chapter 1 Financing

Learning Outcome _ 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
Innovations in Banking systems have been continually evolving over the past two centuries,
Banking and and what have come to be regarded as traditional banking activities and
Finance
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
Innovation Challenges, Interest-Free Banking and New Areas of Financing 179

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 -
2011 2012 2013 2Q14 2015 2016 2017 2018 As of 1
January
2019
Leverage Ratio Supervisory Parallel run 1 Jan 2013 -1 Jan 2017 Migration to
monitoring Disclosure starts 1 Jan 2015 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! 3.5% 4.0% 45% 5.125% 5.75% 6375% 7.0%
conservation buffer
Phase-in of deductions from CET1 (including 2ft% 40% 60% 80% 100% 100%
amounts exceeding the fimit for DTAs, MSRsand
financials)
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 Phased out over 10 year horizon begmning 2013
non-core Tier 1 capital or Tier 2 capital
Liquidity coverage ratio ニニ introduce minimum standard
Net stable funding ratio period ；siencsar(i

begird
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 a
competitive 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

ニ
principles of Islamic law (Sharia) and its practical application thr 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 Transactions
Islamic 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

Microfinance
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
ニ
spur entrepreneurship. These indi 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
こ
microfinance, w 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
Banking Laws and Regulations 191

Part Ten Laws relating to Financial
Systems
Banking Laws and Regulations
Chapter 1
■ 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
Privatization 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 1962
2. SBP Act 1956
3. FI (Recovery of Finance Ordinance) 2001
4. Exchange Control Manual
5. Banking Tribunals Ordinance 1984
6. Banking Companies Tribunals (Validation of Orders) Act 1994

7. SBP Banking Service Corporation Ordinance 2001

8. Khushhali Bank Ordinance 2000
9. Microfinance Institutions Ordinance 2001
10. Payment Systems and Electronic Funds Transfer Act
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 minors5 account,
5 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

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 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.
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 exchange
there 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 treaî 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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Characteristics of Negotiable trument
s
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. • 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
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

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
ニ
maker, drawer, ac 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,
ニ
to a banker，and if crossed specially, to the t 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. Engage in 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.

1. Authorization to deal in Foreign Exchange.
Chapter n deals
II. with:
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
f
(c) Form M' 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
で
of the time t 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 of
agricultural 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 i
possibility 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%4its 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 cian 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，assigned
either 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.

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.
223
Banking Laws and Regulations
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-22 Security.
Regulation R-23 Periodic inspection and verification.
Regulation R-24 Tenure.
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
Definitions
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
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 Technology

k) 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
j) Head of Islamic Banking
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
least
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 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-1
LIMIT ON EXPOSURE TO A SINGLE PERSON/GROUP

1. Thetotal 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 Fund based Total Fund based
outstanding(fund outstanding outstanding (fund outstanding
and non-fund limit and nonfund limit
based) exposure based) exposure
limit limit
31-12-2009 30 20 45 35
31-12-2010 30 20 40 35
31-12-2011 30 20 35 30
31-12-2012 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-2
LIMIT 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-3
MINIMUM CONDITIONS FOR TAKING EXPOSURE
1. While considering proposals for any exposure (including renewal^ enhancement

and rescheduling/restructuring) exceeding such limit asmay 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-4
LIMIT 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-5
LINKAGE 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

B) ACQUISITION OF 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-8
CLASSIFICATION 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 exceed
2.5 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 exceed
2.5 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-1
CORPORATE GOVERNANCE/BOARD OF DIRECTORS AND
MANAGEMENT
The 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 Reputation
b) Track Record
c) Solvency and Integrity
d) Qualifications and Experience
e) Conflict of Interest
f) 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-Executive6 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-2
DEALING 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-3
CONTRIBUTIONS 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
REGULATION M-2
ANTI-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 consider
include:
x Know your customer policy (KYC)
x Information about the correspondent bank’s management and
ownership
x Major business activities x Their location
x Money laundering prevention and detection measures x The purpose of
the account
x 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 the
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
enclosed listwith the regulationsof
of characteristics (relating to Anti
financial Money Laundering
transactions and
that may be a KYC)
cause for Bank
of State increased scrutinyor
of Pakistan as the
Annexure-X.
relevant regulations of the host country,
whichever are more exhaustive.
REGULATION 0-1
UNDERTAKING 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 0-3
RECONCILIATION 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 0-4
MAINTENANCE 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 0-5
FOREIGN 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 0-1
UNDERTAKING 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 0-3
RECONCILIATION 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 0-4
MAINTENANCE 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 0-5
FOREIGN 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 Ordinance7
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.
7 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 International
Chamber 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 1
International Court of Arbitration
The 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 5
This 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 6
This 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 7
This 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
一
intermediaries channel 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. Maturity transformation 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-
各
free ones (e lending to multiple
borrowers to spread the risk).
3. Convenience denomination
Matching 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/borrowing
Deregulation 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 the
2. 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 and
overall business plans of the institution and shall oversee that the affairs
8. 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 and
appropriate 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.

Introduction To Financial Management

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Introduction To Financial Management

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Introduction to

Financial Systems &

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, August 2011

Part 2: Structure of the Financial System

Part 3: Securities and Exchange Commission of Pakistan

Chapter 1：Securities and Exchange Commission of Pakistan 83

Part 4： Financial Instruments

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

Chapter 1:Concept, scope and significance 131

Chapter 1:Major Functions of Financial Policy in a Developing 14

Part 8: Financial Sector Reforms

Chapter 1: Importance, Scope and Impact

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

Part 10: Laws relating to Financial Systems

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 System

■ 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

■ Discuss the role and importance of

2 Financial Systems and Regulation | Reference Book 2

，Pakistan’s financial system consists of:

• Money (Pak Rupee)

• Banks and financial institutions

• State Bank of Pakistan.

A. Money legal tender or a medium of exchange

Money is any object or record that is generally accepted as payment for

• It can be used as a store of value. Money must be an object that

It can be used as a standard for deferred payment. Since money is used as a

Overview of the Financial System 3

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

(Treasury bills, FIBs) prize bonds, etc. Supply of money must be

Financial Systems and Regulation | Reference Book 2

Rs. 5 115 x Greenish

Rs.10 115 x Green

Rs. 20 123 x Orange Green

Rs. 50 131 x 65 Purple

Rs. 500 147 x 65mm

163 x 65mm Mustard

Overview of the Financial System 5

inflation. In our country, however, the political agendas of the government

The government must aim to minimize the budget deficit by spending no

1990 1995 2000 2005 2010 2015

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

• Aim to decrease imports of luxury goods

• Aim to minimize deficit financing

Aim to privatize loss-making government-owned organizations. Funds being used to

Impact of Money on Local Trade

A measure of changes in the

Financial Systems and Regulation | Reference Book 2

Bena^ Food Raw material Fuel & Power 細 •へ

350 I Whole sale price index

Overview of the Financial System 9

PtM 良5说奶奶 10,309.40 18.1 -1,691.80