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LAHORE SCHOOL OF ECONOMICS

Financial Sector reforms and the
efficiency of Banking sector in Pakistan
Quaid Ahmed Khan
09U0682
BSc IV
Section C

Submitted to Miss Summaira Sajjad

Contents
Chapter 1: Introduction.................................................................2

Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

1.1: Banking in Pakistan:............................................................2
1.2: Relevance of the topic:........................................................2
1.3: Background information......................................................3
1.4: Managerial and Academic concerns:....................................6
1.5 Key words:..........................................................................10
1.6: Study Objectives:...............................................................11
Chapter 2 Literature review.........................................................12
2.1: The banking sector of Pakistan; pre reform period:..............12
2.2: Initiation of liberalization and privatization reforms:..........15
2.3: Efficiency analysis, models used:.......................................19
2.4: Findings and short comings:..............................................21
Chapter 3: Methodology..............................................................23
3.1: Banking sector reformed:.....................................................23
3.2.1: Data Envelopment Analysis:.........................................24
3.2.2: Types of Returns to scale:.............................................25
3.2.3: Types of efficiencies:....................................................26
3.3: Model Orientation:.............................................................28
3.4: Framework:........................................................................30
3.5: Data Collection:.................................................................35
References:............................................................................... 36

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

Chapter 1: Introduction
1.1: Banking in Pakistan:
For any thriving economy, one of the pillars it has to stand on is the Banking sector. The major
role of the banks, that is, to channelize credit towards the industry and production units and to
encourage domestic saving by providing various types of deposits, is indeed what makes the
economy grow and sustain. In order to make this possible, it is important that banks are regulated
and efficient, so that the economics process is not hampered by the improper functioning of the
banking sector.

1.2: Relevance of the topic:
Since the beginning, the economy of Pakistan has not been a very stable one. One reason for that
is the instable financial sector of Pakistan, especially the banking sector. The role that the
banking sector plays is a very crucial one, which needs to be understood first. In order to
understand that we should know how a typical bank primarily operates. The bank generates
revenue through taking in deposits. The purpose of deposits is twofold. Firstly it provides an
opportunity to the public and private savers to earn income on their savings. The interest that is
given on the deposits is the revenue for the savers, which happens to be the incentive for saving
too. On the other hand, the core deposits provide the bank with funds that they can lend out.
Again, there are two direct benefits of this. Firstly the bank gets an opportunity to loan out funds
which have to be paid back with an interest charge. The spread, which is the difference between
the interest the bank gets on loaning out funds and the interest that the bank has to pay to the
depositors helps in generation of revenue. Secondly, there are these private and public parties
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who get an opportunity to take credit, set up a production house or an industry altogether which
is ultimately beneficial for the economy.
As we can see that the role of the banking sector is quite an important one, it is essential that the
banks operate in such a manner which is of in the better interest of the consumers, the financial
sector, the economy and ultimately the bank itself. For this, banks must operate in an efficient
manner. Only when efficiency is brought in, it would be possible for the banks to earn reasonable
revenue that is vital for its operations and growth and that consumers of financial services
provided by the bank are such that they are not left worse off.

1.3: Background information
Before independence, the Muslim and Hindu community had the Reserve Bank of India as the
central bank of India. As there was a central bank already existing in India, the financial sector
was functioning very smoothly as the central bank was playing its regulatory role. However, with
the creation of Pakistan in 1947, there was an unfair distribution of assets between the newly
created India and Pakistan. Prior to the partition, the dominant Hindu majority of India owned
most of the banks of India. After the partition, the banking community immigrated to the new
India and in Pakistan, there were a very few number of skilled members. So, apart from the many
other problems Pakistan faced, this was one. That is, there was an acute shortage of skilled
bankers who could run banks in an efficient and viable manner that could assist in the
functioning of the Pakistani economy. In addition to this, there was another problem. The unfair
division of assets had just left one bank in Pakistan, namely the Habib Bank Limited (HBL).
Since Habib bank was just a bank owned by the government and not a central bank, the financial
sector was not a regulated one. Moreover, this bank was not in a situation to cater for the needs
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of the populous country of Pakistan. With limited assets base and lack of skilled bankers, the
banking sector of Pakistan was not in good health, not in a condition which could support the
economy in the most befitting manner. The importance of a central bank was strongly felt as the
economy had already taken in huge losses during the transitional independence period and it
continued to do so as the banking sector of Pakistan was not a regulated one. Muhammad Ali
Jinnah issued directives for the creation of a central bank and planning for it started on priority
basis. The 1st day of July, 1948, marked the inception of The State Bank of Pakistan. The
constitution of the bank remained unchanged during the initial years. However, at the very start
of 1974, like many other institutions, the State Bank of Pakistan was nationalized under the
nationalization policy. Initially the purpose of this bank was to be the issuer of Pakistani currency
notes and to keep with them reserves which would help Pakistan in maintaining a monetary
system that shall be in advantage for the economy of Pakistan. However, with the change in its
constitution, the role of this bank in Pakistan’s economy increased. Now the role of this bank
increased, in addition to the previous role, it had to regulate all the banks operating in Pakistan,
to maintain the exchange rate system and to formulate a credit and monetary policy as such that
it is in the better interest of Pakistan. The biggest role of this bank is to issue notes and to
regulate the banking sector of Pakistan so that it continues to function in harmony. It basically
provides the banks of Pakistan a set of rules and a framework which they have to adhere to.
Prudential regulations are the ones that are of prime importance. They provide the basic
requirements that all the banks in Pakistan will and have to follow. To name a few, these
regulations deal with the liquidity, capital and deposit requirements of the banks. . Till today, the
State Bank continues to play its role as a central bank and over the years, it has enjoyed greater
and greater autonomy.

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Another important role the State Bank of Pakistan has played is the encouragement of the
private and public sector banks to open up its branches in urban and far flung rural areas so that
banking services are available to whole of Pakistan and not just to the people who dwell in city
centers. The State Bank was to some extent successful in this target of theirs. In 1949, the
number of bank branches was 147 but in 1947, this figure had gone up to 3,418. This is a
testimony to the fact that the banking services was being made available to the commoners as
well as that banking system was becoming an inherent part of the economy. Total number of
accounts held by these banks amounted to 7,275,719. However, a serious blow to the banking
sector was the separation of West Pakistan from its East wing. The number of branches fell from
3,418 to 2,600. It was a potent threat to the survival of the banking sector as the industrial loan
demand showed a considerable decline. Nonetheless, Pakistan managed to successfully come out
of this threat and the banking sector flourished. However, the efficiency of these banks was still
an unanswered question. Unfortunately, this was not the only problem Pakistan was facing. In
1970’s, along with the Bhutto era came the nationalization policy. Along with ten major
industries, considerable nationalization was done in the banking sector too.
The nationalization of the banking sector indeed made the financial system to look like the most
regulated one, which should have brought in efficiency. Many of the nationalized banks were
merged to form the five big nationalized commercial banks, namely:





Habib Bank Limited
National Bank of Pakistan
United bank Limited
Muslim Commercial Bank
Allied Bank limited
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Since the time of nationalization to the reforms in 1990, these banks had a very strong position in
the financial sector of Pakistan.
In 1990’s, financial sector reforms were introduced with the help of the Government of Pakistan
and foreign financial institutions. These reforms were aimed at deregulating the banking sector,
providing relief to the banking sector by the privatization of numerous national banks.

1.4: Managerial and Academic concerns:
Without any doubt, we can see the banking sector is very important to the economy of Pakistan
as it ensures its survival and growth. For that it is important that the banks operate under
circumstances which ensure maximum efficiency.
Unfortunately, the economic and financial policy of Pakistan has not been the one which is very
stable. With every change in the government regimes, be it a different political party or the
transfer of power from the civil to military regime and vice versa, every regime has brought its
own set of policies that they think shall be in the better interest of the country. Same goes for the
banking sector. Though the constitution has not changed much but the changes it brings about in
its functioning, especially the regulations it sets for the banks to follow are detrimental in the
outcome, whether it is efficient or not. One major concern that shall be highlighted in my
research is that whether or not the privatization of banks in Pakistan has been successful in
bringing in more profitability in this sector or were the banks doing much better when they were
in the hands of the government.
The nationalization of banks in the 1970’s had its own advantages. Firstly, prior to the
nationalization process, wealth was concentrated in the hands of a few. This meant that few

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families had control over the financial streams. So, basically the policies came from them and the
credit that was to be given to various industries was to be decided by them. In simpler terms, the
establishment and survival of industries were dependent on these private banks which had
majority of the loan able funds. If they found out that returns from any particular industry would
be greater, they would make loans to production units in those industries instead of making loans
to other industries. This did increase the returns of the bank but the problem was that this
practice was not beneficial from the national point of view.
During the early years, Pakistan was in a process of building up its economy. There were infant
industries that need to be supported and many were to be built from scratch. For that credit had
to be diverted to these priority sectors. From the national point of view, the returns from
financing them would not be much profitable for the banking sector in the short run but the
returns from the industry would be very higher as compared to the costs incurred in the long run.
Hence, these projects would be very much viable. So, the private banks would never be taking
these external benefits into account and would never give credit to these institutions but if these
banks were nationalized, only then credit could be diverted towards priority sectors.
In addition to this, another direct advantage of the nationalizing policy was that without any
second thoughts, a number of bank branches were opened up all over Pakistan, especially the far
flung rural areas. This had two direct advantages. Firstly, the banks now had an opportunity of
increasing its asset base and to increase the number of accounts so that more and more funds can
be loaned out. The second advantage was that the banking services were now being made
available to a greater number of consumers. Consumers previously who had no access to the
banks now had an opportunity of opening up bank accounts or use other services provided by the
banks.
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However, these major advantages coupled with other minor ones like better regulated financial
sector were over shadowed by the disadvantages brought by the process of nationalization.
Firstly, though the government was successful in targeting credit towards priority sectors, the
element of bias was never removed. In fact it grew even stronger. Prior to the nationalization
process, credit was directed to those sectors which they thought would provide the banks with
greater returns. This time around, a political bias was involved. Loans at times were made to
sectors that could not generate returns good enough or those projects were not profitable from
the national point of view but were given credit only because they had political support. Either
the industry itself was to be established by political leaders or people at the helm of affairs or the
creditors were people who had strong political connections. A lot of times it was witnessed that
the loans were made without taking appropriate guarantees, the loans were pledged against weak
collateral assets. This meant that the risk of non-performing loans faced by the banks increased
exponentially. The loans were not being made on merit and hence this caused the number of
non-performing loans to increase. These NPL’s were not at all in favor for the smooth
functioning of the financial sector of Pakistan.
In addition to this, though the number of branches increased and the banking services were made
available to a larger population but this did not help with the efficiency cause. In fact, this
backfired. The banks did increase a lot of jobs and helped with the unemployment but most of
the times the banks were over staffed and made its operations counterproductive. Moreover, the
banks operating costs witnessed an exponential increase in its administrative costs.
Moreover, there was no competition amongst the banks since all banks were government banks.
It did not matter which bank had the largest market share hence inefficiency was on the rise in

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the banking sector. Even the top, most important positions were given to employees on political
basis instead of making the appointments on merit. The inefficiency ultimately resulted in lower
domestic savings and hence a low economic growth rate. Inefficiency in the banking sector
deteriorated tremendously.
All of these disadvantages associated with having state owned banks gave rise to the thought the
banks should be privatized. This thought culminated into an actual process when the
privatization reforms were introduced. With the privatization reforms in place, many of the state
owned banks were privatized. In addition to the privatization of the banks, one other important
point of these reforms was that investment in the banking sector was encouraged. Public parties
were encouraged to open up banks as many regulations were relaxed and the licenses to open up
new banks were given away. The banks now can be classified into the following types:



State owned banks
State owned banks that have been privatized (Private Banks)
Private banks
Foreign banks.

With these banks and other new banks in place, the competition amongst banks increased and the
efficiency improved.
From the managerial point of view, the research I am conducting is important in more than one
way. Firstly, the fact needs to be established that how much of a nuisance was the nationalist
policy. We need to ascertain the fact that whether or not there was a need of nationalizing the
banking sector. This has to be seen in the view of the planned goals and whether or not hose
goals were successfully achieved. In addition to this, the research would ponder over the results
of nationalization which called for the privatization of banks. This has to be seen with a view that
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whether or not the banks have been successful in achieving the desired efficiency levels and has
their profitability improved or not. It shall then be of assistance to officials that whether the steps
taken have been successful or not and whether these steps should be taken again when the need
arises or they should be revoked.
From an academic point of view, this research would explore the advantages that come along
with regulating the banking sector and to encourage the competition amongst the banks. How
this leads the banks into operating more efficiently and hence being a sector that indeed helps in
the functioning of our economy. Moreover, it would provide insights on how efficiency can be
measured using empirical evidence. Data would be used in order to reach the conclusion that
how helpful is privatization in making the banking sector more efficient. It shall also serve as a
guideline for future researches in this area.

1.5 Key words:
Nationalization: the process where an institution is run and owned by the state.
Privatization: the process where the ownership of state owned institutions is transferred to the
public at large.
Efficiency analysis: Analysis using empirical data to ascertain how profitable banks are, by using
input and output approach. DEA analysis shall also be used
Non-performing loans: Loans that are not recovered.
Collateral / Guarantees: Assets pledged against a loan. They can be sold by the bank in case a
creditor defaults.

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Public banks: banks owned by the state
Privatized banks: banks previously owned by the state, privatized now.
Domestic private banks: Banks set up by private parties.
Foreign banks: Banks that are owned by nationals or governments of countries other than
Pakistan.

1.6: Study Objectives:
The prime objective of this study is to ascertain that whether or not the government has been
successful in the implementation of these reforms. If they have been, has efficiency of the
banking sector increased? It is only when the efficiency of the banking sector improves that the
financial sector operates in a more systematic way which ultimately leads to the growth of the
Pakistani economy.

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Chapter 2 Literature review
2.1: The banking sector of Pakistan; pre reform period:
The financial sector of Pakistan evolved differently from banks in the developed worlds. The
partition plan was announced on June 3, 1947 and August 15, 1949 was fixed as the date on
which independence was to take effect. The financial sector was in discussion and it was decided
that the Reserve Bank of India should carry on with its functions even after the establishment of
Pakistan until September 30, 1948 mainly due to organizational and procedural difficulties
involved in instantly establishing and operating a Central Bank. At the time of independence, the
total numbers of Banks were 38. Out of these 38 banks 2 were commercial which were Habib
Bank Limited and Australia Bank of India. The total Deposits stood at Rs.880 million whereas
the advances were Rs.198.
After habib bank had filled the gap and had laid down the preliminary basis for banking in
Pakistan, the governor general of Pakistan Muhammad Ali Jinnah issued the order for the
establishment of a State Bank of Pakistan on 1st of July 1948. State Bank of Pakistan came into
form under the quasi-government ownership. At this time the role of banks was limited, which
accounted for only 25 of the total 195 bank branches in the country. Consequently, the State bank
of Pakistan was originally authorized to develop commercial banks and maintain financial
stability so commerce and trade could thrive in the newly-established state. Hence the banking of
Pakistan is as old as Pakistan. Then in 1949, National Bank of Pakistan was formed. It started
with six offices in former East Pakistan. There were 14 Pakistani listed commercial banks
working in the country on December 1973. The names of these banks are listed below:
1. National Bank of Pakistan
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2. Habib Bank Limited
3. Habib Bank (Overseas)Limited
4. United Bank Limited
5. Muslim Commercial Bank Limited
6. Commerce Bank Limited
7. Australia Bank Limited
8. Standard Bank Limited
9. Bank of Bahawalpur Limited
10. Premier Bank Limited
11. Pak Bank Limited
12. Lahore Commercial Bank Limited
13. Sarhad Bank Limited
14. Punjab Provincial Co-operative Bank Limited
As discussed above the financial sector in Pakistan was first dominated by state owned
institution. Specifically in the period of nationalization in 1970, all private institutions were
changed into state owned institutions and restrictions were imposed on private ownership. These
state owned institutions were fulfilled the financial need of government, public enterprises and
some private big organizations (Khan 1995). Continuing this policy, the whole of the banking
sector was nationalized in 1972. Furthermore, big commercial banks were merged for the
formation of National Commercial Banks. In the period of 1972-1990 the five NCB’s were the
main player in the banking sector. 92% of the banking assets were captured by these NCBs
which showed their authority and power in the banking sector. The holding of such massive
assets by these NCB’s was actually one of the main reasons why restrictions were levied on
private commercial banks. No such private ownership was allowed during the nationalization
period. (Rehman & Raoof, 2010, p. 110)
Due to the high restrictions and interventions by the government, the performance of the banking
sector was not up to the level that was expected. All this led to low efficiency, low growth and a
fall in the investments in the private sector. These outcomes were the result of high tax rate, non
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diversification in financing, narrow range of financial products and bureaucratic behavior.
During this time period which had seen multiple negative outcomes there was now a need for a
system which had strong and profound banking system. Such a system was injected in the
society in the form of Banking Sector Reforms in 1991. This idea had created aroused many
arguments, for instance questions like why did we need fiscal reforms in banking sector? What
was wrong with Pakistani banking system that such immense reforms had to be undertaken?
In the later stages of reforms, Dr Ishtar Hussian had addressed all these issues very rationally and
practically in the later stages of reforms. His basic argument was that we need financial
Reforms because the banks in Pakistan were owned by the state. So the prime objective of the
banks was to cater to the needs of the government, trade financing, subsidizing the fiscal deficit
and serving few commercial sectors. The lending by the banks was biased as it was under the
influence of political forces. The bank staff was appointed on political basis and also worked
under their pressure. We could clearly see that there were no such loans given to the medium and
small enterprises. Not only the service sector but the agriculture sector was also ignored. Most of
the rural population was provided jobs by the agricultural sector and this sector was ignored to a
large extent. Even if loans were issued their chances or recovery was very little. Approximately
75% of the loans issued by the banks were unclaimed under high political pressures. Many
factors lead to inefficiency of the banking sector such as over branching, poor customer services,
Overstaffing, ineffienct administration and waste of resources. Looking aside the above
illustration, banking sector did face a very high tax rate while other sectors paid only 35% of tax
the burden was passed on to the customers in the form of high lending and low deposit rates. All
these factors when seen altogether made the appearance of banking sector very unattractive for
the new investors who could actually bring a change in the banking system of Pakistan. Thus, in
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order to improve the competence of the banking sector it was decided to implement financial
reforms in the banking sector. (Rehman & Raoof, 2010, p. 111)

2.2: Initiation of liberalization and privatization reforms:
The banking sector in Pakistan has witnessed severe changes over a period of 64 years since
Country’s independence in 1947. After looking at the outcomes of nationalization and how
government intervention in the banking sector has lead to chaos in the finance sector. For this
purpose, reforms were introduced in different phases. The first phase started from 1991, in which
the ban was lifted from the private owned banks and they were granted

authorization to start

their operations. These ten banks started their functioning in the latter half of 1992. Along with
this, within the next two years three foreign banks and two provisional banks were established.
And not only that, Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL), the two
main nationalized banks were denationalized in 1993.Consequently, Pakistan moved towards
liberalization and financial sector deregulation. Now, the main focus for Pakistan was to improve
the efficiency of the banking sector. State Bank of Pakistan also decided to improve their
performance as a strong and specialized regulatory authority. And SBP wanted to enhance their
role to keep a check and balance on the publically, privately and foreign owned banks. To serve
this purpose, it was advised by the State bank of Pakistan that all banks would put forward their
performance reports, their targets and strategies formulated by them to improve their future
working. (Rehman & Raoof, 2010, p. 111)
The second phase reforms began in 1997. State Bank of Pakistan was given full control for
regulations and monitoring and the Banking Council was dissolved. As a result to this State Bank
of Pakistan established two new systems to monitor the performance of each ban and this

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consisted of CAMELS (capital adequacy, asset management, management quality, savings,
liquidity and sensitivity to market risk system.) And CAELS (capital adequacy, asset quality,
earnings, liquidity and sensitivity). Furthermore, a minimum capital requirement was also fixed
and implemented in the second phase as 500million rupees. (Rehman & Raoof, 2010, p. 112)
The main objective of these financial reforms was to enhance the efficiency of the banking sector
by introducing:
1. Privatization of NCB’s
2. Corporate Governance
3. Capital Structure
4. Improving Asset Quality
5. Liberalization of Foreign Exchange Regime
6. Consumer Financing
7. Mortgage Financing
8. Legal Reforms
9. Prudential Regulation
10. Micro Financing
11. Small and Medium Enterprises Financing
12. Taxation
13. Agriculture Credit
14. Islamic Banking
15. E-Banking
16. Human Resource
17. Credit Rating

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18. Supervision and Regulatory Capacity
19. Payments
(Rehman & Raoof, 2010, p. 112)
The outcome of these reforms showed that within a span of 5years the industry reached to 4
trillion rupees in 2005. The GDP of the Banking sectors assets grew from 47.2% to 55.6%. The
growth in the banking sector had outpaced the nominal GDP. This result was a sharp disparity
with the GDP asset ratio in 1990. Thus the transformation that we see in the financial sector i.e.
from nationalization to privatization and the role played by State Bank of Pakistan is exceptional.
As not only the GDP and profitability of banking was improved the capital adequacy ratio also
increased. Along with this the loan infection ratio decreased significantly. The Banks were
operating at the capacity considerably higher than it was in the 90’s. All these positive results
made it explicit that the financial reforms introduced played a significant role in the banking
sector of Pakistan. Thus these reforms have made the financial sector of Pakistan competent and
efficient. (Rehman & Raoof, 2010, p. 112)
Emphasizing on the role of the privately owned banks if we look at the theoretical rationale
behind the workings of the state owned enterprises and privately owned enterprises we can
clearly see the difference in the twos workings. In State owned enterprises (SOEs) decisions are
politically motivated and biased. It is characterized by tardiness, lethargy and inefficient use of
resources. Also it is commonly though that the workings of a state are corrupt. Unlike the State
owned enterprises, the private enterprises are profit orientated; ensure the efficient usage of
resources, improvement in the technical efficiency, human resource development, which includes
training of staff and the physical extension of banks. They work rationally and without any
pressure from the state. For them time is money and it is utilized as efficiently as possible.

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Hence, private owned banks and other enterprises play a much stronger role in enhancing the
growth of Pakistan’s economy altogether. (Hussian, Ullah, Saeed, & Rafiq, 2012, p. 41)
Today, the Banking sector is playing a fundamental role in the growth of the country’s economy.
In accordance with the state bank of Pakistan, the banking system of Pakistan is a two-tier
system including the State Bank of Pakistan (SBP), commercial banks, Specialized banks,
Development Finance Institutions (DFIs), Microfinance banks and Islamic Banks. (Nawab, p.
14) By June 2010 the banking sector of Pakistan comprised of 36 commercial banks including 4
public sector commercial banks 7 foreign banks and 25 local private banks) and 4 specialized
banks with a total number of 9,087 branches throughout the country. (Nawab, p. 14)
The current formation of the financial sector in Pakistan is the result of numerous policy shifts
and developments. Like many other developing countries, Pakistan also undertook the procedure
of financial restructuring through reforms in early 1990s to establish a more market-based
system of financial intermediation and Government financing, conduct the monetary policy more
efficiently through greater reliance on indirect instruments and increase the contribution to the
rapid development of the stock markets. (Nawab, p. 14)

2.3: Efficiency analysis, models used:
In order to find efficiency of banks, various researchers use various techniques. Some have used
simple financial ratios, some have used various regression techniques but most have them have
used the frontier analysis. The frontier analysis can be further sub divided into two major
categories, stochastic and deterministic. (Berger, 1998) The stochastic frontier analysis can then
be further subdivided into the parametric approach and the non parametric approach. The

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parametric technique enjoys preference over the non parametric one as the latter one has certain
deficiencies when it comes to measure efficiency. Reason being, in calculating the efficiency, this
technique does not take into account the random effects. By not doing so, the results which one
might get could be the inflated ones, rendering the results as dubious (Grabowski et al., 1994).
The parametric approach, the researchers usually have a choice amongst three approaches, the
first being the stochastic frontier approach, second being the distribution free approach and third
being the thick frontier approach. The most popular amongst these three are the stochastic
frontier approach which is then again divided into parametric and non parametric technique. So,
to arrive at results that are reliable and certain, the parametric approach to frontier analysis is
used by many. In instances where it seems as if the inefficiencies will follow an asymmetric
distribution and the random errors follow a symmetric distribution, a composed error term is
used and hence the results come out to be more accurate (Berger, 1998).
The deterministic frontiers are the least popular. One barely finds any studies which show that
deterministic frontiers have been used in order to find efficiency scores. It basically because only
a small portion of the data actually supports the frontier, which ultimately leads to problems like
sampling, outlier and statistical noise. This results in the undermining of efficiency scores
(Kaparakis et al., 1994).
Another technique that has been used is model built using a translog cost function together with
a composite fixed error term (Mahmood, Loan, 2006). The composite error term helps in finding
out that if a firm lies above or below the cost frontier, is it due to internal shocks or does it results
from the internal inefficiency. It should be noted here that in such a type of a model one basically
is looking at cost efficiency. The efficiency is dependent on optimal costs.

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Other techniques used, especially in the case of Pakistan is the use of CAMELS and CAELS
ratios. Both of these are basically measures which help in the calculation of a given set of ratios,
using the balance sheet and income statement components. CAMELS ratio includes the capital
adequacy ratio, asset quality ratio, management quality ratio, earnings and profitability ratio,
liquidity ratio and sensitivity to market ratio (Khalid, 2006). In case of CAELS, the management
ratio is left out. Both of these measures have been adopted by the State Bank of Pakistan
(Qayyum, 2006). The major reasons for the use of these ratios are the simplicity of calculations
involved and the easy interpretation of results. However, the disadvantage is that it is just too
simple. CAMELS as an efficiency measure would not result in concrete findings, as it is possible
by Data Envelopment Analysis (DEA). In DEA, an efficient decision making unit (DMU) is
there and rest are compared with it whereas in the case of these ratios. In CAMELS, no such
comparisons can be made. Comparisons that are possible can be of comparing ratios with those
of the best firm in the market.
Data Envelopment Analysis is the most common model, whose results are accurate. It happens to
be a non parametric technique, linear programming technique (Avikiran, 2005). Majority of
researches, especially foreign ones have used this. It is specifically targeted towards the
measurement of efficiency when it comes to the Decision Making Units (DMU’s), banks in this
case. The DEA basically compares each DMU with the role model in the given set of DMU’s. A
frontier is basically made using observed measures and a frontier is made. The firms lying on the
frontier get a value of 1 and are considered efficient whereas the firms who are not that efficient
get a score of less than 1 (Akhtar, 2002). This way, comparison within firms can be made easily.

2.4: Findings and short comings:

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The studies that are related to the case of Pakistan are very limited in number, especially when it
comes to the usage of DEA model. Analyses using CAMELS and CAELS ratio have been very
common. (Khalid, 2006) The CAMELS ratios showed that the banks have been slow in showing
improvement in the initial years, right after the major reforms of early 1990’s. There was an
improvement but it was slow in the initial years. Massive improvement was seen in the later
years. The foreign banks were the ones who showed most improvement. This is mainly due to
the fact that they were new into the market and the way they operated was in a really
professional manner. The national banks were the ones who showed the least amount of
improvement. If there was any improvement, it was too small or there was an actual deterioration
in the ratios. Even the DEA analysis show that there have been considerable improvements after
the initiation and implementation of the privatization and liberalization reforms (Qayyum, 2006).
Even when the translog function was used, the results were somewhat similar (Mahmood, Loan,
2006). It showed that the reforms had resulted in the improvement of efficiency but there were
still a lot of room for improvement. It is just not that the reforms completely lead to improvement
of efficiency of all the banks to an extent that most of them managed to get a place exactly on the
frontier. (Ghumro et al., 2012) even tries looking up into finding an answer to the fact that how
successful privatization has been. In this study, the individual case of Allied Bank is taken up and
it shows that there has been an immense improvement in ABL’s state of affairs.
However, the other important thing is the consistency of inputs and outputs taken and the
approach used. Irrespective of the approach used. The DEA analyses do show that the banks have
turned out to be efficient when financial liberalization reforms are undertaken (Avkiran, 2005).
Transition countries, when subjected to such reforms do in fact give promising results (Bonin et
al., 2005).
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Our neighbor, India, also has been a country which had national banks in its early years. Down
the road, they also introduced various financial reforms (Das, Gosh, 2005). It should be noted
that it is important to follow the global trends, in order to profit from rapidly changing economic
conditions. Hence, India too implemented similar reforms and these reforms bore fruit (Saha,
Ravisankar, 1999). Since there are a lot of similarities between the two nations, India and
Pakistan, chances are that the effects of the reforms could be similar too.
Given that these reforms lead to efficiency, it is not a rule of the thumb that such reforms alone
lead to improvement. Factors like banks size, the number of branches and the geographical
location of a bank too play an important role in the determination of efficiency (Luo, 2001). The
banking structure too plays an important part (Altunbas, Chakravarty, 1999). Some studies
exhibit contradicary findings, hence regressions need to be carried out with bigger samples hence
accurate correlations are found when it comes to different variables and efficiency.

Chapter 3: Methodology
3.1: Banking sector reformed:
The banking sector of Pakistan has been subjected to many reforms, the most crucial of them
being the introduction of privatization and liberalization reforms in the banking industry of
Pakistan. In the privatization phase, the banks that were previously under government ownership
were now being put under private ownership. Either the banks were fully privatized, to an extent
that all the shares were held by the public or private parties or there was a combined ownership.

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

This meant that majority of the share holdings were in the hands of the public or private parties
and government only had minority share holding of the bank. A strategic element was involved
in this. The bank size was too big and there was a serious doubt that the banks operations would
be jeopardized because of total private ownership, with the old administration going out and the
new one coming in or it was a matter of national interest. Or there were financial sector reforms
which meant that there was financial liberalization. Financial liberalization was aimed towards
the deregulation of market, change in prudential regulations the change in bank’s licensing
procedure, making the process even simpler or just reducing the minimum capital required, so
that more banks could enter the market and the competition could increase.
To ascertain whether or not these reforms have been successful, we will be looking at the
efficiency of banks. Four categories of banks have been considered:
1.
2.
3.
4.

Foreign Banks.
Government Sector Banks
Privately owned banks
Privatized government banks

The classification of banks into these four categories will basically help in better understanding
of the efficiency scores as all of these four categories consist of banks with a unique part.
Foreign banks are those banks that are owned by countries other than Pakistan or are owned by
nationals other than Pakistanis. The profits earned from these banks are remitted abroad.
Government sector banks are those banks whose ownerships lie with the state of Pakistan. They
are directly controlled by the Government of Pakistan. Privately owned banks are those banks
which have been basically opened up by the private parties of Pakistan and their shares belong to
them. Most of these banks were opened up after the initiation of the reforms, with more

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

deregulation and lesser barriers in entry. Then the privatized banks are those banks which were
previously nationalized or from scratch belonged to the government but now their ownership got
transferred to private individuals or to the public.

3.2.1: Data Envelopment Analysis:
The aim of this research as stated earlier is to determine how efficient banks are, after going
through many reforms. Different researchers and theorists used different models to determine
how efficient banks have been. The most popular amongst those models has been the Data
environment analysis (DEA) which uses data on the input and output quantities of a group of
countries or business units to construct a piece wise linear surface over data points.
Basically, the banks are considered to be the decision making units (DMU). This is because
banks are our point of concern, whose efficiency scores we need to find, as this is the place
where all the decisions regarding its operations are made. Thus, the decisions took in the DMUs
then have a strong effect on the efficiency scores. DMUs are where the population process takes
place, using multiple inputs and outputs. It is not necessary that the number of inputs and outputs
are to be equal; this means that one to one relationship is not necessary. For example, there can
be two inputs and three outputs or vice a versa. But what is of importance here is that all the
outputs and inputs taken into consideration should exhibit some kind of relationship. For
instance, if deposits are taken as an input, these deposits are converted into loans and then given
out to bank’s customers. It is quite evident from the above mentioned example that a relationship
exists amongst the two variables. Hence efficiency analysis can be carried out using the DEA
analysis.

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan
3.2.2: Types of Returns to scale:

Initially, the original DEA model was limited to firms that exhibited constant returns to scale
phenomenon. It meant that if inputs in the DEA model are doubled, the outputs should be
doubled up too. However, due to this constant return to scale condition, the DEA model had
limited applicability.
Later, the Variable Returns to Scale (BCC model) was introduced. This meant that now, with the
doubling of inputs, it is not necessary that the output doubles too.
The CCRs model equation (Charnes et al., 1978):
si

m

θ - ϵ (

∑ s´i

s

+

i=1

+¿

)

∑¿
r=1

n

θ xi 0

Subject to 0=
y ro

j=1

,

+¿

n

=

∑ x ij λ j− s´i

-

∑ y rj λ j−s¿i

,

j=1

0 <=

λj

,

s´i

+¿¿
si ,

,

∀ ,j,r

The BCC model’s equation is (Banker et al., 1984):

+¿

si

m

Minimize, θ - ϵ (

∑ s´i
i=1

+

s

∑¿

)

r=1

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan
n

Subject to

y ro

θ0 xi 0

=

, i=1,2,….m

j=1

+¿

n

=

∑ y rj λ j−s´i

∑ y rj λ j−s ¿i

,

r= 1,2,….s

j=1

n

1=

0 <=

∑ λj
j=1

λj

,

s´i

,

+¿¿
si

∀i

,j,r

In my research, I will be following the constant returns to scale approach as this is the better one.
The reason is that it is very much possible that the return of inputs varies, they do not have to be
constant every time. As indicated in later studies.
3.2.3: Types of efficiencies:

The two models described above talk about technical efficiency only. Efficiency can be broken
down into two components (Farell, 1957):
Economic Efficiency

Technical efficiency

Allocative efficiency

So when we are considering the technical side only, no price or no cost data is required. The
above mentioned model implies that when we have “n” number of units, the DMUs, outputs are

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

them produced in different amounts,

y rj

( r=1,2,3,…..s) using the same “m” inputs ,

x ij

(i=1,2,3…m). This goes for the constant returns to scale model. The model is the same, even for
the variable returns to scale, except for the fact previously, that the condition imposed ƛ

n

∑ λ ( j=1)
j=1

is now removed.

We can also define efficiency as a way in which we are producing outputs using a set of inputs at
a minimum costs. If this happens, the transformation would be the efficient one. Farrell (1957)
has talked about economic efficiency in terms of technical efficiency and allocative efficiency.
Now we shall first decline what is technical efficiency and what is alloactive efficiency.
Technical Efficiency:
Technical efficiency is where one obtains the greatest possible production of goods and services
whilst using the given set of inputs. This means that the inputs are taken as given. Now what
bank has to do is basically use those given set of inputs in such a way that the output produced is
them maximized. This means that the conversion takes place with the minimal waste of inputs
and with the lowest opportunity cost.
Alloactive efficiency:
This efficiency takes place when there is an optimal allocation of inputs in order to produce the
outputs of a firm.

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In order to explain this concept, we shall take an example. In this example we assume that

there is a bank that uses ony 2 inputs, these inputs would be (

X1

&

X2

) to produce a single

output(Y).The functional form will be

Y=f(

X 1∧ X 2 ¿

This way, an isoquant curve can be drawn. So any firm that is on the curve will be considered as
an efficient firm. If the firm is below that curve, it is inefficient, technical efficiency is not there.
If a firms is somewhere above the curve, then the firm is said to be over efficient. This means
that the firm is not using it input in an optimal manner and hence lacks allocative efficiency. So
in order to be back on the efficient frontier, the firm needs to cut down on its inputs to produce
the same level of output.
This was basically a non-parametric approach as efficiencies have been calculated without using
a specific functional form. Moreover, the above example is that of an input–reducing concept.
Another point to be noted is that the technical efficiency can further be broken down into scale
efficiency and pure technical efficiency. Only when there is a constant return to model, technical
input-orientated approach can be used. However, this is rarely the case as the DMUs are rarely
fitting in the constant returns to scale model. As for that, they need to be operating at an optimal
scale. Hence, we should be looking at the variable returns to scale approach. Otherwise, using
the constant returns to scale approach, the total efficiency measures will also include scale
efficiencies.

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

Scale efficiency: Refers to the fact that how big a DMU is, at what scale is it operating. A DMU
is said to be efficient when it is operating at an optimal scale. If it reduces its size, it will then
become efficient.

3.3: Model Orientation:
Models orientation can also be of two types, one is the input orientated approach and the other is
the output orientated approach. In the input orientated case, The DEA method defines the frontier
by seeking the maximum possible reduction in input usage, with output levels held constant.
While in the output-orientated case, the DEA method seeks the maximum proportional increase
in output production, with input levels held fixed. These two measures provide the same
technical efficiency scores when a constant return to scale (CRS) technology applies.
Input orientated: This model suggest that an inefficient bank is made efficient by a proportional
reduction in its input whilst its outputs are held constant.
Output orientated: When we talk about an output orientated model, have a bank that is ineffienct
is made feint through a proportional increase in its outputs whereas the inputs are not changed. It
should be duly noted that the constant returns to scale mode, produces the same efficiencies
score, irrespective of the approach type used (input orientated or output orientated). However if it
used the variable returns to scale model, the results would change with the approach used in
calculation of efficiency sores.
Then DEA analysis uses a mathematical model in order to build up a frontier. It is handy to use
as it is does not require a specific distributional form for the error term and has no assumption
about the functional form. In the DEA analysis, the inputs and outputs are used to determine the

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envelopment surface which is the efficiency frontier. Firms that lie on the frontier are the ones
that are efficient and firms that do not lie on the frontier are inefficient.
This research will basically be concerned with the output oriented approach because in the case
of banks, the banks takes in money from one end, that is mainly deposits as cash inflows and
converts in to cash outflows as loans. The aim of the bank should be of being efficient in this
process.
The efficiency scores are usually between 0 and 1. A firm that is efficient gets a score of 1 & a
firm that is not efficient gets a score of less than one.
Efficient DMU score=1
Inefficient DMU score ≤ (not below 0)
For an output orientated model, the output needs to be maximized using a given set of inputs:
Max TE
m

Subject to

∑ μ y ir−x jr + w ≤ 0
i=1

r=1,2,3,…,k

n

v j x jr

-

∑ u . j x jk
j<1

ui

&

rj

≥0

As efficiency=output/input

3.4: Framework:

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

Here the inputs are:
1. Deposits
2. Labor
3. Capital
The outputs are:
1. Loans and advances
2. investments

Inputs:

Ouputs:

1. Deposits
2. Labor
3. Capital

Efficient
Conversion

1. Loans and
advances
2. Investments

The two of the most common and helpful approaches for determining the inputs and outputs are
as follows:
1. Production approach: Here, the aim of the bank is to provide the output using minimum
of inputs or using a set of inputs to maximize the outputs. This approach is useful in the
study of finding operating efficiency of a bank.

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2. Intermediation approach: Here, banks are regarded as financial intermediaries who
basically convert surplus money into loans etc for its customers. In this research,
intermediation approach will be used as banks major function is to act as an intermediary
between people who have surplus funds and who save and people who are short of funds
and need money to spend.

Framework:
Deposits

Capital

Loans &
Advances

Efficiency

Labor
Investments

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Another way to measure the efficiency of the banking sector of Pakistan is to look at the
CAMELS ratio and use those ratios in a repression model to generate the efficiency score
CAMELS stands for:
C = Capital adequacy
A = Asset Quality
M = Management soundness
E = Earnings
L = Liquidity
S = Sensitivity to market risk

“S”

“C”

Sensitivity to
market risk

“L”

Capital
adequacy

“A”

Efficiency

Liquidity

Asset
Quality

“E”
Earnings

“M”
Managemen
t
soundness

Indicators:

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Capital adequacy:
CAR ratio, capital/liability ratio
o Total capital/Total liabilities.

Assets Quality:
Earning assets/Total assets or NPL’s/Gross advances
o (Net advance + net investment + money at call) / Total Assets
o Total NPL’s / Total loans(gross)

Management Soundness:
Total expenses to total income or earning per employee
o Total expense / total income
o Total income / total no of employees

Earning and Profitability:
Return on asset or return on equity
o Net profit / total assets
o Net profit / total equity
Liquidity:
Loans to deposits ratio
o Total income / total assets

Sensitivity to market risk:
GAP ratio = RSA-RSL
o Net advances + net investments + money at call – (Deposits + borrowings)

Regression analysis for efficiency using CAMELS ratio:
After calculating the six components of the CAMELS ratios, they would be put in the regression
equation as independent variables and the regression would be run so that the efficiency score
can be found out. The functional form would be:
Efficiency = f(C, A, M, E, L, S)

3.5: Data Collection:

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Financial Sector Reforms and the efficiency of Banking Sector in Pakistan

For DEA analysis, the inputs and outputs used should be coming from the same financial report
(balance sheet or income statements). In the case of this study, for the DEA analysis, I shall focus
on balance sheet items. The inputs and outputs come from the balance sheet of a bank. In the
case of calculation of financial ratios, which would be the CAMELS, the income statement and
balance sheet figures of a bank’s financial report will be used.
For this very reason, secondary data collection technique will be used. The published annual
financial reports will be used, which is a reliable source for data collection. These reports are
available online and with the Lahore Stock Exchange and are made in a standardized format,
published annually, which makes it even more reliable. Data collected will be of four years
(2008-2011).

References:

Khalid, U. (2006). The effect of privatization and liberalization on banking sector

performance in Pakistan. SBP Research Bulletin, 2(2), 1-23.
Burki, S and Ahmad, A. (2011). The impact of bank governance on bank performance in

Pakistan. The Lahore Journal of Economics, 16, 271-300.
RAFAEL LA PORTA, FLORENCIO LOPEZ-DE-SILANES, and ANDREI SHLEIFER.

(2002). Government ownership of banks. American Finance Association, 57(1), 1-38.
AMMARA MAHMOOD and UMAYR LOAN*. (2006). Effects of financial
liberalization on the cost efficiency of pakistani banks a stochastic frontier

approach. Pakistan Economic Social Reform,64(1), 93-116.
A. RAUF BUTT, MEHMOOD-UL-HASSAN and ABDUL RAOO. (1999). Global
privatization trends and associated policies for state-owned enterprises and banking
institutions in Pakistan.Pakistan Economic and Social Review, 37(1), 61-82.

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Hussian, S. W., Ullah, A., Saeed, M., & Rafiq, M. (2012). Banking Industry - Post
Privatization Performance in Pakistan. Banking Industry - Post Privatization

Performance in Pakistan , 41.
Nawab. (n.d.). “The Rapid Growth of Banking Sector in Pakistan and its Impacts on

Revenue Generation” , 12.
Nawab. (n.d.). “The Rapid Growth of Banking Sector in Pakistan and its Impacts on

Revenue Generation” , 14.
Rehman. (2010). Efficiencies of Pakistani Banking Sector: A Comparative Study.

Efficiencies of Pakistani Banking Sector: A Comparative Study , 112.
Rehman, & Raoof. (2010). Efficiencies of Pakistani Banking Sector: A Comparative

Study , 111.
Rehman, & Raoof, A. (2010). Efficiencies of Pakistani Banking Sector: A Comparative
Study , 111.

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