1. SAARC Finance Governors’ Symposium 2011 (10-11 June, Kumarakom, Kerala) Perspectives on Financial Stability Yaseen Anwar Deputy Governor State Bank of Pakistan

2. Central Bank Goals and Objectives Central banks across the globe are responsible for maintaining price (or monetary) stability as their foremost objective, along with safeguarding the stability of the financial system, whether or not they directly regulate and supervise the financial sector. Two debates which generally exist regarding these primary objectives relate to: – a) the nature of the formal mechanism required to monitor and maintain financial stability; – b) whether these objectives are closely aligned or entail a trade‐off in the associated policy‐response. 2

3. Financial Stability and State Bank of Pakistan State Bank of Pakistan derives its goal of financial stability from its legal mandate, as specified in the State Bank of Pakistan Act, 1956, “…responsible for securing monetary stability and soundness of the financial system”. Financial stability is defined as a situation in which the function of efficient financial intermediation continues without disruptions despite exertion of internal and external shocks, and financial risks are monitored and managed well such that the possibility of systemic crises is minimized. State Bank of Pakistan sees financial stability as an evolving process, as the financial sector adapts itself to the needs of the economy and financial globalization. 3

4. SBP’s Existing Framework for Financial Stability Assessment The mandate for maintaining financial stability in Pakistan rests with the State Bank of Pakistan (SBP) in its capacity as the central bank and the regulator of the banking sector. State Bank of Pakistan views its objective of safeguarding financial stability in the context of smooth and efficient financial intermediation, encompassing financial institutions, financial markets and the financial infrastructure, such that the process can withstand disruptions caused by internal and external events, and potential threats and risks are managed with the objective of minimizing systemic risk. As part of its financial stability assessment mechanism, SBP also undertakes an independent review of the Non‐Bank Financial Companies (NBFCs), the Insurance sector, Pension Funds, and Capital Markets, though these segments of the financial sector are under the oversight of the SECP. 4

5. Asset Composition of the Financial Sector 5 CY02CY03CY04CY05CY06CY07CY08CY09CY10 Asset (bln Rupees)3417.73943.74518.35201.55957.57115.27710.68866.29872.9 Growth Rate (percent)12.315.414.615.114.519.48.415.011.4* As percent of Total Assets MFIs0.1 0.2 NBFIs6.26.67.07.67.88.07.65.34.8 Insurance3.8 3.94.14.64.4 4.1 CDNS24.925.021.718.016.114.614.816.618.6 Banks65.064.567.370.471.972.773.073.572.3 As percent of GDP MFIs0.1 NBFIs4.64.95.25.65.75.95.03.42.8 Insurance2.82.92.82.93.03.42.92.82.4 CDNS18.218.816.113.311.710.89.810.811.0 Banks47.748.350.151.852.453.948.147.642.6 Overall73.375.074.473.772.974.166.064.759.0 * YoY.

6. Impact of GFC on Pakistan As in other Asian countries, there was no direct impact due to – low level of integration with global financial system – No exposure to toxic assets which caused the contagion impact Indirect Impact on economy transmitted through – Trade flows – Rise in commodity prices – Foreign investment flows – Access to internal markets Pakistan already had large macro-economic imbalances in 2007. Slowdown in economic growth impacted the quality of banks’ asset portfolio. 6

7. Broad Objectives of Financial Stability Strengthen both micro prudential and macro prudential regulatory frameworks Increase shock absorbers in the financial system to handle periods of stress Reduce channels of procyclicality Reduce externalities of systemically important financial institutions – inter-connectedness and cross-border resolution Strengthen governance, risk management and transparency of financial institutions – align incentives with prudent longer time outcomes 7

8. SBP’s Framework for Financial Stability On-Site Inspection – CAMELS-S rating system Off-Site Surveillance – CAELS rating system Stress-Testing Financial Soundness Indicators 8

9. SBP’s Framework for Financial Stability SBP follows a well developed framework for the off‐site surveillance and on‐site supervision of banks and DFIs. In doing so, it makes use of the CAELS (Capital Adequacy, Asset Quality, Earnings, Liquidity and Sensitivity) rating system for the off‐site monitoring of banks and DFIs as a key component of its supervisory and stability framework. This system encompasses a temporal and cross‐sectional analysis of financial ratios. The exercise not only helps in identifying key risk areas of banks and DFIs, but also in the efficient use of scarce on‐site supervisory resources. The analysis of CAELS ratios for the (aggregate) banking system is periodically published in the Quarterly Performance of the Banking System (QPR) and annually in the Financial Stability Review (FSR). 9

10. SBP’s Framework for Financial Stability For the on‐site inspection of banks, SBP uses the CAMELS‐S framework (Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, Sensitivity and Systems & Controls) on a regular basis. The key ratios for each component of the framework and their respective benchmarks are specified in the SBP On‐site Inspection Manual. The CAELS framework referred to above, used for off‐site surveillance of banks, is a sub‐set of the CAMELS‐S framework. 10

11. Stress Testing Another notable component of the existing framework is the stress testing exercise conducted on the periodic data received from banks. Stress testing refers to a set of quantitative techniques used to assess the vulnerability of the financial system to exceptional but plausible shocks. Generally, stress testing involves five steps namely: – (1) identifying major risks and exposures in the financial system; – (2) collecting relevant data; – (3) developing scenarios or shocks to be applied; – (4) deciding and implementing the methodology for stress testing; and – (5) calibrating the effect of shocks to the capital, assets and/or profitability of the financial system or individual institutions. 11

12. Stress Testing In recent years, SBP has started to conduct stress testing for all banks on a quarterly basis, the aggregate results of which are published in SBP’s Quarterly performance review of the banking system and henceforth the bi-annual Financial Stability Review. SBP has also issued guidelines on stress testing for commercial banks in Pakistan to enable them to formulate requisite frameworks for the proactive management of risks. The process is currently based on single factor sensitivity analysis, with subsequent refinement and enhancement of scope in process to cover multi‐factor scenario analysis at a later stage. 12

13. Financial Soundness Indicators FSIs are the most widely used set of indicators used to monitor: – (a) the performance of the financial system; – (b) financial system’s vulnerability to various shocks; and – (3) its capacity to absorb losses stemming from the shocks identified. The analysis of FSIs usually includes the examination of temporal and cross‐sectional variation in the indicators and comparative analysis with peer groups. The core set of banking sector FSIs is grouped according to the CAMELS framework. These FSIs are used to quantify information related to the stability or vulnerability of the banking sector. 13

14. Financial Soundness Indicators (%) Indicators200720082009Q1Q2Q3Q4-CY10 CAPITAL ADEQUACY (percent) Risk Weighted CAR12.312.214.013.713.913.814.0 Tier 1 Capital to RWA10.010.111.611.411.711.611.8 Capital to Total Assets10.510.010.110.39.9 9.8 ASSET QUALITY (percent) NPLs to Total Loans7.610.512.613.112.914.014.7 Provision to NPLs86.169.669.970.973.271.166.7 Net NPLs to Net Loans1.13.44.14.23.84.55.4 Net NPLs to Capital5.619.420.420.218.421.826.1 EARNINGS (percent) Return on Assets (After Tax)1.50.80.91.1 1.0 ROE (Avg. Equity & Surplus) (After Tax)15.47.88.911.110.99.99.8 NII/Gross Income68.270.372.474.074.775.674.7 Cost / Income Ratio43.250.151.251.852.653.653.0 LIQUIDITY (percent) Liquid Assets/Total Assets33.628.232.732.434.233.635.0 Liquid Assets/Total Deposits45.137.744.543.745.344.445.9 Advances/Deposits69.775.267.766.463.063.161.4 Financial Soundness Indicators 14

15. Way Forward While the optimal regulatory framework continues to be debated, it is all too true that central banks need to play a key role Operational independence for crisis prevention should be assured, while recognizing that governments will inevitably be involved at the crisis management stage Funding models require a judicious mix of traditional deposit based and wholesale funding Rethink of macroeconomic models Diversifying sources of financing by – Developing capital markets, in particular the corporate debt market – Initiating and promoting a mortgage refinance company to develop the housing market 15