Effect of Privatization

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SBP Research Bulletin Volume 2, Number 2, 2006

OPINIONS

The Effect of Privatization and Liberalization on Banking Sector Performance in Pakistan Umer Khalid∗ 1. Introduction
A well functioning financial system is necessary for enhancing the efficiency of intermediation, which is achieved by mobilizing domestic savings, channeling them into productive investment by identifying and funding good business opportunities, reducing information, transaction, and monitoring costs and facilitating the diversification of risk. This results in efficient allocation of resources, contributing to a more rapid accumulation of physical and human capital, and faster technological progress, which in turn lead to higher economic growth. Anxious to achieve higher growth, policy makers in many developing countries saw public ownership of banks and other financial institutions as necessary in order to direct credit towards priority sectors. It was in this backdrop that the financial sector in Pakistan was nationalized in the early 1970s under the framework of the Banks Nationalization Act 1974. The nationalized domestic banks were consolidated into 6 major national commercial banks and several specialized credit institutions were established1. The objective of the nationalization was to direct bank credit towards specific developing sectors and to provide a source of funding to the government. By the end of the 1980s, it became, however, quite clear that the socio-economic objectives, sought through the nationalization of the banking sector were not being achieved2. Instead, the pre-dominance of the public sector in banking and Non-Bank Financial Institutions (NBFIs), coupled with the instruments of direct monetary control, were becoming increasingly responsible for financial inefficiency leading to the crowding out of private sector investment. The dominance of public sector banks ∗

The author is an Analyst in the Research Department of the State Bank of Pakistan. The author would like to thank Mahmmod ul Hasan Khan for his comments on an earlier draft of the paper. Errors and omissions are the responsibility of the author. Views expressed are those of the author and not of the State Bank of Pakistan. 1 See Bonaccosi di Patti and Hardí (2003). 2 Husain (2004). © 2006 State Bank of Pakistan. All rights reserved. Reproduction is permitted with the consent of the Editor.

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Opinions

at the beginning of the 1990s was apparent with a share of 92.2 percent in total assets (Table 1) of the banking sector. The remainder belonged to foreign banks, as domestic private banks did not exist at that time. Similarly, high shares existed for deposits of the public sector banks. With these characteristics, the banking sector at the end of FY90 did not provide a level playing field for competition and growth. The importance of state owned banks in many developing countries contrasts worryingly with recent research findings, which show that state ownership of banks is with negative effects. Privatization of government owned banks and other liberalization measures introduced were the cornerstone of the financial sector reforms initiated in the early nineties in order to revitalize the 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 setting up of new banks in the private sector with 10 new banks getting licenses to commence their operations in 1991. Consequently, towards the end of 2002, the structure of the banking sector in Pakistan had changed considerably (Table 1) as a result of the privatization/liberalization policies pursued in the broader canvas of financial sector reforms. The share of public sector banks in the assets of the banking system was reduced to just 41 percent by 2002 compared to over 92 percent in 1990, while that of private banks had reached over 45 percent...
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