The International Monetary Fund (IMF) conducted an assessment of Pakistan's banking supervision in 2004 and noted that the country has a high degree of compliance with the Basel Core Principles (BCPs) for Effective Banking Supervision. A 2004 report by the State Bank of Pakistan (SBP), the country's banking supervisor, cites the results of the IMF assessment and declares that the SBP is fully compliant with 22 of the 30 BCPs and sub principles; largely compliant with 4 and materially non-compliant with the remaining 4 BCPs. Areas of particular strength, as noted by the IMF, include the SBP's supervisory capacity, risk management of banks, prudential regulations, on-site and off-site supervision, and remedial measures. However, since some reforms of the regulatory structure were recent, their effectiveness could not be sufficiently evaluated by the assessment. According to the IMF, areas of less than full compliance in the legal framework relate to regulator independence, consolidated supervision, and country risk. However, the IMF assessors also concluded that these shortcomings should not pose a significant risk to the banking sector in Pakistan. The 2004 Banking System Review notes that since the IMF assessment, the SBP has become fully compliant with a few more principles and is making substantive progress in other areas and expects to become fully compliant with the remaining principles soon. A more recent ADB report (2008) reiterates the same areas of supervisory shortcomings as those highlighted by the IMF, and states that with the help of a loan and technical assistance from the ADB (during 2008-2010), Pakistan will be addressing them and moving its legal and regulatory framework toward international best practice.

General Overview

The 2007 Article IV consultation report of the International Monetary Fund (IMF) published in 2008 observes a financially sound and highly profitable banking sector, though with limited competition among major banks. Further, "progress has been made in deepening the financial markets and strengthening the soundness and profitability of the banking sector" (p. 3). In 2004, the IMF conducted a Financial System Stability Assessment (FSSA) of Pakistan and published Reports on the Observance of Standards and Codes (ROSC) on banking supervision and securities regulation as well as monetary and financial policy transparency. The FSSA concludes that the Pakistani banking system "has a high degree of compliance with Basel Core Principles [BCP] for Effective Banking Supervision" (p. 12) and that the recent reforms initiated by the State Bank of Pakistan (SBP), the country's banking supervisor, have brought the country "broadly in line with international standards" (p. 12). Areas of particular strength in the SBP's supervisory powers include risk management of banks, prudential regulations, on-site and off-site supervision, and remedial measures. The SBP is also found by the FSSA to have adequate supervisory resources and an enhanced quality of supervisory staff in the years leading to the assessment. However, since some reforms and up gradation of the regulatory structure were recent, their effectiveness could not be sufficiently evaluated by the FSSA. The FSSA does point to certain areas of less than full compliance in the legal framework of supervision in the country. They relate to regulator independence, consolidated supervision, and country risk. However, a comprehensive review of the Banking Companies Ordinance, a key governing law of banks and banking supervision, was underway. The FSSA avers that the completion of the review could potentially "address deficiencies in full compliance of the Basel Core Principles concerning legal provision" (p. 12). Information on the SBP website cites a draft Banking Act of 2006 that would repeal the Banking Companies Ordinance. However, there are no updates on the actual enactment of this Act.

The 2004 Banking System Review published by the Banking Supervision Department (BSD) of the SBP cites the results of the 2004 IMF FSSA and declares that, per the FSSA, the SBP is fully compliant with 22 of the 30 BCPs and sub principles; largely compliant with 4 and materially non-compliant with the remaining four BCPs. However, the report notes that "since the release of [the IMF] assessment SBP has become fully compliant with a few more principles" (p. 96) by applying a capital charge on banks for market risk effective December 2004, and by issuing comprehensive guidelines on country risk. The SBP report also notes that it is making substantive progress in other areas and expects "to become fully compliant with the remaining principles soon" (p. 97). The report, nevertheless, does not clarify the compliance level of Pakistan with respect to each individual BCP.

In the context of the Accelerating Economic Transformation Program (AETP) launched by the Asian Development Bank (ADB) and including loans, technical assistance and a protracted program cluster with four subprograms spanning two years (2008-2010), a report was published by the ADB in September 2008 outlining the reforms that are sought to be implemented by the AETP. Among the three broad areas to be addressed are, per the report, "(i) removal of short-term distortions in the agriculture and energy sectors; (ii) strengthening of financial intermediation; and (iii) development and implementation of a national structural transformation strategy" (p. iii). To ensure the strengthening of financial intermediation, the ADB comments, Pakistan needs to tighten its legal and regulatory framework of financial supervision so as to achieve risk mitigation and management, consumer confidence in the banking sector, and increased access to financial intermediation. Other important areas for improvement include the enhancement of autonomy and governance of the SBP and improvement in consumer and depositor protection. With this in mind, the target of the AETP is to enact and implement a new Banking Act and a new SBP Act by 2009; and a new Consumer Protection Law and a Deposit Protection Law by 2010.

Elaborating on the progress made on these fronts in Subprogram 1, the 2008 ADB report states that a new Banking Act has been drafted to align it with international best practices. The minimum capital requirements have been raised to move closer to Basel II. A 10-year financial sector strategy work has been launched by the SBP "to broaden and diversify financial markets while developing supportive financial safety nets, safeguards for consumer protection and effectively fighting against money laundering and financial crimes" (p. 84). Legislative amendments enabling a consolidated supervisory framework, allowing the SBP to be the lead supervisor of financial groups and conglomerates in compliance with BCP 24, and transferring the licensing, regulation and supervision authority of deposit-taking institutions to the SBP have been approved by the Cabinet. The country's anti-money laundering legal framework will be strengthened to assimilate international standards and best practices. As for the autonomy and governance of the SBP, the Subprogram 1 initiated work on a new SBP Act to grant greater autonomy and accountability to the SBP in its monetary and financial policies, make its regulatory and supervisory oversight of financial institutions more effective, and clarify its role as a lender of last resort and in safety net arrangements. A Consumer Protection Department has also been established in the SBP and work started in drafting a Consumer Protection Law. Lastly, a draft law and concept paper on the setting up of a Deposit Protection Scheme has been prepared and published for stakeholder consultation.

The report does acknowledge that even prior to the AETP, Pakistan had taken steps to develop its banking sector through substantial deregulation, transformation of the sector from a predominantly state-owned system to a largely private-owned market-based system, and ensconcing the SBP as a more responsive and independent regulator. Further indication of its reforms is the increasing consolidation of the banking sector and the formation of fewer but stronger banks. Financial conglomerates are becoming the norm, with broadened product offerings, cross-selling and involvement in other financial as well as non-financial activities such as investment banking, insurance, leasing, advisory, and brokerage services. According to the ADB Pakistan also continues to systematically revise and update its legal and regulatory framework to balance growth and depth of the sector with stability and to keep in line with best international practices. The most recent challenge arises from the implementation of Basel II for which risk management practices at many banks will need to be improved.

Particularly given the increasing conglomeration, risk monitoring has become difficult and faces conflicts of interest and political contagion. There are also risks of double counting of capital, large exposures, and transfer of losses from banks to the less regulated nonbank financial affiliates to avoid scrutiny. Another shortcoming that the ADB finds in the regulatory structure is its fragmentation and arbitrage. It notes an "awkward separation of powers between SBP and the Securities and Exchange Commission of Pakistan (SECP)" (p. 12). While the former regulates banks, development financial institutions, microfinance banks, and exchange companies, the latter regulates non-bank finance companies (NBFC). Therefore, while the banks can perform NBFC functions through separate subsidiaries, the affiliates will be supervised by the SECP. There are, however, only 8 investment banks in Pakistan and they hold less than 1 percent to the financial sector assets, with banks making quick inroads in the NBFC sector with more and more consolidation. However, investment banks can still use the term "bank" in their names and it creates confusion in the depositors' minds as to the SBP's oversight role.

The 2006 SBP report provides information on steps taken by the SBP to achieve consolidated supervision, especially in the context of the liberalization of the financial sector, burgeoning mergers and acquisitions, business diversification of banks, cross-ownership of institutions and between sectors, conglomerations, and increasing foreign ownership of banks in Pakistan. The report notes that the SBP interacts closely with the Securities and Exchange Commission of Pakistan (SECP) on a regular basis for coordination in the supervision and regulation of financial conglomerates. The SBP has also signed memoranda of understanding (MoUs) with fifteen central banks and foreign supervisors to achieve home-host supervisory cooperation and information exchange. Summing up, the Banking System Review observes that though overall resilience of the banks has improved and this robustness is shared by a majority of banks, there are contributing risk factors aggravated by aggressive lending practices of banks. However, the Review notes that these trends do not pose a significant risk to banking sector stability in the short term. Moreover, "the deceleration in credit growth, close monitoring of incremental NPLs, and the growing emphasis on internal control and risk management systems" (p. 83) as also "the on-going implementation of Basel II, increased minimum capital requirements and mergers & acquisitions are expected to play a key role in improving the stability of banking sector" (p. 83), notes the 2006 Banking System Review.

The SBP is established as the supervisory, regulatory and licensing authority for the banking sector - comprised of banks as well as designated non-bank financial companies (NBFCs) - under the Banking Companies Ordinance. Other pertinent laws and regulations that have a bearing on banking supervision in Pakistan, per the 2004 IMF FSSA, and that govern the banking sector participants are the State Bank of Pakistan Act, 1956 (as amended), the Banks (Nationalization) Act of 1974, the Financial Institutions (Recovery of Finances) Ordinance of 2001, the 1984 Companies Ordinance, and Statutory Regulatory Orders (SROs). Furthermore, as the 2004 FSSA notes, reforms initiated since 1997 have provided greater impetus to the legal, business, and accounting framework that encompass banking supervision and its participants. One of the most notable reforms has been the enactment in 2001 of the SBP Banking Services Corporation Ordinance to separate the core functions of the SBP from its non-core functions and vesting the latter in a separate, newly-created subsidiary of the SBP, the SBP Banking Services Corporation. The FSSA further observes that the transparency practices with regard to banking supervision generally follow international best practices. Overall, "the institutional framework and objectives of the SBP...are clearly defined in the Banking Companies Ordinance 1962, SBP Act 1956 and Companies Ordinance 1984" (p. 48). Also, "the policies and process of policymaking are well-defined and transparent. Various departments of SBP devise policies relating to their function" (p. 49).

The 2006 Banking System Review published by the SBP provides an overview of the banking sector as it performed in the financial year 2006 and the first half of 2007. It states that "as the predominant source of financing, the banking sector in Pakistan continued to support the financing needs of a burgeoning economy" (p. 71). Bank loans increased by a sustainable 20 percent whereas the repayment capacity of the customers strengthened due to a strong economy. Asset quality has also improved significantly, going by the non-performing loans (NPL) ratios at banks. In addition, capital adequacy and profitability strengthened in 2006 and maintained their levels in 2007. Overall financial soundness indicators and stress testing exercises reveal a robust and resilient banking sector. The ownership of the banking sector has witnessed a shift from the public sector and foreign ownership to that of local private banks. As of 2006, the latter owned 72.9 percent of banking assets in Pakistan, notes the Banking System Review. The banking sector is also more consolidated now and this trend implies that its stability is dependent on a few large banks controlling a majority of assets and deposits. The ten largest banks controlled 74.2 percent of the assets and 77.8 percent of the deposits of the sector as of June 2007. In terms of the concerns facing the industry the Banking System Review cites maturity mismatches, need for consolidated supervision, and the status of risk management systems at banks.

The 2005 IMF report titled "Pakistan - Financial Sector Assessment Program - Technical Note - Condition of the Banking System" mentions the efforts in Pakistan to promote Islamic banking services. The SBP exempted Islamic commercial banks from the ban on opening new branches as a result of which the first full-fledged Islamic bank (Meezan Bank) was established in 2002. Conventional banks also opened new branches that exclusively provide Islamic banking services to customers. Further, the SBP was developing prudential regulations for Islamic banks with an aim of aligning them with the accounting and auditing standards recommended by Accounting and Auditing Organization for Islamic Financial Institution, Bahrain and international best practices. Islamic banks were envisaged to be subject to conventional banking regulations as well as additional Islamic banking requirements.

The Principles

1. (1) Clear responsibilities and objectives for each supervisory agency.

II

The SBP is established as the supervisory, regulatory and licensing authority for the banking sector - comprised of banks as well as designated NBFCs - under the Banking Companies Ordinance. Other pertinent laws and regulations that have a bearing on banking supervision in Pakistan, per the 2004 IMF FSSA, and that govern the banking sector participants are the State Bank of Pakistan Act, 1956 (as amended), the Banks (Nationalization) Act of 1974, the Financial Institutions (Recovery of Finances) Ordinance of 2001, the 1984 Companies Ordinance, and Statutory Regulatory Orders (SROs). Furthermore, as the 2004 FSSA notes, reforms initiated since 1997 have provided greater impetus to the legal, business, and accounting framework that encompass banking supervision and its participants. One of the most notable reforms has been the enactment in 2001 of the SBP Banking Services Corporation Ordinance to separate the core functions of the SBP from its non-core functions and vesting the latter in a separate, newly-created subsidiary of the SBP, the SBP Banking Services Corporation. The FSSA further observes that the transparency practices with regard to banking supervision generally follow international best practices. Overall, "the institutional framework and objectives of the SBP...are clearly defined in the Banking Companies Ordinance 1962, SBP Act 1956 and Companies Ordinance 1984" (p. 48). Also, "the policies and process of policymaking are well-defined and transparent. Various departments of SBP devise policies relating to their function" (p. 49). The 2008 ADB report, however, notes an "awkward separation of powers between SBP and the Securities and Exchange Commission of Pakistan (SECP)" (p. 12). While the former regulates banks, development financial institutions, microfinance banks, and exchange companies, the latter regulates NBFCs. Therefore, while the banks can perform NBFC functions through separate subsidiaries, the affiliates will be supervised by the SECP. There are, however, only 8 investment banks in Pakistan and they hold less than 1 percent to the financial sector assets, with banks making quick inroads in the NBFC sector with more and more consolidation. However, investment banks can still use the term "bank" in their names and it creates confusion in the depositors' minds as to the SBP's oversight role. The above reports notwithstanding, there is no explicit rating for Pakistan against this principle.

1.(2) Operational independence and adequate resources.

II

The 2004 IMF FSSA notes that as a result of post-1997 reforms, the supervisory power of the SBP has been strengthened and its independence has been enhanced. However, some curtailments remain in terms of the power of the Federal Government to issue directions to the SBP in certain circumstances. For instance, under the State Bank of Pakistan Act, the government may direct the SBP to purchase, hold and sell shares or debentures of any banking company, financial corporation or institution. In addition, if the Federal government deems that the SBP fails to carry its obligations under the Act, the former can supersede the latter, and transfer its powers and supervisory jurisdiction under the Act to another agency as it finds fit. The FSSA also observes an apparent conflict of interest in the SBP's role as regulator and its role as owner of nationalized commercial banks, since the SBP continues to remain the majority shareholder of those banks though some of these banks have since been partially privatized. The FSSA, therefore, recommends Pakistan to remove those sections of the State Bank of Pakistan Act that curtail the SBP's autonomy. The Pakistani authorities' response to this recommendation is that they are in the process of strengthening the SBP's autonomy, as called for in the assessment. This step is being undertaken in the framework of the Banking Law Review Commission's review of the country's banking regulatory set-up. Though not referring directly to the Commission's review, the 2007 IMF Article IV consultation report notes that measures taken recently by the SBP "constitute an important step in the direction of...increasing the operational independence of the central bank" (p. 17). The 2008 ADB report also attests that in the context the Subprogram 1 of the ADB's AETP, Pakistan has initiated work on a new SBP Act to grant greater autonomy and accountability to the SBP in its monetary and financial policies, make its regulatory and supervisory oversight of financial institutions more effective, and clarify its role as a lender of last resort and in safety net arrangements. Nevertheless, none of the information provided above directly addresses Pakistan's compliance with this principle.

1.(3) A suitable legal framework for authorization and ongoing supervision.

II

The SBP is established as the supervisory, regulatory and licensing authority for the banking sector - comprised of banks as well as designated NBFCs - under the Banking Companies Ordinance. The 2004 IMF FSSA observes that "the SBP has made progress toward establishing a bank supervision system at the level of international best practice and achieves a degree of compliance with most of the Core Principles" (p. 28). The SBP has exclusive and extensive authority to license, supervise and inspect all institutions" (p. 30). The notable gap that the FSSA notices in this supervisory framework is that financial entities within the same group but performing distinct functions, such as banking or investment banking or leasing, are subject to supervision from different functional supervisory authorities, jeopardizing consolidated supervision of the financial entity as a whole. The FSSA, therefore, recommends providing explicit power to the SBP in the Banking Companies Ordinance to share supervisory information with other domestic and foreign supervisory authorities. As for the SBP's licensing powers, the 2007 SBP report states that both the Banking Companies Ordinance and the State Bank of Pakistan Act provide the legal framework for licensing of bank branches. Further, the SBP has introduced a comprehensive branch licensing policy under the Banking Companies Ordinance in 2006-2007 to enhance banking coverage and increase bank outreach in rural and remote parts of the country. The policy allows banks to open branches in the areas they prefer within broad parameters and provided they meet the SBP's capital and risk management criteria. Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

1.(4) A suitable legal framework to address compliance with laws as well as safety and soundness concerns.

II

The SBP has extensive and exclusive powers to supervise and inspect banking institutions, per the 2004 IMF FSSA. Further, it has the power to set and enforce prudential safety and soundness standards and regulations. The SBP has adequate staff and infrastructure to conduct comprehensive off-site and on-site supervision of the licensed banking entities. However, there is insufficient information publicly available as to Pakistan's compliance with this principle.

1.(5) Legal protection for supervisors.

II

As the 2004 IMF FSSA states, "the legal protection normal for employees of a bank regulator performing their functions in good faith is present in the Pakistan legislation" (p. 30). However, there is insufficient information publicly available as to Pakistan's compliance with this principle.

1.(6) Arrangement for sharing of information between supervisors and protection of confidentiality of shared information.

II

There is insufficient information publicly available as to Pakistan's compliance with this principle. The 2004 IMF FSSA recommends providing explicit power to the SBP in the Banking Companies Ordinance to share supervisory information with other domestic and foreign supervisory authorities.

2. Clearly defined permissible activities for banks and control of the use of the word 'bank'.

II

As the 2004 IMF FSSA observes, "the BCO [Banking Companies Ordinance] defines permissible activities of 'banking companies' and the term 'banking' itself, and all institutions using the term 'bank' and its derivatives must be regulated by the SBP or companies specifically authorized by the SBP to do so" (p. 30). Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

3. Criteria for structure, directors, operating plan, controls, financial condition and capital base.

II

Per the 2004 IMF FSSA, "criteria for establishing banks and approving the scope of their operations address the appropriate considerations" (p. 30). Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle. As the 2007 SBP annual report mentions, the SBP has amended its Code of Corporate Governance to strengthen its fit and proper test criteria for the Board of Directors, CEOs/Presidents, and other key management officials of banks and designated NBFCs and to spell out their respective responsibilities.

4. Authority to review and reject transfer of ownership.

II

The 2004 IMF FSSA finds that the SBP has the authority to review and approve potential significant acquisitions by banks as also their acquisition of a significant shareholder interest in an established bank so as to evaluate the risks associated with such acquisitions both to the supervisor and the supervised. However, as the FSSA notes, the banks are not required by law to bring any significant incorporation to the SBP's attention or to seek its approval of the same. In practice, though, the banks do apprise the SBP inspectors of their intent to such acquisitions so as to elicit their response to such a move and to make them abreast of the changes in their business strategies as a result of such a move. The law does indeed require banks to submit to the SBP their proposals for acquisitions of a significant shareholder interest in an existing bank for its review and approval of the same. Despite the conclusions drawn in the FSSA, there is insufficient information publicly available as to Pakistan's compliance with this principle.

5. Authority to review major acquisitions and investments.

EN

The 2004 IMF FSSA finds that the SBP has the authority to review and approve potential significant acquisitions by banks as also their acquisition of a significant shareholder interest in an established bank so as to evaluate the risks associated with such acquisitions both to the supervisor and the supervised. However, as the FSSA notes, the banks are not required by law to bring any significant incorporation to the SBP's attention or to seek its approval of the same. In practice, though, the banks do apprise the SBP inspectors of their intent to such acquisitions so as to elicit their response to such a move and to make them abreast of the changes in their business strategies as a result of such a move. The law does indeed require banks to submit to the SBP their proposals for acquisitions of a significant shareholder interest in an existing bank for its review and approval of the same. The FSSA recommends that regulations requiring banks to seek the SBP's review and approval of proposed investments in a subsidiary domestically or abroad be put in place, and also that the criteria by which the SBP approves or rejects such proposals be established. In response, the Pakistani authorities state that the Banking Companies Ordinance is supplemented by SBP Circular No. 7 and another SBP guideline issued in 2003 in requiring banks to exercise due diligence in matters of mergers and in setting up subsidiaries. The 2003 SBP Banking System Review points out that "the requirements of CPs [core principles] regarding licensing criteria are fully complied with while issuing licenses to newly merged or acquired banks" (p. 66). Nevertheless, as the FSSA points to certain deficiencies in regards to Pakistan's compliance with this principle and the 2003 SBP Banking System Review is a self assessment, it is fair to conclude that Pakistan complies with this principle, albeit with certain shortcomings.

6. Minimum capital adequacy requirements (meet Basle Capital Accord for internationally active banks).

II

Per information on the SBP website, "the Banking Companies Ordinance had been amended in 1997 which empowers the State Bank to prescribe capital requirements for banks. In exercise of these powers the State Bank has laid down Minimum Capital Requirements for banks based on Basel capital structure." The 2004 IMF FSSA indicates that the SBP has issued appropriate prudential regulations for banks. However, "market risk related computations and capital charges are not in force" (p. 30) in Pakistan. Risk weighted capital adequacy requirements are in place and are applied on both a solo and a consolidated basis. A majority of banks also follow these requirements and their capital adequacy ratios were above the minimum requirement. The FSSA observes that "amendment to the BCO [Banking Companies Ordinance] to establish and enforce a Minimum Continuing Capital Requirement (MCCR) for banks (PRs [Pakistani Rupees] 1 billion--about US$17.4 million), a risk-weighted capital adequacy ratio (in excess of 8 percent) and strict enforcement of Prudential Regulations have led to re-capitalization and consequent improvement in the health of the banking system" (p. 29). The 2005 IMF FSSA - Technical Note adds that the Islamic banks are subject to the same capital adequacy requirements as conventional banks, although "for the musharakah contracts the measurement of the capital is an outstanding issue" (p. 16). The report noted that the Islamic Banking Department was working on the matter. The SBP also envisaged the reduction in banks that fell below the minimum capital threshold with the expected merger of several small banks. The 2007 SBP annual report states that a comprehensive Roadmap for implementation of Basel II was issued in 2006 to refine the banks' risk management structures. The Roadmap lays down new capital requirements that incorporate a capital charge for operational risk in addition to credit and market risks. In an attempt to smoothen the process of Basel II implementation in Pakistan, the SBP and its supervised banks have embarked on a capacity building exercise.. Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

7. A method exists for the evaluation of procedures related to loans, investments and portfolio management.

II

The 2004 IMF FSSA indicates that the SBP has issued appropriate prudential regulations for banks. Specifically with respect to this principle, the SBP has issued rules instructing the banks and laying down requirements on their credit and investment policies and procedures and the internal control systems to be put in place. These rules provide "substantive guidance for bank operations" (p. 31) in this area. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

8. Policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves.

II

The 2004 IMF FSSA indicates that the SBP has issued appropriate prudential regulations for banks. Specifically with respect to this principle, the SBP has issued directives establishing asset classification and provisioning policies and procedures for banks and they provide "substantive guidance for bank operations" (p. 31) in this area. The 2005 IMF report adds that banks in Pakistan normally do not write off their bad loans "out of concern that this would compromise their legal position in pursuing loan recovery" (p. 8). The SBP also issued in 2002 its write-off guidelines for banks to guide them in clearing their old non-performing loans. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

9. Prudential limits and management information system on concentration of exposure.

II

The 2004 IMF FSSA indicates that the SBP has issued appropriate prudential regulations for banks. Specifically with respect to this principle, the SBP has issued directives establishing policies and procedures related to concentration of exposure and they provide "substantive guidance for bank operations" (p. 31) in this area. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

10. Arm's length rule and monitoring for connected lending.

II

The 2004 IMF FSSA indicates that the SBP has issued appropriate prudential regulations for banks. Specifically with respect to this principle, the SBP has issued directives establishing policies and procedures related to connected lending and they provide "substantive guidance for bank operations" (p. 31) in this area. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

11. Policies and procedures for country risk and transfer risk.

II

As the 2004 IMF FSSA finds, Pakistan is "in less than full compliance of supervisory standards that relate to" (p. 12) provisions for country risk. However, the FSSA does not raise much concern over this issue as a major risk to the banking sector stability since de facto compliance by banks is high. Nonetheless, the FSSA recommends Pakistan to "consider issuing guidelines setting out requirements that banks have information and management systems that allow for proper identification, monitoring and controlling of country and transfer risk" (p. 34). The Pakistani authorities respond by stating that since banks do not have extensive exposure to, and have other limitations on, international investment; this issue is not of particular concern. The 2004 ABP report, nevertheless, notes that since the IMF's 2004 assessment, comprehensive guidelines on country risk have been issued. Nonetheless, there is insufficient information publicly available as to Pakistan's compliance with this principle.

12. Measuring and monitoring market risk. Limit and/or specific capital charge on market risk exposure.

II

The 2004 IMF FSSA notes that the SBP has provided guidance to banks on measuring and monitoring market risk and was assessing in its 2004 on-site inspections whether the banks had in place risk management processes especially with regard to market risk and other material risks. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

13. Comprehensive risk management processes.

II

The 2004 IMF FSSA notes that the SBP has provided guidance to banks on measuring and monitoring market risk and was assessing in its 2004 on-site inspections whether the banks had in place risk management processes especially with regard to market risk and other material risks. The 2005 IMF report further notes that Islamic banking institutions are not subject to any specific risk management requirements given their enhanced risks in addition to the risks associated with conventional banking since they share risks to their profit with their customers. The 2007 SBP annual report states that a comprehensive Roadmap for implementation of Basel II was issued in 2006 to refine the banks' risk management structures. The Roadmap lays down new capital requirements that incorporate a capital charge for operational risk in addition to credit and market risks. In an attempt to smoothen the process of Basel II implementation in Pakistan, the SBP and its supervised banks have embarked on a capacity building exercise. This includes upgrading the IT systems of banks to enable regulatory reporting as required by the Basel II disclosure requirements, and enhancing their expertise through seminars and workshops conducted by the SBP on the Basel II Accords. Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

14. Adequate internal controls.

II

The 2004 IMF FSSA projects a positive view of the internal control measures in the Pakistani banking sector. It states that the SBP "pays close attention to the membership of a bank's policy and executive bodies, the procedures for making decisions and delegating powers, the quality of internal control and the resources made available for it and the practical procedures for informing the decision making body" (p. 31). The 2003 SBP Banking System Review also notes that the SBP "has been promoting a good corporate governance culture and internal control environment within the banking industry through frequent interaction with the industry" (p. 66). It also states that the SBP has issued Internal Control Guidelines "to provide the banks with model approach towards achieving robust internal controls" (p. 66). Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

15. Strict "know-your-customer" rules and high ethical and professional standards.

II

Per the 2004 IMF FSSA, there are no laws that "specifically and comprehensively" (p. 31) address money laundering and terrorist financing in the country. However, Pakistan is working on a draft law that promises to comprehensively define money laundering and incorporate international best practices in the areas of money/laundering and terrorist financing, avers the FSSA. In addition, the SBP has also issued two prudential regulations pertaining to "Know Your Customer" and "Anti-Money Laundering Measures."

In this context, the 2008 ADB report also attests that Pakistan is committed to implement legal and institutional measures to meet the Financial Action Task Force (FATF) 40+9 Recommendations on Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT). The range of efforts include joining the Asia/Pacific Group on Money Laundering that supports the implementation of the FATF 40+9 in the region, the adoption of the Anti-Money Laundering Ordinance in September 2007, and the establishment of a financial intelligence unit, the Financial Monitoring Unit (FMU) within the SBP. However, the ADB calls for more improvements in the regime, noting that the supervisory structure is cumbersome and that the FMU lacks operational autonomy. The SBP provides interim budget support and administrative oversight to the FMU.

Regarding customer due diligence, the 2008 U.S. Department of State (DoS) report states that the SBP has introduced anti-money laundering (AML) regulations that are generally compliant with Financial Action Task Force (FATF) recommendations pertaining to "'know your customer' and enhanced due diligence procedures, record retention, the prohibition of shell banks, and the reporting of suspicious transactions." However, the report does not specify the extent of this compliance. On suspicious transaction reporting, the U.S. DoS report observes that the Anti-Money Laundering Ordinance promulgated in 2007 stipulates publishing suspicious transaction reports (STRs) on money laundering. However, the report cites two key inadequacies of the Anti-Money Laundering Ordinance. For example, "the definition of what constitutes a suspicious transaction is not adequate as it does not cover cases where an individual 'suspects' or 'has reason to suspect' that funds are the proceeds of criminal activity." Also, the Anti-Money Laundering Ordinance does not require the filing of STRs concerning terrorist financing.

According to the 2008 U.S. DoS report, the Anti-Money Laundering Ordinance of 2007 created the Financial Monitoring Unit (FMU) to perform the typical duties of a financial intelligence unit (FIU), namely to collect, analyze and disseminate all STRs submitted by entities subject to the Anti-Money Laundering Ordinance. The U.S. DoS report also states that, from July 2006 through June 2007, the FMU received 22 STRs from various banks. The FMU subsequently sent five of these STRs to law enforcement agencies for further investigation. The report primarily attributes the relative paucity and limited utilization of STRs to Pakistan's lack of a central repository for the reporting of STRs. The SBP and the SECP serve as Pakistan's primary financial regulators, and both are equipped with AML units even though, according to the U.S. DoS report, these units "often lack defined jurisdiction and adequate resources to effectively supervise the financial sector on AML/CTF [anti-money laundering/combating the financing of terrorism] controls." Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

16. Effective supervisory system consisting of on-site and off-site supervision.

II

Per information on the SBP website, "in consonance with the responsibilities envisaged under the Core Principles recommended by the Basle Committee, the On-Site examination capabilities at the State Bank of Pakistan have been substantially augmented to bring them at par with the expected international standards." The SBP has four supervisory departments, as reported by the 2004 IMF FSSA. They are the Banking Supervision Department (BSD), the Bank Inspection Department (BID), the Banking Policy (and Regulations) Department (BPD), and the Islamic Banking Department. The BSD has an off-site Monitoring Division that assesses the stability and soundness of individual banks and the banking system as a whole providing an early warning system to identify areas for prompt corrective action. A pre-inspection package, consisting of periodic financial statements of banks analyzed and computed into statistical reports along with commentary, is thus prepared for on-site inspectors highlighting areas to be addressed during inspections. Further, the Risk Management Division monitors the various risks inherent in the business lines, product portfolios and business strategies of different banks as well as aggregate risks in the banking sector as a whole, notes the 2004 FSSA. It also monitors capital adequacy, liquidity reserves, and the sensitivity of such capital and reserves to various scenarios, and issues guidelines to the supervised banks on the development of a risk management framework. The BID conducts both comprehensive and targeted inspection of entities in close consultation with the BSD under the standardized inspection procedures laid down in the comprehensive inspection manual of 1999. As for Islamic banks, the 2007 SBP annual report mentions that the SBP has revised the format for their inspection reports and added a component titled "Shariah Compliance" to bring them in line with the Shariah Manual. Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

17. Regular contact with bank management and understanding of bank's operations.

II

As the 2004 IMF FSSA notes, the SBP does not maintain regular contact with bank management as part of its on-site and off-site supervision. However, it does meet with bank officials as and when required. The meetings with senior management normally occur every 12 to 18 months and are held at the close of the on-site inspections. Meetings with the Boards of Directors are less frequent and are held on a need basis. However, as the FSSA records, the SBP has established a practice in January 2004 whereby meetings are to be held annually and more frequently if the bank gets an unsatisfactory rating after an on-site inspection. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

18. Analytical reports and statistical returns on solo and consolidated basis.

II

The 2004 IMF FSSA notes that the SBP is fully authorized under the law to request any information it deems necessary from the supervised banks to carry out effective supervision. The banks are required to submit different prudential reports on an unconsolidated basis to the Monitoring Division of the SBP that scans the submissions for accuracy before they proceed for full supervisory analysis. In 2004, the SBP was almost ready to introduce electronic submission of prudential data by banks, per information in the FSSA. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

19. Independent validation of supervisory information through on-site examination or external auditors.

II

The SBP "has the legal right of full access to all bank records or information" (p. 32), observes the 2004 IMF FSSA. The SBP can also make use of external auditor reports to supplement its off-site supervision. Licensed banks are obliged to submit audited financial statements. The SBP approves auditors by means of establishing a panel of auditing firms deemed capable of auditing three categories of banks. Nevertheless, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

20. Ability to supervise on a consolidated basis.

NC

The 2004 IMF FSA finds that "consolidated supervision has yet to be developed in Pakistan" (p. 32). Legal provisions for consolidated supervision have also been cited by the FSSA as one of the "areas of less than full compliance of supervisory standards" (p. 12). The FSSA, therefore, recommends Pakistan to develop proper legislative basis to enable effective consolidated supervision by the SBP, including the power to exchange confidential supervisory information with other domestic authorities and foreign host supervisors. The 2006 SBP report provides information on steps taken by the SBP to achieve consolidated supervision, especially in the context of the liberalization of the financial sector, burgeoning mergers and acquisitions, cross-ownership of institutions and between sectors, conglomerations, and increasing foreign ownership of banks in Pakistan. The report notes that the SBP has interacts closely with the SECP on a regular basis for coordination in the supervision and regulation of financial conglomerates. The SBP has also signed MoUs with fifteen central banks and foreign supervisors to achieve home-host supervisory cooperation and information exchange.

21. Consistent accounting policies and practices that provide a true and fair view of the financial condition of the bank.

II

Per the 2004 IMF FSSA, "accounting and auditing standards are of a high and internationally acceptable quality" (p. 38). Further, accounting standards and practices are modified as required for application to Islamic institutions. According to a 2007 Institute of Chartered Accountants of Pakistan (ICAP) presentation, accounting standards adopted by the ICAP would be applicable in accordance with the three tiers of corporate entities. Tier one companies comprising public interest entities must comply with International Financial Reporting Standards (IFRSs) by 2009. They include listed companies, public utilities, unlisted banks and large companies that meet certain size criteria. Further, the ICAP has adopted all but IFRS 1 and IFRS 4. A few other international standards although adopted are pending approval of the SECP. Earlier, in a 2005 assessment of accounting and auditing practices in Pakistan, the World Bank commended Pakistan for making progress in aligning national accounting requirements with IFRSs. Nonetheless, the World Bank as well as the ICAP presentation identify certain hindrances to the full adoption of international standards.

Per the 2005 ROSC, the SBP regulates financial reporting by banks and similar financial institutions in accordance with the Banking Companies Ordinance. In addition to the requirements laid out in the Companies Ordinance, the Banking Companies Ordinance outlines the supplementing accounting and auditing requirements. At the time of the 2005 assessment, the World Bank observed that "due to the exemption granted to financial institutions from the applicability of [certain standards set forth by the IFRS] these formats are deviating from full compliance with IFRSs" (p. 4). Furthermore, the report pointed out that the SBP's Banking Supervision Department needs to improve monitoring and enforcement of accounting and financial reporting requirements. Despite the information provided in the above mentioned reports, none of these said reports provides an explicit rating for Pakistan against this principle.

22. Adequate supervisory measures to ensure timely corrective action.

II

The SBP has a "wide range of corrective measures" under the State Bank of Pakistan Act and the Banking Companies Ordinance to discipline a bank that fails in its safety and soundness concerns or fails to comply with the Banking Companies Ordinance or other SBP prudential regulations, as noted by the 2004 IMF FSSA. Corrective measures include imposing directives, levying monetary penalties on the bank or its management, replacing directors or senior managers, seizing the bank's business license, imposing a moratorium on operations until its restructuring, and initiating a winding-up order. However, other than descriptive information, the 2004 FSSA does not explicitly address Pakistan's compliance with this principle.

23. Banking supervisors must practice global consolidated supervision over their internationally-active banking organizations.

II

As noted by the 2004 IMF FSSA, the SBP does have the power to supervise the international operations of the domestically licensed banks. However, these inspections are rare owing to the limited nature of such activities by locally incorporated banks as well as the costs involved with such inspections. The IMF, therefore, recommends in the FSSA, explicit provision of authority to the SBP to conduct consolidated supervision, both domestically and abroad. The 2006 SBP report provides information on steps taken by the SBP to achieve consolidated supervision, especially in the context of the liberalization of the financial sector, burgeoning mergers and acquisitions, cross-ownership of institutions and between sectors, conglomerations, and increasing foreign ownership of banks in Pakistan. The report notes that the SBP has signed MoUs with fifteen central banks and foreign supervisors to achieve home-host supervisory cooperation and information exchange. Further, as the 2008 ADB report attests, legislative amendments enabling a consolidated supervisory framework and allowing the SBP to be the lead supervisor of financial groups and conglomerates in compliance with BCP 24 have been approved by the Cabinet. However, other than descriptive information, the reports do not explicitly address Pakistan's compliance with this principle.

24. International exchange of information with other supervisors.

II

The SBP is not empowered under either the Banking Companies Ordinance or the State Bank of Pakistan Act to share confidential supervisory information with other government authorities or with foreign supervisory authorities overseeing the overseas operations of Pakistani banks, the 2004 IMF FSSA observes. The 2006 SBP report notes that the SBP has signed MoUs with fifteen central banks and foreign supervisors to achieve home-host supervisory cooperation and information exchange. Further, as the 2008 ADB report attests, legislative amendments enabling a consolidated supervisory framework and allowing the SBP to be the lead supervisor of financial groups and conglomerates in compliance with BCP 24 have been approved by the Cabinet. Nevertheless, there is insufficient information publicly available regarding Pakistan's compliance with this principle.

25. Supervision of local operation of foreign banks and information sharing with home country supervisors.

II

Per the 2004 IMF FSSA, "local branches of foreign banks are subject to the same prudential, inspection, and reporting requirement as domestic banks" (p. 33). The 2006 SBP report notes that the SBP has signed MoUs with fifteen central banks and foreign supervisors to achieve home-host supervisory cooperation and information exchange. Nevertheless, there is insufficient information publicly available regarding Pakistan's compliance with this principle.