Impact of financial reforms on efficiency of state-owned, private and foreign banks in Pakistan

Abstract

This article uses a unique bank level data from 1991 to 2000 and evaluates how financial reforms affect banking efficiency of domestic and foreign banks in Pakistan. The results suggest that banking efficiency falls during initial reform period when banks adjust to enhanced competition but increases in more advanced stages of reform. While in general foreign and private banks show superior efficiency and factor productivity than do state-owned banks, the relative performance of foreign banks worsens after the consolidation stage of the financial reforms is over. We show the importance of link between bank size, asset quality and bank branches with efficiency indexes and also note that every 10% increase in share of nonperforming to total loans decreases banking efficiency by 6 to 10%.

Acknowledgements

We would like to thank Naim Sipra and Hammad Siddiqui for their comments on a previous draft and Mushtaq Khan for stimulating discussions.

Notes

¹ See Isik and Hassan (2002), Yildirim (2002), Ataullah et al. (2004), Patti and Hardy (2005) and Figueira et al. (2007).

² This classification resembles with Patti and Hardy (2005) who consider a pre-reform period (pre-1993), first-reform period (1993–1997) and second-reform period (1998–2002).

³ We use the definition of SBP (2003) to categorize commercial banks into state-owned, private and foreign banks.

⁴ We do not extend the hypothesis test to PTE and SE because they are obtained by decomposing TE and, therefore, are expected to follow same pattern as TE.

⁵ For similarity, see Elyasiani and Mehdian (1995), DeYoung and Hasan (1998) and Isik and Hassan (2002).

⁶ While the ratio of nonperforming loans to gross advances started rising in the early 1990s, major provisioning for these loans took place in 1996. Before 1996, the banks followed a practice of rescheduling loans (called ‘ever-greening’) that otherwise should have become nonperforming (SBP, 2003).

⁷ A closer examination of banks in the entire study period shows that among 12 top performing banks, all except one are foreign banks. Similarly, from amongst 10 least performing banks, seven banks are state-owned, one is private and two are foreign banks.

⁸ The year 1998 was most eventful in Pakistan's history due to nuclear detonation followed by economic sanctions on Pakistan, forcing the government to freeze the foreign currency accounts in all Pakistani banks in summer 1998.

⁹ For instance, eight private commercial banks started functioning in late 1992 while four more private commercial banks were established in fiscal year 1994–1995 and 1995–1996.

¹⁰ Some of these attributes relate to ‘political intervention, over-staffing, over-branching and inefficiencies’, which have led ‘to the problems of large nonperforming loans, high administrative expenses, huge losses and eroding capital base’ (SBP, 2003).

¹¹ More specifically, foreign banks provided such services as traveler's cheques, credit cards and ATMs, etc. more than a decade ago, while their domestic counterparts were not so quick in responding to these initiatives.