Financial Sector Inter Mediation Loan in Pakistan

8/2/2019 Financial Sector Inter Mediation Loan in Pakistan

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ASIAN DEVELOPMENT BANKOperations Evaluation Department

PROJECT PERFORMANCE AUDIT REPORT

FOR

PAKISTAN

In this electronic file, the report is followed by the Management response.


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Project Performance Audit Report

PPA: PAK 23341(Final)

Financial Sector

Intermediation Loan

(Loan 1371-PAK)

in Pakistan

July 2005

Operations Evaluation Department

Asian Development Bank


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CURRENCY EQUIVALENTS

Currency Unit Pakistan rupee (PRe/PRs)

At Appraisal At Project Completion At Operations Evaluation(June 1995) (October 2001) (October 2004)

PRe1.00 = $0.03225 $0.01752 $0.01658$1.00 = PRs31.01 PRs57.08 PRs60.30

ABBREVIATIONS

ADB Asian Development BankBEL Bankers Equity LimitedBSAL Banking Sector Adjustment LoanCDR credit to deposit ratioCLA Corporate Law AuthorityCMDP Capital Market Development ProgramCOS country operational strategyDFI development finance institutionDLC Dawood Leasing Company LimitedEA executing agency

EFS export finance schemeELL English Leasing LimitedESAF Enhanced Structural Adjustment FacilityFED foreign exchange depositFSDIP Financial Sector Deepening and Intermediation ProjectFSIL Financial Sector Intermediation LoanFX foreign exchangeGDP gross domestic productICP Investment Corporation of PakistanIMF International Monetary FundLIBOR London interbank offered rateMOC Ministry of Commerce

MOF Ministry of FinanceNBFC nonbanking finance companyNBFI nonbank financial institutionNBP National Bank of PakistanNCB nationalized commercial bankNIC National Insurance Corporation LimitedNLC Network Leasing Corporation LimitedNIT National Investment Trust LimitedOEM operations evaluation missionOTC over-the-counterPCR project completion reportPFI participating financial institution

PIC Pakistan Insurance CorporationPICL Pakistan Industrial and Commercial Leasing LimitedPKI Pakistan Kuwait Investment Company (Private) LimitedPPAR project performance audit reportRRP report and recommendation of the PresidentSBP State Bank of PakistanSECP Securities and Exchange Commission of PakistanTA technical assistance


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NOTES

(i) The fiscal year (FY) of the Government ends on 30 June.(ii) In this report, $ refers to US dollars.

Director General, Operations Evaluation Department : Bruce MurrayDirector, Operations Evaluation Division 2 : David EdwardsEvaluation Team Leader : Tetsu Ito

Operations Evaluation Department, PE-664


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CONTENTSPage

BASIC DATA iiiEXECUTIVE SUMMARY ivI. BACKGROUND 1

A. Rationale 1B. Formulation 1C. Purpose and Outputs 2D. Cost, Financing, and Executing Arrangements 2E. Completion and Self-Evaluation 4F. Operations Evaluation 4

II. PLANNING AND IMPLEMENTATION PERFORMANCE 4A. Formulation and Design 4B. Achievements of Credit Line 7C. Achievement of Policy Reforms 11D. Organization and Management 14

III. ACHIEVEMENT OF PROJECT PURPOSE 15A. Performance Indicators 15B. Project Outcome 17C. Sustainability 18

IV. ACHIEVEMENT OF OTHER DEVELOPMENT IMPACTS 19A. Socioeconomic Impact 19B. Environmental Impact 19

V. OVERALL ASSESSMENT 19A. Relevance 19B. Efficacy 20C. Efficiency 20D. Sustainability 20E. Institutional Development and Other Impacts 21F. Overall Project Rating 21G. Assessment of Borrower and ADB Performance 21

VI. ISSUES, LESSONS, AND FOLLOW-UP ACTIONS 22A. Key Issues for the Future 22B. Lessons Identified 22C. Follow-Up Actions 24

Tetsu Ito, evaluation specialist (team leader), was responsible for the preparation of this report,and conducted document reviews, key informant interviews, and guided the fieldworkundertaken by Yawer Sayeed and Farid Alam (staff consultants) and A. Ali Qureshi (researchassistant). Barbara Palacios, senior evaluation officer, supported the team with researchassistance from Manila.

The guidelines formally adopted by the Operations Evaluation Department (OED) on avoidingconflict of interest in its independent evaluations were observed in the preparation of this report.To the knowledge of the management of OED, there were no conflicts of interest of the personspreparing, reviewing, or approving this report.


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iiAPPENDIXES

1. Compliance Status of Key Loan Covenants on Participating Financial Institutions 252. Profile of Bankers Equity Limited (Under Liquidation) 283. Characteristics of Subloans 294. Overview of Subprojects 315. Profile of First Dawood Investment Bank (Formerly Dawood Leasing Company 36

Limited)6. Profile of English Leasing Limited 407. Profile of Network Leasing Corporation Limited 448. Profile of Pakistan Industrial and Commercial Leasing Limited 489. Profile of Pakistan Kuwait Investment Company (Private) Limited 5310. Policy Matrix 5711. Statistical Data 66

Attachment: Management response


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BASIC DATA

Project Preparation/Institution BuildingTANo.

Technical Assistance Name Type Person-Months

Amount1

($ 000)Approval

Date

2393 Capital Market Development AdvisoryTechnicalAssistance

21 865.0 7 Sep 1995

Key Project Data ($ million)As per ADB Loan

DocumentsActual

ADB Loan Amount/Utilization 100.0 24.5ADB Loan Amount/Cancellation 75.5Amount of Parallel Financing 216.0

228.0

3

Key Dates Expected ActualFact-Finding 521 Apr 1994Appraisal IIIIV June 1994 26 Nov16 Dec 1994Loan Negotiations III Mar 1995 1719 Jul 1995Board Approval III Apr 1995 7 Sep 1995Loan Agreement 7 Oct 1995Loan Effectiveness 4 Jan 1996 28 Jun 1996First Disbursement 23 Jun 1997Loan Closing 31 Dec 2000 31 Dec 2000Months (effectiveness to completion) 60 54

Borrower Government of PakistanProject Administrator Bankers Equity LimitedExecuting Agencies Dawood Leasing Company Limited

English Leasing Limited

Network Leasing Corporation LimitedPakistan Industrial and Commercial Leasing Company LimitedPakistan Kuwait Investment Company (Private) Limited

Mission Data No. of Missions Person-DaysContact 1 14Consultation 3 11Fact-Finding 1 96Appraisal 1 168Project Administration Review 2 13Project Completion 1 23Operations Evaluation 1 76

1Financed by the Japan Special Fund.

2World Bank. 1994. Financial Sector Deepening and Intermediation Project (FSDIP).

3During implementation, FSDIP was significantly restructured and its loan amount was reduced.


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EXECUTIVE SUMMARY

The Asian Development Bank (ADB) approved the Financial Sector Intermediation Loan(FSIL) to the Islamic Republic of Pakistan for $100 million on 7 September 1995. The FSILsobjectives were to (i) support the Government in its financial sector and capital market reforms,(ii) diversify the credit delivery system and strengthen the resources base of qualified financial

institutions, and (iii) meet part of the investment requirements of the private sector. To meetthese objectives, the FSIL was structured as a credit line with a substantial program of policyactions addressing broad financial sector issues. The FSIL was to share the same purpose,scope, and policy requirements with the World Banks Financial Sector Deepening andIntermediation Project (FSDIP) approved in October 1994. In conjunction with the FSIL, ADBalso approved a technical assistance (TA) grant for capital market development (TA 2393-PAK).

Under the FSIL, the Government was to relend the loan proceeds to nine financialinstitutions, which signed on the project agreements with ADB. The participating financialinstitutions (PFIs) were to onlend the loan proceeds to private sector activities that requiredforeign exchange (FX) to finance the cost of eligible goods and services. Bankers Equity Limited(BEL), a development financial institution (DFI), was to administer the credit line. At the time of

loan approval, ADB estimated the total private investment for the next 2 years to be about$4.9 billion per year and identified a substantial gap in the credit market. On this basis, ADBexpected that the FSIL would be fully committed within 3 years of loan effectiveness. However,only $24.5 million was actually disbursed to the five PFIs (four leasing companies and one DFI)under the FSIL to support 73 subprojects; the remaining $75.5 million was cancelled. The loanwas closed on 31 December 2000 as originally scheduled. The credit line under the FSDIP wasnot utilized and was cancelled in three stages, with final cancellation in December 1998. InJanuary 2004, the Government fully prepaid the FSIL.

The Operations Evaluation Mission (OEM) attributed the underutilization of the FSIL tothe (i) cost of hedging the FX risk, (ii) nonavailability and cost of the third-party guarantee by thePFIs to the Government, (iii) restrained domestic credit demand during 19982000,

(iv) downtrend in the domestic market interest rate from 1998 to date, and (v) relatively highpool-based dollar interest rate of ADB relative to the London interbank offered rate (LIBOR)from 2001 to date. The first three factors were aggravated by unstable political and externalconditions facing Pakistan during 19982001.

Of the 73 subloans for a total of $24.5 million, 62 for $11.4 million were fully repaid bysubborrowers; 1 for $4.3 million is being repaid; 1 for $7.2 was rescheduled and is being repaid;3 for a total of $0.4 million had defaulted and court decisions were made; four for a total of$1.0 million have defaulted and are currently under litigation; and there is no information on2 subloans totaling $0.2 million. At the OEM, three PFIs maintained profitable operations whilethe remaining two were facing financial problems due to the fraudulent practice of previousmanagements, which surfaced subsequent to FSIL implementation. As a result, the two PFIs

have suspended payments to the Government under the FSIL. BELs management had alsobeen involved in fraudulent activities soon after its privatization in 1996, and the DFI waseventually put under receivership. The Government and ADB unsuccessfully explored thereplacement of BEL as project administrator as well as third-party guarantor of the FSIL to theGovernment.

The policy matrix of the FSIL included 45 policy actions concerning the(i) macroeconomy, (ii) financial sector and institutions, and (iii) capital market. The 31 policyactions in the first and second components were identical to those in the policy matrix of the


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FSDIP. The remaining 14 actions under the third component covering the capital market werespecific to the FSIL. During the two reviews the Government and ADB, in coordination with theWorld Bank, were to exchange views on the progress of the policy reform program. Bothinstitutions retained the right to suspend their credit lines in case of a substantial failure by theGovernment in complying with the policy matrix. However, ADB did not review the policy matrixduring review missions, and the World Bank voided the FSDIPs policy matrix.

The OEM confirmed full compliance with 40 of 45 FSIL policy actions. Of the remainingfive actions, three were deemed partly complied with, one was not applicable, and the remainingone could not be verified. Many policy requirements under the FSIL were only broadly defined,indicating either the direction of reforms or the need for studies and/or reviews. Others werespecific, but formed a fractional part of broader reforms supported under the subsequentlyextended ADB loan Capital Market Development Program (CMDP), the Enhanced StructuralAdjustment Facility (ESAF) from the International Monetary Fund, and the Banking SectorAdjustment Loan (BSAL) from the World Bank.

The OEM assessed the FSIL as irrelevant. To fill the shortage of FX term funds to meetthe investment demand from private entrepreneurs was the key rationale for the FSIL. However,

the FSIL was not designed as such, and subborrowers simply availed themselves of localcurrency term funds. In fact, financial institutions were not allowed to extend FX term loans atthe time of FSIL approval. Appraisal of the FSIL overlooked this key regulatory constraint. TheFSIL objectives lacked prioritization, and the credit line and the policy matrix were not closelylinked. Given the growing concern on the deteriorating performance of commercial banks andDFIs at appraisal of the FSIL, ADB could have prioritized the restructuring of these institutionsthrough program lending. Alternatively, the FSIL policy matrix could have focused on issuesdirectly related to the credit line or nonbank financial institutions. Either way, the project couldhave been more cohesive, timely, and relevant.

The OEM assessed the FSIL as partly efficacious. The credit line under the FSIL wassignificantly underutilized. Of the five PFIs, two effectively utilized the FSIL to attain sound

company growth. The experience of another PFI was not so encouraging because of theunderperformance of its largest subloan, which represented 29.4% of the total disbursementunder FSIL. The fraudulent activities and the subsequent financial problems of the remainingtwo PFIs undermined the significance of the FSIL. The overall contribution of FSILs credit lineto the countrys financial intermediation and private sector activities was far less than expected.

The financial and capital market indicators suggest the noteworthy recovery of thebanking system and the capital market in the recent years. However, the Government attributedthis recovery mainly to CMDP, ESAF, and BSAL rather than the FSIL. The OEM supported thisview of sequencing of influences and impacts. Perhaps, the key contribution of the FSIL topolicy reforms was that it highlighted the need for a more significant financial sector programand full-fledged policy-support loans in view of the complexity and urgency of reforms required

in the sector.

The underperformance of the project administrator marks the management of the FSILcredit line as inefficient. The service provided by the administrator was not worth theadministration fees that PFIs paid. ADB, on its part, vigorously marketed the FSIL to financialinstitutions while partly offsetting the underperformance of the administrator. However, fourfinancial institutions that had finalized the project agreements could not actually utilize the FSIL.ADBs effort in this regard was not fully cost-effective.


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The outcomes of the FSIL, though far less than expected, are likely to be sustained.Most subprojects visited by the OEM had maintained positive project outcomes. Management ofthe three PFIs appeared to have clear vision of a viable business model. The policyachievements under the FSIL are generally irreversible, complemented by significant follow-onmeasures.

The OEM assessed the overall impact of the FSIL as negligible given that (i) itscontributions to institutional strengthening of the five PFIs was marginal, and (ii) itssocioeconomic and environmental contributions were considerably less than what had beenexpected.

On the basis of the above, the overall rating of the FSIL is unsuccessful. The OEMconfirmed the earlier audits successful rating of TA 2393-PAK, which contributed to capacitybuilding of the Securities Exchange Commission of Pakistan.

The FSIL demonstrated the risks associated with a project that was formulated based ona weak logical framework, namely (i) inconsistency between the project rationale and objective;(ii) excessively broad project objective (without specifying immediate objective, or purpose);

(iii) weak linkages among expected project outputs (or lack of cohesiveness in project scope);and (iv) lack of an explicit monitoring mechanism. Most importantly, the experience with theFSIL underscores the necessity of a clear project purpose. The project purpose should not beused only to design the project; it should constantly be referred to in monitoring projectimplementation. When a project encounters unforeseen events, the project purpose should bethe basis for adjusting the project scope/design or, if necessary, to cancel its implementation.This judgment can only be effective if the project purpose is clearly stated.

The FSIL encountered a series of negative unforeseen events, resulting in suspension ofthe repayment from two PFIs to the Government as well as insolvency of the guarantor of theserepayments. The OEM was of the opinion that the FSIL should have been restructured orcancelled in 1999 when the project administrator (as well as guarantor) was put under

receivership and a replacement could not be assigned. Such a decision could be made inconsideration of not only the project purpose but also the project cost and risks. The OEM wasof the view that a system was not effectively in place within ADB to appropriately reassess theseimportant aspects and take responsive action to restructure/cancel underperforming loans.

There were changes in ownership and management of the two PFIs and theadministrator during FSIL implementation. Subsequently, gross criminal irregularities andmisappropriations were detected which necessitated harsh legal and regulatory measures.These experiences underscore the need for ADB to thoroughly reevaluate the continuingqualification criteria as and when there is a management or ownership change in PFIs duringproject implementation. Even after loan completion, ADB should monitor major events of theconcerned financial institutions to the extent possible. Such monitoring activities would deserve

extra resource allocation in some cases, depending on the type of issues that subsequentlysurface and the extent of ADBs direct or indirect loan exposure to the institutions.

In the past, ADB defined fraud and corruption terms narrowly, focusing on procurementissues in ADB-financed activities, under the anticorruption policy adopted in 1998. However, itwas recognized that this narrow definition may place ADB in a position where parties that it hadfound not to have maintained the highest ethical standards might find ways to participate in ADB-financed activities other than those covered by contracts. On this basis, ADB in November 2004defined fraudulent practice as any action, including misinterpretation, to obtain a financial or other


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benefit or avoid an obligation by deception. With this new definition in place, ADB could havetaken more decisive action when the fraud scandals in the two PFIs and BEL surfaced. TheOEM held the view that strict adherence to the revised anticorruption policy is essential toimproving the governance of ADBs credit lines.

A credit line with a program of policy actions addressing broad sector issues may not be

effective unless it is designed cohesively. The FSIL was diffused in scope; the logical linkagebetween the credit line and the policy matrix was weak. Given that the entire loan amount wasto be directed to the PFIs, the Government did notpay attention to the policy matrix. Reflectingthe underutilization of the loan, ADB's emphasis on the policy matrix also faded duringimplementation.

Parallel financing with another aid agency should be justified on the basis of project cost,credit demand, and complementary effects of the loans. Even when a counterpart aid agencyhas appraised the project, ADB should independently and diligently assess such appraisal.Regular contact with the counterpart aid agency throughout project implementation should beessential. Withdrawal/cancellation of the counterpart agencys support should be a signal that areview and reassessment of the project are warranted.

Under the FSIL, PFIs were required to submit summary environmental impactassessment reports for all subprojects. The Loan Agreement, however, did not specify thecontents of the report. Perhaps partly for this reason, ADB did not pay enough attention to thisrequirement, and the PFIs did not submit adequate information on the environmental aspects ofsubprojects. This experience underscores the need for diligent application of the ADBenvironmental policy revised in November 2002, especially the guidelines on EnvironmentalAssessment for Financial Intermediation Loans and Equity Investments.

It is recommended that the Ministry of Finance (i) discuss the possible restructuring ofthe remaining balance under the FSIL with BEL and the two PFIs that have suspendedrepayments; and (ii) clarify BELs status as FSIL administrator and guarantor, and verify PFIs

payment obligation as regards the administration and guarantee fees. MOF should inform thePRM of outcomes of the recommended follow-up actions by end-June 2006.

Bruce MurrayDirector GeneralOperations Evaluation Department


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I. BACKGROUND

A. Rationale

1. From the late 1980s to the early 1990s, the Government of Pakistan implemented majorpolicy reforms in the financial and industry sectors as well as in the external trade regime.

These reforms stimulated private sector investment, and resulted in the growth of the industrysector and the gross domestic product (GDP) by 7.9% and 5.8% per annum, respectively, fromFY1987 to FY1992. Under the Eighth Five-Year Plan (FY1993FY1998), the Governmentcontinued to emphasize the role of the private sector and set the GDP growth target at 9.9% perannum. To achieve that target, the Government underscored the need for further improvementof financial intermediation and capital market development.

2. The Asian Development Banks (ADB) financial sector operations in Pakistan between1968 and 1994 were represented by 19 development finance institution (DFI) loans, covering 14projects and totaling $957 million. These projects aimed to support domestic banks to cope witha growing credit demand from private sector investors. However, the findings of the evaluationof the projects were not encouraging: 78% were partly successfulmainly because of low loanrecovery, but also because of the complex technical, administrative, and legal aspects of theprojects.1 Based on this observation, ADBs country operational strategy (COS) 2 prepared inJuly 1995 envisioned the refocusing of financial sector operations in Pakistan from traditionalDFI loans to policy-based lending.

3. The report and recommendation of the President (RRP) gave the following rationale forthe Financial Sector Intermediation Loan (FSIL): The main source of economic growth inPakistan in recent years has been the private industry sector. This has necessitated increasedprivate sector investment in the manufacturing and other productive sectors. Concurrently, thecountrys financial sector has experienced a shortage of foreign exchange term funds to meetthe investment demand from private entrepreneurs. At the same time, a number of constraintsremain in Pakistans financial system inhibiting efficient financial intermediation and thedevelopment of the capital markets. The proposed Project responds to those requirements.

B. Formulation

4. During the 1992 Country Programming Mission, the Government requested ADB toassist the newly privatized DFIs and commercial banks. At about the time ADB's firstconsultation mission was fielded in late 1992, the World Bank was at the early stage ofprocessing its Financial Sector Deepening and Intermediation Project (FSDIP). 3 After dialogueand ADBs participation in the World Banks processing missions, it was decided that ADBwould provide parallel financing with the World Banks FSDIP, sharing the same scope, design,and policy requirements. It was agreed that in implementing the policy matrix, ADB would focusmainly on the capital market and the World Bank on the banking sector. The two institutionsbelieved that this collaboration would enhance the leverage on necessary financial sectorreforms and provide resources to narrow the large financing gap in the financial system. ADB

1ADB. 1995. Pakistan: Economic Review and Bank Operations. Manila.

2ADB. 1995. Country Operational Strategy Study for Pakistan. Manila.

3World Bank. 1994. Financial Sector Deepening and Intermediation Project (FSDIP), for $216 million equivalent.The World Bank supported the financial sector reform in Pakistan during FY1989FY1991 through a FinancialSector Adjustment Loan (FSAL). To build on the achievements under the FSAL, the World Bank approved theFSDIP. The key elements of the FSDIP included (i) an umbrella credit line, (ii) a policy matrix, and (iii) technicalassistance to carry out financial sector reforms as well as to implement the credit line.


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2fielded processing missions between April and December 1994. The loan negotiation wascompleted in July 1995 and further consultation was undertaken in August 1995.

C. Purpose and Outputs

5. The FSIL objectives, as stated in the RRP, were to

(i) support the Government in its financial sector and capital market reforms, with aview to increasing the efficacy of financial sector policies and management;improving efficiency in the systems intermediation function, thereby reducing thecost of financial intermediation and enhancing domestic resource mobilization;strengthening the institutional capabilities of concerned organizations; andpromoting the development of the capital market;

(ii) provide an efficient and broader range of services to the private sector, diversifythe credit delivery system and strengthen the resource base of qualified publicand private sector banking and nonbank financial institutions (NBFIs) throughsupplementing their long-term foreign exchange resources; and

(iii) support private sector development through meeting a part of its investment fundrequirements, with focus on high technology and export-oriented industries,including small-scale industry.

6. Following the FSDIP, an umbrella credit line, a policy matrix, and a technical assistance(TA) grant were the key elements of the FSIL. At the time of loan approval, two joint-ventureDFIs, one private commercial bank, and six private NBFIs had been identified to qualify forparticipation. It was assumed that in the event of substantial failure by the Government to meetthe policy requirements, the disbursement of the credit line would be suspended (or theundisbursed portion cancelled).

D. Cost, Financing, and Executing Arrangements

7. On 7 September 1995, ADB approved the FSIL to the Islamic Republic of Pakistan for$100 million from ADBs ordinary capital resources. At the time of loan appraisal, ADBestimated the total private investment for the next 2 years to be about $4.9 billion per year andidentified a substantial gap in the credit market even considering the FSDIP. On this basis, ADBexpected that the FSIL would be fully committed within 3 years of loan effectiveness.

8. The Government was to relend the loan proceeds to participating financial institutions(PFIs). Any public and private sector financial institution could be a PFI provided that it couldcomply with the financial covenants (Appendix 1) and ADB would approve its participation. ThePFIs were to onlend the loan proceeds (or provide leases) to private sector activities thatrequired foreign exchange (FX) to finance the cost of eligible goods and services. 4 The

4To qualify, subborrowers were to be enterprises that (i) carried on any legitimate private sector activity other thanreal estate or trading; (ii) had a debt/equity ratio not greater than 60/40; and (iii) were not in default of repayment toany bank or development finance institution (DFI), and the principal sponsors of which were not sponsors of otherenterprises in default of repayment to any bank or DFI. Moreover, all the subprojects were to fully comply with allapplicable environmental regulations and legislation in Pakistan. In principle, subloans were to finance up to amaximum of 60% of the debt or lease requirements of subprojects. The PFIs were to finance at least 20% of thedebt or lease requirements from its own resources and the rest from other sources including FSIL.


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3maximum subloan5 size was $8 million, and the free limit was $3 million.6 Each of the PFIs wasthe executing agency (EA) of the FSIL. Bankers Equity Limited (BEL) was to administer thecredit line through an administrative unit (AU)7 of its organization (Appendix 2). The AU was to(i) monitor the eligibility status of each PFI, (ii) provide information on financial institutionsinterested in participating in the FSIL, (iii) channel repayments due to the Government from PFIs,and (iv) account for expenditures under the FSIL. In addition, the AU was expected to maintain an

environmental expert to address the environmental aspects of subprojects and to assist PFIs inenvironmental matters in respect of subprojects.

9. The lending rate to the Government was determined in accordance with ADBs pool-based variable lending rate for dollar loans. The Government's relending rate to the PFIs wasADB's lending rate plus an administration fee of 0.5% to BEL.8 Non state-owned PFIs wererequired to have repayment obligations guaranteed by a suitable third-party guarantor. State-owned PFIs, not subject to this guarantee requirement, were subject to a fee of 0.5% payable tothe Government. Each PFI was to onlend to subborrowers at prevailing market interest rate.The PFIs were to have either an FX risk covered under an appropriate facility, enter into a swapagreement with acceptable counterparties, or pass on the risk to subborrowers.9 The loan to theGovernment had a repayment period of 15 years, including a grace period of 3 years. Therelending to the PFIs had a repayment period of a maximum of 15 years, including a graceperiod of not exceeding 3 years. The repayment period applicable to subloans should notexceed 12 years, including a maximum grace period of 2 years. A lending mechanism, eligibilityrequirements, and terms and condition of the FSIL were similar to those of the FSDIP.

10. The policy matrix of the FSIL included 45 policy actions10 concerning the (i) macroeconomy,(ii) financial sector and institutions, and (iii) capital market. The 31 policy actions in the first andsecond components were identical to those in the policy matrix of the FSDIP. The remaining 14actions under the third component covering the capital market were specific to the FSIL. Of the45 actions, 26 were to be taken up during the first interim review (first quarter 1996); and theremaining 19 during the second interim review (first quarter 1997). During the two reviews theGovernment and ADB, in coordination with the World Bank, were to exchange views on theprogress of the policy reform program. The Ministry of Finance (MOF) was responsible forreporting progress in the macroeconomic, sector and institutional components of the program,and the Corporate Law Authority (CLA)11 was responsible for the capital market component.

11. One TA12 was attached to the FSIL. It aimed at (i) increasing the transparency andenhancing the operational efficiency of the stock market, (ii) improving efficiency in the mutual

5In this report, subloan includes lease investments made by PFIs under the FSIL.

6Before requesting a withdrawal for subloans above the free limit from the FSIL, the PFIs were required to submit anapplication to ADB, with detailed information on subprojects, for approval. For subloans below the free limit, thePFIs were required to submit the simplified application documents for ADBs confirmation.

7BEL established the AU, supported under FSDIP, to administer the credit lines from the World Bank and ADB.

8

According to the Loan Agreement, the Administrator shall receive from the Borrower a fee payable at the rate ofone fourth of one percent (0.25%) per annum on the amount withdrawn from the Loan Account and outstandingfrom time to time with respect to subloans. Under this arrangement, PFIs were to pay 0.5% on the outstandingbalance of subloans, and 0.25% of the revolving fund (the difference between loan payable to the Government andloans receivable from subborrowers) at a later stage.

9The Loan Agreement did not specify the currency for relending and subloans. Instead, it merely noted foreignexchange risk of the Loan shall be borne by the Qualified Enterprises.

10In addition, the policy matrix indicated 14 actions taken prior to the approval of the FSDIP in October 1994.

11The CLA was an attached department of the Finance Division of the Government, responsible for regulating thecapital market.

12ADB. 1995. Technical Assistance to the Islamic Republic of Pakistan for Capital Market Development. Manila (TA2393-PAK, for $865,000, approved on 7 September 1995).


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4fund industry with focus on Government-owned investment companies, and (iii) expanding theresource base of the leasing industry. CLA was the EA.

E. Completion and Self-Evaluation

12. Under the FSIL, $24.5 million was disbursed to support 73 subprojects and the

remaining $75.5 million was cancelled. The loan closed on 31 December 2000 as originallyscheduled, and the project completion report (PCR) was circulated in January 2002. The PCRrated the FSIL as partly successful based on the following: first, the projects principal objectiveof supporting the Governments efforts to reform the financial sector was achieved; second, the$24.5 million disbursed out of $100 million had minimal impact on the financial and privatesector development; third, seven measures13 in the policy matrix were not fully complied with.The PCR offered adequate information on the PFIs performance and the implementation statusof the policy matrix. However, it did not assess subproject benefits and attributions of the actualpolicy reforms to the policy matrix. Hence, the PCR assessment of the project outcome wasweak.

13. The consulting services and consultants report for the attached TA 2393-PAK (footnote12) were largely completed in October 1997. The training component was delayed because ofthe transformation of CLA into the Securities and Exchange Commission of Pakistan (SECP) asan independent regulatory body. The TA closed in October 2003, almost 6 years beyond thetargeted closing date. The TA completion report, circulated in May 2004, rated the TAsuccessful noting its substantive outputs that laid the foundation in building the capital marketinstitutions.

F. Operations Evaluation

14. The Operations Evaluation Mission (OEM) to evaluate the FSIL was conducted from 19September to 10 October 2004. The OEM met with representatives of MOF, Ministry ofCommerce (MOC), State Bank of Pakistan (SBP), SECP, Karachi Stock Exchange, NationalCommodity Exchange Limited, BEL, five PFIs, 12 selected subborrowers, the World Bank, andother relevant institutions. This project performance audit report (PPAR) incorporates the OEMfindings, observations of concerned ADB staff, and a review of reports and documents related tothe FSIL. The OEM also considered the TA performance audits successful rating14 of TA 2393-PAK (footnote 12) in view of its complementarity with the FSIL. The draft PPAR was circulatedto the Government and within ADB. Comments received were considered in finalizing the PPAR.

II. PLANNING AND IMPLEMENTATION PERFORMANCE

A. Formulation and Design

1. Inadequate Appraisal of Market Regulations and Conditions

15. The diagnosis of the FSIL relied largely on the appraisal of the World Bank's FSDIP. Onthis basis, the RRP succinctly assessed the policy and institutional issues in the financial sector.

13These covenants concerned (i) prudential regulations for minimum capitalization of nonbank financial institutions,(ii) study on restructuring of State Life Insurance Corporation (LIC) and Pakistan Insurance Corporation (PIC), (iii)implementation of the LICs and PICs restructuring plans, (iv) empowerment of the Controller of Insurance, (v) ratesetting of the insurance industry, (vi) restructuring of the mutual fund industry, and (vii) formulation andimplementation of an action program of the mutual fund industry.

14ADB. 2003. Technical Assistance Performance Report on Selected Advisory Technical Assistance for CapitalMarket in Pakistan.Manila.


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5However, its assessment of the FX forward/swap market and the related regulation was weak.The RRP noted: to assist subborrowers (or lessees) in managing this risk, the PFIs will havethe foreign exchange risk covered under an appropriate facility available in the market orarrange, if possible currency swaps with acceptable market counterparts. If none of these canbe arranged, the PFIs will pass the foreign exchange risk to subborrowers. However, neither aFX forward/swap market nor any particular facility was readily available for financial institutions

to hedge against FX risks associated with medium-term loans.

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Moreover, SBP did not permitfinancial institutions to extend FX term loans at the time of FSIL approval. These suggest thatthe proposed handling of the FX risk by PFIs reflected an overly optimistic view of FXforward/swap market development as well as lack of understanding of the FX regulation.

2. Inconsistency between Diagnosis and Project Design

16. The RRP correctly pointed out that the loan recovery of financial institutions is at anuncomfortably low level, particularly for some NCBs [nationalized commercial banks] and DFIs.Without taking decisive remedial measures, these NCBs and DFIs will face permanentdifficulties in improving their portfolio, which could undermine their overall solvency. Thedifficulties in the financial sector go beyond the lack of available long-term credits.16 Despitethis concern, the FSIL policy matrix did not adequately address the emerging issue of non-performing loans. Perhaps the more critical aspect of the FSIL concerned the credit line,especially its timing: should ADB have prioritized the credit line of this kind when the difficultiesin the financial sector went beyond the lack of long-term credits?

3. Overambitious Objective and Lack of Cohesiveness in Scope

17. The objectives of the FSIL referred to financial sector and capital market reforms,efficacy of financial sector policies and management, efficiency of the systems intermediationfunction, cost of financial intermediation, domestic resource mobilization, diversity of thecredit delivery system, resource base of qualified public and private sector banking andNBFIs, private sector development, and so on. Each subject was relevant to the country'sdevelopment strategy as well as to ADB's COS. Nevertheless, to tackle all these areas in oneproject was overly ambitious. It reflected a lack of focus and weak prioritization, leading to aproject scope that was not cohesive.

4. Weak Linkage between Project Components

18. The lack of cohesiveness in scope related to the hybrid nature of the FSIL. The creditline was to support the private sector investment and operations of qualified financialinstitutions, while the policy matrix was to support reforms of the entire financial sector. A logicallinkage was missing between the credit line and the policy matrix so that it was possible for aPFI to be penalized for the Governments failure to comply with the policy conditions. This was apotential design flaw of the FSIL.

15The RRP referred to the forward cover scheme introduced by the state-owned National Bank of Pakistan (NBP) asone of the available hedging mechanisms. However, the NBP scheme was applicable only to registered importersand exporters and not to financial institutions, and no other hedging mechanism was readily available in themarket.

16As reported in the RRP, the banking system in Pakistan was on the verge of a crisis in late 1996 (footnote 48).


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65. Weak Financial Covenants for Nonbank Financial Institutions

19. The FSIL did not specify a particular type of financial institution eligible for the credit line,and thus, it was open to DFIs, banks, and leasing companies. 17 This flexible arrangementprovided a buffer against possible fluctuation of the domestic interest rate and otheruncertainties, which could affect the demand for this credit line.18 However, more appropriate

financial covenants should have been identified for leasing companies so that the FSIL couldcomplement the countrys weak regulatory framework on NBFIs and their governance. It isnoted that prudential guidelines were not yet in place for leasing companies at the time of FSILapproval. Among the covenants that should have been considered are (i) capital adequacy, (ii)provisions for nonperforming assets, (iii) portfolio concentration, (iv) connected lending/leasing,and (v) FX exposure limit. It is also noted that the FSIL policy matrix did not adequately addressthe regulatory issues on NBFIs.

6. Some Weakness in the Policy Matrix

20. The policy matrix of the FSIL was comprehensive and consistent with its objectives. Ithad two unique features: (i) most policy requirements were broadly defined, indicating either thedirection of reforms or the need for studies and reviews; and (ii) 31 of 45 policy actions echoedthe FSDIPs policy matrix. These features could be justified, considering that this policy matrixwas a supplementary component attached to a DFI loan. However, the policy measures in theareas directly related to the credit line could have been prioritized and detailed so that the FSILcould have been more focused and coherent. In particular, the introduction of the prudentialguidelines for NBFIs should have been a key program measure. Corporate governance inNBFIs is another area that the FSIL could have focused on. TA 2393-PAK (footnote 12) wasappropriately designed to complement the capital market component of the policy matrix, whichaimed at improving the stock exchanges operations and market rules.

7. Inadequate Collaboration with the Other Multilateral Agency

21. The capital market component of the FSIL policy matrix, together with TA 2393-PAK,was to complement the FSDIP. Likewise, the World Banks technical assistance to BEL was tocomplement the FSIL. As the usual practice in parallel financing, there was no cross-conditionality or cross-default clause between the FSIL and the FSDIP. Nevertheless, closecoordination between the two organizations was envisaged during interim reviews of the policymatrix. In this way, the FSIL and the FSDIP assumed unique collaboration at the design stage.This collaboration was well intentioned, and could have worked better if there were enoughcredit demand for the two loans. One critical issue, however, was that the RRP did not analyzethe slow progress of the credit line under the FSDIP, which was approved 9 months earlier than

17

The RRP projected that about 50% of the FSIL would be utilized by DFIs and the balance by private sector banksand NBFIs.

18In general, banks were more favorably placed in terms of cost of fund, mobilizing noninterest-bearing demanddeposits whereas nonbanks, including leasing companies, could accept only high interest-bearing time deposits.Additionally, being in competition, nonbanks were offering interest on those deposits at a higher band than thecommercial banks. The leasing companies also relied heavily on borrowed funds. Therefore, the lending rates ofleasing companies were also higher. Therefore, even with the cost of guarantee and forward cover for the FSIL,these companies could have a comfortable margin until such time that the overall interest rate regime was at ahigher level. For leasing companies, the cost of the FSIL ranged between 17% and 19%, with the lending rateaveraging 21%24%.


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7the FSIL.19 This suggests that ADB failed to capitalize on this collaboration even at the time ofappraisal.

B. Achievements of Credit Line

1. Loan Utilization

22. The FSIL became effective on 28 June 1996, more than 5 months after the targeted date.This delay was attributable to the late (i) finalization of the Administration Agreement betweenthe Government and BEL due to the decision to privatize BEL subsequent to FSIL approval(para. 46); and (ii) submission of the legal opinion on the subsidiary and project agreementsacceptable to ADB.

23. The following five institutions actually utilized the FSIL: (i) English Leasing Limited (ELL),(ii) Network Leasing Corporation Limited (NLC), (iii) Pakistan Industrial & Commercial LeasingLimited (PICL), (iv) First Dawood Investment Bank Limited (formerly Dawood Leasing CompanyLimited [DLC]), and (v) Pakistan Kuwait Investment Company (Private) Limited (PKI).20 ELL,NLC, PICL, and DLC are not state-owned leasing companies,21 while PKI is a DFI jointly ownedby the Governments of Pakistan and Kuwait. In addition, one more leasing company and threecommercial banks also signed project agreements but did not actually utilize the FSIL. As of theterminal date of subloan applications for ADB approval/authorization on 30 June 2000, the totalcommitted amount (by the nine financial institutions) under the FSIL was $55.8 million. Theuncommitted balance of $44.2 million was cancelled on 31 July 1999. Of the committed $55.8million, ADB had disbursed $24.5 million to finance 73 subloans of the five PFIs by the loanclosing date of 31 December 2000 (Appendix 3). The remaining balance of $19.9 was cancelledon the same day.

24. The OEM attributed the underutilization of the FSIL (including the revolving fund, orthe fund generated from the recovery of subloan principals) to the (i) cost of hedging the FXrisk, (ii) nonavailability and cost of the third-party guarantee by the PFIs to theGovernment,22 (iii) restrained domestic credit demand during 19982000,23 (iv) downtrend inthe domestic market interest rate from 1998 to date, 24 and (v) relatively high pool-baseddollar interest rate of ADB relative to the London interbank offered rate (LIBOR) from 2001

19

The credit line component of the FSDIP was not utilized, and was cancelled in three stages with final cancellation

in December 1998. The Implementation Completion Report of the FSDIP noted that onlending terms andconditions of the FSDIP could not be met by the beneficiaries, pointing to the fact that it was apparent even duringappraisal that there will be serious problems in finding eligible FIs [financial institutions] to participate.

20ELL, PICL, and PKI finalized the project agreements with ADB during MarchMay 1996, while NLC and DLCfinalized the agreements in October 1997.

21DLC transformed itself into an investment company in 2003.

22The third-party guarantee was not required for PKI as half of its shares were owned by the Pakistan Government.

23Total bank's credit outstanding/GDP decreased from 40.1% in end-June 1998 to 38.0% in end-June 1999, andfurther to 34.9% in end-June 2000, based on GDP data before revaluation in FY2004 with retrospective effect fromFY2000 (Table A11.5, Appendix 11).

24The average 6-month Treasury bill yield progressively decreased from 18% in June 1998 to 1.7% in June 2003except that it temporally increased to 14% in June 2001.


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8to date (Figure 1).25 The first three factors were aggravated by the political situation andexternal conditions during 19982001.26

Figure 1: ADB Pool-Based Interest Rate versus LIBOR (%)

0.0

1.0

2.0

3.0

4.0

5.0

6.07.0

8.0

J-91

D-91

J-92

D-92

J-93

D-93

J-94

D-94

J-95

D-95

J-96

D-96

J-97

D-97

J-98

D-98

J-99

D-99

J-00

D-00

J-01

D-01

J-02

D-02

J-03

D-03

ADB Pool-based ($) 6-month LIBOR ($)

ADB = Asian Development Bank, D = end of December, J = end of June, LIBOR = London interbank offered rate.Sources: Asian Development Banks Treasury Department and the International Monetary Fund. 2003. International

Financial Statistics Yearbook. Washington, D.C..

25. As noted earlier, there was no mechanism available in the formal market to hedge theFX risk associated with medium-term loans. Under the circumstances, SBP offered 1-yearrenewable forward covers to the PFIs especially for the FSIL, at an annual cost varying between7.5 and 13.0% (of the disbursed amount). All the PFIs except PKI27 initially took this forwardcover from the SBP, and some later resorted to the so-called synthetic hedging. 28 In eithercase, the FX risk was only partially hedged, and the costs of hedging were high.

25Under the situation, PKI inquired about the possibility of converting the pool-based interest rate scheme to theLIBOR-based loan (LBL) facility in April 2002. However, ADB responded negatively with reference to its lendingpolicy stipulating that "only those loans with undisbursed balances of more than 40% of original loan amount as of30 July 2001 are eligible for transformation to the LBL facility."

26Amid the Seachin and Kargil conflicts, the resulting tension with India, and in the aftermath of the nucleardetonation on 28 May 1998, the country had to face international sanctions that led to the freezing of FX accountsand the imposition of stringent austerity and exchange control measures. Thereafter, the civilian politicalGovernment was taken over by the military on 12 October 1999, which saw furtherance of international pressures.The situation was aggravated by the 11 September 2001 terrorist attack on the United States. In a criticalturnaround, the Government decided to extend support and facilities to US military intervention in Afghanistan, thatmove led to the easing of the sanctions and brought Pakistan back to the international fold. Following thesuccessful rescheduling of its bilateral debt obligations and increased inflow of remittances and external aid, gross

FX reserves increased to more than $10 billion by end 2003, the highest amount ever, allowing the Pakistan rupeeto stabilize.27

PKI opted for synthetic hedging from the start of FSIL implementation because it had access to FX liquidity andinvestment opportunities.

28It is a mechanism prevalent in Pakistan wherein a financial institution buys foreign currency from the informalmarket, the so-called Kerb Marketand places it with a bank or financial institution on long-term deposit or invests indollar denominated bonds. Thereafter, the depositor draws a Pakistan rupee-denominated credit line of similarmaturity by pledging the FX deposit or bond. Even though the cost may be high, many institutions preferred to lockin their open positions through this particular mechanism at that time, given the high exchange rate volatility andabsence of forward cover or swap facilities. The informal currency market thrives on informal remittance, known ashwalaor hundi from Pakistani expatriates, especially from the Middle East, which bypasses the normal bankingchannels.


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926. At the initial stage of the FSIL, BEL was the only eligible financial institution that waswilling to offer the third-party guarantee at a fee ranging from 1.8% to 2.5% per annum,acceptable to the PFIs. Subsequently, BELs financial problem surfaced, and the SBP took overthe management and suspended its operations (Appendix 2). Consequently, the GovernmentsFinance Division barred BEL from issuing guarantees as per SBPs decision in November 1999.Mainly for this reason (and nonavailability of the third-party guarantee from other eligible

financial institutions),

no disbursement had been made under the FSIL since December 1999.

29

27. In January 2004, the Government fully prepaid the FSIL, amounting to $24.5 million. PKIprepaid its loan for $14.9 million under the FSIL in March 2003.30 DLC and NLC have beenrepaying the loan to the Government on schedule, while ELL and PICL were in arrears at thetime of the OEM. The OEM estimated that the total outstanding balance of the remaining fourPFIs payables to the Government under the FSIL was around $8.3 million. 31 On the asset side(of PFIs), PICL and ELL recovered their subloans while the total receivables of DLC and NLCstood at $1.2 million equivalent32 at the time of the OEM. On this basis, the OEM estimated therevolving fund retained in the four PFIs under the FSIL to be around $7.1 million.

2. Characteristics and Performance of Subloans

28. Appendix 3 summarizes the characteristics of the subloans. The PFIs received a total of$24.5 million to finance 73 subloans, of which 70, totaling $9.7 million and representing 40% ofthe total amount and 96% of the total number, were below the free limit of $3 million. Of the totaldisbursed amount, $14.8 million for 3 subloans was through PKI, $4.7 million for 42 subloansthrough PICL, $3.1 million for 15 subloans through DLC, $1.0 million for 6 subloans throughNLC, and $0.9 million for 7 subloans through ELL. All the subloans below the free limit wereactually below $1 million. The three largest subloans, or 60.5% of the total disbursement, hadmaturities of 710 years. Twenty-one subloans had maturities of 35 years, and the others lessthan 3 years.

29. Of the 73 subborrowers, 55 were in Sindh Province, 15 in Punjab Province, two inNorth-West Frontier Province, and one in Balochistan Province.33 FSILs sectoral distributionwas $7.5 million (3 subloans) to the chemical/fertilizer industry, $7.3 million (20 subloans) totextile, $3.3 million (1 subloan) to oil refining, $2.1 million (13 subloans) to food processing, $1.0million (2 subloans) to power and energy, and $3.3 million (34 subloans) to others (transport,

29Aside from the total disbursed amount, ADB had additionally approved/authorized more than $13 million for 633subprojects of NLC. However, ADB could not disburse this amount due to the absence of third-party guarantees.This was a major disappointment for NLC.

30Two of the three subloans of PKI are still active. At the time of OEM, payment of the principal of the larger subloanof $7.2 million had not started based on the rescheduling arrangement. The OEM could not verify the outstandingbalance of the other active subloan of PKI.

31DLC, ELL, NLL provided the OEM with their outstanding balance of payables to the Government in dollars whiledata from PICL was denominated in PRs (without indicating the FX rate used). Data provided by BEL to the OEM

was incomplete, while the Ministry of Finance could not provide the aggregate loan balance under the FSIL.Therefore, this total outstanding balance is estimated based on data from the PFIs. In doing so, PICLs outstandingbalance in dollars was computed using the FX rate as of end-June 2004 ($1=PRs58.1). It is noted that PICLcontinues to resort to forward cover from the SBP for the liabilities under the FSIL. Meanwhile, the OEM could notverify the premium that PICL paid to the SBP under the current arrangement and the period it covers.

32All the subloans were actually denominated in PRs. However, one of the PFIs could not submit completeinformation on subloans to the OEM, while the information submitted by BEL was also incomplete. ADB, on its part,did not keep track of PFIs actual disbursements in PRs during FSIL implementation. For this reason, this PPARrefers to ADBs disbursement in dollars for each subloan as proxy for the actual subloan amount. On this basis, thePFIs indicated their receivables from subloans in dollars using the exchange rates at which the subloan wasoriginally booked.

33Data on geographical distribution is based on the location of manufacturing plants (not the head office).


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10information technology, medical products, cement, poultry feeds, and a school). Forty-eightsubloans were for expansion, 17 for modernization, and 8 for new products.

30. Of the total 73 subloans for $24.5 million, 62 for $11.4 million were fully repaid bysubborrowers; 1 subloan for $4.3 million is being repaid; 1 for $7.2 million was rescheduled andis being repaid; 3 for a total of $0.4 million had defaulted and court decisions were made; 4 for a

total of $1.0 million have defaulted and are currently under litigation; and there is no informationon 2 subloans totaling $0.2 million34 (Appendix 4).

3. Performance of Participating Financial Institutions

31. Appendixes 5 to 9 describe the performance of the five PFIs and the significance of theFSIL to their operations. The five PFIs largely complied with most of the financial covenantsunder the FSIL during the period that ADB approved/authorized subloans.35 To date, DLC, NLC,PKI have maintained profitable operations while ELL and PICL are facing financial problemsdue to the fraudulent practice36 of previous managements.

32. DLC received $3.1 million for 15 subloans, 13 ($2.9 million) of which were fully repaidwhile the remaining two ($0.2 million) defaulted and are under litigation. NLC availed of $1.0million for six subloans, five ($0.9 million) of which were fully repaid by subborrowers and onefor $0.1 million was recovered through litigation. PKI availed of $14.8 million for three subloans,of which one ($3.3 million) was prepaid, one ($4.3 million) is being repaid, and one ($7.2 million)was rescheduled and is being repaid.37 The management of both DLC and NLC consider thelong tenor and its demonstration effect38 to other lenders to be an important benefit they enjoyedfrom the FSIL. They also find some benefit from cultivating a relationship with institutions likeADB. These are the reasons why DLC and NLC have not prepaid the loan to the Governmentdespite its relatively high interest rate.

33. NBFIs have been facing increasingly strong competition from commercial banks inrecent years. DLC, NLC, and PKI have responded by diversifying and/or broadening theiroperational scope. For example, DLC became an investment bank in 2003, and addedinvestment banking services and housing finance to its operations. In 2001, NLC diversified intooperating leases, in addition to financing leases, and recently it set up a subsidiary specializingin microfinance. PKI has expanded its activities into asset management, stock brokerage, andsmall and medium enterprise (SME) financing.

34. ELL extended seven subloans for $0.9 million under the FSIL, of which six ($0.8 million)were fully repaid on schedule and one ($0.1 million) was recovered through litigation. PICLextended 42 subloans for $4.7 million, of which 37 for $3.7 million were fully repaid; 1 for $0.1

34The current PICL management could not verify the two subloans, $19,565 and $172,826, respectively, which arerecorded in the ADB project files. Therefore, the OEM could not verify the use of $192,391, and information onthese subprojects is tentatively based on ADBs project files. Moreover, there are discrepancies between ADBs

and PICLs records as to disbursement amounts of another three subloans.35 The OEM could not independently verify the collection and infection ratios of all the PFIs (except DLC).36

ADB defines fraudulent practice as any action, including misinterpretation, to obtain a financial or other benefit oravoid an obligation by deception under the anticorruption policy (adopted in June 1998), which was revised inNovember 2004. Prior to this revision, ADB narrowly defined the fraud and corruption terms, focusing onprocurement issues in ADB-financed activities.

37DLCs and NLCs payables to the Government under the FSIL at the time of the OEM were $2.3 million and $0.8million, respectively, according to these institutions. They resorted to synthetic hedging to cover the FX riskassociated with the remaining balance under the FSIL.

38DLCs management noted that having ADBs name on the balance sheet adds value to the company in seekingcredit from other institutions. It is noted that all the PFIs (except PKI) indicate ADB as the source of their long-termborrowings in their recent annual reports.


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11million had defaulted and court decisions were made; 2 for $0.7 million have defaulted and arecurrently under litigation; and PICL does not have any record of the remaining 2 subloans for$0.2 million, as noted earlier.

35. Since its establishment in 1992, ELL had been managed by a group of individuals whosold their 18% equity stake in the company in 2001 to ELLs present chairman. Soon after this

equity transaction, the management restated the companys financial statements for 2000 in theyear 2001 and accused the previous finance manager of committing fraud. The managementextended its control of the company by delaying board elections. SECP suspended ELLsleasing license in December 200139 and appointed an auditing firm in May 2002 to investigatethe affairs of the company from July 1998 to December 2001. The board elections of ELL werefinally held when the new sponsor, with support from other institutional shareholders of thecompany, took control. The auditing firm concluded that the previous management swindledcompany resources causing ELL to lose PRs106 million. The previous management group wasarrested and remains in custody of the National Accountability Bureau. The new managementhas been diversifying its revenue base by expanding capital market investment, and reported acumulative loss of PRs63 million during 20012003. In 2003, ELL suspended payments to theGovernment under the FSIL. Payments continue to be suspended.40

36. The current sponsors of PICL acquired its controlling stake of over 50% in 2001.Subsequent to the acquisition, the new sponsors determined that the previous management hadgrossly misstated and underreported nonperforming leases,41 and kept very low provisions.42The entire management and the companys auditors were replaced. As a result of the detailedaudit, PICL needed to make a large amount of provisions for nonperforming leases in 2001 and2002, thus creating huge losses. It is reported that the previous sponsors have fled the countryto escape prosecution. PICL is currently pursuing the rescheduling of the repayment of FSIL-related liabilities to the Government.43 MOF has not responded to the request.

C. Achievement of Policy Reforms

37. The requirements under the FSIL policy matrix have been largely met (Appendix 10) andare summarized as follows:

(i) The OEM confirmed full compliance with 24 of 26 FSIL policy requirements,which were to be met before the first interim review originally scheduled in thefirst quarter of 1996.44 The policy requirement concerning the FX forward market

39The immediate reason for the suspension was ELLs noncompliance with the newly introduced minimum capitalrequirement of PRs200 million for leasing companies.

40ELLs outstanding balance payable to the Government under the FSIL was $0.8 million at the time of the OEM.Since 2003, ELL has not taken FX cover for the outstanding liabilities under the FSIL. In 2003, ELL requested theGovernment for loan rescheduling. However, the Government suggested that ELL contact ADB. ELL then wrote aletter to ADB in 2003 but never received a reply.

41

While the total number is not large, the size of a handful of nonperforming leases is fairly substantial according toPICLs management.42

Infected leases were purposely rescheduled to benefit from a regulatory loophole wherein it was not required atthat time to report such restructured leases as nonperforming assets. (This regulation has since been changed andthe rescheduled lease/loan continues to be a nonperforming asset until repayment regularizes for at least a year.)Moreover, as the provisioning requirement was determined after deducting the forced sale value of the assetpledged, the previous management got inflated valuation of leased assets to reduce its provisioning requirements.

43PICL booked PRs258.3 million as the outstanding balance of loans payable to the Government under the FSIL asof the OEM. The OEM could not identify the FX rate that PICL used to calculate this amount.

44The Loan Agreement included one more policy requirement, which was not included in the policy matrix,concerning the growth of SBP credit to the private sector vis--vis overall private sector credit. The OEM confirmedthe compliance with this requirement.


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12is deemed partly complied with. The requirement concerning empowerment ofthe Controller of Insurance is not applicable as this office was abolished in 2000.

(ii) The OEM confirmed full compliance of 16 of 19 FSIL policy requirements, whichwere to be met before the second interim review originally scheduled in the firstquarter of 1997. The requirements concerning risk-weighted capital adequacy

norms for NBFIs and restructuring of the two state-owned insurance companiesare deemed partly complied with. The OEM could not verify if the premiumsetting exercise by the Insurance Association of Pakistan was reviewed asenvisaged under the policy matrix.

38. Many policy requirements under the FSIL were only broadly defined, indicating either thedirection of reforms or the need for studies/reviews. Others were specific, but formed afractional part of broader reforms supported under other policy-based loans including the CapitalMarket Development Program (CMDP)45 and the Financial (Nonbank) Markets and GovernanceProgram (FMGP),46 Enhanced Structural Adjustment Facility (ESAF)47 from the InternationalMonetary Fund (IMF),48 and Banking Sector Adjustment Loan (BSAL)49 from the World Bank,The relevant Government agencies generally acknowledge the contributions of thesesubsequent loans in policy and institutional reforms, but not the FSIL despite the noteworthycompliance status in the policy matrix. This suggests that the FSIL policy matrix only played amarginal guiding role for the Government in implementing relevant measures.

1. Central Bank Operations

39. The key achievements of the FSIL policy matrix in relation to SBP operations concerned(i) transition from direct to indirect instrument in monetary control; (ii) strengthening of prudentialguidelines, including introduction of the risk-weighted capital adequacy requirement, for banksand DFIs; (iii) strengthening of the legal bases for loan recovery; and (iv) rationalization ofSBPs refinancing schemes. In achieving the first item, SBP maintained close consultation withIMF under ESAF and other arrangements during 1990s. SBP also continued working with theWorld Bank in policy dialogues under BSAL to achieve the second and third items. In relation tothe fourth, SBP streamlined its concessionary refinancing schemes, except the export financescheme (EFS) during FSIL implementation. To date, SBP has progressively raised the EFSinterest rate per policy discussion with IMF.

40. A policy agenda of the FSIL that has not been fully realized is the development of anefficient FX forward/swap market. Consequently, synthetic hedging remains prevalent.

45ADB. 1997. Program Completion Report on Capital Market Development Program in Pakistan. Manila. (Loan 1576-PAK, for $250 million, approved on 6 November 1997).

46ADB. 2002. Report and Recommendation of the President to the Board of Directors on Proposed Loans andGuarantees to Pakistan for the Financial (Nonbank) Markets and Governance Program. Manila (Loan 1955-PAK,

for$260 million, approved on 5 December 2002).47 International Monetary Fund. 1998. Enhanced Structural Adjustment Facility. Washington, D.C.48

The IMF described the financial sector issues in this period as follows The structural weaknesses in the bankingsystem are evidenced by a worsening level of nonperforming loans, a slowdown in domestic deposit mobilization,creeping dollarization of the economy, and an increasing dependence on volatile foreign currency deposits. Inparticular, the stock of nonperforming loans almost quadrupled from the equivalent of US$1 billion in 1989 toUS$3.8 billion (PRs 135 billion, equivalent to some 30 percent of the banks portfolio). Consequently, the solvencyof the banking sector is threatened and two large nationalized commercial banks (and all development financeinstitutions) are experiencing liquidity problems. (IMF. 1996. Staff Report. Washington, D.C.). To address theseissues, the Government formulated the banking reform program in 1997. Implementation of the program wassupported under the ESAF and Banking Sector Adjustment Loan (BSAL) and complemented by the CMDP.

49World Bank. 1997. Banking Sector Adjustment Loan.


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132. Regulation and Supervision of Nonbank Finance Companies

41. One of the key FSIL requirements was the restructuring of CLA. Promulgation of theSecurities and Exchange Commission (SEC) Act in December 1997 could be considered as adescendant of this measure, forming the legal basis for transforming CLA into an independentbody, the SECP. Prior to the establishment of SECP, regulatory and supervisory authority over

leasing companies was transferred from SBP to CLA by virtue of an amendment to the BankingCompanies Ordinance 1997. CLA raised the capital base requirements of the leasing industryfrom PRs100 million to PRs200 million to be effective by 30 October 1999 (later extended to 30June 2001). SECP started operations in January 1999 supported under the CMDP, and byDecember 2002, regulatory and supervisory authority over mutual funds, venture capitalcompanies, investment finance service companies, discount houses, and housing financecompanies had been completely transferred to it. Subsequently, SECP issued NonbankingFinance Companies (NBFC) Rules 2003 covering all NBFIs except DFIs, supported under theFMGP. The rules define the minimal capital requirements for the respective NBFCs.

42. Introduction of risk-weighted capital adequacy norms for NBFCs is one of the twooutstanding policy measures under the FSIL. SECP is currently reviewing NBFC rules 2002while planning to introduce the risk-weighted capital adequacy requirement.

3. Insurance Reform

43. The key achievements in insurance reform under the FSIL included (i) progressiveincreases in the minimum capital requirement for insurance companies, and (ii) corporatizationof the state-owned Pakistan Insurance Corporation (PIC) in March 2000. 50 Moreover, theNational Insurance Corporation Limited (NIC) was also incorporated as a public limitedcompany in March 2000 supported under the CMDP and TA 2866-PAK. 51 Since theincorporation, the Boards of these two companies have been reconstituted with experiencedpersonnel from the private sector. However, progress in reforming the State Life of Pakistanhas been slower than expected and is being pursued under the FMGP.

44. The FSIL envisaged empowering Controllers of Insurance (COI) under MOC, while theCMDP assumed the establishment of an independent and autonomous body replacing COI toregulate the insurance industry. On this basis, the draft Pakistan Insurance Regulatory AuthorityBill was prepared under TA 2825-PAK.52 However the final Government decision was to makeSECP responsible for this task, and the SEC Act 1997 was accordingly amended in October2000. The oversight arrangement over the insurance industry remains unclear; SECP and MOChad issued their own rules and SECP has no significant enforcement powers, including powersof revoking licenses.

4. Capital Market Reform

45. The key achievements of the FSIL policy matrix in relation to the capital market includes(i) establishment of the SECP, (ii) enhanced accountability and improved operational efficiencyof the stock exchanges, and (iii) privatization of mutual funds run by the state-owned InvestmentCorporation of Pakistan (ICP) in 2003, and the ongoing privatization of mutual funds run byNational Investment Trust Limited (NIT). The second item included (i) establishment of the

50PIC was then renamed as the Pakistan Reinsurance Company.

51ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Reform of the Insurance Industry. Manila(TA 2866-PAK,for $700,000, approved on 15 September 1997).

52ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Capital Market and Insurance LawReform. Manila (TA 2825-PAK, for $100,000, approved on 14 July 1997).


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14investor protection funds in all stock exchanges; (ii) issuance of the insider trading guidelines,stock exchange members (inspection of books and record) rules and other market regulations;and (iii) introduction of a mandatory disclosure requirement on quarterly accounts of listedcompanies. All these measures were supported under TA 2393-PAK (footnote 12). Privatizationof the state-owned mutual funds was supported under CMDP, TA 2865-PAK,53 and TA Loan1577-PAK(SF).54

D. Organization and Management

1. Credit Line

46. The performance of BEL, both as the administrator and guarantor of the FSIL credit line,was unsatisfactory. Moreover, ADBs inappropriate responses to the following events withrespect to BEL are considered partly responsible for the discouraging performance of the FSIL.

(i) Privatization of BEL in 1996.The Government announced the privatization planof BEL, 3 months after the FSIL was approved. The ADB project officer raisedthe possibility of conflict of interest should a private financial institutionadminister the FSIL. Less development orientation under private ownershipshould have also been a concern. Nonetheless, ADB consented to theGovernments plan without resolving these issues. As anticipated, BEL did notactively identify potential beneficiaries of the FSIL, and failed to properly accountfor expenditures under the FSIL. It merely channeled disbursements andrepayments between the Government and the PFIs, and offered little additionalvalue to the information submitted by the PFIs to ADB. Understandably, the PFIsfelt that the administration fee was quite high, considering the scope and amountof service BEL extended.

(ii) Suspension of BELs operations in 1999. Soon after the privatization, BELsnew management was involved in fraudulent activities and swindled thecompanys financial resources. In August 1999, SBP took over BELsmanagement and suspended its operations. Subsequently, BEL was broughtunder receivership and the Government and ADB unsuccessfully explored thepossibility of replacing the FSIL administrator. Likewise, no one took over thethird-party guarantees for the outstanding balance payable to the Governmentfrom the PFIs under the FSIL. It is intriguing that BEL continues to be the third-party guarantor and administrator of the FSIL credit line despite its beingliquidated and the Government has prepaid the FSIL to ADB.55

53ADB. 1997. Technical Assistance to the Islamic Republic of Pakistan for Restructuring of Public Sector MutualFund. Manila (TA 2865-PAK, for $800,000, approved on 15 September 1997).

54ADB. 1997. Report and Recommendation of the President to the Board of Directors on Proposed Loans to theIslamic Republic of Pakistan for the Capital Markets Development Program. Manila (Technical Assistance Loan forCapacity Enhancement of the Securities Market [TA Loan 1577-PAK(SF), for $5 million, approved on 6 November1997]).

55Accordingly, DLC and NLC continue to pay the third-party guarantee and administration fees to BEL during theOEM. ELL stopped paying these fees due to its financial problem. The OEM could not verify whether or not PICLcontinued to pay the administration and third-party guarantee fees.


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1547. ADB vigorously marketed the FSIL to financial institutions and conscientiously assessedtheir applications. Understandably, however, the assessment did not go beyond the auditedfinancial statements. The ADB Review Mission of July 1997 reassessed the eligibility of PFIs. Areview of the project files suggests that ADB paid less attention to the PFIs performance afterthis mission until the PCR mission of July 2001. The PCR recommended that the PakistanResident Mission (PRM) monitor ELL and PICL. 56 However, no document in the project files

suggests that these institutions were monitored.

48. The PFIs submitted adequate subproject information for ADB's approval/authorization.ADB, on its part, diligently assessed the subloan applications. Initially, ADB did notapprove/authorize some subloan applications for failure to meet FSILs requirement. Eventually,the rejection ratio was reduced as the PFIs gained better understanding of FSIL's requirement.In addition to the regular correspondences, the concerned ADB project officer visited most PFIsto discuss the outstanding issues that impeded higher loan utilization, and pursued ways toenhance disbursement during the review missions in 19961997. Most PFIs appreciated ADB'seffort in this regard. However, there is no record of subproject visits by ADB review missions.

2. Policy Matrix

49. Only one document57 is available in the project files that may give some information onthe progress in the policy matrix, suggesting little policy dialogue took place during FSILimplementation. The PCR pointed out a midterm review mission was not fielded, which was amajor shortcoming of project administration, as a mission would have allowed the reassessmentof the Projects sustainability and purpose. The OEM supports this view. The World Bankvoided the policy matrix when it cancelled the FSDIP in 1998.

III. ACHIEVEMENT OF PROJECT PURPOSE

A. Performance Indicators

50. Table 1 contains the key financial sector indicators related to the FSIL. The indicatorssuggest that (i) the banking sector and the capital market were stagnant during FY2000FY2001 compared with FY1995FY1999; (ii) banking performance in terms of both volume andefficiency started to recover in FY2002; and (iii) secondary capital market transactionsincreased from FY2003, and the primary capital market indicated signs of recovery fromFY2004. The next paragraphs further assess these indicators.

56Administration of the FSIL was transferred from headquarters to the Pakistan Resident Mission in January 2000.

57The document is not dated and the author is not indicated. No cover letter is attached to the document.


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16Table 1: Key Financial Sector Indicators

Banking IndicatorFY1995FY1999

FY2000FY2001

FY2002FY2003 FY2004

Bank Credits/GDP (%)a

36.640.1 34.334.9 36.5-39.9 28.228.9 30.9-33.7 36.8

Interest Rate Spread (%) 3.85.6 4.65.2 4.1-4.7

Bank Assets/Financial Sector Assets (%) 84.287.9 89.491.6 92.4-92.7

Capital Market IndicatorFY1995FY1999

FY2000FY2002 FY2003 FY2004

Number of IPOs 059 25 2 11Market Capitalization/GDP (%)

a9.625.8 10.012.5 18.6

8.210.4 15.7 26.0Average Daily Trading Volume (million shares) 9.5103.4 118.2192.7 214.4 553.8 = not available, FY = fiscal year, GDP = gross domestic product, IPO= initial public offering.a

The Government rebased the GDP in FY2004 with retrospective effect from FY2000. Consequently, the GDP inFY2000 was increased by 20.5%. Data in upper rows do not reflect this revaluation while data in lower rows reflect therevaluation.

Source: Appendix 11.

51. The total bank credits (as % of GDP) contracted from a range of 36.440.1% duringFY1995FY1999 to 34.334.9% during FY2000FY2001. 58 This can be explained by thesurfacing in 1997 of the distressed state of the banking system and the subsequent bankrestructuring (footnote 48), and the restrained credit demand due to political instability andexternal shocks during 19982001 (footnote 26). The banking reform initiated in 1997 started tobear fruit from 2002, supported by the favorable macroeconomic and external conditions. Thetotal bank credits (as % of GDP) increased from 28.228.9% during FY2000FY2001 to 30.933.7% during FY2002FY2003, and further to 36.8% in FY2004. 59 Bank credits to themanufacturing sector (as % of GDP) also slightly increased in recent years (Appendix 11). Theinterest rate spread was reduced from 4.65.2% during FY2000FY2001 to 4.14.7% duringFY2002FY2003, suggesting enhanced competition in the financial market. Many banks haveincreased their earning assets while diversifying their operations into leasing and investmentbanking, squeezing out some NBFCs from the market for the recent years.

52. Market capitalization (as % of GDP) decreased from a range of 17.625.9% duringFY1994FY1997 to 9.612.5% during FY1998FY2002, and increased to 18.6% in FY2003.60Market capitalization further increased to 26% in FY2004. 61 The recovery in marketcapitalization reflected the rise in share prices, supported by the favorable macroeconomic andexternal conditions. The average daily trading volume in shares progressively increased from6.5 million in 1994 to 214.4 million in FY2003 (except for FY2000), and significantly increased to553.8 million in FY2004. The number of IPOs dropped from a range of 1051 during FY1994FY1997 to 05 during FY1998FY2003, but increased to 11 in FY2004. 62 Overall, theseindicators suggest signs of recovery in the capital market in recent years.63

58Based on the GDP figures before the revaluation (footnote a, Table 1).

59Based on the GDP figures after the revaluation (footnote a, Table 1).

60Based on the GDP figures before the revaluation (footnote a, Table 1).

61Based on the GDP figures after the revaluation (footnote a, Table 1).

62As of 21 March 2005, 12 IPOs were recorded in KSE for FY2005.

63Subsequent to the OEM, the Pakistan stock market experienced a major bullish run. The KSE-100 index, whichsurged by 65% since January 2005 to a peak of 10,303 on 15 March 2005, fell by about 35% to 6,725 on 13 April2005.


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17B. Project Outcome

1. Credit Line

53. Profiles of selected subprojects in Appendixes 59 illustrate the outcomes for 12subborrowers of 13 subprojects totaling $16.7 million (68.2% of the total disbursed amount),

including the three largest subprojects.

64

Of the 12 subborrowers, 9 subborrowers' annualturnover as of the OEM ranged between PRs15 million and PRs28 billion, and 11 subborrowerstotal employees ranged from 18 to around 3,800. Of the 13 subprojects, 8 had higher production,and also 8 contributed to job creation ranging between 2 and 400. Nine subprojects weregeared to earn or save FX; two were concerned with introduction of high technology; one wasengaged in high value-added products; while none of the 13 subprojects were particularlyenvironment-friendly.65 The OEM noted that most of these 12 subborrowers had other fundingoptions with interest rates comparable with those of the subloans under the FSIL. Mostsubborrowers also highlighted the simple and quick appraisal process as well as tax benefits ofleasing relative to bank loans. The OEM could not collect information to evaluate the financialand economic rate of return of any of these 13 subprojects.66

54. The total disbursement of $24.5 million under the FSIL may be negligible whencompared with the size of the financial sector assets of $34.8 billion equivalent and banksforeign liabilities of $1.3 billion equivalent (as of end-2000, when the FSIL was closed). However,this amount could be large enough to influence the PFIs operations. Disbursements under theFSIL were 8.723.2% relative to the respective PFIs assets; and 24.739.7% (as of end 2000)relative to the PFIs total long-term liabilities. The total assets of the five PFIs represented 6.3%of the NBFIs total assets (as of end-2000). This was not a negligible amount and suggests thatthe FSIL could have been a catalyst for improving the NBFI/leasing subsector if it had beenappropriately framed and implemented. DLC and NLC effectively utilized the FSIL to attainsound companies growth. DLC management confided that because of their participation in theFSIL, their project appraisal capacity improved. PKIs experience with the FSIL was not soencouraging, given the underperformance of its largest subproject (which was also the largestamong all the subprojects). The fraud scandals and the subsequent financial problems of ELLand PICL significantly undermined contributions of the FSIL. The subloans through ELL andPICL performed relatively well. However, the FSIL was not effective in improving thegovernance of those institutions. It could also be said that ADB sent a wrong signal to otherlenders who trusted ADBs due diligence capability. Overall, FSILs net contribution to financialintermediation was far less than expected.

64Thirteen subloans included three each from PICL, DLC, and PKI, and two each from NLC and ELL. Elevensubloans had been fully repaid, and two are still repaying. Six are located in Karachi, three inIslamabad/Rawalpindi, and three in Lahore. The 13 subprojects are not statistically representative samples. Giventhat 12 of the 13 subloans were repaid on schedule or earlier, the sample subloans presumably outperformed theremaining 60 subloans (of which 49 were repaid on schedule or earlier) in terms of project benefits.

65

The project agreements stipulated that PFIs shall prioritize development projects that are (i) geared to earn or saveFX, (ii) based on high technology, (iii) environment-friendly, and (iv) based on high value-added processes. Onthese bases, the RRP identified the following as expected project benefits: additional capital formation, valueadded, employment, FX earnings or savings, and promotion of new entrepreneurs. The RRP did not quantify thesebenefits. Review of the project files and the OEM interviews suggest that both ADB and PFIs did not pay muchattention to these four criteria in identifying subprojects.

66The Loan Agreement/project agreements did not specify the type of data to be collected and the timing of theircollection for benefit monitoring and evaluation (BME). Hence, the PFIs and BEL did not particularly attempt tomonitor the subproject benefits. Understandably, some subborrowers were not willing to submit post-projectinformation to the PFIs and reluctant to meet with the OEM. The PPAR on the Second Development FinanceProject in Indonesia (ADB. 2004. Project Performance Audit Report on the Second Development Finance Project inIndonesia. Manila) highlighted the weak BME as a general issue in most of ADBs DFI loans.


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182. Policy Matrix

55. The FSIL policy matrix concerned (i) central banking, (ii) NBFIs, (iii) insurance industry,and (iv) capital market. The FSIL measures on central banking represented a small fraction ofbroader reforms supported by ESAF and BSAL, forming the basis of the recent recovery of thebanking system. Establishment of the SEC, an indirect output of the FSIL, was a key initial step

in strengthening the regulatory and supervisory framework of NBFIs, and insurance and capitalmarkets. Moreover, the comprehensive review of the stock exchanges operations supportedunder the FSIL and TA 2393-PAK resulted in the introduction of several important market rules.All these achievements formed the basis for implementing the CMDP, leading to th

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