Framing policies for a digital economy

We are starting a new chapter in banking reforms. I want to praise the recent developments and the future evolution of digital banking in the larger context of digital Pakistan strategy and the financial sector reforms, which does not end. 

Digital banking and eCommerce are ingredients of overall digital strategy. I would like to limit my remarks on the financial sector and how digital banking fits into that. We should not forget the purpose for which the State Bank of Pakistan (SBP) is promoting digital banking. And that is it is an effective tool for strengthening intermediation and financial inclusion in the country in the pursuit of larger, equitable and sustainable development of Pakistan. 

We should not barely focus on a small piece but contextualise what is the actual purpose of digital banking. 

Let me add a caveat: the banking sector’s performance can not be isolated from the overall macroeconomic environment. When the environment is stable and the track record in management and governance is sustainable, the banking sector does well. Under the present fragile, fluid and uncertain environment, it will be unfair to expect from the banks and other financial sector institutions to do well. But that is context for the present. What we are talking about is the future and I don’t think the present situation will persist. 

It is important to highlight the evolution in banking sector reforms. The first generation of reforms started in the 1990s and got an accelerated momentum in early 2000s and it focused on liberalisation of the financial system, privatisation of nationalised commercial banks, autonomy and capacity building of the State Bank, pricing of financial products and evolution of direct credit ceilings and reliance on markets mechanism for allocation of credit. Recovery of non performing loans was stepped up by forming a corporate and industrial restructuring corporation. 

A code of corporate governance was enacted and forced through a three or four tier structure. Appointments of CEOs were made on a predefined fit and proper criteria so that charlatans can not come and occupy this space. A number of banks were asked to either wind up businesses or merge, and delinquent boards were suspended or dismissed, creating a deterring effect to malpractices. Other reforms were also undertaken. 

As a consequence of the first generation reforms, 80% of the banks became private banking assets. Instead of subsidies from the exchequer, banks have become profitable and last year they contributed Rs 200 billion in the form of corporate taxes. Quality of human resources inducted became high and technology started to seep up in the operations. Financial performance indicators went upwards to meet the and non performing loans shrunk to single digit. 

Despite these achievements, I am not very satisfied with the progress. There is a lot of fluidity as far as the banking sector is concerned. A large number of issues and problems have surfaced since the completion of the first generation reforms that need to be resolved. 

The outreach of the newly privatised banks, earning huge profits, remains limited to corporates, big names and high net worth individuals, trade financing and fee based activities. They did not make any efforts to extend credit to underserved sectors such as the SMEs, small and medium farmers, low cost housing, personal and consumer financing. Their network in underdeveloped areas was confined to deposit mobilisation rather than lending. Prudential regulations were amended to enable the banks to lend to these sectors. To broaden the access to new modes of banking institutions that were introduced were firstly, the ones that shunned banking due to their faith were given the opportunity to choose Islamic banking which offered Shariah compliant products. The other set of institutions was microfinance banks. 

We took pride in becoming the first central bank in the world to regulate microfinance banks. We were advised against it but now, most of the central banks around the world are regulating microfinance banks. That is what we had done in order to cater to the people at the lower end of the spectrum who never had access to finance. 

We moved into microfinance to serve women entrepreneurs but the progress has not been great and they are still confined to big cities and have not gone into small towns or the rural areas. To meet the needs of the project finance, we established the joint venture DFIs with the assistance of foreign partners. An upsurge in all the activities was noticed in the earlier years in broadening the access and SMEs went up to 17% of the overall private sector credit. Unfortunately, this has slowed down once the government became the dominant borrower and the results 20 years later today are disappointing. 

The size of the banking system is small relatively to the economy and its peers. The advances to deposits ratio has tumbled below 50% and most of those assets are invested in government securities. The share of SMEs in the private sector has come down to 7% now from 17%. 

Agriculture credit has remained stagnant in relation to demand. The number of accounts in the banking system are still quite low compared to our neighbouring countries. In comparison to our peers, Pakistan lags behind in terms of financial market development, financial assets, depth of financial institutions, credit to private sector, insurance penetration and development of capital markets. 

No doubt that the above outcomes arising from the dismal performance of the formal financial services industry are to a large extent responsible for recurring macroeconomic imbalances, frequent balance of payments crisis, in addition to the government’s role as borrower from the banking system, and the role of banks themselves. 

The latest data shows that only 21% of the adult population has a bank account compared to 78% in India and 53% in Bangladesh. As a consequence of the low deposit GDP ratio, Pakistan’s national savings rate has never exceeded 15% and that we should thank our workers abroad who are remitting 5-6% of the GDP as the savings. The rest of the savings are below 10%. 

An investment rate of 20% which is required for growth can not be achieved with a low savings rate. As a consequence, we would need to borrow from commercial banks as well as external borrowers. What the banks need to think about is how to mobilise these savings, which are intangible, illiquid assets which have to be liquified and brought into the formal financial sector. We have to realise that today, the external debt servicing takes away 85% of the export earnings, which is not a sustainable situation. 

The formal financial sector has the responsibility to mobilise savings and for the government to curtail deficits. Unless we do that, we would be going to the IMF and borrowing every now and then. Now I come back to my vision. Back in February 2001, in my address to the institute of bankers, I made the following plea: “We have to consider e-banking not only as a technological issue but also as a viable business proposition as the number of internet users in the country is growing exponentially. The State Bank and the government can act as facilitators and problem solvers but the banks themselves will have to gear up sooner or later to reap benefits for eCommerce.”

“They have to enforce deadlines to move to this mode of transactions which is e-banking.” Now that licences for digital banking have been granted, I would still reiterate the same message 22 years later. There is no reason that the existing commercial banks who are allowed under their existing licence can not embark upon this line of business. 

It generally started in the early 2000s. ATM interoperability was created in the early 2000’s. The electronic transactions ordinance was promulgated in 2000 providing legal recognition to digital signature and documentation, reducing the risk associated with the use of electronic medium of business. Commercial banks were allowed to openly operate internet merchant accounts 22 years ago. SBP acquired SWIFT connections and made it mandatory for the banks to maintain SWIFT connectivity for settlement of cross border financial transactions. 

The other major initiative SBP took was to complete the largest single project of computerisation worth $30 million. To fully automate the SBP operations, set up a data warehousing and established electronic links with the banks. At the same time, the real-time gross settlement system, now called PRISM, was set up to provide a platform for wholesale transfers and settlement of funds.  

By 2002, almost 40% of bank branches had been automated with a phenomenal growth rate. The number of online branches jumped to 1336 in 3 years time. In the last 5 years the progress of e banking has been impressive and the central bank and its leadership needs to be commended for that progress. Its share in the total value of retail payments has risen from 34% to 42%.

But paper-based transactions are still dominating with Rs 190 trillion. This is this slice of pie that digital banks have to nibble forcefully not on the edges but going to the middle, and increase e-banking to at least 80 to 90% in the next 5 years. 

Currency circulation has doubled in the last 10 years. The number of internet banker users is only 8 million and that of mobile banking is 12 million so even if we add this up, this accounts for only 30% of unique mobile phone users. The five new banks have a substantial market of 80% of mobile phone users. And the number of smartphones with 3G and 4G has been rising and broadband penetration is also rising very rapidly. So this is the chance for digital banks to serve.

The digital banks should advance the goal of financial inclusion. Granting of 5 licences is only the first step by the State Bank to the long journey and this is the right step in the right direction. 

The hard work for digital banks begins now as the expectations from both regulators and the public at large are quite high. First they have to demonstrate that their transaction costs are lower than the existing providers, and that the customers enjoy much greater convenience as it saves effort, time and hassle. Their fees and service charges are lower while speed of transaction is faster, accuracy of reporting is better, payments are secure and cyber security is ensured. In other words, these new digital banks should display high levels of efficiency at lower costs. Secondly, they are to diversify their asset bases functionally, sectorilly, geographically, by size and gender. 

Commercial banks are earning considerable margins by investing in risk free government paper. The IDR today is 17% which is not what the banks should actually be doing. This is stifling private-sector growth, particularly in those sectors and geographies which have the potential for its option for credit. These are the areas where financial sectors as a whole, but particularly islamic banks, have been unable to break so far because very naturally, the alternatives for them are fairly attractive and reaching out to this underserved sector is more risky as well as costly. Why? Commercial banks do not have access to a lot of parameters and data to properly assess prospective borrowers. Small borrowers, particularly females, are unable to meet the documentation and collateral requirements of the banks. The administrative costs of processing thousand small loans decrease the profitability prospects 

By using machine learning, data capture and data analytics, for discerning the patterns, the digital banks can develop credit scoring models for lending and deployment who do not have to go through extensive documentations or are able to offer securities, collateral or guarantees. The CRM platforms are able to track customer history, and provide quick feedback to online communication. 

That comes with upfront costs in research and development to develop these models but these costs should be considered as investment in customer acquisition, expansion of network, focused history of credit risk and establishing competitive advantage. This will take a few years and digital banks will have to be patient. 

Those looking for instant gratification and quick returns will be disappointed in the long term. 

Thirdly, the digital banks have to develop a portfolio of investments not only in sectors such as SMEs but also in non-traditional economic and social activities like human development by providing  loans like Qarz-e-Hasna to poor families, to students that are talented but don’t have financial means to study. In my experience at IBA, where we had the National Talent Hunt Program, really reinforces my belief that there is a lot of talent in this country but they are not given the opportunity. 

They should also provide financial services for educational, health facilities and agri-businesses outside of cities where there is demand for quality services. 

Next up, collaboration with fintech should be incentivized. Banks need to come up with KPIs to enhance business efficiencies, accelerate innovation, integrate systems without customization and improve customer experience. They can extend the functionality of their products to fintech companies, saving time and money and thus staying agile in the marketplace. Fintech companies can help in digitization of the supply chain and involve payments at much increased pace. This should enable the digital banks to offer intuitive and innovative solutions to their customers. 

Fifth, the digital banks would have to maintain financial strengths and capacity to absorb unanticipated shocks and stress. Human resources who are capable of solving the problems instead of shoving the papers as is the case with commercial banks would have to be inducted and trained. A balance between tech savvy and business professionals will have to be maintained. A new culture, smartly different from what we have currently would have to be nurtured by the digital banks. 

Sixth, with rapid technological advances, digital banks have to constantly strive to catch up with new innovations and practices. Partnerships with foreign technology providers and services will help achieve some great enhancements and refinements in software applications which will help keep that competitive edge and customer satisfaction. 

Let me conclude with a word of caution, the risk arising from adoption of technology has enabled an addition to the credit risk and other risks which are associated with financial intermediation. Ensuring cyber security, preventing fraud, identity theft, hacking of the databases and having poor customer interface which can break down the back of the systems, congestion of traffic that leaves the customer waiting for long periods would require close vigilance and attention by chief executives and management of digital banks; something that the executives cannot just delegate to their subordinates and sleep in slumber.

Dr. Ishrat Husain
Dr. Ishrat Husain
Dr Hussain is a former governor of the State Bank of Pakistan.


  1. What are the 3 main components of digital economy?
    Image result for Framing policies for a digital economy
    “Digital economy” refers to the use of information technology to create or adapt, market or consume goods and services.

    According to US economist and statistician Thomas Mesenbourg in his 2001 paper, three components distinguish the digital economy from the regular economy:
    Infrastructure. …
    E-business. …

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