Banking Companies Ordinance (BCO) 1962 defines banking as

Banking Companies Ordinance
(BCO) 1962 defines banking as an activity whereby banks accept deposit funds
from the public which are loaned out to others or invested in other projects.
Banks are liable to pay this fund back to the deposit holders upon the demand
from them or upon maturity. The definition defines two major roles of banking
i.e. deposits and lending. Thus banks act as financial intermediaries between
savers and borrowers. A failure of these intermediaries would not only mean a
complete or partial loss of the hard earned money of the savers but also the
fact that there would be no institution to lend the money to the people who
have less of it. Thus machinery of the entire economy would be crippled. During
the last five years world has experienced one of the worst financial crises in
history. A crisis that seems to originate from the United States’ soil soon got hold
of the economies worldwide. There were a number of factors involved in giving
birth to this crisis but one dominant reason was the subprime lending; a
product of banks. Thus a weak and prone to shocks banking system has the
capability to shake the entire economy. This fact is supported in a number of
researches being carried out on the topic e.g. the empirical studies of
Crockett (1997), Gonzalez-Hermosillo (1999) and international monetary fund
(1998) showed that the figure of nonperforming loans (NPL) rose both before and
during the period of various crises.

Financial stability and crises has been studied and worked
upon by a number of authors but there are very few who gave an analytic and
rigorous definition of the terms. Andrew Crockett (1997) defines financial
stability as a situation where the key institutions and markets that make up
the system are stable. The stability requires of them the confidence which
people can show on them and also their ability to meet their contractual
obligations without any assistance or interruption from outside. This stability
also means that the participants are able to transact freely at prices that
reflect the true market forces mechanisms and not some short term artificial
price hikes.

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According to Mishkin financial instability is a situation
where the information coming into the financial system is tampered with,
resulting in inability of the financial system to channel its funds to
productive investment opportunities (Mishkin 1994).

1.2  Objective

The
impacts of the recent financial crisis were not felt heavily by the banking
sector in Pakistan.
Although there were some impacts on trade and currency depreciation but banks
seem to absorb the shocks well as there was not a single case of any financial
institution going bankrupt. The purpose of this research is thus to construct a
Banking sector fragility index (BSF) in order to find out whether the banking
system of Pakistan
was fragile or not during the time when the world was hit by the crisis. This
will also let us know that had the crisis episode been prolonged would our
banks still be able to withstand the shocks.

1.3  Statement of the problem

Was
there any time in the preceding four years when the banking system in Pakistan was
fragile? Fragility here does not mean bankruptcy rather tendency of the bank
towards malfunctioning.

1.4  Scope

The
scope of the study will be limited only to the commercial banks working in Pakistan.
Furthermore the time period of the study would be from 2006-2009.