ISHRAT HUSAIN Pakistan’s banking sector reforms which were initiated in the early 1990s have transformed the sector into an efficient, sound and strong banking system. The most recent comprehensive assessment carried out jointly by the World Bank and the IMF in 2004 came to the following conclusion:
“ for reaching reforms have resulted in a more efficient and competitive financial system In particular, the predominantly state-owned banking system has been transformed into one that is predominantly under the control of the private sector. The legislative framework and the State Bank of Pakistan’s supervisory capacity have been improved substantially. As a result, the financial sector is sounder and exhibits an increased resilience to shocks.”
The major changes that have occurred in the banking sector during the last decade or so can be summarized as follows:
80 percent of the banking assets are held by the private sector banks and the privatization of nationalized commercial banks has brought about a culture of professionalism and service orientation in place of bureaucracy and apathy.
The banks that were losing money due to inefficiencies, waste and limited product range have become highly profitable business. These profits are, however, being used to strengthen the capital base of the banks rather than paying out to the shareholders. The minimum capital requirements have been raised from Rs. 500 million to Rs. 6 billion over an extended period in a phased manner. The consolidation of the banking sector into fewer but stronger banks will lead to better management of risk.
The banks that were burdened with the non-performing and defaulted loans have cleared up their balance sheets in an open transparent, across-the-board manner. Contrary to the popular myth the main beneficiaries of the wirite-offs of the old outstanding and unrecoverable loans have been from almost 25 percent to 6.7 percent by Dec. 2005. Small individual borrowers the ratio of non-performing loans of the Commercial Banks to total advances has declined.
The quality of new assets has improved as stringent measures are taken to appraise new loans, and assure the underlying securities. Online Credit Information Bureau reports provide updated information to the banks about the credit history and track record of the borrowers. Loan approvals on political considerations have become passé. Non-performing loans account for less than 3 percent of all new loans disbursed since 1997.
The human resources base of the banks has been substantially upgraded by the adoption of the principles of merit and performance throughout the industry. Recruitment is done through a highly competitive process and promotions and compensation are linked to training, skills and high performance. The banks now routinely employ MBAs, M.Coms, Chartered Accountants, IT graduates, economists and other highly educated persons rather than Clerical and Non Clerical Workers. The banking industry has become the preferred choice of profession among the young graduates.
Banking Technology that was almost non-existent in Pakistan until a few years ago is revolutionizing the customer services and access on-line banking, Internet banking, ATMs, mobile phone banking and other modes of delivery have made it possible to provide convenience to the customers while reducing the transaction costs to the banks. Credit Cards, Debit Cards, Smart Cards etc. are a thriving and expanding business in Pakistan. Once the RTGS is put in place the payment system in Pakistan. Would enter a new phase of modernization.
Competition among the banks has forced them to move away from the traditional limited product range of credit to the government and the public sector enterprises, trade financing, big name corporate loans, and credit to multinationals to an ever-expanding menu of products and services. The borrower base of the banks has expanded four fold in the last six years as the banks have diversified into agriculture, SMEs, Consumers financing, mortgages, etc. The middle class that could not afford to buy cars or apartments as they did not have the financial strength for cash purchases are the biggest beneficiaries of these new products and services.
Along with strong regulation, supervision and enforcement capacity of the State Bank of Pakistan a number of measures have been taken to put best corporate governance practices in the banking system. ‘Fit and proper’ criteria have been prescribed for the Chief Executives, members of the Boards of Directors, and top management positions. Accounting and audit standards have been brought to the International Accounting Standards (IAS) and the International Audit Codes. External audit firms are rated according to their performance and track record and those falling short of the acceptable standards are debarred from auditing the banks. These practices were put in place in Pakistan long before the scandals of Enercon, World Call and Pramalat had shaken the corporate world.
The foreign exchange market that was highly regulated through a system of direct exchange controls over suppliers and users of foreign exchange has been liberalized and all purchases and sales take place through an active and vibrant inter-bank exchange market. All restrictions have been removed with full current account convertibility and partial capital account convertibility. Foreign investors can now bring in and take back their capital, remit profits, dividends and fees without any prior removal and directly through their banks. Similarly, foreign portfolio investors can also enter and exit the market at their own discretion.
The main lesson learnt from the last decade suggest that financial sector functions effectively and efficiently only if the macroeconomics situation is favorable and stable. The need to maintain macroeconomic stability will thus remain paramount in the years to come.
The agenda for further reforms in the financial sector is still quite formidable and the challenges to spread the benefits of financial liberalization among the middle and low income households and small and medium farms and enterprises are still enormous.
There are several areas of dissatisfaction with the banking sector that need to be addressed.
The most serious complaint against the banking system in Pakistan today is that the depositors are not getting adequate return on their bank deposits. The difference between the monthly weighted average rates of lending and deposits is taken as an indicator of the spreads earned by the banks. It is true that these spreads have widened in the recent months land this phenomenon has caused resentment among those whose only source of income is their returns from bank deposits. But it is important to examine the facts and their form judgments
The monthly comparisons are meaningless because PLS deposit rates are changed every six months, while the lending rates are continuously adjusting because they are automatically linked to T-bills or KIBOR rates.
During the last eight months the weighted average deposit rate has risen from 1.6 percent in July – Feb, 2005 to 3.9 percent in July – Feb, 2006. This trend reflects that the return on the new deposits mobilized is much higher than what the average rate indicates. The old deposits are earning much lower rate because they were lodged at the time when the overall structure of interest rates had come down significantly. This lag is adjustment between the deposit and lending rates is due to the costs incurred by the depositor in shifting deposits from one bank to the other.
The additional deposits mobilized in the last twelve months amounted to Rs. 382 billion i.e. a growth rate of 16.8 percent. This growth rate took place despite deceleration in the volume of Resident Foreign deposit accounts. So if the deposit rates were unattractive then this high growth rate in deposits mobilized by the banks appears to be puzzling. The reason for this high growth is that the fresh deposits were fetching an average return of 6.2 percent in March, 2006 compared to 3.5 percent in July, 2005 – rise of 270 basis points in nine months. In the coming months the average rate is likely to move further upwards bringing them to positive real interest rates.
Why have the profits of the banks risen so sharply in the last few years? There are several reasons that need to be understood:
First, the drag of non-performing loans has been eased considerably reducing the need for setting aside the provisions for loan losses. As these provisions were made at the expense of the profits the banks are now reaping the benefits of building up substantial provisions and taking the hit on their profits in the past.
Second, the corporate income tax rate on banks’ profits has gradually come down from 58 percent to 38 percent saving on their tax deductions. These savings not only get translated in to higher profits but also act as incentives for better performance because the tax rate no longer acts as a penalty.
Third, the diversification of the banks assets into new and so far underserved segments such as agriculture, mortgage, auto, SMEs, Consumer and Credit Cards have raised their net interest margins. As competition has become quite tough in the corporate segment the margins on corporate loans have been squeezed considerably. But the spreads earned in these new segments are quite attractive. Thus a large part of the profits originate from lending to these underserved segments of the population. This is a Win- Win situation as small farmers, small businesses and middle class consumers, who had so far been denied access to bank credit, are able to get financing the banks are able to earn higher spreads.
Fourth, there has been a shift in the maturing profile of both the banks’ deposits and banks’ loans. Half of the total deposits are now placed for short term duration earning negligible rates of return compared to the past where the distribution of deposits were concentrated in medium to long duration earning much higher returns.
On the assets side, more of the bank loans are being disbursed for fixed investment purposes. These have long maturity structure and pay higher interest rates in double digits.
This shift in the composition of deposits and advances has helped earn the banks a higher spread boosting their profitability.
As the majority of the banks are operating in the private sector they will remain guided by the bottom line considerations i.e. the profits. Consolidation and market competition will act as a deterrent on abnormal profits but it is the responsibility of the regulator to ensure that these profits are not made by taking excessive risk with the depositors’ money or by banks indulging in collusive practices. The regulator has to ensure that the access to credit is further broadened and small farming households, small and medium businesses and middle classes are able to meet their legitimate credit needs. At the same time the regulator has to take stringent action against those banks found guilty of anti-competitive or collusive practices.
Another popular indictment against the banking sector is that they are financing speculative activities such as stock market trading, real estate, commodities, auto etc. The facts do not support this indictment. Direct and indirect exposure by banks in stock market equities has been limited to 20 percent of their capital i.e. the maximum amount all the banks can collectively provide for this activity is only 40 billion. The outstanding stock of bank advances in March, 2006 stood at Rs. 2063 billion. Thus the bank credit allocated for stock market equity trading is less than 2 percent of the total advances of the banking system. If we further assume that some amounts are diverted from consumer loans or corporate loans also the exposure of the banks may double to as much as 4 percent but the securities and collaterals against the diverted loans may not necessarily be the scrips themselves.
Real estate financing by banks is restricted to mortgage loans only and the purchase of plots cannot be financed by the banks. Mortgage loans can be disbursed in installments after physical verification of the various phases of construction. The total disbursements of loans for mortgage amounted to Rs. 11.4 billion in FY 05.
Commodity financing and its prevailing rates are not attractive for the borrowers as there has been net retirement of commodity loans in the first nine months of the current fiscal year.
The regulatory environment for the banks to indulge in lending for speculative purposes is not very propitious. The State Bank of Pakistan supervisors are not only vigilant in their on-site inspection but they monitor the banks on a continuous basis and can detect irregularities and violations fairly quickly. The more deterrent effect of strong oversight by the supervisors is enough to discourage such activities. The penalties imposed by the supervisors on recalcitrant banks are quite severe.