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Challenges in banking sector of Pakistan

In last few years, banking system in Pakistan has entered into a new phase of evolution yet facing various issues, where political instability and economic uncertainty remain the main problem. On one side, banks are making profits, defaults are on decline and have surplus liquidity in recent years but on the other side, economic conditions in the country have deteriorated in last two years due to political instability. Economic growth is an apt indicator for the growth of the banking sector; Pakistan’s economic expansion has been quite impressive from the perspective of GDP growth rate in last five years and was even highest in last fifteen years. Whereas Pakistan’s banking sector remained sound and stable in 2017, with total assets growing to Rs 18.34 trillion (USD 159.5 billion) from Rs 15.83 trillion in 2016. However, Pakistan’s banking sector profitability declined by three percent to Rs 39 billion in 2QCY18 mainly due to increased expenses incurred by big banks on pension and compliance costs.

Despite a rise in loans due to low interest rates, banks continue to invest large sums into risk-free government securities to bolster their earnings. As per State Bank of Pakistan’s latest issue of “Quarterly Compendium: Banking Statistics”, first tier (1-5), second tier (6-10), third tier (11-20) and fourth tier (21-28) banks in the sector had earnings of 52.1, 26.3, 18.3 and 0.8 percent respectively of the total profits as of June 30, 2018. Whereas foreign banks’ profit from the total pie was 5.5 percent.

Latest earnings reports of Pakistan’s top-five banks have also shown that key financial metrics of National Bank of Pakistan (NBP) have improved markedly and the bank has outpaced its peers in profit growth due to changes in business strategy in the first half of the current calendar year. With most banks facing a significant decline in profit due to various reasons including different provisions and loss in trade business, NBP announced a growth of 46%. However, three of the big five banks saw their after-tax profit go down massively in the same period. It is being said that earnings of top-five banks can be seen as an indicator of the health of Pakistan’s banking system.

Lending ratio to the private sector in Pakistan is less than other South Asian countries, yet banks are making huge profits as compared to the regional countries. As per a newspaper report, returns of Pakistani banks have been around eight percentage higher than regional peers over the last five years. Now the question arises, how the banks are making profits. There are a number of revenue sources for a bank including lending to public and private sector companies both big and small, and procuring government papers, bonds and notes. Investment in government securities are preferred investment opportunities for a bank in Pakistan, which government uses for subsidizing the fiscal deficit.

As a matter of fact, banks are only lending to big companies and business houses and are reluctant to lend to small and medium enterprises which is struggling to raise debt from the market. As per the official statistics of SBP, commercial banks holdings in the government securities slightly rose to Rs 7.372 trillion as on June 30, 2018, compared with Rs 7.363 trillion in the corresponding period last year. Government budgeted Rs 1.0 trillion in borrowings from the banking sector for FY19 and it is expected that this number will be revised upwards due to the ongoing economic scenario and liquidity within the banking sector. State Bank of Pakistan (SBP) has announced to auction Rs 5.15 trillion worth of Market Treasury Bills (MTBs and Pakistan Investment Bonds (PIBs) in September-November 2018 to help the government finance the budget deficit. The SBP would sell Rs 4.850 trillion of three, six, and 12 months debt through T-bills. The central bank also plans to offer Rs 150 billion worth of three, five, ten and twenty-years PIBs.

Banks can only make profits if it is investing (i.e. lending) at a higher interest rates while covering the risk elements and paying less to its depositors, the more the delta the more the profit. Due to various reasons, banks have little incentive to do anything else except to lend to the government which is both risk free and highly remunerative. However, independent economist view this as a dysfunctionality in the financial sector.

It is important that Regulator put a limit on the banks in investing in government securities and lending to small and medium enterprises. This is not an ideal solution but it will force banks to focus on small and medium enterprises which is a life line of Pakistan’s economic growth.

The big disadvantage of state owned banks now is that government has barred them from charging high spread (interest rates) on some of government related doubtful loans thus government tries to keep financial expenses minimum but it impacts the profitability of the banks. In addition, government owned banks do not write off bad loans easily due to fear of inquiry by the National Accountability Bureau (NAB). There should be an independent committee for investigating the reasons for bad loans and banks should write off loans on the basis of their recommendation only. This can also be out-sourced to some third party financial managers so as to mitigate the risk of inquiries by NAB.

In addition, banks seriously need to improve the corporate governance. We have seen heavy fine on HBL by the US regulatory authorities and numerous fraud and embezzlement cases are also investigated in NBP in recent years. SBP and SECP have to take certain steps in implementing corporate governance in the banks. Whereas banks should also establish procedures for compliance checks. The SBP should take measures to put in place and enforce good governance practices to improve the internal controls and bring about a change in the organizational culture.

In today’s world both internal and external factors affect the banking system which need constant supervision by the regulator. There should be a formal and comprehensive documentation of economy. A very large number of individuals are still not in the banking ambit and operate outside the orbit of banking system. It is very important to bring that segment in the net and banks would be able to attract billions of rupees. Moreover, present government has ambitious plans to construct affordable housing schemes though government has yet to announce the policy framework for housing schemes and house building loans in this area will help government in providing affordable housing to the people.

Regarding the future outlook of the sector, SBP says profitability will depend on the momentum of advances, developments in the foreign-exchange market and performance of the capital market. The Pakistan’s economy is projected to grow at a rate of over 5 percent and the country’s banking industry is expected to reflect this growth. The onus for this lies in the capabilities of SBP as an able central regulatory authority, whose policies have shielded Pakistani banks from excessive leveraging and making high risk investments. The key challenges for the industry are to reduce Non-Performing Assets (NPAs), increase financial inclusion and raise capital for regulatory compliance.

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