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Can state bank of Pakistan contain erosion in profitability of banks?

Commercial banks are the core providers of liquidity to the private sector and the biggest investors in government securities (Treasury Bills, Pakistan Investment Bonds and Sovereign Sukuk). These are also the biggest investors in the shares of public limited companies (through investment portfolio and fully owned asset management companies). For considerably long time experts have been saying that banks have to redefine their business model. A review of the third quarter of CY18 performance of banks is likely to prompt the investors to reduce their exposures in banks. Two out of big five banks were imposed huge penalties in the United States and whatever happened at BankIslami Pakistan demands that the central bank must improve its monitoring and controlling mechanisms.

A quick review of third quarter performance of banks tells us a rather depressing story. Despite the two recent hikes in the interest rates, profitability of Pakistan’s banking sector declined to Rs31.6 billion, down by 27% YoY adjusted for penalty on Pakistan’s one of the oldest and largest commercial bank, Habib Bank Limited (HBL). The decline in sector profits can be attributed to Rs6.8 billion aggregate provisions, lower non-interest income and higher non-interest expense during the outgoing quarter. This analysis is based on the details of the listed banks that have announced 3Q2018 financial results.

Therefore, the first point to be analyzed is the massive provisioning by the banking sector. Collectively banks made significantly higher provisions during the quarter, amounting to Rs 6.8billion as compared to Rs 2.1 billion provision reversal in the same period last year. Bulk of these provisions was made by the big banks with UBL (Rs3.1 billion), NBP (Rs2.0 billion) and HBL (Rs1.7 billion. NBP made significant provisions on its loan portfolio while HBL booked charge for impairment in investments. Simultaneously, UBLs provision charge originated from both its international loan book as well as impairment of equities. Within the listed banks, the big five (HBL, UBL, MCB, NBP, ABL) posted a 48% YoY decline in earnings (normalized for HBL penalty). A against this mid-tier banks (BAHL, BAFL, MEBL) continued with growth momentum and reported profitability growth of 17% YoY.

Net Interest Income (NII) of the banks improved by 9% YoY to Rs 122 billion for 3Q2018, led by higher interest rates and better deposit mix. However, on a sequential basis, NII declined 2% despite higher rates due to lower asset base as well as differences in re-pricing period of assets and liabilities post change in policy rate. Non-interest income of the banks declined by 11% YoY, mainly due to lower capital gains (Rs 993 million were made during 3Q2018 as compared to Rs7.8 billion for 3Q2017). Non-interest expense rose by 12% YoY mainly led by HBL (non-interest expense up by 29% YoY) due to costs associated with compliance. Excluding HBL, expenses rose by 8% YoY. Resultantly, cost to income of the sector rose to 63.5% in 3Q2018. A point to be noted is that the central bank has raised policy rate by 225 bps in 2018, 100bps of which were raised at the beginning of 3Q2018. Effective tax rate of the sector declined to 40% for 3Q2018 as compared to 54% for 3Q2017. However, normalized for HBL penalty amount, effective tax rate was at 35% in 3Q2017. The higher effective tax rate is due to banks booking super tax on a quarterly basis (as a result of change in law) as compared to no super tax charge in 3Q2017.


Some of the experts are basing brighter outlook of the banking sector on a single point that the central bank will further increase the interest rate. The hike in interest rate can’t be ruled out because in any case Pakistan will have to approach International Monetary Fund (IMF), which considers hike in interest rate a preemptive action to contain inflation rate. This hypothesis is incorrect because Pakistan suffers from cost pushed inflation. The hike in interest is highly detrimental for Pakistan’s largest foreign exchange earning sector, textiles and clothing and cement. At present textiles and clothing sector faced double-edged sword, hike in interest rate and out of proportion increase in electricity and gas tariffs.

Within the banking sector, Islamic banks are suffering due to surplus liquidity. According to a sector analyst the problem is likely to further aggravate as outstanding sovereign Sukuks mature. The incumbent government does not seem interested in floating fresh Sukuk. This lack of interest is being attributed to two points: 1) the prime focus is on securing foreign exchange to overcome balance of payment crisis and 2) these is also pressure of conventional banks on the government to keep on borrowing through risk-free instruments to insulate the conventional banks from the risk of hike in non-performing loans.

The woes of the banks offering Shariah compliant products are even more complicated. On one hand they are suffering due to surplus liquidity and on the other hand they are often accused of lending at higher rates, as compared to conventional banks. At present bulk of their lending, within consumer finance goes to housing and car financing. An increase of 300 basis points in lending rates would render these uncompetitive in the market.

Any increase in private sector borrowing also seems limited because of: 1) ongoing political noise resulting in confidence deficit and 2) changing geopolitical conditions in Pakistan’s back yard. With United States adamant at re-imposing sanctions on Iran, ongoing proxy wards in Yemen, Syria, Iraq and Afghanistan are likely to keep the investors away from South Asia and MENA. If no fresh investment is made in Pakistan in adding new productive capacities, unemployment rate is also likely to remain high and people will be forced to eat their saving rather than making investment.

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