WEAKENING DEPOSIT FRANCHISE

THE PROBLEM IS COMPOUNDED BECAUSE OF LIMITED OPTIONS FOR UTILIZING DEPOSITS

SHABBIR H. KAZMI
June 02 - 08, 2008

For Pakistani banks, the structure of the deposit franchise has historically enjoyed positive correlation between the interest rate environment and bottom line profitability. The spread has widened with every increase in policy rate. This is due to immediate re-rating of advances, combined with the lag effect associated with a shift in deposit rates.

However, with the SBP's latest directives imposing a minimum rate of 5% on PLS savings accounts, effective June 1, 2008, the lag effect has been disposed off. Assuming the minimum rate policy maintained the banking system as a whole and the bigger banks in particular, will face immediate pressure on funding costs. It is also believed that the medium-sized banks with higher costing deposit bases already in place will be least affected by the move; with a relatively lower increase in interest expense to be countered by higher interest income.

DISCOUNT RATE HIKE

The latest 150bps increase, bringing the discount rate to 12% will translate into higher earning yields in the immediate aftermath of the discount rate hike, six-month KIBOR rose to 13.8% from 11.4%. However, greater incentive to lend could be countered by private sector demand compression, whereas the incidence of higher NPLs, and consequently higher provisions, will also likely manifest itself to a greater degree. Greater shifting of government borrowing to commercial banks could be a silver lining. According to some banking sector analysts, minimum 5% return on PLS accounts penalizes banks with the strongest deposit franchise. Invariably, the bigger banks, as the incremental re-rating in deposit rates occurs, will be most affected. Consequently, the medium-sized banks already having a relatively higher-costing deposit base will be relative winners. Sustainability of this policy measure going forward is a key consideration. There has been a disparity in the rates paid by the big banks and the smaller banks. The average spread of big banks has been exceptionally high. If they have to pay a notified return their cost of fund could go up substantially.

STATUTORY REQUIREMENTS

With the Cash Reserve Requirement (CRR) and Statutory Liquidity Requirement (SLR) both raised by 100bps to 9% and 19% respectively, further liquidity constrains will arise, and could impede credit expansion. Further upward pressure on deposit rates is a likely outcome on the back of greater competition among banks. Analysts estimate the CRR increase will squeeze approx. Rs 35 billion of liquidity from the system.

CASH MARGIN

Aimed at strengthening the Rupee, a cash margin requirement of 35% against all imports, except for selected fuel and food items, will raise cash available to banks' treasuries. Subsequent deployment stands to enhance treasury-based income for banks.

BANKING SECTOR IMPLICATIONS:

It is apprehended that the latest monetary policy fine tuning will likely trim 10%-15% off the sector's earnings in full-year 2008. Impact will vary for individual banks; where the medium-sized banks will likely emerge as relative beneficiaries. Nevertheless, the consensus is that for the banking sector as a whole, negative sentiment has been overplayed, leaving opportunities to take positions in selected scrips.

WAY FORWARD

Most of the analysts fear that the hike in return on deposit will also escalate the rate being charged on the lending. They are also of the opinion that the persistent increase in interest rates has already affected borrowing by the private sector and further hike in lending rates could prove fatal for the trade and industry.

Two of the emerging trends need further deliberation. First, banks have been investing heavily in government securities and second, banks' exposure in equities market is getting really out of proportion. Both these indicators show that banks are venturing into areas which are not their primary areas of activities.

The situation has arisen because of slowdown in credit off take by the private sector due to increase in interest rates with regular intervals. On top of this the growing appetite of the government for money to meet budget deficit has encouraged banks to offer the largest amounts at fabulous rates. However, banks should not be accused for following this policy. It is the government which has been luring the banks to indulge in this type of financing.

As regards banks' investment in equities market the reported exposure to the tune of 50% of paid-up capital is a little alarming. According to some banking sector experts, till recently, banks were allowed to invest up to 20% of their shareholders equity in the listed companies. It is necessary to mention here that in India banks are allowed to take exposure up to 5% of shareholders" equity in the equities market.

Another serious concern is growing stake of foreign investors in Pakistan's commercial banks. Some of the analysts term it the success of the government that at present foreign investors enjoy substantial stake in the local banks. However, the critics say that while the initial inflow was minimal, the outflow would be many times this minuscule amount and recurring expense every year.

Interestingly two contradictory statements hit newspaper headlines, 1) exceptional growth of M2 is the main reason of inflation in the country and 2) banks face liquidity crunch. These two statements are beyond comprehension because they negate each other.

However, some of the sector experts believe that banks are not serious in mopping up overflowing liquidity mainly because they do not find many options for utilizing the existing deposits.