INVESTMENT BANKS : HOW MANY CAN SURVIVE?

Declining profits and difficulty in resource mobilization needs consolidation of institutions through mergers and acquisitions

By SHABBIR H. KAZMI
May 18 - 24, 1996

Investment banks in the private sector in Pakistan started emerging in 1989 with the listing of Crescent Investment Bank (CresBank). Since then over a dozen such banks have been listed. Over the years, these banks were performing well mainly due to various incentives available to them and the buoyant capital market as well as high demand of funds as a lot of new industrial units were being established. However, over the last two years the profitability of these banks has gone down substantially.

The fast expansion of the investment banks sector was due to higher profit margins and the fact that these banks catered to the needs of the private sector — a niche that was previously left to the whims of the inefficient state owned financial institutions.

Investment banks are subject to relaxed regulations i.e. lower reserve requirement, being allowed to invest all their reserve funds in Federal Investment Bonds — earning a relatively higher yield, lower tax rate applicable on them and comparatively lower initial paid-up capital requirement.

The private investment banks, since their inception under revised government policy, have been playing a major role in the development of the capital market in the country. Being able to trade both on their own account as well as on their client's, lately, there has been a shift in their activities which are now focused on specialized services such as corporate finance, advisory services, underwriting and placement, etc., to match the growing demand for funds and new equity issues, and in the emergence of new financial products. These services have helped the investment banks in generating dependable and reliable source of fee-based income.

According to financial experts, the investment banks do not suffer from liquidity crunch, it is mismatch between resource mobilized and the type of funds required for their operation. The shortage of long-term funds forces them to concentrate on short-term lending and getting actively involved in trading of already listed equities.

The investment banks, in principle, differ from development financial institutions (DFIs) which often enjoy soft-term credit lines from multilateral donor agencies. Activities performed by investment banks include syndication of loans or bonds, issuing guarantees, fund management, long-term financing and corporate finance. Corporate finance includes placement of equities and debt instruments both domestic as well as offshore, underwriting - equity and debt instruments. Whereas, the commercial banks activities are concentrated on providing short-term finances mainly for working capital.

During the1990-94 period, the investment banks were able to generate a lot of fee based income mainly from underwriting of public issues. Most of the scrips were over-subscribed and the underwriting commission was straight income. Similarly, because the prices of shares were constantly moving up, they also made good capital gains on their investment portfolios.

The year 1991 saw major changes in government policies including opening of the market to foreign investors, privatization of public sector companies, deregulation of economy and allowing commercial banks in the private sector. Foreign exchange restrictions were liberalized and Pakistanis were permitted to maintain foreign currency accounts. All these policy measures were responsible for the accelerated economic activities specially in the capital market. During the1991-95 period, more than 200 new companies were listed with a total paid-up capital of over Rs, 85,685 million. With 1994 being the year of highest number of listings, the total paid-up capital amounted to over Rs.34,661 million.

Progress Review of the Capital Listed on the Karach Stock Exchange

Year

No. of listed Paid-up companies

Capital (Rs. in Mill)

1989 438 22,521.9
1990 487 28,056.2
1991 542 37,024.3
1992 628 58,198.5
1993 653 69,476.1
1994 724 104,137.2
1995 751 122,709.3

* Figures are up to September 1995 Source Karachi Stock Exchange

The reason for the present slowdown of the activities of investment banks is that most of the major business groups either have direct equity stake in an investment bank, a commercial bank, a leasing company or modaraba. This, in a way, has also minimized their dependence on NIT or other traditional institutions for underwriting. Since the groups also knew, at that time, that the scrips would be over-subscribed, they involved their own in-house companies happily in underwriting.

It may not look possible in the presence of Prudential Laws but one can suspect many marriages of convenience (watta-satta) taking place whereby one group looks after the financial requirements of the other group and gets reciprocal favours.

As there was also no restriction on the period for retaining the shares of new companies and the capital market was buoyant these banks could always take big blocks which they off loaded while the market prices were higher and felt contented with the capital gains.

However, with the change of complexion of capital market — now bearish — number of new flotations reduced, rates of lending gone down and promulgation of new laws for NBFIs — making long-term resource mobilization even more difficult, the profitability of these banks is bound to go further down.

Another area where investment banks have concentrated in the past was foreign currency deposits which contributes 70 to 80 per cent of total deposits. With the introduction of new laws controlling resource mobilization, although the implementation has been deferred till June 30 this year, short-term deposits in foreign currency deposits would no longer be available to the investment banks. The law specifies minimum duration of two years and also demands mobilization of forex deposits from outside Pakistan.

Had these laws been implemented, soon after the announcement in February this year, most of the investment banks would have faced serious problems. If they had to refund the money and there was no alternate arrangement available for replenishing the funds, it would have been almost impossible for them to continue their operations.

According to an analyst at a securities companies, the government should have looked into this mismatch earlier as it was in conflict with the basic function of investment banking. Most probably the central bank was not worried because it was the need of the time. Now, as the government wants to control the credit extended to the private sector, it appears that these laws are to be used as one of the means to control credit expansion to the private sector. It may help the central bank curtail the credit but it can be harmful for the financial sector as well as the industries. Curtailing the credit to the private sector may slow down the pace of industrialization and economic activities. The central bank must define a time frame for the investment banks to adjust to the new laws.

It is also necessary that proper demarcation of limits for all types of financial institutions should be defined. Presently, the activities of commercial banks, investment banks and leasing companies are so overlapping that it is almost impossible to differentiate between these institutions.

Almost all the commercial banks provide medium and long-term funds and have established modarabas to avail of maximum tax advantages. Even the development financial institutions are involved in the leasing business. The obvious reason was that all these institutions needed local currency funds as the DFIs have started lending in local currency. They have also ventured into taking deposits in local currency and consumer banking. This includes IDBP, PICIC, NDFC and BEL. All of these are primarily DFIs but to meet their requirements of Pak rupee funds, have opened branches actively involved in consumer banking.

Similarly, after getting the permission to mobilize funds through Certificates of Investment (CoIs), the leasing companies got access to short-term funds and are providing working capital loans. According to sector experts, over 50 per cent of their deposits of COIs fall in the category of short-term deposits — around 3 years maturity period.

Although, it has helped these financial institutions to go for unorthodox operations which has improved their profitability, it is not a long-term solution, in the view of financial experts. The financial sector complains that the domestic situation which is very vulnerable, does not allow the depositors to commit their funds for the longer periods. This includes the persistent of any financial scam. The country has witnessed the closure of investment companies, cooperatives and Mehran Bank fiasco.

While the rates of return on various types of deposits do not match with the rate of inflation and people have also seen various financial scams, they are not ready to deposit their funds for longer periods. That is one of the reasons that people deposit their money in the shape of dollars — carrying lesser rate of return. The worth of dollar also appreciates in case of rupee devaluation. In this case the dollar depositors even earn more in terms of absolute amounts as the rupee persistently keeps on depreciating against the dollar.

At the time when rumours were all over the country that government may freeze the forex accounts, the depositors of large amounts were not upset for two reasons. The bankers assured them that the government would not take such a step. Besides, they had already borrowed a substantial amount in Pak rupees against the forex deposits.

Pakistan's capital market, although bearish for quite some time, is expected to take a turn around. Lately the prices of shares has shown some increase. The capital market has gone for product diversification - introduction of debt instruments. Privatization and market liberalization has continued.

The fee-based income through various activities would soon comprise a major portion of total revenues as currently very few institutions have been able to provide such services. Taking the difficulties of long-term resource mobilization and increasing number of investments banks into account, a very tough competition among these institutions is expected in the years to follow. Well trained and experienced managerial staff, backing of a financially strong group and stress on customer services will be the biggest assets of an investment bank.