Having concluded a difficult year in 1995, what are the prospects for this sector?

Apr 20 - 26, 1996

In the not so distant past, every final year MBA student from a good university could look forward to receiving at least a couple of good job offers from their prospective employer of choice — a foreign bank. With rapidly growing profits in a de-regulated environment, working in the foreign banking sector offered security, a chance for rapid promotion, excellent financial rewards as well as social prestige. Foreign Banks weren't too discriminating either; demand for MBA's far outstripped their supply.

Today the picture is very different. Recruitment has slowed to a trickle, and those that are being hired find that it takes solid performance or extraordinary talent to get their jobs made permanent. Banks are already realizing that the large build-up in staff and other costs which they incurred over the last two years in a bid to expand their operations may well have been in haste. Among Foreign Banks operating in Pakistan today, cost control has suddenly emerged as a primary strategic goal.

A sharp drop in profits

A close look at the statistics and the graphs which we have provided for you in this, our fourth annual survey of the foreign banking sector in Pakistan, tells the story very clearly. From our survey of the largest 14 foreign banks operating in the country (our selection criteria being all those banks above Rs. 2 billion in deposits at the end of December 1995), combined pre-tax profits have fallen from Rs. 5.5 billion in 1994 to Rs 4.1 billion at the end of 1995, a drop of 25%. After taxes, combined profits of these 14 banks was a mere Rs 1.2 billion, a 51% drop from the previous year.

A look at various ratios also illustrates the bleak performance. After-tax Return on Assets was a poor 0.5% ( compared to internationally accepted benchmarks of 1%, and that too in competitive developed country markets ). With Rs. 13.5 billion in combined equity capital committed to the country by the foreign banks, the industry ROE was an abysmal 9% for 1995. Indeed, the actual return on equity will be even lower once you include additional capital that was brought in subsequent to year end to support asset growth during 1995.

These are extremely weak numbers, especially for foreign banks operating in a third world country where returns are usually higher than average to compensate for the additional risks of operating here.

Why care about foreign banks ?

The traditional view among the bureaucracy at the State Bank in recent years has on balance been "anti" foreign banks. The view was that they were making too much money by exploiting the inefficiencies of the domestic nationalized banks, picking up the cream of the deposit and trade finance business without having to participate in various "social welfare" financing schemes that each and every government managed to somehow dream up to further bleed the financial system. As a group, the constant complaints from foreign banks about the inconsistencies in banking policy and regulation largely always fell on deaf ears mainly because of this bias.

That view started to change as foreign banks increasingly became the largest conduits for foreign exchange money flows coming in to the country, not only into foreign currency deposits by individuals and corporations but also due to the banks' capacity as custodians for the foreign portfolio money flowing into the stock markets and as financial advisors for direct investors in areas such as the power sector.

In recent months, the largest foreign banks were also asked to arrange special institutional deposits from their offshore affiliates on special terms and conditions in a bid by the government to shore up the country's foreign exchange position. By offering terms which amount to LIBOR plus 3.5% for 3 month dollar funding, the SBP was able to raise $400 million from this source. These funds were critical to meeting IMF requirements for forex reserves. With Pakistan's commercial relationship with the international financial community essentially restricted to these foreign banks located here plus another dozen or so who do not have local branches, avenues for further financings are constrained. All of a sudden, foreign banks have become of major importance to the national economy.

Within this context, the poor performance by foreign banks operating here should be a source for concern. If the results which were seen in 1995 continue for another two to three years, which may well be the case given current conditions, there could well develop a situation where banks slowly curtail their activities in the country to the point of only servicing the local interests of the parent bank's multinational customers; or only have representative offices looking after correspondent relationships, like Chase Manhattan has done. If taken to this point, there would be real implications for Pakistan's foreign exchange reserves as well as the ability to attract foreign investment.

Despite saying this, we do not of course advocate special rules to pander to the concerns of foreign banks. But we do believe that there should be a very clear government view on the future development of the banking sector, one which understands that growth in the financial system underpins growth in the industrial sector and a view which appreciates that a progressive banking regime is vital to a country that aims to be a regional financial centre and a gateway for Central Asia.

Why 1995 was a bad year for Banks

Rise in costs: As early ago as the PAGE Foreign Bank Survey that we published in 1994, we had estimated that difficult times were ahead. The basic premise was that there would be a sharp increase in the cost of funds that banks pay for their deposits, due to several factors. Firstly came the cyclical rise in U.S interest rates in 1994, in which 3 month LIBOR rates rose from 3. 5% to over 6%. This directly affected foreign banks, in which invariably the majority of deposits were denominated in U.S dollars.

The next blow came from the State Bank of Pakistan, which increased the cost of the forward cover fee, in effect the cost of providing bankers with exchange rate protection against a devaluation of the Rupee against the dollar. After absorbing significant exchange losses themselves because the cost of the forward cover was almost always insufficient to cover the actual devaluation, the SBP started pushing up the fee from 3% to its current 4.75%.

With these factors already in play, 1995 brought additional pressures . Competition for deposits definitely increased as private banks such as Askari and Al-Habib suddenly became viable banking alternatives for prime individual and corporate customers. Many large deposits from the Middle East which regularly flowed into Pakistan suddenly stopped coming in, not only because of the country's worsening financial position this year but due to incidents such as the investigation of Nawaz Sharif and his family's dealings through various foreign currency accounts and the self-created shortage of foreign currency bank notes in the market subsequent to the "mini-budget" last year.

Add to that the fact that many foreign banks already loaded up on costs in the latter part of 1994 in anticipation of a further boom in 1995. For example, total non interest expense as a proportion of revenues at the 14 banks in our survey grew from 15.8% in 1994 to 18.1% in 1995. Staff costs rose at an even faster rate, growing from a combined Rs 995 million for the survey in 1994 to Rs 1.3 billion in 1995, a rise of 33% on the year and a 76% rise over 1993.

Thus a situation developed where there was too much banking capacity chasing too few new, substantial customers. The average cost of funds paid by foreign banks on their savings accounts rose by an estimated 1.5% during the year.

Lending Constraints: On the other side of the banking equation, the huge borrowing demands by the government dominated proceedings with the State Bank making a vigilant effort to both provide enough funds from the banking system to finance the budgetary deficit and to keep the yield on government securities stable in order not to further worsen the government's debt servicing burden.

The abolition of the Credit/Deposit Ratio early in 1995 in a bid by the SBP to adopt more orthodox monetary policy management initially led some commentators to conclude that lending by the banking sector would increase sharply. Instead, the State Bank chose to use " moral pressure ", verbally telling banks that they were not to increase their lending portfolio by more than an understood amount. Over the course of the year foreign banks did indeed increase their lending sharply from the year before, by 36% to Rs 82 billion with the Advance/Deposit Ratio increasing from 51% at the end of 1994 to 61% at the end of 1995.

The State Bank responded by coming down hard on 3 banks, two of them foreign. ABN-Amro and Citibank were both fined, along with Askari Bank, for having exceeded their assumed lending limits. They were forced to keep an additional 2% of their deposit base - on top of the mandated 5%- in a non-interest bearing account with the State Bank which in Citi's case would involve an opportunity loss in excess of Rs 50 million a year. Lending growth by foreign banks slowed to a trickle almost immediately afterwards.

Despite predictions from money market analysts that interest rates on government securities would have to rise given the large funding requirement, the SBP's actions to constrain bank lending allowed them to keep a tight grip on money market rates. The 6 month T-Bill yield stayed in a very tight range either side of a 12.5% yield throughout the year. With the Rupee cost of a US $ deposit costing foreign banks just under 12%, the yield pick-up by investing in T-Bills continued to remain tight.

As one leading foreign banker put it to us "In a normal business when margins come under pressure you try to expand your volume to compensate. But if your margins come down and you are unable to expand your volume, what are you supposed to do?"

How various banks coped with a difficult year

Even though we tend to analyse foreign banks as a group, there was a great variation in the performance between the individual institutions. Only four banks, Bank of America, Habib Bank AG Zurich, ANZ Grindlays and Faysal Bank were able to register an increase in pre-tax profits from the previous year; which under the circumstances was an outstanding performance. Faysal, Habib AG Zurich and Emirates Bank were the only three to show an increase in after-tax Return on Assets. Faysal Bank was subsequently awarded the title of " Best Commercial Bank in Pakistan" by Asiamoney magazine.

The basic business model among foreign banks to cope with the current constraints has been to a) try and put a cap on costs b) try and expand the amount of revenues coming from commissions , fees and brokerage and c) expand the funding base to incorporate a greater proportion of Rupee deposits, which are inherently more stable than foreign currency funds and also generally cheaper.

Towards that end, many foreign banks initiated advertising campaigns highlighting transaction accounts which offered unlimited check-writing as well as an effective yield upward of 11% calculated on the basis of daily balances providing there is a minimum balance in the vicinity of Rs 200,000 to Rs 500,000 depending on the individual schemes on offer. Citibank's 'Profit Plus' , Faysal Bank's 'Rozana Munafa' , and Standard Chartered Bank's various deposit products were the most heavily advertised and informed sources tell us that they have all met with a good response, underscoring the point that there is a demand for such offerings.

Expanding fee income is a more tricky assignment, and different banks employed different methods. Building up trade finance volume has invariably been a key objective, not only for the fee income which it brings but also because of the opportunity to get access to the more lucrative foreign exchange business. Getting two way business i.e export volume and import volume is the key because offsetting FX receivables to FX payables yields as much as 10 paisa between the bid and offer price. Those banks that have a heavy concentration on one type of business typically yield between 2 and 3 paisa. A look at the table under the column ' non-interest efficiency', which shows the ratio of non-interest income to non-interest expense, is a good indicator of the ability of banks to generate fee income. Again, Bank of America and Habib Bank AG Zurich have shown strong abilities in this area, with the latter and ANZ Grindlays being the only ones able to show gains in this ratio for the year ending December 1995.

Once the market for corporate debt expands to a multiple of what it is now, banks could make a nice living trading in these securities. The proposed Rs 1 billion for ICI is the first really large offering of TFC's and hopefully could accelerate the development of the market.

There is already much anecdotal evidence, alluded to at the beginning of this article, that banks are already trying hard to control their cost base from the high levels of last year. Citibank especially, which grew its cost base dramatically with the intention of building its credit card base, has the most work to do. Whilst they will be rewarded in the current financial year as revenue flows from credit cards start to increase rapidly, the danger will come from a sharp escalation in potential loan losses from credit cards, especially in a weak economy.

Hong Kong Bank and Mashreq Bank announced large net losses for the year, which in Mashreq's case was the second loss in succession. Whilst Mashreq Bank's travails stemmed from loan losses on lending done several years ago by a previous management group, very much in their credit is their ongoing commitment to banking in the country. This is highlighted not only in the fact that they increased their net capital allocated to its Pakistan branches during last year to Rs 1. 2 billion from Rs 700 million the previous year but is currently advertising heavily to attract both foreign currency and Rupee deposits. Hong Kong Bank, depsite being a major force throughout the rest of Asia, seems to have taken a much more subdued approach to this market despite its underwriting commitment to the proposed $100 million Privatization Fund.


The difference in approach between the two banks highlights another key element of foreign bank strategy in Pakistan; invariably those that make a long-term commitment to the market, seeing through the difficult years, could well end up with the biggest long-term gains. American Express Bank has seemed in recent years to be on a holding pattern, most likely due to travails at its headquarters in the U.S which at one point contemplated selling the bank as part of its bid to dispose of 'non-essential' businesses and focus on its credit card operations. The bank has lost a lot of its talented executives to other foreign banks, and had the slowest deposit growth (up 2%) amongst all the foreign banks in our survey. IndoSuez and Deutche Bank have continued their low profile business in Pakistan, although other subsidiaries of their parent organizations have stepped up their activities. Carr-Mashriq, an affiliate of W.I Carr, a sister company of Banque Indosuez is a very active member of the Stock Exchange. Deutche Morgan Grenfell, the Investment banking arm of Deutche Bank, currently holds the mandate to find the 26% strategic shareholder for Pak Telecom.

Outlook for 1996

This year looks to be another tough one with little prospect for earnings growth among foreign banks. Bankers indicate to us that there are likely to be more loan losses amongst foreign banks this year. Loan pricing, even for the best multinational customers, is likely to be on the increase this year as the profitability of these accounts has eroded due to increases in banks cost of funds.

The broader picture of course, depends heavily on government actions for the rest of the year, especially the degree of business confidence accompanying the budget and the success of the big privatizations . Should the PTC sale be concluded at a good price, and if export growth can be maintained, the accompanying sense of financial stability will do no end of good to the prospects for the sector.

"In a normal business when margins come under pressure you try to expand your volume to compensate. But if your margins come down and you are unable to expand your volume, what are you supposed to do?"