COMMERCIAL BANKS IN
Signs of improvement are visible but complete turnaround in
performance is not expected till the completion of reforms
By SHABBIR H. KAZMI
Nov 12 - 18, 2001
The banking sector in Pakistan has been going
through a comprehensive but complex and painful process of
restructuring since 1997. It is aimed at making these institutions
financially sound and forging their links firmly with the real sector
for promotion of savings, investment and growth. Although a complete
turnaround in banking sector performance is not expected till the
completion of reforms, signs of improvement are visible. The almost
simultaneous nature of various factors makes it difficult to
disentangle signs of improvement and deterioration.
Commercial banks have been exposed and withstood
several types of pressure since 1997. Some of these are: 1)
multipronged reforms introduced by the central bank, 2)
freezing of foreign currency accounts, 3) continued stagnation
in economic activities and low growth and 4) drive for
accountability and loan recovery. All these have brought a behavioural
change both among the borrowers as well as the lenders. The risk
aversion has been more pronounced than warranted.
Commercial banks operating in Pakistan can be
divided into four categories: 1) Nationalized Commercial Banks
(NCBs), 2) Privatized Banks, 3) Private Banks and 4)
Foreign Banks. While preparing this report efforts have been made to
evaluate the performance of each group which enjoy certain strengths
and weaknesses as per procedure followed by State Bank of Pakistan (SBP).
The central bank has been following a supervisory framework, CAMEL,
which involves the analysis of six indicators which reflect the
financial health of financial institutions. These are: 1)
Capital Adequacy, 2) Asset Quality, 3) Management
Soundness, 4) Earnings and Profitability, 5) Liquidity
and 6) Sensitivity to Market Risk.
To protect the interest of depositors as well as
shareholders, SBP introduced the risk based system for capital
adequacy in late 1998. Banks are required to maintain 8 per cent
capital to Risk Weighted Assets (CRWA) ratio. Banks were required to
achieve a minimum paid-up capital to Rs 500 million by December 31,
1998. This requirement has been raised to one billion rupee and banks
have been given a deadline up to January 1, 2003 to comply with this.
The ratio has deteriorated after 1998. However, it
was a fallout of economic sanctions imposed on Pakistan after it
conducted nuclear tests. The shift in SBP policy regarding investment
in securities also led to a fall in ratio. However, most of the banks
have been able to maintain above the desired ratio as well as direct
their investment towards more productive private sector advances.
Higher provisioning against non-performing loans (NPLs) has also
contributed to this decline. However, this is considered a positive
Asset quality is generally measured in relation to
the level and severity of non-performing assets, recoveries, adequacy
of provisions and distribution of assets. Although, the banking system
is infected with large volume of NPLs, its severity has stabilized to
some extent. The rise over the years was due to increase in volume of
NPLs following enforcement of more vigorous standards for classifying
loans, improved reporting and disclosure requirements adopted by the SBP.
In case of NCBs this improvement is much more
pronounced given their share in total NPLs. In case of privatized and
private banks, this ratio went up considerably and become a cause of
concern. However, the level of infection in foreign banks is not only
the lowest but also close to constant.
The ratio of net NPLs to net advances, another
indicator of asset quality, for all banks has declined. Marked
improvement is viable in recovery efforts of banks. This has been
remarkable in the case of NCBs, in terms of reduction in the ratio of
loan defaults to gross advances. Although, privatized banks do not
show significant improvement, their ratio is much lower than that of
NCBs. Only exception is the group of private banks for which the ratio
has gone up due to bad performance of some of the banks in the group.
However, it is still the lower, except when compared with that of
Given the qualitative nature of management, it is
difficult to judge its soundness just by looking at financial accounts
of the banks. Nevertheless, total expenditure to total income and
operating expenses to total expenses help in gauging the management
quality of any commercial bank.
Pressure on earnings and profitability of foreign
and private banks caused their expenditure to income ratio to rise in
1998. However, it started tapering down as they adjusted their
portfolios. An across the board increase in administrative expenses to
total expenditure is visible from the year 1999. The worst performers
in this regard are the privatized banks, mostly because of high
salaries and allowances.
Earnings and profitability
Strong earnings and profitability profile of banks
reflects the ability to support present and future operations. More
specifically, this determines the capacity to absorb losses, finance
its expansion programme, pay dividend to its shareholders and build up
adequate level of capital. Being front line of defense against erosion
of capital base from losses, the need for high earnings and
profitability can hardly be overemphasized. Although different
indicators are used to serve the purpose, the best and most widely
used indicator is return on assets (ROA). Net interest margin is also
used. Since NCBs have significantly large share in the banking sector,
their performance overshadows the other banks. However, profit earned
by this group resulted in positive value of ROA of banking sector
during 2000, despite losses suffered by ABL.
Pressure on earnings was most visible in case of
foreign banks in 1998. The stress on earnings and profitability was
inevitable despite the steps taken by the SBP to improve liquidity.
Not only did liquid assets to total assets ratio declined sharply,
earning assets to total assets also fell. T-Bill portfolio of banks
declined considerably, as they were less remunerative. Foreign
currency deposits became less attractive due to the rise in forward
cover charged by the SBP. Banks reduced return on deposits to maintain
their spread. However, they were not able to contain the decline in
ROA due to declining stock and remuneration of their earning assets.
Movement in liquidity indicators since 1997
indicates the painful process of adjustments. Ratio of liquid assets
to total assets has been on a constant decline. This was consciously
brought about by the monetary policy changes by the SBP to manage the
crisis-like situation created after 1998. Both the cash reserve
requirement ((CRR) and the statutory liquidity requirement (SLR) were
reduced in 1999. These steps were reinforced by declines in SBP's
discount rate and T-Bill yields to help banks manage rupee withdrawals
and still meet the credit requirement of the private sector.
Foreign banks have gone through this adjustment
much more quickly than other banks. Their decline in liquid assets to
total assets ratio, as well as the rise in loan to deposit ratio, are
much steeper than other groups. Trend in growth of deposits shows that
most painful part of the adjustment is over. This is reflected in the
reversal of decelerating deposit growth into accelerating one in year
Sensitivity to market risk
Rate sensitive assets have diverged from rate
sensitive liabilities in absolute terms since 1997. The negative gap
has widen. Negative value indicates comparatively higher risk
sensitivity towards liability side, while decline in interest rates
may prove beneficial.
Deposit mobilization has dwindled considerably
after 1997. Deposits as a proportion of GDP have been going down.
Growth rate of overall deposits of banks has gone down. However, the
slow down seems to have been arrested and reversed in year 2000.
Group-wise performance of deposit mobilization is
the reflection of the varying degree with which each group has been
affected since 1998. Foreign banks were affected the most due to their
heavy reliance of foreign currency deposits. They experience 14 per
cent erosion in 1999. However, they were able to achieve over 2 per
cent growth in year 2000. Similar recovery was shown by private banks.
Deposit mobilization by NCBs seems to be waning
after discontinuation of their rupee deposit schemes linked with
lottery prizes. Growth in their deposits were on the decline. Despite
the decline NCBs control a large share in total deposits. Aggressive
posture of private banks in mobilizing more deposits in year 2000 is
clearly reflected in their deposit growth, from 1.9 per cent in year
1999 to 21.7 per cent in year 2000. This has also helped them in
increasing their share in total deposits to over 14 per cent in year
Due to the shift in policy, now banks are neither
required nor have the option to place their foreign currency deposits
with the SBP. Although, the growth in foreign currency deposits
increase the deposit base, it does not add to their rupee liquidity.
The increasing share of foreign currency deposits in total base is a
worrying development. In order to check this trend, SBP made it
compulsory for the banks not to allow foreign currency deposits to
exceed 20 per cent of their rupee deposits effective from January 1,
Bulk of the advances extended by banks is for
working capital which is self-liquidating in nature. However, due to
an easing in SBP's policy, credit extension has exceeded deposit
mobilization. This is reflected in advances growing at 12.3 per cent
in year 1999 and 14 per cent in year 2000.
Group-wise performance of banks in credit extension
reveals three distinct features. 1) Foreign banks curtailed
their lending, 2) continued dominance by NCBs and 3)
aggressive approach being followed by private banks. Private banks
were the only group that not only maintained their growth in
double-digit but also pushed it to over 31 per cent in year 2000. With
this high growth, they have surpassed foreign banks, in terms of their
share in total advances in year 2000.
Over the years there has been a declining trend
both in lending and deposit rates. Downward trend in lending rates was
due to SBP policy. The realized trend in lending rates was in line
with monetary objectives of SBP, though achieved with lags following
the sharp reduction in T-Bill yields in year 1999, needed to induce
required change in investment portfolio of banks.
Downward trend in deposit rates was almost
inevitable. One can argue that banks should have maintained, if not
increased, their deposit rates to arrest declining growth in total
deposits. However, this was not possible at times of eroding balance
sheet, steady earnings were of prime importance. Consequently banks
tried to find creative ways of mobilizing deposits at low rates.
However, due to inefficiencies of the large banks, the spread has
Assets of banking sector, as per cent of GDP, have
been on the decline. Slowdown in asset growth was also accompanied by
changing share of different groups. Negative growth in the assets of
foreign banks during 1998 and 1999 was the prime reason behind
declining growth in overall assets of the banking sector. Share of
NCBs have been decreasing since private banks were allowed to operate
in 1992. In terms of asset share, private banks are now as large as
Problem bank management
The central bank is the sole authority to
supervise, monitor and regulate financial institutions. It is also
responsible to safeguard the interest of depositors and shareholders
of these institutions. Lately, SBP took actions against two private
banks which became a threat to viability of the financial system in
the country. These were Indus Bank and Prudential Commercial Bank. On
the basis of detailed investigations, the license of Indus Bank was
cancelled on September 11, 2000. After successful negotiations,
management and control of Prudential Bank handed over to Saudi-Pak
Commercial banks have been going through the
process of restructuring. There are efforts to reduce lending rates.
The SBP has been successful in implementing its policies. Most of the
banks have been able to adjust to new working environment. The
proposed increase in capital base will provide further impetus to
financial system in the country.
In the post September 11 era, the GoP borrowing
from SBP and commercial banks is expected to come down substantially
and private sector borrowing to increase. However, a temporary decline
in repayment ability of borrowers may increase provisioning for the
year 2001. The situation is expected to improve in year 2002.
Unless efforts are made by banks to shrink spread,
depositors will not be able to get return which corresponds with the
rate of inflation in the country.
Privatization of NCBs is expected to be delayed due
to external factors. However, it is an opportunity for the banks to
further clean their slate.