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Signs of improvement are visible but complete turnaround in performance is not expected till the completion of reforms

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.

Capital adequacy

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 development.

Asset quality

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 foreign banks.

Management soundness

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 2000.

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

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 2000.

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, 2002.

Credit extension

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.

Banking spreads

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 remained high.

Asset composition

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 foreign banks.

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 group.


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.