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Overall size of financial sector increases to Rs 4.5 trillion

 Oct 31 - Nov 13, 2005

The ongoing financial sector reforms, along with favourable macroeconomic conditions, have led to significant changes in the size, structure and performance of the financial sector during 2004. One of the most striking features was the shift in the ownership structure from the public to private sector. It is a significant development because for the first time, since the nationalization in 1974, the private sector institutions have attained such a dominant share. The changes in the ownership structure reflect the government's efforts to promote the role of the private sector in the economy. The institutional composition of the financial sector indicates that it not only continues to be heavily skewed towards commercial banks, but the dominance of the banking sector has gained further strength in the overall financial sector.

During this period the overall size of the financial sector (measured by assets) increased to Rs 4.5 trillion, with an impressive rise of Rs 569 billion. Over 80% of this rise came from the banking sector, which further increased its dominance in the overall financial sector.

Not only were banks able to expand their core business activities, but they also strengthened their capital base, improved asset quality and profitability during the year. The risk weighted capital adequacy ratio improved to 10.5% as against the minimum requirement of 8% and the actual level of 8.5% in 2003. The non-performing loans to total loans ratio came down from 17% to 11.6%. The growth in profitability was accompanied with a narrowing average spread and net interest margin. This reflects the increased competition and improvement in the efficiency of the banking sector. The liquidity position of the banking sector also changed substantially. The liquid assets to total assets ratio dipped from 45.1% at the end of 2003 to 36.5% by end 2004.

DEPOSITS of the banking sector have registered a double-digit growth during the last three years, mainly due to booming economic activities and increased inflow of remittances. However, this impressive growth in deposit, despite declining rates of return offered by banks, also shows visible changes in the composition of deposits. Bifurcation of deposits into current and fixed categories indicates that the share of latter in the total deposits of the banking sector dropped to 16.6% by end 2004 compared to 29.1% at end 2001.

Fixed deposits are not only concentrated in short tenors, but the share of these short-term deposits in total fixed deposits has also increased to 57.4%. This clearly indicates that the average maturity period of deposits has reduced considerably, particularly during the last two years. This situation is likely to prevail, at least in the short-run, because depositors may not be willing to lock-in their funds for longer tenors in a rising interest rate environment.

An analysis of deposits by size shows that the share of large sized deposits in total deposits of the banking sector has increased. This suggests that the deposit base has become sensitive to interest rates. The fact is that large deposits are generally interest rate sensitive. Therefore, it may be said that the volatility of deposits has increased over time. However, banking sector analysts say, "The rise in large deposit is mainly due to large borrowing, where the accountholder prefers to keep the funds with the same bank, which has provided the funds."

ADVANCES of the banks are also on the rise for the last three years. During 2004 banks disbursed an incremental credit of Rs 514 billion, taking the total outstanding credit to Rs 1.62 trillion. This growth can be attributed to ongoing banking sector reforms, surplus liquidity and growth-oriented monetary policy. Easy availability of agriculture credit, focus on SMEs and changing pattern of consumer spending were some of the factors, which provided the economy demand-pulled stimulus.

An analysis of advances and loans of the banking sector highlights four major developments: 1) although the diversification of banks' loan portfolio has increased, exposure to textile sector remains high, 2) aggressive marketing and booking of loans under consumer finance may impair the quality of the loan portfolio, 3) the boom in real estate and stock market, leading to enhanced exposures of banks in these sectors has the potential to affect the quality of assets and 4) changes in the sectoral distribution of credit has increased the average maturity period of the credit portfolio.

The corporate sector continued to enjoy the largest share in total bank credit, estimated around 54%. Share of SMEs was at 17.5%, agriculture and commodity finance at 14.9% and consumer finance along with staff loans at 11.9%. Within the corporate sector the largest share was for fixed investment. A further break-up of credit indicates that the textile sector borrowed the largest percentage of over 20% of total advances of the banking sector pertains to this sector. Other sectors borrowing heavily were cement, automobiles, electronics, power generation and petroleum refining. The borrowing was mainly for the purchase of plant and machinery for BMR and creation of new capacities.

Although the distribution of advances by size has not recorded substantial variation, sectoral distribution has witnessed visible changes since 2001. The share of the public sector in total outstanding advances has come down considerably. While it may be attributed to improved financial health of public sector entities, the key factor has been the aggressive privatisation policy being followed by the government and growing size of the private sector.

Government has assigned priority to agriculture sector due to its key role in attaining self-sufficiency in food items and its contribution in the GDP. The scope of agriculture credit scheme, which was previously restricted to production loans for inputs, has been extended to the whole value chain of the agriculture. To ensure credit extension to all the farmers, commercial banks are required to extend credit along with specialised institutions.

Consumer finance has also increased significantly to Rs 152.6 billion by end 2004. In this category the largest percentage pertains to personal finance, around 46%. Housing finance registered the remarkable growth of more than 200% during 2004 mainly because banks were able to offer attractive products at low interest rates. Simplification of credit approval system also enabled larger percentage of people to avail the facility. Auto finance also increased substantially and reached nearly Rs 50 billion by end 2004.

INVESTMENT declined by more than Rs 140 billion during 2004 but holdings of the banking sector recorded a compounded annual average growth of over 20% during 2001-03; in fact it more than doubled. This was due to 1) sterilization efforts by the central bank, which resulted in a shift of holdings of government debt from State Bank of Pakistan to the scheduled banks and 2) the efforts of the banking system to lock-in their funds in government securities in a declining interest rate environment. The situation reversed during 2004 due to changing market expectations about the pace of the rise in the interest rates. Contrary to the gradual tightening of the monetary policy during 2004, banks continued to bid at higher rates in auctions, particularly during July-December period, which led to either the rejection of such bids or acceptance of smaller amounts as compared to the announced targets. As a result, the banking sector was unable to invest in government securities.

The changes in the structure of banking sector deposits, advances and investment suggest that the risk profile of the banking sector has changed substantially during the last three years. To analyse the credit risk of the banking companies a number of parameters are used. One such measure is loans to assets ratio. The aggregate loans to asset ratio of commercial banks has undergone a visible change of 8.9 percentage points to reach 51.6% by end 2004. The distribution of the loans to assets ratio among the various commercial banks indicates that 23 banks out of 35 have a ratio of over 50%, which was the highest since 1997. While this confirms that credit risk of banking sector has increased during 2004, it also indicates that the sector is now more focused on its core business activities.

Liquidity risk of the banking sector emanating from increased maturity mismatch between assets and liabilities is generally measured by the liquid assets to total assets ratio and the loans to deposit ratio. The liquid assets to total assets ratio slipped to 36.9% by end 2004. A drastic reduction of around 9 percentage points since 2003 in the liquid assets to total assets ratio must be interpreted with caution, as the banking sector has had excess liquidity during the past two years. The distribution of the liquid assets to total assets ratio among the commercial banks indicated that for a large number of banks this ratio ranged between 30 to 40 percent at end 2004.

Loans to deposit ratio is another widely used indicator of liquidity, which increased to 63.7%, the highest since 1997. A closer look at this ratio indicates it was above 75% for 13 banks. This high level of the ratio for a number of banks suggests that these may be resorting to borrowing to fund their assets, as the banks have to maintain cash reserve requirement of 5% and statuary liquidity requirement of 15% of their demand and time deposits with the central bank.

ISLAMIC banking in Pakistan has recorded significant growth, mainly because the central bank has been following three-pronged strategy. By end 2004 the total deposits under Islamic banking were over Rs 30 billion and assets touched Rs 40 billion. The share of Islamic banking may look too small, when compared with conventional banking, but keeping in view the growth trajectory its share is expected to grow substantially in the near future. The asset base of Islamic banking seems skewed towards corporate finance, in addition to a significant exposure to SMEs and consumer finance, with a relatively small share in agriculture. Lately, the central bank has also introduced an Islamic Export Refinance Scheme. In terms of future prospects and challenges, one key issue is the development of Shariah compliant liquidity instruments for managing SLR requirements.

The growth of banking sector is commendable but it is also a fact that the underlying risks to the sector have increased. The positive point is that the financial soundness indicators clearly show that the absorption capacity risk has also improved, as a whole. The indicators also hint towards prudent management of the overall risks as well as sustainability of the impressive growth. One such indicator is the capital base, which is considered the first line of defense against potential shocks arising from adverse changes in the working environment.

The banking sector in the country is operating under dual capital requirements 1) the minimum paid-up capital requirement as stipulated by the central bank and 2) the minimum capital to risk weighted asset (CRWA) ratio as prescribed in the Basel Capital Accord (Basel-I). The central bank has already raised the minimum capital requirement to Rs 2 billion and banks are required to minimum CRWA ratio at a minimum level of 8%. Banks are also required to allocate capital for market risk in addition to the capital requirements for credit risk. These changes are expected to establish a proper risk based capital adequacy framework, as market risk includes the exposure arising from changes in interest rates, equity prices and exchange rates.

The financial data for end 2004 indicates that the aggregate capital adequacy (CAR) for banks has increased to 10.5% as compared to 8.5% for 2003 and the required level of 8%. Distribution of banks' CAR indicates that 1) all commercial banks have their CAR above the minimum required level of 8% and 2) out of 35 commercial banks, 22 banks have their CAR above 10%. This strong CAR position, despite substantial changes in the asset-mix, clearly establishes that the risk bearing capacity of the banking sector has improved substantially and banks are well poised to sustain credit and market risks.

In line with the changing dynamics of the banking sector, the Basel Committee on Banking Supervision has finalized new Capital Accord, known as Basel-II in June 2004. Capital adequacy requirements in Basel-II have been made more risk-oriented by 1) linking capital to operational risks and 2) changing the risk management approaches for credit and market risks. In an effort to create a true-risk based banking environment and to keep the banking system aligned with international banking standards, the central bank has issued detailed guidelines for the phase-wise implementation of Basel-II in the country. While Basel-II will help in managing risk more prudently, its successful implementation remains a major challenge.

Globally commercial banks have significant exposure in the real estate but banks operating in Pakistan have considerably very low exposure in this area. Banks' direct exposure to the real estate, as the outstanding amount of housing finance in total advances is around 1.3% as against a maximum amount capped at 10% of net outstanding advances. However, an indirect exposure also exists due to loans collateralised by real estate. In this scenario the exposure of the banking sector towards real estate is substantial. Over 20% of banking sector advances is collateralised by real estate, including land and buildings. A further break up of real estates shows that the share of advances collateralised by residential properties increased to more than 7% lately. This hike can be attributed to a sharp rise in consumer finance and inflated prices of real estate. The share of loans collateralised by non-residential buildings has also increased, indicating rise in prices of real estate in general.

Despite all the possible safeguards and supporting macroeconomic environment both the internal and external factors have the potential to adversely affect this impressive performance. Various factors can impair quality of assets and add to non-performing loans (NPLs) stemming from these shocks. The point of satisfaction, to some extent, is that under the prevailing system the probability of sudden rise in NPLs is low. Within the banking sector, the NPL ratios vary from bank to bank. This indicates that besides the macroeconomic environment, internal credit policies and post-disbursement monitoring plays an important role in determining the size of NPLs. Based on historical perspective it may be said that banking sector risks have increased, but fortunately, the regulatory framework and measures have also improved the risk-bearing capacity of the banking sector. A review of the regulatory measures indicates that banks are equipped with various policy tolls to prudently manage their risks.


It can be concluded that banks are now in a better position to sustain risk and any particular sector may not affect their overall asset quality. However, it is equally important to keep an eye on macroeconomic environment. Hike in inflation rate, declining foreign exchange reserves (leading to exchange rate volatility) and higher oil prices have the potential to impact the GDP growth rate.

The recent earthquake and the resulting devastation will also have a negative impact on the economy. However, the positive point is that the public response in general and international donors in particular, have lessened the immediate adverse impact to a large extent. It must be kept in mind that the country needs billions of dollars and many years for the reconstruction of housing and commercial units and rehabilitation of millions of people, who have virtually lost every thing they had.


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