BANKING SECTOR, KEY THEMES AND OUTLOOK

Growth in the banking sector is both a derivative of and catalyst for economic growth

By ALI FARID KHWAJA
May 09 - 15, 2005

The banking sector is indeed set on a high growth path. In the first quarter of CY05, the sector's profitability is up by 118% (sample of listed banks excluding Bank Alfalah). The largest increase in profitability was in Union Bank, whose profit after tax increased by a massive 222%. Other banks like Muslim Commercial Bank, Bank of Punjab and Meezan Bank also reported a doubling of bottom-line. It is interesting times indeed for the banking sector. On one hand, the profits and growth in assets is at record levels, and on the hand the State Bank of Pakistan is pushing for consolidation in the sector by increasing the minimum paid-up capital requirement. The banking sector's bull-run and positive outlook has attracted foreign investment in the sector. Taemasek, the investment arm of Government of Singapore, entered the domestic banking sector by acquiring stake in NDLC-IFC Bank (NIB). Other banks opted for rights issue or issued bonus shares to increase their capital base. All this activity in the sector indeed demands an inquiry into the future outlook and prospects, on which I shall dwell upon in this column.

I believe, and have been arguing in my banking sector reports, that the growth in the banking sector is both a derivative of and catalyst for economic growth. Unlike many of my peers who credit the current boom in the economy to exogenous factors like the 9/11 and capital inflows, I believe that it was the transformation, brought through reforms of the banking sector, which was the main stimulus behind the economy. During the last decade, the banking sector was deregulated and privatized. As a result, the number of commercial banks, increased from five nationalized banks to forty. Various governments of Pakistan have been successful in privatizing four out of the five big banks (namely, Muslim Commercial Bank, Habib Bank, United Bank and Allied Bank). Privatization not only brought in new management but also brought in efficiency gains and monetary expansion. Banks, which were once used primarily as a source of employment and loans for rent seeking by the state, transformed into lean mean profit machines. It was this change in the ownership structure of the banking sector, which led to the growth in money supply, innovation of new products of consumer finance that has been the trigger for the current growth in the economy.

Certainly, credit should be given to the State Bank of Pakistan and its Governor Dr. Ishrat Husain, who has been the mastermind behind the reforms, transformation and institutional strengthening of the financial sector.

The impressive growth in the financial sector is a direct reflection of the current upturn in the economy. The trading volumes are at high levels, with imports expected to reach US$ 18.5 billion and exports to reach around US$ 14 billion. This growth in trading volumes has been behind the growth in trading fees based income. Interest rates are in the negative range, although the central bank has been raising the interest rates since the last year. This has allowed banks to charge commission on minimum deposits as well as has spurred credit growth. The growth in consumer demand, currently at 56% of GDP (domestic demand), especially in the auto and housing sector, has been driving the core income of the banking sector. The capacity expansion in the manufacturing sector, led by the textile sector, has also been aiding the asset expansion of the banks. Hence, the banks are gaining from every activity, which is going on in the economy.

The pertinent question, which begs an answer, is that is this growth in the financial sector, sustainable. I wrote on this issue in one of my reports published by Alfalah Securities where I quoted the Governor of State Bank of Pakistan Dr. Ishrat Husain. The Governor elucidated that over the last couple of years, the banking sector's: 1) credit quality has improved to level international standards, 2) minimum paid up capital has increased to ensure stability, 3) core income has been the major income driver, 4) regulations to curb speculative lending have been implemented, 5) technology of the banks has been up-gradated and 6) the sector has been privatized.

CREDIT QUALITY: Gross Non-performing loans have come down from 25% to less than 10% of gross advances. Provisions against NPLs cover 70% of gross NPLs. Net NPL to net advances ratio is around 3%.

CAPITAL BASE: The minimum paid-up capital requirement has been raised from Rs500 million to Rs2 billion (to be achieved by end-CY05). This would further be raised (expected to reach Rs6 billion in the next five years). Average Capital Adequacy Ratio (CAR) of the sector stands at 11% (above the requirement of 8%).

EARNING EFFICIENCY: The core income has been the major profitability driver. According to our estimate, the average core income to total income ratio was 63% in CY04 as compared to 57% in CY03. The spreads have declined to 3.5-4.5% as compared to 7.5-8% five years ago. Cost to income ratio has fallen to around 45% due to restructuring of the sector.

TECHNOLOGICAL DRIVE: The SBP launched Technology Upgraduation project, under which the number of ATM machines have increased from scratch to 800 and half of the branches are connected online and have Internet banking facilities. Banks have installed Real Time Gross Settlement System (RTGS), which allow inter-bank transfer of funds. Banks like MCB, Faysal and NBP are investing in database management systems like SYMBOL which would not only reduce data minimizing costs but would also allow better risk management

All these factors ensure that on the risk side the institutional framework has been beefed up and risks are curtailed. The almost 'too good to be true' gains in the banking sector are originating directly from the efficiency improvement and expansion in the financial sector.

My outlook for the banking sector growth in CY05 is very bullish. I believe, the banks would continue to report high growth even though the interest rates are rising. The main earnings driver would be core income, which would benefit from the recent increase in net interest margins and the record growth in credit off-take. On the non-core income side, the profitability depends on how well can banks capture in on the trading income. Banks, which have presence in the trading industrial belt of Punjab, like Askari Commercial Bank, Bank of Punjab, and those banks, which have overseas presence, are likely to be the primary gainers. On the consumer finance side, Bank Alfalah is clearly poised to lead the sector. The major strength of the bank is its aggressive marketing of its consumer finance products. There are more boards of Alfalah's credit cards in the city than any other bill-board. Many domestic banks are eyeing expansion in the Middle East and the region. The on-going expansion in branch networks in the banks would ensure that the growth in advances and deposits continue in FY05. It is very safe to assume that the banking sector's profits would continue to grow by 30-35% in FY05.

The key risks for the banking sector in my view are: 1) rising interest rates, which would increase the cost of debt of consumer and lead to bad debts, 2) credit quality, in the euphoria of expansions, banks might be compromising on managing credit risks. The important question which needs to be probed and on which I shall try to research is, how much debt can a domestic consumer sustain. From just basic knowledge, I believe that from the current levels, the consumer finance market is still largely untapped. However, banks, especially those that are aggressive in consumer finance (Askari, Alfalah, Union, UBL) should be prudent in expanding their loan books.

In a nutshell, the bet on the banking sector is a bet on the economy. If the economy remains on the boom path, banks would continue to reap its dividends. I expect the GDP to grow by 7.1% in FY05, dip to 5.8% in FY06 and increase by 6.5% in FY07. The ADB expects the economy to remain on 7%+ growth path for the next three years. In both scenarios, banks would continue to benefit. The expansion areas would be rural banking, SME banking, regional expansion, innovative products in consumer finance (especially mortgage finance) and designing risk-hedging instruments. From equity investment point of view, I believe the banking sector is a good buy for investors due to this growth story. It's a simple way of piggy backing on the economy's high growth, which we trumpet so often.

The author is an economist and a financial journalist