The continuous widening spread can have a dampening effect on economic growth

May 08 - May 14, 2006

The performance of commercial banks for the year ended 31st December 2005 is remarkable. Not only that the overall performance of the sector is good some of the players have performed exceptionally well. It seems that achieving the minimum paid-up capital requirement of Rs 9 billion, as per time frame specified by the central bank, will not pose any problem for most of the banks. Despite need to retain the profit, some of the banks have paid attractive dividend. However, some of the analysts are of the view that the banks may not be able to replicate this performance over the next couple of years, unless they offer attractive return on deposits.

Lately, the central bank has kept cut-off yields on Treasury Bills almost flat and also mopped up additional liquidity, bids accepted were far higher than the pre-auction target announced. One can interpret the outcome of the auctions in different ways. While the general perception is that the money market faces liquidity because the central bank has been mopping up all the funds. However, the auction results clearly show that the central bank fixed a lower target but accepted amounts close to the total offers. Therefore, it may not be correct to say that the central bank is responsible for the current liquidity crunch.

The other point of view was that banks were sure that the central bank might not improve the yield, which may rather go down. Therefore, they wanted to lock as much funds as possible and also for the longer duration at the highest possible cut-off yields. They were also sure of taking advantage of discount window and SBP's intervention in case liquidity crunch touched certain level. As compared to previous auctions the central bank accepted bids for less than half a billion rupees only at the latest auction, which was unusual and surprising for most of the financial analysts.

One of the reasons commercial banks in general and some players in particular have posted huge profit was substantial spread, as high as 7.5% in certain cases. This was possible for banks enjoying extensive branch network and virtually cost free deposits. However, for some of the banks the cost of funds was high because they were pursuing an aggressive deposit mobilization policy to cater to the growing credit demand. It has become evident now that the days of paying low return to depositors are gone. It is also evident that depositors are not keen to lock their funds for longer duration, only because the returns are negative when compared with the prevailing rate of inflation in the country.

The banks usually attempt to raise the spread to maintain profitability when the intermediation expenses increase. However, there seems to be no need to do so because quantum of non-performing loans as well as provisioning has been going down significantly in the recent past. It is on record that both the asset quality and profitability of the banks have improved significantly. Therefore, the current rise in the spread is rather intriguing and calls for identifying the causative factors.

According a central bank report, the banking business has undergone significant structural changes during the preceding three years. In particular, the nature of banks' lending and deposit taking activities has experienced a shift in terms of both, outreach and diversification of banking services. New products have been introduced and a healthy competition among the players has appeared that enabled the customers to avail banking services at a more competitive rates. In this scenario, the dynamics of banking spread has also changed and therefore, the rising spread may not necessarily be depicting the operating inefficiencies in the sector, rather it may be reflecting the shift in structure of deposits and advances portfolios.

The structure of deposits changed significantly in 2005 compared with the preceding years. In particular, the maturity profile of banks has shifted towards sorter tenure as the current and savings deposits registered a growth of 31% and 13% respectively during the year. Although, fixed/term deposits also witnessed a growth of nearly 40%, but the fixed deposit with the maturity within six months registered a growth of 96%. As a result the share of short term deposits in total deposits increased from nearly 36% to about 50%.

The structure of loan portfolio of banks has also witnessed significant changes since year 2002 in terms of clientele and the nature of loans. In particular the banks have been lending to new sectors like consumers and SMEs that are relatively riskier in nature (and in some cases have relatively longer maturities) and thus yield higher returns. Further more, the credit to corporate sector also witnessed a shift in structure in the form of rising share of fixed investment loans with relatively longer maturity compared with the working capital loans.

On top of this the product mix has also been changing. The new product mix with concentration of fresh deposits in shorter tenure and lending in longer tenure is also reflected in the banks' gap analysis. The maturity gap is measured by the difference between assets and liabilities, adjusted by total assets. The contrast in the incremental advances and deposits has moved the distribution of returns in a direction that is favourable to banking sector profitability.

With the stable banking soundness indicators and the structural changes in the composition of lending and deposit rates, it may be too early to warrant and immediate policy response by the central bank. Nonetheless, if the widening persists, then it will raise a serious concern because the continuous widening spread can have a dampening effect on economic growth as a continuous high spread discourages both investment and savings. It is therefore, desired that banks should try to overcome the mismatch and resulting liquidity risk by mobilizing longer tenure deposits by offering attractive returns.