May 12 - 18, 2008

In the absence of a well functioning and efficient financial sector no economy can grow and improve the living standards of its population. Primarily financial sector development and economic development are inter-related. In Pakistan 95 % of the financial sector comprises of banks and therefore robustness and dynamism of banks directly leaves impact on economic growth and development of the country. In recent years, growth and turnaround in Pakistan's banking sector has been remarkable and unprecedented. Recognized as Pakistan's and region's best performing sector, the banking industry's assets have risen to over $60 billion, its profitability is exceptional and non-performing loans (NPLs) are substantially low, credit is fairly diversified and bank-wide system risks are well-contained. In year 2007 almost 81% of banking assets are in private hands.

According to economic survey of Pakistan the banking spread, as measured by the difference between weighted average lending rate (WALR) and weighted average deposit rates (WADR), declined slightly by 14 basis points during FY07 after following a rising trend in the preceding three years. More importantly, if the impact of non-remunerative deposits is excluded from the WADR, the decline in banking spread appears more pronounced (at 50 basis points) during FY07. The asset quality of the banking industry improved in FY07 as both the net NPLs to net advances ratio and gross NPLs to advances ratio showed a consistent decline. The declining NPLs ratio coupled with the increase in capital base of the banking sector has resulted in a decline in vulnerability of banks financial soundness to the asset quality. Further, a bank-wise deposit distribution shows that except public sector banks and Islamic banks, all other banking groups recorded a substantial decline in the deposit mobilization during Jul 07-Feb FY08 compared to the corresponding period of FY07. This decline was recorded despite a rise in deposit rates by most of the banks. Moreover, the slowdown in deposits of one of the domestic private banks under the category of small domestic private banks is mainly explained by the net withdrawals from the deposits of public sector enterprises (PSEs) and corporate sector. On the contrary, the sharp rise in deposits of public sector banks was on account of a sizeable increase in deposits of government and PSEs in one large bank within this category.

Besides other indicators capital adequacy ratio of the banking system has improved from 10.9 percent in year 1999. Loan infection ratio has significantly come down, closer to the internationally acceptable level, as compared to very high infection ratio at 15.3 percent in year 1999. These indicators seem more attractive while looking at the commercial banks perspective. In terms of their core business activity, the banks are now operating at the capacity significantly higher than what was in 90s and the loan to deposit ratio now is around 70 percent.


Privatization has significantly contributed in improving profitability of privatized banks, though it has not reduced but enhanced the intermediation spread. Pakistan's banks have historically enjoyed low cost of funds as a result of their large low cost deposit base resulting in some banks enjoying interest spreads of around 7.5-8.5 %. Asset quality, which constrained banks' performance in the 1990s, has since improved with the reported gross NPL ratio declining to 7.7 % at the end of the first nine months of 2007, from a staggering 23.5 % in 2000.

Liberalized environment of the past few years drove Mergers & Acquisitions activity in the banking sector, resulting in 36 transactions in between 2001-07. In addition bank's profitability has also been driven by changes in assets and liability management; key trends in this area have involved:

1. Rise in share of earning assets

2. Rising focus on business income has helped raise advances/total asset ratio

3. Corporate loans remain an important share of lending, the rise in share of SME, consumer finance and agriculture which typically carry higher charge than corporate loans

4. Deposit as a % of liabilities rose consequently borrowing to liability ratio declined and banks have access to cheaper deposit funds as a large proportion of deposits were either non-interest or low interest bearing short term deposits

Market fundamentals are reality and call for the banks to be thinking of their long term interests. During recent past the banking sector in the country has undergone massive growth. The domestic banks have provided more than one trillion rupees credit to corporate sector and individuals from 2003-04 to February 15, 2007. This hefty expansion in the banks lending have resulted into strong corporate earnings of the banks and massive growth in their clientele. Taking advantage of surplus cash flows (after 9/11 incidents) the banks have extended a record credit in the shape of corporate loans; consumer financing; car financing, credit cards, home loans, etc.

Improvement in profitability has been supported by high economic activity but it is important to recognize that sustained economic growth, rather than sporadic improvement in real GDP, helps the financial institutions to earn higher profits. According to SBP analyses in quantitative terms, one percent rise in the real GDP growth tends to improve the profitability by 113 basis points. In addition, low interest rates and inflation for most of the period in the last four years also supported the financial sector profitability, as one percentage point increase in real interest rates and inflation tends to reduce the ROA by 27 basis points in each case. Pakistan's economy to a higher growth trajectory during the last four years contributed significantly towards the improved profitability of the financial sector.


Banking sector's long term sustainability requires a more fundamental change accompanied by

1. Financial system which is socially inclusive and facilitates access to financial services. Although finance has helped promote economic growth, but its contribution to providing access to finance to poor and disadvantaged region is limited.

2. A system that is well diversified and competitive

3. Stronger corporate governance and risk management aligned to principles of Basel II

4. Greater degree of consolidation to provide a stronger and robust banking system

The investment friendly environment of M&A activity may continue provided there is political stability. Likely players would include foreign banks seeking a footprint in Pakistan or a consolidation among smaller local banks, where the process may be shareholder driven. Bigger banks are unlikely to pursue an aggressive deposit/asset growth strategy, especially against the backdrop of the current political environment. Bigger players are more likely to focus on consolidating their existing position and enjoying the high interest spreads, which could prevail at least in the short term. However banking spread will eventually be aligned as competition deepens both for deposit and loan products. Fall in cost/income ratios coupled with sizeable balances in savings or short term deposit accounts (with less than 6-months maturity) or transactional accounts which offer low returns below the inflation rate should facilitate decline in spreads. However, a factor to consider here is the high administrative expense to total expense ratio because of rising remuneration of banking professionals and high operating costs. The rural areas, despite having two-third share in population, have only one-third of the bank branches, catering to their needs. Realizing the importance of access to financial services, the SBP should make it the cornerstone of its future strategy. Despite significant improvement in financial indicators, relative to its regional comparators, Pakistan's financial market has a relatively lower depth and penetration. Moreover, Pakistan's financial system continues to be predominantly bank based with the bond markets barely constituting 5-7% of GDP and the low pension and insurance coverage.


Banks need to enhance their focus on scaling up their core business activities, improving operational efficiencies and building professional expertise. Sustainability of banking sector performance is dependent on continued macroeconomic stability, stronger vigilance to ensure effective compliance of industry with the prudential regulatory and supervisory framework, and banking sector's maturity to reorient their business models to enhance their penetration ratio and address the asset: liability mismatches. In Pakistan like the rest of Asia, the rise in per capita income, emergence of middle income group and relative wealth increases are together bringing with them new demands for retail banking industry.

The transformation of banking sector offers some interesting perspectives and lessons for banking sector reform. This industry is on the verge of facing emerging challenges and risks that are not uncommon in financial systems. Going forward, Pakistan's financial sector strategy for next decade will aim at addressing the upcoming goals while laying the foundation for a profound and proficient system which is aggressive and financially inclusive.

In the current scenario banks are aggressive and understand that having cleaned up their loan portfolios and balance sheets, they need to re-position themselves to take advantage of the boosting economy. Over the next few years, commercial banks will have to focus on product innovations and diversifying their reach to infrastructure, housing, SME and microfinance industry while exploring and reaching out to new and under-banked regions. The investors and the industry are seeking better investment and financing alternatives and solutions, with demand for private debt, asset based and mortgage based securities, credit derivatives and hedge products etc. now emerging from different segments of economy and population. Banks will need to poise themselves to meet these demands for continued growth.