BANKING SECTOR OF PAKISTAN - A KEY GROWTH DRIVER OF THE ECONOMY
Sep 15 - 21, 2008
Banking sector of Pakistan has been transformed over a short period of around eight years from a sluggish and government-oriented sector, largely with bureaucratic culture, into a much more competitive and profitable industry. In recent years, the healthy performance of financial sectors ñ in large part banking sector ñ has been crucial for economic growth. The continuous growth in assets and favorable industry scenario has proved to be the key drivers in attracting the foreign direct investment in Pakistan.
The overall banking industry of Pakistan has undergone a huge leveraged volume expansion. The banks have increased their geographical outreach, via opening up of new branches by many-folds. In fact, the increasingly competitive environment has led to the massive expansion. This has, in turn, resulted into improvements in many areas, such as; customer services, improved geographical coverage and product innovation. All major reforms in the banking sector have resulted in a more resilient and efficient banking system, which is better placed to absorb significant macroeconomic shocks.
Banking system liberalization and restructuring was well designed and well sequenced. The liberalization process led to privatization of various large banks. This was aimed at addressing key issues faced by the overall banking sector, and the main issue was increasing non-performing loans and legacy involved in that. The regulatory body played a vital role in the overall reform of the sector. The new Risk Management Systems were introduced, which were in line with the Basel-II accord. The new risk management systems are revolved around taking measures to reduce impairment in the banking industry, and in particular, assigning capital to the risk weighted assets. This is being implemented into a phased manner; the first step is to implement the standardized approach and the second step is to implant the IRB ñ internal rating based ñ approach. State Bank of Pakistan has advised all banks to increase their paid-up capital in line with the new guidelines issued.
Our banking industry has become well-prepared to face any unforeseen negative development on macro-economic fronts. It is pertinent to mention that our industry is one the fastest industries in implementing new risk management guidelines in Asia. These all reforms actually helped the sector to better withstand even in the economic instability and political chaos. The sector, despite all negativities facing by the country, is performing tremendously, unlike many other sectors in the economy. The entry of world class banks such as Barclays, SAMBA, Temasek Holdings and Royal Bank of Scotland, has further given strength to the sector and showed the confidence in the banking industry of Pakistan. It is expected that these big names would add value through bringing in innovation and superior systems in the industry.
While there are so many positive factors, the banking industry also remains prone to various challenges stemming from operating environment. The State Bank of Pakistan (SBP), in continuation of its tight monetary policy, made changes in discount rate, Cash Reserve Requirement (CRR) and Statutory Liquidity Ratio (SLR). Further more, the bank put the minimum floor on the PLS savings accounts at 5% that came out as an unpleasant surprise to the banking sector. The central bank tried to slash banks' lending ability that has been a cause of heavy financing to the government particularly and also exerting some pressure on the interest rate spreads, thus reducing overall top line growth of the banking industry. The increase in CRR/SLR would reduce liquidity from the system by approximately PKR 60 billion. Rising margin requirements for imports would reduce pressure on the exchange rate as it would discourage speculation. However, 38% of import bill is contributed by food and oil. Therefore, pressure on currency would persist in the future. The hike in discount rate would have significant impact on money market rates as the already-rising KIBOR, call money rates and PIB yields would further move up. The TFC are also expected to witness widening of credit spreads due to the liquidity crunch.
As far as impact of SBP's monitory policy on banks is concerned, the increase in CRR would reduce liquidity for banks and would consequently impact deployment of funds. The discount rate hike would increase KIBOR by 50-100 basis points and would benefit banks as it serves as a benchmark for pricing of floating loans. The cost of fixed deposits would also increase as major portion of corporate deposits are linked to KIBOR. The SBP's steps to increase minimum return on PLS accounts would also personalize banks as it benefit as a slight enhancement in ROA would lead to significant improvement in target prices.
The year 2008 has proved to be the toughest year for the banking industry, mainly because of the above discussed strict measures taken by the regulator, that have dented the banking sector earning, though it still remained at a very comfortable level. The initial setback to the industry was the plunge in the net earnings of around 16% during the first quarter of 2008 owing to the incremental provisioning banks had to make on the back of removal of Forced Sale Value (FSV) benefit by the State Bank of Pakistan (SBP). Secondly, the government, in FY09 Budget, removed the tax benefit against the provisioning of non-performing loans and stipulated that the tax cushion could only be availed when loan converted into bad debt. Furthermore, the provisioning made against consumer portfolio shall not exceed 3% of the revenue generated through the respective group.
Nevertheless, the banking industry remained upbeat on its growth strategy. During first half of 2008, advances portfolio witnessed double digit growth. The government emerged as the main borrower of the credit to cover up the rising fiscal deficit gap as the government borrowings increased by PKR 129.6 billions. Moreover, credit to the private sector witnessed low rise of PKR 75.6 billion, which was mainly working capital based. Deposits on the other hand, grew by around 15% to reach PKR 3.7 trillion. The advances to deposit ratio hovered around 75% of the banking industry of Pakistan. As regards earnings, interest rate spread observed a rising trend till the first five months of 2008. However, in CY08 the spreads started cooling down due to central bank's continuous pressure on banks to improve their returns on deposits. It is important to note that although the banks faced some pressure on earning, yet they remained the most profitable entities comparing to the other economic sectors. Also, the overall reforms with regard to the provisioning requirement, as well as capital enhancement in line with the new risk management framework, proved to be the key success factors for the banking industry, which in turn, have strengthened the overall internal control systems of the banking industry. The capital of the banks acted as a buffer against market downturns and any other shocks. Over the last one year or so when the macro-prudential indicators started to show signs of deterioration under pressures of both local as well as global factors, performance of the banking system on key financial soundness indicators continued to remain remarkable.
The success of the banking sector, among many other things, is also underpinned by strong and vigilant regulatory framework. It is important to see the current condition in a long term perspective. There is ample room for growth in banking assets as the current level of penetration of financial services is still quite low. Moreover, the banking sector is major credit provider to real sectors and growth in GDP provides an essential impetus to the growth in the banking products. This potential demand in the country would be the driving force for the growth and performance of the banking sector. At the same time, the challenge for the banks is to show resilience at a time of temporary adverse market trends.