Nov 10 - 16, 2008

Banking system in Pakistan has entered a new phase of evolution. Global financial crisis though not substantially undermined the sector, however shattered the confidence of local financial markets. While still on sound footing, banks future remains uncertain. Pakistani banks have been enjoying a period of boom; high incomes, low defaults and surplus liquidity for some years, but now facing grim and serious situation on socio economic front. This is due to the slowing economic growth, inflation and large amount of advances given without looking at the credentials and repayment capacity of the customers.

Statistics for current fiscal year are evident of the gloomy outlook of the entire industry. The profits of the banks have declined and the return on the equity and assets has shrunk in the quarter January-March 2008. This is also due to fact that although the rate of return on the banks' loans has increased but the overall spread has declined due to the rise in the deposit rates. Latest reports indicate that the spread is increasing once gain. An upward trend prevails in the non-performing loans (NPLs) since 2006. Loan defaults are not abnormal for banks, being an integral part of the banking business. But now huge defaults are becoming unmanageable which is troublesome. Although primarily consumer loans account for major chunk of bad debts but it is not limited to one or the other sector. Over time the overall loan portfolio is getting more infected, especially the increase in NPL to loan ratio of the corporate sector-the largest borrower. This ratio increased from 6.7% in March 2007 to 7.8% in March 2008. This sector complains against the tight monetary policy and increase in the interest rates. Given the overall economic conditions, an increase in the loan default ratio of this sector may not be ruled out.

In the wake of disintegrating portfolios the State Bank of Pakistan is striving hard to restore confidence of depositors by depicting optimistic image of the industry. According to SBP data the banking sector has strong capital adequacy well above the minimum requirement. The capital adequacy ratio of the system is 12.1% as of June 2008 that is well above the international benchmark. The non performing loans ratio and the ratio of non-performing loans to capital are also quite low and within acceptable ranges. The infection ratio (net) in June 2008 has improved to 1.1% from 1.6% in Dec-2006, signifying that the banks set aside more reserves out of their earnings to cover the increase in non-performing loans. Therefore, the NPL coverage and capital impairment ratios have also improved. Furthermore, Pakistani banks largely focus on conventional lending and are not exposed to sub prime credit instruments in the international market.


Despite all resilience inherent in the system and limited exposure to US derivative market ongoing global financial crisis pressure is mounting on the banking sector, which may impact its growth prospects, profitability and liquidity, undermining its overall financial strength. Initially this impasse has left following repercussions on the whole system.


Pakistan's domestic banking industry has been under pressure due to liquidity crisis since May due to the surge in the current account deficit, slow capital flow and a tight monetary stance. The overnight inter-bank lending rate touched the level of 40% per annum on 4th October, 2008, leading to a situation in which some banks started bouncing cheques of large amounts in order to retain funds with them. The liquidity constraint in the system has resulted in a rising trend in overnight call rates, reduction in excess liquidity held by banks over and above the required amount, and the lack of availability of liquid assets eligible as collateral for borrowings under OMOs/discounting. The SBP has also taken strict notice of the unwarranted recent increase in overnight call rates and has advised banks to act prudently in sharing the liquidity in the system to ensure call rates are reflective of the fundamentals in the money market.

Domestic banking system is getting badly choked on lack of liquidity. The bouncing of cheques by commercial banks and an inordinate hike in the overnight inter-bank interest rates show a severe crisis in the monetary system, which would result in lack of confidence in banking system of the country. SBP needs to change the tight monetary policy as it has been causing shortage of liquidity, putting the entire banking system at risk. Banking circles confirmed that small banks were in a difficult situation as large banks had stopped lending to such banks because of risk factor and general shortage of funds. Owing to dearth of funds credit to industry is shrinking and the demand for credit might see more difficult time in the days ahead.


Commercial banks, facing a liquidity crunch have been finding it hard to maintain the mandatory cash reserve ratio (CRR) and statutory liquidity requirement (SLR) with the central bank through inter-bank lending. High Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) have also badly affected the smooth functioning of the banks. Keeping in view the current crisis the SBP has reduced the CRR by 200 basis points in two phases in order to ease the current liquidity squeeze and provide a relief to banks. It is expected that overall Rs61 billion will be released into the banking system. It is the core function of the central bank to maintain the trust of the system by protecting the interests of depositors. That is why the central bank intervened promptly. It has not only reduced the Cash Reserve Requirement by 2% in two phases to improve the liquidity position of banks but has also injected more dollars in the market to stabilize the rupee. Furthermore, high KIBOR, and inability to mobilize of higher level of deposits are seriously causing problems for the banks. Most recent increase in saving rates for the NSS would cause further problems for the banks. It could lead to a deposit war and higher saving rates.


Last but not the least, rumors of default/bankruptcy or freezing of foreign currency accounts along with personal lockers have created serious problem in the country. The rumors were active that United Bank Limited, Bank Alfalah, International General Insurance (IGI) have defaulted after the US and European financial crisis. Despite the newly appointed advisor for finance assurance, the hundreds of thousand people are desperately withdrawing their deposits and lockers from the banks. A huge cash withdrawal of Rs161 billion from depositors' accounts of commercial banks from July 1 to September 20 has pushed up dollar demand and sparked capital flight estimated to be worth $500 million to $1 billion.


The whole system faces major challenges arising from various socio-economic risks, including stock market turbulence, rising trend in the interest rates, widening fiscal and trade imbalances, and worsening security conditions. Due to continued downfall in our foreign reserves, substantial decrease in foreign inflows, high ratios of capital flight and government borrowing from the banking sector the banking industry is feeling the pinch. Amongst other causes for concern the most important is the country's economic situation especially the depreciating value of rupee. This gave rise to rumors about freezing of foreign currency deposits etc. In some cases, such rumors play an important part in bringing out the collapse of the banking system irrespective of its technical and financial soundness. The past experience of freezing of foreign exchange deposits also lent some credence to such rumors.


In today's world both internal and external factors affect the financial markets and especially the banking system needs constant supervision by monetary authorities. Sincere efforts are needed to restore the confidence of local and international investors to invest in the country. In this regard Prudent banking practice is essential. Regulatory bodies have to devise and implement integrated corrective policies to make amends. There should be a proper and complete documentation of economy. A high proportion of disposable funds are not deposited in the formal financial sector on account of the existence of huge black market/informal sector in the country which should be streamlined. Rationalization of government borrowing from the central bank and commercial banks is also necessary. Reduction in banking spread is imperative which is highest in Pakistan in order to attract more domestic savings. Stabilization of macro-economic conditions and upgrading of Pakistan's credit ratings is vital to rescue the whole system from being melted down.

State Bank is observing the whole matter and assessing far reaching consequences of current plunge. As a part of long term planning mechanism recently, the banks have been given a time frame for enhancing their paid-up capital gradually to Rs23 billion by December 2013. Apart from strengthening the capital base of the banks, one effect of this measure would be the consolidation of the system as those which would not meet the requirement may chose merger with other major and sound banks or to close down. Banking system has a concrete foundation. However it can not survive in isolation as economic, political, social and psychological factors impart their direct impact on the system and play their role in determining the solvency. A constant surveillance and scrutiny is imperative.