WHAT IS DRAINING LIQUIDITY FROM THE BANKING SYSTEM?

CREDIT DEMAND SLUMP DIVERTS BANKS TO GOVERNMENT PAPERS

SHABBIR H. KAZMI
Aug 24 - 30, 2009

It is said that commercial banks are facing liquidity crunch. At times the central bank has to inject liquidity. However, at the time of Treasury Bills auction the bids submitted by the primary dealers tell an entirely opposite story. Rejection of bids for the three and six month papers and acceptance of 12-month bids only also leaves one skeptical. Therefore, there is a need to explore the ongoing phenomenon to come up with appropriate corrective measures.

Liquidity crunch is mainly caused when the banks are not able to mobilize sufficient deposits or there is a sudden increase in credits. At times banks may face some pressure due to seasonal or cyclic increase in credits. However, such hikes are predictable keeping in view the historic trend, to a large extent.

As stated above one of the possible reasons for liquidity crunch could be depletion in deposits. The data for January-March quarter of 2009 recounts an interesting story. The commercial banks (both conventional and Islamic) operating in Pakistan have reported an increase of Rs73 billion in their deposits during the first quarter of 2009.

The Islamic banks reported an unimpressive increase of Rs4 billion in their deposits while conventional banks also showed encouraging growth in their deposits during January to March 2009. Deposits of Islamic banks increased to Rs276 billion at end March 2009 from Rs272 billion at end December 2008. Total deposits of the scheduled banks increased to Rs3.874 trillion from Rs3.801 trillion during this period.

Despite global and domestic slowdown the banking sector has registered significant growth in deposits that was a good omen for the growth of the financial sector in particular and economy of the country in general. The banks continue to depict growth in their deposits, assets and also earned an impressive profit in FY09 although the economy of the country was experiencing a slowdown at that.

On the flipside sudden spikes in credits could also cause liquidity crunch. However, a review of last eighteen months clearly establishes that credit upsurge has remained subdued. This could be attributed to two factors: lower demand for funds by the trade and industry; and financial institutions reluctance in extending credit.

In such a scenario the alternatives for banks are to invest in capital markets or government securities. Apparently this phenomenon seems to be operative for the time being, at least. The results of Treasury Bills and Pakistan Investment Bonds clearly show that commercial banks have enhanced their investment in government securities to overcome subdued private sector demand for funds.

However, some of the banking sector critics say that around the globe government securities carry very low interest rate but it is the other way round in Pakistan, be it treasury bills/ investment bonds or national savings schemes. While banks pay pathetically low return to the depositors they earn as high as 12% on their investment in Treasury Bills. Unless the government keeps on paying such fantastic return on its securities, banks would never bother to learn to cater to the needs of private sector.

However, bankers are of the view that when private sector credit started declining they had no option but to invest in government securities, else they would have to return the deposits. Besides, when the government becomes the biggest borrower and also offers very attractive rates along with 100% security of the investment, banks as 'Ameen' have to look at the security and return on the deposit.

According to the banking sector experts, Pakistan's financial sector suffers from a serious structural problem. Banks have become the sole provider of short, medium and long term credit, which is a gross deviation from the basic mandate. However, this has happened only because there are no providers of medium and long term financing. There are no low-spirited DFIs and investment banks and leasing companies are becoming 'extinct entities' or 'endangered species'.

Lately, an effort has been made to make commercial banks 'defacto' holding companies. They became sponsor of modarabas, mutual funds, and insurance companies, and also undertook leasing business under the umbrella of 'universal banking'. The concept may have worked elsewhere in the world but did not click in Pakistan.

According to another banking sector expert, "the main reason behind the relatively weaker banking sector in Pakistan is that bulk of the deposits has less than one year maturity. The ultimate outcome is that banks are reluctant in providing medium and long term credit. Unless tenor of deposits stretches to above three years, banks would never be able to disburse medium and long term funds."

According to a depositor, "there is no incentive for saving in this part of the world. Return on deposits is pathetically low, even blow the inflation rate. On top of this various types of taxes are charged which further reduce the returns."

Pakistan seems to be a hard-cash society where people prefer to receive and pay in cash. This is mainly because of evasion of taxes, capital gains exempted from tax and dividend income being taxable. Unless a change is brought in the mindset of people funds would not start flowing towards the banking system.