Mar 8 - 14, 2010

The Pakistani banking sector is amongst a few in the world which have withstood the global financial meltdown and managed to survive the monetary contraction at home.

This success cannot be attributed to any extraordinary effective banking regulation but rather to the fact that Pakistani banks have stuck to the conventional, plain-vanilla banking model, which is built on taking deposits and making loans and investments. Pakistani banks, are not, for the most part, involved in the kind of complex and/or risky banking practices that unchained paralyzing effects on major financial giants during international financial crisis.

Prior to the financial meltdown, the Bretton Woods system which was established in 1944 was perceived to be infallible. But recent experience has clearly proved that this is not the case. The Obama administration now wants to raise the risk parameters in the US banking system as well. It reminds us the Glass-Steagall Act of 1932, and the period when commercial banks and investment banks could not be combined together.

In Pakistan banking is quite simpler than the West. The challenge we faced in the past and are still facing to some extent is non-performing loan (NPL) formation. This can create problems for the banking system in the future due to higher interest rate environment. In CY'09 NPL formation had eased off as most of the NPLs in the doubtful and loss category had been reflected in the P&L account.

NPL for the banking sector including depository financial institutions (DFIs) grew by a mere Rs11bn in 4QCY09 versus Rs25bn in 3QCY09, depicting a decline of 56% QoQ, which is a good sign. This was not because of discount rate cut but it was due to the new restructuring law and forced-sale value (FSV) benefit availability of 40% on residential, commercial and industrial properties.

On the restructuring side the SBP has relaxed the criteria by bringing in a new category of "Regular" which has benefited the banks in 4QCY09 and will help in CY10 as well.

In Pakistan there are two avenues for banks to generate revenue. First is the interest based revenue and the second option is non-interest based income generation. Interest based revenue can come from corporate, consumer and investments while non-interest income can be generated from fee based, forex, equity, and dividend income.

Most of the banks have done reasonably well on the interest side as they have cashed in on the banking spread which remained at an average of 7.48% in CY09 which is quite high relative to the regional banks and also to the last year's spreads. During January 10, we have witnessed decent spread of 7.25% which suggested that the spread would remain at an average 7.25% in CY10. Yield on earning assets has reduced a bit but we believe the liability management by banks will help support spreads in CY10.

At the end of Feb'10 total deposits in the Pakistani banking sector stood at Rs4.4trn while gross advances were Rs3.3trn and investments Rs1.7trn. The banks are still hesitant to lend to the private sector and continuously investing in the government securities. It shows banking sector's conservative strategy. Banks are choosy while lending and prefer to lend to a few sectors like agriculture, power, oil & gas, and textile spinning.

Credit to private sector was recorded at 117bn as of Feb 20th 10. This was recovery from a negative Rs83bn in Oct'09. Credit to private sector has gained post Oct'09 and it is a good sign for the banking system but we expect this to slow down as the system money supply (M2) is not going to increase from 9.5% in FY'10.

Moreover, high interest rate environment will be the key factor behind the banks' reluctance to lend to the private sector. We expect the banks to gain confidence in lending when the discount rate will be lowered to 10%. This reluctance to lend to the private sector is due to the stricter parameters adopted by the banks for any type of lending.

This can be witnessed from the first two months' gross advances in CY'10 which grew by a meager 0.61%. Deposits have grown by 1.62% in first two months outpacing the advances growth. Besides this investments grew by 1.76% in Jan-Feb'10. Still the banks seem conservative on lending and are not at ease while placing their deposits in investments other than government securities.

We expect the NPL formation will further ease, however, we don't expect consumer lending to shoot as the consumption-led growth is not there in the system anymore and risk management parameters of the banking sector have become strict.

The author of this article is senior research analyst UBL Fund Managers Ltd.